Charlie McElligott: US Markets Are On The Cusp Of A "Tightening Tantrum"

It's still too early to say for certain, but after stocks dumped on Monday as investors finally appeared willing to discount trade war fears (after President Trump promised that he'd be making a major trade-related announcement after the close), Charlie McElligott's projection that September will be a month of "two halves" has aged gracefully - as has his analysis showing that US equity funds are heading for disaster now that longstanding market fundamentals are finally beginning to shift.

With the Fed's discussion about possibly pausing rate hikes at "neutral" still ringing in the ears of many investors, Macrovoices' Erik Townsend seemingly couldn't have chosen a better time to interview McElligott as this week's featured speaker on the Macrovoices podcast. During the interview (which was accompanied by a slide deck fleshing out McElligott's observations surrounding constricting global financial conditions in greater detail), McElligott explains why investors should be worried about a reversal in the yield curve, as it portends the long-awaited unraveling of one of the longest equity bull markets in history.

To sum up, McElligott is trying to show that we are much further along in the Fed rate hike cycle than many investors believe.

While the Fed's projections (which perennially lag the market) are still calling for another 75 basis points of hikes by the end of 2019, short-term interest rate futures are only pricing in 44 bps over the next year. A look back at the yield curve relative to Fed rate-hike expectations and US equity performance in the years leading up to the financial crash suggests how this dynamic might play out.

McElligot

Once conditions tighten and yields begin to rise, the transition from historical melt up to a period of tightening financial conditions will finally have started in earnest, ushering the long-awaited correction in bonds, US stocks are destined to follow.

My major message here is that I think there is an increasing likelihood that 2019 – even though the Fed is currently telling us they are projecting three hikes, the market is only pricing in 44 bits of hikes versus the Fed’s 75 bits – that there is an increasing likelihood that the Fed might have to pause if not ever to get to those three hikes.

But what’s so important about the short-term interest rates and these spreads, or these curves, is that it’s giving us a much more real-time prognostication tool with regards to where the market thinks the Fed is nearing the end of this normalization cycle. And the end of this normalization cycle is critical for the culmination of this phase 1 transition from the Cyclical Melt-Up phase into the phase 2 “Financial Conditions Tightening Tantrum” phase that is going to have major implications for the cross-asset universe and fund performance.

But the potential inflection points aren't limited to the US. Indeed, when the shift begins in earnest, it will be a global phenomenon. And evidence is already appearing in China, where the slowdown of that country's credit impulse as the PBOC tries to manage a painful but necessary deleveraging is a logical starting point for any conversation about tightening global credit conditions. McElligott addresses this in his slide deck with a chart illustrating the change in China's yoy credit creation, which has fallen sharply into negative territory. Over the past two years, China has tried to rein in their "social financing" to contain contagion risks associated with their planned transition to a services based economy.

Ultimately, this has tightened credit conditions in a way that has an outsize impact on the emerging world, though it impacts G-10 economies as well. 

McElligot

To be sure, Chinese data has a strong seasonal skew, particularly around the beginning of the year, but, as the data show, the impulse tapers down from there. The end result is plainly obvious: The Chinese credit impulse is slowing.

As that credit impulse – these new loans that are being forced out to banks per quota – those asks from the PBOC and from the central planners have eased. What ends up happening is that (in that second panel) all system liquidity then slows as well. There is a seasonality.

There is a very powerful seasonality with Chinese credit impulse, with Chinese credit financing. Certainly, into their New Year, at the start of the year, there is a huge impulse to feed that multi-week shutdown. Then you kind of taper off from there. What ends up happening, though, is that you are seeing – under this deleveraging regime – a diminishing magnitude of these impulses.

All of those middle panels and lower, show what the diminishing magnitude of that impulse has on Chinese financial conditions. Meaning (in that fourth panel), Chinese financial conditions are moving lower. That means tighter financial conditions.

This slowdown is contributing to an disinflationary wave emanating from China which has been amplified by the weakening yuan (given China's massive trade surplus, cheaper goods in China translate to cheaper goods everywhere else).

The next panel speaks to the Chinese inflation surprise index trailing lower. You see these peaks and then these fades. The yellow line is the global inflation surprises. Meaning: Is inflation data (CPI or CPI core data) around the world beating or missing? On average, those are missing now. China is the engine that drives global inflation is what I’m communicating here.

Circling back to the US, McElligott elaborates on his original point. Namely, that while dissipating term premiums in US debt have received more attention than they deserve so far this year - particularly since the widely held expectation that the yield curve would steepen haven't panned out (much to Bill Gross's chagrin). But while anxieties about a possible yield-curve inversion are understandable given the historical precedent, bulls should be much more concerned about tightening in the short-term credit complex, McElligott argued.

Interest rates on three-month Treasury bills, the essential cash equivalent, and the three-month LIBOR (the cost of money), have quietly (aside from some noise earlier this year about the blowout in the OIS-LIBOR spread) crept back to pre-crisis level, as the chart below illustrates...

McElligot

Instead of paying attention to proprietary indexes of financial conditions, McElligot argues that traders should instead focus on these short term rates for the simple

"Commercial paper – this is the stuff that lubricates the financial system. General collateral repo on the bottom. That’s the stuff that makes the system work, that funds businesses. It’s critical to keep moving."

Listen to the full interview below: