There was something different about yesterday's furious rate selloff.
That's the post-mortem take from Nomura's cross asset strategist Charlie McElligott, who notes that amid yesterday's "Monster" rates selloff, overall volatility was surprisingly mundane (although it is certainly ticking up today, now that the liquidation has gone global.)
The difference also manifested itself in a violent repricing of economic expectations, which followed yesterday’s ADP print, which according to McElligott was a +3.5 std dev surprise while the record ISM Non-Mfg print was a whopping +5.8 std dev surprise.
As a result of the spectacular economic data, which followed the September monster average hourly earnings beat (and ahead of tomorrow's NFP print which based on the ISM index could print as high as +500K jobs), as well as last week’s Fed meeting "that really accelerated this interest rate sensitivity to the economic data, when Chairman Powell iterated just how data-dependent the Fed’s policy normalization path will be going-forward, as opposed to auto-pilot", the “growth skepticism” has - for now- evaporated as evidenced in Eurodollar futures calendar spreads, where as recently as late August, the market had only priced-in 1.5 hikes (~33.5bps) for all of 2019 versus the Fed’s projected 3 hikes (75bps); now, as of this morning, EDZ8Z9 has gapped wider and is now pricing-in over a full two hikes now (57.5bps).
In light of the above, the market also appears to have aggressively repriced the market’s long-run neutral rate (aka r-star) projection - a process which according to Nomura began in late Aug, but was kicked into overdrive from the early Sep, and which has now, according to McElligott who quotes Spinal Tap, "gone up to 11."
Why is the higher r-star estimate a critical component of the latest market phase transition?
Because, as McElligott explains, "the higher the neutral rate projection, the more (theoretical) ability to digest additional rate hikes before Fed policy goes to outright “restrictive”—and as such, this has then caused investors to “push back” / delay their “end of cycle” projections from sometime in mid-2020 to now potentially into 2021, creating the recent positive “Cyclical Bullishness” in U.S. risk assets."
It also explains the abovementioned lack of a volatility spike, because the inflection from "bear flattening", which defined the yield curve for much of 2018, to “bear steepening” is sending an important message for stocks, as it’s this upgrading of R-star / neutral rate which is re-pricing the long-end of the curve.
Effectively the market is saying that in the absence of an “inflation shock” (which would drive a front-end yield spike / “power flattening” on “accelerated Fed),” that we are on track to “grow faster than we are tightening”
Another way of putting it is that Wednesday's "economic assessment upgrade" and view that we are "growing faster than we are tightening" is why we are not seeing that same "rate - and VaR shock" contagion into risk-assets that defined the market in late January, early February, and which - as McElligott notes - "was BY-FAR the #1 client inquiry yday, i.e. 'Why are higher yields not negatively impacting Stocks here?!'."
Of course, had clients waited one more day, they would realized that perhaps it was just a question of the market's delayed response.
Which also brings us to another key question: if equity markets were not selling off - at least not until the last hour of trading (perhaps triggered by JPM's late downgrade of Chinese stocks) - then who was dumping bonds?
McElligott's answer is quite curious: observing the open interest in the long bond future (USZ) which jumped 33k yday on 2x’s volume and on a day when the 2-5-30 UST Butterfly (shown below) richened 7bps — he notes there is some intrigue as to potential sources of yesterday’s massive selling—and is indicative of 1) foreign “real money” (China?) 2) risk-parity funds (Dalio) or 3) both. Of note: CTAs do not appear to have joing the selloff just yet. This could be a key catalyst as to when the next, and even greater, round of selling kicks in.
Sellers aside, another consequences of the upgrade in r-star is that yesterday's move was opposite to the risk-negative steepening scenario which McElligott has pegged as a mid- 2019 potential, "where the steepening would conversely be driven by the front-end rallying, as “tighter financial conditions” in theory would negatively impact growth data and in-turn, cause market expectations of Fed hikes to the be REMOVED from the front-end."
This is the dreaded "tightening into a slowdown" scenario.
