Below is an interview we did for our “10 Things You Need To Know Before The Opening Bell” newsletter with Russ Certo, head of rates at Brean Capital, on some of the big stories affecting global markets.
BUSINESS INSIDER: What is one big story in the bond market that no one seems to be talking about?
RUSS CERTO: In a relative sense, I suspect the market is critically gauging the prospective quantity, scope, and timing of tapering of the Federal Reserve’s asset purchases. However, I think there could be ultimately significantly more meaning and value in fully and accurately anticipating the more vexing challenges and relevance of fine-tuning its forward guidance. Aspects related to the scope of the taper are likely to be technical. Forward guidance evolution will likely have a more qualitative relevance to markets. A focus on the latter and the evolution of the ultimate Fed message will have impacts not only on global equity, foreign exchange, commodity and interest rate and credit valuations, but also on volatility in these markets.
BI: How are investors approaching the current yield spread between U.S. Treasuries and German Bunds, which just hit a fresh 8-year high?
RC: There is good reason to believe that there are significant capital inflows into European sovereign bonds from the Pacific Rim recently. In fact, not only have the underlying bonds rallied, but the euro is making a 2-year high at the moment as diversified reserves globally are making their way back to euroland for a variety of direct foreign investment purposes. Some monies may also be diversifying as the Federal Reserve has embarked upon a tapering of asset purchases, a tacit indication of confidence in the underlying economy and/or removal of extreme crisis-era monetary policy measures. Both interest rates and currency values also reflect a disconnect of market expectations, and many investors globally were likely underweighted both complexes.
BI: The February nonfarm payrolls report revealed signs of acceleration in wage growth. Meanwhile, food prices are surging. Is the TIPS market respecting the risks of increased inflation?
RC: I acknowledge your observation, which I have called “a tale of two markets.” The TIPS market has been stubborn in reflecting some of the volatility which we have seen in other commodity and capital markets. For a quick tally, coffee has surged by 78% this year, cattle prices are making all-time highs, lean hogs are up 25% in the year to date, and this has extended to sugar, corn, soybeans, cotton, and even orange juice — something we pointed out in the softs a few commentaries back. I’m sure more than a few have been looking at their natural gas bills, as the futures are up 15% in the year to date, or even gas prices at the pump (over $US4 a gallon in the United States). Precious metals have also percolated and are seeing significant real demand globally versus more financial market position liquidation. Trading any of these is not for the faint of heart, and there does seem to be a disconnect — or decoupling — between the nominal performance of TIPS versus general risk assets and those represented by the inflation complex.
BI: To the extent that weather distortions are still weighing on yields, when do you think the market will start to move past that?
RC: I think the market HAS, to some extent, shrugged off bad weather effects, as interest rates increased by near 20 basis points last week, partially as an interpretation of economic data, ex-weather effects. Historically, weather effects which have adversely impacted demand side activity and consumption have proven to ultimately spur pent-up demand. I can’t wait until spring myself — or next year’s or quarter’s comparison to a bevy of economic statistics adversely impacted by wintry weather. As a glaring example, Janet Yellen even gave lip service to these “transitional” impacts, and the most recent Federal Reserve Beige Book tally of economic activity cited weather 119 separate times.
BI: Which developments in global financial markets would you flag as most concerning for the bond market right now?
RC: All markets are going to have to accurately, as always, interpret the incrementalism and “tea leaves” of central bank policy changes. Some have introduced the concept of “owning the tails” — or tail risk of markets — in case of a material surprise relative to expectations in either dovish or hawkish expressions from the central bank community, or real demand shocks, or meaningful acceleration in economic fundamentals. There is some empirical analysis which would suggest moderate gains in domestic equity markets again this year to follow last year’s outsized gains. I suppose that if the real economy weans itself off of enormous amounts of fiscal and monetary stimulus and returns to real economic allocation of resources that the economy and markets can handle the passing of the policy baton. Allowing businesspersons to make real decisions without being encumbered with the uncertainty of policy distortions can be a powerful metric to deploy all the cash sitting on the sidelines. Growth for the right reasons. However, markets will have to balance record amounts of margin credit, historically tight credit spreads, and elevated valuations of most risk assets globally. Transitioning from artificial imbalances to real activity is the very thin line that policymakers and markets will have to walk.
Editor’s note: This Q&A went out to subscribers of our “10 Things You Need To Know Before The Opening Bell” newsletter on Tuesday morning. Sign up below to get the newsletter and more of these interviews in your inbox each morning.
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