Despite the panicky "reverse engines!" dynamic last Friday in the US rates market – with popular “reflation” trade expressions (which had been seeing vicious unwinds) suddenly breathing new life as Fed’s Dudley clarified his "misconstrued" comments on "little pause" with short-term rates hiking – RBC's head of cros asset strategy Charlie McElligott points out that 5y5y inflation remains stuck, EDZ7/8 curve is flattening again, and the EDZ789 butterfly too is again fading.
Nominal UST yields continue to be gravitationally ‘held’ around this low 2.30s level, ahead of today’s 10Y sale later…
SUMMARY:
- Last Friday’s ‘rates reversals’ post Dudley “clarification” not driving “reflation” follow-through across-assets.
- Still strong / expansive data (although signs of mean-reversion with regards to fewer ‘beats’ / more ‘misses’) proving unable to break the rates ‘range trade.’
- Fiscal / tax policy sentiment trending ‘worse,’ supporting UST ‘bid’ in conjunction with geopolitics.
- Crude the lone “reflation” stand-out but unable to single-handedly lift risk-assets higher against this backdrop.
- Key proxies going-forward: $/Y ‘breaking lower’ again will be a key ‘leading indicator’ with regards to risk-appetite, especially with regards to Asian sentiment and its impact on US rates–while 5Y breakevens are indicating lack of ‘belief’ in US inflation ‘stickiness.’ Both led S&P ahead ahead of its August / September ‘fade’ last year as well.
- Specifically to equities, reticence from buyside to take-down ‘net length’ now beginning to sting as recent ‘hiding-places’ are now dragging (index heavyweights in ‘secular growers’ i.e. tech, cons disc) and generally very ‘high beta’ long portfolios (crowded ‘market’ factor) means increasingly painful drawdowns.
- The is especially notable in light of recent client conversations lamenting the performance drag from ‘long vol’ with some increasingly willing to go light on protection…while spot VIX is now +26% MTD which could perpetuate the performance challenges today.
Much the same way I’ve highlighted here for weeks that it seems that the economic data itself no longer has to ability to ‘tie break’ this range trade in rates, the ongoing inability for the White House / GOP to build anything even close to resembling ‘consensus’ on taxes continues to worry markets as well, which in turn is contributing to the overall UST ‘bid’ (this was actually the key driver in DB capitulating on their ‘UST short’ yesterday, acknowledging that taxes / fiscal stimulus are nowhere in sight, taking their 10Y yield target from 3.60 to 2.25!).
Over the weekend, AP picked-up on the obvious: essentially, that it’s ‘back to the drawing board’ over the D.C. holiday break on taxes. The House is pro-BAT, the Senate is anti-BAT and the White House is on the tape stating that a VAT is not an alternative option either (for now, at least)–AKA they are nowhere. In its current construct, you’re simply not going to get the depth of corporate tax rate cuts the market had anticipated, and there will be no bipartisan support if the GOP intends to retain their focus on the ‘top tier’ individual tax cut. Gary Cohn further muddled the optimism on taxes when essentially noting that taxes are likely NOT an August event, but instead that they “are committed to getting it done this calendar year.” Booooooh.
So despite / against all of these ‘UST-bullish’ inputs (not even discussing the ‘edge-less’ geopolitical flare-up), it should be noted that large swathes of the sellside over the weekend and into yesterday actually pivoted-back towards bearish on USTs. UniCredit and SocGen both noted ‘long duration’ caution over the weekend, on account of central banks having the tools to achieve steeper curves in conjunction with economic data ‘holding up well.’ JPM too piled-on but more aggressively in a note titled “Time to Whack Bonds” for the same reasons (hawkish Fed, data trajectory), while TD also pitched an outright ‘short’ call in UST 5Y.
