The trade war that tripped over itself

Summary

• Fundamentals — The dynamics underlying the phase one deal.

• Duration infatuation — Let’s not forget to who we owe our good fortune.

• Brexual healing — Bank of England along for the ride.

• The week ahead — All eyes on bonds.

US equity markets have reached all-time highs in the hopes that the US and China will reach a “phase one” trade deal by the end of the year. The optimism surrounding the trade talks grew exponentially throughout the week when reports surfaced that Beijing and Washington had agreed to include a rollback in tariffs as part of a “skinny” trade deal. These reports were supported by comments from Gao Feng, the Chinese Commerce Ministry spokesman, who suggested that “top negotiators agreed to remove the additional tariffs in phases” conditional on progress being made. In what has become a tradition in the White House, President Trump appeared to contradict all of these developments, indicating that a rollback in tariffs is on the table but nothing had been formalized. I figured now would be a good time to hit everyone with a few reality checks of what appears to be going on behind the scenes. I’ll start with expectations — the Bank of America’s fund managers survey, which covers US$ 955 billion in assets under management, tells us that 65 percent of participants expect some form of a “skinny” deal by the end of the year. That’s a lot, but it’s not surprising. The US election is just around the corner and many would argue that President Trump needs a win following the Ukraine whistleblower case that surfaced in later summer. Chinese officials appear to believe the same thing. A report from the New York Times indicated that "China believes a quick deal was the best chance for favorable terms, given the pressure of the congressional impeachment inquiry as [President Trump] seeks re-election in 2020”. Essentially, China knows that President Trump needs a win and is hoping to use the impeachment inquiry as leverage to secure tariff relief — Reuters reported that China is pushing to get the majority of tariffs lifted. If China manages to pull this off, they will have essentially lobbied to lift the majority of tariffs in exchange for a signature on an interim deal in which the details are sketchy at best. Like I mentioned in Crazy like a fox, all we know for certain is that China has agreed to restore agricultural purchases to the levels back in 2017. What about the currency pact? Well, the Chinese Yuan strengthened through 7 USD for the first time since August and I’m willing to bet the PBOC (People’s Bank of China) puts the breaks on that appreciation sooner rather than later. Remember that the PBOC was leaning against depreciation earlier this year to avoid upsetting President Trump (see Canada is not for sale). All of this to say that whatever currency agreement Washington thinks it has with Beijing doesn’t matter — the PBOC will do whatever it wants and they have more than enough issues to grapple with. If you were wondering about some of those structural issues like Huawei and more broadly the intellectual property (IP) problem, well, those issues will be addressed in phase two or three. For those unaware of how widespread the IP problem is, take a look at this business insider article which shows some of the most shameless knock-offs. It’s important to note that many people have given up on a sweeping deal, in fact, Chinese officials don’t think some of these thornier issues I mentioned above will even get addressed. Look, this “skinny” deal is going to be sold as a massive reform that paves the way for broader talks — that’s not true. This deal is essentially one in which the US provides tariff relief in exchange for nothing.  Of course, this opens up the door for President Trump to go “crazy like a fox” — we might have gotten a taste of that on Friday when he suggested that nothing regarding tariff relief had been formalized. Back in May, I suggested that one of the reasons President Trump raised tariffs on Chinese goods in the first place was due to the stock market reaching new highs. This was based on the notion that the President is using the stock market as a “scorecard” to his presidency. As stocks reach record highs, President Trump is willing to become more volatile given that he is essentially “playing with house money” so to speak. This was indeed the beginning of the “trade war feedback loop” I’ve mentioned countless times. With stocks breaking new highs, we might expect the President to push back on the deal, especially given that the US gets essentially nothing in exchange. The President’s willingness to do so will, of course, become a function of how it will play out among his voter base given that the election is just around the corner. Data out of the US suggests that the economy is slowing and much of the manufacturing trouble witness abroad, which originated with the trade war, has started to make landfall in the US. That’s the reality of a 17-month trade war that has started tripping over itself. This was one of the worst weeks for long-term bonds since the US election, as investors began to rotate out of consensus trades into more cyclical investments. There is a sense that some market participants are beginning to put faith in the idea that the coordinated push for accommodative monetary policy is starting to work its way through the system and that global growth may be bottoming. Indeed, the Fed has indicated that they are comfortable with the level of accommodation in the system and we received a similar, although more cautious, narrative from the Reserve Bank of Australia (RBA) last week. The Bank of Japan (BoJ) also indicated on Tuesday that it would cut purchases in Japanese government bonds (JGBs) to try to steepen their yield curve — adding to the bearishness in bonds. Sprinkle on a few headlines that tariffs may be rolled back and you’ve got yourself perfect conditions for a broad rotation into more cyclical assets. Since the start of the year, the market has generally been long worst-case scenario, where the worst-case scenario is a recession. As such, investors have been piling into fixed income products, especially longer duration assets (like 30-year bonds) because they are more responsive to interest rates. When bonds became too expensive, investors shifted gears and piled into bond proxies which include growth stocks and more broadly stocks that are less correlated with the business cycle. Gold also got some love, breaking out of an 8-year range. This dynamic has taken place over the last 10 months and has created a crowding effect into these different “risk factors”. One of the more popular products has been the low-beta/low-volatility ETFs, something that derivatives strategies Marko Kolanovic as JP Morgan has talked about for a long time. The chart below is an updated version of the one that Kolanovic presented in a report back in the summer. The recent spike shows a rotation from low-volatility to value stocks or, in plain English, a rotation from stocks that are not correlated to the business cycle to those that are. The plain English definition is not completely accurate but it is enough to understand the underlying mechanics. 

