Momentum Massacre

Summary

• Recap of the week — Momentum massacre.

• ECB — The promise of perpetual liquidity.

• Monetary/fiscal policy — Is QE the key to the transition?

• Oil market update — Saudi production going offline.

• The week ahead — Eyeballing the dot plot.

This week marked one of the sharpest reversals in bond yields since President Trump took office in 2016, unwinding any gains in August. The move higher in yields this month was largely attributed to some decent economic data in the US and reasonably positive developments on the geopolitical front around the globe. There was a big risk that the US consumer was going to stop spending following a dismal consumer sentiment print in August. Adding to the worries, polling data showed that more voters now thought the US economy was getting worse than better — the first time since President Trump took office. Well, it turns out that the US consumer is feeling pretty good about things as Friday’s retail sales report smashed expectations — as did the preliminary read on the University of Michigan sentiment survey. Geopolitical developments were also positive on the margin — Boris Johnson saw his no-deal Brexit plans fade as the opposition parties continue to fight against a no-deal Brexit. While in Hong Kong, the withdrawal of the extradition bill that sparked the protests back in March was largely viewed as a step in the right direction. The latest developments in Italy also helped drum up confidence, with the new coalition being formed (averting a take over from Mateo Salvini and, to top everything off, there appears to have been some progress on the US/China trade deal. All of the above helped set the stage for a large sell-off in bonds, which were arguably already stretched from the August rally. What important to note is that the actual macro backdrop hasn’t changed all that much (as I mentioned in my previous email). After all, Boris Johnson is still determined to pull out of the EU — whether that comes in October  or January is the real question. Carrie Lam’s withdrawal of the extradition bill isn’t going to stop protests (too little and too late). Italy’s new party is comprised of longstanding political adversaries which does not bode well for its longevity and I wouldn’t say the China trade soap opera is going to end any time soon. So, on the margin, yes things are better, but only slightly, which makes this break out in yields unlikely to be sustained.The chart below shows the change in the US 10-year yield and the red circle shows the US election in 2016.

What’s more interesting is the havoc that this rapid rise in yields played on positioning in bond proxies in the equity market such as secular growth stocks and momentum. The behavior of secular growth stocks (like tech companies) is similar to that of longer duration bonds because tech company earnings are expected to come further in the future (just like the cash flows on longer-dated bonds). As such, these "long duration" trades in equity markets often trade in similar patterns to longer duration bonds. What is interesting is that momentum has recently become strongly negatively correlated with the slope of the US yield curve. Now, this largely reflects the composition of a momentum funds holdings. Remember that these funds buy their winners and sell their losers. This type of strategy tends to perform well in stable macroeconomic environments. Now, as central banks pivoted to more accommodative policy, momentum underperformed as the stocks that were in that basket were more geared towards higher interest rates (think bank stocks). As the new macroeconomic environment of perpetual liquidity started to establish itself, momentum began to recover, selling value stocks (more cyclical stocks) and buying growth and low-volatility stocks (the recession trade in the equity markets). The positive string of data we started to see at the beginning of the previous week cause the US yield curve to steepen, being driven by the long-end, which caused a material sell-off in duration. That bled through to the equity markets this week in spectacular fashion. The chart below shows the 8.5 standard deviation move in the short value long momentum trade that many investors had exposure to the last few months.

The slightly positive news, again on the margin, caused markets to snap and investors to rotate into value from these "safer" trades. To be fair, JP Morgan had warned about this a few months ago by showing the relative performance of low-volatility to value. If you're a believer in mean reversion, this very well could have been a reversion back to the mean.

In any event, the latest developments have not really changed the macro backdrop and any further deterioration of the global economy can just as easily push the world back into the trades that they just unwound. This week served to show just how crazy things can get under the hood of the S&P500, which was up a sheepish 1.5 percent on the week.

