Not So Sterling!

You would be forgiven if, at some point during last week, you pinched yourself to check if it was just a nightmare. A lot happened. We found out Trump had universal tariffs in his deck of cards, and that he might use a National Economic Emergency to force them through; Trudeau quit and Canada’s parliament was halted; fires ravaged LA; Huang’s comment crippled Quantum computing stocks; gilts came to a boil as yields simmered; Zuckerberg copied Elon’s homework; and US data continued to make the Fed look dumb and dumber.

💰 Bond Markets

There was a time in my life when I yawned audibly whenever I came across the word ‘bonds’. I thought nothing in finance was more boring, except perhaps factor models. Maybe the only time I didn’t yawn was when I found out European rates had gone negative. It felt bizarre. What I didn’t know back then is that bond guys, who I imagine in boring suits and thick horn-rimmed glasses, were loading up on negative-yielding bonds to the sky, amassing an $18 trillion pile at some point. Then, in August 2022, the ECB’s deposit facility rate—the one rate that rules them all—was raised by 50bps to zero, and then by 75bps a month later. By October, the EU portion of this (negative-yielding) pile had all but vanished.

The reason bonds made me audibly yawn is that I lacked imagination. I thought all you did with them was buy them and… either sell them when the price went up, or hold them to maturity and pocket the interest rates. I thought the exciting part was figuring out what to do with the coupons. One of Gartman’s 22 rules of investing is buy high, sell higher and in my mind, this was the only appeal of negative-yielding bonds—that you could find a bigger idiot. But bonds are way more complex! Consider for example Japanese investors. Of the countries that kept rates negative, Japan did so the longest. Japanese rates turned positive as recently as March 2024—two and a half years after everyone else started raising rates to thwart inflation. Up until late 2022, bond guys bought Japanese negative-yielding bonds and hedged the currency risk to earn a spread over treasuries. This is known as a synthetic bond. Such alchemy is what makes bonds so exciting. Since then, I’ve seen all sorts of synthetic bonds as bond guys try to squeeze every drop of juice from international bond markets, so I no longer yawn at the word. Anyway, because Japan kept rates so low, Japanese investors had an insatiable appetite for Treasuries. Long story short, they own a lot of treasuries. Their appetite, while not quelled, has diminished, and should they choose to start selling their treasury holdings, it would be devastating. The chart below shows that Japanese investors offloaded some of their holdings in the one-year period between October 2023 and 2024.

Fast forward to today and the current outlook is as follows: the US is running a huge trade deficit; Maganomics is expected to be inflationary; oil and gas have been rising; the recent Fed cuts could be inflationary (with long and variable lags) or at least not restrictive enough; and Japan is expected to raise rates perhaps as soon as this month. Yields had no choice but to go higher. Add good US data to these factors and you see why market-implied odds for a rate hike have increased.

Which brings us to the gilts meltdown this week. In case you haven’t heard, UK rates aka gilts careened higher and breached multi-year highs. The important thing isn’t that gilts increased, it’s that they went higher than yields as the circle in the chart shows.

Gilts are usually lower than Treasuries because of massive hedge interest by UK pensions.

The whole thing started with a weak 30-year auction.

First, let me point out that the consensus is that gilts moved higher because of yields

Yields were already moving higher, but the weak auction revealed that investors wanted a premium over yields because of idiosyncratic issues specific to the UK that are linked to it’s fiscal policies. Further evidence of this is that the Sterling fell. Typically, a currency increases along with it’s country’s rates.

You need to know three things about UK’s fiscal space. One, the budget that was introduced in August 2024 was the biggest in a long time. Two, it prosed over 40B in taxes and 70B in spending creating an environment of reduced growth and increased inflation in the short-term. Three, it left little wiggle room for the government’s own expenditure therefore as gilts rise, so do interest rate expenses, which eat into the headroom. This presents a dilemma for Reeves: either raise taxes, or cut back on spending; both pointing towards stagflation (low growth, high inflation).

So you have increased uncertainty around fiscal policy and potential stagflation. The net effect is an increase in UK’s term premium—the idea that long-term bond holders need a higher return due to increased uncertainty over longer durations—to a higher level than the US.

The tumbling British Pound is a release valve because it makes UK assets cheaper to foreigners, which increases their attractiveness. That’s why FTSE rose 1.55% last week as US indices closed red. But a weak Sterling makes imports expensive (inflationary) so the BOE’s rate cuts have been pushed further back into the future.

FYI the British Pound closed near 1.2200 on Friday— the day’s low. This signals that this is far from over. The bond market want Reeves to give a clear path forward, but she is adamant that her policies, as they currently stand, will work. She has a hard decision to make and we will see how this all plays out.

🌐 Economic Releases

On the data front, some important numbers came to light. German CPI m/m came in at 0.4% vs a forecast of -0.2% prev. European and Australian inflation over a one-year period also rose (2.40% vs 2.2% prev. and 2.30% vs 2.10% prev.) This shows a worrying pattern of reflation among several countries.

