RBC On The Treasury Standoff: “Someone Is Going To Get Hurt Badly”

Following up on his note from yesterday in which he discussed the unwind of the Trumpflation trade and the beginning of the “pain trade“, and having received feedback from clients following yesterday’s sudden reversal in the US Dollar (which is fading fast following the latest hawkish comments from Janet Yellen), RBC’s Charlie McElligott writes that the general tone is “downplaying fear of a larger VaR-episode (see: last Jan / Feb in the market neutral community via an excruciating factor rotation) developing at this point beyond the “now regularly scheduled” January mean-reversion, largely due to the remarkably-tight range now built-into US rates (as they ping between 2.30 and 2.40 for 10s and 2.90 to 3.00 for 30s).

That said, he notes that government bond shorts are staying firm as “leveraged funds are impressively adding to shorts last week despite the rally”, while ‘real money’ has continued to add duration, forcing a price stalemate. His conclusion “there is no clearer example of this positioning standoff than by looking at the CFTC 5Y UST futures positioning data– somebody is going to get hurt badly“

Additionally, below we present some additional commentary on other asset classes from the head of RBC’s cross-asset strategy.

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As I’ve been stating over the past few weeks, there are multiple fronts with regards to answering the “what inning are we” question and the ‘reflation trade.’ Per expectations, we see the ‘slow-to-turn super tanker’ real money community having to get more cyclically-geared for a higher-rate world (recall those CIO discussions in December where many noted that they hadn’t looked at banks / energy / industrials “in years” and certainly not as anything close to overweights). Not surprisingly and true to the YTD theme, last night’s NYSE MOC imbalances AGAIN were led by Financials (largest notional buy imbalance) and Industrials (3rd largest buy imbalance). With bonds, language we continue to hear from overseas real money (“the” demand driver for USTs over the past 5+ years) too is that they’d be sellers of a squeeze towards the 2.20 level.

Also, we see smart-beta ETF $$$ flows showing a “slow to get the memo” dynamic, where we see all of the back-half of 2016 equity factor themes perpetuating: ‘Value’ (dwarfing all others) and ‘Size’ (small cap focused) are dominating year-to-date ETF inflows against ‘Low Vol’ and ‘Momentum’ outflows. Status quo upheld.

All of these flows (real money reweighting and smart beta ETFs) are helping neutralize / dampen the effect of tactical traders unwinding their “Trumpflation” bets.

That said, I think the largest talking-point while making client rounds is that we’re clearly through the ‘easy part’ (one-way markets) of the ‘reflation trade’—and that this is now where we’re going to see the grinding / choppy moves with more frequent volatility and drawdowns.

Frankly, the “animal spirits” component of the recent blisteringly +++ global data in my mind is what is currently keeping the trade “propped-up,” and likely into the next quarter. PMIs and the consumer and business confidence readings portend an extension of the theme, which is why I think there are still months left to go, with a likely ‘force in’ in stocks to make new highs that will require higher rates.

For what it’s worth too, many in the tactical / discretionary macro community are looking at re-engaging on ‘long Dollar’ and ‘long reflation’ into this recent pullback, looking for the same ‘final push’ higher in coming months as the energy base-effect keeps inflation expectations firm (which as I must remind you continue to screen as the largest macro factor input of SPX price drivers) and as perceived reflationary-boosts ‘kick-in’ (wage growth / average hourlies earnings move higher as well).

From there though (say out 3-6 months), I believe it’s possible we hit a potential ‘double whammy’: 1) higher data brings higher expectations—which set up for data disappointments (thus the mean-reverting nature of economic surprise indices) and / or 2) increasingly hawkish Fed rhetoric (as exemplified by dove Lael Brainard’s pivot hawkish yesterday) off the higher data leading to accelerated Fed action.

Let’s then look-back to the market response post the Dec 14th 2016 Fed meeting: Stocks sold off hard as real rates screamed higher upon acknowledgement of the Fed’s ‘dot plot’ (3 hikes in both ’17 and ’18). Why? Because at that point I think the market realized that the significant moves we’ve seen with inflation expectations could set us up for a “pick your poison” scenario, where we see either a 1) stagflationary environment (as inflation surpasses growth) or a 2) ‘Fed behind curve’ error, where we are forced to tighten faster than the economy is growing.

These two scenarios will continue to weigh in traders’ minds looking forward. If we lose the ‘animal spirits’ and the headline data, there will be even more pressure on fiscal-policy (i.e. what NOW with the tax plan / how is it funded without a BAT?) shifts to hold risk-market at lofty levels, which could make the back-half of ’17 look like the first-half of ’16: long duration, long defensives / low vol / divvy yielders / ‘up in quality’ to the front of the pack. “Back to the future” if you will.

POPULAR TRADE / ‘JANUARY EFFECT’ UNWINDS HITTING THEIR ZENITH YESTERDAY?: