Duration infatuation

Summary

• Global update - CoronaVirus infects market optimism.

• Central banks - and the beat goes on.

• Market dynamics - El Chop-oh.

• The week ahead - Fed is on deck.

The global economy is showing signs of stabilizing; however, the recovery remains fragile.

News of a deadly SARS-like virus dominated headlines last week.

With upwards of 2000 people infected worldwide, the newly identified CoronaVirus has spread at an alarming rate. Officials fear that the Chinese new year this weekend could amplify the spread of the virus. Market participants are on edge, given that there remain several unknowns surrounding how dangerous the infection is and the transmission mechanism through which it spreads. Asian markets were down around 4 percent on the week across the board by Friday's close.

Will the Chinese Yuan get sick?

Assuming we do not all perish from a mysterious virus, the real question is whether the market will be selling Yuan (CNY) until this outbreak is contained. Many banks have been pushing long volatility positions on CNY or shorting the Asian dollar basket (ADXY) altogether as a "virus hedge." A drastic fall of the CNY over the next few weeks could bring the currency back into the news, raising the risk that any decline is misinterpreted as currency manipulation.

The outbreak puts more onus on economic data to keep markets stable.

The pandemic in China could pump the breaks on any nascent recovery coming out of Asia. The outbreak could deal a hefty blow to the service sector, which has managed to avoid importing any trouble from the slump in manufacturing. Virus aside, Asian data has been coming in better than expected. South Korea printed 2019 Q4 growth at a faster than expected pace, and trade in the region is also starting to recover following some good numbers from Taiwan and South Korea. Notably, shipments from South Korea to China rose in January.

Lukewarm data in Europe underscores the depth of the bloc's rut.

So far, 2020 has not been great for the Euro area. What started with Germany posting the slowest growth in 6-years has culminated in a manufacturing slump that is now a year old. However, it wasn't all doom and gloom last week. Manufacturing PMI's (Purchase Managers Index) show a recovery is underway in the sector while the services sectors remain stable. Both are positive developments that will help reduce the likelihood of a recession in the bloc.

Protests in France intensified over the weekend.

The latest string of protests are in response to President Macron's pension reform, which seeks to unify the country's 42 different plans into a universal one. Lasting seven weeks, the protests are starting to flow into the economic data. Composite PMI data declined, moving in the opposite direction to the rest of the bloc, which has stabilized or rebounded. Furthermore, consumer confidence fell for the first time since July of last year. The protests add to Macron's headache, which undoubtedly got worse following the US' threat to impose tariffs in response to a digital tax imposed last year. That tax targeted companies like Facebook and Google. The US has threatened to increase tariffs as high as 100 percent on US$ 2.4 billion of French goods.

Euro area is the next in the trade war hot seat.

Roughly a year ago, the Commerce Department decided that there were too many Mercedes on Fifth Avenue and that it represented a grave threat to national security. I'm joking about the Fifth Avenue comment but not the national security bit. Well, this week, at the World Economic Forum in Davos, President Trump put EU leaders on notice that this national security threat was not going to go away. The President wants to hammer out a few more trade deals before the Election in November.

Robust manufacturing data in the UK clouds the outlook for the Bank of England (BoE).

The decisive rebound in manufacturing and services suggests that the "Boris Bounce" may be more than just myth. Although it was only one data point, there has been a decisive reaction in markets that now place a 50-50 chance the BoE cuts or leaves interest rates unchanged. The next meeting will be Governor Mark Carney's last at the BoE.

The IMF cut its global growth forecast for 2020 down by 10 bps to 3.3 percent.

The estimate for 2019 was revised down to 2.9 percent and marked the 6th revision to that forecast. The Fund highlights the role accommodative financial conditions played in kickstarting the nascent recovery in Asia. That point is particularly important going into the new year given that TD estimates that the net supply of government bonds will fall by 40 percent. That's important because a tight supply of sovereign bonds will foster a greater search for yield, which can keep financial conditions accommodative for longer. Of course, even the IMF is skeptical about inflation and highlights that an optimal policy mix involves some fiscal spending. Now, doesn't that sound familiar?

There are no signs that central banks will remove accommodation from the system.

The Bank of Canada (BoC) opened the door to a rate cut this week, lowering GDP projections for the fourth quarter.

The statement removed the reference to interest rates remaining "appropriate" and sounded relatively downbeat on the economic outlook. That's consistent with comments from Governor Poloz in which he warned that the damage from global trade tensions would likely be permanent. Ultimately, the BoC has opened the door for a rate cut this year if the outlook does not improve.

