Bank of America: "We"ve Seen This Movie Before: It Ends With A Recession"

In a merciful transition from Wall Street"s endless daily discussions and more often than not- monologues - of why vol is record low, and why a financial cataclysm will ensue once vol finally surges, lately the main topic preoccupying financial strategists has been the yield curve"s ongoing collapse - with the 2s10s sliding and trading at levels last seen in April 2015, and with curve inversion predicted by BMO to take place as soon as March 2018. And, according to at least one other metric, the yield curve should already be some -25bps inverted. This is shown in the following chart from Bank of America which lays out the correlation between the US unemployment rate and the 2s10s curve, and which suggests that the latter should be 80 bps lower, or some 25 basis points in negative territory.

Here is some additional context from BofA"s head of securitization Chris Flanagan, who views "the recent sharp flattening of the yield curve, which has seen the 2y10y spread go from 80 bps to almost 50 bps since late October, as the natural course of events at this stage of the economic cycle. Unemployment is low, and probably headed lower, and the Fed is intent on raising rates to stave off future inflation; we"ve seen this movie before and it typically ends with a flat or inverted yield curve. Based on history (and gravity), we think the most likely path forward is that the 2y10y spread reaches zero or inverts sometime over the next year or so and that recession of some kind follows in 2020 or 2021. (Given that the curve has flattened 30 bps in just over a month, projecting an additional 50 bps flattening over the next year is not really too bold.) Of course, much can happen along the way to change that outcome, but for now that seems to us to be the most likely course of events to us."

Here Flanagan openly disagrees with the BofA"s "house call" of a steepening yield curve, and explains why:

We note that flattening is not the house call: BofAML rates strategists believe the curve will steepen due to easier fiscal policy, higher deficits, and a higher inflation expectation and the Fed will require higher 5y-10y yields as a precondition to flattening or inverting the curve. We recognize that the flattening process has already taken longer than we expected a few years back, due to multiple dovish Fed hikes, and we acknowledge the potential for what we think would be steepening detours along the way. In our Year Ahead Outlook, we tried to be especially mindful of the fact that a year is a long time and a lot can happen along the way. This would be a good example. Nonetheless, the Fed"s recent intentness on tightening in the face of low inflation readings makes us believe the last 50 bps of flattening likely will be achieved over the course of 2018.

Flanagan asks if a flattening curve is "a serious (grave) present day problem?" While it is true that a yield curve flattening and inversion always precedes a recession, the timing remains in flux. As a result, BofA notes that based on the history of the late 1990s and the 2005-2007 period, when the curve previously flattened into the 50 bps area, "we think it could be as long as 2+ years from now before spreads begin to meaningfully widen, which means 2020. In the meantime, again with history as a guide, we think securitized products spreads can continue to grind tighter. In other words, we are unlikely to see meaningful spread widening until recession actually arrives or is imminent. The recent sharp curve flattening is certainly noteworthy, but, in our view, it is way too early to start positioning for meaningful spread widening. The bull run in credit spreads has not yet ended and probably will last longer than many might expect."

Finally, for some timing context, BofA shows the following chart of GDP growth vs the yield curve: the curve hit zero by the end of 2005 and inverted in 2006; economic growth steadily slowed in 2006 and 2007 but it wasn"t until 2008 that the downturn accelerated. Credit spreads widened and began anticipating the downturn in mid-2007, after the curve had been flat for over a year.

"When To Worry?": How Long After The Curve Inverts Does The Recession Begin

The recent (bear) flattening of the US yield curve to levels not seen since before the GFC, a move which has only accelerated in recent weeks as the stock market hit all time highs, has prompted some to question the strength of the US economic cycle, and others to ask outright how long before the curve inverts, signaling an imminent recession. Here, as Citi"s Jeremy Hale notes, just as "Dr. Copper" can sometimes be viewed as a stock market precursor, so "Professor Curve" (particularly when inverted or aggressively flattening) can be viewed as a signal of that policy is too restrictive relative to economic fundamentals (especially when using term premium suggests the curve should already be inverted). That said, during an expansion it’s generally normal for the curve to flatten, as the economy expands and the output gap closes, as shown in the chart below. This can be attributed to expectation of a higher Fed funds rate, but also a lower term premium, or more ominously, an inability to pass through inflation to the broader economy, leading to tighter financial conditions which ultimately manifest in an economic contraction.