UoM Inflation Expectations printed 3.3% vs 2.8% prev. Later you will see why this is a problem. The unemployment rate and the NFPs came in better than expected effectively pushing rate cuts further back to the future.

💵 Central Banks

It’s funny how Goolsbee said the rise in yields had nothing to do with expected inflation and then consumer expectations immediately said hold my beer. Goolsbee is adamant that inflation is cooling. He stated that inflation over the past six months was 1.9% and that current high annual inflation largely reflects the uptick of early last year. He expects rates to go down if conditions are stable and there is no uptick in inflation, with full employment…, and gave it a 1-1.5 year window: “12 to 18 months from now, rates would be a fair bit lower if current expectations are met.”, he reckoned. Concerning tariffs, Goolsbee said that it all depends on whether it was a one-off effect or not.

Other Fed members struck a similar tone on inflation. Fed’s Waller expects inflation to continue making progress towards 2%, but acknowledged that geopolitical conflicts and tariffs could be a source of renewed price pressure. Fed’s Schmid said he thinks the last stage of inflation could be the most challenging, and doesn’t expect inflation to reach 2% before 2026. Fed’s Collins sees housing factors as a major inflation driver and expects more inflation relative to recent past. Fed’s Harker noted that it’s taking longer to get to 2% but acknowledged that the Fed has had some success by getting inflation down from its peak. All of them agreed that labor is currently not an inflation driver.

ECB’s Villeroy is concerned that ECB rates are significantly above the neutral rate but said that if there is reflation, ECB rates will head to neutral by summer. The neutral rate, or R* is the rate that doesn’t stimulate or contract the economy. He estimates the neutral rate close to 2%. He also expressed concern over the widening spread between French and German rate spreads.

BOJ’s Osaka Branch Manager said that compared with previous year, more big firms in the region are expressing willingness to hike wages earlier than before. He also said that a significant number of firms are keen to hike wages so this year’s wage negotiations are likely to deliver solid pay hikes. The question is whether the expected wage hikes would be higher than inflation as the Economy Minister Akazawa said this week that they are aiming for an economy where wage gains outpace inflation. Akazawa remarked that “If BOJ manages to stabilize inflation around 2%, we can achieve wage growth that exceeds inflation.”

You can read all of this week’s central bank comments in this pdf.

💱 Currencies

GBPUSD lost -1.40% and closed Friday at the lows circa 1.2200. There is touted support at this level but absent a change in stance by Reeves, the sell-off may continue. Here is how other currencies performed.

There was dollar strength across the board on the back of speculation about universal tariffs, some fed talk, a stronger US jobs report and higher inflation expectations.

📉 Stocks

A lot happened in stocks this week. Here is how global indices performed (Note the 1.55% gain in FTSE after the Sterling’s decline made stocks cheaper to foreigners)

The volatility index rose this week to no one’s surprise. You can take your pick from several explanations: the S&P 500 lost 1.94%, effectively giving back it’s YTD gains; Trump floated the idea of a universal tariffs; and rate cuts were parred back by US data.

The Hang Seng continued it’s decline due to Chinese deflation worries and TSX fell after Trudeau quit and Canada halted it’s parliament.

Energy was the best performing sector this week as oil increased further and the narrative that energy demand will increase to meet AI’s needs. A notable mention among energy stocks is Constellation energy.

Insurance stocks were down because of the large compensations for the losses cause by the fires

Utilities with exposure to California also fell and XLU lost -1.95%.

Homebuilders were up 0.13%

Quantum computing stocks took a nosedive after Nvidia CEO Jensen Huang said that ‘very simple quantum computers’ are still 20 years. Shkreli had written a thesis on X saying a drop in this stocks was inevitable.

The are some charts circulating that show that US equities could continue the slide. Here are a few.

S&P 500 rich vs breadth

Correlation between equities and bonds is now negative.

Stocks may fail to continue higher because of bonds.

₿ Crypto

Here’s what happened in Crypto this week.

Sorry wrong chart.

The Crypto rally was postponed after Bitcoin and Altcoins retreated from their weekly highs. Bitcoin started the week strong—briefly breaching 100k—but then fell to a weekly low of $91,193.20. Doge dropped 12.7%. Ripple held up fine, relatively speaking (-2.35%) , and this could be why.

CMC pointed out that the funny thing about this correction is that no one seems to be worried it’s happening. There is no crying on X—okay, maybe just a little.

Also, there are large buyers at these levels who seem to be gearing up for a rally.

More companies are betting on Bitcoin and there are more ETF inflows.

The crypto rally hinges on how the Trump administration choose to regulate the asset. Google searches about ‘crypto regulation’ peaked after the election.

While crypto enthusiasts expect broad deregulation, the reality may be a few powerful regulations to eliminate bad actors while positioning America as the global crypto hub. I just hope the meme coins will be okay.

⛽ Commodities

Last week I mentioned that NatGas was poised to go higher due to bad weather and already-low reserves. NatGas opened a gap higher then spent the early parts of the week filling it—there were milder weather forecasts at the time plus China were reportedly selling it’s supply. It then rallied to close 18% higher as weather in the UK, US (a cold storm) and Europe was much colder than expected. The UK is reported to have had a night with temperatures below -19c—the coldest in 15 years. They came out to say that they think there is enough gas and electricity for the winter, but the use of the word enough was worrying. Later, Centrica warned that UK gas reserves are worryingly low.

