Heisenberg Report

A Correlation Flip, And A Quick Recap Of Charlie McElligott’s 2020 Macro Outlook

For most of January, equities had no trouble pushing higher even as bond yields seemed to be gently suggesting that Q4’s reflation optimism was overdone.

Eventually, though, bonds stopped being so “gentle”. The coronavirus outbreak effectively added a fundamental justification to a bond rally that was otherwise explainable by, for example, a bullish seasonal, a simple fading of reflation narrative that perhaps overshot late last year and rebalancing flows as equities melted up.

More simply: In the virus scare, the market suddenly had a “real” reason to pivot back to the vaunted “duration infatuation”. In the final, dramatic act, convexity flows came into play and shorts covered, pushing 10-year US yields back down near 1.50% and 30-year yields below 2%.

Read more on the dynamics that pushed yields back near the August panic-lows

Headed into February, it was clear that equities had once again seen enough of falling bond yields. We’ve seen this movie before. Falling yields are supportive of stocks for a variety of mechanical, “textbook” reasons, but past a certain point, market participants can no longer ignore the message from the bond market about growth.

And so, over the last week+, we’ve seen the equity/rates correlation flip back positive (stock/bond correlation back negative).

“The spread of the coronavirus brought about a situation in which sinking bond yields were more indicative of fear about the growth outlook than a positive force for equity valuations”, Bloomberg’s Luke Kawa wrote, in this week’s edition of The Weekly Fix (the link is to a previous week’s edition, but you can sign up there – it’s free).

That suggests that, on balance anyway, days when yields rise will be days when stocks do the same, at least until the virus panic recedes.

Once we get beyond the virus – or, for the tinfoil-hatters among you, if we get beyond the virus and thus are still around to talk about rates strategy a year from now, as opposed to being boarded up in our basements eating canned corn and rationing drinking water – the path ahead for yields will ultimately be determined by the same, familiar dynamics that have become deeply entrenched. That is: Barring a serious, coordinated, global fiscal stimulus push, we’re likely to remain stuck in low gear.

With that in mind, I’ll leave you with a couple of passages from Nomura’s Charlie McElligott who, between delivering the usual rapid-fire tactical trade ideas this week, took a few minutes to recap his overarching 2020 macro outlook as follows:

Thematically, the Dec19 “reflation” trade was more a function of year-end illiquidity interacting with post “Phase 1” relief rally to create a “false optic” which lured many traders into the “Global Growth Bottoming / V-Shaped Recovery” narrative—which then went horribly awry as the Coronavirus tied-“growth scare” escalated thereafter.

Looking-out 1Y into end 2020, I am simply on the record as saying that there was no true catalyst for a “Rates Sell-off” to the extent that many strategist and market participants were prognosticating by YE 2020 of 2.25 or even 2.50 (thinking instead that we close year end 2020 in that ~1.70-1.90 range for 10Y yields) in light of:

  1. The Fed’s complete focus on maintaining “easy” financial conditions—and thus their asymmetric policy reaction function;
  2. A still-“Goldilocks” US Economy with “good enough” growth but still benign inflation;
  3. A high likelihood that due to the distortions which are being created in the Bills market (via OMOs) that the Fed will need to extend purchases into short coupons by April—and ultimately, front-end USTs thereafter—in order to created “ample reserves” and ease funding conditions;
  4. And finally, the long-term investor “stickiness” on the themes of 1) the never-ending trajectory of Debt accumulation, 2) the fading US Demographic impulse and 3) the negative impact of technology “Disruption” all conspiring into a “disinflationary” future state—at least in the absence of things getting SO bad that politicians are then forced to unleash powerful “Fiscal Stimulus”

Note that final sentence: “…at least in the absence of things getting SO bad that politicians are then forced to unleash powerful fiscal stimulus”.