Markets Outlook: Markets suffering from a case of “blues and twos”

Market highlights

• Two-year yields have covered their prior six-month range in the last week alone – and whether or not this move is sustainable matters a lot
• Investors have a complete data docket to contend with this week, and signs of stronger-than-expected inflation could hit the market like a ton of bricks
• It was a volatile week in FX where the rally in US yields eventually prevailed
• Higher US yields continue to pressure gold, which remains mired in a downtrend that began last August

The Week Ahead

2-year yields have covered their prior six-month range in the last week alone – and whether or not this move is sustainable matters quite a lot. While the USD and risky assets could shrug off actions in the long end, they’ll find it harder to ignore “Blues and 2's” (2-Year Yields) moves without question.

*Blues are a sequence of individual future contracts bundled on a 4-year duration. Corporates use these IMM US Libor interest rate strips to hedge floating rate Libor loans, which the market speculates against.

Despite consistent messaging from the Fed leadership last week that reinforced their "patiently accommodative" policy stance, interest rates continued to climb sharply with the market pricing a whole rate hike by early 2023 and nearly three rate increases (cumulative) by the end of 2023.

I think worth keeping an eye on is the pickup in direction volumes in the 1y mid curve exposures. So far it’s been centred on Sept and Dec expiries, but if the move continues rates traders could perhaps start shifting into June. Or is EDU3, which is currently being acknowledged as the line in the sand for downside plays?

Fed officials have largely shrugged off the recent moves in yields, viewing the rise in rates as reflecting a more positive growth outlook. However, the sharp repricing of Fed policy tightening – coupled with the rapid increase in real yields across the curve – presents risks of an unwanted tightening of financial conditions. Real yields have now become a source of volatility for pain trades rather than a source of support.

This week will be the last opportunity for Fed officials to shift their tone in this regard, given the upcoming blackout period ahead of the March 16-17 FOMC meeting.

Meanwhile, the RBA will need to fabricate a more convincing scenario to argue that QE keeps yields down, even as their buying again met ferocious selling last night. Many Australian bond sellers are probably punters trapped offside by hard-to-keep promises from the central bank.

Just like the 1.2000 floors in EURCHF attracted speculators to the SNB line in the sand on the allure of a free-money trade that, of course, ended up anything but free money, the RBA's late-cycle bond-buying commitments have similarly drawn too many longs. Rule #2 in my trading manual is "Nothing is ever free and easy when it comes to speculation." (Rule #1 is to never boast about winners).

Investors will also have a complete data docket to contend with this week, and signs of stronger-than-expected inflation could hit the market like a ton of bricks. And even if the Fed plays down the impact of base effects, traders will be fast to call their bluff.

Adding to the inflationary repricing, US January core PCE comes in at 0.3% month-on-month and 1.5% year-on-year, higher than expectations for 0.1% month-on-month and 1.4% year-on-year, and after 0.3% month-on-month and 1.5% year-on-year.

Oil Markets

It’s a similar story for most commodities and linker currencies, with crude prices getting caught up in the domino effect. Still, it's quite surprising how resilient oil has traded given broader market moves so far, suggesting OPEC unity rather than supply management cessation.

The OPEC+ meeting on March 4 is an increasingly essential ingredient and producers face the tricky task of sorting through the various moving parts to form a strategy that makes everyone happy. But let's not beat around the bush: more supply needs to come onto the market to ensure OPEC+ meets incremental demand and keeps internal discipline ducks in a row.

Evidence of a tighter oil market in 2021 prompted several brokers to make upward revisions to oil price targets, which helped push Brent to a 13-month high last week. While it’s true that the market is likely to be undersupplied this year, what’s getting ignored is the fact that this deficit is entirely dependent on OPEC+ supply cuts. The artificial shortage created by the OPEC+ agreement will help to accelerate the draw-down of global inventories. Still, the upside in oil is likely to be capped by the ~9mb/d of spare capacity in OPEC+. 

Currency Markets

It was a volatile week in FX where the rally in US yields eventually prevailed. The deterioration of risk sentiment into the end of the week shook relation sentiment from its foundations, triggering a short USD squeeze compounded by the fact liquidity dropped precipitously on Friday.

Gold Markets

Higher US yields continue to pressure gold, which remains mired in a downtrend that began in August, with gold ETF and futures speculative positioning both coming off from the top to about 80% of the last year's range.

Technical trends kicked in when gold gapped down to $1,756.30 from $1,765/66, then triggered stop losses in a cascading effect as the rise in US bond yields triggering inflows into USD is the most forceful headwind for precious metals.