Tightening Tantrums, Cycle Highs And A Look Ahead To 2019

It looks like news that China is seeking the WTO’s blessing to slap sanctions on the U.S. for non-compliance with a ruling on dumping duties has soured the mood on Tuesday, serving as it does as a stark reminder that trade tensions between Washington and Beijing are likely to escalate materially going forward.

The dollar inflected higher when that Reuters story hit, reinforcing the notion that negative trade news is dollar positive. That’s been the controlling dynamic since April. Headed into 2018, fears that the Trump administration’s trade stance was a weak dollar policy by proxy along with twin deficit jitters weighed on the greenback, but by Q2, it became apparent that between late-cycle stimulus and the prospect of tariffs serving to drive up consumer prices in the U.S., the administration’s policy mix was actually a self-feeding driver of dollar strength. That same policy mix served to supercharge U.S. growth, catalyzed a buyback bonanza and bolstered corporate bottom lines, leading to a historic divergence between U.S. equities and the rest of the world.

The world seemingly reached a tipping point with that divergence in August, beyond which the dollar needs to take a breather in order to avoid an outright EM collapse that would invariably boomerang back to Wall Street. In other words, the paradox is that for U.S. stocks to make new highs into year-end, they actually need to underperform their global counterparts.

Complicating all of this is a Fed that’s pigeonholed by the overheating U.S. economy and the above-mentioned inflationary effects of the tariffs. That dilemma was underscored on Friday with the hotter-than-expected AHE print, which showed wages rising at the fastest annual pace since 2009.

(Bloomberg)

On Tuesday, Nomura’s Charlie McElligott is out with his latest daily missive and he touches on all of this on the way to providing folks with what he calls a “playbook”.

“The cross-asset universe is once again positioned-for a bearish move in U.S. Rates”, Charlie contends, before delivering a list of three factors to explain how we’ll “get there”:

1. The first piece fell into place last week, with the big “beat” in U.S. AHE YoY (along with last month’s +++ revision) helping to build a case for potential acceleration of Fed normalization in 2019 (or to drag mkt probabilities of ’19 hikes higher towards Fed dots), after the past few weeks had actually seen market implied hike probabilities in ’19 actually decline modestly
2. Now too we see the return of the “supply shock” catalyst for a “bearish Rates” move:  following last week’s massive U.S. IG issuance (3^rd largest week all-time at $60B), the market expects another $25-$30B in the pipeline this week (~$9B in high grade supply yday), on top of a combined $73B of 3-, 10- and 30- year Treasury securities to be sold this week–the 2^nd largest amount across said tenors in one week since 2010
3. The next catalyst for further “bearish Rates” developments: Thursday’s U.S. CPI data
4. From there, it’s about October’s large “Quantitative Tightening” impulse  between 1) Fed balance sheet runoff escalation (SOMA run-off “maxing out” at $50B), 2) ECB bond-buying reduction (with purchases cut “in half” from E30B / month current going down to E15B / month) and 3) the ongoing “stealth taper” from the BoJ off the back of their new YCC range allowing for reduced purchase amounts

We’ve talked about all of that at length. On point number 3, the worst possible scenario is that it too comes in above estimates (where “too” refers to Friday’s hot AHE print), heightening market concerns about a hawkish Fed and translating into real wage growth that’s even more negative than it was last month. Consensus is 0.2% MoM on core and generally speaking, it looks like Wall Street thinks the YoY print will edge back down to 2.3% (see here for details on the July report).

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McElligott says the price action on Friday following the AHE beat gives everyone “a glimpse into the future, as the U.S. wage growth data drove a powerful financial conditions tightening impulse across the ‘holy trinity’:  1) higher USD 2) higher real yields 3) higher inflation expectations.” For what it’s worth, it also snapped the 5s30s tighter still.

Obviously, that’s not great news for EM as it perpetuates the dollar liquidity drain meme that we’ve been documenting here for months on end.

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“Why is EM such an obvious example of ‘financial conditions tightening tantrum?'”, McElligott goes on to ask, before answering his own question as follows:

It’s an expression of the “USD Shortage” thesis–a mix of 1) Fed policy normalization 2) QT and 3) increased UST issuance to fund enormous increase in U.S. deficit spend–sucking USD / USD-credit from a world which has engorged on it during the post-GFC period.

Next, Charlie underscores the shift noted above, where U.S. equities’ ability to rise with a stronger dollar is now constrained, seemingly by the sheer scope of the EM pain and the concurrent threat of a spillover. To wit:

Specifically as “tightening” pertains to Equities, Quant-Insight now tells us that the price sensitivity between SPX and USD in the short-term (83d) macro factor model to be the most NEGATIVELY SENSITIVE in four months, after having seen the most positive relationship between the SPX and USD in a year and a half as recently as July. This tells us that “something inflected,” as now instead of the “higher Stocks, higher Dollar” relationship we have experienced for most of 2018 (as a read on U.S. assets displaying “positive-cyclicality”), the relationship has now “flipped,” with “higher Dollar” now a headwind for Stocks.

He goes on to make a similar point about the S&P, reals and breakevens. The market, Charlie says, is starting to think the Fed will have engineered restrictive policy assuming hikes in September and December.

“When taken in conjunction with Eurodollar 1Y out calendar spreads now about to inflect inverted (ED6-10 already inverted and ED5-9 to invert at Friday’s contract roll), it tells me that the Rates market is anticipating that the Fed at the very least will have stopped hiking interest rates ~ mid-year 2019 (with the UST curve likely then too to STEEPEN in anticipation)…if not outright expecting a potential for a small rate CUT thereafter”, he continues.

(Bloomberg, Nomura)

So what’s next? Well, Charlie is again calling for a possible spike in rates vol. catalyzed potentially by the QT “impulse” (Fed balance sheet rundown proceeding, the ECB taper to €15 billion/month and the BoJ’s efforts to try and at least take the first halting steps towards normalization with tweaks to JGB buying and tolerating more upward/downward movement in 10Y yields) and then, a “cycle-high” in stocks by year-end.

After that (i.e., in 2019), he sees the potential for the curve inflection mentioned above (steepening shows up when the Fed reaches the end of the road on hikes), to catalyze the long-awaited Growth-to-Value shift.

We’ll leave you with his notes on that and a chart that illustrates the latter point taken from one of his previous pieces.

I will likely express my view on the high potential for a spike in interest rate volatility in late- Oct following the “QT impulse”. Thereafter, in light of the ongoing performance challenge within the Equities fund universe (both HF- and MF-), I anticipate more “grabbing” thereafter into year-end with broad index likely printing a cycle-high in December.

2019–especially around the mid-year UST curve steepening inflection–then poses the opportunity to play for the largest “QE to QT” gem of them all: particularly “Value” over “Growth” opportunities within U.S. Equities, as the market reassesses owning “expensive” stocks in the 9^th inning of a cycle.