Why Tomorrow's TIPS Auction May Seal The Fate Of The Reflation Trade
With the dollar bouncing back and bond yields and breakevens rising, RBC’s head of cross-asset strategy, Charlie McElligott, ‘sniffs’ that the market is trying to convince itself to turn “cautiously constructive” again on Trump tax movement.
However, as he details below, there are a few red flags to pay attention to…
- ‘Sniffing’ that the market is trying to convince itself to turn “cautiously constructive” again on Trump tax movement, as per two ‘stories’ out overnight / this morning centered around “simplification” / “narrowing the scope” of the policy effort.
- Despite ‘capitulatory-looking’ price-action in rates yesterday, we’re likely in the ‘7th inning’ of the ‘short rates’ stop-out. As such, this actually is helping drive the reformation of both ‘reflation’ / ‘deflation’ camps looking for tactical trading opportunities.
- A timeline then can develop for an opportunity to put ‘reflation’ back on: 1) charts indicate the short-term potential for higher rates / USD and lower gold which takes us back to 2.30 ‘gap fill’ level; 2) we see the recent ‘rates longs’ re-engage there at low-end of range, which in turn drives a final ‘capitulatory wave’ to the 2.05 level, perhaps boosted by final nerves into the French election or further ‘mean-reversion’ lower in economic surprise indices; then at this point, 3) many will then be looking to fade the rates rally and reapply ‘reflation’ as global data still ‘deeply expansive,’ recent geopol ‘stressors’ again fade to sidelines, the US budget (and this ‘simplicity’ movement with tax policy) takes shape the Fed continues to message ‘statements of intent’ on both hikes and tapering of balance-sheet—in turn, seeing rates again travel higher.
- One ‘red flag’ continues to be the negative risk-asset price input that is Chinese industrial commodities prices, which are currently ‘rolling over’ (see yesterday’s “LOSING THE IMPULSE” note). This is due to the market perception that as the economy has strengthened to the point where the PBoC will drive a contraction of liquidity (reduced OMOs) / slow ‘credit stuffing’ efforts, which collectively show extremely high correlation to commodities pricing and global inflation. In the current macro regime, as global inflation goes, so too does ‘risk-asset’ pricing (this is why I continue to watch Crude like a hawk—which, it should be noted, is HIGHER again despite bearish APIs last night).
- Tactically it will be critical to watch tomorrow’s TIPS auction as a read on ‘risk appetite for inflation.’ If we get a clunker, it’s likely we resume the ‘capitulation’ in the ‘short rates’ camp STAT, which is sure to drive more of the same ‘defensive’ / ‘low vol’ / ‘bond proxy’ equities leadership. Conversely, if the TIPS auction takes well, it should be read as the ‘reflation camp’ feeling again emboldened after the recent squeeze / cleaner position post ‘stop outs,’ and we’re likely to see $ rotating back into the ‘cyclical beta’ / ‘value’ / ‘small cap’ stuff tied to higher rates.
- This is the reason that ‘growth’ equities (Tech, Cons Discretion a la FAANG / PANE) continues to ‘hold-in’ okay on the week-to-date—because they offer the least ‘binary’ of exposures to this very current ‘reflation’ or ‘deflation’ / ‘cyclical’ or ‘defensive’ coin-flip.
- The biggest risk to ‘growth’ continues to be the seasonal ‘April Effect’ phenomenon where “12m momentum factor mkt neutral” unwinds (as we are currently experiencing), most likely ahead of considerable historical data showing long term alpha generation by ‘defensive shift’ ahead of “sell in May” seasonality.
One dynamic I’m ‘picking-up’ is the market again attempting to convince itself to turn “cautiously constructive” on Trump tax policy movement, under the guise of an increased focus around “simplicity” and “refocusing of efforts.”
Nearly all would agree that any tax cut is a directional ‘positive’ for risk assets / inflation. The issue has been the Administration attempting to ‘bite off more than they can chew’ with an entire sweeping re-write of the code / system. Instead, a much more reasonable—and thus, achievable—approach would be to focus on the corporate tax cut and infrastructure side first to address ‘jobs and the economy.’ Two items out today are speaking to this “simplification” buzz:
1. Axios is reporting that Gary Cohn has “…privately said he’s warming to the idea of eliminating the local and state tax deductions to pay for tax cuts and simplify the code” per inside sources. Okay, that’s a positive step.
2. Separately, the NYT is running an Op-Ed from a number of conservatives with ties into the Trump Administration (Kudlow, Forbes, Laffer, Moore) which makes the case for more “simplification” with a focus on “jobs and the economy.” They propose a system where to get to a 15% corp tax cut, you’d 1) allow businesses to immediately deduct full cost of capital purchases 2) impose a low tax on repatriation of foreign profits 3) roll-out the infrastructure bill funded by the repatriation of foreign profits. To make this work, Republicans and the Admin need to “stop insisting on ‘revenue neutrality,’ drop the ‘BAT’ / ‘carbon tax’ talk, and push-back efforts to unwind the complexities of the individual tax system until 2018. Get ‘this’ out first, as the Op-Ed notes the risk that “…financial markets and American businesses are starting to get jittery over the prospect that a tax cut won’t get done this year. A failure here would be negative for the economy and the stock market and could stall out the “Trump bounce” we have seen since the president’s election.”
