Nomura’s McElligott Asks: What Happens To The Rates Trade If Trump Really Is Playing ‘4D Chess’?

Jerome Powell is really up against it now.

As Mario Draghi learned on Thursday, this is one market that’s going to be quite difficult to “out-dove” (so to speak) and Friday’s US payrolls report has intensified expectations for rate cuts stateside.

About a week ago, it became apparent that if Powell is intent on delivering a “dovish surprise” going forward, he’ll need to, at the very least, confirm at the June meeting that a rate cut is coming in July. Now that the headline on May payrolls missed even the lowest estimate, Powell would probably have to go ahead and cut rates in June in order to fully placate markets.

Even Credit Suisse – which sees a rate cut in July – thinks it’s unlikely that the Fed will cut in June and, indeed, if they did cut this month, it would risk emboldening Donald Trump in the trade war ahead of the G20. That could be extremely dangerous.

“I will make that decision in the next two weeks after the G20. I will be meeting with President Xi and we’ll see what happens, we’re probably planning it sometime after G20″, Trump said Thursday, referencing his threat to slap tariffs on another $300 billion in Chinese imports.

Concerns about accidentally facilitating more tariffs aside, it may not be possible for the Fed to live up to what the market is pricing even if they wanted to. Importantly, Nomura’s Charlie McElligott thinks that when it comes to what rates are ostensibly “saying” about Fed expectations, we may be witnessing another “false optic”, although with different underlying drivers from what played out in late March.

Read more on the accelerants of the March bond rally

McElligott notes that he’s still committed to his core structural steepener view, consistent with the Fed commencing an easing cycle and “going big” right out of the gate. That said, from a tactical perspective, Charlie is concerned that things might have overshot based on a number of factors, including “renters” exacerbating the rates rally by piling into popular STIR trades as a hedge against risk-off moves tied to the trade conflict.

“My recent tactical observation on the all things ‘Receiving Rates- / Long ED$ & options upside- (and short ED$ calendar spreads) / Long USTs & options upside- / Long UST Steepeners- / Long Duration- and their positioning-related potential for a price overshoot… leaves me concerned about scenarios where the Fed could fail to meet the market’s incredibly dovish expectations”, he writes. In the event the Fed simply can’t catch up to the market (or at least not immediately), the risk is that these crowded trades get unwound leading to a “sloppy reversal”.

Charlie proceeds to describe what’s different about late-May/early-June (versus late-March).

“The latest Rates rally escalation again looks tied to negative convexity flows, but less-so via the usual suspects in MBS”, he writes, noting that this time around, it looks “more tied to extremely heavy-handed Dealer short Gamma hedging of legacy and massively popular low strike receivers and curve caps” which have seen “insatiable demand from the buy-side over the past year”.

That, in turn, prompts Charlie to suggest that the dealer short Gamma trade “has been a real flow behind much of the incessant and almost price-insensitive buying of ED$ ‘at the highs’ seen over the past few weeks”.

When you throw in the “renters” (mentioned above) and systematic investors levering up into previously suppressed rates vol. in an effort to sustain their exposure, you’re left with a situation that’s potentially ripe for an unwind. As McElligott puts it, “[this is] a dynamic where levels in the front-end have likely overshot [or] maxed-out for the time being, and have now potentially created a false optic of excessive Fed easing expectations.”

(Nomura, Bloomberg)

If the Fed disappoints those expectations, and if the “renters” turn into profit-takers, and if, as Charlie writes, you get “mechanical deleveraging from systematic target volatility funds [assuming] the recent spike in realized Rate vol were to sustain”, well then cue the “sloppy” unwind mentioned above. Indeed, he notes there’s already a bit of de-leveraging showing up in Treasury futs (chart on the left above).

Now, with all of that in mind, recall our discussion from “‘Maybe Trump Is A Genius After All’”, in which we suggested (somewhat jokingly) that this could all be part of Trump’s master plan. That perhaps – just perhaps – Trump is aware, if only by intuition, that while the Fed is inclined to ignore pressure from the White House, it’s not similarly inclined when it comes to market pricing.

As we put it on Wednesday, “perhaps fed up with the perceived recalcitrance of a central bank which, until January, was still hiking rates, Trump has finally decided to simply risk driving the global economy off a cliff in an effort to force the Fed’s hand.”

David Rosenberg suggested something similar this week. “What if he finally gets the steep Fed rate cuts he has been demanding? After that, he ends the trade wars, tariffs go to zero, and the stock market surges to new highs – just in time for the 2020 election!,” David exclaimed, in a tweet.

We focused on what happens to stocks in that scenario. In his Friday note, McElligott asks what would happen to the rates trade outlined above in a similar scenario.

Because we’re already bumping up against 1,000 words, we’ll just leave you with two final passages from Charlie:

The obvious fundamental input here besides “flows driving lower prices” is now the meaningful chance that EVEN IF the Fed were to move forward with a preemptive “insurance cut” of up to 50bps in the next 1-3 months… the market implied potential for 4 cuts before the end of next year looks like a “stretch,” as it would potentially require the “worst case scenario” double-whammy of 1) Tariffs and 2) Recession.

And even going further out on a limb, what happens to the Rates trade IF (big IF) this entire “Tariff Escalation” story is indeed the Trump “4D chess” conspiracy theory, attempting to force the Fed’s hand in getting a rate cut he so desperately wants, before thereafter inking watered-down trade deals in front of next year’s election?!  FWIW this was a constant point of discussion in my meetings last week in [Asia].