McElligott On Where Things Stand

Admittedly, I have a difficult time deciding what the “average” market participant cares about these days.

That’s in part because, after years of almost total isolation, I don’t know what an “average” person cares about, let alone the average version of some subset of people, in this case market participants.

That’s a joke. But not really.

I try to find a “happy” middle ground in the daily color presented here — sophisticated enough to keep “serious” investors engaged, esoteric enough to satisfy “real” traders and accessible enough that the layperson doesn’t run away screaming. I’m not always successful, but I do what I can.

One theme I’ve attempted to drive home since the June FOMC is the extent to which the perceived shift in the Fed’s reaction function altered the way some market participants are compelled to interpret the data.

From a 30,000-foot perspective, the upward shift in the dots wasn’t “momentous,” and I generally agree with the broad-strokes thesis that it wasn’t a “game-changer.” But that gets to the whole “Who is your audience?” question alluded to above.

The figure (below), shows a ~35bps flattening in the 5s30s since April’s CPI “shocker” (released on May 12).

That matters in and of itself for “real” traders, but more broadly, it says something important about the nexus between inflation, the Fed and the fate of FAIT (if you will).

“Ever since [April CPI], the market has seen crowded ‘reflation’ bets slowly bled, culminating in the spasmic unwind following the Fed’s seeming acknowledgement that their inflation target has been achieved,” Nomura’s Charlie McElligott said, in a Wednesday note.

Although obvious to anyone truly immersed in markets, the read-through from this might not be readily ascertainable for some everyday investors. Indeed, it’s possible that some folks are flummoxed by a power-flattening in the curve just as the very inflation overshoot risk that helped drive the reflation trade realized.

McElligott captured things concisely. “It’s all because ‘that’ type of inflation became a relative ‘flattener’ at this juncture,” he wrote, emphasis in the original.

Why? Well, because the read-through from the “early” realization of an inflation overshoot is higher front-end yields on the assumption of a more hawkish Fed, while the long-end rallies (i.e., yields drop) as the market “efficiently” prices in the growth ramifications of future Fed tightening right now.

“[The] slowing growth implications of the eventual tightening of US financial conditions makes duration attractive again,” Charlie went on to say Wednesday, adding that this is particularly true “with the [inflation] base effect now pivoting from [a] tailwind to a headwind.”

If you assume the labor market will soon “catch up” as frictions abate and we move closer to “recapturing” the ~7.5 million workers still MIA as of May NFP, it’s easy to posit a Fed that becomes even more “hawkish” (scare quotes because that’s still a highly relative term), on the way to accelerating the taper timeline. An accelerated taper timeline implicitly brings forward liftoff. That, in turn, suggests more (upward) pressure on front-end yields.

“Further complicating ‘reflation ON, reflation OFF’ are… concerns globally around the COVID ‘Delta’ variant, with a mounting number of lockdowns and / or travel bans [presenting] a headwind to the global growth ‘reopening renaissance,'” McElligott added.

But there’s a silver lining for equities. The self-evident read-through from the “reflation ON, reflation OFF” churn is dispersion, which tamps down index-level vol. Toss in what Charlie described as “VERY lumpy short vol flows” and you’re left with SPX five-day realized at 3.7 and the index printing record highs.