To RBC, This Is The Single Largest Risk To The Market Right Now

From everyone's multi-strat wizard, the head of RBC's cross-asset strategy, Charlie McElliggott

The Single Largest Macro Risk To The Buyside

The US Dollar is the “grand unifying theory asset” for nearly any and all “profile” global macro or thematic equities trades in the marketplace right now, as it represents investors being long this “new” version of “economic growth.” As such, performance is significantly tied to the direction in the US Dollar.

SO THEN…let’s take it back to the “January Effect.” I’ve been doing a bunch of client marketing this week, with the ‘meat’ of the discussion being largely centered upon buy-side concerns surrounding said “seasonal mean-reversion” metastasizing into something larger. I qualify this as “something larger,” because at this time, NONE of the YTD performance reversals from Q4 have been outright PNL destroyers. Sure, popular shorts like USTs / ‘long duration,’ EM stocks, gold and equity ‘growth’ factor are all squeezing higher out of the gates—but by and large, so too are popular longs like small cap equities, inflation, copper, ‘high beta cyclical’ equities, ‘value’ factor and HY.

The fact is, there has been a ton of money made / performance driven by, for example, ‘long Russell 2k’ vs ‘short USTs’ / ‘short ED,’ or being long equities ‘value’ against short equities ‘growth’ since back mid 2016 when we began seeing positioning pivot this way (and accelerating post-Trump). But the problem is that for many, much of that positive PNL was booked last year. So an ‘upside-down out of the gates’ January is more than inauspicious—it’s an outright “non-starter” for risk managers in light of the performance-challenged era of the past few years. Fund willingness to stomach slow starts in January to begin the year—especially in light of the proliferation of ‘tight stop’ multi-managers with a massive institutional AUM concentration, and a pod / center book structure which exacerbates crowding—can “turn wrong-way fast” when CRO’s become de facto heads of trading into potential deleveraging.

* * *

OKAY, SO BACK TO THE US DOLLAR. A macro trade entirely built around the framework of “US domestic growth and reflation” + pro-business policy mix + a sprinkling of “animal spirits” = long Spooz / long Russell / long value vs growth / long cyclicals vs defensives / short FY / short Eurodollar futs (largest net spec shorts ever recorded per last Friday’s CFTC data) / long CNH / long copper vs short gold / short EM / short EUR / short Yen’ again almost singularly hinges on the Dollar.

(As an aside: believe me, I ‘get’ that it seems counter-intuitive that a reflation trade would be positively correlated with the USD….but as the Trump story is about DOMESTIC growth (indiv and corporate tax cuts, fiscal spending, border adjustments and potential tariffs which restrict flow of cheap goods = PUREPLAY domestic inflation…higher Dollar is key to perpetuating the current regime.)

If we see the Dollar materially weaken from here, the entire trade is in jeopardy.

From a “consensual positioning” perspective which touches on this current “mean-reversion dynamic in the marketplace: say this big bond rally were to gather steam into a much more punishing squeeze of the ‘all-time’ UST short base (largely due to the previously mentioned lack of “tolerance” for beginning of year performance pain). Yields would collapse and likely drag the USD lower with it. Above trades would likely unwind as well.

Fundamentally with the USD bull-case, this is a large part of why there is SO much focus on key items like the border-adjusted tax element of the Trump policy push. A large part of the Dollar’s strength (beyond ‘just’ the data) post- the election has been based upon this, where if the corporate tax rate were cut to say 20%, the Dollar would by economic theory have to then appreciate 20% (and of course too, an additional ‘tax factor’ driving the USD bull-thesis is that a meaningful chunk of $2.5T of profits held overseas by US corporates would be repatriated following a ‘business friendly’ incentive package / one-time cut to the repatriation tax to say 8-10%).

There is a view though within some verticals of the business community is that the border-adjusted system represents a very significant risk (consumer retail most notably) to their businesses / the broad economy as imports become more expensive and will create trade distortions (while the CBO itself says that the border-adjusted system would NOT reduce the trade deficit, which is a driver of its political popularity). There is so much discourse on this issue currently on this topic within the C-suite in fact some in policy circles are now saying they believe it appears increasingly likely that the ‘full’ border tax adjustment (currently in the Houses’ version of the bill) ends up being watered down to a sort of “relocation penalty” (which would likely then appear in the Senate-version of the bill).

Again, this is all a hypothetical, but if some of this ‘sense’ around said USD ‘bull driver’ turning potentially bearish was to ‘leak’ into the market, it would take some of the air out of the “long USD” trade–and that is where things could go off the rails. If the Dollar broke lower, its likely too that bonds and duration would rally; defensives (staples, utes, reits) and growth (tech / biotech / discret) squeeze against crowded value unwinding (fins, energy, indus); yen and euro would squeeze mightily; gold squeezes while copper pukes in a favorite commodities ‘pair’ unwind; HY could reverse weaker vs IG (currently everybody long CCC vs BB on the high beta trade)…this would be the theoretical path to our next pain-trade or even VaR shock.

As such, status quo positioning and thus performance is ALL about ongoing strong data trend, more than any other quarter in recent memory. And boy do we have lots of it recently.

* * *

So we have that going for us in a major way…but how long can this momentum last now that we’re in the ‘hard part’ of the trade and the ‘implementation challenges’ await on the policy side?

It need be noted that this “USD reversal lower as largest risk” thesis comes against the supporting ‘reversal context’ of short-term tactical opportunities TRADING AGAINST REFLATION within rates, curves, EM and gold for instance (highlighted by my colleague Mark Orsley this morning), which is taking advantage of technical reversals / loss of Q4 trend momentum. And of course too, if all of global rates were to ‘countertrend rally’ in unison (largely on technical), it is possible that the USD might not end up moving much at all as differentials remain static.

Nonetheless, 1) the rates move lower on positioning excess being unwound due to YTD performance pain and reversing technicals, along with 2) the potential “watering down” of the tax policy’s USD-drivers need be monitored going-forward for all portfolios due to the high likelihood of causing a similar turn lower in the US Dollar.

IT’S ALL THE SAME TRADE

U.S. DOLLAR AND LONG SPX (OCTOBER TO PRESENT):

U.S. DOLLAR AND CFTC 5Y US TREASURY FUTURE NET SPECULATIVE POSITIONING (SHORT–INVERTED):

U.S. DOLLAR AND CFTC RUSSELL 2K FUTURE NET SPECULATIVE POSITIONING:

U.S. DOLLAR AND ‘VALUE’ FACTOR MARKET NEUTRAL (LONG ‘VALUE’ / SHORT ‘GROWTH’) SINCE Q4:

EQUITY HEDGE FUND RETURNS CORRELATED TO VALUE FACTOR MKT NEUTRAL…WHICH IS DEPENDENT UPON HIGHER USD / HIGHER US RATES:

U.S. DOLLAR AND U.S. FINANCIALS SINCE Q4:

U.S. DOLLAR AND LONG CYCLICAL BETA EQUITIES SINCE Q4: