Despite "Mega-Relief-Rally", RBC Warns Beware "The Reflation Trap"

The most widely-expected "base-case" outcome of the first round of the French election occurred... and yet, as RBC's head of cross-aset strategy Charlie McElligott notes, risk-markets have still screamed-higher in comedic relief rally fashion.


 McElligott write, this sounds obvious, but two points:

1) the hedging-flows into the event-risk now come off (i.e. Japanese owners of OATs punting on their EURJPY downside hedges, thus EURJPY +2.7% on day as an example) and


2) we now see general investors ‘unshackled’ and able to add exposure to the region in what has rapidly become the world’s favorite risk-region.

But, now is where it gets interesting though, as the ‘risk-ON’ / ‘bond bear’ catalysts by-and-large are again being priced back into the market, with little thought of downside.  This is where expectations are again ripe for an overshoot.

So taking a step back from Euro-phoria for a hot-second…I wanted to touch on a concept that Mark and I have been discussing / working-on - this idea of a tactical “US reflation trap.”

This move higher in rates is playing-out exactly as we expected and spoke to last week: the squeeze / capitulatory ‘force-in’ to that 2.15-18 level, then followed by a double-whammy of 1) event- / geopolitical- risk fade (France, Syria / Russia, and China now ‘handling’ NK) and 2) new hope on Trump fiscal progress (tax plan roll-out and ‘trending’ Freedom Caucus support of new ACA repeal & replace) sees a push up to 2.35/40 levels.  In turn, this emboldens the ‘bond bear’ camp further—especially if you look at Fischer’s comments last week as him essentially telling-us that June is a “go” for the Fed.

Here too is where I come back to my recent focus on China commodities price-action, and the view that the recently better data there means that the clamps are now being put back on the ‘PBoC liquidity pumping mechanism’ (from daily operations to social financing to new loans cram-down).  Check out some of the distress in Shanghai commod futures recently:

Take a look at the Bloomberg Commodities Index trend-support break:

As I’ve stated approximately 1000 times in recent weeks, there is no factor more critical to risk-asset upside that ‘inflation expectations’ - which are of course fueled by the price input that is commodities.  Looking at those forward prices above, there is ‘real’ downside coming. 

This is now bleeding through to the Chinese equities complex, with Shanghai Comp -1.4% today (crashing through its 200DMA to the downside) and -2.9% MTD; Shenzhen -2.4% today and now -5.7% on the MTD; while perhaps most-glaringly, the Shanghai Property Index closed -2.2% on the day today as a risk appetite bell-weather.  The liquidity tightening in conjunction with shadow-banking crackdown is now a real negative driver.

A world away, the US economic data ‘upside’ dynamic is now fatiguing, with the ‘soft’ data mean-reverting lower, while on average, the ‘hard’ data is now modestly surprising LOWER on a z-score basis.  Still expansive, but this ‘true-up’ will come with adjustment.

With this sudden pivot with the market again turning bullish on US fiscal policy progress, it is critical to note that there is still significant Democrat pushback to tax plans on principle of ‘tax cuts for rich’ (Schumer comments this morning) while the prickly determination of ‘revenue neutrality’ being required for long-term tax change now looking unlikely per reports on the ‘death of the BAT’….which now means that ‘dynamic scoring’ will be required for just short-term tax changes, which still need to be still be ironed-out amongst the sponsoring GOP itself.  Trump’s “big announcement” Wednesday is already being downgraded by his own White House budget director Mick Mulvaney, stating that they will be speaking to governing principles and guidance on tax rates, rather than policy details.

Finally, one need highlight what the removal of this French event-risk does to the mindset of both the ECB and the Fed with regards to their not-so-secret ‘market stability’ mandates: it eases them.  As such, the eventual ‘easy’ election of Macron will likely see Draghi quicker to exit their extraordinary policy now, as the background conditions continue their better trajectory.  I would expect the forward guidance laid-out this week to be upgraded as such.  And looking at the Fed, this dictates a similar response - it provides them an easier backdrop to hike into.

Of course I understand that this ‘green light to hike’ in theory means higher front-end rates.  But against the backdrop of ‘pivoting lower’ data beats and a breakdown of the commodities which have been driving higher ‘inflation expectations,’ the market risk remains concerned around the idea that the Fed will be ‘tightening faster that we are growing’—especially with a growing handful of perceived ‘cracks’ (retail messy, subprime auto, C&I loan growth collapse as debts are instead serviced, multi-year highs in bank card default rate) developing in real-time.

As such, I continue to believe we ‘range trade’ in both rates and stocks.