The European central bank (ECB) delivered on expectations, cutting rates by 10 bps, introducing interest rate tiering and an asset purchase program of 20 billion a month for as long as necessary. The ECB has essentially come out with a policy of perpetual liquidity, ignoring the criticisms from within the ECB as well as the CEO of the faltering Deutsche Bank. Several members from the ECB came out saying that “the broad package of measures, in particular, the asset purchase program, is disproportionate to the present economic conditions”. The main point of contention is that there is a clear scarcity of low-risk assets, remember that high-yield debt in Europe has a negative yield! Needless to say, the European bond market is distorted. What's worrying is that there’s clear disagreement within the ECB’s governing council at a time of great uncertainty — Yet another challenge for Christine Lagarde when she takes the reigns of the ECB later this year. If the internal dissent can’t be controlled, it could manifest in more public comments from governing council members which will likely serve to undermine the stability and credibility of the ECB. Reuters reported that over a third of policymakers were in opposition to the new package. While many people have come out in opposition to Mario Draghi’s new stimulus package, the message was clear — We need fiscal stimulus! I’d like to go back to the Bill Dudley opinion piece that was posted on Bloomberg (link here), where Dudley highlight that, under normal circumstances, central banks should respond to underlying economic trends and not concern themselves with how politicians might interpret their actions. Dudley was directly referring to the idea that the Fed was indirectly underwriting the trade war — supporting reckless trade policies by providing a cushion for markets. The main thing he wanted to highlight was that central bankers and politicians shouldn’t be playing games with each other. Central bankers should never be put in a situation where they must sit on their hands, watching the world crumble before them, just to force politicians to take action. Although central bankers may seem "out of touch", they have stepped up to the plate and provided support in fear that politicians would fail to do so. One thing that Draghi’s new stimulus package just might do is incentivize European politicians to take out more debt and start ramping up spending. That’s the thesis from Barnaby Martin, who is at Bank of America. He argues that when asset purchases (also known as quantitative easing or QE) are large enough, they can have a material impact on a Country’s debt to GDP ratio. The chart’s below are from the note and show how central banks have begun to absorb more sovereign debt as a percentage of GDP.

With policies like QE, the risk gets transferred from market participants to central banks, reducing volatility in fixed income markets given that central banks will always be buyers of bonds (and are not price sensitive). Now, in theory, this should help facilitate the transition into fiscal policy by producing stable prices for government debt. Just look at the debt to GDP of Japan, a country with one of the highest debt to GDP ratios in the world, and volatility in their government bonds (JGBs) is almost non-existent. Of course, that is also a function of their yield curve control policy where they peg the 10-year yield to around 0 percent but, regardless, having a larger buyer of debt has proven to stabilize the market. Now I know this seems a bit far fetched but, what is the alternative? What would be the best way for central bankers to motivate politicians to start spending? Would it be for the central banks to come out and say that they will never buy government assets again and start unwinding their balance sheets? Of course not. Now, this borders on something called modern monetary theory (MMT) which, contrary to popular belief, is not that modern. The basic idea is just a harmony between fiscal and monetary policy, something that’s found in traditional economic theory. I’ll eventually dedicate an email to this idea of MMT. What's interesting is that QE tends to be bearish for bonds. The chart below is from Nordea and shows that bond yields don't typically fall during QE.

In theory, this doesn’t make sense since the market is gaining a price-insensitive buyer (the central bank) during that period. The only rational explanation is that investors take on more risk during these periods, rather than buying safer assets. For those wondering what this chart looks like for the US... here’s the same chart courtesy of Kevin Muir.

There was a meaningful attack on a pair of Saudi Arabian oil processing facilities, knocking nearly half of Saudi oil production offline for weeks. The big question remains, where did the attacks come from? There is speculation that the attack originated from Iraq where there are many Iranian militias fighting proxy wars. Mike Pompeo, the Secretary of State, came out and said that Iran was responsible for hundreds of attacks on Saudi Arabia and this one is likely no different (although he is a big Iran hawk). I think the scary part in all this is that it appears that the drones used to carry out these attacks were worth about US$ 15 thousand, underscoring just how difficult it is to prevent these attacks. After John Bolton, the National security Advisor, was let go last week, many thought that there would be some form of compromise in the white house (Bolton was strongly against any dealings with Iran). Apart from there being one less mustache in the white house, it appears that the relationship between Iran and the US may be in for some tough times. Oil prices are currently up 20 percent from their close on Friday and, it appears that Iran is prepared for an all-out war should the US retaliate and take out some of their oil infrastructure. It’s starting to seem like the lull in geopolitical uncertainty last week was just the calm before the storm. We’re going to have a fairly busy week this week with the Fed, Bank of England, Bank of Japan and the People’s Bank of China providing an update on their monetary policy this week. The most important of the 4 is going to be the Fed which is widely expected to cut interest rates by another 25 bps this week. All eyes will be focused on the latest forecasts for GDP, inflation and the Fed Funds rate. The market has started to price out the chance of an additional rate cut following the one priced in for Wednesday. The dot plot will help guide expectations. Meanwhile, in the UK, the Bank of England will undoubtedly remain on hold as the country continues to face an uncertain destiny with Brexit still looming. The Bank of Japan (BoJ) is also expected to remain on hold this week. There were concerns a month ago that the demand for safe-haven currencies would force the BoJ to act against the currency appreciating but those fears have since stopped as the JPY has pushed higher to levels seen in early August. These could, of course, be reignited should a war break out with Iran. The latest developments in Saudi Arabia will likely be front and center throughout the week. The drone strikes removed about 5 percent of the global oil supply and geopolitical tensions are likely to continue to rise. Emerging markets are at risk this week if things boil over and investors de-risk. Meanwhile, South Africa, Brazil, Indonesia, and Taiwan central banks all meet this week with Brazil and Indonesia expected to cut rates. Tiago Figueiredo