The Dollar and Treasury Yields in Limbo: Three Possible Scenarios

From February 12th:

Since last year widening high yield US credit spreads, falling global risk securities, commodities, currencies, and inflation expectations have all coincided with shrinking global foreign exchange reserves. This combination of factors has produced declining treasury yields as one would expect in a risk-off environment.

If the dollar were to break upward resistance in an ongoing bull run then those trends should persist as US securities continue to beat EM. To see a return to risk taking, my expectation would be for all or most of those aforementioned trends (in bold) to bottom and reverse. If the dollar were to break support and correct against a broad range of currencies, a reflation trade may be in order as inflation expectations stabilize and treasury yields rebound. In this scenario the dollar squeeze would dissipate allowing EM to outperform US securities. However, if the dollar were to correct or reverse only against the Euro, Yen, and precious metals while treasury yields continued to fall, then a more long lasting risk-off phase may be underway.

-A Look at Global Markets - Where are we now?

After a wave of risk aversion swept through a broad range of markets to begin the year, February ushered in a powerful bottom and rally in the assets which were most hit. Although this short-term volatility works to created confusion, depending on how events unfold it can provide us with ideas for how to position in such instances. The following is an exercise that uses the price action in the 10 year treasury yield and the dollar to come up with three potential scenarios for how the global economy and financial markets may proceed moving forward.

Following a December downtrend that brought the 10 year treasury yield to the 2015 bottom, it has been range bound between 2% and 1.6% / 1.56%. Meanwhile, the dollar index hit $100 resistance and also sold off right around the time the Fed decided to increase policy rates for the first time in this cycle. The dollar index has only just found support again at the $93 level in what has been range bound trading since the beginning of 2015.

Three Possible Scenarios:

1) Global Reflation and Currency Convergence

The 10 year yield breaks above 2% and tests 2.5% or greater.

The dollar index definitively loses $93 support in a downtrend that marking $100 as at least an intermediate term top.

Market participants anticipate that the Fed will proceed with caution by allowing domestic and global economic activity to pick up first before signaling a dramatic change in monetary policy.
The dollar squeeze that wrecked havoc on the balance sheets of leveraged dollar shorts begins to dissipate.
Assuming that this outcome comes to pass, the dollar capital (reserve) outflows that have plagued foreign central banks and economies in general would likely reverse while Eurodollar recycling recovers (revival in the foreign dollar denominated credit cycle).
As a result, the fear of a major Chinese yuan depreciation would recede as capital outflows abate.
With inflation expectations shifting up as the dollar falls, would the Fed's inflation forecasts suggest that they would allow inflation to overshoot in order to make up for years of missing their 2% target?

What to look for:

Appreciation in a broad basket of currencies
A steeper US treasury yield curve as long-term rates rise faster than short-term rates
TIPS trend higher relative to treasuries as inflation expectations improve
US real rates fall as nominal interest rates lag inflation
HY credit spreads continue to narrow especially in the energy sector
EM and commodity related securities outdo their US counterparts
Global equities (European periphery, Nikkei, Chinese stocks etc.) trend up along with the 10-year treasury yield
Bank and financial as well as high beta stocks rise
Commodities led by gold and precious metals continue their rebound after bottoming

2). US growth rebounds relative to the rest of the world

The 10 year yield remains near the current range or breaks below 1.55%.

The dollar either continues to consolidate between $100 and $93 or trades above $100.

Market participants price in a steeper path for US policy rates going forward by pushing up short-term treasury rates in anticipation of improving US growth or as inflation approaches the Fed's 2% target.
The Fed allows inflation to bottom but communicates that a period of overshoot is undesirable.
The US economy would continue to lead, but decelerating relative growth in the rest of the world results in subdued long-term treasury bond yields.

What to look for:

The dollar strengthens against a broad basket of currencies
Short-term treasury rates rise faster than long-term rates
Inflation expectations bottom but remain within the Fed's comfort zone
US real rates rise as nominal rates increase relative to inflation
Credit spreads widen or at least fail to narrow materially
EM, commodities, and related securities are mixed, range bound, or remain under pressure relative to US securities

3). Risk aversion and Panic

The 10 year yield trades below 1.55% as it trends towards the 2015 low of sub 1.4%.

The dollar index remains range bound or breaks $93 support in a correction before resuming the prior uptrend.

Market participants price in a flatter path for US policy rates going forward (or a greater probability of easing) as expectations set in that US and global growth are decelerating markedly.
In this case, the Fed like the ECB in 2011 has either already mistakenly tightened monetary policy prematurely or is at risk of doing so.
If this bears out, then the monetary policy tightening which has taken place since 2014 would have contributed to lower long-term rates on safe US securities, not higher! Interest rates follow NGDP and credit growth (the driver) where a data dependent Fed is then forced to shift short-term policy rates in response. Low and falling (high and rising) long-term treasury rates are symptomatic of depressed (rapid) global economic activity. US nominal GDP increased by 4.75% year-over-year in Q3 2014 compared to 3.23% in Q1 2016.
In a risk-off environment, market participants would bid up the price of treasury securities as they seek insurance against falling risky assets. It would be another reminder that in times of panic, US government securities are the safest collateral.
The Eurodollar system would be under even greater strain (the need for emergency central bank dollar liquidity swap lines?).
Financial stress in Europe especially in the periphery countries would be very prone to flaring up again.
Chinese yuan depreciation fears would very likely intensify.
Geopolitical risk?

