Many questions in bubbly markets

The reflation trade is pausing for breath at the moment withencouraging vaccine news, accommodative economic policies and better-than-expected earnings all contributing to the positive mood in recent days. In fact, global stocks had been on a thirteen-day winning streak until Wednesday, the longest run since 2003. Records in stock markets are an everyday occurrence it seems; see Japan’s Nikkei which hit thirty-year highs earlier in the week. 

All this positivity is obviously bad for bond markets and while prices sink, so yields surge with the well-watched US 10-year Treasury yield bursting through the March 2020 liquidity squeeze top at 1.27% and touching 1.33%. The pace of the sell-off in fixed income is now getting increasing attentionwith those 10-year yields up more than 30 basis points since the start of January. How far and fast is too much for the Fed is a key question going forward. Steady and slow can extend the party in stock markets, but fast and furious would probably see risk assets do an about-turn very sharply. 

Interestingly, a couple of other market dynamics have shifted which are worth exploring further. Firstly, the divergence between rising inflation expectations (more than 2%) and subdued real yields (-1%), which had been hurting the dollar,has changed very recently. Those real yields have increased while inflation expectations – responsible for much of the yield increase so far – have plateaued. Does this mean markets are just reflecting a more positive assessment on growth? Or are they discounting a swifter return to normal by the Fed to address the risks of inflation?

The blow out US retail sales released Tuesday also witnesseda slightly different market reaction than we’ve been used to. Unlike recently where we saw weakness in non-farm payrolls data and CPI figures take the dollar lower, it seems that positive data surprises are now good for the greenback. Importantly, the odds of data going forward into Spring and beyond surprising to the upside are potentially increasing as the US opens up and hits its vaccine targets. Oh yes, and more than $1 trillion of new stimulus is expected, on top of rising prices. This could see the heavily backed dollar short trade come under more pressure, especially if current price action in DXY confirms a bottom is in play.

One market enjoying the good times currently is the FTSE 100 which is up more than 5.7% this month. With the Brexit risk premium gone and the impressive rollout of Covid vaccines (23% of the UK population have now received a dose of Covid vaccine), UK indices, which have been undervalued for some time, are now gaining momentum. Of course, the FTSE is being helped by the fact that it is top heavy with “value stocks” in banking, energy and mining sectors which investors are leaping into on the back of the healing global economy. Sterling too is riding high, top of the major currency charts year-to-date. It has had a tendency to overshoot on the undervaluation side in the past few years, and this may now be the case on the upside too with 1.40 looming above in cable.