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Nomura: The Market Is Sniffing Out The Possibility Of A 2019 Rate Hike Pause From The Fed

Courtesy of ZeroHedge. View original post here.

Authored by Charlie McElligott, head of cross-asset strategy at Nomura

USD stuck “sideways to lower”—and that is a ‘risk-asset’ positive, with Commodities higher for five of the past six sessions / EEM ‘up’ seven of the past eight sessions

  • The PBoC strengthens the Yuan fix by the most since June ’17, and stronger for the 14th consecutive day
  • The Euro is now +350 pips off the one-year lows made two weeks ago, and it looks to be about the crowded short being squeezed—EURUSD again higher despite weak Italian Confidence data
  • EM a mixed-bag, with TRY back under the cosh in outsized-fashion but against majority EMFX actually firmer, led by Won as the South Korean government plans their largest budget increase in 10 years, as tactical longs in EM are increasingly emboldened to add yieldy-trades

But is there more to the USD weakness than simply the PBoC and tactical positioning dynamics?

Nomura FX Strategy is pushing EUR vs US “curve convergence,” looking for 100bps+ move in US/EUR 5s30s box (1Y fwd EUR flattener vs USD steepener) under either of two scenarios:

  • “Easy Way”—inflation recovery allows ECB to eventually normalize, against the Fed nearing the end of its hiking cycle
  • “Hard Way”—a global recession steepens the U.S. curve (forcing the Fed to cut), but the ECB can’t cut as it is already at the lower bound; as a result, the Euro curve can flatten into a recession

Speaking of the U.S. yield curve, the release of the  San Francisco Fed’s research paper on the significance of yield curve inversions seems “conveniently-timed” to me, and frankly, looks like a “pre-emptive CYA” into a potential “hike twice more in ‘18 then pause at start ‘19” scenario—as it is likely that Sep and Dec hikes will indeed see the “mainstream” curves invert (although to be clear, the paper says to instead watch the 3m10Y curve [still steep at 75bps] as the best indicator—but nonetheless does give credence to growing Fed-speaker “inversion as a recession signal” narrative)

Market participants are thus “sniffing” the possibility of a “start of ’19 pause” from the Fed (as two more Fed hikes in ’18 will seemingly take us near “neutral”): the probability of a March ’19 hike is now ‘only’ at 50%, down from 63.5% less than a month ago

Perhaps then, this post-Jackson Hole view on the Fed possibly losing some resolve to hike much more beyond Sep & Dec is why the Dollar is down, and aligns with the FX Strategy call on the US / EUR curve—WE ARE APPROACHING THE END OF THE ‘POLICY DIVERGENCE’ (BULLISH) DRIVER FOR THE U.S. DOLLAR

Similarly, EDZ9-EDZ0 spread remains inverted at -2bps, speaking to a view that Fed normalization will end in ’19 before the first cut in ’20 (into a possible U.S. recession), which is why we have been pushing 1y or 2y expiry 2s10s or 5s30s curve caps as broad “risk-hedges,” playing for a steepening of the UST curve as the market removes hikes from the front-end

Turning to U.S. Equities, the bullish call on SPX and “Momentum” view voiced the 8/14 note (“NOISY AUGUST TRADE CONTINUES, BUT SEASONALITY TURNING POSITIVE FOR RISK”) continues to ‘gallop along’—Spooz +2.7% / “1Y Momentum” +3.0% since

Beta of S&P 500 to HFR Equity Hedge Index is now at +55.3%--the highest level since Feb 2nd—as the month and a half ~4% to 5% to MTD underperformance of Equities Long-Short- / ~3% MTD underperformance of Equities Market-Neutral- funds versus S&P forces funds to “take up” their market exposure

So we now have the context for this current & powerful relief rally in U.S. Equities:

  • Huge underexposure / underperformance dynamic from both HF and MF over the past two months, driving “chase” behavior on “performance anxiety”
  • Seasonality (especially in the back half of Sep) for SPX and “Momentum” to rally sharply (“Mo Longs” work over course of month, but over the last two weeks, “Mo Shorts” really break-down, driving majority of + PNL)
  • Seasonality for a “pivot higher” in Sep for U.S. economic “surprise” indices
  • Growing belief in “Fed Pause” easing concerns over “tight” of financial conditions / Fed “policy error” of “hiking into a slowdown”

This view that the Fed is “nearing the end” of normalization then too contributing to a softer USD—also contributing to “easier” financial conditions

Remember as recently stated—U.S. Equities are showing an increasingly NEGATIVE sensitivity to “tighter financial conditions”, with SPX is now negatively-sensitive to 1) Inflation Expectations 2) Real Rates 3) USD

THUS, any market-view that the Fed is approaching “pause” to avoid “over-tightening” is POSITIVE for U.S. Equities

* * *

NEGATIVE SPX SENSITIVITY TO ‘INFLATION EXPECTATIONS’ MACRO FACTOR VARIABLE:

Source: Quant-Insight

NEGATIVE SPX SENSITIVITY TO ‘REAL RATES’ MACRO FACTOR VARIABLE:

Source: Quant-Insight

NOW NEGATIVE SPX SENSITIVITY TO US DOLLAR AS MACRO FACTOR VARIABLE:

Source: Quant-Insight


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