Rates Market is Vulnerable to Momentum Traders


The US Treasuries market in vulnerable to momentum players, writes BAML in a recent rates strategy report. This could open up the upside to higher yields. It’s an interesting observation and a less well known driver of bond prices. Equity market momentum tends to get all the headlines. BAML presents compelling evidence that momentum could be a significant driver. They show a chart of how the 2-year note has been riding the strongest trend since 1991, and another chart that shows how net positioning in futures has followed 5-year yields closely, which BAML suggest could be a good indicator of momentum trader positioning. Their analysis argues that investors ranging from CTA strategies, convexity hedgers, to foreign private investors could all exacerbate the recent moves, which they also illustrate with a couple of illuminating charts. Meantime, over in Europe, 10-year Bunds have already eclipsed their Q1 target, now exceeding 60bps. With the front-end remaining vulnerable to an increase in volatility, and term premia not being the driver of higher rates in EUR, BAML see some risks to the upper bound of their expected trading range in 10y Bunds. However, the outright rally in 30 year, as well as the sharp move lower in breakevens are reassuring signs that there is likely to be a limit to the sell-off in Bunds, given demand for longer-dated forwards, and the incompatability of current breakevens with a more hawkish ECB, BAML say in this report. As such they see value in spread wideners and they remain comfortably paid USD 5y5y vs EUR 5y5y – incorporating a steepening bias in the US vs EUR. In the shorter term, momentum players and increased issuance should see Treasury risk extending the move higher in rates in the US. They target 2.85% for quarter end. BAML clients can view the full piece on BAML Mercury.  

EM Rates: Clearer Skies, Time To Harvest Yield

MRB have just published their quarterly emerging markets fixed income report which sees them pull the trigger on their positive bias on EM rates by formally upgrading their view on EM local-currency debt (EMLCD) within a global fixed-income portfolio. The weaker dollar is obviously a major component of this view, where they say this weakness will continue to insulate EM bonds from any future commodity-associated turbulence. Sure China will probably take a hit and therefore this could impact those commodity countries that export to it, but all in all, MRB see the currency implications for commodity-exporting economies as being relatively benign. Underpinning this constructive outlook, strong underlying fundamentals in the form of both global trade drivers and local monetary conditions will support positive returns from EMLCD on a 6-12 month view, the report say. They upgrade Brazil, Colombia and Russia, and downgrade Mexico and Peru to underweight. In Asia, the steep underperformance of the Philippines warrants an upgrade from underweight to neutral. They also initiate coverage of Argentine local debt, which despite offering the highest yield in the universe, warrants only at neutral weight in light of local policy uncertainties. Click below to contact the provider to request trial access to this piece, or to request samples.

The Return of Term Risk Premium

Julian Brigden of MI2 Partners says investors need to watch the movement in the Term Risk Premium (TRP), which he defines as the additional yield investors earn for taking duration risk vs rolling their money overnight, and which also offers a reasonable metric of central bank credibility. TRP is currently negative (levels not seen since the mid 60s), which renders the metric an oxymoron, says Brigden. Back in the mid 60s, when the TRP finally corrected, bond holders were annihilated. Brigden believes things could be about to change for TRP. He thinks the new regime under Fed Chair, Jerome Powell, will be dominated by a narrowing of the gap between current pricing in fixed income and US nominal GDP, as the market begins to anticipate higher terminal interest rates. This would naturally imply a steeper rather than flatter US yield curve, he concludes. In terms of strategy, Brigden reckons the time is ripe to close remaining short positions at the front end of the curve, and then look to re-engage with an increased short position at the long end of the curve (He has suggested shorting 10-year Treasuries on a break of 2.3% and 2.39-2.43%). This report can be purchased on RSRCHXchange, or alternatively contact the provider directly. 

Is Sterling’s Strong Start to 2018 Warranted?

Sterling appreciation this year hasn’t been driven by economic data surprises or rate expectations, writes Pantheon macro, rather it is a story of genuine sterling strength. The appreciation undoubtedly reflects investors reappraising the U.S. government’s policy towards the greenback, however, sterling additionally hit a seven-month high against the euro last week and it has appreciated against nearly every other major currency. Pantheon argues that the lack of recent news about Brexit talks might have eased investors’ fears, further arguing Sterling’s appreciation has been fuelled by speculation. Shorts have declined, while long positions have increased. Markets are right to
 take a sanguine view on the risk of a hard Brexit, but while good news are now largely priced-in, sterling probably won’t continue to ascend rapidly, says Pantheon Macro. Click below to request trial access, or samples of Pantheon’s work. 