The European Central Bank (ECB) left rates unchanged and laid the groundwork for the strategy review.

The decision was broadly in line with market expectations. The ECB is now in "wait and see" mode after the rollout of its massive stimulus package last year. Inflation remains moot and growth tepid, raising fears that Japanification has begun to set across the bloc. One attempt to combat secular stagnation is the strategy review. The ECB will complete its strategy review by the end of the year and will consider communication, its monetary policy tool kit, and it's metrics for measuring price stability. That's a reasonably comprehensive overview of some of the crucial functions of the ECB.

With weak growth, accommodative monetary policy, and low inflation risk, the market's infatuation with duration will likely continue in 2020.

The assassination of Qaseem Salmani and the outbreak of the CoronaVirus has kept the demand for safe-havens strong.

Global sovereign bond yields drifted lower this week, resulting in a bull flattening in many sovereign curves. The flatter yield curves represent a combination of lower growth prospects resulting from the outbreak as well as lower inflation expectations from a US$ 10 plunge in oil prices. In the US, real yields are flirting with zero again. Of course, US Treasuries have the added "benefit" of the expectation that the Fed will transition its term-repo operation into outright QE later in the year. That will come as a result of a short-supply of T-bills, which will force the Fed to reinvest proceeds further out the curve. Without a real catalyst for inflation, it will be difficult to imagine bonds selling off. The chart below shows two measures of inflation expectations (inflation swaps and breakeven rates) along with real yields for the 10-year maturity. The red line shows the 2-percent inflation target.

Source: Fred

The S&P500 logged its first material loss in 2020.

Cyclicals led the decline in stocks with energy and industrials underperforming, while utilities, real estate, and secular growth remained buoyant. Although tech has remained unscathed, the parabolic rise in large-cap tech stocks since the start of the year looks a bit frothy. With several heavyweight tech companies reporting next week, it's not difficult to envision a few choppy sessions if earnings do not go according to plan. It's also reasonable to assume that next week will bring more pandemic-esque headlines, which should put a damper on sentiment.

Dealer gamma remains positive, but the safety net is much smaller.

There are plenty of catalysts that could make for choppy trading next week. Unfortunately, we should also add dealer gamma to the list. Dealer gamma, following the massive option expiry last Friday, has reduced significantly, sitting around US$ 2 billion after reaching as high as nearly US$ 12 billion. The chart below shows the combined number of contracts that need to be hedged at each strike price for the SPX and SPY products. I've included options only out to 6-months as these will be the most relevant for hedging flows. The takeaway is that dealers are close to being short gamma, which will result in their hedging orders going with the market. As such, expect next week to be a slippery week.

Source: CBOE & author calculations

Equity factors reflect the surge in bond prices.

I think it is as good a time as any to remind everyone how bond yields work their way into the equity market. As bond yields decline, investors pile into bond proxies to get around the frothy fixed income valuations. That means that investors are chasing the legacy long positions that have been established in bonds in the equity market. This dynamic has turned conventional economics on its head; instead of high-risk stocks providing higher returns, low-volatility stocks have produced higher returns. The risk of embedded bond risk in the equity market is real. The chart below shows how the returns of a momentum ETF shifted from being correlated to growth (red box) to low-volatility/bond proxies (green box). Another take away from the chart is how little love value stocks (cyclicals) have gotten despite economic growth appearing to have bottomed. That's mostly a function of inflation risk, which continues to remain subdued, providing little upside risk to interest rates. Of course, I flag this risk because should inflation rear its ugly head; a massive unwind will happen in low-volatility and momentum-based products.

Source: Yahoo finance & author calculations

Markets look set for a relatively rough week.

The Fed will be the main event next week.

The Fed will likely remain on hold and will continue to push the narrative that monetary policy is in a "good place." Questions remain surrounding the term repos and how the Fed plans to taper them while sticking to the QE lite story. In reality, it seems to be more of a question of when not if they start purchasing more duration. The CoronaVirus will continue to dampen sentiment until there is confirmation that the virus has stopped spreading. The BoE will also be up this week, and, as mentioned above, the decision could go either way. The UK will officially leave the EU this week after three and a half years of back and forth. In terms of data, we will get some GDP estimates for the Eurozone and the US and some more data from Japan.

Tiago Figueiredo