Some of you might be wondering why all of this matters. After all, Investors are just poisoning themselves for a recession right? Well, there’s more to it than that. The problem is, if everyone is doing this, then bond risk is essentially embedded everywhere across asset classes. Remember that one key aspect of risk management is understanding the correlations of different asset classes and using these correlations to hedge a portfolio. When the risks of your underlying investment are embedded in your hedges you can benefit greatly when things move in the right direction (think Q1 this year) but can get burned quickly when things move against you (think Q4 2018). The chart below is from Marko’s latest note and shows two investment strategies which (in theory) should have nothing to do with each other — I’ll let you guys tell me if these two return series look correlated. 

With that in mind, now is a good time to remind everyone not to forget what everyone owes their good fortune to. The promise of perpetual liquidity from central banks earlier this year was the rising tide that lifted all boats (stocks, bonds, credit, etc), with the riskier of the bunch benefitting from the search for yield dynamics I highlighted in The rise of tourism in financial markets. Anything that serves to undermine this promise will result in a massive rotation in markets, not unlike the one we saw in mid-September which is being coined the Momentum Massacre. As a reminder, the steepening of the yield curve in early September resulted in a multi-sigma move in the popular long momentum/short value trade which flew under the radar of many news outlets. Well, this week's dramatic sell-off in bonds is going to have sweeping implications for both risk factors as well as different sectors. Just to hammer home how widespread this “group think” problem is, I’ll turn to Goldman Sachs who has an excellent chart showing how the various consensus trades this year correlate with real yields. As a reminder to readers, yields can be decomposed into 2 components; inflation expectations (which are known as breakeven inflation rates) and real rates (which are proxies for growth prospects). The real component is a market-based measure of growth and as I highlighted in Waiting on Carl to get up outta here, these yields have become more and more correlated with trade headlines than the underlying economic data. Since that post, real yields have continued to climb, putting pressure on all of these consensus positions.

What’s making matters worse is that plenty of bonds have broken through their 50 and 100-day moving averages, causing CTA's (momentum trading hedge funds) to sell their positions, exasperating the sell-off. I won’t get into the annals of convexity hedging but remember that the underlying hedging dynamics that occur within equity markets also occur in bond markets. There are plenty of second-order effects from this move in yields also. These CTAs, assuming they are cross-asset, will likely funnel into higher-risk currencies and equities — indeed we’ve seen the Chinese Yuan appreciate to levels seen in early July (of course there are other factors at play there as well). It comes as no surprise that Gold was one of the biggest victims of this week's bond sell-off. With that in mind, it appears that many investors have been reaching for upside in stocks through call options. This is evident in the massive levels of delta and gamma in the market. The chart below comes from Nomura’s quant team and shows the levels of each 6 months out. 

With equities continuing to hover around all-time highs, it will become more likely that market participants begin to monetize these calls and start to take on more "organic" exposure by buying more S&P500. According to Nomura’s Charlie McElligott, backtests show that when both delta and gamma are at these high levels, we generally see a pullback in the index. Admittedly, these tests are more significant for the Nasdaq than the S&P500 but regardless they indicate that we may see some form of pullback next week. The Bank of England (BoE) left interest rates unchanged last week however, the tone of the press conference caught some market participants off guard. Although the risk of a hard Brexit has fallen drastically, there remains rampant uncertainty in domestic politics. The UK will hold a general election on December 12th following Boris Johnson's push for approval from Parliament last week. The 3-year Brexit saga has fatigued voters while eroding the loyalty of the two major parties (Conservatives and Labour). Unfortunately, there isn’t much choice in the matter, voters will have to choose between a socialist government under Jeremy Corbyn which plans to renegotiate a deal before a referendum, or, stick with Johnson who continues to push for his Brexit deal. Despite Johnson's disastrous few months in office, Predictit, a website that lets individuals gamble on outcomes in markets, places the probability of a conservative government at 76 percent. Indeed, the BoE is aware of this and was keen to downplay any positive developments noting that policy easing may be necessary if the Brexit situation gets worse. There’s also the risk that the global outlook doesn’t improve and that the UK continues to import trouble from the global manufacturing malaise. Given that the BoE slashed their growth and inflation forecasts, the market has moved to price in some form of an interest rate cut by the end of next year. The bottom line is that the tone struck by the BoE is in stark contrast to the good vibes that have proliferated in the market following the phase one trade deal. Needless to say, headline risk will continue to be the main driver in markets and monetary policy will continue to be along for the ride. Make no mistake that the next week will be all about bonds. There will be a few macro catalysts on the horizon, not least of which will be the inflation release in the US. This release has garnered more attention than usual due to Jerome Powell’s comments at the last FOMC which indicated that interest rates would remain where they are until there was a significant move higher in inflation. Looking at the 5-year 5-year inflation swaps, we can see that inflation expectations remain fairly moot and while breakeven inflation rates have been on the rise, there remain well below target at around 1.7 percent. Remember that the main thing to watch for will be trade. The market remains optimistic that an interim deal will be struck. Assuming that this is done, the market will then focus on the lagged effects of the synchronized easing from central banks and hope that their efforts are enough to kickstart the global economy. Against all of this, investors will also be keeping their eyes on the latest rotation into cyclical stocks and looking for signs that it may go too far too fast. Along the same vein, it will be interesting to see how equities handle the higher yields, generally speaking, this should put downward pressure on equities since the discount rate is now higher. interns of other events, Powell will be speaking on Capitol Hill this week to address the Congressional Joint Economic Committee. Apart from CPI, the US will also be reporting retail sales on Friday — this will be an important read to see how healthy the consumer is. In the UK we will be getting GDP, employment, inflation, and retail sales which will be important following the recent BoE meeting which had market participants starting to price in a rate cut. The Reserve Bank of New Zealand will meet on Thursday with market participants expecting the bank to cut rates by a quarter point. Tiago Figueiredo