Prophets

The Daily Prophet: Shutdown Jitters Pale Next to Inflation Fears

Connecting the dots in global markets.

The bond market has withstood a lot of headwinds in recent years, not the least of which was the start of Federal Reserve's interest-rate increases. But now, traders are on edge in a way that we haven't seen in a long time, and it's all because of inflation.

While the rest of the markets fretted about a potential  U.S. government shutdown, bond traders on Thursday clamored for the $13 billion in 10-year Treasury Inflation-Protected Securities, or TIPS, auctioned by the U.S. Treasury. The bonds, which are designed to hedge against faster inflation, attracted $2.69 of bids for every $1 offered, the highest so-called bid-to-cover ratio since May 2014. The breakeven rates on 10-year Treasuries, or what traders expected the rate of inflation to be over the life of the securities, reached 2.09 percent on Wednesday, which is also the highest since 2014. The breakeven rate may not seem that high until you realize that it has risen from less than 1.70 percent in June, which qualifies as a huge move in the bond market. "Whether it's wage fears or the rise in commodity prices, the inflation view is shifting and I repeat my belief that higher cyclical inflation in 2018 is a large underappreciated risk," Peter Boockvar, the chief financial officer at Bleakley Financial Group, wrote in a research note after the auction.


Among the forces sparking inflation: the strongest domestic and international economies since the start of the decade, the lowest unemployment rate in 17 years, oil’s return above $70 a barrel, a softening dollar and still-easy monetary policy marked by negative real interest rates, according to Bloomberg News' Jeanna Smialek and Matthew Boelser. "The Fed meets in two weeks. I have to wonder whether this line will remain in the statement, one that has been in every single statement in 2017: 'Market based measures of inflation compensation remain low.'" Boockvar wrote his note.

THE GREAT STOCK MELT UP DEBUNKED
Even though stocks may have ended slightly lower Thursday, the phrase "melt up" is being used a lot to describe the lstrong start to the year in U.S. equities. The bears like to throw it around in a derisive manner whenever they feel the market has disconnected from reality. The strategists at Bloomberg Intelligence took a deep dive into this debate and conclude the recent action is more characteristic of a normal bull market than irrational exuberance. For one, flows into equity mutual funds remain depressed as measured by Investment Company Institute data. As of Jan. 3, equity funds haven't recorded a week of inflows since mid-2017, and 12-week flows have been negative since 2015. BI also notes that a melt-up is usually defined by upward momentum in price that lacks fundamental support, but the recent rally has strong underpinnings from tax reform and improving economic data. In the 1920s, the rate of reported EPS growth averaged 24.1 percent annually in the first six years of the decade, and then slowed to 10.2 percent as stocks accelerated into their peak. In the 1990s, EPS growth averaged close to 20 percent before easing to 7.3 percent in the latter part of the decade. Now, expectations imply stronger earnings growth, with estimates for gains of about 11 percent in EPS over the next two years normalized for tax policy. That compares with an average of 3.8 percent the prior five years. 


STERLING IS ON A RUN
The U.K. currency is quietly enjoying a comeback. The pound shot above $1.38 this week, marking its highest level since June 2016, when voters elected to leave the European Union. The Bloomberg Pound Index, which measures the currency against a basket of developed market peers, is the highest since September of that year, bringing its gains since late August to 6.6 percent. Besides the prospect of higher interest rates from the Bank of England, renewed hopes of a soft Brexit could also be spurring sterling, according to Jordan Rochester, a currency strategist at Nomura International. Indeed, Prime Minister Theresa May has provisionally agreed to pay about 40 billion pounds ($55 billion) as part of the country’s exit from the EU. An analysis by Bloomberg Economics shows it’s a price worth accepting if it helps the U.K. win favor with EU negotiators and secure a trade deal that’s beneficial to the economy. Bloomberg News' Fergal O'Brien reports that it would pay for itself in less than three years by limiting damage to output, even if Britain only secures what BE describes as a “relatively unambitious” agreement.


SANCTIONS? WHAT SANCTIONS?
The MOEX Russia Index last closed at a historic level a year ago. just before President Donald Trump’s inauguration, amid optimism that the U.S. would soften sanctions. A year later, relations between the two nations are strained again, but Russian stocks are flying higher anyway, flirting with new record highs. The gauge has risen 26.4 percent since mid-June, topping the 22.3 percent gain in the broader MSCI Emerging Markets Index. With oil -- a key Russian export -- up almost 30 percent over the last year, investors are brushing off the risk of penalties, according to Bloomberg News' Ksenia Galouchko. The biggest equity exchange-traded fund that tracks Russian equities has attracted $190 million this month, compared with three consecutive months of outflows at the end of last year. Inflows are putting upward pressure on the ruble, which has forced the Finance Ministry to intervene to limit the gains. "We’ve now started to conduct operations on purchasing foreign currency in the open market as part of the budget rule,” Finance Minister Anton Siluanov said Wednesday at the Gaidar Forum in Moscow. “We won’t allow the exchange rate to strengthen sharply.”


GOLD STARS ALIGN
Call it the pause that refreshes. Gold’s breakneck rally eased this week, but there are some pretty powerful tailwinds that suggest the gains aren't over. Chinese New Year buying and option prices signal the stars are aligning for the metal to extend its 6.6 percent gain in the past six weeks, according to Bloomberg News' Todd White and Eddie van der Walt. Options traders are betting on at least another month of rising prices. They’re charging more for benchmark call contracts than for puts, and by the biggest premium since November. The bias, measured in implied volatility, has increased to about 0.6 percentage point. Gold tends to do well in January and February, when demand spikes in the biggest consuming nation, China. Over the past decade, the metal advanced by about 6 percent on average in the first two months combined. The Lunar New Year, which is often celebrated with gifts of gold in much of Asia, falls on Feb. 16 in 2018.


TEA LEAVES
Greece, whose financial troubles almost brought down the euro zone a few years ago, is working its way back to respectability. Investors on Friday will find out just how much progress it has made in getting its finances in order. That's when S&P Global Ratings is due to update its credit ratings on the country. Judging by the bond market, there's a chance that S&P might boost Greece's rating from B-, which is still deep in junk territory. Greece has been one of the few stars in the bond market of late, as investor demand has pushed the nation's 10-year yields down to 3.80 percent from last year's high of 7.84 percent in February. Gross domestic product is forecast to expand 2.2 percent this year, the same as the euro zone overall, according to data compiled by Bloomberg.

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    Robert Burgess at bburgess@bloomberg.net

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    Max Berley at mberley@bloomberg.net

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