“With economic growth remaining weak and monetary policy being the main support for risky assets YTD, investors have been defensively positioned with an ‘up-in-quality’ bias”, Goldman writes, in yet another note documenting the dramatic rotations unfolding beneath the market surface, where the consensual “long Momentum/short Value” trade is, by some accounts, still in the early stages of what will eventually be remembered as a total capitulatory unwind.
The bank continues, noting that “positioning in ‘safer’ assets had become crowded during the ‘risk off’ in August and a number of the popular pair trades have become negatively correlated with falling real yields”.
The following chart shows the correlation of 10-year US real yields to a variety of crowded equities plays including long Momentum, long Min. Vol., Defensives versus Cyclicals, Growth versus Value and Large versus Small.
That’s a pretty remarkable visual, and it underscores the notion that the backup in rates in September was “patient zero”, so to speak, when it comes to explaining the epic factor rotations and reversals that were the talk of the proverbial town last week.
Now, 10-year real yields have retraced nearly the entirety of the August rally, and that’s come in lockstep with the Momentum unwind/Value surge.
“As the market repriced growth expectations higher, real yields increased alongside breakeven inflation and most of the ‘winning’ assets from August have given back those gains given the stretched positioning”, Goldman went on to write, in the same note.
The following visual shows how much of the August rally in the various YTD consensus trades mentioned above has been retraced in September:
Note that Momentum, Growth over Value and Defensives versus Cyclicals have now unwound the entirety of their respective August rallies and then some amid the dramatic rotations.
Still, some say this is far from over. The selloff at the long-end has taken a breather this week amid risk-off sentiment tied to the Saudi attacks and ahead of the Fed meeting. Meanwhile, indications from Riyadh that most lost production capacity will be restored relatively quickly pushed crude lower on Tuesday, dragging energy along for the ride, in a reversal of Monday’s action.
But the overarching story remains the same. Any sustained inflection for the better in the economic data combined with positive news flow around a burgeoning Sino-US “interim” deal, could lead to another selloff in bonds, to the renewed detriment of all the crowded trades at the heart of last week’s Momentum unwind/Value-rotation.
And remember, even as this is likely painful for some who have been piling into these trades, an ongoing rotation needn’t necessarily be bearish at the index level. “Given record high gross and near record low net exposure, the most likely way to increase exposure is by closing shorts”, JPMorgan wrote last week.
Underscoring the macro component, Goldman notes that “the Global manufacturing PMI [just] showed the first monthly increase after 15 months of consecutive declines”.
On that point, don’t forget that monetary stimulus acts with a lag. You shouldn’t be surprised to see manufacturing activity pick up in the months ahead in light of recent action from policymakers. That would go double if Beijing ends up putting the pedal to the proverbial metal with more fiscal measures and OMO cuts on top of the RRR cut.
Of course, this could all just as easily swing back in the other direction on any decisively negative trade outcome or other geopolitical land mine that triggers a flight to safety or otherwise undermines the growth outlook further.
At the end of the day, the fate of September’s “rotation flirtation” (as Goldman calls it) depends on the evolution of the macro story.
And if you had to describe that story right now, “fluid” is probably the best adjective.