EUR/USD sentiment stays mixed, a buy or a sell?

Outlook:

The calendar today has two items of interest—initial jobless claims and consumer credit. Claims may be over-emphasized as implying something about tomorrow’s payrolls.

Data aside, we see to themes for today—Yellen’s strange mention of equity prices and the equally strange sell-off in German Bunds.

We were appalled to hear that Yellen again mentioned equity prices at a conference yesterday with IMF chief Lagarde. Within minutes, US prices started falling, as anyone could have predicted, including Yellen. She said "I would highlight that equity market valuations at this point generally are quite high. There are potential dangers there." She also said stability risk across the US financial system are "moderated, not elevated." She also said "We’ve also seen the compression of spreads on high-yield debt, which certainly looks like a reach for yield type of behavior." Gee, after near zero returns for so many years, does it even need mentioning that equities are bubbling or high-yield paper is attractive? Everyone in finance knows about these two effects and there was no need for Yellen to state the obvi-ous—so why did she do it? After having caused a storm be saying bio-tech was overpriced and trigger-ing a mini-crash in the sector, you’d think she would have learned to keep her trap shut about equity prices unless that was exactly the effect she was seeking.

Yellen is no fool and we don’t believe for a minute that she was taken unawares and put her foot in her mouth by mistake. She was sending a message—that someday soon the Fed will be raising rates and managers in any market who are going to freak out and cause Shock Waves are idiots. Plenty of Feds have worried out loud about the markets underestimating the price and liquidity effects of the First Hike, notably NY Fed chief Dudley, whose focus is on the money and bond markets. It’s practically an unwrit-ten rule that the Fed chairman does not comment on equity price levels, so Yellen was being deliberate. We see a problem in the form of the Fed having no punishment capability against the idiots who will, indeed, sell off equities when the First Hike does come. What is the Fed going to do—ridicule people by name in public?

The WSJ’s Hilsenrath has an interesting take on the Yellen remarks. He says this is not the equivalent of Greenspan’s “irrational exuberance” in 1996, when the market was punch-drunk. Yellen specifically says the market is not over-exuberant. She said “… risks to financial stability are moderated, not elevat-ed at this point. And I say that because we’re not seeing any broad-based pickup in leverage. We’re not seeing rapid credit growth. We’re not seeing an increase in maturity transformation. And I would call those things kind of the hallmark of a financial bubble or the precursors of a financial crisis…”

So if she is not actually talking about danger in equities, what is she talking about? Hilsenrath deduces “Ms. Yellen clearly doesn’t want markets to be stretched and caught off guard when the Fed starts rais-ing short-term interest rates, presumably later this year. Fed officials regularly worry about keeping mar-ket expectations aligned with their own. They want to avoid a repeat of the bond market’s “taper tan-trum” of 2013, when long-term rates shot up as the Fed considered ending a bond-buying program.” Well, if she wants to address the bond market, why not do it directly?

Separately, Atlanta Fed Pres Lockhart said market expectations for a September interest rate hike are in "reasonable alignment" with Fed thinking. This sounds already out of date. While hope springs eternal of a Q2 rebound, if ADP is right and Friday’s payrolls are low, expectations of robust US growth are a pipedream. We also don’t see Europe continuing to surpass the US as it did in Q1—there are no one-way streets in economics—but delay is looking more likely by the minute. Consider the productivity numbers reported yesterday. Falling productivity means no rises in wages, and no rises in wages implies a moribund housing market, crummy retail sales, and so on. Consumer credit today could be interesting. It has been tepid of late, taken to imply the consumer is saving gasoline price cuts and not all that confident about the economy improving their lives anytime soon.

