The market always needs a story – a reason to get out of bed in the morning, so to speak.
In the post-election environment, “reflation” is that story and the extent to which that narrative is waxing versus waning pretty much determines how we’re going to trade on any given day (USDJPY is perhaps the best real time referendum on whether the market is still buying the Trumpian fairy tale).
The problem markets face today is that stories can only get you so far. The narrative itself is enough to drive markets in the short-term, but eventually, reality has to catch up to the story. Otherwise, it’s just that – a story. Or, “wishful thinking”, as it were.
If you haven’t been asleep since say, mid December, you’re aware that markets are losing their collective patience. Here’s a chart from Goldman that illustrates reversals in the Trump trade since the peak in the bank’s RAI:
That’s why I’ve said repeatedly that we’re at an inflection point. The Trump administration has to prove that the script the market has been sticking to since the election approximates reality. That is, is the White House serious about tax reform and fiscal stimulus, or was that all bullsh*t designed purely to get the President elected so Steve Bannon could implement his social agenda and promote nationalism?
And so, as we await Trump’s “phenomenal” tax plan (which I assume Gary Cohn is furiously working on somewhere, chained to his desk), consider the following from BofAML who notes that we are fast approaching a “show me the money” moment.
The impending “show me the money” moment
The market faces three challenges in assessing the post US election reflation trade:
- Gauging relative value opportunities – not all markets are pricing reflation chances equally, and two weeks ago we highlighted such opportunities in Asia and Europe.
- Benchmarking policy uncertainty – as we highlighted last week, high uncertainty can result in low volatility, which can result in attractive hedges.
- Evaluating the discrepancy between the rates market and risk assets – stable nominal rates are hiding significant tensions between real rates and risk assets. We believe that the next few weeks will see these addressed. As we argued before, the US administration will have to demonstrate whether a fiscal program is going to make it onto the legislative agenda before the summer recess. If it does, finding cheap reflation trades becomes paramount, policy uncertainty is resolved near term, and the contradiction between rates and risk is closed with rates and USD moving higher. If it does not, the market likely will focus on the most expensive reflation assets, and risk reprices lower. This creates asymmetric upside risks to the dollar and to rates, in our view.
Since its initial post-election repricing, rates have been trading in an incredibly tight range of 2.35-2.50% in 10y USTs. However, this hides a pronounced increase in breakevens, and decrease in real rates, partly responsible for the lackluster USD performance. That in turn suggests that the rates market is attaching a significant probability to a failure of the new administration’s goal of delivering fiscal stimulus. Should we get progress on tax reform, we believe this should be bullish USD and bearish real rates, as a growth impulse gets priced back into the market.
Real rates are interesting not just in their behavior relative to breakevens, but also relative to broader risk markets. As in the run-up to the 2013 taper tantrum and the 2015 Bund tantrum, real rates have dislocated dramatically relative to credit, volatility and equities. Progress on fiscal reform should allow the rates market to play catch-up. Disappointment, on the other hand, seems already priced in.