Putting the recent 2s10s flattening in context (blue line on chart above), assuming this cycle started at the December 2013 steepness of 264bps, the curve has flattened for the past 60 months. On average, historic flattening cycles last for 2-2.5 years and flatten ~270bps from peak to trough. As Citi notes, we have flattened three quarters on the way there, or roughly 204bps so far in this cycle, therefore in comparison to previous episodes; perhaps this flattening dynamic is growing grey hairs... but it’s certainly not finished yet.

Indeed, if history repeats, then another 67 bps flattening is implied before we see an inversion of the curve. And while this cycle of curve flattening has been particularly slow, assuming a runrate of 40bps of flattening per year, then we could see a flat curve within 18 months (Figure 3, left). So "should we be worried?" Citi asks and answers that, rightly or wrongly, market participants with grey hairs would preach that all is well until the curve begins to invert. Ah yes, but that"s not the full story, as Citi explains below:

Sometimes inversion provides a timely signal for the economic cycle a la 2000, where Professor Curve predicted almost the ding-dong high in the SPX. However the 2006 episode of inversion dished up 7 months of pain for equity bears, with 18% further upside for the SPX. Ditto for the 1989 episode where equities continued to rally 22% into the 1990 recession (Figure 3, RHS). For now, we’re comfortable with the flattening dynamic with regards to other markets but would become increasingly cautious as the curve approaches zero.

In other words, once the curve inverts, it could either mark the top-tick of the market right there... or leave up to 22% more in equity upside before stocks finally crash.

Citi"s optimism - for now - aside, one notable distinction about the current flattening is that, unlike much of the curve move in 2016, this one has been driven by the front end, i.e. a bear flattening.  The front end of the US curve has significantly re-priced since September with the extension of the debt ceiling and the realization that fiscal easing could be achieved by the Trump administration.

Also worth noting is that while the short end has been driving curvature, the long end has been relatively rangebound, at least over the past year. What Citi finds particularly interesting is that even with ‘impending’ fiscal expansion in the US and balance sheet normalization by the Fed, term premia are actually still negative and suggest that the nominal 10y UST should trade closer to ~1.6% if the priced in forward short rate was at end pre-Election levels (Figure 6, LHS). This would suggest that there is, of course, a risk that the unusually low term premium - pushed to near record low levels by foreign central banks QE and NIRP, herding investors into long-term US duration - could suddenly rise; of note, perceived inflation risk could reverse its course quickly if inflation
suddenly trended up.

Some Fed estimates suggest that term premium is ~0.9% lower than it would be without the Fed’s large securities holdings, and that this term premium effect will gradually diminish with the reduction of the Fed’s balance sheet. But the Fed’s normalization has been well telegraphed; therefore the market has had the opportunity to anticipate this for several months (this goes back to another point made by Citi"s Matt King that the market has lost the ability to discount the future). In fact, the central bank depresses the term premium by limiting the uncertainty surrounding monetary policy. In short, Citi is skeptical of the material  impact that BSA may have on nominal yields given a relatively hawkish Fed. Furthermore, as the Fed continuing to tighten, it is possible the US economy is ‘locking in’ any gains that may be passed through to CPI. It is worth noting that in the last two cycles, US firms (and others) have had trouble - if not found it impossible - passing wage costs through to prices.

So even if a curve inversion does not spell imminent recession, what is next for the (shape of the) curve? Well, more of the same flattening it appears, as the curve takes more aggressive steps to flatten.

As Hale explains, the term premia and the forward curve suggests further flattening ahead (Figure 10 bottom LHS and top RHS). It’s also worth noting that in the past throughout Fed hiking cycles, the curve flattens on average between 100-125bps (Figure 10  bottom RHS), we’re currently around half way through on that basis assuming the Citi Fed call is right. But relative to other cycles at this stage, perhaps we have moved far enough for the time being. Citi"s fair value model using ACM term premium, the breakeven curve and a proxy for the r* also suggest flattening is close to fair value for now (Figure 10 top LHS).

But more medium term as the Fed keeps tightening, the curve will likely continue to flatten, and may even begin to bull flatten, should inflation expectations fall further. Ironically, Citi concludes, if the Fed wants higher long-term rates, and with them a steeper yield curve, it may need to hold back on further interest rate hikes until inflation surpasses the target/ backward driven inflation expectations rise.

Until then, however, expect people to keep talking about the flattening yield curve.

One Year Later: These Are The Best And Worst Performing Assets Under President Trump

"A Happy Trumpiversary to all our readers this morning"

       - Deutsche Bank

Today marks exactly 12 months since the US election on November 8th 2016, and as Deutsche Bank writes in "A Happy 12 Month Trumpiversary For Markets?" a lot has happened in the last year, although most surprising may be that for all calls of market collapse should Trump get elected, the S&P 500 has actually soared over 20% in the past 365 days according to Goldman which recently calculated that the Trump rally so far ranks as the fourth-best 12-month gain following a presidential election since 1936, trailing only Bill Clinton (1996, 32%), John F. Kennedy (1960, 29%), and George H.W. Bush (1988, 23%). 

