"This Has Been A Tough One": Here Is The Fed Scenario That Would Hurt The Most

Having commented extensively in recent weeks on what to expect from the Fed today, Nomura's Charlie McElligott is out with a "cheat sheet" laying out his final thoughts on how the market may react to the Fed's statement at 2pm today.

At the very top level, whereas the market is now stuck with the perception that today's announcement has a "binary" nature due to the view that "anything less than "dovish" surprise or cut could create a “hawkish” price impulse across the enormous duration length accumulated across the in Rates/Steepeners/Receivers complex, the market has a distribution of outcomes."

  • Hawkish Surprise: According to the Nomura strategist, a “hawkish” interpretation from the market would risk a "Duration Unwind” scenario he has been warning about for weeks, leading to the "potential for a sloppy profit-take across Rates", while within Equities the reaction would be more nuanced, leading to a "Momentum" unwind, as the “Slow-flation Risk Barbell” of “long Low Vol / Defensives and long Secular Growth” would likely be hit, while placeholder shorts in Value/Cyclicals would likely rip higher. What the net impact on the S&P is is unclear, although it is quite likely that the alligator jaws between yields and stocks will snap shut.

   

  • Dovish Surprise: If the Fed somehow manages to pull off a “dovish surprise” today (in the aftermath of Draghi shocker from yesterday which as explained yesterday pushed the dovish Fed threshold even further), the best expressions according to McElligott would come via "tactical longs/ upside in Russell (Friday Calls look good, big underperf and cyclically levered + sensitive to “weak USD” and FWIW, our CTA model for RTY futures near partial “cover” levels of the current “-66.5% Short” down to just “-43%” at a SIGNIFICANT NOTIONAL to cover on a closer above 1553—with spot 1554 last) and / or EEM regular upside—say July—where 42.5C comes with implied ~17.5 vols and in-line with realized @18."

Of note, should the Russell shoot up, it will likely force a short squeeze upon the CTA universe, as spot closing above the 1,553 trigger level would see substantial covering from -66.5% short to -43%.

Drilling into the specifics, here are the details from Charlie McElligott's Final Fed Call:

  • Man, this has been a tough-one; without a doubt, a June “cut” is obviously trending higher (from ~2% less than a month ago to the current ~20% prob) following Draghi’s “whatever it takes 2.0” moment yesterday—I myself am probably closer to 40% probability of a CUT today after assessing yesterday’s latest inputs…still not my base-case, but rapidly moving higher.

  • As previously stated, the Fed is now in a very precarious situation and HAS TO be conscientious of the market-pricing such a powerful “dovish” outcome, as any “disappointment vs heightened expectations” risks another SELF-IMPOSED ERROR via de facto TIGHTENING of financial conditions and another “tantrum” scenario, as the massive length in Rates / Front-End / Duration  / Steepeners / Receivers & Curve Caps would then likely see a powerful blast of selling / profit-taking in said crowded trades which could “tip over” into something much sloppier—along with similar dynamic in Equities “Momentum”, that being “Slow-flation” positioning long Defensives and Sec Growth vs short Value / Cyclicals
  • The logic with the “June Cut” is “why would the Fed delay the inevitable?” as 1) the market is giving it to them and their own dots will be dropping too; on top of fact that 2) they risk creating a “tantrum” of their own-making which ultimately makes their job even more difficult via “tighter” FCI with them already being so close to the zero bound as-is; said another way, what is the downside to cutting today vs the ‘financial conditions tantrum’ risks if they don’t?
  • However I think they can “thread the needle” still without a cut today via a very clear message on Fed easing intentions going-forward—by removing “patience,” by talking “insurance” line while discussing their willingness to act on further growth- and inflation- deterioration, by dropping dots to neutral / towards EFFR and potentially bringing-forward the end of QT even sooner (an early end in August is Lew Alexander’s house view now)
  • This above scenario—no “cut” but powerful “dovish” guidance—would likely see Rates and Equities initially impulse sell-off, before stabilizing again thereafter, as markets realize that cuts are even a greater inevitability—thus, those future Fed cuts simply get pushed out into 2020 with calendar spreads inverting further negative

What would hurt?

As McElligott explains, his "base case" is that markets are positioned for ”worst-case” outcomes in Global Growth-, Inflation- and Trade Tariff- scenarios; the risk then is that they are caught wrong-footed by 1) a heavy-handed CB & coordinated policy response and / or 2) a positive macro input (trade deal, stabilization of PMIs / inflation)

Clearly “trade deals,” better data and an activist/coordinated global CB response sold as “sustaining the expansion” would run counter to the “Slow-flation” / “End-of-Cycle” view which has seen a massive push from investors into Duration / Bond-Proxies and out of “growth” assets like Equities and Commodities

So what price-action would hurt “HERD” positioning the most?

