Selloff Reflections

“Why now?”, a couple of my favorite strategists asked, in the wake of a brutal selloff on Wall Street and an extension of what, by now, can fairly be characterized as an inexorable bond rally. They were talking specifically about the curve flattener, but that simple question is a good jumping-off point.

10-year US yields ended near the lows, at 1.172%, flattening the 2s10s. Futures volumes were robust. Note that as of Monday afternoon, benchmark US yields were almost 60bps from the 2021 highs.

Rather than “Why now?”, I tacitly suggested the better question might be “Why not now?” Or maybe, “If not now, then when?”

Delta variant concerns aren’t new, of course. And neither is the specter of a full-on crisis in one of the world’s most populous nations. Right now, it’s Indonesia. In May, it was India.

But positioning was stretched in equities, both on the discretionary and systematic sides. Although the bond rally catalyzed the usual shifts within equities, at the asset class level stocks were largely “agnostic” (as Deutsche Bank put it) to surging inflation in the US and a hodgepodge of other factors which, all else equal, might have been expected to trigger profit-taking. That confluence of factors finally pushed things to the breaking point. I think the bond rally was the most important among them.

For weeks, I’ve gently suggested that the optics were going from bad to worse as yields fell and the curve continued to flatten. Eventually, stocks were bound to hear “growth scare,” irrespective of compelling evidence that the bond rally was positioning- / flow-driven. Past a certain point, it doesn’t matter. You’re painting a picture. The outline is there courtesy of the price action. Any fundamental narrative that’s semi-plausible will work when it comes to filling in the color. A rapidly proliferating mutation of a deadly virus is more than adequate, especially when paired with an overwrought story about a prospective Fed policy mistake.

When it comes to explaining why the monthsold bond rally suddenly metamorphosed into a full-on risk-off trade, it’s difficult to know how much weight to assign to US accusations against China for Beijing’s alleged role in cyber attacks. Like the Delta variant, Sino-US tensions are nothing new. Yes, formal allegations by the US and the UK marked a serious escalation, but how many serious escalations does that make since 2018? There’s a serious escalation every other week (at least). And it doesn’t matter who’s in the White House.

Speaking of Beijing, TD wondered (aloud) if China might be contributing to the US rates rally in another way. “We attribute the recent decline in yields to the unwind of crowded reflation trades after a hawkish June FOMC,” the bank’s Priya Misra said Monday, adding that “seasonals and a lack of fiscal deal progress added fuel to fire.” And yet, she also suggested that FX intervention by China may have added an incremental bid for Treasurys. “We don’t yet have updated TIC data to confirm that Treasury demand from China has been positive in June-July, but we think that growth in USD holdings should have resulted in inflows,” she went on to say. “This would also be consistent with the strong bid for duration during non-US hours.”

BMO’s Ian Lyngen and Ben Jeffery weighed in with a characteristically trenchant take, noting that while flattening is consistent with how one would expect rates to behave as the Fed looks towards tightening, it’s nevertheless early. The bond market is trading Fed hikes nearly a year and a half ahead of expected liftoff. In addition, Lyngen and Jeffery reminded folks that curve flattening through an outright rally at the long-end typically doesn’t play out until later in the cycle. As for the macro, they wrote that considering expectations that the summer “represented the proverbial ninth inning of the pandemic, the realization that the coronavirus will remain a meaningful risk has served to further dim the global outlook.” When you toss in the prospect that inflation could curtail consumption, “the case for lower rates going forward finds more fundamental backing,” they added.

Deutsche Bank’s George Saravelos seems to agree. “We wrote about ‘peak vaccine’ optimism more than a month ago and the market seems to be belatedly pricing this in,” he wrote on Monday. “But the market’s increased pricing of what we have dubbed ‘secular stagnation 2.0’ is about much more than the new delta variant,” he added, on the way to delivering a similar take to that offered by BMO’s US rates team.

Specifically, Saravelos cautioned on “various warning signs on the post-vaccine transition including stalling consumption in high-frequency data in many economies,” which he called “part of broader post-COVID scarring.”

“As prices have risen, the consumer has been cutting back demand rather than bringing forward consumption,” Saravelos declared, before driving it home, noting that “this is the opposite of what one would expect if the environment was genuinely inflationary.” Instead, “it shows the global economy has a very low speed limit and consumers remain very price-sensitive.”

Again, the question might be: “Why not now?”