It’s been an eye-popping run for the 1-month price reversal strategy advocated by Nomura’s Charlie McElligott in December.
The trade – which he touted in a CNBC appearance on December 18 – has returned +6.5% this month and nearly 8% since what he calls the “pre-trade set-up” five days into the year-end turn.
By way of review, some manifestations of the pro-cyclical rotation trade which was part and parcel of the market zeitgeist in Q4 have been faded in 2020. We discussed that in a wider context here, but remember that Charlie’s call was actually a call on a “reversal of the reversal”, if you will. That is, Q4’s pro-cyclical rotation represented a reversal of the vaunted “slow-flation” trade, both in rates and stocks, in favor of higher yields, Value and Cyclicals. January, by contrast, has seen some of that reflation optimism faded via renewed outperformance of the “old” favorites (e.g., Secular Growth, Defensives, bond proxies and anything sensitive to duration).
The following chart shows that this year has been even kinder to this strategy than the seasonal would suggest.
Key to all of the above is the inability of bonds to selloff in earnest. Naturally, Q4’s reflation optimism precipitated bear steepening, and the assumption was that signs of an inflection in global growth in the new year would push long-end yields higher still.
But that hasn’t panned out. Instead, 10-year yields in the US are approaching YTD lows and the curve is now ~13bps off the late-December wides.
To be sure, bonds have benefited from the safe-haven bid tied to two largely unforeseeable events in 2020: The assassination of Qassem Soleimani and the outbreak of a deadly virus in China that’s stoked pandemic fears.
But there’s more to it than that. We talked about this at length in “‘Coiled’ Bonds, ‘Kinetic Tension’ And The Return Of Reflation Frustration“.
On Thursday, McElligott delves into this a bit further, providing some highly useful color around the resilience of bonds above and beyond the big-picture, macro forces (i.e., in addition to the Goldilocks US economic backdrop, the likely morphing of Fed T-bill purchases into coupon buying, an impossibly high bar for additional Fed hikes and the structural factors weighing on inflation).
After touching on a “major uptick” in zero-coupon callable issuance, Charlie notes that “another catalyst… is the continued remarkable annual performance of US Equities, which then likely drives ongoing Pension Fund ‘de-risking’ / rebalancing into USTs”. He points to “the incredible relationship” between US Treasury stripping and S&P 500 total return over the past half-decade (left pane).
Over there in the right pane is spec positioning in ultras. Those folks are “getting punished by their massive shorts”, McElligott writes, citing additional color from colleague Ryan Plantz, who notes that “a huge portion of [the] recent short bias has been driven by heavy sales in the WN point of the curve which saw another -2mm/01 of selling in last week’s report [taking] the grand total of selling since the end of October up to -$56.5mm/01 (!) which accounts for more than half of the entire spec community sales over that period”.
Locally, all of these bullish duration/bull flattening catalysts are more fuel for the reversal strategy in equities, but looking further out, I suppose what we would note is that in the absence of a concerted fiscal stimulus push that is some semblance of convincing from Germany or China, and/or a political turn in the US that raises the odds of MMT (or, at least, “MMT-lite”) becoming a reality, it’s hard to see inflation expectations picking up materially. That, in turn, makes it difficult to project a decisive selloff in bonds.
You might point to the ECB and Fed strategy reviews as a catalyst, but the very fact that policymakers are having to embark on broad rethinks is itself evidence that the structural factors are deeply entrenched and, in fact, not well understood.
Bonus: Here is McElligott’s CNBC discussion from December 18