With stocks blasting off the moment today's stellar ADP report hit (even if subsequent PMI and ISM soft data roundly refuted the highest surge in private payrolls in over two years), pushed higher by the momentum ignition in USDJPY, some traders have declared today the day the reflation trade has (again) come back. Perhaps, however as RBC's Charlie McElligott correctly points out, something sticks out: "conversations with a number of clients shows me that many have been recently debating internally on ‘throwing in the towel’ on the trade, especially after the brutal start to the week with the US rates rally. That is what makes today’s move in US rates after the strong headline ADP print so remarkable and FURTHER anxiety-inducing for said ‘reflationistas.’ Treasuries suddenly cannot sell-off." And without both the 10Y, and crude, validating the move in stocks, it is only a matter of time before the anti-reflation trade takes hold in stocks. Here are some thoughts from RBC's McElligott as to what may be causing today's persistent bid in the Treasury complex.
# RBC Big Picture: THINKING OUT LOUD
#HOTTAKE: Crude +2.8% off WTD lows. Breakevens ‘firming’ after their recent weakness. Energy leading S&P sectors MTD / ‘value’ factor and cyclical ‘longs’ outperforming WTD in equities, while HY has led IG in credit over the same period. US banks index BKX is +2.0% off its lows made Monday morning. Booyah.
These are the things that the ‘reflationists’ have so desperately needed to see, as PNL from the trade in 2017 has been quite ugly relative to generic ‘index’ and / or ‘peer’ returns,whether for macro or ‘unconstrained’ funds. In fact, conversations with a number of clients shows me that many have been recently debating internally on ‘throwing in the towel’ on the trade, especially after the brutal start to the week with the US rates rally.
That is what makes today’s move in US rates after the strong headline ADP print so remarkable and FURTHER anxiety-inducing for said ‘reflationistas’...
# Treasuries suddenly cannot sell-off.
The ADP number should speak positively of course for potential upside in Friday’s NFP and thus, likely higher US rates (labor mkt impact on Fed hike trajectory)….yet on the day, TY is now FLAT (aided by an ISM non-manu which mean-reverted modestly lower on the headline print, as the ISM employment component printed weakest in 6m, although the ‘export orders’ index jumped to 62.5 from 57 prior and best since 2007, per RBC Econ Jacob Oubina).
So what is happening here? I believe that the Asian buyers of USTs are back, especially the Japanese, in conjunction with the start of their new fiscal year. Posit: they are ready to deploy cash after having significantly scaled-back activity over the past months into YE. The year-end Yen repatriation flows are done with…so they are back ‘buying dollars’ as USTs look cheap, especially with hedging costs so low (as cross-currency basis has cheapened enormously since January) and USDJPY at year’s lows (USD assets attractive). Makes some sense right? New incremental buyer returns to market, especially after having missed a buying opportunity at the start of their fiscal year, as the rally forced them to miss the move yet again.
Back to ‘reflation’ though and the funds who’ve been ‘long it.’
With USTs currently unable to sell-off (admittedly aided by heavy US IG issuance as well, and what is I’m sure ongoing short-covers from ‘late-comers’ to the ‘short rates’ trade), it’s going to again be getting nervy from the PNL side. IF these folks were to commence ‘capitulation,’ we’d likely see that ‘Maginot line’ at 2.30 level in 10s challenged and likely, broken. Obviously a break lower in yields would then impact the cross-asset world, with a thematic “up in quality” move, with money rotating into defensives and out of ‘high beta.’ In credit, this is an IG +++ move with HY as source of funds. In equities, this would only perpetuate the YTD trend of “into growth, out of value” / “out of cyclicals into seculars,” and also drive further strong performance in ‘low vol’ bond proxy sectors (Utes, Staples, REITS, Telcos).
All of this said, I still wouldn’t be throwing in the towel on ‘reflation’ completely at this point, simply on account of the sudden ‘one-sidedness’ of the sentiment shift AWAY from ‘reflation’ over the course of the year (especially post the ACA repeal failure). The two keys: oil and / or tax-policy ‘optionality.’
This is why I pushed the thematic ‘XLF upside / XLK downside’ trade earlier in the week, at the chance you get an upside surprise ‘trigger’ in either of the two x-factors. This trade would look interesting too bc of the positioning ‘kicker,’ with so much crowded into ‘secular growth’ tech as a new ‘safe haven’ free of business cycle and Trump policy risk, while conversely, $$$ is tactically coming out of banks as rates reverse lower.
The key for ‘higher oil’ is to see the ‘rest of world’ inventory drawdown to ‘flow through’ to US. Currently, that’s a nothing-done. The good news though (as noted the other day here) is that WTI Cushing crack-spreads remain at year plus highs, showing strong demand for refined product like gasoline ahead of the Summer driving season. And of course too, I believe the market is already in motion working to ‘price-in’ an OPEC extension, or even-better, larger inventories increase the likelihood for perhaps even DEEPER OPEC cuts which could get crude (and inflation expectations) again ‘going’, taking stocks higher, credit tighter and equity vol lower. We’d then see a new ‘kicker’ as the crude-triggered inflation impulse YoY gets new ‘legs.’ Tax policy ‘optionality’ is a MUCH hazier dynamic…because just as the market began sniffing potential movement for VAT compromise, the White House stated that last night it was off the table. Ugh. Nonetheless, because it’s ‘growthy’ and ‘reflationary’ impact is so theoretically massive, very few are going to ‘short’ it with a desperate Trump and GOP likely to pull out all stops to get something done that WILL at the very-least lower rates from current effective levels.
# So now to the flipside: lower crude and NO tax policy movement. This would almost certainly-drive the full ‘reflation liquidation,’ with rates seeing NEW LONGS (already being built per open interest breakdowns, but likely to then catch systematic / CTA buyers on the momentum of the rally) while too driving further money into ‘defensives’ and ‘secular growth’ stocks, which almost by themselves can keep the SPX at the index-level supported (think Facebook, Apple, Amazon, Netflix and Google and their embarrassingly high contribution to SPX index return YTD). Energy, Financials, Materials and Industrials would be in a truly bad spot. Add in concerns around the read on the state of the US auto industry (-4.0% in the past week) and you get a really bad sentiment swing.
And as per the nearly two-year macro factor regime, any swoon in ‘inflation expectations’ via 1) a move lower in crude and alongside 2) the impact of potential slowing of economic confidence (reversion of data as ‘fiscal policy / deregulation joy’ were to fade with ‘no news’ on taxes), it’s almost certain that FINALLY, stocks would see a repricing in risky-assets.....