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‘Worry When The Curve Steepens’, Nomura’s McElligott Warns

"What do prior cycles show us about market anticipation of the 'flip' to 'steepening' after the Fed’s last cut?"

When last we checked in on Nomura’s Charlie McElligott, he was busy updating folks on his (extremely) prescient mid-August call to play for a bounce in the “consensus” U.S. equities fund strategy/Long Growth/Momentum after a period of egregious underperformance exacerbated by the late-July selloff in Facebook and FANG+ and also by a squeeze in some of the market’s most-shorted names.

Thanks in no small part to the dollar taking a mid-August breather (on the heels of Trump’s Fed criticism, the PBoC’s move to squeeze yuan shorts, and the market’s dovish interpretation of Jerome Powell’s Jackson Hole speech), EM got a fleeting reprieve and the concurrent reduction in spillover risk from international turmoil to U.S. equities helped push the latter to new record highs. Along the way, hedge funds were forced to grab for exposure in order to catch up with benchmarks that had left them behind.

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Charlie eventually took profits on that recommendation after it performed extremely well into September and earlier this week, he expanded a bit on the idea that rates vol. could spike in October on QT pressures (i.e., Fed balance sheet rundown, ECB taper and BoJ reduction of JGB purchases).

He went on to suggest what more than a few other folks have tipped: namely that by mid-2019, the Fed will have reached a limit in terms of hiking without accidentally making policy so restrictive that it becomes perilous. After that, Charlie thinks we might see an inflection in the curve as the market begins to anticipate rate cuts.

“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”, McElligott wrote on Tuesday.

ED

(Bloomberg, Nomura) 

On Thursday, Charlie is back and his latest note features a look back at previous episodes when the market has anticipated an inflection point (i.e., an imminent steepening).

“The curve will steepen when the market believes that policy has transitioned into ‘restrictive’ territory, anticipating that ‘tighter’ financial conditions will then ‘bite’ the economy, ultimately driving the Fed to EASE (with CUTS then being-priced into the front-end)”, he writes, adding that “we are in the midst of witnessing a number of inversions / ‘kinks’ in short-term interest rate curves, with calendar spreads approx. one year out showing small CUTS being priced between mid-to-late 2019 and corresponding 2020 dates.”

So what do previous cycles tell us about the “flip to steepening”? Well, here’s Charlie’s retrospective, which we’ll present without further comment…

Via Nomura

What do prior cycles show us about market anticipation of the “flip” to “steepening” after the Fed’s last cut?

The ’98 experience: The ‘slowest’ market response–2s10s steepened 60bps 15 months after the Fed’s last hike, but amazingly only a year before the Fed actually cut again; shortly after the curve began steepening, the SPX began what was ultimately a 20% drawdown

The ’00 experience: Fed begins tightening again in mid-’99 following the EM & LTCM response helped created a final “blow off top” in Tech bubble;the 2s10s curve inverted in Feb ’00, and began to steepen in March ’00, a full two months AHEAD of the SPX local peak; ultimately, the Rates market “sniffs out” that the Fed is done and will instead need to cut again, steepening a massive 250bps while the SPX trades -37% all-in

Worry

The ’06-’08 pre-GFC experience: the Fed made their final hike in mid-2006, while the 2s10s curve began to steepen from -20bps in Nov ’06 to +44bps by Sep ’07; by the time the Fed actually began cutting rates in reaction to the housing slowdown, it was already “too late,” with 2s10s steepening 285bps all-in, with SPX down a brutal -52% over the same period time

Worry2

What could “push back” my mid-2019 timing-expectation for this “cycle shift” / “risk-off” signal? The Fed of course, as what the market constitutes as “restrictive policy” will be dictated by the potential for the Fed to “move the goalposts” with their assumption of where the “Neutral Rate” should be—theoretically then allowing for the absorption of more hikes / added “dots”

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