Rates: A global DM Bond / Rates selloff (+$200B inflow YTD per EPFR; +100% Long across CTA Trend in global DM Bond and STIRs; still over +2.5 SD “Gross-Exposure” position across DM Bonds from Risk-Parity since ‘11); “bear-flattening” of the UST curve (“Steepeners” remain SO crowded and 5s30s cash having more than tripled in 8 months); and most acutely, a shock lower in the front-end / ED$ (Whites, Reds, Greens, TU, FV)

Equities: A broad SPX melt-up to new highs (over $150B outflows in Global Equities YTD; Net-Exposure remaining near multi-year lows; HF L/S “Beta to SPX 3.9th %ile since 2003; heavy Defensive / Low Vol / Anti-Beta tilt; Leveraged Funds now with ~$53B of US Eq futures Shorts in aggregate YTD)—and a LOT of clients saying “the highs are in”); particularly, a “Value” factor / Cyclical squeeze vs Secular Growth & Bond Proxy selloff—aka pure “Reversal” factor and the opposite of “1Y Momentum,” which is currently the “Slow-flation Barbell” Momentum long in Growth and Low Vol I’ve referenced ad nauseum vs the Momentum short in Cyclical / Value)

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One final observation from the Nomura strategist is that there is a "particularly perverse short-term outcome" for US stocks which sees the market “force-in” with dovish-Fed this week and gap to new SPX highs simultaneously into “bullish” June serial Op-Ex seasonality, as buy-side Overwriters roll their in-the-money calls which creates large net buying of Delta.

However, once next week's Op-Ex seasonalilty turns lower (-1.4% on average & lower 87% of time when SPX returns are positive the 4w going “in” to June Op-Ex), all against the corporate bid going “dark” (75% of SPX companies in their “Buyback Blackout” beginning yesterday), while a massive amount of the market’s current “long Gamma” profile rolls off post Op-Ex so you’d lose some of that current ‘gravity’—thus a “RIP HIGHER” this week, then “SELL OFF WITH A DEFENSIVE SEASONALITY” next week…yikes

This would then be fascinating, because some would potentially mis-read this very seasonal and FLOW-CENTRIC “rip higher then sell-off” the week post-Fed as some sort of a “vote of no-confidence” in the Fed cut move—which wouldn’t actually be the case

Nomura's conclusion: "If this were to play out—a “make SPX highs” after a dovish surprise, then sell-off next week with people sweating it as a (mis)read “fade the Fed” trade—then would set the tables for an EVEN HIGHER PUSH in SPX thereafter…for the same Equities “under-positioning” metrics I discussed y’day and shorts would likely be further pressed as dynamic hedges into any selloff."

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One final point: whether or not this scenario - rip higher, drift lower - materializes due to a misreading of the Fed's intentions or not, readers may recall that this is also the "worst case" scenario laid out by BofA two weeks ago (see "BofA: Why If The Fed Cuts Now, It Would Be A "Huge Risk "), when the bank's CIO Michael Hartnett said that the foundations for the S&P rising to 3,000 in the summer - which is BofA's base case (before the S&P slides back down in the second half) are already there. In light of this, the risk is that the Fed does precisely what the market now expects with certainty, that it cuts rates as soon as July.

This is shown in the chart below, when in the aftermath of the Asian crisis of 1998, the Fed cut rates only to cause the dot com bubble... and its subsequent bursting and the plunge in rates from 6%+ to just 1% as the first 21st century bubble popped. 

It is this risk, perhaps more than anything McElligott has listed above, that threatens markets now as well: an overly easy Fed cutting rates, only to create a historic meltup just ahead of the 2020 election, and eventually bursting the biggest asset bubble in history.

There's more: the Fed could cut and join the ECB and BOJ among those central banks that are losing credibility, as a result of it "patiently" flipping from hikes to cuts with no material change in macro: after all, as BofA notes, in the past 6 months US CPI is unchanged and the US unemployment rate down, while as Goldman wrote last week "since the March SEP meeting, stock prices are higher, the unemployment rate fell to a 50-year low, consensus growth forecasts are unchanged, and the very tariffs on Mexico that prompted the latest calls for rate cuts have been taken off the table."

So will Powell bite the bullet and stand firm pointing out that the economy is still doing quite well, and certainly not in need of easing (especially as trade war inflation is yet to bite) or will he pull a Draghi and capitulate dovishly, which while praised by Trump on twitter and seen as evidence of political intervention by the president in the Marriner Eccles building, will be mocked by the market which will henceforth be certain that not even a modest drop in risk is permitted costing the Fed its last shred of credibility, and triggering the "huge risk" of greenlighting the "final bubble"?

The answer in just a few minutes.