As Deutsche Bank then picks up, "needless to say that the victory was unprecedented and also a massive shock around the world. Following Trump’s victory, it was widely expected that we’d see a much higher chance of fiscal spending but also a reinforcement of the backlash against globalisation and associated forces of which migration policy and trade were probably first and foremost. In reality what we have seen in the last twelve months is plenty of evidence of backlash against globalisation, hostility and controversy, but very little in the way of fiscal policy."

Here is the rest of Jim Reid"s observations on how the market has progressed so far under president Trump.

The debacle around healthcare reform probably best characterises the difficulties the President has faced in that regard. So with today marking the one year anniversary, we thought we would take a look at how markets have performed over that time period. For the purpose of this we’ve included our usual monthly performance assets, as well as a few other US assets. First and foremost after running the numbers what stands out is the sheer number of assets which have seen positive returns. Indeed in USD terms, out of a sample of 41 assets, 38 have seen positive total returns.

 

As we know US equity market performance has been relentless. The S&P 500 has returned +23.5% over the last 12 months and has seen a positive total return in every month since Trump was elected. Interestingly this hasn’t actually been the best 12 month performance for the S&P 500 following an election. That award goes to the 1944 election victory for Franklin D. Roosevelt which saw the S&P 500 rally +36.8% in the year following. The twelve month performance post Trump ranks 7th in the last 23 elections. Meanwhile the Dow has rallied +31.5% and the smaller-cap Russell 2000 index has returned +25.4%. It hasn’t just been US equity markets that have seen blockbuster returns though. Indeed it’s very much been a global rally. The biggest winner is the FTSE MIB (+47.8%) while also in Europe the DAX has returned +34.1%, Stoxx 600 +27.9%, Greek Athex +38.2% and IBEX +24.9%. The UK’s FTSE 100 has returned +21.4% while in Asia the Nikkei is +25.5% and Hang Seng +30.7%.

 

In bond markets, as we know Treasuries have seen some huge ranges but ultimately performance has been benign. Indeed Treasuries have returned -0.1%. In fairness the big move for Treasuries came in the first few weeks of the election victory where we saw 10y yields spike nearly 80bps. If we take performance from the yield highs of last December then performance is actually more like +3.5%.  

 

More significant for bonds though has been the shape of the yield curve. Having spiked as high as 136bps, the 2s10s curve has now flattened to just 68bps and is at the flattest since 2007. The 5s30s curve (79bps) is also at the flattest in 10 years. Alternatively 2y yields have moved from 0.854% on election day to 1.629% now and the highest in the last year. 10y yields were at 1.855% on election day, touched as high as 2.626% in March and are now at 2.309%. The equivalent for 30y yields is 2.616% on election day, 3.212% high in March and 2.770% now.

 

So while equity markets may have benefited from high expectations for fiscal spending, US Treasuries have by and large priced out any expectation with each passing day under Trump’s presidency.

 

In terms of other markets, credit markets have returned anywhere from +2.9% to +14.4% with higher beta credit outperforming (HY and Sub-Financials). Emerging markets have also had been swept up in the rally with EM bonds returning +4.7% and EM equities +28.6%. Commodities have been more of a mixed bag. Gold is unchanged over the time horizon while Silver has dropped -7.8%. On the other hand Oil is up +26.6% and Copper +29.7%.

Bitcoin Bloodbath Leads Tech Stock Tumble; Gold Gouged As Credit Curve Crushed To New Lows

hmmm....

We started the day with a gold flash-crash...

Then Durable Goods data and The Chicago Fed"s National Activity Index both tumbled and massively missed expectations -smashing the Citi Macro Surprise Index to its weakest since August 2011...

Then Nasdaq (led by FANGs) tumbled at the cash open after levitating overnight  - oddly reactive to the tumble in Bitcoin...

Bitcoin was clubbed like a baby seal - down over 15% - the biggest drop since Jan 2015...

On the day, only Nasdaq closed red...markets closed weak (NOTE, the European close saw a buying panic reappear in Nasdaq briefly)

FANG Stocks fell most since the day after the tech-wreck closing NOT "off the lows"...

VIX was smashed back to a 9 handle...But as the chart below shows, it didn"t help push stocks back up...

Treasury yields all fell on the day - even the short-end was bid in a very strong auction. The drop started on the dismal data early...

