Back on September 19, as breakevens were … errr… “breaking” higher (taking the reins from reals when it comes to the bond selloff amid a rally in crude and a bounce in commodities more generally), we asked if the reflation trade might be making a comeback.
That week was a good one for the “convergence” trade. In fact, that five-day stretch in some ways vindicated those who began calling for a recoupling of downtrodden ex-U.S. assets with their buoyant American counterparts. EM outperformed and Chinese equities soared, for instance.
Fast forward a couple of weeks and oil prices have continued to rise on the back of Iran jitters and despite Donald Trump’s best efforts to convince the Saudis to engineer a pullback. Well, if oil continues to rally and drags the entire commodities complex along for the ride, it’s possible that could help underpin the vaunted “convergence” trade.
Have a look at the divergence (proxied by the ratio of the S&P to the MSCI All Country World) plotted with the BCOM:
(Bloomberg; more on this from Luke and Sarah here)
This is something Marko Kolanovic mentioned in his latest note, out last week. “Our view in favor of a rotation towards the RoW and EM is based on the premise that the global growth cycle is not over and that stresses in EM are much less severe than those leading into the 2015 crisis”, Marko wrote, on the way to noting that in 2014-2016, commodities plunged by 45%, versus comparatively meager recent losses.
Well, for his part, Nomura’s Charlie McElligott thinks we are indeed seeing a “Cyclical Melt-up 2.0”, which is (basically) another way of suggesting that the global reflation narrative (and thus the risk-on impulse) has legs.
“The pieces are in place for the tactical October ‘Cyclical Melt-up 2.0’ [with] USTs and USD on their back-foot post Canada / NAFTA 2.0, while Commodities and EMFX rally to multi-week highs [and] Brent moves towards its 100-month MA”, Charlie writes on Monday, adding that “this ‘up-in-risk’ trade comes despite disappointing Asian & Euro-Area Manu PMIs as well as a weaker Japanese Tankan print.”
Of course all of the above hinges in part on a continuation of a soggy greenback and on that score, McElligott says “the case for Dollar weakness continues, with ‘Policy Convergence’ again a talking-point (ECB-led but boosted by BoJ’s ongoing ‘stealth taper’), while too, we see the ‘rising trade protectionism’ global ‘left-tail’ downgraded.”
That latter point obviously refers to the new NAFTA deal.
Charlie goes on to note that October’s QT (Fed balance sheet rundown, ECB taper and the BoJ’s ongoing effort to execute the “stealth taper” without breaking something) appears to be emboldening the bond bears further. The 10Y short in the U.S. is getting ridiculous, for instance:
McElligott also reiterates the importance of the reversal in EDZ9Z0 (i.e., it’s not inverted anymore). There’s more on that here, but the bottom line is that, to quote Charlie’s Monday note, it represents “the buyside seemingly ‘upgrading’ their view of the U.S. economy by delaying the ‘end of cycle’ trade.”
The bottom line, from McElligott’s perspective, is that you don’t want to “get caught short into the Cyclical Melt-Up 2.0”. To wit:
The View: Expecting a strong move for “risk-assets” throughout October on 1) U.S. EPS-season “macro blinders” for Equities managers 2) “weak Dollar” perpetuating risk “virtuous cycle” (+++ for Commods & EM and broad “Inflation Expectations”) and 3) big “Quantitative Tightening” à “Bearish Rates” flows (“hawkish pivot” / “supply shock” / inflation trajectory) keeping pressure on UST yields (higher)—thus making “Cyclicals over Defensives” / TIPS over Nominals as the top tactical positioning for the month.