Mizuho Week Ahead – (Yield) Genie in a Bottle

Mizuho daily market insights by Vishnu Varathan, Head, Economics & Strategy, Asia & Oceania Treasury Department, Mizuho Bank, Ltd.,

Genie in a Bottle

This is not a Christina Aguilera tribute. But whether central banks can keep the bond yield in the bottle may be the bottom-line for markets; whether it is bond markets caught in an upheaval, FX markets seeking direction (and tipping points on yields) and equities balancing optimism with yield threat. And the FOMC (Wed) is front and center of that. Clearly, Powell’s take on bond yields partly reflecting recovery optimism has not been that comforting.

So the real question is at which point the Fed will deem bond yields a threat to overall financial conditions; to take a more active, ‘holistic’ approach like the ECB. The BoJ will also get in on the action in revealing its bond yield taming inclinations (Fri). Volatility spilling over t o FX markets, with potential for USD squeeze is a risk worth watching. Any resulting relif to AUD strength will be welcome though IDR instability is a bugbear for BI. While the RBA expresssly prefers a weaker AUD, admission that AUD is not overvalued; constrains credible options on currency. But containing spill-over yield volatility may be top of the agenda. Ambivalence on AUD and consternation on yields are reasons to scrutinize RBA Minutes (Tue).

Meanwhile, Australia’s jobs data (Thu) as well as retail sales (Fri), ordinarily a close watch, may not quite be high up in terms of being a RBA policy catalyst. Reason being, the RBA’s doubled QE and JobKeeper/Seeker backstop for jobs and retail sales as wage support meet COVID re-opening. But while the RBA is expected to be comfortably on cruise-control, Bank Indonesia (Thu) is also worth watching for the rhetoric given that it may be more grudgingly on hold.

Admittedly, Bank Indonesia’s 25bp rate cut alongside credit boosting (more lax macro-prudential tweaks) measures at the last meetings significantly diminishes the need for BI to act this time. But to be sure, it is IDR volatility amid rising UST yields/USD that negates easing options. So while the the RBA pushes AUD back, the rupiah is pushing the buttons for Bank Indonesia. All said, much hinges on whether the Fed rubs bond markets the right way to keep the (yield) genie in a bottle. But reflation is rife with mixed signals: “my body is saying let’s go .. but my heart is saying no”.

FOMC: Will the Fed Do an ECB?

The up-coming FOMC meeting will arguably be very closely watched, perhaps even fussed over, despite the wide consensus of no significant changes to policy setting. And not just for updated “Dot Plot” and economic forecasts, which are the quarterly FOMC touch points.

Admittedly, with US economic upturn on a much firmer footing and further reinforced by the US$1.9 trillion Biden fiscal stimulus set to be signed off, US GDP rebound is expected to be north of 6%. In turn, this is likely to trigger upward revisions to the Fed’s US growth and inflation outlook; invoking questions of whether the “Dot Plot” will be upwardly biased, and to what degree. That is however a second order risk given the Fed’s propensity to allow the economy to “run hot” in this recovery will err on the side of generosity; at least at this point.

Instead, reference, if not response, to UST market upheaval will be what’s under utmost scrutiny for a meeting where no action is expected. Especially amid lack of clarity on the Fed’s proclivity; ranging from some degree of concern (Brainard) to comfort with rising yields reflecting optimism (Powell). Specifically, whether the Fed will demonstrate an inclination to tame excessive UST yield (upside) volatility; even if it does not unveil new policy tool options or expand/extend facilities. Not unlike how the ECB pushed back against bond market utility; flagging faster bond purchases to quell recent upswing in long-end yields. To frame another way, whether the Fed does an ECB or not may be this FOMC’s focal point. Given the ECB’s activism, there may be greater sensitivity to an absence soothsaying on yields. That is to say, upswing in UST yields and attendant volatility in USD and asset markets, is a bigger risk if the Fed is perceived to take a benign view on rising yields.

US-China Meeting: Baked Alaska

The Biden Administration will kick off its maiden face-to-face meeting and talks with China this week in US-China talks scheduled to be held in Alaska. The US contingent will be led by US Secretary of State Anthony Blinken and top Chinese diplomat Yang Jiechi will be helming the Chinese delegation. Whether Baked Alaska, a delectable plate of diabetes, will be featured on the dessert menu may be debatable; but very low expectations baked into the Alska talks is understandably a given.

For one, and to be fair, there is just so much on the table, that the talks cannot conclusively address real issues in a meaningful way; much less result in resolution, or even a decisive course of action. Moreover, it is in US interest (Biden Administration) to keep talks broad, covering sensitive issues such as human rights in Xinjiang, tensions in Hong Kong and differing positions on Taiwan alongside trade. This is so trade relations considered amongst a wider suite of hot potato issues, give US more political leverage. But that also means China is less likely to concede ground; even symbolically. And so, right off the bat, a stalemate is the likely outcome. On trade, the “half full” version is that “Phase-1” deal will remain in place.

But further progress on “Phase-2” and/or rollback of tariffs will be impeded by a higher bar. On territorial/geo-political disagreements, there is little wiggle room. The post-Trump Biden Administration cannot appear to be “weak” on China while the “sovereign” issues of China have never been up for debate; much less, compromise.

EM Asia Risks: Beware High-Yield Spill-Over From UST Upheaval

US bond market upheaval resulting in volatile in long-end UST yield surge alongside a steeper yield curve have disproportionately hurt lower-yielding EM Asia currencies/bonds; resulting in relative resilience in higher-yielding EM Asia currencies/bonds.