The Treasury yield curve slumped flatter once again with 2s10s dropping to a 78bps handle - lowest since Aug 2016

2s30s tumbled again to 134bps - the flattest since the last recession begain...

The Dollar Index roller-coastered to end the day slightly higher...

Yen was sold hard today (and Yuan weakened)...

Both Gold and Silver flash-crashed overnight but rallied on the weak US data...

On the bright side, WTI Crude saw a modest bounce today... testing below $3 briefly...

We note that while Bitcoin was battered today, it found support at its exponential trendline off March lows...

All 20 of the largest cryptocurrencies were deep in the red...

Finally, we note that at least one corner of the equity market might be getting nervous about the S&P 500 Index hovering near all-time highs. Options contracts that pay off with a drop in the benchmark gauge outnumber those betting on a gain by a rate of more than 2-to-1, the most since January 2016, according to data compiled by Bloomberg.

Since the start of the bull market, the S&P 500 has lost 0.3 percent in the 10 days following put-to-call ratios at or above the current level, compared with a 0.6 percent gain in all 10-day stretches during that period.

May Payrolls Preview: The Tiebreaker

After a poor March jobs report, followed by an April scorcher, the May payrolls report due at 8:30am on Friday will be the tiebreaker, not only for the current state of the economy where both soft and hard data have been deteriorating in recent weeks, but perhaps also for the June rate hike decision, which as the Fed noted in its May FOMC minutes, may not take place without "evidence" that the recent "transitory weakness" in the economy is over. Here are the consensus expectations for tomorrow"s report:

• May Nonfarm Payrolls Exp. 185K (Range 140K to 235K) vs April 211K


• Unemployment Rate Exp. 4.4% (Range 4.30%-4.60%) vs April 4.4%


• Average Hourly Earnings M/M Exp. 0.20%, vs April 0.30%; Y/Y Exp. 2.60%, vs April 2.50%

Payrolls Expectation

In terms of overall expectations, the consensus is looking for 185k nonfarm payrolls to be added to the US economy in May - the same as the April consensus - compared to 211k actual jobs added in April. That according to RanSquawk would be in line with the 185k/month pace seen in 2017 thus far. On one hand, there is potential for upside surprise, as per today"s stellar ADP report which came in at 253K, far above the 185K expected. On the other, Goldman believes a favorable swing in the weather between the March and April survey periods boosted last month"s hiring pace, and suggests the 211k pace of April job growth "likely overstates the near-term underlying trend", as such there will be payback in the May report. Also, Goldman cautions that the ADP measure has been running above official private payroll growth so far this year, by 60k per month on average, so take it with a grain of salt.

Unemployment rate

The unemployment rate is forecast to hold steady at 4.40%, matching the lowest reading recorded since 2001, and beneath the FOMC’s NAIRU projection between 4.70% and 5.00% (made in its March forecasts). A 4.4% print would be stronger than the Fed’s own year end forecast of 4.50%. If May unemployment stays at or near that level, it would be further evidence the economy has reached full employment and is at full capacity, meaning virtually everyone seeking work has found a job, even if that doesn"t explain why wage growth remains anemics. If the rate dips lower, that could put upward pressure on wages and inflation, or alternatively it will prompt questions about the quality of jobs added.

Earnings

As a result, most of the attention is likely to fall on the earnings data for signs of inflationary pressures. Average hourly earnings (AHE) are seen rising by 0.20% M/M, easing a touch from the +0.30% pace seen in April. On an annualised basis, the pace of AHE growth is seen rising by 0.10 ppts to 2.60%. In its latest Beige Book, the Fed stated that “most firms across the districts noted little change to the recent trend of modest to moderate wage growth,” though many firms reported offering higher wages to attract workers “where shortages were most severe.”  According to RanSquawk, HSBC notes that though wage growth has picked up, as of late, it remains sluggish when compared to previous cycles. Looking at the May wage number in particular, Goldman warns there may be a negative surprise pointing out that the May payroll period ended on the 13th, which is associated with meaningfully below-average wage growth.

Goldman"s summary:

We estimate nonfarm payrolls increased 170k in May, a moderate slowdown from April’s +211k pace and modestly below the three-month moving average of +174k. While labor market fundamentals remained broadly stable – featuring a further decline in continuing jobless claims – recent deterioration in service sector employment surveys suggests hiring may be slowing at the margin. We also believe a favorable swing in the weather between the March and April survey periods suggests the 211k pace of April job growth likely overstates the near-term underlying trend, which we believe is closer to 175k (and should slow further as the economy moves beyond full employment). Relatedly, May is also an important hiring month, and labor supply constraints in some geographies and industries suggest some additional downside risk. On the positive side, both jobless claims and the ADP report suggest more favorable labor market fundamentals, and the end of the federal hiring freeze suggests scope for above-trend growth in federal employment.

