I’d say you could feel the incredulity in the room, but I’d be lying.
Months of hand-wringing over a combustible mix of inflationary dynamics (from base effects to coordinated stimulus to supply chain disruptions) culminated in a second consecutive scorching-hot CPI report, only to leave 10-year US yields ~11bps lower on the week and more than 30bps below their YTD peak.
The easy way out is to call this counterintuitive — to feign surprise. Bonds “should” have sold off, especially considering supply. Instead, TLT had its best week of the year. Tech “should” have shuddered in tandem (i.e., alongside the bond selloff that didn’t happen), as higher yields and another upside inflation surprise further undermined the case for all things duration. Instead, rates-sensitive tech logged a fourth straight weekly gain (figure below).
The Nasdaq is just one good session from a record high. And while it would be too much to say Q1’s rates mini-tantrum is now a distant memory, it’s probably fair to question whether the four-decade bond bull really died a few months back, or whether we were too quick to write the obituary.
Circling back to what I said here at the outset, it would be too dramatic to say anyone is incredulous. The truth is, scarcely anyone cares about anything by a Friday afternoon in June. Or at least no one you’re likely to hear from. “We have equal amounts admiration, respect, and jealously for those increasing number of out-of-office responses which list a September return date and do not include the words ‘sabbatical’ or ‘pursuing other interests,'” BMO’s Ian Lyngen quipped.
It’s probably not that market participants are convinced the top is in for yields or that the Fed is definitively right about the purportedly “transitory” nature of inflation. Rather, it’s more that much of this narrative was priced-in both in rates and equities during Q1. Now, it’s a waiting game.
Some are looking to fade the rates rally, but only for a trade. “The recent move lower in rates was likely driven by position squaring and delta hedging of short vol positions ahead of CPI/FOMC,” TD’s Priya Misra said, while suggesting a tactical 10-year short. “The last two jobs reports were weaker than consensus [but] momentum remains solid,” she remarked, adding that although “the recent [CPI] move is mostly driven by supply chain disruptions and reopening-related demand, [inflation] is likely to remain strong [and] can bring some caution at the Fed about being too dovish.”
Commenting further, in a separate note, BMO’s Lyngen addressed what he called “the collective market refrain” which, paraphrased, is “Why are yields not surging with inflation, especially considering how hot the economy is likely to run at least for several more months?”
“The short-squeeze narrative is attractive insofar as it offers an explanation that is easily dismissed as temporary and, perhaps more importantly, preserves the framework of the fundamentals setting the outright level of rates,” Lyngen said, before half-jokingly noting that the squeeze story “offsets the lament of ‘seven years of (macro) college down the drain.'”
It may not even matter. Maybe it’s position squaring, maybe it’s the market cozying up to the Fed’s “transitory” narrative, maybe it’s seasonals or maybe the world will take what it can get in an environment where (nominal) yields are at least positive in the US compared to negative-/zero-yielding alternatives. Regardless, Lyngen said, traders are left to “grappl[e] with the implied sustainability of the price action itself.”
In the same vein, Nomura’s Charlie McElligott wrote Friday that “the liquidation of ‘reflation’ and ‘hawkish Fed’ trades clearly crescendo[ed], as despite another really strong US core CPI print, the ‘transitory’ nature of a large part of the gains as well as still-stagnant wages and an incredibly disappointing labor market, all lend further credibility to the Fed’s ‘slow play’ stance and forces a positioning cleanse of insanely crowded ‘Short UST’ positioning.”
The bottom line, Charlie said, is that there is “little-to-no willingness to hold out another few months to confirm or deny whether inflation is indeed ‘transitory’ or not, because the carry- and / or theta- bill is bleeding many of these trades out of existence.” (That’s what I meant above with the “waiting game” bit.)
In equities, realized vol has been crushed. One-month is around 10, three-month at ~12. On Nomura’s model, vol control likely added almost $41 billion in notional exposure over the past two weeks.
According to McElligott’s client conversations, many think the reflation impulse may have peaked already. Now, folks are keen to pivot towards a “Goldilocks” view, which means, to quote Charlie one more time, “mov[ing] away from hard ‘directional’ trades and into ‘Short Vol / Carry / Roll’ types of trades, built on a dovish Fed now having further ‘cover’ to delay and ‘slow-play’ tapering, squelch[ing] volatility for another few months.”