Turning The Titanic

All it took was a surprisingly “hawkish” (scare quotes because it’s all very relative) shift in the dot plot and an accompanying upward revision to near-term inflation forecasts to shake things up.

Although some post-FOMC themes looked a bit tired headed into the weekend, the dollar came into Friday headed for its best week of the year while gold paced for one of its worst weeks since the onset of the pandemic panic (figure below).

As noted here Thursday, commodities had a terrible go of it, as dollar strength collided with China’s ongoing crackdown to pull the rug out on what had been an almost bulletproof rally.

The reflation trade was definitively “off” post-Fed. In equities, yes, but especially in the curve. The two-day flattening in the 5s30s was dramatic enough for Bloomberg’s Cameron Crise to roll out “medieval” as a descriptor.

Steepeners, especially in the 5s30s, “have been a popular trade since the election/vaccine, and were supported by the notion that the Fed was complacent about inflation and willing to ignore the evident price pressures,” he wrote. The curve flattening was “a kick in the shins” and “the nasty squeeze to dollar shorts” was insult to injury. “It’s a deleveraging event for many,” Crise said.

Rightly or wrongly, the knee-jerk reaction in equities to the curve flattening was a shift back to growth shares on the assumption rates are saying something (bad) about the growth outlook (figure below).

BofA’s Michael Hartnett called this “the perfect storm for cyclicals.” In a Thursday note, he cited “excess positioning, China tightening, fading US fiscal hopes and now a hawkish Fed” in declaring a correction “well underway.”

He flagged homebuilders, copper, materials and transports (figure below), on the way to saying that although the “vaccine continues to dominate the virus, cyclicals are cyclical, and a Q3 correction [is] likely.”

Hartnett went on to say that a pullback in some reflation trades is “perhaps necessary to test [if] the secular inflation trade uptrend is for real.”

As long as equities manage to avoid a large swoon at the index level (and remember, gamma gravity is a big part of what’s kept things in-range this week despite Fed fireworks), the combination of stable stocks and lower long-end yields should help offset the tightening impulse in financial conditions from a stronger dollar and higher reals. Or at least that’s the idea.

“We’ve long maintained that the persistence of easy financial conditions sets the stage for the Fed to follow-through with tapering – assuming there are fumbles in the communication process that tighten said conditions,” BMO’s US rates team said Friday morning.

“This implies that Thursday’s bond rally and relative stability in equities and risk assets will leave the FCI sufficiently easy as to provide the needed cover for the Fed to execute on an official taper announcement in November/December,” the bank’s Ian Lyngen and Ben Jeffery added, before conceding there’s “a lot of recovery yet to be realized between now and the point at which the Committee will decide when to shift the pace of asset purchases – however, Powell is turning the Titanic, not making at TikTok video… there is no mulligan.”