Like it never happened.
Coming off a Wednesday defined by Wall Street’s biggest comeback of the year, Thursday found stocks comfortably in rally mode.
By the time the closing bell sounded, the S&P was up nearly 1.9%. It was the third-best session of the year, and the third consecutive day in the green.
As noted on Wednesday evening, sentiment would be driven by the yuan fix, and although the PBoC did, in fact, set the daily reference rate weaker than 7 for the first time in a decade, the fix was still stronger than estimates, suggesting Beijing is not in a hurry to escalate things further.
A little over an hour later, July trade data out of China showed a surprising uptick in exports and the imports print wasn’t as dour as feared.
Amusingly, the S&P is now up for the week, no small feat considering Monday’s 2.98% loss was the worst day of the year.
The bond rally was back – sort of. Thursday’s 30-year auction (the last of this refunding round) helped Treasurys pare morning losses, which came alongside reports that Germany is set to loosen up the fiscal purse strings. Ultimately, yields were richer on the day. The 10-year fell back to 1.72% from a day high of 1.788%.
Through Wednesday morning, 10-year US yields had fallen some 40bps over the preceding five sessions, the biggest five-day drop since the debt ceiling crisis. Obviously, the sheer scope of the rally (and the concurrent collapse in yields across the globe as the rate cut frenzy went into overdrive, likely helping to “confirm” growth and inflation worries), raises questions about how much further it can run.
“The reason to expect further gains isn’t a fair value argument; rather, it is momentum, and that the balance of risks is still skewed to the downside, be it due to a further intensification of the trade war, or no-deal Brexit risk”, Goldman wrote Thursday.
Although the bank turned neutral on duration today, they acknowledge the possibility that yields could fall further. “We believe the declines could take yields roughly 20-25bp below our current forecast levels (taking UST 10s to 1.5% as an example), but we expect this rally to be somewhat uneven across the various regions”, the bank says, adding the obvious, which is that “if recession fears mount with support from underlying data, yields could be headed lower than the levels we show in our risk intensification scenario, with 10y US Treasuries joining other G10 sovereign yields in setting new lows”.
And listen, this isn’t all about fundamentals and the power of narratives. Or if it is, you should understand that there are mechanical flow drivers at play once positioning gets lopsided and the pile on starts.
“Wednesday’s overshoot ‘stop-in’ across US Rates and USTs was not just about the usual narratives [be it] central bank policy errors, currency wars, races to the bottom, trade wars spurring a recession and/or ‘surprise’ rate cuts”, Nomura’s Charlie McElligott wrote Thursday, on the way to describing this week’s action in rates as yet “another reminder of the power that options market ‘Gamma’ holds over the underlying assets, in standard ‘tail wags the dog’ fashion”.
We’ve been over this on countless occasions in these pages and lord knows Charlie has pounded the table on it ad nauseam, but here’s the relevant passage from his Thursday note, just to drive home the point:
The endless amount of upside buying in US Rates- & UST- options as “end-of-cycle” hedges over the past year + have simply gotten Dealer vol desks (and a number of systematic Rate Vol selling strategies in earlier versions of the 2019 “Bond / Rates Rally”) short a lot of Gamma via this incessant Receiving “force-in” (with Convexity hedgers also part of the feedback loop as they mechanically “have to” chase new multi-year levels)…and all into an environment ripe with almost endless macro catalysts for a “right tail” move in Rates (most notably the CB “dovish pivot” due to the global growth slowdown / disinflation / trade war escalation) which has added a mechanical “pile-on” to the vapor moves.
This panicky action in rates has obviously been a key driver of cross-asset consternation, which is why it would be nice if it would abate. Of course, you don’t want some kind of abrupt tantrum spike in yields either, but the point is simply that, as McElligott went on to say Thursday, “the directional correlation between duration and higher rate vol should likely mean that a stabilization (or a steady reversal lower) of the ‘panic-grab overshoot’ witnessed Wednesday should help to calm the recent spike in broad cross-asset volatility”.
The wild card is the yuan. CNH was up 0.13% on Thursday, at 7.07, smack in the middle of the new “range”, if that’s what you want to call this new post-7 reality that traders are being forced to navigate. One-month implied vol. eased for a third session.
Fingers crossed. “Thoughts and prayers”.