Fear Of Atonement

“There is just ‘no bid’ in broad US Equities INDEX upside,” Nomura’s Charlie McElligott said Wednesday.

The all-caps on the word “index” was in the original. The emphasis was meant to draw a distinction between the apparent lack of interest in broad market “crash-up” scenarios versus demand for upside in what Charlie called “the thematic stuff,” where that means equities expressions seen benefitting from the economic “boom” thesis in the US.

Perhaps a subtle shift is afoot. McElligott noted that economically-sensitive stocks are now “everybody’s ‘inflation overshoot’ hedge.”

So, while there’s undoubtedly still a sense in which market participants want to be leveraged to the summer “renaissance” narrative, the same cyclical plays are also seen as hedges against a less rosy scenario where “good reflation” morphs into “bad inflation.”

By contrast, uncertainty around the implications of an inflation overshoot for US monetary policy “means forward Vol in the Equities space remains in high demand, thus crazy rich Skew / downside Put Skew,” Charlie went on to say.

This is yet another reminder that the risks associated with a sustained overshoot in realized inflation are myriad and multi-faceted. I touched on that in “Something May Be Up.”

There’s the straightforward risk of an unwind in anything and everything tethered to the (apparently outgoing) “slowflation” macro regime. Notably, it’s doubtful that most market participants have any conception of what “anything and everything” encompasses in that context. Fielding emails over the past two weeks, it’s readily apparent to me that many younger investors don’t understand what “duration” means in the context of equities and aren’t generally apprised of the extent to which IG credit is exposed.

Beyond that, a sustained inflation overshoot could reduce monetary policy visibility to near zero, the Fed’s best efforts to “forward guide” markets notwithstanding. As detailed here over the weekend, the Fed’s explicit (sometimes aggressive) insistence that they “won’t hesitate” to “use their tools” if inflation spirals is effectively a hard and fast commitment to draconian rate hikes in the event the current experiment in fiscal-monetary coordination goes “wrong.” In other words, they’ve materially reduced their optionality, seemingly because they truly don’t believe it’s possible that realized inflation can sustain materially above trend for any length of time.

And the Fed could be right. Lost in the non-stop coverage of one month’s CPI data is the fact that it was one month’s CPI data. That hardly makes a trend and while it wasn’t all base effects, forecasting is impossible right now, so why so much emphasis on what economists “expected”?

“While it is believed that they would be able to control the narrative and their stance inside the 2Y horizon, if their dovishness is confronted by rising inflation, they would have to atone for it afterwards with more aggressive hikes,” Deutsche Bank’s Aleksandar Kocic said, before noting that “in reality, we are still in the recovery phase, short about 8 million jobs from where we were before the pandemic.”

Given the distance from pre-pandemic levels of employment (NFP would have to remain robust for six to 12 months just to recover pre-COVID levels in the labor market), it’s possible “the market does not change its vantage point,” Kocic went on to say.

Recall that last week, post-CPI, the market essentially shrugged off the upside surprise, even if the media didn’t.

Things get more interesting later, though. “Beyond a 12-month horizon, there should be a decision point when rates take off in either direction,” Kocic wrote, in the same note. “This could be a volatile repricing across a wide range of market sectors.”

In the meantime, equities are left to ponder an uncomfortable reality.

“As the vaccine implementation success has accelerated economic renormalization ahead of schedule — in conjunction with the unprecedented magnitude of both monetary and fiscal stimulus — USTs / Duration are now an obvious performance drag and a rare (albeit still occasional) source of portfolio Volatility, due to the implications of what an actual inflation ‘overshoot’ will mean for accelerated Fed tightening,” McElligott went on to say Wednesday, adding that high demand for forward vol in equities is a consequence of an “increasing lack of forward visibility on interest rates, general financial conditions and liquidity.” A Fed pivot would affect all three.