One way – the simple way – of describing market action this morning is that the relief “trade truce” rally has fizzled (again).
The slightly more convoluted way is to say that “the ongoing collapse in UST yields along with concerns therein surrounding the nascent inversions in the front-end of the UST curve (3s5s, 2s5s, 2s5s swaps, 1m USD OIS 2Y-1Y fwd spread) have markets again “reverse-engineering” a growth-scare. This fear in-turn is at least partially contributing to “risk-renter only” behavior with signs of widespread monetization of tactical G20 upside trades in everything from SPX (upside call- and call wing- vol was crushed yday) to EMFX tactical longs.”
The latter description of events in the past 12 hours is what Nomura’s Charlie McElligott uses to explain why the euphoric rally observed on Monday after this weekend’s “historic” dinner date between Trump and Xi – and which concluded with even more questions than answers – has ended, and the gap is on its way to be filled, while the yield curve inverted at two key front-end junctions, the 2s5s and 3s5s, signaling that either a policy mistake or a recession may be imminent.
But it’s not just the market recoil on the realization that little was achieved over the weekend – adding to the selling pressure are increasing signs that the global economy is headed for a slowdown as overnight we saw South Korea and Taiwan Mfg PMIs slump into “contraction” alongside declines from Singapore, Indonesia and Malaysia over the weekend, which in turn has slammed Australian 10Y bond yields which are nearing lows while Chinese 10Y bond yields currently sit at 20 month lows and, according to Nomura’s Charlie McElligott, “reflecting the severity of the growth slowdown.”
Meanwhile in the US, the next big scare is that the inflation bogeyman is about to go gentle into that good night, after a rapid decline in US inflation expectations has been a key part of this “growth scare” concern, with US Breakevens tumbling – alongside crude – and now sitting at 16m lows. This was confirmed by Monday’s ISM Mfg Report, which revealed that input costs are slowing dramatically, with the 60.67 print from the prior 71.6, a 17 month low and the largest decline in four years.
Takikng a step back to admire the big-picture, McElligott writes that with UST Term Premium again melting to lows last seen in September, “the risk is that a negative feedback loop develops where the ongoing rally in USTs is viewed both as 1) confirming a US slowdown and 2) “pulls forward” the already extraordinarily heightened market concerns surrounding the timing of a US recession.”
And sure enough, between the “perception risk” of the collapsing – and inverting – yield curve and the impact of collapsing crude and broad inflation expectations, the market is again at risk of the old “we have already tightened ourselves into a slowdown” mentality – discussed earlier by Nomura’s Bilal Hafeez who noted that Fed policy is now too tight – gaining further foothold and bleeding sentiment, which in-turn is accelerating the “end-of-cycle”/”policy failure” optics discussed over the weekend by JPMorgan.
And here a startling observation by McElligott, who points out that due to this shift in sentiment and collapse in growth indicators, instead of simple de-risking, he has seen macro hedge fund client “pivots” inquiring about transitioning from “end-of-cycle” trades into forward looking actual slowdown and outright recession trades (low-strike receivers / receiver spreads and maintaining their forward curve caps / fwd steepeners), to wit:
I am receiving increasing inquiries from macro funds inquiring on more defined “end-of-cycle” trades to play or hedge against the coming slowdown or outright recession looking out 1 to 2 years—low strike receivers / receiver spreads, with many maintaining their forward curve caps / forward steepener bets
Finally, the cross-asset strategist observes that his Risk Parity model also shows that the market’s most important strategy is in “de-risking” mode as the economic cycle turns sharply:
In a positioning confirmation / “nod” then to this growth- and inflation- slowdown scenario, it is finally worth noting that we see our Risk Parity model having added enormous notional size in global Government Bonds (USTs and JGBs) over the past month, against very large selling of global Equities and Credit.
While subjective, here is Nomura’s model showing how much stocks Risk Pars have sold in the last month…
… offset by buying of gov’t bonds.
Whether this means that risk parity is done liquidating stocks, or just beginning, remains to be seen.
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