“The Door Is Open To Surprises”: One Bank Warns On VaR Shock Potential

Late Friday evening, I noted that specs trimmed their record net short in Treasurys in the week ended January 23.

This (modest) short covering notwithstanding, I still contend we’re set up for a dramatic repricing of rates in the months ahead.

True, there are all manner of political black swans that could trigger a flight to safety bid, driving rates lower and in the process properly f*cking hedge funds whose net short position (relative to their historical net longs/shorts) is a six-sigma event.

Indeed, the “real” money (a term I think is something of a misnomer) is still long. Way long – if 5Y positioning is any indication.

(Detusche, CFTC)

Be that as it may, upside risks to inflation and anomalies like record low real rates in Germany argue for “surprises.” Surprises like the the taper tantrum and the bund shock of 2015 which dramatically reversed the ECB QE vol suppression that allowed vol sensitive investors to push the leverage in safe haven bonds.

For more on why “rate risk remains a focal point,” consider the following from Deutsche Bank to start your Saturday.

Via Deutsche Bank

Volatility has touched multi-year lows in equities in recent sessions, while remaining elevated in rates, an outcome we find to be consistent with our understanding of prevailing macro conditions. The rate risk remains a focal point on our risk spectrum, as we believe the repricing in this space will proceed with major central banks continuing to surprise the markets with less accommodative policies. A quick glance at measures of breakeven inflation reveals how these indicators have risen in major economies since mid-2016, including US (+80bp), Germany (+50bp), and Japan (+35bp), all three determined by 10yr inflation linked bonds. In the meantime, nominal 10yr yields have risen as well, but failed to exceed the move in linkers, leaving real rates negative in Germany (-90bp), Japan (-50bp), and modestly positive in the US (+35bp). An equivalent 2yr real rate in the US is still negative (-40bp). We believe negative real interest rates are only appropriate at times when central banks are engaged in fighting deflations and/or recessions. Neither of these conditions appear to be a meaningful risk in this environment.

This leads us to believe that central banks are still finding themselves behind the curve in normalizing their policies, leaving the door open to potential surprises. The Fed’s latest dot-plot, released in December shows a lower median for 2017 than what it was six months ago. Think about this for a moment. For all the changes that have occurred in investor’s perceptions of growth and inflation risks since then, the Fed is telling us it currently sees a lower path to fed funds in 2017 than it did back then. This is not sustainable and will likely reverse itself through the Fed acting more forcefully to normalize policy. The ECB’s decision to pass on any action earlier this [month] was in line with our expectations, as the central has surprised at its last meeting. In the meantime, it has been six months since the last time BOJ surprised the markets, so we are staying more attuned to the upcoming rhetoric from Tokyo.