The $1.5 Trillion Short And Noisy Inflation Trades
Submitted by Derrick Wulf of No Easy Trade blog,
One of the highlights of an otherwise uneventful press conference by Fed Chairman Janet Yellen earlier this week was her carefree dismissal of recent inflation gains as mere “noise.” This was significant for two reasons: first, it implied a level of forecasting confidence that seems wholly inconsistent with the “data-dependent” policy approach we have been told to expect from the Fed, and second, it was an entirely inaccurate characterization of the data. Much of the recent increase in CPI has in fact come from traditionally stable categories such as services, which have posted annualized three and six month gains of more than 3% for several months now, while weakness has actually come from the more volatile components such as “commodities less food”. The official BLS release for May even characterized the price increases as “broad based,” all of which strongly suggests there’s something more than mere noise behind these figures.
It’s important to remember that the FOMC has tactically embraced “forward guidance” as a monetary policy tool, and committee members know that in order for it to be effective they must speak with confidence and conviction. Most recently, their confidence has helped to reduce volatility and compress risk premia in a number of asset classes, but it also comes at the risk of damaging their credibility in the longer term. Moreover, history has shown time and again that the financial markets have an uncanny ability to seek out complacency and test the conviction of both investors and policymakers alike. Why should this time be any different?
On the day after Chairman Yellen’s press conference, investors aggressively bid up inflation trades across numerous asset classes. Gold and silver rallied sharply, TIPS implied inflation breakevens widened (despite a new slug of 30-year supply), Treasury yields rose, and the yield curve steepened. Based on investor positioning and market sentiment, I think there’s decent potential for additional gains in these inflation expressions in the days and weeks ahead.
In rates, for example, investors have accumulated significant short positions in the front end of the curve against longs in the 30-year sector, indicating potential for a meaningful curve steepening when these trades are unwound. Positioning surveys consistently show that “real money” investors are overwhelmingly short their duration benchmarks, while the CFTC’s Commitment of Traders data show record net short positions exceeding $1.5 trillion in notional rates exposure among speculators in the eurodollar futures markets.
Within the macro community, meanwhile, a number of large investors inspired by none other than Ben Bernanke in his paid private dinner musings maintain significant long-end rates exposure on the belief in a lower terminal fed funds rate. Frequent reassurances by various fed officials that inflation risks remain subdued has emboldened their view that 30-year yields can fall lower still.
But any time the Fed gets behind the curve on inflation, the yield curve steepens, and the post-FOMC price action yesterday warns that this may in fact soon be the case. Moreover, the charts show potential for a technical break in the 5s / 30s curve that may encourage additional unwinds of crowded curve-flattening trades.
A glance at the 30yr yield chart also indicates potential for additional long-end weakness, with the recent bull-trend already broken and a potential reversal now underway.
A break above 3.50% would confirm the reversal and likely seek 3.75% next. If the inflation trade has legs, however, it may not be long before 4% is revisited.
Key to this trade will be incoming data on wages, incomes, and consumer confidence, as well as investor sentiment regarding fed credibility on the outlook for inflation. Considering the recent rhetoric in the context of current market positioning, I perceive some vulnerability on this front, which may well lead to more than just a bit of noise on the charts.
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