For round three I want to look a bit more holistically at rates, especially in $ rates, where I believe there is tug of war between economics and flow. As I have been making the case, the U.S. economy is slowing at the same time oil prices are falling and China is deleveraging. Yet, in the past few weeks, $ rates backed up despite a break in cal'18 backwardation in the brent curve and a continued hammering of industrial metals in ferrous and non-ferrous. For me, this move in px in commods warranted a big rates rally as the ramifications for inflation and growth are quite apparent. (see iron ore v US ISM in last post). Of course the Fed getting June priced has had an effect on the curve as well, but the back end move looks to have more than just Fed mongering. On that note, I would be getting out of the 2s and silver shorts from last piece, as the market has reassigned almost 10 more bps to the ff curve for this year, which should be a peak at almost 1.5 hikes.
There are two things clearly weighing on USTs in the back end, however, even if they were to continue, rates eventually price the expected path of inflation and growth and both are trending lower.
1) As I talked about in the previous note, which I have seemingly discounted, the Fed has a put in the yield curve and its having an effect on the long end when hikes are priced in. The qualitative difference in this tightening cycle is the threat of SOMA changes keeping ultras in range. A hawkish Fed into slowing growth should see 2s10s near 80 bps, but the “SOMA put” (I coined that) has prevented that. I actually think the board is using this as a policy tool to keep the curve in check as it bothers them why LSAPs and gradual rate hikes into escape velocity are having the same effect on the yield curve, this is the Bullard question. This allows the Fed to price hikes into the curve without pushing 5s30s below 105bps, even though Rosengren recently said, b/s talk is still just "speculative."
2) The second point is the power of flows. As the three biggest holders seem to be inclined sellers, two have already been selling over past six months, and one is threatening to (Fed, Japan, China), the back end is nervous. In the second half of this piece I will try and dispel these concerns, especially on the Asia front. The case for counter flow in a time period of weakening economic data should bolster 10s for the next 3-6 months.
First, a macro view
The Fed has an aggregate demand problem
Considering the consumption issues we have seen in Q1, its not surprising to see the US's trade def with China narrowing. As the trade relationship is largely denominated in goods, it makes sense to track this relationship as barometer of aggregate demand in the US economy. This is one of the reasons in the post "export dollars import goods" world, the dollar strengthens into economic weakness. Going into the past two recessions, the US's trade def with China narrowed significantly on a YoY% basis, which is what we are seeing now. The Fed may have gotten their wish with employment gains, but the knock on into discretionary consumption is slowing.
Consumption is slowing again
The Fed will point to upticks in survey confidence as measure to prove that Q1 weakness in consumption was just a blimp. Consumption is turning lower again. Which should not be surprising since RWE from CPI is basically at 0, so wage growth is not there, which happens to be happening at the same time as increasing credit issues with delinquencies and charge offs rising. The Fed will brush it off into June, but can the board with a dovish bias, really tolerate negative consumption?
Hard to see how PCE deflator goes higher with gasoline rolling
The move in the oil gut from crude stocks into refined products has taken rbob curve into a strong front month contango. According to the recent EIA reports, gasoline builds have been quite large as oil production in the US has surged to over 9.2 mbd. This will not be helped by the fact that the twelve month average for total vehicle miles is slowing. If the summer driving season does not save the gas curve, PCE could be heading swiftly lower into the Fed's desired third hike in Sept. Does the Fed get a third in if PCE deflator is back near 1.2, I don't think so.
Inflation, there just isn't any. Core sticky CPI ex shelter 3m annl
Peak inflation has rapidly turned into disinflation. Post election, the Fed has thought they were near target in inflation so a hiking cycle is justified. I have been making the case that Keynesian aggregates have diluted a profound truth in inflation. There are two segments of CPI driving core prices, shelter and healthcare. The problem that Kashkari and to some extent Evans has picked up on, these are not discretionary areas of the economy, so rising prices are not indicative of economic advancement. Getting to r*, wont help rents and healthcare prices come down. And the scary truth is, if it wasn't for shelter, deflation is alive and well.