Bye Bye Yellen, Hello Inflation

Outgoing Fed Chair Janet Yellen’s certainty about the Fed’s traditional impact on inflation, and its primacy in setting policy should now fade as Jay Powell, a disciple of the private equity business rather than academic economics, takes hold of the monetary reins, writes Steven Blitz from TS Lombard. According to the  FOMC meeting in January, in the coming year inflation is expected to move up, which is rooted in its upgrading of the economy’s performance while unemployment rate stays low. Blitz, takes a broader view of inflation, expecting that core consumer inflation runs just under 2% which will be high enough for the Fed to act on. As Powell takes charge, TS Lombard believes market participants should be aware that Fed actions will lose their singular ties to core PCE, and what will matter is what participants are doing with their money. Click below to request trial access from TS Lombard directly.

Asia Rates: Macro to Flatten Regional Curves

In Asia, the tussle between global and local factors will continue this year. But Jonathan Sequeira and Andrew Tilton of Goldman Sachs say that global factors are likely to dominate, pushing rates (particularly at the short-end) higher and flattening the yield curves. They expect to see this narrative play out in Korea, Taiwan and most of ASEAN with China and Indonesia as exceptions. They are less bearish on India than in October but only on short term rates, and are, overall, cautious on the Philippines.

2018 Fixed Income Frontier Outlook

EM local currency bonds were the ‘star performer’ last year delivering returns of 14.3% (Bloomberg Index), writes Stuart Culverhouse of Exotix Capital, and he remains positive on them for 2018. While the outlook for EM debt overall remains bullish, Culverhouse says investors struggling to find value in EM hard currency will look to local currency trades for higher returns, as they did last year. EM local currency debt will also benefit if the dollar weakens and if cheap local currencies (including Mexico, Turkey, Ghana, Ukraine, South Africa, Colombia and Kazakhstan) receive support from an expected turn in the EM rate cycle.

Japan: Lessons from the 1951 US Treasury-Fed Accord

Sean Darby, chief equity strategist at Jefferies writes that with the US 10-year yield convincingly breaking through 2.5%, German five-year bund yields above 0% for first time since Dec. 2015 and global growth numbers being revised up quicker than analysts can pen reports, Japan’s JGB 10-year is becoming the last bastion of ‘zero rates’. Although by no means perfect, there are some lessons for Japanese equity investors from the 1951 US Treasury-Fed Accord. We highlight some turning points.

 Oil on Fire and Fury, Can Prices Get Cut from their Anchor?

BAML like most firms on the street have had to revise up their 2018 forecasts for crude, and they did that 2 weeks ago raising forecasts on Brent prices to a 2018 average of $64/bbl compared to $56 prior. In their latest report they say that the upside pressure on the crude market seems relentless, and Brent prices in January are now tracking the highest monthly average price since November 2014.   Of course this has been helped by a weakening of the DXY and trade weighted-USD.   Meanwhile, loose fiscal policy in the US, a recovery in growth in Europe and an acceleration in EM growth have all combined to push the dollar lower and oil prices higher. As such, say BAML, oil prices in local currency have not moved up as fast, temporarily cushioning the negative price elasticity effects on the demand side. Meanwhile, relentless producer selling has kept long-dated oil prices anchored at a $12/bbl discount to the prompt, creating a very attractive carry proposition for oil investors. Can oil break $90? Yes, say BAML, but only if the long-dated anchor breaks. In other words, the back–end of the curve needs to move to $70/bbl for Brent to reach $90/bbl. In turn, a de–anchoring of long-dated oil prices could come on the back of three risks, say BAML: a geopolitical supply disruption, an OPEC deal extension, or tighter–than–expected supply/demand balances. How realistic would a de-anchoring be? BAML say that the collapse in forward oil prices in 2014/15 effectively knocked Canadian oil sands out of the marginal supplier position that they had held for 10 years and in turn placed that marginal supplier position in the hands of US shale. So how much shale supply will come on line at current forward price levels? In their view, long-dated Brent oil prices at $58/bbl or WTI prices of $54/bbl are pricing in an OPEC supply contribution equivalent of 1/3 of demand growth over the next 5 years and a US shale contribution of 1/2 of demand growth). So can spot prices move a lot higher? Looking back, front-to-sixty month prices sustained backwardation levels as high as $20/bbl for 2 years in 2012-14 , suggesting that Brent is capped below $80/bbl, BAML conclude.

Three Reasons why the Dollar will Stay Weak

We have been bearish on the dollar for a year, says Tan Kai Xian at Gavekal, and we still are. There are three reasons given. Firstly, the market has fully priced in US rate hikes. But it has not priced in any tightening from other developed economies. This will put upward strength on the major crosses with the dollar. Moreover, at this level, the dollar is not undervalued. It may not even be overvalued. Furthermore, December’s tax cuts could cut the prices at which US corporations sell their goods. This in turn will lower the US dollar’s real effective exchange rate. This note follows two previous notes put out by Gavekal on how different markets and asset classes are being affected by the weak dollar. Their central idea is that a falling dollar encourages borrowing, which leads to faster growth and inflation, which is further increased by the tax cuts and deficit spending. The result will be an inflationary boom.