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Nomura’s Charlie McElligott Outlines ‘The Largest Pain Trade In The World’

Earlier this week, in “Control“, I described the moribund action in US rates.

If (when) the Fed adopts yield-curve control, US bond yields will be just another policy variable, I sighed, noting that as things stand now, the Fed has no need to make it official.

In the summer doldrums, rates are content to ply a hapless range, with 10s, 2s, and, by extension, the 2s10s, moving sideways in a listless drift — a raft in calm waters.

“The theme of the volatility-devoid-range in 10-year yields has been nothing if not pervasive over the past several weeks as the hopes of a breakout in the wake of the June NFP read withered as rates quickly retraced into the prevailing zone”, BMO’s Ian Lyngen and Jon Hill lament.

But things could get interesting again in September, Nomura’s Charlie McElligott said, in a Thursday note.

Why September? Well, first, why not August?

Not August, because, as Charlie reminds you, next month is characterized by positive seasonality for Treasurys. And, given the recent pause in the re-opening push across states representing more than 75% of the US population, the Fed is likely to attempt a “dovish overshoot” at next week’s meeting.

Any explicit forward guidance would perpetuate the “ZIRP in perpetuity” message, which McElligott describes as “soul-crushing” for traders, who have been “beaten into submission”, as rates vol. is “smothered” under a monotonous, lackadaisical bull flattener.

This helps explain the relentless rally in tech and gold. Concerns about the US economy have contributed to nominal yields’ inability to take off in earnest, even as breakevens have drifted higher. The attendant bull flattening grind favors secular growth and other equities expressions tethered to the duration infatuation in rates at the expense of cyclicals/value (bottom pane), while the ongoing collapse in real yields pushes gold higher (top pane).

From this, it’s obvious what the pain trade is.

“What would the largest pain trade in the world then be?”, McElligott asks, before answering,

I would surmise a rise in nominal- and real- yields, because this would trigger counter-moves across the asset spectrum, particularly with 1) Gold’s recently “grabby” vertical move as everybody owns it now (real yields higher would mean gold lower), with any potential bond selloff also likely to 2) trigger a reversal in crowded legacy US Eq “Growth” factor over “Value” positioning as well (particularly into any bear-steepening, which sees “Value” benefit to the pain of “Momentum”)

So, essentially a reversal of everything shown in the figure.

But this is unlikely to occur in the very near-term for the reasons mentioned above. Seasonality is positive for TY, and illiquidity in August means the chances of fireworks in equities are greater, which in turn has the potential to catalyze outsized risk-off flows into Treasurys. We saw this last August, when convexity flows contributed to an already bullish backdrop for bonds (as escalations on the trade front catalyzed a growth scare and inverted the 2s10s), and there’s plenty to be concerned about geopolitically over the next few weeks.

But September could be another story.

“The key window then for a UST bond selloff becomes September (and Q4 thereafter), with a powerful ‘issuance impulse’ likely to tilt the supply/demand dynamic finally in favor of tactical ‘bears’ when traders return following the Labor Day holiday”, McElligott goes on to say.

Remember, last September featured an early-month bond rout as yields snapped back higher, triggering one of the most violent factor rotations in recent memory. Citing a colleague, Charlie takes you down memory lane, documenting the bearish impulse in US rates from increased investment grade issuance in September.

  • In ’19, September was the largest month for IG issuance. (10yr notes sold off 40 bps in first two weeks in Sep, and finished the month 16bps cheaper.  The extreme repo blow-out during this period was also a big part of the move)
  • In ’18, Sep was 2nd largest month for IG issuance. (10yr notes sold off 14 bps in first two weeks in Sep, and finished the month 20bps cheaper)
  • In ’17, Sep was 4th largest month for IG issuance. (10yr notes sold off 6 bps in first two weeks in Sep, and finished the month 22bps cheaper)
  • In ’16, Sep was 3rd largest month for IG issuance. (10yr notes sold off 11 bps in first two weeks in Sep, and finished the month 2.5bps cheaper)

Obviously, the high-grade corporate supply picture in 2020 is distorted by the massive issuance seen during the first half, when companies took advantage of the Fed’s implicit guarantee to tap a suddenly wide-open primary market, so you have to make allowances for that when you eyeball the figure (below).

It’s that supply impulse as well as negative seasonality for TY in September (tied to that same IG issuance tsunami) that makes it a good candidate for a selloff in the US rates space.

And don’t forget, a shift in the mix from Treasury against the new “set” QE schedule from the Fed, likely means Jerome Powell won’t be out-running Steve Mnuchin (so to speak).

That too is a potential catalyst for a selloff at the long-end and, with short rates pinned, a prospective steepener, all else equal.

Caveat: all else is never equal, though, and the steepener debate is vociferous, to say the least.

“Taking all of this into account, a bearish USTs/Rates expression sets up best into the anticipated August rally peak, potentially playing then for a tactical September UST reversal lower/curve bear-steepening/higher Rate vols trade”, McElligott writes on Thursday, noting that such a development “would likely go hand-in-hand with a ‘Value over Growth’ trade within US equities in September” and into the fourth quarter.


 

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