OPECs precious '18 backwardation is dead and its a big deal for g8 rates
I have been in the camp that the repricing inflation expectations and the surge in the inflation surprise indexes was largely oil related and rooted in base effects. The Nov OPEC deal was predicated on getting the market into the front end and have physical drain out storage. While in a sense this did work, it discounted the pace of US production and more importantly exports. Now OPEC is in a tricky spot pre their May meeting, especially if demand is slowing, which Vitol says it is. If the Saudi's lose control of oil, the knock in g8 rates is massive in terms of inflation expectations and the current paradigm of a pressured Draghi and trigger happy Yellen.
Copper curve (z7-z8) saying Chinese slowing should continue
Seems like Chinese deleveraging is getting a bit more attention. Despite the fact that I think a Chinese slowdown should lead to a rally in rates, the reaction is prudent, for now. Judging for how long the Chinese regulators will tighten in terms of liquidity is anyones guess. However, the copper curve will always give you a pretty good idea. Calendar 18 spread is back in serious contango, looking more consistent with sub 2% on 10s. If growth is to remerge, it would be shown here, and its not registering.
Does buba know the German effect?
Part of my bullish bunds bias for this year was Chinese econ beta. The buba and Weidmann can go on about Draghi being behind the curve, because look we've had two months of above trend headline inflation, but if China slows, Frankfurt is in trouble. The knock out PMIs seem to track Chinese industrial activity pretty well, and those are pointing lower; 50% of German exports are China bound. The question for buba is, if China spills over in coming months do they back off Draghi? Hard to say, considering this is the same group of folks that probably still uses monetary aggregates as a predictor of low frequency inflation, so continuing m3 growth has an inflationary spill, even if growth slows. I continue to believe Draghi is trying to push through until the data drops off in Q3 to continue his backdoor bailout, even if there is a hawkish hiccup in June.
Bunds follow China Manufacturing PMI
Part of the flow vs fundamentals argument has also transpired in bunds, with different characteristics. Bunds have gotten shelled in the past two weeks as April inflation was a beat and growth in core EU broadens. I talked about the flaws in the April HICP data in my previous post under buying vol in erz8, German packaging Easter effects on core HICP is always skewed. My early readings for EU core HICP is back below 1, which is the safer zone for Mario to delay. It will be hard for him not to make changes to guidance in June at this rate, but calls for a taper announcement in Sept, seem premature to me. Combo of fading German data and more dovish Mario will lead bunds higher. If owning DM rates, would rather own USTs, but Bunds offer nice China beta.
Just as everyone is loading up on EUR......
The market has gotten excited again about the ccy pair it loves to short. The feeling of the tsunami of geo-politcal risk fading following Macrons landslide win, doesn’t warrant a +1.10 Euro in my view. I actually think the medium term case for a Euro short makes all the sense in the world and even offers a hedge to owning EGB’s. If the reason to rally for EUR is a faster rate of tapering, its an easy fade. ECB taper is arguably a bigger threat to EU stability at this time, given amount of sov debt due (Italy 800B in 3 yrs) and size perif budget deficits have gotten. So to lay it out; ECB pushes off more than the market expects, EUR sells off on rate diffs, case 2 is ECB announces taper plans in Sept meeting and the periphery spreads blow out, EUR eventually falls even more. Seems like a good short to me.
Will the ECB learn from Trichet?
Vice-President Constancio: "Loose for longer is less risky than a premature withdrawal of stimulus"
Hard to cut rates into accelerating inflation, AUD 1y1y
AUD has been hammered in this China deleveraging. Without a serious China rally in growth, the RBA will be in pause considering their secular debt issues in the housing market, but it seems to me the likelihood of them easing in ’17 seems low as well. Consensus is now even pricing in a chance of a RBA cut in the back end of the year. However, to me, if the RBA is stuck, receiving rates in AUD has passed. Inflation is picking up over 2% and 1y1y trades 35 bps over o/n rates. Another thing is, its a decent hedge to the broader deflationary based book, second paying rates in AUD vs a market that thinks easing could happen with inflation over 2% makes sense.
Receiving ILS rates, Flug and BOI will overlook inflation given oil
This is an interesting one because the case to be receiving rates in an econ that grew 6% last q is one that is not often made, especially when o/n rates are 10bps. Im not completely sold on this one but as I think much of the inflationary pick up is transient, Flug and the BOI will be in no rush to move on rates. The early Q1 move in CPI seems to have gotten the market overly excited, but as oil related costs are big import cost for the Israeli economy, big rate of change moves can easily skew the number. I expect Flug to discount the CPI number as survey data in PMIs and consumer confidence is turning lower. Flug stays the course as energy prices revert lower. The other big thing is the strength of the ILS. BOI cant have shekel below 3.6., economy relies too heavily on tech, tourism and fine jewels exports, recent strength in ILS will not be tolerated.