US rates—despite very ‘capitulatory’-looking trading behavior yesterday—actually held a key level, as the 2.18% ‘50% Fibo Retracement’ in the UST 10Y of the post Trump move, which wasn’t able to be broken to the downside. Add in the ‘faint whiff of movement’ again with Trump tax / US fiscal policy today, and risky-assets / rates / notably breakevens are moving nicely higher currently.
With that ‘hold’ in rates, the USD also put in a low and bounced from yday afternoon, which has helped $/Y recover as a broad ‘risk-asset proxy.’ Regarding everybody’s favorite “new” long European equities, we are seeing ‘cyclicals’ as leadership sectors with the aforementioned ‘higher rates’ so far today (Financials, Industrials and Materials as 3 of 5 sectors currently ‘up’ on the session, while ‘duration-sensitive’ / ‘defensives’ REITS, Utilities, Healthcare, Staples and Telco are all in the red). Not surprisingly then, we can anticipate similar behavior then from US ‘reflation’ equities plays today: value factor, cyclical beta, small caps, leveraged balance sheet etc.
A potential timeline in my head from working with my colleague Mark Orsley is the sense that the ‘rates short’ capitulation is in the 7th inning—with the rates desk noting that the short covering seen was on “decent but not high volume.” Mark / the desk’s view is that there is still an ultimate ‘wave’ to come…but probably not before we see another move HIGHER in rates back towards that huge 2.30 level to ‘fill the gap.’ Currently Mark notes that rates and USD are all showing the potential for ‘short-term bounces,’ while conversely, gold looks exposed for a similar near-term pullback. Perversely, it is this point where another rally in rates (perhaps more fading in ‘economic surprises’?) is likely to squeeze and force liquidations of the UST / rates shorts to the 2.05 level…at which time you’d want to be fading this rally and reapplying ‘reflation’ trades.
The global data still being deeply expansive (current), the gradual removal of geopolitical stresses / flashpoints (May), increasing news-flow on the Trump budget and potentially taxes (May+) and continual-messaging from the Fed on their intent to stay firm with desire to taper the balance sheet (coming months) will all conspire to drive rates again higher by late May / early June.
This is where you’d then expect to see the ‘cyclically geared’ stuff to again outperform, which in turn would see the closure of that ‘barbell approach’ I noted earlier this week to ‘get you through’ the next month time-period (long both defensives and secular growth to near-term benefit from the rates reversal lower, but to provide some beta-y upside on a risk ‘relief rally’ around the inevitable geopolitical calming achieved by the end of May).
From the ‘chief risks to outlook’ side: Chinese industrial commodities continue to gain my attention though from a ‘deflationary’ perspective, with further selling almost across the board last night in Shanghai futures
(Aluminum, Copper, Nickel, Tin, Zinc, Lead, Rubber, Silver and Deformed Bar all lower, while Gold saw respite on ‘haven’- angle):
As I outlined yesterday, 1) ‘inflation expectations’ and both 2) energy- and industrials- commodities prices are ubiquitous as factor drivers in the QI cross-asset model. This drawdown in industrial metals then is an ominous trend, as it points to the fading ‘inputs’ going forward without further liquidity being injected into the system. A number of clients have highlighted the correlated between Chinese liquidity injections / open market operations / loan and social financing growth and commodities / global inflation measures.
This is why I continue to ‘bring it back’ to this chart of Chinese credit creation and its impact on global inflation via the supply chain:
So as the ‘deflation’ or ‘reflation’ / ‘cyclicals’ or ‘defensives’ binary debate plows on within equities, ‘secular growth’ continues to be the favorite hiding place for those looking to avoid policy- and duration- risk. Currently though, it’s subject to the ‘April Effect’ phenomenon I’ve been discussing over the course of the month, which shows basically that 12 month ‘momentum longs’ significantly underperform 12 month ‘momentum shorts’ on apparent rebalancing. As ‘value’ led the 9 months of last year, and ‘growth’ led majority of the current YTD, these two areas are most-susceptible to drawdown as part of this—to the benefit of ‘anti-beta’ (low vol) factor.
This rebalancing is likely based-upon the ‘Sell in May’ phenomenon, where long-term data (Dec 31, 1990 through March 30, 2017) shows better returns from rotating stock holdings into defensives (bonds, ‘low vol’ or staples / defensives) btwn May-Oct. versus outright staying long S&P 500 ‘all year long.” Per Fidelity: