Light at the end of the tunnel

I wrote two weeks ago how I was bullish risk, and then a week later I wrote about how I thought the bond market was melting down. (Seriously Geo, will you make up your mind?) After some uncertainty around which theme would dominate market direction, it looks like the bullish narrative is winning out.

The bond market selloff caused some choppiness in risk assets, but stocks remained resilient and today we are unequivocally breaking out across many markets in a bullish way. This was triggered last Friday by Nick Timiraos’ article in WSJ hinting that the Fed could slow its pace of hikes to 50 bp in December, and then some weak US second tier data yesterday that triggered a break of 3820 resistance in the S&P 500. I’m now long S&P 500 futures with a stop below 3780 and long a 1 month 3900/4100 call spread.

Top: S&P 500 futures, Bottom: 30y Treasury futures. SPX has been resilient in the face of the Treasury selloff, and has broken resistance at 3820, completing a chart bottom.

Bonds are rebounding, so I have “covered” my short 30 yr Treasury position by buying the equivalent amount of 5 yr Treasuries (319 contracts of FV for every 100 contracts of US), turning it into a steepener. I don’t think we’ve seen the last of the buyer’s strike in long bonds. However the narrative that has taken hold in the market is that inflation is peaking and recessionary signals are piling up, which should put pressure on 5 yr yields. I agree with this narrative, and laid out a case for why a recession will be good for stocks, not bad.

Here’s why a 5/30 steepener makes sense - as the economy sinks into recession and the Fed realizes it has hiked too much, 5 yr yields tend to roll over and trend lower faster than 30 yr yields. As the recession accelerates, the Fed loosens monetary policy in response, trying to stave off deflation in the near term but sowing the seeds for inflation in the long term.

Blue line = 5 yr Treasury yields. White line = 5/30 yield spread. The vertical white lines show where 5 yr yields peaked in 2007 and 2018. Also notice the 5/30 spread doesn’t spend much time below 0%

There is some evidence that the shelter component of CPI (the largest component, at 38%) is about to turn from a headwind to a drag on inflation any month now:

When shelter inflation rolls over, the drag will be persistent and lagging to the downside as much as it was to the upside. This should provide a tailwind for short end Treasuries and risk assets.

“But employment is still hot and the Fed is still hawkish! What if they keep hiking to 5% or more?” some of you might be wondering. To that objection, I have two data points. First is that the Treasury (and therefore the Fed, by extension), is worried about the Treasury market breaking due to poor liquidity. They are so worried that they are looking into buying back Treasuries in the more illiquid parts of the curve (funded by issuance on the short end, so it’s not QE). The turbulence in the UK gilt market and the Treasury market crash of Mar 2020 were previews of what could happen in Treasuries, so the Fed doesn’t want to be overzealous with rate hikes from here on out to cause a repeat of those episodes.

The second data point supports my first - Nick Timiraos’ article hinting at a slower pace of hikes after November came at a time when the market overshot even the most hawkish Fed members’ projection of terminal rates.

June 2023 Fed fund futures

Time for some charts!

ETH/USD - I’m bullish and long, targeting 2000 and wrong below 1360

GBP/USD - I’m long (again) on the break of 1.1500 and targeting 1.1750. Wrong below 1.1400

Usd/cnh - I think China got tired of having to sell Treasuries to fund intervention, so they significantly weakened CNY via the fix on Monday, which sent usd/cnh as high as 7.37. It looks like they finally attracted some buyers for CNY, as the next day they supported CNY via the fix and usd/cnh reversed violently down to 7.18. This suggests that usd/cnh overshot to the upside and is now in correction mode. This should relieve China of the pressure to sell Treasuries for intervention for now.

Eur/usd is breaking a trendline that goes back to Feb and also horizontal resistance at 1.0000

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