On wages, Goldman warns there may be disappointment:

We estimate average hourly earnings increased 0.2% month over month and 2.5% year over year in May, reflecting the interaction of firming wage growth with negative calendar effects. The May payroll period ended on the 13th, which in our model is associated with meaningfully below-average wage growth. However, we are more constructive on wage growth generally, exemplified by the acceleration in the  employment cost index to a cycle-high pace in Q1.

Factors arguing for a stronger report:

• Jobless claims. Initial claims for unemployment insurance benefits declined, averaging 241k during the four weeks between the April and May payroll survey  periods, a new cycle low. Additionally, continuing claims dropped by an encouraging 63k from survey week to survey week, roughly the same pace as in the prior month.


• ADP. The payroll processing firm ADP reported a 253k increase in private payroll employment in April – above consensus expectations – suggesting a solid underlying pace of job growth. The ADP measure has been running above official private payroll growth so far this year (by 60k per month on average), and we believe the May ADP reading received a boost from the net strength in the financial and economic indicators also used in their model. These considerations make the task of teasing out the underlying signal from the report more difficult.


• End of federal hiring freeze. The administration’s hiring freeze n for federal workers (excluding defense and public safety) went into effect on January 23 and concluded on April 11 – the Tuesday of the April survey week. Its impact on overall payrolls appears fairly limited, with average monthly payroll growth in these categories slowing from +3k in 2016 to -4k during the three months of the freeze. The impact also seems minor when compared to federal job growth during the 1981 federal hiring freeze at the start of the Reagan administration (see Exhibit 2). Assuming the 2016 trend in labor demand growth continued this year, the cumulative impact of the 2017 freeze was approximately -20k (on the level of federal payrolls). Accordingly, we see some scope for an above-trend reading in tomorrow’s report,  reflecting pent-up labor demand (we assume +10k for total government payrolls).

Arguing for a weaker report:

• Service sector surveys. Service-sector employment surveys n have deteriorated somewhat in recent months, with the ISM non-manufacturing survey falling to 51.4 in April (from its recent high of 55.2 in February) and available May surveys weakening on net. Our overall non-manufacturing employment tracker fell to 53.4 in May from 54.4 in April, with declines in the Philly Fed and Richmond Fed employment subindices but improvement in the New York Fed and Dallas Fed measures. More encouragingly, the key labor market subcomponent of the Consumer Confidence report remained strong, rebounding 0.8pt to 11.7, not far from its cycle-high reading. Service sector payroll employment grew 173k in April and has increased 129k on average over the last six months.


• Labor supply constraints. We view the labor market as close to full employment, with the unemployment rate roughly 0.3pp below its structural rate and yesterday’s Beige Book referencing increased reports of labor supply constraints. As slack diminishes further, this should exert both upward pressure on wages and downward pressure on job growth. From a hiring perspective, May is a particularly important month, with non-seasonally adjusted payroll growth averaging 838k over the last five May reports. As shown in Exhibit 3, we find that payroll growth tends to slow during late spring in years with relatively tight labor markets, as defined by an above-median Q1 employment gap (i.e. 2017).1. Labor constraints appear particularly binding in May (and August) in these years. One potential explanation is that the May payroll  period occurs after much of the start-of-year seasonal slack has been wound down (earlier in the Spring hiring season) but before the entry of students and recent graduates into the labor force (in late May and June).

• Continued retail weakness. Retail employment growth has fallen n from its historical trend of 15-20k per month to -2k on average over the past six months. We believe the structural shift of retail sales from brick and mortar stores toward less labor-intensive e-commerce firms will continue to weigh on payrolls growth in that industry, with the impact on the order of 10k per month relative to its previous trend. This drag on retail employment has appeared particularly pronounced recently – with a 50k cumulative drop in retail payrolls over the last three months – and we note the possibility that weak brick and mortar sales trends in Q1 may be accelerating the pace of this structural shift. Similarly, we note the possibility that the weakness in April home sales and housing construction may have weighed on hiring in that industry.


• Seasonals. Since 2010, May payroll growth has surprised negatively relative to consensus in four of the seven instances. While this is only slightly more than half the time, the average surprise has been fairly sizeable at -50k over this period. This may suggest downside risk to the extent the BLS seasonal factors have not fully evolved to reflect this tendency.