The Counter Flow Argument for USTs
What has become apparent over the past five months is that flow in USTs is strong weigher on price. Evidence has been in the JPY xccy which has tightened dramatically since Q4 as the Japanese have been big net sellers in USTs. Not going to get deep in this now, but I believe this has given the folks at the BIS a false sense of security with regard to the dollar shortage. As treasury reloads in issuance at the same time the Fed is supposedly going to be SOMA changes, dollar liquidity could vanish again. Anyway, one has to think the Japanese cap duration in USTs if hedging dollars is relatively cheap. Seasonally, Japanese buying picks up in the summer months, especially will be true if tensions with NK escalate further. USTs have been hit by a mountain of foreign selling and the market expects SOMA changes by y/e to be the dagger, I dont see it.
Does China Need to Sell UST's to Defend RMB, This does not look like 2015
The difference between deleveraging and a currency problem has big ramifications for $ rates. Ive been in the China deleveraging camp but Zhou and the PBOC could actually be winning and the need to sell UST's to save RMB like November, is not there. Later tic data will confirm, a repeat of December in China selling is not needed. I also list a decent short play in BRL if CNH pressures continue to build. Of course if China does deval thats the ultimate boon for rates as it will unleash a deflationary storm. The question is, does China need to continue selling USTs to defend the RMB, it doesn't look like it from my angle. The other aspect is selling USTs has a negative feedback loop. When China was selling aggressively in Nov, the dollar just ripped on steeper rates. Selling in size triggers a dollar reaction China is looking to avoid.
RMB is actually hanging in, dare I say.
Divergence in rates is now beginning to move in CNY’s favour. The chart below shows 12M LIBOR v 12M SHIBOR. RMB is gaining a carry advantage, something it lacked it ''14-'15 when PBOC was cutting rates.
Asia FX is strong, Wasn't going into China deval in '15
If EMFX is about to blow out again, BRL will lead the charge
Not an expert on pending pension reforms but Brazil econ still way too dependent on Chinese econ development in the industrial sector. BCB is cutting rates aggressively, which reduces carry over MXN, (still love 1y1y in MXN). Econ looks stuck with retail sales trending lower again and unemployment persistently high. If CNH blows, BRL goes with it on weakening domestic econ that has a lot of beta to Chinese industrial sector.
HKD stresses can be solved
People have been saying that the recent weakness in HKD is a test on HKMA and indicative of China weakness, as the USD/HKD trades near its upper band. Im not as sure, HKMA can raise rates following PBOC lead and spot weakness would soften, also 12m fwds are still falling.....
The perks of carry and capital controls (RMB demand and savings in Hong Kong)
RMB deposits in Hong Kong have fallen 49% since their December 2014 peak and 24% since September 2016 to 507b RMB. This is partly due to cap controls of course, but also PBOC rates moves. The rate of offshore CNY deposits in HK has fallen below mainland rate for first time since 2015. PBOC tightening is working and cap controls could get them to national congress in Nov with stable CNH.
China holdings of treasuries inverted v 10y breakevens
If they were selling, breakevens should have risen. Nominal exposure is 10x TIPS, so when they sell, it should be seen in breakevens.
Where would ER and ed$'s be if not for fears of hawkish CB's?
For an FYI.... it looks like I didn't get this one out in time
June is a lock
Looking at the ed$ curve, a June hike is effectively priced, this is also seen in the ff curve which shows a +85% chance of a June go. Of course my thinking is the Fed should be talking down rate hikes, which is still possible, but they seem pretty set on their 2017 agenda, hike 2x by Dec, so they can announce SOMA changes. However, in my view, the current econ warrants the dovish board to tone it down. So Im looking at a flattner in edk7-m7 as a pretty convex play in case June implieds are walked slightly lower. Assuming stable fra/ois, the thing settles around 10.5ish, so risking half a bp for a walk down, which gets this spread to 7. Hard for the Fed not to go in June now, but even reducing implieds would make this trade a winner.
