Week ahead previews are of course a Sunday tradition here at HR, and I’m just going to come right out and say it: our last two week ahead previews turned out to be extremely prescient.
And it’s a good damn thing, because to the extent the last year’s worth of Sunday evening preview posts have conveyed a dour outlook or else implicitly suggested trouble was brewing, those week ahead previews were, well, not very prescient. So we were due, goddammit.
Our January 28 week ahead outlook post posited a scenario wherein a veritable minefield of risk for bond traders could result in simultaneous selling in bonds and stocks leading to trouble for risk parity and balanced portfolios just one week after Steve Mnuchin rattled the FX market with his weak dollar Davos rhetoric. Here’s that January 28 post:
Fast forward from that post to last Sunday’s week ahead piece and this was our headline:
Needless to say, the week before last was indeed “crazy” and last week was in fact full of “high drama”, with the former characterized by a dramatic drawdown for risk parity and balanced portfolios and the latter defined by the blowup of the short vol. ETPs and two separate days of the Dow falling 1,000 points or more.
Now that the “VIX Minksy moment” has cleared the deck in terms of the rebalance risk posed by short vol. ETPs and now that the model-driven selling is supposedly (more on why we say “supposedly” here) out of the way, market participants will be back to focusing on what caused things to come unglued in the first place: the fear that more evidence of inflation pressures will lead to more selling in bonds, ultimately pushing 10Y yields beyond 3%, a level that more than a few people are watching very closely.
Aside from Monday’s flash crash, there seemed to be little that could stop yields from rising last week as more evidence of fiscal largesse (think: the budget deal) continues to conspire with inflation fears to weigh on bonds.
As we detailed on Saturday night in “Release The Long End!“, the stock selloff may have served to transform the pension rebalance bid for FI into an offer, removing yet another impediment to rising rates.
“The approval of tax cuts brought expectations of higher interest rates since September, reflected in the increase in the risk neutral rate, which peaked in the past few weeks, but the recent sell-off has been driven by an increase in the term premium, reflecting inflation and fiscal risks,” Barclays writes on Sunday, before reminding you that the budget deal boosts spending by USD300bn over the next two years, which “adds to the large deficit increase brought by the tax cuts and [has] already triggered negative commentary from Moody’s.”
The fact that no discernible safe-haven bid for Treasurys emerged outside of Monday’s manic 3:00-3:10 panic buying is probably not a great sign if you think the bond selloff will continue to weigh on stocks.
and where is the Treasury safe haven bid?! aside from that knee-jerk lower in 10Y yields on Monday at 3:00, there doesn't seem to be any sign of a rally in bonds amid this equity rout
— Walter White (@heisenbergrpt) February 9, 2018
It’s against that decidedly precarious backdrop that we’ll get CPI this week. And yes, that’s just as dangerous as it sounds. A beat on that print could conceivably cause serious problems for equities to the extent it underscores what the AHE beat from the January jobs report seemed to be screaming.
“The risk, of course, is a strong CPI reading [as] that could push the 10-year yield toward 3 percent, from 2.85 percent now,” Bloomberg’s Brian Chappatta writes on Sunday, before noting that “at least some speculators expect such an outcome with block trades in puts on 10-year Treasury futures Friday pointing toward demand for protection against yields rising to that level by March 23.”
We estimate a 0.22% increase in January core CPI (mom sa), which would lower the year-over-year rate to +1.7%. Our forecast reflects a boost from January seasonality, and likely continued strength in shelter inflation. On the negative side, we expect a small drag from telephone hardware methodological changes. We estimate a 0.38% increase in headline CPI, reflecting firm consumer energy and food prices in January.
And here’s Barclays again with what amounts to a quick summary of everything said above:
The USD has benefited from the bout of global risk aversion and expectations of faster Fed tightening. The increase in yields, especially in the US, has morphed into a global equity selloff that soured risk sentiment, as investors worry that inflation could be making a comeback amid firming wage growth, requiring faster normalization than previously anticipated. However, still-subdued inflation does not offer much evidence to support those concerns. This week, the narrative will be put to the test with the release of CPI. We expect headline CPI to rise a soft 0.4% m/m (1.9% y/y) in January, aided by gains in energy prices. We look for core CPI to increase 0.2% m/m (1.6% y/y). Inflation is likely to remain under control, and we have revised our CPI path downward on updated energy assumptions.
So those are two pretty benign takes. And you better hope they prove to be correct. Whatever the case, that CPI number is one of the big event risks this week. Notably, we’ll also get inflation data out of the UK, days after the BoE delivered a hawkish hold.
Meanwhile, there were more indications over the weekend to support the contention that central banks are not as yet inclined to step in and rescue you. On Sunday, the ECB’s Nowotny said the following on Austrian television:
[The recent drop in equities is] a normalization, a reasonable wake-up signal to show that stock markets can’t just keep rising all the time.
Behind it there is an expectation in markets that central banks will increasingly raise interest rates, and there are certain good reasons for that. The U.S. is expanding. However, one has to say that the task of central banks isn’t to satisfy markets but to ensure overall economic stability. So if necessary, interest rates will have to rise and markets will adapt to that.
How does that sit with you?
btw. Nowotny on Sunday:
"The task of central banks isn’t to satisfy markets"
Cue Picard….. pic.twitter.com/lZY2neGwHP
— Walter White (@heisenbergrpt) February 11, 2018
Additionally, we’ll get Japan GDP this week. Remember, the more upbeat the outlook in Japan, the more markets will suspect that Kuroda will be inclined to follow the Fed and the ECB down the path to normalization. Don’t forget that if you want to time travel “all” the way back to January 9, it was the BoJ trimming purchases of 10-25Y JGBs that set the stage for the bond rout and effectively forced them to send a message later in the month that they were not going to let yields rise any further.
The Riksbank is on deck too as well as IP data from Europe.
Global stocks will start on the back foot. Last week was miserable for Asia (horrific week for mainland equities in China and the worst week since the crisis for Hong Kong), for European shares (DAX in correction territory) and also for emerging market equities (also in a correction). The first test will be if the late Friday rally in the U.S. helps everyone get up on the right side of the bed.
“Traders will be slinking into their desks hoping that Friday’s surge into the U.S. close means the bleeding will stop for now but after last week delivered the biggest rout in Asian stocks since 2011, expect any rallies at the start of this week to be fragile and fearful,” Bloomberg’s Garfield Reynolds writes, adding that “China and Hong Kong will be a key focus again after shares there led the recent rout and with just three days left before the Lunar New Year holidays start in China.”
Oh, and watch HY credit, which certainly seems to be cracking.
The last two weeks have indeed injured the bull – it does bleed. But a correction isn’t a bear market and as Goldman has been keen on pointing out over the past week, “drawdowns within bull markets of 10% or more (but less than 20%) are not uncommon (there have been 22 since 1945).”
Be that as it may, this fucker is on the run and make no mistake, it is wounded.
It’s been a helluva run, so there’s no shame if you want to get out now and watch from the safety of the chopper as one of the greatest bulls in history finally falls to its knees in what promises to be a truly epic death scene…