Date: October 10, 2018
Powell Places Risky Bet as He Stokes Too-Good-to-Be-True Economy
Federal Reserve Chairman Jerome Powell is pinning his hopes of stopping the U.S. economy from overheating on a variable that a former colleague called “the most significant unobservable of all:” inflation expectations. In recent public appearances, Powell has argued that the Fed can countenance a fall in joblessness to an almost 50-year low without triggering an inflationary surge in large part because Americans believe the central bank will keep prices under wraps. “The key is the anchored expectations,” he said last week. The problem is that it’s not easy to divine what inflation beliefs are and how they might change. What’s more, there’s no measure of where companies — arguably the most important players in setting prices — expect the cost of living to go. That makes Powell’s focus on price expectations a potentially risky move as the Fed gradually raises interest rates. “The concept of inflation expectations is quite under-theorized and hard to pin down empirically,” Powell’s former Fed colleague, Daniel Tarullo, said in a speech last October. Janet Yellen, Powell’s predecessor as Fed chair, also understood the limitations: “Economists’ understanding of exactly how and why inflation expectations change over time is limited,” she said in a speech in September 2017. If inflation were to get out of control, that would be bad news for investors. In recent days, the stock market has been rocked by a rise in Treasury bond yields primarily driven by the economy’s strength — not by expectations of faster inflation. Yields could march higher still if rising wages and surging oil prices trigger a spike in consumer prices, forcing the Powell Fed to rethink its gradual strategy for containing inflation. “There’s going to be a little tighter jobs market and a little faster inflation” than the Fed expects, Michael Feroli, chief U.S. economist for JPMorgan Chase & Co. in New York, said in an interview. “The risk is they’ll have go a bit further” in raising rates as a result, he said. Government data on Thursday are expected to show that consumer price inflation eased to 2.4 percent last month from 2.7 percent in August, according to the median forecast of economists surveyed by Bloomberg. The inflation measure the Fed targets — the personal consumption expenditures price index — historically runs about quarter percentage below that gauge.
Italian Spread Is in No Man’s Land With Budget on Collision Path
Implied volatility on Italy’s 10-year bond futures climbs as the government stands firm on its budget plans, which appears to set it on a direct collision course with the European Union. Wings should be in focus via call spreads on any limited BTP outperformance driven by conciliatory budget comments and subsequently, outright puts may attract, given concerns over debt sustainability in the medium term. Still, liquidity remains problematic following unprecedented price action seen in May. Double-digit basis point swings becoming commonplace with 10Y BTP yields +14bps Tuesday morning, before ending the day -9bps, driven by Italian political noise; budget proposal still on a conflict path leaves the BTP/Bund spread vulnerable below 300bps. Impaired market depth on heightened volatility increases risk premium demanded and while current spread levels may ultimately offer value over the medium term, the near-term risk-adjusted return keeps asset allocation cautious; sentiment to be tested at Thursday’s bond auction. BTP sell-off is yet to cross the contagion threshold and leaves no change to the ECB approach, with limited spillover to peripherals; Italian CDS imply ~7% probability of currency redenomination in the next five years, based on the spread between 2014-2003 contracts (see more here from Oct. 8 on limited contagion, but remains vulnerable to higher beta)
China’s About to Sell Dollar Bonds in Middle of a Trade War
A year after its first sovereign sale of dollar bonds in well over a decade, China’s about to tap that well again. This time around, the reception isn’t likely to be quite as enthusiastic. The $3 billion issuance of five-year, 10-year and 30-year securities, due Thursday, follows a jump in yields on benchmark Treasuries, and a slump in the yuan against the dollar thanks in part to China’s deepening trade-war with the U.S. While the Ministry of Finance hasn’t identified a purpose for the sale, underwriters had long expected a follow-up to last year’s $2 billion deal to help build out a benchmark yield curve for Chinese offshore borrowers. “Market conditions are quite different from last year,” said Anne Zhang, executive director for fixed income, currencies and commodities at the private banking arm of JPMorgan Chase & Co. in Hong Kong. “The ongoing trade war, U.S. Treasury yield spike, coupled with emerging-market volatility and anticipated dollar-bond supply ’till year-end are all making investors take a more cautious view” and press for a bigger premium on the sale, she said. The likelihood of a bigger spread over benchmark Treasuries is based in part on secondary trading in the securities sold last year, which drew orders for about 11 times the amount on offer. The premium on the 10-year tranche was at 41 basis points in Wednesday afternoon Asia trading, after being priced at 25 basis points, according to data compiled by Bloomberg. Even with a wider spread, the sale could help to limit damage to a Chinese offshore dollar-debt market that’s grown to roughly $700 billion as investors question the outlook for China’s securities. Chinese issuers have sold $125 billion of dollar bonds so far this year, on course for a slowdown from $208 billion for all of 2017. “It’s still better to have a sovereign-benchmark anchor in the global market — especially amid the current emerging-market turmoil and ongoing trade tension,” said Hong Hao, chief strategist at Bocom International Holdings Co. in Hong Kong. Hong expects the sale to help lower the funding cost for higher-rated Chinese companies.