With fixed income and FX markets just showing signs that the Trump reflation trade is at risk of faltering, next week sees some important speeches. On Tuesday, President Trump will address The House in what is expected to be a more detailed policy proposal. Throughout the week, we see a number of Federal Reserve speakers with the best saved until last when Yellen and Fischer speak on Friday.
At the current juncture, economic data is taking a bit of a back seat. Market participants will be very eager to hear what Trump and the Fed speakers have to say, and with positioning still very much aligned with the reflationary trade that has prevailed since the US election, there is potential for some interesting price action.
From time to time, commentators try and describe our overall macro perspective as somewhere between “perma bear” and “frustrated bear” or even “cautious bull”. At the moment, what we see are a number of markets where either price is trading at important support, sentiment is or has recently been at an extreme and positions held by speculators are large by historical comparison. It is this juncture of price, momentum, sentiment and positioning coupled with important upcoming events that has our interest piqued, regardless of what moniker we are given by commentators. Let’s jump into the details.
We obviously don’t know what the details of any of next week’s speeches are going to be. We don’t know whether Fed officials will indicate whether they will raise rates at their March 15th meeting. If they do, then markets will have to adjust their thinking as pricing indicates that a rate rise is seen as being about a 40% probability. Regarding Trump, he is likely to be pretty robust, if not flamboyant with his language. He is surely going to deliver a very optimistic speech in which he will give some details on key policy areas like tax reform, deregulation and infrastructure spending. The key will be whether markets hear the right message or not.
Chart 1 below shows the yield on the US 10 year “generic” bond. As can be plainly seen, yields are testing important short term support around 2.30%. What can also be seen is after the initial surge higher post the US election, yields have been basically trapped in a sideways range. This is clearly an interesting juncture. Either yields start moving higher (bond prices lower) if bond traders/investors believe that economic reflation truly is beckoning. Or, disappointment sets in that proposed policies will struggle to deliver sufficient near term economic momentum.
Chart 1 – The US 10 year bond yield
We have explained in recent weeks why we were cautiously constructive on US bonds, holding some modestly bullish positions. Given the pivotal position portrayed above, we will be (temporarily) exiting some of these bullish positions early next week so that we can watch how market action develops. However, we still feel that the burden of proof lies with the bond bears (those believing in the reflation narrative). Not only do we think that the “hard” economic data is not as robust as many think, we continue to think that the upward momentum in inflation dissipates in the next few months.
Traders have built very large short positions in bonds. If price doesn’t start to decline soon (and yields rise), then these guys will begin to question whether they should maintain their bearish bond bets. If prices actually begin to rise, and yields break below the 2.30% support area, we suspect that a process of short covering will occur which holds the potential to be quite nasty for the bears. In chart 2 below, we show the positioning of speculators as shown by the futures market. Not only has the net position shown a record bearish bet recently, but short positions alone are at an historical extreme.
Chart 2 – US Bond Futures and speculative positioning
What happens in the US bond market will be mirrored somewhat in the FX markets. To be more precise, if the reflation narrative wins out, and US bond yields rise, the US Dollar should rally and vice versa. Speculative positioning is similar in the FX market, but arguably less extreme, in that long Dollar bets prevail overall. However, the picture here is a bit more nuanced. With commodity and emerging market currencies having outperformed, we see traders are having placed both “risk-on” as well as reflation trades. Or put another way, they have been chasing both yield and economic reflation, and generally speaking it has been working.
Perhaps the purest way of expressing both risk on yield seeking and global reflation in the FX market has been to be bullish of the Australian Dollar versus the Japanese Yen. Data shows that speculative traders on the futures markets are long the Australian Dollar and short the Japanese Yen (charts not shown), and we suspect that this has been a popular trade in the OTC markets as well. Indeed, with commodity prices (copper and in particular iron ore) rising rapidly since last summer, the trade made perfect sense (in hindsight; that wonderful indicator!).
Chart 3 – The Australian Dollar versus The Japanese Yen
As with many markets at the moment, it would appear that speculators have piled into industrial commodities as another way of expressing the Trump reflation trade. Any disappointment on the reflation trade could easily lead to a reduction in the near record long positions held in copper which would undoubtedly be a significant drag on the Australian Dollar’s performance versus the Yen. For the sake of clarity, we have been holding small bearish trades in the Aussie versus the Yen in the last week or so.
Rather than go into detail on every market we follow, the message we believe is quite simple. Whether it be in equities, or fixed income, or FX or commodities, traders and investors collectively jumped on the Trump reflation narrative late last year. Many of these trades have lost momentum and yet bullish positions have barely been reduced and sentiment remains complacent almost everywhere, if not outright scarily bullish (think equities here).
Now these bullish bets on the reflation narrative could continue to make money in the weeks ahead, but it does feel like we need to have some new fuel added to the engine here. Will Trump deliver some goodies in his speech? Will Yellen her colleagues sound more hawkish? Will speculators dump positions if they see price move against them? The confluence of price, momentum, sentiment and positioning indicate that the events of the next week or two will be important in either validating the reflation narrative or challenging it. Stay tuned.