LIVE MARKETS Fed could lean more on balance sheet reduction as yield curve flattens

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FED COULD LEAN MORE ON BALANCE SHEET REDUCTION AS YIELD CURVE FLATTENS (1030 EST/1530 GMT)

Dramatic flattening in the U.S. Treasury yield curve has increased concerns that the Federal Reserve could go too far when it begins raising rates in a bid to tackle unabated inflation, and possibly tip the U.S. economy into recession.

The U.S. central bank could, however, lean more on balance sheet reduction to reduce the impact of rate hikes on the yield curve.

The closely watched two-year, 10-year yield curve reached 57 basis points on Monday, the smallest yield gap since Nov. 2020, and was last at 62 basis points. It has flattened from 92 basis points in early Jan. and 130 basis points in Oct.

While the curve remains far from an inversion, which is viewed as an indicator that a recession is likely in the next one-to-two years, it’s rapid flattening reflects increasing fears that the U.S. central bank could make a policy error.

Shorter-dated Treasury yields have surged and stock markets have been volatile as Fed officials including Chair Jerome Powell signal that they will take a more aggressive stance to stamp out persistent price pressures.

Deutsche Bank analyst Steven Zeng said that the Fed could shrink its balance sheet at a faster pace, based on the bank’s projections that excess liquidity, particularly in the Fed’s reverse repurchase agreement facility, could stay high for another two years.

“The implication is that the Fed could aggressively use balance sheet unwind as a policy tool to mitigate excessive flattening of the curve resulting from faster pace of rate hikes,” Zeng said in a report.

Money market investors lent the Fed $1.65 trillion in the facility on Monday as they continued to struggle with excess cash and a dearth of safe, short-term assets.

Fed policymakers on Monday said they’ll raise interest rates in March, but spoke cautiously about what might follow, signaling a desire to keep options open in the face of an uncertain outlook for inflation and a pandemic still ongoing. read more

(Karen Brettell)

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JUST HOW MUCH FRENCH M&A IS ON HOLD? (1005 EST/1505 GMT)

We’re less than 100 days away from the French presidential election which is typically seen as the worst possible time to announce a big M&A deal involving a French blue chip.

The idea being that with the campaign cruising towards full speed, many candidates for the Elysee palace would happily jump on any scent of controversy to make the failure of a deal a key proposal in their platform.

In that context, many analysts, such as at Barclays, doubt France’s leading supermarket groups, Carrefour and Auchan, would announce a deal, should one be ready, before the French head to the voting polls.

Why the controversy?

“We believe that the possibility of significant layoffs resulting from any potential deal, and the presence of financial investors, including private equity firms, will likely mean any transaction would be subject to close scrutiny by the French government”, Barclays analysts argued in a note.

“We can’t rule out that the latter could block any potential deal, as was the case last year, when Couche-Tard contemplated an acquisition of Carrefour”, they add.

At Bernstein, the research team notes that there would be clear antitrust issues given both groups’ large market shares and commented that competition authorities would “have fun” reviewing a potential merger.

How much potential Gallic M&A is on hold is anyone’s guess but it’s likely that now wouldn’t be the right time to consolidate the telecom sector or announce a pan-European deal involving a French bank.

(Julien Ponthus)

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U.S. STOCKS TRY TO PUT JANUARY BEHIND THEM (0939 EST/1439 GMT)

Major U.S. indexes are little changed on Tuesday in the wake of gains from the past two sessions, as focus turned to data on manufacturing and job openings.

Nevertheless, there is early strength in transports. The Dow Transports (.DJT) are jumping nearly 3%, underpinned by a surge in UPS (UPS.N).

This after the S&P 500 (.SPX) just had its biggest monthly drop since March 2020, and its worst start to the year since January 2009. read more

Meanwhile, Philadelphia Fed President Patrick Harker said it may be appropriate for the Federal Reserve to raise interest rates four times this year, and to move more aggressively if the factors leading to higher inflation, such as supply chain issues, are not mitigated. read more

U.S. January ISM Manufacturing PMI is due at 1000 AM EST. The expectation calls for a reading of 57.5 vs 58.7 last month. Prices paid is expected at 68.1 vs 68.2 in December.

Here is where markets stand early on Tuesday:

(Terence Gabriel)

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S&P 500 AND THE TEST OF A WARRIOR (0900 EST/1400 GMT)

The S&P 500 index (.SPX) is quickly nearing an area on the charts where it must prove its mettle to add confidence that its sudden strength is more than just a counter-trend bounce.

Last Thursday, the SPX ended down 9.8% from its January 3 record close. With this, the benchmark index closed at its most oversold level on a daily basis since late-February 2020.

Since then, it has mounted an impressive bounce of more than 4%, and reclaimed its 200-day moving average (DMA):

The daily RSI plunged to 16 last Thursday, suggesting the market was especially ripe for a bounce. Now, with the market’s rally, it has recovered to the 50 area. However, it is facing the resistance line from its early November peak.

Meanwhile, despite reclaiming the 200-DMA, the 100-DMA, which acted as more direct support throughout much of the 2020-2022 advance, is still resistance at around 4,570.

Additionally, the SPX’s January 10 low at 4,582.24 appears to be another key hurdle. If the SPX can reclaim this level, coupled with the RSI regaining enough strength to move above the 70.00 overbought threshold, it could add credence to the view that the SPX found an important low last week.

However, if the SPX rolls under resistance, and closes back below the 200-DMA, which ended Monday around 4,435, it can suggest potential for new lows below 4,222.62.

In that event, traders will be watching for the 23.6% Fibonacci retracement of the 2020-2022 advance, at 4,198.70, to potentially hold again, while the RSI forms a higher low. Since early 2020, more enduring SPX lows have been accompanied by a bullish momentum convergence.

(Terence Gabriel)

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Terence Gabriel is a Reuters market analyst. The views expressed are his own

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