We’re at “an Inflection Point” – Here’s How Not to Play it

By Heisenberg

Over the weekend, we talked a bit about the “seismic battle taking place between the bullish growth, bullish risk asset, bearish rates reflationary consensus, and the bearish risk asset, bullish rates stagnationary camp.”

You can probably surmise which camp we fall into.

To be sure, the “stagnationary camp” has had its way of late (well, a little Friday jawboning higher of yields notwithstanding). 10Y yields have come under enormous (downward) pressure thanks to policy uncertainty emanating from Washington, a “dovish” Fed hike, jitters about the US economy (heightened by poor auto sales and a lackluster NFP print) and geopolitical tensions. Meanwhile, the dollar has been pushed lower commensurate with the rally in Treasurys.

But now we probably need to ask ourselves the opposite question we were asking just weeks ago. That is, it doesn’t look like the specs who frantically covered their 10Y shorts in the weeks following the Fed are too keen on putting on longs. And on Monday the dollar is taking its cues from rates. So once again we find ourselves at what BofAML calls “an inflection point.”

For their part, the bank thinks we’re now more vulnerable to “renewed optimism” (i.e. a move higher in rates and the dollar) than we are to more reflation frustration. But there’s a caveat with regard to how you should play things. Read below as BofAML explains why “breakevens are the wrong reflation trade.”

Via BofAML

Trump trades, what Trump trades? We believe markets are at an interesting inflection point. The rates market is pricing the least hikes by the end of 2018 since the December rate hike. USD positioning is the least long in many years…


EM positioning is starting to look crowded…


Our markets have gone full circle on Trump trades, despite the fact that the political imperative to get tax reform done has only increased. As we have been arguing over recent weeks, rates and FX are vulnerable to renewed optimism rather than exposed to disappointment. However, breakevens are the wrong reflation trade.

Tapering reinvestments is not bullish for rates. At the same time, the FOMC minutes raised the prospect of a continued tightening of monetary policy including a tapering of reinvestments before year-end: “Provided that the economy continued to perform about as expected, most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the Committee’s reinvestment policy would likely be appropriate later this year.” As we have argued elsewhere, the main take-away from this should not be the potential pause in the hiking cycle as reinvestment tapering starts, but rather, what increase in term premium does the Fed expect tapering of reinvestments to deliver. As such we remain bearish duration and favour a short in real yields over a long in breakevens.

EM vulnerabilities are growing, making us cautious on breakevens. This is particularly true in light of the vulnerabilities in EM. A risk-off move in EM (and equities) would likely weigh on breakevens given the knock-on effect on the broader reflation thematic, as well as commodity markets in particular. A more cautious stance on EM therefore goes hand in hand with a higher information ratio in USD real yield shorts vs breakeven longs.

“This Was Inevitable at Some Point”: Is There a Storm Coming for Emerging Markets?

By Heisenberg

Remember August, 2015?

No? That’s ok, I barely do either. What with all the conspicuous, brain-cell-killing, fine spirits consumption between then and now.

But what I do remember is that the Fed had a tough call to make the following month. China’s “surprise” move to devalue the yuan threw markets into turmoil and the committee was concerned that anything other than a conciliatory dovish lean (that is, “a clean relent”) had the potential to exacerbate what looked like the beginning of a global unwind by putting upward pressure on the dollar and catalyzing EM turmoil

Well fast forward to today and EM assets have shaken off talk of a Fed rate hike cycle. Indeed, Q1 was a good quarter for emerging markets. As Goldman wrote last week, “EM outperformed DM on a cross-asset basis, with MSCI EM up c.5% more than MSCI World, EM credit outperforming DM HY credit by c.1.5%, and EM FX up 3.6% against the dollar.”


So the question after Wednesday’s Fed minutes is this: is EM truly prepared for what’s coming or did we get a false sense of security during the first quarter thanks in no small part to three months of USD weakness?


Below, find some commentary from analysts on this very subject collected and summarized by Bloomberg.

Via Bloomberg

Emerging-market bonds, stocks and currencies will probably retreat as the Federal Reserve starts shrinking its super-sized balance sheet this year, investors and analysts say. South Korea’s won had the biggest drop among Asian currencies on Thursday, while 10-year bond yields rose in Malaysia and China. Minutes of the Fed’s March meeting released Wednesday said the reductions need to be “gradual and predictable.” Its balance sheet ballooned to $4.5 trillion after three rounds of bond purchases.

