Over the weekend, we talked a bit about the “seismic battle taking place between the bullish growth, bullish risk asset, bearish rates reflationary consensus, and the bearish risk asset, bullish rates stagnationary camp.”
You can probably surmise which camp we fall into.
To be sure, the “stagnationary camp” has had its way of late (well, a little Friday jawboning higher of yields notwithstanding). 10Y yields have come under enormous (downward) pressure thanks to policy uncertainty emanating from Washington, a “dovish” Fed hike, jitters about the US economy (heightened by poor auto sales and a lackluster NFP print) and geopolitical tensions. Meanwhile, the dollar has been pushed lower commensurate with the rally in Treasurys.
But now we probably need to ask ourselves the opposite question we were asking just weeks ago. That is, it doesn’t look like the specs who frantically covered their 10Y shorts in the weeks following the Fed are too keen on putting on longs. And on Monday the dollar is taking its cues from rates. So once again we find ourselves at what BofAML calls “an inflection point.”
For their part, the bank thinks we’re now more vulnerable to “renewed optimism” (i.e. a move higher in rates and the dollar) than we are to more reflation frustration. But there’s a caveat with regard to how you should play things. Read below as BofAML explains why “breakevens are the wrong reflation trade.”
Trump trades, what Trump trades? We believe markets are at an interesting inflection point. The rates market is pricing the least hikes by the end of 2018 since the December rate hike. USD positioning is the least long in many years…
EM positioning is starting to look crowded…
Our markets have gone full circle on Trump trades, despite the fact that the political imperative to get tax reform done has only increased. As we have been arguing over recent weeks, rates and FX are vulnerable to renewed optimism rather than exposed to disappointment. However, breakevens are the wrong reflation trade.
Tapering reinvestments is not bullish for rates. At the same time, the FOMC minutes raised the prospect of a continued tightening of monetary policy including a tapering of reinvestments before year-end: “Provided that the economy continued to perform about as expected, most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the Committee’s reinvestment policy would likely be appropriate later this year.” As we have argued elsewhere, the main take-away from this should not be the potential pause in the hiking cycle as reinvestment tapering starts, but rather, what increase in term premium does the Fed expect tapering of reinvestments to deliver. As such we remain bearish duration and favour a short in real yields over a long in breakevens.
EM vulnerabilities are growing, making us cautious on breakevens. This is particularly true in light of the vulnerabilities in EM. A risk-off move in EM (and equities) would likely weigh on breakevens given the knock-on effect on the broader reflation thematic, as well as commodity markets in particular. A more cautious stance on EM therefore goes hand in hand with a higher information ratio in USD real yield shorts vs breakeven longs.