We’ve spilled what feels like gallons of digital ink in these pages discussing the extent to which the consensus macro narrative for 2020 has coalesced around the idea that some 70 global rate cuts and an abatement of trade tensions will together usher in a sustainable pro-cyclical rotation.
That’s part and parcel of the street’s year-ahead outlooks, many of which call for a breakeven-led selloff in bonds. Year-end 2020 yield forecasts vary and, as we showed on Thursday, actually aren’t as high as you’d think they might be given what feels like blind faith in the reflation story and the street’s propensity to project higher yields a year ahead.
Still, the overarching point stands: “Reflationary growth” is the consensus view. Just look at the 2s10s, for example, which has steepened back out beyond 30bps to the widest in more than a year.
If you ask Nomura’s Charlie McElligott, the “spasm” into trades associated with the “reflationary growth in 2020” story probably isn’t entirely warranted.
“My 2020 view is much more realistic ‘return to goldilocks’ US economic environment–where by the end of the upcoming year that UST yields aren’t very far from current levels—as opposed to some of this outright giddy ‘reflation’ thematic which we currently see trading in the market”, he writes, in a Friday note that contains his year-ahead macro outlook.
He also reminds folks that he has, on too many occasions to count in 2019, “advocated that things are FAR LESS BAD than the ‘Everything Duration’ trade was indicating”.
Specifically, he cites the bond rallies in August and March as examples of yields overshooting to the downside in no small part “due to negative convexity spasms” which created an “imminent recession false optic in Rates”.
That’s something we spent a ton of time talking about around those episodes, especially in August. As JPMorgan’s Josh Younger observed at the time, “the magnitude of convexity hedging YTD was likely the largest of the post-crisis era”.
It thus made sense that yields fell further than what was explainable by fundamentals alone.
“Fundamentals explain less than half of the move in rates and inversion of the yield curve in recent weeks”, Younger said in an August presentation to clients.
Understanding that is what allowed Charlie to “nail the September Bond selloff on even the slightest ‘less bad’ inputs, particularly from US / China trade and global data”, he says.
Of course, with “bond risk” embedded everywhere thanks to consensual positioning under the hood in equities, where all manner of expressions were tethered to the vaunted “duration infatuation” in rates, the sharp bounce in yields in early September (and also early last month) had multi-sigma ramifications for crowded trades including and especially Long Momentum/Min. Vol. versus Short Value/Cyclicals.
Now, McElligott says the “things are better than anyone thought” story has likely become a little too embedded in consensus outlooks for the upcoming year — that is, we have, perhaps, swung a bit too far the other way, at least in terms of expectations if not actual positioning.
“As a contrarian, consensual group-think views into the year-ahead are often exaggerated and ‘fade-able'”, Charlie says, before delivering the following two highly amusing bullet points (and these are verbatim, which gives you a window into his unfiltered style):
Recall last year at this time you had GS projecting another 4 Fed rate HIKES over the course of 2019, while the Bloomberg MLIV user survey taken Dec ’18 was forecasting UST 10Y Yields to finish 2019 at 3.03%, while the consensus from economists was 3.32% (!!!)–versus the current reality of 1.93% LOL!
Even more hilariously for Bunds, last year’s Bloomberg MLIV reader survey was projecting a median forecast of 0.45% for German 10Y yields by end of this year, while economists forecast 0.90%–versus the current -0.23% (that’s NEGATIVE) reality
The bottom line, for McElligott, is that “there is a lot of ‘sudden optimism'” out there, reflecting investors’ propensity to get swept up in the new market zeitgeist, as the old, legacy “end of cycle slowdown into recession” narrative is suddenly out of favor, and dropped off on the side of the road like a bad date.
It’s possible that the “reflationary growth optimism” view will be little more than a “rental”, Charlie goes on to say. After all, he reminds you, “there remains no true ‘impulse reflationary growth catalysts” outside of everyone suddenly coming around to the fact that the world is not ending, and adjusting positions accordingly.
And so, McElligott lists four factors that he says will ultimately keep US yields in check, or at least in a range that likely doesn’t end up seeing the kind of upside breakout indicative of true, reflationary euphoria. We’re going to present these without further comment (these are slightly abridged):
- The Fed, whose asymmetric policy response reality going-forward sees almost “no bar” to CUT, versus an impossibly “high bar” to HIKE (requiring a sustained inflation overshoot); Thus, the current “still-benign” inflation dynamic will keep the Fed’s MonPol “easy” and focused on maintaining the current 20m lows in US “Financial Conditions
- “Goldilocks” US Economy is back, neither too hot nor too cold, with the same old “American exceptionalism” and labor data indicative of the health of the consumer, yet with such “tame” inflation—which means rates stay range-bound and can’t really break of out of this same 1.60-2.00 yields range
- Secularly, the “Three D’s” will continue to create a long-term investor “buy-in” to a slow disinflation “bleed”: the overall trajectory in the growth of Debt being disinflationary; fading Demographics being disinflationary; and tech Disruption being disinflationary
- And finally, US Treasury Bonds will remain supported near current levels based around my view that the Fed’s current “QE-Lite” of T-Bill purchases / Open Market Operations will ultimately over the course of 2020 turn into something that is closer to “OUTRIGHT QE”