Posted by on December 15, 2016 2:45 am
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Categories: Bond Convexity Deleveraging Economy Finance Futures contract Global Economy money Nikkei Nikkei 225 Real interest rate Swap US Federal Reserve Yen

Having hit it out of the park recently with several fantastic cross-asset pieces, including “RBC Warns January Is Setting Up As A “Massive Mean-Reversion” Month” and “RBC Answers “THE” Question Every Investor Is Asking: “What Could Derail This Rally?””, today in the aftermath of the FOMC’s press conference, RBC’s cross-asset head Charlie McElligott is out with another must read report, explaining why we find outselves at a “dangerous fork in the road.”

But before we present it to readers, a more topical point touched on by McElligott is how to determine what happens to markets tomorrow, specifically: whether today’s selloff will continue.  His answer:

It’s likely that the very potent mix of higher $/Y and hits being taken in UST portfolios should induce further UST pressure from that specific audience. Sidenote:If they sell the Nikkei tonight despite the enormous weakening in yen today…I’ll start turning rather nervous for risk assets.

If Charlie is right, tomorrow is not shaping up to be a pretty day for risk assets, because in the early Japanese session, the Nikkei was indeed being sold…


… even as the Yen retraced just a modest part of its massive intraday move today.

* * *

Here is the rest of RBC’s note:


#HOTTAKE: Geez. 

The initial post-Fed takeaway was the collective “uh oh” from the buyside which was forced to suddenly shift to a worldview that the Fed is now “behind the curve,” with three hikes seemingly to come in ’17 (up from 2 in Sept projection), and then three more in each of the following two years.  Off the back of this reassessment, the more troubling observation came in the form of the exponential move in “real rates”:

A violent move to this extent in real rates and USD (BBDXY seeing a +2.6SD move on day) is pure “FINANCIAL TIGHTENING,” which of course “mucks-up” the plumbing of a global economy funded in Dollars.  This is not supportive of the “reflation trade.”  We need some +++ inflation data, stat. 

Rates blew through 2.50 on their way to 2.57, and now markets are fixating on 2.75 as the next stop.  These new levels brought out convexity sellers / swaps payers from the mortgage universe, but there is also seemingly a willingness from the leveraged-crowd to let their shorts ride / further pay in swaps, as it continues to generate so much positive PNL.  Into year-end with ever-diminishing liquidity / bank balance sheet, it would support the case for this to run.  Feedback too from the overseas ‘real money’ crowd also indicates that this rates-move can continue to run, as they won’t be buyers with yields closing at new highs (and especially above the ‘round #’ 2.50 level).  It’s likely that the very potent mix of higher $/Y and hits being taken in UST portfolios should induce further UST pressure from that specific audience (sidenote: if they sell the Nikkei tonight despite the enormous weakening in yen today…I’ll start turning rather nervous for risk assets).

The potentially good news is that generally-speaking, the risk-parity community has gone through a massive deleveraging of their bond / duration length over the recent move, so there might not be the same scale of ‘unemotional selling’ as we’ve gotten accustomed-to during prior episodes of rate volatility….while too the only modest move in VIX (just +3.7% because out of the money call vols were down roughly equivalent to the marginal move higher in OTM put vols, mitigating one another—H/T Jon Simon) won’t bring out the ‘risk-control’ / ‘vol target’ universe in forced / mechanical risk-based deleveraging either.  Incredibly, 15-, 30- and 50-day historic SPX vols all sit below 10 still.

Stocks acted largely as one would expect on an asymmetrical rates move higher: bond proxies / ‘low vol’ / defensives were absolutely crushed on account of the escalation of the duration unwind:

The REAL issue for us ‘secular reflationists’ is that the recent positioning-pivot ‘winners’—small caps, high beta cyclicals, ‘value’ factor—were also beaten-up along-side the rates sensitives.  And in nearly perfect fit with the “January Effect” quant factor reversal strategy scenario (where quants go long Q4 ‘losers’ against short Q4 ‘leaders’), the two key factor inputs (being 1- December outperformance of “momentum market neutral” and 2- “anti-beta market neutral”) that we are watching as indicators were both ‘signaling’ again, with the two strategies as the two best-performing components in my thematic monitor today (green box):

Optimally I think if markets come in to rates ripping to new highs tomorrow morning in sloppy-fashion, risk markets could be in for something.  But if we are able to expose some UST buyers and keep a lid on the rates move, it would allow financials / banks to work tomorrow, and stocks could very well likely “stop the bleeding.”  Per the script I’ve been outlining, I think then we have to set-up for the January ‘mean reversion’ potential where bonds rally against stocks, which in theory would allow re-setting of bond shorts and equities longs into a still picking-up backdrop of inflation and global PMIs. 

Now instead, we must downshift that assessment and wait to take in new information in the coming-days with regards to this now very disruptive introduction of “financial tightening” and the implications for risky-assets. 

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