The demand-supply gap ensures the path to 'zero' for German yields

Outlook:

We don’t have any top tier data in the US today, leaving us with housing data and durables to come, plus preparation for the Fed next week. The blackout period on Fed officials commenting on official policy business come into force today. We are left with remarks by NY Fed Dudley, who said "I expect the first quarter weakness will prove to be largely temporary”… and "because the economic outlook is uncertain, I can't tell you when normalization will occur. The timing is data dependent."

Well, Dudley is no help at all. We are left with the vague reading that the Fed has a tightening bias. Two points: some are saying that a giant number at the next NFP on May 8 could put June back on the table. This may be true but we are at risk of over-interpretation. The Fed wants lots of growth data, not just one good number. Secondly, nobody knows how much the strong dollar in influencing the Fed. The Fed mandate is against inflation and for full employment—it has no dollar mandate. The strong dollar probably causes a little delay, but that’s all. And consider that as trade talks come to a head this week, the Fed wants to be nowhere in sight.

Other big themes show more development. About Greece, Draghi has said membership in the eurozone is “irrevocable.” Yesterday ECB VP said default does not automatically trigger an exit. In fact, Grexit should not happen. Having said that (to the European Parliament), Constancio also said the ECB cannot fund Greece indefinitely into the future. The stance is changing. The ECB is now positioning the euro-zone as a roach motel—you can get in but you can’t get out. This is a logical strategy—Greek leaders can’t use Grexit as a tool to blackmail the institutions, and we know Greek citizens want to remain in the eurozone. This may seem like a good position for the institutions to take, since by refusing to let Greece go, they retain some power over it.

But they may be forgetting a critical factor—with power comes responsibility. Classic Keynesianism calls for strong countries to make cause with weak ones. In other words, Keynes would say Germans are supposed to fund Greek pensions, at least temporarily. This is not the Maastricht or Stability Pact ideal, of course, where every country stands on its own two feet. But most analysts agree with the Greek lead-ership—the bailout was badly designed and has failed. As with the American Cuba policy, doing the same thing and expecting a different outcome is not very smart. We would like to see concrete plans from the Greeks. What, aside from keeping pensions, do they want?

Another theme is US military involvement in the Middle East. We don’t know what to make of the sev-en US Navy ships helping the Saudis and Egyptians block access to Yemen by Iranian ships (reportedly carrying weapons). The ships are to be joined by the aircraft carrier Theodore Roosevelt and some other ships, too, bringing the total to nine and the number of sailors and Marines to over 9,000. The US is act-ing as an ally backstopping the Saudis, not the leader, so if there is a showdown with the Iranians, it won’t be US boots. Yeah, sure. Remember, the dollar always go up when the US puts its military power on display. Historically, the reserve currency issuer is always the top military power of its day. Consid-ering that the US has botched every military adventure for over a decade, you’d think the prospect of US military involvement would be a dollar-negative.

Another theme is the negative European and especially German note and bond yields. Today the head of Pimco in Germany told the WSJ “The 30-year could potentially go to zero as well. I wouldn’t put a su-per-high probability on that, but there are two things: the net supply of [German] debt is zero and the Bundesbank needs to buy around €190 billion of Bunds.”

The WSJ reports “Many analysts originally expected the ECB to steer clear of purchasing longer-dated bonds in its QE program to avoid disrupting pension and insurance companies, which need to buy these bonds to match their lengthy liabilities. However, the market impact of QE has been substan-tial, particularly given the scarcity of German bonds for the ECB to buy. The yield on the 30 year crum-bled from 0.96% to 0.63% over the first three days of quantitative easing and has since been grinding lower.”

The chief investment officer at UBS, Mark Haefele, makes an important point: investor worry is driving demand for Bunds. “But there’s an asymmetric risk. There’s no way you can make a decent return, but you can lose a lot of money. People are starting to talk about the limitations of negative rates. At some point it would become preferable to store Swiss franc notes in a vault.”

And on China, reviews are starting to appear of former TreasSec Paulson’s new book, Dealing With China: An Insider Unmasks the New Economic Superpower. Paulson is a genuine China expert. He says “Frankly, it’s not a question of if, but when, China’s financial system will face a reckoning and have to contend with a wave of credit losses and debt restructurings.” The trigger would be a real estate collapse. “Slowing economic growth and rapidly rising debt levels are rarely a happy combi-nation, and China’s borrowing spree seems certain to lead to trouble.”

A special worry is shadow banking via “trust companies,” amounting to some $2 trillion, which creates moral hazard. China has $4 trillion in reserves and can manage the situation—and we might not even know about it, since “Transparency in China too often means the government having all the infor-mation.” And the Chinese government is fully aware of these problems. So it needs to get busy. If a cri-sis develops and we do find out about it, we would get contagion in the US. We say Paulson’s interpreta-tion is exactly what we have been deducing from news reports over the past few years and not new or startling, but impressive when put together in one place.

We have a lot of Big Picture geopolitical and macro events to mull over, but not a good FX sentiment reading. It’s all too likely that the euro wobbles around for the next few days without delivering a breakout. We can always find reasons to buy or sell other currencies, especially when an interest rate change might be in the offing (AUD, NZD) or an election poisons sentiment (sterling). Now would be a good time to retreat from trading or any heavy decision-making.