While currency and fixed-income traders are having second thoughts about the extent of the Trump reflation trade just days before the inauguration of the 45th U.S. president as Bloomberg’s Vincent Cignarella writes, most readily observed in the recent 50% drop in 10Y real yields, which have slid from 0.74% in mid-December to just 0.38% in the past month, it is still far too early to call the time of death on the Trump rally.
Which brings us to the Icarus trade, laid out by Bank of America, which we pointed out last week. As a reminder, BofA’s tactical view is that after a Jan/Feb wobble, stocks & commodities will have one last 10% melt-up in H1. Call it the “Icarus trade”. The current melt up, which started back in Feb 2016, will be followed by a meltdown later in ’17 BofA’s Michael Harnett predicts.
This is how it will play out according to the BofA strategist. The current rally started in Feb 2016 with…
- bearish Positioning (BofAML Bull & Bear indicator = 0, cash = 5.6%, big >2SD underweights in Emerging Markets & energy)
- excessively bearish Profits (credit spread blowout, PMI’s crashing toward 45, global EPS negative)
- and Policy impotence (“Quantitative Failure”).
Thus the rally is likely to end with…
- bullish Positioning (BB indicator = 8, cash = 4%, unambiguous long positions in stocks, Japan & banks)
- excessively bullish Profit expectations (global PMI’s >55, US wage growth >3%)
- and Policy hawkishness (Fed jacks up short end of yield curve, ECB tapers).
Are we there yet? No, says BofA. Here’s why:
- Positioning is bullish but not dangerously euphoric (B&B indicator is 3.6, FMS cash @ 19-month lows of 4.8% but elevated versus 15-year history, global equities trade just 3% above 200-day moving average).
- Profits likely to be revised higher following strong Dec’16 ISM print (implies 10% US EPS growth – Chart 2); credit spreads well-behaved with US & European spreads at 18-month lows; however PMI’s getting closer to “peak” and US wages close to 8-year highs.
- Bond market yet to aggressively price-in hawkish monetary Policy: US financials conditions in “easy” territory according to our simple model; US yield curve has stopped steepening but yet to see a “bear flattening”; ECB “taper” remains one of the key catalyst for rates volatility, although for the time being it remains unlikely.
Sure, Hartnett concedes, you can get a wobble in coming weeks. Investors are partial to the “buy the election, sell the inauguration” argument. Fed anxiety could pick-up between the two winter FOMC meetings: Feb 1st & March 15th, especially given December surge in US wage growth. And Trump/Mexico/China headlines/tweets have the ability to rattle sentiment as the new President seeks to immediately boost his ratings via populist trade policies & legislation …from Occupy Wall Street to Occupy Detroit or Occupy Silicon Valley.
Still, Hartnett does not see it… yet.
Positioning, Policy & Profit arguments for a big Q1 correction. The conventional wisdom has flipped from “Davos Man” portfolios to “Joe Six-Pack” portfolios in recent quarters. But let’s not forget the extremity of the starting point of this Great Rotation: global interest rates were at 5,000 year lows in Jul’16 and this induced acute dislocations in asset/sector/regional valuations…
- $1.5 trillion inflows to bond funds in past 10 years vs $0 to equity funds
- Real assets at 90-year lows versus financial assets
- US stocks at 60-year highs versus European stocks, and so on.
Thus we should expect the ongoing rotation out of entrenched Wall Street to Main Street (Table 1) assets to be violent, extreme, and ultimately overshoot
* * *
Which brings us to the just as sensitive topic of “Treasury Wars”
Recall that one of the most hotly debated issues in the past week, one which involved such bond titans as Bill Gross, Jeff Gundlach and Scott Minerd, is what level of bond yields will hurt all financial markets. Gross said 2.60%; Gundlach and Minerd agreed on 3.0% as the magic number. Previously, Goldman said 2.75% is the 10Y yield bogey.
So, to add to the confusion, here is BofA’s Harnett with his own (inconclusive) take on this most critical of topics.
According to BofA, 5.0% on the 10-year Treasury yield has historically been the level above which rising bond yields = falling stock prices. Using data from 1962, the relationship between Treasury yields and the correlation between stock and bond returns has exhibited a number of different regimes (Chart below). For example, high 6-16% yields in the stagflationary 1970s were often associated with equity bear markets (especially in real terms), while more recently, the post-GFC era of excess liquidity & financial repression has coincided with a big bull market in equities.
However, while the historic 5% threshold offers comfort to today’s equity bulls, the “hurt” level from bonds is likely lower this cycle given the starting point for rates. And note that the “taper tantrum” showed that much lower bond yields can be associated with stock market selloffs. This is well worth bearing in mind given the likely end of QE in Europe and Japan in the next 12-18 months. Once that is signaled to the markets, look for rates volatility to hit stocks.
And the punchline: note that the current Treasury drawdown is the 4th largest since the Volcker/oil shocks of ‘80-81. Losses in recent months exceed the losses leading up to big financial market events such as the Continental Illinois bankruptcy (1984), Orange County & Mexico defaults (1994), the dot-com crash in 2000 & Japan VaR shock in 2003.
And should the 30-year yield rise >3.5% in Q1, the Treasury (G8O2) drawdown would be the largest ever.
In other words, the “bond shock” story bubbles away in the background. And with the next 50-75bps rise in yields (due to perhaps expectations of trade wars or Chinese repatriation, or even further gains in inflation), the risk of a financial “event” is likely to jump.
As Hartnett concludes, ominously, “2016 started with pessimism and ended with optimism; 2017 starts with optimism…“
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