“The market’s legacy ‘long’ position in US Rates and Duration has pushed to a very dangerous space now”, Nomura’s Charlie McElligott writes, in a Monday note which amounts to a deep-dive into the collision of the long-end selloff and the knock-on effect for US equities factor performance.
The better part of my own weekend was spent recapping and otherwise expounding on this. Long-end US yields are rising, the curve is steepening and that’s feeding a rotation in stocks out of secular growth, min. vol. and other expressions tied to the duration trade in rates and into cyclical value and high beta (it’s something of a “pain trade“).
This is the story right now, and if you’re intent on keeping yourself apprised of how reopening optimism is manifesting in markets, you absolutely have to engage with this dynamic. Note in the figure (below) how last week looked very similar to early September: A steep rise in long-end yields accompanied by outperformance from small-caps and value.
As McElligott reminds you, CTA’s legacy long in US rates and duration is attributable to “a decade of ‘goldilocks slow-flation’ and central banks’ intent on a ‘lower- and flatter- forever’ message via the mix of policy, large-scale asset purchases and forward guidance”.
The “100% Long” signal in Nomura’s CTA model for 10-year Treasury futs is “now through its deleveraging trigger, while the even more leveraged ED$ position too is now at risk of experiencing the same ‘un-emotional’, forced selling blast”, Charlie writes.
(Nomura)
Obviously, this kind of forced selling could exacerbate the bearish bond impulse emanating from optimism around the reopening story, rising crude prices with the OPEC+ deal now extended, massive supply from Treasury, the ongoing tsunami of corporate issuance and, of course, Friday’s blowout jobs report.
And let us (please) not forget what’s going on in Europe, where the Germans are leaning into fiscal stimulus, the EU Commission is pushing a €750 billion jointly-guaranteed rescue fund and the ECB is ramping up bond-buying, which paradoxically is bearish (for bonds) to the extent the market believes twin fiscal and monetary bazookas will lead to recovery and eliminate existential risks to the bloc (e.g., tamp down periphery spreads and quell “breakup” speculation, which has never really gone away).
McElligott calls all of this “death by one-thousand axe wounds”. Here is Charlie recapping it all in his signature parlance
Why are bonds breaking down with such a violent shock of bear-steepening? Death by one-thousand paper-cuts axe-wounds….
- The recovery in risk-sentiment into the global economic “reopening” has of course been breath-taking, as the U.S. May NFP posted a shocking +4.2 z-score upside surprise, while the U-Rate too was smashing +4.3 z-score positive surprise–with both triggering a wave of unwind from the YTD legacy risk-off / FTQ trade
- And as the macro “recovery” narrative has shifted over the past few weeks, the Fed’s desired “reach for yield” behavior (to create “wealth affect” via financial asset inflation and stabilization of “financial conditions” which can create a virtuous economic feedback loop) has been achieved in earnest, with risk-free yields suffering under YCC / negative rate talk relative to spread-product and risk-assets, which are de facto “back-stopped” by outright Fed purchases in Credit and “The Put” to do more
- One of the largest catalysts for the Bond selloff from a “secular significance” perspective has of course come from the German “capitulation” into fiscal stimulus and away from standard “austerity” profile, with the EZ “coronabond” debt mutualization arrangement gaining further traction–all too while Germany rolls-out their own large domestic economic stimulus package as well
- The long-end has been particularly sensitive to the v-shaped +70% rally off the late-April lows in Crude Oil as well, as further OPEC+ supply cut extensions squeeze further blood from that stone (already this morning we see Energy stocks exploding higher despite flat WTI–MRO +24%, OXY +20%, APA +17%, NBL +15%–meaning more “short squeeze” pain for legacy Cyclical Shorts, as “Value” continues to rip)
There it is – the new zeitgeist. That mirrors the running commentary from these pages over the weekend.
Charlie also mentions the obvious supply/issuance deluge as a catalyst for the steepening impulse.
“Clearly too we are dealing with not only the remarkable and relentless waves of UST issuance (particularly duration-weighted with the new 20Y) in light of the various COVID-19 stimulus bills, but US Corp issuance has simply been unprecedented in this ‘rush to fund operations’ surge due to the multiple economic shocks as well, with YTD IG Corp issuance at $1.336 TRILLION, as YTD %Δ running ~ +89%!”
That latter point can’t be emphasized enough, although I’ve certainly done my best to pound the table until my hands are sore. Here is the bar chart again on IG (and HY) corporate issuance by month:
And, just to give you a better sense of what this looks like compared to previous years, the following visual shows you the run rate.
The message is that all of this has conspired to trigger a selloff at the long-end, and that could be exacerbated by systematic deleveraging, in the event this cheapening/steepening impulse accelerates much (or any) further.
“The CTA model in UST 10Y (TY) shows the ~20% loaded 3m window set to ‘FLIP SHORT’ tomorrow if today’s reference level holds”, McElligott goes on to write, adding that if that plays out, “the overall model signal [would] drop from +100% Long down to +60% Long”.
That entails mechanical de-leveraging, and Charlie notes that both the 2-week and 1-month lookbacks in his model “already pivoted to ‘short'”. That, he says, means there’s “certainly already been Trend sellers in the market” but the QIS model doesn’t put any weighting on those particular windows.
As noted here on Sunday evening, a disorderly rise in long-end yields at a time when Steve Mnuchin is flooding the market with supply to fund virus relief is probably a non-starter for the Fed, and let us not forget that as near-term bullish (for risk assets) as rising yields may be to the extent they reinforce and otherwise “validate”/”confirm” economic “hope”, a vicious bear-steepening episode that gets out of control would be a veritable disaster for all manner of crowded duration trades/expressions.
The U.S. stock market cannot rally if long rates go sharply higher, IMO.
In late February Brainerd mused about how YCC may be necessary in the next downturn. Seems very prescient today.