But this is a transitional quirk, owing to a:

i. migration from lower-yielding assets to the ultimate “safe asset” (USTs) under no arbitrage conditions coinciding with;

ii. yield-seeking in the risk asset universe benefitting higher-yielding asset.

This however should not be mistaken for sustained, fundamental insulation from higher UST yields and a steeper yield curve. In fact, the real, hidden risk is that high-yield EM Asia not only eventually catch down, but could incur a sharper payback.

In particular if sustained rise and steepening in the UST yield curve expose vulnerabilities from”twin deficits (lifting credit premium) and acute susceptibility to cost-push inflation (eroding real returns). Especially if the sharp and brutal UST yield curve steepening hits 2013-14 “taper tantrum” trigger threshold of 180-200bp. This is a mere 40-60bps away, warning against complacency about buffer for high-yield EM Asia FX/bonds persisting without a glitch.

Bank Indonesia: IDR Negates Options

Bank Indonesia is worth watching for the rhetoric given that it may be more grudgingly on hold. To be sure Bank Indonesia’s 25bp rate cut alongside credit boosting (more lax macro-prudential tweaks) measures at the last meeting negates the need for BI to act this time. After relaxing both housing and auto loan requirements, BI had noted a nascent pick-up in loan demand. And this appears to suggest that policy traction is underway, justifying a pause to assess.

In addition, BI is also resorting to moral suasion to get banks to pass on rate cuts. And if successful in its attempt to improve transmission, BI may arguably not need not ease further. Nonetheless, with a weak recovery outlook, chances are BI would prefer more easing than competing macro-stability objectives could comfortably accommodate. And this is why IDR volatility amid rising UST yields/USD is the factor that definitively negates easing options.

The RBA’s Thorny Challenges

The RBA has two thorny challenges. First, the spillover of (upside) volatility from UST yields. Second, reflation-related AUD strength; which, with the exception of “risk off” triggered by sharp upside in UST yield surge, tends to be dominating via commodity channels amid optimsim about vaccine-led recovery. On the first, we gather form the March MPC that the RBA’s preference for now is a flexible approach to managing bond yield volatility; without necessarily upping the B/S commitments from QE and YCC. This is understandable given that the data are pointing to a fairly resilient recovery; as successful COVID containment flanked by resolute fiscal policy support (trained on jobs, with the JobsKeeper backstop) have backstopped unemployment and helped with a faster turnaround in retail sales.

In fact, if anything, signs that the housing market may be getting a tad too hot a little too soon suggest that the RBA has a slightly higher bar to expanding QE/extending YCC (out the curve). On currency too, the RBA must work within uncomfortable constraints. While RBA chief Lowe has openly expressed preference for a weaker AUD, he has also conceded that AUD is not overvalued. Which is to say, the RBA has no solid grounds for intervention at current levels; not without the RBA wading into “manipulation” territory. And this implicit ambivalence on AUD casts policy doubts. The big picture is that the RBA’s thorny challenges, and front-loaded stimulus – monetary and fiscal – place constraints on a set-piece policy response at this juncture. Instead a flexible approach within the current QE and YCC regime may be optimal. And signals of this will be watched for in the Minutes.

FX Theme: USD Consternation

With uncertainty about how much the Fed will lean against the brutal surge in yields, FX markets may be struggling to pin down a USD view given that there is more than one way to skin this (USD dynamics) cat. For a start, challenges in assessing USD impact from the ebbs and flows of the reflation tide is accentuated by lack of clarity on Fed’s reactions to, and threshold for, rising yields. And the primary confusion about USD reaction/expectations are anchored in the conflict between:

i. US leading the way out in the global recovery (USD positive) and;

ii. relatively exceptional monetary and fiscal stimulus that the US is committed to (USD negative).

Our best guess is that USD dynamics are not cast in stone; or for that matter neatly fitted into any one mould either. But there are three key factors that could help shape USD views. First, UST yields; and specifically, real UST yields. The main take-away is that USD is most likely to maintain the positive correlation to real yields.

That is, if real UST yields are rising, USD is likely to follow suit more durably (compared to nominal yield triggers). Second, the USD continues to be a gauge of risk aversion. So USD will rise on risk off and ease back when risk sentiments are positive. This “RORO” (“risk on, risk off”) USD overlay is the exception to yield triggers (as low yields and stronger USD may coincide on “risk off”). Finally, whether ‘USD Smile’ has shifted from the left half (stronger USD on more negative outcomes) to the right half (stronger USD on more positive outcomes). While we suspect the ‘USD Smile’ continues to function mostly in the left half, justifiable doubts sow consternation about UST yield triggers and USD reaction.

US Treasuries

The ECB’s calming effect on long-end bond yield proved to be fleeting; and 10Y UST yields, after subsiding briefly during the week, rebounded even more strongly to end up above 1.6% (~1.63%). This was encouraged by in-coming US activity data that have surprised on the upside, more than offsetting the slight core inflation undershoot from earlier. Crucially, the passing of the $1.9trln Biden stimulus bill has re-energized reflation bets expressed more aggressively via nominal long-end yields to prompt another brutal bear steepening.

Markets, in looking for affirmation on bond yield direction, can only conclude that the bond yield ball has been served squarely on the FOMC court this week. And the bar may be somewhat high to engineer a retreat in UST yields. Especially if the Fed does not unequivocally walk back it’s degree of comfort with higher yields (as a reflection of economic optimism). We expect that 10Y UST yields may be in the 1.48%-1.75% range; a jump considerably above 1.8% could trigger more pronounced pullback in EM (including Asia) FX/asset markets.

Credit Source: Mizuho Bank Ltd