Reflation trade?
A few quick and early comments this weekend. The first caveat, almost more of a reminder to myself than to you, is that trading off the current fundamental assessment of economic conditions can be problematic. There are short term perceptions and positioning that can overwhelm other, longer term considerations. (This is a much more important and painfully learned disclaimer than the pages mandated by regulators).
Yields this week rose to close at recent highs. The ten year note yield was up 13.4 bps on the week to 188.6. One-year Eurodollar calendar spreads also closed at the highs of the week, though they are still mostly clustered around 27 bps, so it’s still mostly perceived to be a one hike a year world. The prevailing theme seems to be the idea of a ‘reflation’ trade, given China stimulus, and eye-popping rallies in iron ore, Shanghai rebar contract, etc. The chart below shows rebar, iron ore, crude and the Bloomberg Commodity Index (BCOM). BCOM is in green and indicates a more shallow rally, but it’s pretty clear that going into the week’s FOMC meeting, things are firmer than they were last time, in mid-March.
One of my themes has been that the gap between commodities and stocks would start to narrow. That indeed is (gently) starting to be the case as shown by second chart below. This chart is SPX/BCOM, or stocks as priced in terms of the commodity index. Regarding reflation, the chart reflects that idea, as it’s up 2.5x from 2012 levels. However, the reflation was in paper assets. The chart is hugging an upward sloping trendline, though it also is potentially forming a double top.
This Wednesday’s FOMC announcement isn’t expected to bring much change. However, a Reuters poll of 80 economists found that 2/3rds expect a hike at the June meeting. Of those, 83.2% declined to risk any money buying the May/June FF spread for 2.5 bps which indicates odds of 20-25% of a hike at the June meeting, though Smithers sportingly wagered Jenkins a coffee and scone that the Fed would indeed hike twice this year. OK, I made that last part up, but as has been widely circulated even in polite company, the market does not believe Smithers. Or Rosengren for that matter. Aug/Oct FF spread settled at 5.0, so that spread similarly prices a September Fed hike at 1 in 5.
As an aside, the issue of Brexit is a very real concern, as evidenced by Carney asking banks about contingency plans. It will absolutely be a consideration for the Fed, as the June meeting falls right before the referendum. And the concern factor has likely just gotten “realer” as Obama argued the US case for Britain to stay by threatening the UK with “the back of the queue.” Good strategy.
Market participants hope for the reflation trade, and in this they are allies with the Central Banks. The problem is that CBs want to RE-flate prices and take the sting out of over-indebtedness, by DE-flating their own currencies. So, the BoJ is considering more negative rates (mission accomplished, the yen plunged) and the ECB said it will be expansive in its purchases of corporate bonds (from Deutsche Bank):
We think the scope of ECB corporate bond buying could potentially be much greater than we had initially anticipated in March. The ECB stands ready to buy bonds from Euro Area issuers even when their parent companies are outside of the bloc. Already we can find a number of US, UK and Swiss headquartered names that issue out of SPVs incorporated in the Euro Area. If this trend to SPV issuance catches on, then the ECB’s policies will likely be very reflationary for all credit markets across the globe, and because of a likely refinancing wave – equity markets too.
The beginning of the mission is accomplished for the ECB, as the Euro closed at April’s low. However, these initiatives tend to complicate the Fed’s job of weakening the USD. A large aspect of the commodity/emerging market/hi yld relief rally has been the weaker dollar, spurred on by Yellen’s dovishness in March. This week the dollar index bounced, having tested the low of the range in effect for the past year and a quarter.
Circling back to the idea of the current economic assessment, this week we had a weak Philly Fed, with an extremely soft employment component. The Chicago Fed National Activity Index at -0.44 was the lowest since January 2014. The three month moving average has been negative for 8 straight months. Friday’s Mfg PMI was weaker than expected at 50.8, vs survey of 52. I looked for the NY Fed NowCast for growth, but since we are in the Fed’s blackout period…nothing. However, on April 15 the nowcasts were 0.8% for Q1 and 1.2% for Q2. Going out on a limb, my personal ‘nowcast’ is a revision lower to Q2 given the week’s data. In which case, a forecast for 2% GDP over the year will necessitate over 3% in the second half, and the Fed’s own projection (in March) for 2016 Real GDP is 2.2%.
If the market believes the reflation trade, the curve should steepen. German 2/10 did rally, up 9.6 bps on the week. In the US, the 2/10 treasury spread firmed by 4.6 bps to 106.8. Red/gold Eurodollar pack spread shown below. It’s trying to break its long term downward sloping trendline. But it hasn’t. And if the Fed does happen to tilt a bit tighter in this FOMC announcement, the curve will likely flatten more.
Tight Fed (relative to other CBs)->stronger dollar-> weaker commodities -> pressure on EM -> flatter curve.
Loose Fed -> weaker dollar -> pressure on ECB -> pressure on Japan -> ECB and BoJ stimulate but risk exposing impotence regarding growth -> flatter curve?