The other big thing on the agenda today is trying to understand the European bond sell-off. The FT has about ten different stories on it this morning. Take-aways include this comment from a JP Morgan ana-lyst: “Bunds have been selling off as the market re-prices the ‘term premium’ [risk factors affecting bonds over and above the outlook for inflation and rates] which has been held down by a combination of ECB QE and uncertainties surrounding Greece…. Liquidity has been very poor and this has exacerbated the price action. It is difficult to say when the selling will stop. The combination of higher bond yields in both core and periphery, weaker equities and stronger euro will ultimately arrest this sell off in bonds as people worry about the pass-through into slower economic growth.”

A different FT reporter has this: “Logically, Bund yields would rise if investors expected stronger euro-zone growth and higher inflation. But the consensus view in markets is that the latest moves are more about a correction than a fundamental shift in investors’ views. The US and Japanese experience shows that choppy conditions in bond markets follow the launch of large-scale asset programmes, muddling the signals bond yields send about the state of the economy. What is more, a stronger euro could hit euro-zone exports — so it is too early for Mario Draghi, ECB president, to celebrate. With the ECB continu-ing to buy €60bn in public and private sector assets each month, bond yields could return to a downward path.”

You have to like a guy who starts his paragraph with the word “logically.” It is probably fair to say that the selloff in the bond market has gone farther than anyone could have foreseen and looks like an Event in its own right, which makes one hell of an unusual correction. One analyst noted to Market News that when Bill Gross or Druckenmiller or Buffett say the world is changing permanently, at some point all the average Joe traders gets spooked. And the herd mentality is about to get a poke in the eye on payrolls tomorrow.

But this is to forget the turmoil the US bond market went through when we got QE for the first time, including exaggeration of how far down yields could go—in other words, predicting Bunds at deeply negative rates was never realistic. Well, maybe. Maybe we should also heed Yellen, who said "Long term interest rates are at very low levels, and that would appear to embody low term premiums, which can move and move very rapidly. We do have divergence monetary policies around the world. And we need to be attentive to the possibility that when the Fed decides it's time to begin raising rates, these term premiums could move up and we could see a sharp jump in long term rates."

In other words, the Bund yield will settle back at lower levels sometime soon—this kind of volatility is not sustainable—while US yields will continue to rise for the very good reason that the ECB is still en-gaged in QE to Sept 2016 and the Fed is done with QE. Talk about seismic changes and a permanently changed perspective is rhetorical hogwash. European yields are up on an aberration arising from position adjustment, while US yields are up for real economic reasons.

Here’s the rub—the real economic reasons behind the US yield rise may not be so real, after all. And in any case, it’s not clear that the actual participants in the yield move are doing it for “real economic reasons,” at least not yet. The implication for the EUR/USD is murky, to say the least. One group of FX traders is waiting to see stretched euro highs so they can sell again, meaning the current cor-rection has a short shelf-life. Another group thinks the US economy could very well be in the soup and therefore as long as Europe delivers decent data, they want to buy euros on dips. So far the dippers are winning.

That means we are looking for a catalyst to tell us which viewpoint and which trading strategy is the right one. Payrolls is the obvious choice, but it’s a really bad one, given all the problems with that partic-ular data series. We will refrain from complaining about payrolls’ defects and deficiencies again, but remember that whatever happens tomorrow morning, it will be based on bad reasoning and not actually settle the debate.

Is it even remotely possible that Europe will get good growth and a rebirth of inflation while the US stumbles? Yes, and we have seen it before, too. It’s never pretty for the dollar. So it doesn’t pay to buy into the conventional wisdom that of course the US is the “winner.”

On the other hand, perhaps we are still looking in the rear-view mirror. Economist Ian Shepherdson told Market News that if we can get a big yield rise on crummy data, what will happen when we get good data? "If yields can jump in the month after a disappointing payroll report and a near-zero GDP number, how will investors respond when the data show that the first quarter stall really was just a weather-driven blip, exacerbated by the port dispute?" It’s a really good question!

As usual ahead of payrolls, we advise that no action is the best action. Get square and stay there until the dust settles. We will see spikes and even if your directional bet is perfectly correct, prices will gap over your stops and targets and you can easily end up losing the bet.