Citi: "There Is A Massive Problem" With The Bond Market

Is the global economic recovery over?

That is the question investors are grappling with just as Q1 earnings season - the best since 2011 with its 18% Y/Y expected EPS growth - enters its busiest week yet. Meanwhile, as discussed here extensively in recent weeks, over the past two  months economic data from around the globe, but especially Europe and the US, has come in unexpectedly soft resulting in the first negative print in Citi's Global Eco Surprise Index, and now the most negative since early 2016...

... and, more notably, an inversion in the forward OIS curve - the first in 13 years - which as JPMorgan noted was the clearest confirmation that the US economy is very "late cycle", and that a conventional yield curve inversion (2s10s), a harbinger of recession, is not far behind.

Incidentally, the topic of an economic slowdown gripping the global economy was the topic of Citi's entire macro weekly notes one week ago; curiously, the bank went so far as to "calculate that the Fed has already moved into slightly restrictive territory vs. equilibrium rates and that further tightening from here will be a growth and risk asset negative."

In other words, all else equal, the Fed should end its tightening cycle.

Economic slowdown worries - and indicators - aside, another critical discussion taking place in parallel is whether the market can keep rising even as yields push higher; this has become especially topical as a result of resent speculation that inflation is rising even as growth is slowing, a warning flag that stagflation may be just around the corner.

And, as Citi's global macro strategy team writes in its latest weekly report, "one of the more contentious issues in the market at the moment surrounds the debate as to whether both equities and long term yields can move higher simultaneously. This is an interesting debate, particularly due to the fact that equity markets have failed to gain significant momentum to the upside, whilst equity market volatility has seemed to re-price back to ‘normalcy’."

To Citi, the equity part of the debate is relatively clear: there won't be a resolution for a while, as much of the recent pent up euphoria has fizzled and will need months to be rebuilt:

With regard to stocks, we believe the market needs time. If we take a look at relatively recent previous equity corrections that have occurred in this cycle, it seems that it can take several months of indeterminate price action until the rally continues.

An explanation for this is that when the ‘going is good’, there are lower VaR constraints, lower margin requirements and generally increasing leverage. This is until a small shock causes these constraints to tighten, forcing investors to liquidate, increasing volatility and tightening these constraints further. Perhaps Hyman Minsky was right when he said that stability leads to instability. Unfortunately, it may take a while for risk limits to reset, particularly for those that bought when the RSI flashed +80 (RIP FOMO?).

Citi also notes that the lack of upside momentum can also be explained by the "increased probability that we are now entering into a growth slowdown/ plateau phase of the cycle." And while the bank adds that it can "certainly sympathize with this" as "currently data is indeed cooling but from extraordinarily high levels", Citi still thinks that stocks have at least one more hurrah higher, before the rally crumbles:

we are of the belief that given the current earnings backdrop coupled with the fact some key technical levels (200dma) have held, that the market can rally back to the highs eventually (Figure 3). We continue to hold a tactical long SPX position with a relatively tight stop at 2530. For us, this is something worth risking but not with everything you’ve got.

What about the far more important bond market? Here too, there have been drastic changes. First, recall Citi's assessment from last week:

In February markets seemed to fear a shift from goldilocks to reflation i.e. higher inflation with strong real growth. However the second leg lower in equities seems to have morphed more into a growth scare led by a leg lower in base metals, an asset class that normally does well if inflation concerns are prevalent... With nominal yields, real yields and breakevens falling, money market curves flattening to price less tightening and oil also off, it’s hard to escape the conclusion that markets are suddenly less confident about the growth outlook.

Fast forward to today when the same Citi strategists double down on this incipient deflation threat, as manifested by the long-end and flattening yield curve - now at just 47bps - by pointing out that "macro enthusiasts that we speak to have been disappointed at the lack upwards momentum from 10y UST yields, particularly following the break of 2.60%. Perhaps akin to equity markets, data looks to have contributed to the consolidation in yields."

To be sure, the technicals are still somewhat supportive of the bear case, and bond bears can be encouraged by the fact that a medium term trendline has held even in the face of this growth scare. What’s more, Citi adds, as many market participants are well aware, "we are approaching a key technical level to the topside, but what’s probably more important (from a psychological perspective) is the multi-year downtrend resistance in yields that comes in around 3% (chart below, right-hand side)."

Will this key level be broken? In order to do so, Citi believes that we need to see a combination of acceleration in inflation and a Fed that is willing to let the economy run a little hot.

With regard to the former, there are gradual signs that wage growth and consumer price inflation is creeping up - i.e., small businesses are struggling to fill vacant positions right now, and paired with the subdued headline payrolls number this month, imply to Citi that there is perhaps very little slack remaining in the US labour market - although there has yet to be another similar surprise in inflation to the upside as we saw in the February AHE print; in fact, according to the latest decline in rent and shelter CPI - the biggest component of the basket - inflation pressures may now be subsiding fast.

