‘It’s The Steepener, Stupid’, And Why A ‘Rogue’ Inflation Beat Is The Biggest Tail Risk

For all the focus this year on the steady grind flatter in the yield curve and what that might portend for the U.S. economy, it’s worth noting (and we’ve mentioned this before), that steepening opens the door to volatility.

This is a point that tends to get lost in the proverbial shuffle as the curve flattens and everyone starts to talk about inversion and recessions. It’s worth remembering that the February turmoil was accompanied by curve steepening.

Well, in his latest daily missive, Nomura’s Charlie McElligott draws a distinction between the kind of post-inversion steepening that he warned could be a precursor to a risk-off move and the kind of steepening we’ve seen this week, catalyzed as it was by a repricing of growth expectations on the back of (more) upbeat U.S. econ data.

“In this current case (as opposed to my mid-2019 ‘risk-off’ steepening scenario), the steepening is NOT being caused by the market sniffing a slowdown (and thus repricing hikes ‘out of’ / rallying the front-end)”, McElligott writes, adding that instead, “it’s the sudden repricing (higher) of U.S. economic growth via ‘hot data’ and slowly-but-surely, U.S. inflation expectations as well, which is ‘selling-off’ the long-end.”

Of course the extent to which bear steepening is seen as a boon for risk sentiment depends on how acute/rapid that steepening is. I’m not at all sure a vicious bear steepening episode would be digested well by risk assets; past a certain point, the concurrent uptick in rates vol. would almost invariably spillover.

In any event, McElligott goes on to note that for now, a growth shock-led steepening episode “is the catalyst for the ‘Momentum’ factor unwind, which corresponds with the reversal in the Growth / Value ratio, as ‘Long Growth’ / ‘Short Value’ has been de facto positioning and the performance driver for the last two + years.” Here’s a visual (or a set of them, actually):

(Nomura, Bloomberg)

In a testament to this, momentum was hit hard this week and the spread between the Nasdaq VIX and the “regular” VIX is now nearly at its highest levels since the late March/early April regulatory jitter-inspired tech rout:

Here’s a bit of further color from McElligott on this:

Why?  Because 1) enhanced U.S. economic expectations ( “real-time upgrading” of the “neutral rate” and the delaying of “end of cycle” expectations with EDZ9Z0 spread now firmly “positive” at 4-month highs) alongside 2) “percolating” Inflation outlook sees multi-year laggard (thus, “Value”) “Cyclical” stocks / sectors meaningfully outperforming the “Secular Growth” “hiding places” (FAANG / Tech / Cons Discretionary / Biotech etc), which were accumulated from the “lazy” multi-year “Slow-flation” U.S. economic narrative and are now being-reduced / at risk of being a “source of funds” for rebalancing.

That last point is notable. When you see the rotation, you sell what you’ve got, and everyone’s got the same handful of tech high-fliers, momo names and growth stocks. As far as the the market pricing in a “delay” in expectations for the end of the cycle, McElligott is referencing the move squarely back positive in EDZ9Z0:

(Bloomberg)

As ever, the risk is that we get “proof” that fears of an inflation shock are not entirely unfounded.

“Going forward, a rogue inflation beat without a doubt is the largest risk-off threat to risk-asset psyche, as it disrupts the current ‘steady’ pace of normalization and would pivot the ‘risk-positive’ narrative from ‘growing faster than we are tightening’ to then risking ‘Fed policy error’ due to ‘over-tightening risk'”, Charlie concludes.

In that regard, everyone dodged a bullet on Friday morning, when the AHE print that accompanied September payrolls was inline with expectations (i.e., we didn’t see a repeat of the August data, when AHE came in hot).