• Job cuts. Announced layoffs reported by Challenger, Gray & Christmas after our seasonal adjustment rose sharply (+28k to 59k, a one-year high). Over half of the increase reflects a 20k layoff announcement at Ford Motor that was announced after the May payroll survey period. After taking into this account, the increase in May job cuts was more modest

Neutral Factors:

• Return to Normal Weather. We believe the early-March winter storms likely exerted a meaningful drag on March payroll growth and provided a boost to April. Winter Storm Stella hit the Midwest and East Coast at the beginning of the March survey week, with the level of population-weighted snowfall during a March survey week at its highest since at least 2005. This suggests the April employment report may have benefitted from workers in the establishment survey returning to their jobs in some industries. Our preferred aggregate of weather-sensitive industries (construction, retail, and leisure and hospitality) also rebounded, to +66k from -17k in March. Accordingly, we believe headline job growth in April likely overstates the near-term trend, suggesting scope for moderation in May.


• Manufacturing sector surveys. Employment components of manufacturing n sector surveys were mixed in May, with improvement in the ISM manufacturing employment component (+1.5 to 53.5), but deterioration in several regional surveys, including the Philly Fed, New York Fed, and Dallas Fed employment components as well as the Markit PMI subindex. Our overall manufacturing employment tracker pulled back to 0.6pt to 55.7, still a healthy level. Manufacturing payroll employment rose 6k in April, its fifth consecutive increase, and has increased 12k on average over the last six months.


• Job availability. The Conference Board’s Help Wanted Online (HWOL) report showed a rebound in May online job postings (+4%) following April’s 1% pullback. However, we continue to place limited weight on this indicator at the moment, in light of research by Fed economists that suggests the HWOL ad count has been depressed by higher prices for online job ads.

* * *

Other observations:

Impact on Fed policy:

• With the implied probability of a June hike at around 96%, it would likely take a horrific report to stop the Fed from lifting rates by 25bps. With the rate of joblessness below the Fed’s estimate of NAIRU, as well as its end-2017 target, it would likely look through a big headline miss, so long as wages don’t collapse.


• Many Fed speakers have been paying particularly close attention to wages, observing that they have been a notable weakness.


• Fed’s Kashkari (voter, dove) last month said there may be more slack in the labour market, arguing that stronger wage growth may pull more people back into the labour market, helping participation to rise.


• Fed’s Evans (voter, dove) points out that across the board wage growth has not proceeded as quickly as the Fed would have thought. A sentiment that has also been touched on by the Fed’s Kaplan (voter, slightly hawkish) too.


• Fed’s Williams (non-voter, centrist) went further, and described wages as “stubbornly soft.”


• In terms of Fed hikes, even if wages missed, it may still not be enough to derail the Fed’s hike plans. Pantheon Macroeconomics has argued that in the previous cycle, the Fed lifted rates when AHE were running at 2.60% Y/Y, and it then accelerated sharply to 4.00% within five quarters.


• Given rate changes operate with a four/five quarter lag, Pantheon says the Fed will be aware of the dangers of leaving it too late to raise rates.

Possible market reaction

• The market is pricing in just one full hike in 2017, with the implied probability of two hikes slightly better than a coin flip.


• An upside surprise in the Employment Situation Report may contribute to a repricing where the market converges towards the Fed’s forecasts, though with clear doubts about whether inflation can sustainably pick-up towards the Fed’s inflation goal (PCE has been easing as of late), it is unlikely the market and Fed’s view will converge.


• Given past market reactions, a likely expression to an upside surprise may be a flattening of 2s10s, a sell-off in the long-end, which could help to lift the dollar.


• Stocks are almost guaranteed to go up no matter the actual data.

As Breakevens Plummet, The Narrative Has Reset

For those following the progression, and most recently - unwind - of the Trump reflation narrative, below are some critical observations from Charlie McElligott, head of cross-asset strategy at RBC.

Big Picture: Narrative Reset

On January 11th, I highlighted the risks developing via a potential breakdown of the USD--specifically as it related to its role as ‘chief proxy’ for the “reflation” trade.  Since that time, we have seen the Bloomberg Dollar TWI -2.4%, and with it, reversals in popular “reflation” trades despite BOTH flat benchmark S&P stock index and US 10Y yields over this period: ‘cyclical’ equities have lagged ‘defensive’ equities / ‘long duration’ significantly; ‘value’ has lagged ‘growth;’ ‘small cap’ has lagged ‘large cap;’ ‘momentum’ and ‘anti-beta’ factor market neutral strategies are significantly outperforming Q4 leaders ‘value’ and ‘size;’ popular ‘long copper’ significantly underperforming popular ‘short gold’;  crowded ‘EM shorts’ squeezing higher (from EEM to EMFX); popular short EUR +1.1% over this window et cetera. 