Market Views:

  • Schroder Investment Management (Rajeev De Mello, head of Asian fixed income)
    • The Fed’s minutes confirmed views that the tapering of the balance sheet will be starting sooner than earlier expected
      • The U.S. yield curve could steepen further which would also impact local yield curves, especially those in the more developed part of Asia. Hong Kong, South Korea and Taiwan should also see some steepening
      • “We don’t believe that this announcement by itself would lead to a period of market turmoil. Investor interest in emerging markets has been strong as we would expect it to continue”
    • Other concerns include the uncertainty around the timing and size of U.S. fiscal policy expansion and the uncertainty around the French elections
  • Daiwa SB Investments (Shinji Kunibe, general manager and head of fixed-income management)
    • The shrinking of the Fed balance sheet would hurt U.S. stock performances and slow momentum for the U.S., which would then worsen sentiment for emerging markets as they have benefited from global recovery led by the U.S.
      • Emerging Asia may be hit slightly less than Latin America and EMEA as countries like India remains strong
      • Political stability and good fundamentals make India look more attractive than other emerging economies; Indonesia also looks pretty good
  • BNP Paribas Investment Partners (Hue Lu, senior investment specialist)
    • “This was inevitable at some point. Removing market- supportive measures is a good indication that the recovery in the U.S. is on track”
    • As for EM implications, some economies will obviously face more headwinds than others depending on how much dollar debt is on their balance sheet
      • “For Asia, we are not that concerned, and we think the market generally agrees. Following the recent December rate hike, investors barely blinked”
      • Equity investors have generally already priced in another two, 25bp hikes this year. The bond market is more skeptical that we would even see tightening at this pace
      • Those economies viewed as “fragile” within Asia are in a better situation today as a result of reforms which have been implemented in recent years –- and this is particularly true for Indonesia and India
  • ABN Amro Bank (Roy Teo, senior currency strategist)
    • The impact may not be as large as it will be gradual and well-communicated
      • The market is pricing in slower rate hikes as a result of balance-sheet normalization. EM Asia fundamentals and FX reserves have also improved
  • Standard Chartered Bank (Divya Devesh, Asia foreign-exchange strategist)
  • Fed balance sheet normalization will likely put upward pressure on long-term yields in the U.S., which will be negative for EM Asian currencies.
    • The impact will also depend on whether the balance sheet normalization is happening in conjunction with hikes in Fed Funds rate.

Messages From Emerging Markets and Cyclicals

By Chris Ciovacco

Emerging Markets Break Out

Assisted in part by some improvement in China, emerging markets (EEM) recently cleared a resistance zone that had bounded prices for several months. From Bloomberg:

Since China is a major export market for developing nations from Brazil to South Africa, signs of an improvement in the nation’s manufacturing industry bolsters the case for investing in riskier assets….“Reasonable data from China has opened a window for emerging markets to outperform,” said Maarten-Jan Bakkum, a senior strategist at NN Investment Partners in The Hague, who favors Indian shares. “Emerging markets have been very strong relative to developed markets in the past week.”

Improvement Relative To Defensive Assets

A tick up in the market’s tolerance for risk can be seen in the chart below, which shows the performance of emerging markets relative to intermediate-term Treasuries (IEF). Increasing expectations for even more easing from central banks have assisted numerous risk markets since the Brexit referendum, including emerging economies.

Continue reading Messages From Emerging Markets and Cyclicals

Inflection Point for EM

By Doug Noland

Credit Bubble Bulletin: Inflection Point for EM

Don’t let a relatively tame week in the S&P 500 engender complacency. Perhaps it was not obvious, yet the trading week provided important confirmation for the incipient “Risk Off” dynamic thesis. Indeed, the global bear seemed to roar back to life. Stocks were lower, financial stocks were under heavy selling pressure, and some commodities reversed sharply lower, while safe haven bonds were in high demand. It’s worth noting that financial stocks lagged during the recent global risk market rally and now lead on the downside.

Japan’s Nikkei equities index dropped 3.4% this week, boosting its two-week drop to 8.3% (down 15.4% y-t-d). The Nikkei closed the week at 16,107. Keep in mind that the Nikkei traded at about 20,000 this past December (and about 39,000 in December 1989), and is now only about 1,000 points off February lows. Japanese financial shares trade even worse than the major indices. Japan’s Topix Bank Stock Index sank 4.6%, with a two-week decline of 12.8% (down 32.5% y-t-d). The Topix Bank Stock index traded at 250 last summer and closed Friday at 140.

Chinese stocks (Shanghai Comp) declined another 0.9%, increasing 2016 losses to 17.7%. Hong Kong’s Hang Seng Financial Index fell 5.0%, with a two-week decline of 7.6%. The Singapore Straits Times equities index lost 7.1% over two weeks, with financial share weakness behind 10 straight losing sessions.

Continue reading Inflection Point for EM