On Monday, Nomura’s Charlie McElligott suggested that the details of recent Fed communications combined with China’s increasingly manic stimulus efforts and the currency stability pledge in the fledgling Sino-US trade pact together serve as a “tactical trading ‘green-light’ to pursue ‘reflation’ themes.”
As noted, all of that (with a particular emphasis on an assumed move by the Fed to shorten portfolio WAM in the interest of freeing up room for another Operation Twist later as well as a prospective change to the way the committee thinks about inflation) plays into the idea that the stars are aligning for a steepener, something that would have clear ramifications across assets.
On Tuesday, Charlie is back and he is in rare form.
After noting that the tactical reflation (i.e., reflation as theme for a trade) is still trending across global markets (helped along by three straight days of dollar weakness), McElligott gets right to it, posing the following question:
So here we are, with the US yield curve flattening having stalled and now a nascent but sneaky steepening (again, 5s30s from 21bps in late Sep19 to current 56.7bps) —but when does the US yield curve steepening really accelerate?
For Charlie, there are two possible catalysts, one being a material weakening in the data which would pull forward expectations for rate cuts, prompting bull steepening. The other is the converse, where the reflation catalysts he highlighted on Monday gather more momentum. To wit:
We see this “reflation-impulse” from the triple-impact of 1) the still-developing Fed inflation framework shift; 2) the de-facto Fed “easing” which has already occurred after pivoting away from B/S QT and forward-guiding towards “even odds” on either a cut or hike; and 3) the PBoC’s credit- / liquidity- surge gain further steam and this would alternatively likely drive a “bear-steepening” driven by long-end yields repricing inflation relatively higher than any hiking impact in the front-end—especially in light of the Fed’s new inflation framework shift to “run hot” on inflation.
That last bit sounds convoluted, but it’s actually not. The idea, simply put, is that if the Fed is willing to let inflation run hot, the presumed impact on the long end would trump any impact on the short end from a repricing (higher) of the rate path in response to rising price pressures, with the end result being bear steepening. That, presumably, would be a risk asset positive up to a point – you obviously don’t want to see a scenario where a vicious bear steepener threatens to drive up rates vol.
In any case, below are two notable charts from Tuesday’s note, with the visual on the left showing how important the Chinese credit impulse is for the reflation story (where that here means industrial metals) and on the right, a more poignant illustration of something McElligott talks about all the time, which is the importance of the inflation expectations factor for equities (he notes it explains some 20% of the S&P’s variation).
(Nomura, Bloomberg, Quant Insight)
Despite the current state of affairs that finds risk assets supported by the prospect of the dovish pivot from developed market policymakers, China’s efforts to reflate and progress on the trade deal, Charlie says folks are still asking him what could go wrong. Here’s how he puts it:
Even though it might seems like an impossibility right now with this “foaming at the mouth” market, I’ve recently been repeatedly asked “what could cause this Equities rally to see a reversal?“
To answer that question, he details a “developing scenario” characterized by seasonality around March quarterly options expiry and a potential pivot point in his famous CTA model.
“The first potential catalyst would be the SPX seasonality around March quarterly Op-Ex, where we typically see stocks trade up into, then trade down out of massive quad-witch ‘serial expiry’ (this year on March 15th)”, he writes, adding that “this is particularly important in light of the currently VERY high %iles in SPX / SPY / QQQ consolidated $Delta / and QQQ $Gamma”.
As noted above, Charlie says this is especially critical right now because it will collide with i) Nomura’s estimates that three quarters of the S&P will be in their blackout windows, and ii) what he says are “potential outright SELL flows, as our forward-looking CTA model indicates that over the next two weeks, we will see US Equities deleveraging / sell ‘pivot’ levels being mechanically pulled-higher, as 1Y ago, we saw markets rally powerfully into March Op-Ex—as per standard seasonality.” That latter bit is related to the weight of the 1-year window in his model.
Here’s a visualization of the blackout point:
And here is yet another new way to visualize what’s going on with McElligott’s CTA model – I haven’t seen this particular variant yet, but I think you’ll agree it’s particularly colorful (figuratively and literally):
The gist of this is that while the reflation trade made be viable for a time assuming the market continues to believe that a combination of i) the coordinated dovish pivot from DM central banks, ii) China’s ongoing efforts to juice anything and everything in sight with new credit creation and an apparent rolling back of the years-old de-leveraging push, and iii) the implicit weak dollar policy (not to mention generalized risk-on vibes) baked into the prospective Sino-US trade deal, is sufficient to sustain the risk rally, the end-of-cycle worries aren’t going away and even if they dissipate (say, on the back of some positive data), there are technical factors that could precipitate turbulence in March.
And with that, we’ll leave you with what Charlie says is the “punchline”:
The punchline then is this: IF we saw the seasonal post-OpEx pullback look even more extreme on account of the $Delta / $Gamma meet the “demand vacuum” of the onset of the “corporate blackout” window—all against now higher “sell pivot” levels in the 1Y CTA model for both SPX and NDX potentially driving outright SELL flows—we could have the makings of a “March Surprise”