Again, the thought was that these crowded trades needed to see some of the froth come out…and that is exactly what has happened.  Today we see more of the same, with popular Q4 longs like ‘value,’ ‘high beta’ equities, HY, ‘small cap,’ ‘early cycle,’ ‘copper’ and ‘cyclicals’ all down sharply while popular Q4 shorts / ‘sources of funds’  like ‘long duration,’ ‘low vol’ stocks, ‘defensives’ and ‘growth’ all squeezed higher. 

A current snapshot of market behavior shows us that we are in the midst of a number of ‘other’ large symbolic pivots in the narrative / backdrop

"REFLATION’ BREAKDOWN CONFIRMED VIA ‘BREAKEVENS’: The much discussed ‘reflation unwind’ is now being confirmed by the last holdout of the trade—breakevens—which finally PLUMMETED lower today.  Feeding into this of course is crude, as ‘the’ proxy for inflation-expectations (and S&P energy sector -1.4% on session / -5.2% YTD, 2nd worst sector in the index). 

The downside of the USD firming-up (see next ‘bullet’ below) for risk-assets and the broad ‘reflation’ theme is the point made in recent “Big Picture” observations: crude sets ‘inflation expectations,’ which are a primary macro price-driver input for stocks, rates, credit and commodities (duh).  As the Dollar strengthens now, instead of being a representation of “reflation” as it was at the start of the year…USD now might be transitioning back to a more historical correlation where it is a drag on commodities instead.  This could again change where ‘higher Dollar / domestic reflation’ again “synch” if we were to receive ‘Trump policy clarity’ (taxes) or more robust ‘hard’ economic data that would in turn keep the ‘growth over financial tightening / inflation’ hope alive.

Ironically, to this ongoing point as crude as the most likely factor with regards to both left- and right- “tail” scenarios for stocks, we just received today’s API data after the close with gave us a shocking 14.27mm barrel build (vs a 2.5mm build expected)—which makes the 2nd largest weekly build in US history.  Gulp. 

DOLLAR PAUSES ITS OWN UNWIND, REACCELERATING HIGHER AGAIN: The USD remarkably is now UP 5 days in a row after that initial YTD sell-off which we spoke about up top, proving that its own positioning-excess has ‘come-off’(Mark Orsley today noting that total spec positioning in Dollar futures has been cut by 28% from the recent start of year highs).  This USD-move is largely driven by the move lower in said ‘breakevens,’ which along with ‘nominal yields’ grinding lower again too is helping send ‘real yields’ higher for the first time in weeks.  

Qualitatively too we see a combination of factors helping USD in recent days as well: 1) Fed walking market expectations for a March hike “back up” (Harker ‘pile on’ last night); 2) a growing-sense that a border-adjusted-tax system being included in the eventual Trump tax plan is again pivoting and need by repriced higher by the market (too much debate btwn House and Senate for B.A.T. to NOT be gaining-steam, especially following the ‘upbeat’ Rep. Kevin Brady comments this morning—per the consultants’ language on acceptance between the House and Ryan, B.A.T. probability should be closer to say 70 delta, but taking more time to get over the line with Senate); 3) ECB collective messaging on ‘comfort’ with EUR level and a dovish Draghi yesterday as well as generic EU geopolitical concern pick-up; and 4) very nascent signs of ‘soft’ data converting to ‘hard’ (specifically with regards to ‘labor’ market data, following last week’s NFP print).

NICE PERFORMANCE ENVIRONMENT WITHIN EQUITIES HF UNIVERSE: Ongoing strong YTD performance of the stuff that was essentially a ‘source of funds’ during “peak reflation trade” (‘growth,’ ‘anti-beta,’ ‘quality’ and ‘momentum’ factors all picking-up now after weak Q4’s).  This is indicative of an equities buyside which has increasingly ‘scaled back exposures’ to the ‘pure play reflation’ stuff and ‘thematic Trump policy trades’ which had become extraordinarily susceptible to a rogue tweet or headline.  Instead, exposure to ‘secular growers’ (tech, cons disc or healthcare) or idiosyncratic ‘event-driven’ names instead of ‘pure cyclicals’ is now the largest driver of equity HF performance from a bias-perspective, while overall factor dispersion and correlation breakdown provides an optimal return environment regardless of market direction (the ‘holy grail’ for M/N).  As such, we see that HFR Equity HF Index YTD is +1.4%; HFR Equity Market Neutral HF Index is +1.3%; and HFR Event-Driven HF’s +1.6% YTD.

