While equities continues to plunge in what increasingly appears to be a straight line (sorry JPM [16]) with the occasional mini short covering rally, and are fast approaching the August 24 ETFlash crash lows, the Treasury complex has been relatively quiet. While the lack of recent buying interest may be explained with concerns over ongoing reserve liquidations by the likes of China and Saudi Arabia, if Citigroup is right, that may be about to change.
According to Citi's rates strategist Jabaz Mathai, there is only so much indifference to the risk-asset rout that Treasurys can express before responding. First, he points out that the carnage in many risk assets, not to mention economic conditions, is already as bad, if not worse, than it was in August after the first Yuan devaluation, which in turn forced the Fed to delay the September rate hike to December. To wit:
Fundamentals don’t change as quickly as market prices. The equity market meltdown in August and September of last year, triggered by the devaluation of the Chinese yuan, played a pivotal role in the Fed passing on liftoff in the September meeting. The reversal of this sell-off in October, on the back of some stimulus by the PBoC, gave the Fed an opportunity to go through with lift off in December. However, we are now seeing a re-emergence of the global growth weakness theme in financial markets, with risk assets globally selling off. In the US, as Figure 4 shows, all credit spreads, from AAA CMBS to investment grade corporates to high yield have widened, back to, and in some cases, above levels that existed back in Aug/ Sep of 2015. The Chicago Fed Financial conditions index is tighter now than during the Aug/ Sep period (see Figure 5). Where do we go from here?
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However, now that practically everyone except a few drama majors have realized that the Fed did a "policy mistake" by hiking, the question is how to trade it. Citi has some ideas, and also forecasts that the relative calm in the medium and long end of the yield curve is about to take a leg lower.
There is no quick fix to the headwinds facing global growth, especially in emerging markets dealing with a broken growth model, as our EM strategists have pointed out (see On EM’s ‘broken growth model’). With fundamentals changing slowly and risk appetite falling rapidly, the stage is set for a longer period of risk asset underperformance. With only four trading sessions having passed in the new year, it is reasonable to assume that overweight positions in spread products in fixed income have not been unwound yet. The risk of a fracture in risk markets when lower liquidity meets forced selling, is high in our view. Should this weakening of spread sectors in fixed income continue, we will see a further rally in Treasuries – back in Aug/ Sep, 10y USTs broke below 2%, and there is no reason we can’t get there later this month. We have expressed this view of a rally in rates conditional on a risk –off scenario in one of our five trades for 2016 – selling OTM June IG CDX calls vs. buying OTM receivers on the 5y.
Finally, the all important question: when and under what conditions will the Fed react? Citi's response"
What will the Fed’s response be to a continued deterioration of risk assets? Having downgraded the significance of financial market developments last year from the September to the October meeting, a steady tightening of financial conditions would be acceptable to the Fed – that is clearly the intended consequence of tighter monetary policy. However, the rate of change matters, and a freefall in risk assets will sow doubts within the FOMC. With a balanced Dec FOMC statement, the press conference emphasizing gradualness and the recently released minutes indicating less than complete confidence on higher inflation, the Fed can stick to the slow and gradual tightening guidance. On the other hand, communicating expectations of three or four rate hikes this year (as Stanley Fischer did) raises the possibility of a redux of the mid – 2015 liftoff guidance debacle and a reset of credibility. However, markets are ignoring these statements for now, with the Eurodollar curve flattening in the recent rates rally. The curve between Mar 17 and Mar 16 has flattened by about 7bp from the Dec meeting to 52bp now.
And it will flatten even more before it starts pricing in the rate cut (singular) that the Fed will have to engage in as soon as the S&P enters first a correction and then a bear market, confirming to the entire world that the December rate hike was nothing more or less than the latest policy error by a federal reserve who legacy will be a record of one mistake after another.
