On Wednesday, hours before the Treasury selloff accelerated, Nomura’s Charlie McElligott warned that “the market’s skepticism on ‘higher inflation’ [is] a mispriced risk that could further escalate the rates selloff in unruly fashion.”
Fast forward to Thursday and it’s safe to say that the rates selloff has indeed become somewhat “unruly”. Although Treasurys pared overnight losses a bit once the U.S. got going, the 5-day 10Y yield chart is remarkable:
The catalysts are clear. Wednesday’s bond selloff was sparked by the ADP beat and a hot ISM services print, which together put a lit match to kindling that was extra dry thanks to the temporary abatement of budget woes in Italy.
As noted this morning, futures volumes surged, which means either real money longs capitulated and things subsequently cascaded or else new shorts were built, with the open interest data apparently lending credence to the latter contention.
On Thursday, McElligott is back and he’s got the following assessment to offer:
This is what happens when 1) global “real money” that has been skeptical of the “stickiness” of the U.S. economic trajectory combines with 2) a broad market that has been mispricing inflation upside (as I highlighted again as recently as yesterday morning—inflation, crude, wage growth, quits rate, u-rate…need I go on?!) which then runs head-first into 3) a “positive growth shock” via outright “hot” U.S. data—forcing capitulatory flows (further exacerbated by a sprinkle of MBS convexity hedge flows), and again justifying the leveraged community’s legacy “bearish rates” positioning.
There you go. He goes to marvel that Wednesday’s ADP print “was a +3.5SD surprise (vs the 6m returns), while ISM Non-Manu was a +5.8SD surprise.”
Next, Charlie observes that the market is now catching up to the dots as skepticism about the durability of the U.S. growth story gives way to a perhaps begrudging acknowledgement of reality:
This growth skepticism I have spoken-to previously has evidenced itself in Eurodollar futures calendar spreads, where as recently as late August, the market had only priced-in 1.5 hikes (~33.5bps) for all of 2019 versus the Fed’s projected 3 hikes (75bps); now, as of this morning, EDZ8Z9 has gapped wider and is now pricing-in over a full two hikes now (57.5bps).
In the same vein Luke noted this morning that cumulative Fed tightening priced in for calendar years 2019 and 2020 is now at 61.5 basis points.
As ever, this all comes back to the market’s perception that the Powell Fed is (quite a bit) more data-dependent than the Yellen Fed. The more data-dependent the market believes the Fed is, the more inclined everyone will be to knee-jerk-type responses to super-hot data prints like those we got on Wednesday.
“It was last week’s Fed meeting that really accelerated this interest rate sensitivity to the economic data, when Chairman Powell reiterated just how data-dependent the Fed’s policy normalization path will be going forward”, McElligott continues, before delivering a Spinal Tap reference:
The “real-time” upgrading of the market’s long-run neutral rate projection (which began in late Aug, but was kicked into overdrive from the early Sep monster AHE- “beat” and the “hawkish shift” from FOMC speakers which followed) has now, in the words of Nigel Tufnel, “gone up to 11” .
Next, Charlie notes that for now, this is the “good” kind of long end rate repricing as it reflects economic optimism.
“The inflection from bear flattening then to bear steepening is an important POSITIVE message for stocks, as it’s this upgrading of R-star / neutral rate which is re-pricing the long-end of the curve”, he writes, noting that this reflects the market’s implicit contention that “in the absence of an inflation shock (which would drive a front-end yield spike / ‘power flattening’ on ‘accelerated Fed’), we are on track to grow faster than we are tightening.”
Fingers crossed on that, because as noted yesterday (and as reiterated on Thursday morning), the market’s interpretation of rising yields can turn on a dime, and what’s been unfolding over the past month following the hot August AHE print has all the trappings of an inflation scare.
For now, though, I suppose McElligott is correct to characterize this as an “economic assessment upgrade” and to cite that in explaining “why we are not seeing that same rate (vol) shock bleed into risk-assets that we did in Jan / Feb.” Charlie says the “#1 client inquiry on Wednesday was this:
Why are higher yields not negatively impacting Stocks here?!
Again, the answer for now is that the market is interpreting rate rise as indicative of (and in step with) economic strength. For now.
It’s also worth noting that breakevens and the term premium still aren’t repricing sharply higher.
As far as what lies ahead, we’ll leave you with a handful of additional points from McElligott’s Thursday missive:
- Higher “data-dependence” also means an “asymmetric bias to react to positive data more than negative data”—i.e. the risk of “too good” of data means heightened potential for a Fed “policy error” / “over-tightening”
- Chair Powell’s comments yesterday then underscored the Fed’s willingness to “go past neutral,” which means running beyond “restrictive” policy – meaning they are prepared to “pump the breaks” on an “overheated” economy via “accelerated tightening” policy
- The fact that March ’19 hike probabilities are now at 71% (was down at just 45% at the end of August) communicates that both Dec and Mar are now “done’ in the markets’ eyes; and as it currently-stands, two more hikes would put us above the (intangible) neutral rate
- Historically, tightening cycles (especially where the effective Fed Funds rate runs north of the neutral rate) has meant some form of markets’ crisis along the way: Continental Bank failure / Latam debt crises in the early 80s; the Savings & Loans / Junk bond / Black Monday crises in the mid-to-late 80s / early 90s; the EM crises (Peso, Asia and Russia default) throughout the 90s into LTCM failure in ‘98; the dot-com bubble bursting in ’00; and of course the GFC in ’07-’08