Daily Comment (February 26, 2021)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EST] | PDF

The fifth and final part in our recent Weekly Geopolitical Report series, “The U.S.-China Balance of Power,” is now published.  We also have several other recent multimedia offerings.  There is a new chart book recapping the recent changes we made to our Asset Allocation portfolios.  Here is the latest Confluence of Ideas podcast.  Being Friday, a new Asset Allocation Weekly, chart book, and podcast are also available.  The Weekly Energy Update is available. You can find all this research and more on our website.

Good morning and happy Friday!  Although U.S. equity futures are stabilizing this morning, the overall market action looks like a flight to safety.  Treasury yields are dropping, but the dollar is up sharply, emerging markets are lower, and commodity prices are off hard.  We begin today with market comments.  Policy and economics come next; the minimum wage hike looks to be in danger.  International news is next.  We close with the pandemic roundup.

Financial Markets:  This looks like a market tantrum, and rising interest rates, coming mostly from Treasuries, are the primary culprit.  In our analysis, the 10-year T-note yield is about in line with fair value.  Given market conditions, yields have been unusually low.  At least some of the rise in yields is probably a function of improving growth prospects.  That appears to be how the Fed is viewing it.  Two concerns are surrounding this rise.  First, the lift in yields will adversely affect interest-rate-sensitive parts of the economy and markets.  Residential real estate will likely be the first to suffer, but other areas will eventually cool due to the rise.  Second, and perhaps the most worrisome, is that we live in a shadow banking world where leverage is a key characteristic.  Since the 1990s, every rate increase has eventually led to a financial hiccup.  By itself, this shouldn’t be a big deal; it’s called “risk” for a reason.  But, the pattern since the late 1990s is that these hiccups tend to go systemic quickly.  From LTCM to the mortgage crisis, to the repo meltdown from August 2019 through March 2020, even modest rate hikes tend to expose not only excessive leverage but conditions that threaten market stability.  Unfortunately, it is tough to tell in advance where the problem lies and when it becomes critical.  Our current situation is no different, but the pattern of the past 25 years suggests that there is the potential for another systemic problem lurking, and that will likely also raise fears in the market.

So, what will policymakers do?  We already saw the Reserve Bank of Australia make a surprise bond purchase today.  ECB President Lagarde noted that the bank was “closely monitoring” bond yields.  We haven’t seen anything similar from the Fed, at least nothing in addition to what is already being done.  We do anticipate that, at some point, the Fed will opt for yield curve control.  If it decides against that action, economic growth will be crimped by rising interest rates.  There is nothing wrong with that decision; in fact, that’s allowing the markets to work.  However, that outcome flies in the face of Fed promises to allow the economy to “run hot” to improve the labor markets.  Perhaps the most pertinent question isn’t if the Fed will engage in yield curve control, but what is the path to reach that point.  History would suggest a crisis may be necessary to trigger that action.  For now, we think the FOMC would prefer to let Treasury yields stabilize on their own and allow the financial markets to adjust to a new equilibrium.  It remains to be seen whether that option is available to the FOMC.

Economics and policy:  The parliamentarian rules, the Texas energy crisis evolves, farmers react to high crop prices.

  • Congressional Democrats wanted to put the minimum wage hike in the budget resolution bill. That would allow it to pass outside of filibuster rules.  This tactic was a bit of a stretch.  It is hard to see how exactly a rise in the minimum wage is part of the budget process.  The parliamentarian apparently concluded that the minimum wage isn’t a budget item and must be passed separately.  Although there is some talk about overruling her decision, or firing her, we suspect that the Biden administration, preferring to get its stimulus passed, will move on.  This setback doesn’t mean the action is dead.  As we noted yesterday, Sen. Hawley offered a different proposal that could become the basis for a compromise measure.
  • In the aftermath of the Texas energy crisis, the situation is evolving from an energy problem to a financial one. One of the theories underlying Texas energy markets was that if conditions deteriorated and generators were allowed to increase prices, more electricity would be produced.  Instead, the market failed; prices rose, but no appreciable supply emerged, meaning customers simply got stuck with high bills.  Ranchers and farmers are steadily calculating their losses.  Chickens died in the cold, citrus was frozen, and milk cows were hurt.  This is what we don’t know yet—winter wheat germinates in the fall and then goes dormant in winter.  Although wheat (which is grass, after all) is a tough plant, the deep cold may have harmed the crop, and we won’t know the extent of the damage until dormancy ends in the spring.
  • Farmers, looking to take advantage of high prices, are planning to increase acreage under cultivation this year.
  • Global trade is recovering rapidly, but most of the recovery is occurring in Asia.
  • Nigeria has seen a rapid increase in cryptocurrency trading.
  • Yes, ‘there gr-r-reat’ but apparently scarce!

 International news:  Syria, Armenia, northeastern Africa, and the EU are in the news.

China:  The U.S. is engaging in talks with Taiwan to secure semiconductors.  This action will likely upset China.  China is allowing the CNY to appreciate, despite the impact on exporters.  We suspect some of the tolerance is an attempt to control commodity prices (since commodities are priced in dollars, a stronger CNY lowers the relative cost) and to show the currency should be internationalized.

COVID-19:  The number of reported cases is 113,111,157 with 2,509,729 fatalities.  In the U.S., there are 28,413,949 confirmed cases with 508,314 deaths.  For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics.  The FT has also issued an economic tracker that looks across countries with high-frequency data on various factors.  The CDC reports that 91,673,010 doses of the vaccine have been distributed with 68,274,117 doses injected.  The number receiving a first dose is 46,074,392, while the number of second doses, which would grant the highest level of immunity, is 21,555,117.  The FT has a page on global vaccine distribution.


    • The EU continues to stumble with vaccine distribution, and leaders are getting nervous. One issue is that some Europeans are being picky about which vaccine they prefer.
    • The single does Johnson and Johnson (JNN, USD, 162.76) vaccine is being reviewed by the FDA advisory panel, the last step before approval.
    • Although the overall infection data has been positive, we are seeing an uptick in cases. This bears watching because it coincides with an easing of lockdown restrictions.
    • One item being considered is a “vaccine passport.” Although this document could foster the recovery of travel and tourism, there are concerns regarding who would issue such a document, and the security could become difficult to manage.

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