Countries slapped more sanctions on Russia, and Biden warned that gas prices may go up further because of this. Here’s an up-to-date account of the effect of sanctions and why more sanctions are being piled on.

Dr. Copper, which sounds like a Bond villain, rose 5.82% due to high demand for US supply before Trump takes office.

Gold went up in a straight line to close 2.4% higher. I had highlighted a few reasons why the gold outlook is ultra-mega-bullish in last week’s newsletter but I suspect the move was just linked to yields and gilts.

Cocoa shed -5.94%. There are concerns of a poor harvest and Hershey’s are reported to be petitioning the CFTC to allow them to buy a sh** ton of it (9 times above the limits). Cocoa soared after the election to print all-time-highs in December. The previous ATH was reached in April last year due to many problems in Ghana, the second largest producer in the global supply. If you want to find out what happened you can read this article.

I’ve been looking for reasons why oil is up and the closest I found was this explanation by ING

🤝 Macroeconomics

🇬🇧 UK

I’m sure you’ve heard enough about Britain already. While everything hinges on what Reeves does, there’s a small chance she could be fired. Firstly, she is unpopular with the public who expect more taxes in future and with companies who had to foot higher pension bills. Secondly, her character is in question after it was uncovered that she had lied in her CV. Third, she could be the scape goat of an already quite unpopular party. Polls suggest that Starmer is as unpopular as Biden after only a few months in office.

🇺🇸 US

There were already concerns that the DOGE will not be as effective at reducing the deficit as they claimed. Musk is already recanting on the $2T figure.

We also found out the extent to which Trump is willing to go to push tariffs through. He is considering universal tariffs according to the Washington Post  and a National Economic Emergency—a law that gives him the ability to veto the senate and enforce the tariffs.

🇨🇦 Canada

I linked a tweet last week that explained why Trudeau was expected to quit by Monday. USDCAD bought the rumor but sold the fact after Trudeau resigned and announced that parliament would be halted until March 24th. That’s about all I know about Canadian political developments so far but I will keep tabs on it for future posts.

Canadian payrolls rose 90.0k vs an expected 24.9k, and unemployment dropped to 6.7% vs 6.8% prev. I thought this was bullish CAD, but Jared Dillian pointed out that StatsCanada’s figures aren’t to be trusted, and 40k of those jobs were government jobs which could change after the elections. Here is the full podcast.

🇯🇵 Japan

I see a few weak reasons why the BOJ may hike this Jan. Firstly, they believe that wages will rise a lot this year as more big companies expressed their willingness to raise wages. Economy Minister Akazawa said they want wage gains in their economy to outpace inflation, but the decision to raise rates is the BOJ’s to make.

This raises my attention because the BOJ typically do what the government wants. That they said ‘companies in a wide range of sectors and of different sizes’ and ‘some companies, especially smaller ones…’ sounds like there’s some progress but not a lot. So they may want the BOJ to hike as soon as possible to bring down inflation that is currently 2.9% vs 2.3% previous as this would help wage gains to catch up.

Secondly, dollar-yen is at levels where they have intervened before. Assuming they prefer not to intervene, they either expect US rates to come down soon, or they know a rate hike is imminent. We will find out more about their thinking in coming weeks.

🇨🇭 Switzerland

Swiss inflation fell

🇪🇺 EU

EU inflation rose

and EU sentiment is at it’s worst.

🇨🇳 China

Remember in last week’s post when I discussed how China could be heading for a deflationary period similar to Japan’s ‘Lost Decades’? This week, more wood was added to that fire as Chinese inflation came in at -0.1% vs -0.1% prev. China halted bond buying

and intervened in the Yuan.

They are playing defense because none of their stimulative measures have been well received. The Hang Seng index continues to erase last years gains. It dropped by -3.52% this week.

A story broke out in the WSJ about how Xi Jinping went after a Chinese economist called Gao who said their GDP figure is dishonest. Add all that up and the picture continues to look bleak for China whose 30yr rates are now lower than Japan’s.

👁️ Media Stories

Zuckerberg said Meta would abandon fact-checking in favor of community notes similar to X to promote free speech.

How Analyst Job Cuts on Wall Street Are Reshaping Equity Research- Bloomberg

🕵🏾‍♂️On my Radar

Developments in the gilts market and UK/EU weather.

Canadian political developments, especially their effect on oil and gas.

Yen rate hike possibility

📁 Docket

Expect the R* to make become a bigger concern in the narratives around rates. The concert move in rates this week shows that there is some kind of a global R*.

Global R-star by Andrew Bailey

🎶 Music

I spent a long time writing with the help of classical music. Don’t go away thinking I know about classical music—I just find it helps me write longer. This is the best one I heard.

🔖 Theoretical Stuff

The effect of borrowing on interest rates

Feedback and criticism are welcome.