On Friday morning, as the latest COVID variant panic crescendoed into a mini-crash on Wall Street, I gently suggested that “this is precisely the kind of news that can get you an aggressive bull steepener in the current environment, especially to the extent positioning was set up for belly-led losses as traders bet on faster rate hikes.”
Unfortunately for some, Fed officials have gone out of their way recently to socialize the idea of an accelerated taper which, efforts to “de-link” the timeline on reducing monthly bond-buying from liftoff notwithstanding, opens the door to rate hikes much sooner than most thought possible just a few months back.
Why “unfortunately”? Well, because between Fed messaging, Wall Street calls for a doubling of the current taper pace, purportedly imminent BOE tightening and more rate hikes from New Zealand and Korea, some folks began to lean into trades associated with hawkish central banks who, traders imagined, were inclined to pursue preemptive tightening in order to manage inflation risk.
That purportedly foolproof thesis went horribly awry Friday as bonds staged a truly monumental rally amid collapsing risk sentiment.
“Funds positioned for bear-flattening after the recent pull-forward in central bank [expectations] but now you’re getting a bull steepening, as the market suddenly realizes that if we were to get more border closures which hit growth and further contribute to supply chain woes, you’re sure as hell not getting 2.5-3 Fed hikes in 2022,” Nomura’s Charlie McElligott said, calling Friday’s rates action calamitous. At one point, five-year yields were lower by 18bps.
Prior to the holiday, BMO’s Ian Lyngen and Ben Jeffery described the zeitgeist in rates. “As we ponder Q1, our baseline assumption is that the market will come into the New Year astride a giant grizzly with teeth bared and eye ablaze with any sign of inflation — commodities, holiday price tags and year ahead forecasts — as touchstones to further embolden the push toward higher rates,” they wrote, in a Wednesday note, adding that market participants generally assumed such a move would “be led by the belly of the curve as the Fed will eventually accelerate tapering and bring forward liftoff.”
All of that was upended on Friday. At least temporarily. Oil collapsed 10%. 10-year yields fell ~15bps on the session (figure below).
Bearish fixed income and flattener expressions “have had a heck of a run and could see hastened monetization in order to protect PNL into year-end,” McElligott went on to write, suggesting that’ll be “especially” true given dealer balance sheet constraints and thin markets as 2021 winds down.
Remember, Treasury liquidity has deteriorated recently (figure below) thanks in no small part to what Bloomberg’s Elizabeth Stanton aptly described as “high volatility in short-term yields reflecting shifts in the Fed policy outlook and amid the approach of month-end and year- end.”
In the same Wednesday note cited above, BMO’s Lyngen wrote that “should domestic equities wobble, dovish rhetoric will assuage any meaningful risk-off move provided the Chair responds in a timely manner.”
Consider equities “wobbled.”
McElligott said central banks are “scared of their own shadow,” which helps explain the dramatic belly-led gains — the market assumes there’s no appetite whatsoever from policymakers to risk tightening into a new COVID panic, inflation or no inflation.
Finally, note that the put-call OI ratio on TLT stood at the highest levels since late last year as of Wednesday. The fund had its second-best day of 2021 on Friday.
It certainly feels like we’re passing the point of no return on tightening. If the markets continue to dictate Fed policy, there will always be a reason to remain in accommodation. One day of less than a 5% correction will impact months of monetary policy going forward for the foreseeable future.
Well said. Always a reason for FED remain accommodative…unless inflation risk devalues bonds and the dollar enough to risk damage to wealth which would force the Fed to tighten for the purpose of capital preservation. Heisenberg would make this point more eloquently, if my basic premise is fairly correct.
I would say the optics is really more that the Fed now has more leeway to do what they were already planning and nothing that happened today changed their plans. What is did change was the increasingly heavy pressure they were getting to change their plan.
I think the bond liquidity chart is huge and the most important part of driving financial assets of all types of the past 30 days. It’s all to do with the Macro Systemic Flow of Funds Magic Shell Game (or MSFFMSG). Basically it tells be large institutions were getting ready for the taper and expecting political pressure to force faster tapering. As we know, tapering removes funds from the large institutions. These institutions need to be liquid to allow this to happen while still maintaining all relevant stress test metrics. It is also why Equities have been soft for Nov despite the marginally higher high at OpEx. It is/was always the case that the Fed is unlikely to complete the taper cycle next year before it get thwarted by market volatility.
It really just all goes back to what H has laid out many times: the markets are addicted to accommodation and the unwind will not be easily done. Any chance for a soft landing is years away.
The peanut gallery was all over powell, that the taper was too slow. I want to see some of them recant. I have been saying for awhile that the virus was a risk. It is much better for the FOMC being a little late than too early. Their current approach makes a lot of sense. The latest news is a demonstration of how fragile it all is. If yhe FOMC is smart they will stick to their plan, unless of course things actually get worse.
Yes. Summers, Fox, and the rest of the hike-now brigade will look like fools by February.