McElligott On The Fed, Bonds And Fall ‘Timing Turn’

Market participants may soon brave another “bearish shot” at bonds, which could translate to rekindled interest in some manifestations of the reflation trade in equities.

That was one takeaway from a Thursday note by Nomura’s Charlie McElligott, who wrote that following the positioning washout which flattened the curve and pushed US yields to the lowest since February, VaR is “currently dialed way back.”

The associated bleed in value versus growth (figure below) may now look overdone to some enterprising traders, especially in “an environment where yields could again begin to [move] higher as supply picks back up and QE tapering is announced” over the next several months, McElligott went on to say.

Last Monday’s relatively steep swoon in US stocks may have marked “peak growth scare,” even as “peak growth” (without the “scare”) is still a big part of the macro narrative.

As noted Thursday morning (and I’m going to recycle my own language verbatim), additional fiscal measures may help offset any drag from the worsening virus outlook. Both the bipartisan infrastructure bill and a Democrat-only reconciliation measure were poised to advance on the Hill. Assuming both make it through what it’s fair to describe as a laughably fraught legislative process bedeviled by some of the worst partisan rancor in modern US history, Joe Biden will have largely succeeded in enshrining his economic agenda into law. It’s ambitious relative to the norm. Not so much in the eyes of Progressives. Either way, it’ll be an economic boon. Contrary to what you might be inclined to believe if you get your information from dubious sources, demand-side stimulus does work. It’s just a matter of assessing any associated side effects.

That too could be a good excuse for traders to take another look at some of the reflation/re-opening trades that erased their YTD relative performance during the bond rally.

McElligott noted the hawkish read-through from the Fed statement. “Despite the standard ‘both sides of mouth’ from Jerome Powell in the press conference, the statement read very ‘hawkish’ to me,” he said, citing the upgraded economic assessment, no effort on the Committee’s part to make the Delta variant part of the forward guidance and the nod to “progress” (if not “substantial further”) vis-à-vis taper proximity. He also noted, citing a colleague, that in the past, the “coming meetings” language equated to two meetings.

Whatever the case, “the stone has been cast,” Charlie said, before quoting another colleague’s assessment of the rates outlook (truncated):

While the price discovery of how low yields can go has been anyone’s guess, the one thing that we remain more confident about is that 3-6 months from now we will look back and say that these were the “wrong” yields given the trajectory of the economy and the long-term fiscal outlook. Longer-term it does seem like the balance of risks is skewed in favor of higher yields if the Fed begins to taper asset purchases, and allows for real price discovery as private-side investors are forced to fill the demand gap. It seems perfectly reasonable that these investors will demand a higher yield concession to own USTs given the underlying strength of the economy, the long-term fiscal outlook and ongoing funding needs from the Treasury (i.e., UST issuance).

Ah, price discovery. You know we’re far afield when that concept seems quaint. Or maybe I’m just “old” now and cynical.

In any event, coming full circle, the overarching point from McElligott on Thursday was just that once August seasonality and attendant “pitfalls” (read: lackluster liquidity) are out of the way, any return to the bear-steepener mentality in rates would make for “a benevolent backdrop from a risk-on perspective [as] traders looking to get a bit more front-footed, emerge from their PnL / VaR bunkers, and begin to allocate back into playing some offense again,” whether in bearish rates expressions or another go at reflation trades in equities.

Crucially, you’re reminded that this type of color is tactical in nature. As Charlie put it Thursday, “it’s about that timing ‘turn’ into historical risk-on seasonality for returns as we transition from August, picking up into September, then really zooming positive in October/November.”

I don’t want to say “don’t try this at home,” as that wouldn’t be quite right. I guess the better way to put it is just to say that, as ever, you should be honest (with yourself) about what kind of market participant you are and what kind of access you have when it comes to tailor-made trades.