The one MEGA-input for ‘reflation” that continues to do its part is crude oil. WTI is +12% off its March 23rd four-month lows, which also happened to mark the multi-month lows for many equities “reflation” proxies, but most-notably thematic “cyclicals vs defensives” pairs, “high beta cyclicals” and “value factor longs.” Crude has been the ‘straw that stirs the (inflation expectations) drink,’ and the potent-mix of demand for refined product (gas) ahead of driving season, the international inventory drawdown (ahead of US) and idiosyncratic factors like Libyan field outages all continue to point ‘bullish’ for crude here. Without crude doing this heavy-lifting though, it’s a near-certainty that stocks would be lower and credit would be wider. The refrain from many on the buy-side too is that crude upside is capped ~$55 / $60 level with US shales players continuing to come back online as well—thus there’s not a long of willingness to chase it higher. Perhaps this is why we’re not seeing quite the same ‘positive sensitivity’ with crude and SPX that we once-were, as the sentiment is viewed as “diminishing returns” off the “dissipating energy base-effect with limited upside.”
Equities-wise on the MTD, cyclical sectors had been ‘hanging in’ on account of crude’s performance (Energy, Indus and Materials all in top half of S&P sector performance table MTD), with the exception of financials. XLF is now -2.0% MTD, KBE is 2.9% and KRE is -3.4%. As curves flatten further on account of hawkish near-term Fed but against a significant amount of long-term economic doubts / anticipation of a ‘rollover’ with inflation, we’re seeing tactical / generalist longs throw the towel on a trade that has made money last year…
but to the 2017 ‘newcomers,’ the ‘long banks’ / ‘long financials’ trade has been a real dog.
Cross-asset, the month-to-date behavior in indicative of waning risk appetite, with ‘late cycle’ equities, gold, USD, long-duration, IG credit and ‘low vol’ equities leading—against negative performance MTD from EM equities, S&P 500, equities ‘growth’ (had been a ‘hiding place’), HY credit, ‘value’ factor, small caps and ‘late equities’ and copper. And again, today’s trade is only further driving this divergence.
At this point the two inputs I’m most watching for direction are $/Y and US 5Y breakevens. JPY is so interesting because it (not surprisingly) peaked with the Dollar following the Dec rate hike at the height of the “US domestic reflation” euphoria, and has continued to lose steam with the ongoing ‘risk-off’ strengthening in Yen. As the world’s legacy FX-carry ‘funding currency,’ it’s a ‘big deal’ when Yen is up against 23 of 25 EM currencies YTD, and up against all G10 currencies as well. To see Yen rallying further to new 4.5 month highs against the USD speaks poorly for risk. 5Y breakevens peaked in February and are now back probing the start-of-year lows. This is a simple read on ‘lack of believe’ with US inflation ‘stickiness,’ especially without a further move higher in crude on the transitory ‘energy base effect.’
$/Y AND 5Y BREAKEVENS AS RISK-SENTIMENT / S&P ‘LEADING INDICATOR:
So I think this ‘sums up’ the general belief from most into the past week: geopolitically, most have to assume baseline of no further escalation in N. Korea (especially with Chinese ‘assist’ post Xi / Trump meeting); Le Pen takes the ‘L’ in the second round France vote; and Tillerson keeps matters ‘civil’ with Russia driving a Syria ‘thaw.’ In conjunction with seasonal snapback in / 2.0% + 2nd quarter GDP and still firmly expansive global PMIs, it’s difficult to envision equities ‘stuck’ in this current range. And despite this recent equities malaise, spot VIX is now +26% MTD. So in one sense, you’re actually building the fodder for a ‘wall of worry’ melt-up in stocks post-Spring….right? It’s possible that this is the logic as to why we continue to see so little willingness by funds to significantly cut their net exposures recently despite so many papercuts springing-up.
The challenge of course is ‘getting through’ this period though, as the broad index is now finally trading against you. As such, those mega-positions in ‘hiding places’ such as the oft-mentioned “secular growers” (Tech, Cons Disc, Biotech) become increasingly turbulent and they don’t act so ‘defensively’ any more. And as I’ve been stating recently as well, the historically high ‘market’ factor crowding per the most recent 13Fs show us that ‘long portfolios’ are VERY HIGH BETA, i.e. they will overshoot on upside moves, but in this case, overshoot on drawdowns too.
As such, the one dynamic I’m really watching in equities continues to the 12m ‘momentum’ factor and risk of unwind here (as I showed a few weeks back to seasonal / historical proclivity for such a dynamic in April). This could definitely exacerbate the moves we’re seeing in mega-longs Tech and Financials.
via http://ift.tt/2nBuf4U Tyler Durden