What to look for:

The dollar's correction/consolidation would only prove to be temporary
Short-term treasury rates fall faster than long-term rates
Inflation expectations decline and TIPS underperform treasuries*
The drop-off in inflation results in rising real rates despite declining short-term interest rates*
Commodities and precious metals sell off when the dollar breaks out again.*
Risk assets sell off and credit spreads widen while defensive sectors and securities outperform.
The VIX moves higher

*At first, real rates and the dollar could decline as short-term rates fall more quickly than inflation. Moreover, given that the yen and euro have been used as funding currencies in the dollar carry trade, the paring back of these positions should (as was the case in the beginning of 2016) contribute to the dollar's decline in a risk-off move. Ultimately though in a crisis/panic the dollar's status as the primary global safe haven very well could prove decisive causing it to appreciate against all FX pairs, while the yen also appreciates against riskier currencies.

Final thoughts:

One of the main differences between the three potential outcomes is how responsive the Fed is to its inflation target. As (if) inflation approaches 2%, will they allow it to overshoot the target for a period of time to balance the years of undershooting or will they look to immediately signal further tightening (inflation ceiling)? If the expansion decelerates significantly causing inflation to remain persistently below 2%, how would the Fed react? The way the Fed manages market expectations may prove pivotal.

Unless told otherwise, as it currently stands it's most likely that markets will expect the Fed to increase their policy rates as inflation approaches 2%. Under such circumstances (as has been the case since 2013), market participants will desire to preemptively rebalance their portfolios in anticipation of the Fed by limiting their leverage and/or reducing the risk profile of their asset holdings. In doing so, markets would essentially be tightening financial conditions. This is why an inflation targeting monetary regime where markets perceive 2% to be a ceiling can be so problematic. Any rebound in domestic or global growth that threatens to cause inflation to surpass 2% will trigger markets to tighten. As witnessed after announcing plans to taper QE, the Fed's communication and policy stance has reinforced such expectations by transmitting a hawkish stance during a period when inflation and long-term treasury yields have both been in decline.

The efficacy of monetary policy and the political willingness of major central banks to actively influence global economic conditions have come into question ever since the weak recovery took hold. Monetary policy alone may not be able to spur a strong expansion, but if the above analysis is remotely accurate, it strongly suggests that the Fed's actions can still negatively influence global economic growth through market expectations. Monetary policy tools as they are presently constituted are proving to be asymmetric in this sense. The current tool set is still adept at tightening financial conditions if improving economic fundamentals result in undesirable inflation but may not be able to fully offset weak growth and disinflation.

When it comes to thinking about which of the above outcomes is most probable, the present conditions in the financial markets don't seem to lend themselves to a great deal of conviction one way or another. This may be what is contributing to the volatility markets have been experiencing even prior to the December rate hike. At this juncture patience may be a virtue not only for market participants but also for the Fed.

Supporting Charts

The Yen may have put in a bottom as the 5 years treasury yield's performance stalls against the 10 year yield.

The Euro's stabilization is a sign that one way or another the interest rate differential trade may be coming to an end for now.

The relative strength of HY bonds (HYG) vs treasuries (IEF) bottomed in February as credit spreads narrowed

TIPS and EM dollar denominated bonds also rebounded rapidly since February

Did February mark a bottom for US corporate and EM debt or is this nothing more than a reprieve rally?

There is a similar theme in EM stocks (EEM), Chinese large caps(FXI), and global commodity equities

US equities found support in February but are now facing multi-month resistance

Italian (EWI) and Spanish (EWP) equities have followed the 10 year yield (TNX white line) for over a year

The Nikkei has as well

The Chinese FXI has also moved in concert with the 10 year.

This is also evident in global bank and financial stocks. The 10 year treasury is a proxy for the degree of global risk taking.

Biotech, social media, and internet stocks follow along as they too jump in February

Inflation expectations rose in February after hitting multi-year lows to begin the year.

Unsurprisingly commodity related securities follow inflation expectations and TIPS

Did oil also put in an important bottom after selling off to new lows to start the year?

Gold's vigorous break out and potential uptrend (if it continues) could be hinting at a top for US real rates as US nominal rates could lag inflation going forward.

With all that said, the relative strength of the S&P 500 vs. US treasuries looks like it may be in the process of topping.

Treasury bonds on the other hand have underperformed the VIX as investors seek protection against potential future risks.

The above is a chart of Edward Lambert's effective demand model (his link). The US may have hit this limit in late 2014.

Corporate profits (as a % of GDI) have also been in decline

Dow Theory: The DJ Transports have lagged the DJ Industrials since 2015. This last occurred between 2011-2013 when US stocks spent months consolidating after a sharp correction. Until this downtrend ends, caution may be warranted