“Locally, the clear risk into US CPI today is a world still not set up for any sort of ‘upside surprise’ [on] inflation, with investors remaining at ‘peak skepticism’ levels”, Nomura’s Charlie McElligott wrote Wednesday morning, prior to the latest read on inflation stateside.
You can probably count folks still skeptical. Core CPI rose 0.1% MoM in May, below the 0.2% consensus expected. YoY, core rose 2%, also cooler than anticipated.
In the absence of a marked deterioration in the US economy, the Fed would still need to lean (hard) into the “subdued inflation” story when justifying preemptive “insurance” cuts. ISM manufacturing at Trump-era lows and a bad miss on May payrolls help make the case, but with the unemployment rate still at a five-decade nadir and confidence still largely intact, the data, in aggregate, hardly screams “emergency”. Subdued inflation thus gives the Fed an “out” – they can point to persistent undershoots to help justify rate cuts and fend off accusations that policy has become beholden to the White House.
This is critical for crowded rates trades, something Nomura’s McElligott discussed at length last week.
On Wednesday, Charlie delivers an update, noting that some of the froth has come out. “My anticipated tactical reversal of the Rates/Long Duration/Fed-easing ‘overshoot’ has seen ED$ calendar spreads remove over half a Fed cut in little more than a week”, he writes. EDM9EDM0 was -85bps last week, but has since come back to -66bps, for instance.
McElligott goes on to recap the points he made previously (see linked post) as follows:
Why the tactical reversal thesis? It was largely the belief that the most recent escalation of the rally was an “overshoot” caused by 1) dealer Gamma hedging of massive receiving- / curve caps- options exposure ( hedged via ED$ “grabbing”) and 2) “tourist” / “renter” risk-asset hedges in the front-end, which would idiosyncratically resolve themselves on the first sign of a pullback, as well as a fundamental belief that 3) the Fed remains locally more constrained than current market expectations give credit for, on account of the current all-time series low 3.6% U-Rate, still much easier financial conditions from the start of the year, as well as the Fed’s internal expectations for a pending surge in Core PCE off the back of the imminent fourth tranche of China tariffs…all of which likely merits “just” two Fed cuts in 2019 (“House view” of July and December)
In simple terms: A trio of factors conspired to turbocharge things, in the process creating the conditions for a reversal on any sign the Fed won’t (or, perhaps more aptly, can’t) ease enough to catch up with market pricing.
In addition to real money profit taking, Charlie observes mechanical paring of exposure from the vol-targeting crowd on the back of the spike in rates vol. “Both our Nomura QIS Risk Parity and CTA models estimate a meaningful reduction in gross exposure to UST 10Y futures MoM”, he writes.
“Even just a small beat [on CPI] would accelerate the Treasuries/Rates selloff, and risk the various (and still aggressively priced) Fed rate cut trades priced-into the market, with ED$’s particularly in focus for reversal risk”, McElligott wrote early Wednesday.
Alas, it was not to be. CPI was cool and those who aren’t just “renting” the trade as a risk-off hedge likely won’t be dissuaded from their Fed easing bets. That, despite the fact that Powell actually didn’t say “rate cut” last week.
Oh, and finally, May brought the coolest read on beer away from home on record.