Unfortunately for the bulls, it is this scenario that is manifesting itself today. It emerged overnight when rate weakness spilled over into equities, first in Asia, then Europe and finally in the US where the S&P has slipped to a 3 week low and the Nasdaq is down 2% amid a rout in tech shares.
To the Nomura strategist, there are two immediate reasons explaining the delayed response in stocks"
- Higher “data-dependence” also means an “asymmetric bias to react to positive data more than negative data”—i.e. the risk of “too good” of data means heightened potential for a Fed “policy error” / “over-tightening”
- Chair Powell’s comments yesterday then underscored the Fed’s willingness to “go past neutral,” which means running beyond “restrictive” policy – meaning they are prepared to “pump the breaks” on an “overheated” economy via “accelerated tightening” policy
McElligott then brings up something we highlighted yesterday, namely that as a result of Powell's determination to keep hiking, the risk is that the Fed Funds rate will eventually rise (well) above the neutral rate. To justify this point, he points out that March ’19 hike probabilities are now at 71% (was down at just 45% at the end of August) communicating that both Dec and Mar are now “done’ in the markets’ eyes. And, as we noted yesterday, two more hikes would put us above the (rising) neutral rate.
What happens at that point? As we laid out yesterday, and as McElligott notes, nothing good:
Historically, tightening cycles (especially where the effective Fed Funds rate runs north of the neutral rate) has meant some form of markets’ crisis along the way: Continental Bank failure / Latam debt crises in the early 80s; the Savings & Loans / Junk bond / Black Monday crises in the mid-to-late 80s / early 90s; the EM crises (Peso, Asia and Russia default) throughout the 90s into LTCM failure in ‘98; the dot-com bubble bursting in ’00; and of course the GFC in ’07-’08
But it's not just the US that is at risk: one can argue that as EM rush to catch up to the Fed, they are becoming increasingly exposed to a major event. Indeed, with U.S. 5Y “Real Yields” at the highest since ’09, the U.S. Dollar nearing 1 year highs, Wage Pressures building domestically and Crude Oil at four year highs (in classic “late-cycle” fashion), the Nomura analyst writes that "it is now (perversely) more likely than any other point this year that we see an proliferation of “accidents” from EM economies to forward-looking US corporate cost-driven margin compression."
All of the above leads McElligott to conclude that while being-able to trade sentiment and seasonality tactically month-to-month, "the “Financial Conditions Tightening Tantrum” phase 2 is well under-way…ESPECIALLY now that Fed’s actions are dragging rest-of-world along for the ride":
- Five hikes globally last week for the first time ever (since data began being tracked in 2001)
- ECB now being forced to “policy converge” as well, with ERZ9Z0 now pricing in 41.5bps of hikes from what was just 29bps in mid-August
- Even the “last of the easy money holdouts” at the BoJ can now allow for even more curve steepening / rate vol to take advantage of the YCC range extension, while our Japanese strategists believe will be widened further to 40bps come January (TOPIX Banks hellooooooo)
So what is the take home message here?
Recall that we started with pointing out the key difference between yesterday's, and the January rate selloff - the lack of rate volatility.
Looking out past the October “Cyclical Melt-Up” trade that McElligott advocated as recently as two days ago, he will be watching for "Rate Vol to overshoot perhaps at end of month / start of Nov on:
- this fundamental re-pricing of Rates,
- the capitulation from real-money longs and
- the massive month of October “QT impulse”—with high potential to see near-term Equities concerns escalate as “real rates” accelerate and “tighten” financial conditions
Finally, and going back to the lack of CTA selling, the Nomura strategist notes that the bank's CTA model in SPX futs has been “100% Max Long” although today we see sell pressure under 2939 to get down to “96% Long” as the 2m window flips. Which means that anyone wonder when the equity selloff will really kick in, "we’d expect more selling under 2892 to get to just “58% Long” as the 1m window would flip."
We are now just 3 S&P points away from this key - for the CTAs - support level, at which point the October selloff could easily mutate into the dreaded January plunge...