As for the Fed "variable", Citi repeats what it noted last week, namely "the real Fed Funds rate is probably already crossing above measures of natural real interest rates for the first time since 2007", and yet despite this, "it’s likely that the majority of the committee will opt for continued ‘gradual’ hikes, particularly with equity markets on edge and more and more market participants questioning cyclical growth. There are plenty of risks that could ruin the party, not least the dreaded trade war."

Still, even the Fed is now resigned that tightening will only go so far, and looking five years ahead, even the Fed’s own kinked dots show that easing will be underway:

And if not term premia are too low at the long end for such a resilient implied business cycle. For now we are opting to stick with our 5y1y - 5y10y forward steepeners3 (Figure 8). The curve can’t stay this flat, this long can it? Therefore at these levels it’s worth risking a forward steepener, in our view.

Finally, what about the broader credit market in terms of duration/overall direction? Here, as the CBO reminded us last week, net treasury supply is set to double to just shy of $1 trillion, a transition which - all else equal - should send yields sharply higher (of course, all else will not be equal if a global deflationary scare is unleashed). This to Citi represents "a massive problem" as the market has already priced in all of this, and any moves from this point out will be extremely violent, to wit:

Treasury supply (net) is set to double from circa $400bn to $800bn. At the top of the cycle, this is going to push real yields higher (Figure 9). Especially with reduced flows from the EA and Japan. But there is a massive problem. The market knows this and holds a massive duration short.

In other words, the market is poised at a very precarious (dis)equilibrium: on one hand bond traders are certain that yields will keep rising; on the other the recent sharp reversal in economic conditions threatens to flush the record short overhang, resulting in a plunge in yields, potentially as low as 2% and massive P&L losses for the spec community.  This is something Bank of America noted two weeks ago, when observing the recent dramatic inflows into Treasury funds, which suggest that a move in yields back to 2% is just a matter of time, or as BofA's Michael Hartnett said, these Treasury inflows "are the most visible expression of positioning for risk-off to date."

So until either fundamentals change (reversal of fiscal policy, Fed etc) or the duration short reduces, it is unlikely that anything material will change in this tense but escalating stand off between fears of economic slowdown and rising inflation. Who blinks first? According to Citi, "positions will likely give way first."

Comments

radio man Sun, 04/15/2018 - 10:53 Permalink

Any article quoting JPMorgan pisses me off as of late. Stop screwing with silver and gold so the world can learn the true state of the US dollar.

agcw86 Sun, 04/15/2018 - 11:02 Permalink

Epiphany by the money sharks. What brilliant insight when they are the ones causing the problems. Return to the rule of law and stop the naked shorting of precious metals for starters.

chennaiguy Sun, 04/15/2018 - 11:03 Permalink

bla bla bla bullshit... the cackling stupid zerohedgers are so fucking stupid.. the US dollar will always reign supreme.. everyone in the world will always use USD forever.... go fuck yourselves you stupid gold fucks

VK Sun, 04/15/2018 - 11:05 Permalink

The third option is that the counterparty goes bust. So the bond shorts win, yields do rise but guess what, there won't be enough liquidity in the market to pay the winners of the record guaranteed trade. Lose-lose. 

Captain Nemo d… Sun, 04/15/2018 - 11:06 Permalink

The massive problem is with the economy. Markets are just a place where you buy and sell things. As long as they are neat and clean and the facilities work, no problems there.

aqualech Sun, 04/15/2018 - 11:14 Permalink

Article illuminates that these Citi analysts and others assume that we are reliant on the Fed for all things and that they will be able to maintain control of the bond markets.  Also that it is the Fed’s job to keep risk markets propped up.

adr Sun, 04/15/2018 - 11:16 Permalink

We've been mired in stagflation since the crisis, actually we have been since 1998.

More companies have gone out of business during the greatest stock bull run in history than the largest downturn since 1929.

What does that tell you?

Base cost of living has gone through the roof while real incomes declined. Pushing anyone that has anything to chase the riskiest investments for the hope of any yield.

I said ten years ago that Obama would usher in another 1970s, he even blew that comparison out of the water. Outside the trillions printed to pay off the parasite class, we would have seen things that would have made those breadline photos of the GD look like nothing.

Consuelo adr Sun, 04/15/2018 - 12:47 Permalink

+1 adr.

 

I would only add that the bubble of protection (Welfare, EBT, .gov rent checks, etc.) provided by our 'exorbitant privilege' will give way at some point and your depiction of outsized breadlines will come to fruition - albeit with a slight caveat: Men in those days acted in a civilized manner - as did society in general.   Screen doors left unlocked at night sorta thing.

What comes this time around is probably best left to the imagination.

In reply to by adr

Easyp Sun, 04/15/2018 - 11:22 Permalink

Inflation, a great way of lowering the cost of reckless governmental borrowing. 

Commodities like oil, silver and gold a great way of saying fuck you to inflation......

Ink Pusher Sun, 04/15/2018 - 11:28 Permalink

"There Is A Massive Problem" With The Bond Market"

No shit? Really?<S

Maybe selling trillions in collateralized debt wasn't such a great idea after all eh?

What a bunch of fuckin' imbeciles.

Xscream Sun, 04/15/2018 - 11:35 Permalink

Its kinda like the news networks. On NBC CBS ABC CNN MSNBC Trump is a demon from hell. Yet on FOX he can nothing wrong.Same for the predictors of the economy. Are things going well or is downturn to the crash coming soon. Gives me a headache. The fed has kept the plates spinning a lot longer than anyone thought was possible already. Good luck to all. Sure seems like something big is coming.

hairball48 Sun, 04/15/2018 - 12:17 Permalink

All those charts and graphs makes my hair hurt.

This is all you need to know.

The USA is broke and Mises's crack-up boom, the great reconciliation,  is on its way.

Still stackin'

snblitz Sun, 04/15/2018 - 12:19 Permalink

So long as we have an unsound money system, the entire article isn't really relevant.

Other problems abound like how inflation is calculated too.

Whether stocks go up or down, whether bonds go up or down, whether inflation is up or down, the money thieves will get whatever real wealth you create.

What is the point of playing in a casino that is entirely rigged against you?

The Fed 2% inflation target is talked about like it is a good thing, rather than what it is: the seizure of half your wealth every 30 years.  And that is if you believe the lies behind the government calculated rate of inflation.

At 5% rate of inflation, such as calculated by the MIT billion prices project, half your wealth disappears in 15 years.

Why free people create gold and silver back currencies and how governments and bankers steal everything (an easy read):

https://www.finitespaces.com/2018/04/07/why-gold-is-a-terrible-investment-and-will-save-the-lives-of-your-children/

 

itstippy Sun, 04/15/2018 - 12:22 Permalink

Q1 2018 reported corporate profits look to be stellar - I'm hearing +18%.  That should indicate very robust economic growth.  But (there's a but) . . .

The Q1 reported profits reflect the 2018 Federal tax cuts.  Every penny saved in taxes has been put directly on the bottom line.  Corporate accountants have had a blast.  There hasn't been a big increase in sales or productivity; it's all about lower tax overhead. 

Unfortunately, the Federal government cut taxes while increasing spending.  They'll have to borrow a lot more money.  Interest rates will rise as corporations compete with the Federal government for capital, and since the corporations are already extremely leveraged their funding needs will be great.  A credit crunch looms that will consume all corporate profits.  Both the corporations and the Federal government will demand that the Federal Reserve do something to relieve the pressure.  This will happen within the next few quarters, and only get worse as time goes on.

Our own MAXxxxx has a one-word solution to the coming mess, and shares it with us occaisionally.  Perhaps he'll chip in . . .

ElTerco Sun, 04/15/2018 - 12:34 Permalink

The tightening needs to happen. Leverage is out of control, resulting in pervasive near zombie corporations. The only way to return to sound business practices is to remind people what the real world looks like.

taketheredpill Sun, 04/15/2018 - 13:41 Permalink

"but what’s probably more important (from a psychological perspective) is the multi-year downtrend resistance in yields that comes in around 3%."

"Will this key level be broken? In order to do so, Citi believes that we....."

 

This "key level" better be broken or US equities are fucked.  Go back and look at what happened the previous time the channel top was tested and yields fell back.  Oops.

Oh yeah.  JP Morgan Treasury Bond Sentiment bottomed out last November.  Does sentiment usually bottom out before selloffs?

And the Yield Curve seems to be saying something too....

abgary1 Sun, 04/15/2018 - 15:59 Permalink

The problem is the central banks and neo-classical economic theory.

The pursuit of perpetual economic growth and inflation with little or no volatility is unachievable and destructive.

Volatility is inherent to the economy and the markets and the central banks can do nothing to change that.

Trying to control the world economy by targeting inflation is total illogical.

 

Neo-classical economic theory has no relevance to reality and to understand how illogical it is please read Debunking Economics: The Emperor Dethroned? By Prof. Steve Keen. Please support, intellectually and financially, his efforts to develop new economic theories that are reflective of the complex, dynamic and chaotic economy and markets that exist (Patreon.com/ProfSteveKeen/).

To the ivy league business schools: why won't you admit neo-classical economic theory is irrelevant and support efforts to develop new theories?

Knave Dave Sun, 04/15/2018 - 18:09 Permalink

"Q1 earnings season [are] the best since 2011 with its 18% Y/Y expected EPS growth" only because in the ration of earnings/share (EPS), the denominator has been hugely reduced since a year ago by billions and billions of dollars worth of share buybacks. There are simply a WHOLE LOT LESS shares over which those earnings are distributed. So, it's a meaningless number in terms of saying anything about economic performance.