One challenge going-forward though is the potential of a market breakout higher, where anecdotally I still don’t see a ton of risk-appetite per recent meetings / marketing and PB data on nets / gross.  “Rich valuations” with “Trump uncertainty” / “implementation delays of pro-growth policy” language is the baseline response from clients in US (and the dreaded ‘geopolitical / election risks’ in EU), which speaks to a ‘pain trade’ melt-up scenario being highly-likely as positioning data still shows that many are begrudgingly along for ride with only one foot in the water.

NOT-SO-MUCH FOR MACRO AND SYSTEMATIC HEDGE FUNDS THOUGH: The ‘reflation trend’ had been your friend in 4Q16 for macro funds, where there was a clear trade on post the Trump election, which added gasoline to the fire of “higher USD, short USTs / ED$, long small cap / high beta cyclicals, long crude, long copper, long CNH, long HY credit, short EM, short gold, short Euro, short Yen’ trading.  All the stars aligned, and collectively, Nov and Dec were the best back-to-back months in YEARS for macros. 
 
Then January of this year turned so hard that even scaled-down ‘long USD’ –related trades came off and took performance with it.  Now we chop on absolute index levels by-and-large, while the particulars under the surface (thematic rotation) drive the real returns…NOT DIRECTIONAL BETS / MOVES ACROSS ASSET-CLASSES.  Not for nuthin,’ but the same dynamic hurts CTA / trend-follower / systematic funds.  Not surprisingly, HFR Macro is -0.6% YTD, while HFR Systematic is -1.3% YTD and SG CTA Index is -0.5% YTD.  And we’re now seeing a number of high profile ‘brand name’ macro funds with January data that is worse than the above.
 
VOL BLEED EATING INTO ALPHA: Comments from two separate clients today on protection / directional vol bets dragging on performance:

“Seems like people getting crushed owning vol for a move.”
“Can’t have any premium on…realized vol just continues to bleed away.”

Despite the seeming rationale behind the generic refrain--“Is Donald Trump an 11 vol President?”—it seems that the potent-mix of +++ economic data making a case for 3 hikes (especially jobs, inflation and “soft data” per “animal spirits”) and /or a Fed looking at the risk of being ‘behind the curve’ in light of potential fiscal stim, along with the overall central bank shift away from flattening yield curves is allowing for dispersion of returns (on both the asset class as well as sub-asset class -level) to run like we haven’t previously experienced in the post-GFC era.  Interest rates are again being allowed to move per market forces--at least in the US—and as rates volatility suppression became the calling card of the QE era, interest rates as the ‘vol trigger’ mechanism within modern market structure / asset management is slowly being reset.
 
MISSION-CRITICAL FOR RISK-ASSETS GOING FORWARD: As stated, ‘soft’ data has to convert to ‘hard’ data in the coming months or else; not-just ‘reflation’ trades, but the backdrop for risky-assets in general, gets very mushy.  If the ‘hard’ data can’t see follow-through, the basis for much of what was touched-upon above gets tossed: the Fed would then again possible lower their dot plot as hiking expectations are reset; the rotation into cyclicals and “stuff that works in a higher rate environment” gets reset (exposing everything from financials to industrials to value to HY to bank loans), and we begin talking about the dreaded “stagflation” (remember to watch BE 2s10s curve inversion).
 
See below—first chart is the Bloomberg US Economic Surprise data category ‘breakout’ showing a snapshot of “soft data driving the beats” from Jan 30th.  The second is post- today’s data, which shows that the extent of the ‘soft’ data beats is declining, but against a move higher in ‘labor market’ beats (last week’s NFP).  The downside?  Retail and wholesale sector misses accelerated as an offset.  Stay tuned….

US Yield Curve Steepens To 5-Month Highs As Rate-Hike Odds Soar

Since the last FOMC meeting (9/21) the probability of rate hike by December 2016 has soared from under 50% to 76% today (ahead of tomorrow"s Fed statement). At the same time, the US yield curve has steepened drastically (with 2s10s up over 20bps to 5-month highs).

Chart: Bloomberg

However, unlike the last 4 Fed meetings, the US yield curve is steepening into the statement...

Chart: Bloomberg

It seems something has changed this time. Whether it is technical pressure from Risk-Parity unwinds, or a growing concern of inflationary pressures building (as ISM/PMI pointed to this morning), it is clear bonds are starting to buy the Fed"s jawboning... no matter economic data expectations remain weak at best.