Mizuho Daily – Of Slips & Falls

Vishnu Varathan, Head, Economics & Strategy, Asia & Oceania Treasury Department, Mizuho Bank, Ltd.,

“The path was worn and slippery. My foot slipped from under me, knocking the other out of the way, but I recovered and said to myself, “It’s a slip and not a fall.”” – Abraham Lincoln

Of Slips & Falls

Abraham Lincoln’s point may have been about resilience in the face of adversity, but Lincoln’s words resonate with the slip in long-end UST yields (10Y off 3-4bps at sub-1.7%), which for all purposes was anything but a fall in a true sense of that word. Question is, whether the attendant rise in equities (relishing slightly softer UST yields) will be sufficient to convince markets that recent corrections were a slip, and not a fall. For the record, Dow, S&P500 and Nasdaq were up 0.3%, 0.7% and 1.2% respectively overnight; although down some 0.6%-0.7% on the week across the board.

The wider point being, whether rising UST yields, which have triggered some slippage in prices in parts of the asset market could turn out to be a more lasting fall in valuations; or the “Lincoln effect” will save the day. The answer may lie with Powell (and Yellen). Specifically, to what degree assurances from the Fed (Powell) and US Treasury (Yellen) can avert a larger meltdown that may inadvertently triggered by sustained surge in UST yields.Particularly in the context of Biden’s infrastructure stimulus plan now floated as $3trln compared to campaign ballpark of around $2trln previously. Especially given indications that corporate and wealth taxes may be the funding plan for this massive infrastructure rollout.

Not the stuff of immediate alarm given that a finely balanced Congress is likely to bound by competing interests that get in the way of bulldozing these plans. Nevertheless, that’s an infrastructure with sufficient earth-moving equipment (no pun intended) to tip a slip into a fall with time to digest and as a path is laid. But while slip in UST yields, has prompted a measured slip in the USD (with EUR a tad above 1.19, USD/JPY sub-109, USD/SGD slip to 1.34, but AUD struggling to get traction to mid-0.77), it does not distract from question of whether the bigger picture of USD fall is misguided. Lincoln was clear on motivation, but markets are far from. Slip or fall? Only time will tell.

Is the ‘USD Smile’ Inflecting?

As USD reaction to market sentiments gets harder to predict, the elephant in the room is whether ‘USD Smile’ mechanics is on the cusp of inflecting from; “Left-Side”, that is, rising (falling) on “bad news” (“good news”), to ‘Right-Side”, which corresponds to USD rising in tandem with improving sentiments. Trouble is, things are rarely so clear cut. Uncertainty around calling an inflection is compounded by that fact that at any one point of time the USD is not strictly confined to just one side (half) of the ‘USD Smile’; and so the evidence may be mixed/inconclusive.

Rather, the ‘USD Smile’ is useful as a framework for determining the dominant influence on the USD between;

i) safe-haven “RORO” (“risk on-risk off”) moves, where USD moves inversely with yields, and;

ii) yield-driven reactions that lift USD along with UST yields.

Rising UST yields, especially if reinforced by rising real yields, is arguably a key motivation for ‘USD Smile’ dynamics to shift to the “Right Side”. But perhaps only inconclusively so. Instead, experience suggests that Fed policy shift (e.g. 2013 “taper) shift tends to be a more decisive catalyst in entrenching a shift from “Left-Side” to “Right-Side” of ‘USD Smile’.

For now, it appears an inflection in the ‘USD Smile’ may not be conclusively established. Accordingly, USD reaction function may remain be harder to predict. Specifically, the familiar notion of a weaker USD during “risk on” may be misleading, if not misguided. Thus, bracing for greater vulnerabilities in EM (Asia included) FX amid more USD volatility may be prudent.

Source: Mizuho Bank Ltd