Is The High Yield/Commodity Rally Done For Now?

by: Batur Asmazoglu


Emerging Markets and Commodities have rallied since FOMC.

The FED has turned dovish on weaker data but.

Inflation linker bonds and break-evens have been going higher.

Last Wednesday, the FED surprised the market with a dovish statement days after the ECB. Both FED and the ECB extended a rally that was beginning to lose steam in the face of falling support from data flow. The dovish nature of the FED statement seems to have significantly reduced the risk of UST yields shooting higher. The dollar weakness that has taken over since the FED decision is helping push the emerging market currencies higher against the dollar. It is also helping investors put aside concerns about ability of emerging markets countries to borrow from abroad; slowing growth data from China and profitability of European banks. Most of the market players, including myself, have been surprised by the extent of dovishness that the FOMC expressed this past Wednesday via Yellen's presser and the dot chart. Given that the actual core YoY PCE has been rising for the last three months, it was widely expected that the FOMC would raise the forecasts for the level of core PCE at the end of 2016. For the time being it seems they see this as a temporary situation and we will see how it actually plays out in the coming months.

The FED's dovish signals may have been motivated by a negative turn in some of the US growth indicators. The non-manufacturing ISM has fallen by 5 points since October and it remained on a declining path in February. US pending home sales dropped sharply in January but these are examples of weaker data among stronger ones like employment.

The weaker data might prove to be statically insignificant in the larger picture after some months but after being given the green light by the ECB and the FED, are the risk markets still motivated to perform? An obvious challenge seems to be valuations in both developed and emerging markets are much less appealing than they were in mid-February. During the European High Yield and Sub. Fin. Credit meltdown valuations had clearly been taken too far in an attempt to sell in low liquidity. At the time, investors were worried about the currency devaluation in China, economic slowdown in US and European banks. However, as February progressed US data picked back up and the Chinese central bank got things under control. The rally afterwards that has been fueled by the ECB has been relentless. All of the spread widening that took place during the first six weeks of the year now has been completely unwound. The ECB's and FED's recent policy signals have pushed spread tightening even further but the valuation argument has naturally been eroded somewhat.

China data so far in March have been disappointing, past couple of weeks have seen the release of below consensus Chinese February data for external trade, industrial production and retail sales. The FED has revived the oil price rally in the recent days through USD weakness however inventory data does not seem to support higher prices. Despite shortcomings, investors are likely to hold on to the recent risk rally at least for a while but the rally seems to be becoming dependent on new triggers from the data flow. It looks like the growth data from developed nations and China will prove to be supportive however, the risk of pick up in US inflation remains in the picture. It feels and looks like it is now time to take these long risk trades off as prices have come to a fair level in both emerging markets and credit.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.