Nomura: “This Is Telling Us Something Powerful About The Market’s Sentiment”

Yesterday, one day ahead of the Fed’s rate hike decision (and first Clarida dot, and first 2021 forecast, and potential revision of the “remains accommodative” language), we highlighted something that had generally fallen through the cracks of market punditry: namely, not only do traders now fully price in two rate hikes in 2019 (if still below the Fed’s three), they have once again shifted to expect that the Fed could extend the rate cycle through 2020. One can see this by observing that the spread between euro-dollar futures in December 2019 and 2020 is no longer inverted.

Admittedly, the spread is only 4bps for now, which translates to a mere 16% chance for a single 25bps rate-hike but it represents another key recent reversal in how the market is approaching the Fed’s thinking, and potentially a sign that the widely discussed “Recession of 2020” has been put on ice. Furthermore, it gives The Fed some runway in its belief that it can raise rates without having to worrying about cutting the expansion short.

We bring this dis-inversion up because it serves as the gist of the latest email to clients from Nomura’s Charlie McEligott who after laying out his latest thoughts on what the Fed will do later today (“we expect the long-term dots to move towards 3%; we believe the potential (hawkish) removal of “remains accommodative” language to be a story for the December meeting“), writes that:

“the larger rates talking-point for me over the past week or so hasn’t been about the Fed: following the Eurodollar futures roll and the market’s readjustment closer to the Fed’s 2019 dots over the past few weeks, the EDZ9EDZ0 spread is now no-longer inverted.”

We showed this yesterday as follows:

Why is this reversal in the inverted 2019-2020 Dec ED spread relevant? A few reasons:

First, McElligott writes that the inversion was something he had “previously highlighted since mid-Summer as very telling with regards to the market’s “building consensus” around the “2020 recession” narrative.

Obviously if the market now expects a rate hike – something the Fed would not do in a recession – the sentiment has shifted drastically, and now expects continued expansion at least into the early part of 2021.

McElligott agrees and says that “this matters meaningfully to me”, as “the former EDZ9EDZ0 inversion communicated that the market was pricing-in higher likelihood of a CUT than any further Fed hiking in 2020; NOW, with the spread again positive, the market has (very modestly) inflected towards the (smallish, but ‘there’) potential for another hike in 2020 on a re-gearing of U.S. economic bullishness.

Said another way, this is telling us something POWERFUL about the market’s accelerating +++ sentiment on U.S. economic growth trajectory—which is now viewed as “pushing-back” the ultimate “slow-down / recession” thesis timing.

The shift in sentiment would also revise McElligott’s own trajectory of trades heading into 2019, as it would “delay the potential sequencing of the move in the UST curve “from flatter to steeper,” which Charlie had been projecting as a mid-2019 event and “THE” story for thematic macro regime shift as the ultimate “risk-off” signal indicating that the market is “sniffing” the end of the cycle.

Then again, one can counter that until recently, consensus – in the Eurodollar market – was aligned with McElligott’s view, and that at least for rates traders, the “2020 recession” was largely priced in, and therefore would probably not have been a surprise to risk assets. However, now that the 2020 “event” has been delayed, is precisely when it would have a far greater impact if indeed the global economy downshifted – whether due to China or trade war – and the Fed was, in fact, forced to put an end to the rate hike cycle.

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Finally, a few pure equity market observations from McElligott who adds that “the behavior of U.S. Equities on the index level this past week is that much more impressive being that it comes despite”:

  • U.S. Corporates largely having-entered their “buyback blackouts”
  • The post-serial expiration Gamma roll-off
  • The back-half of September negative seasonal
  • The month- and quarter- end Pension rebalancing “reversal flows” (selling Equities outperformance, adding Fixed-Income)
  • The SOMA balance sheet run-off phenomenon, the largest MBS unwind of 2018 having occurred yesterday

The last point, i.e. the correlation between the Fed’s balance sheet and risk assets, is notable because as of this moment, the MBS portion of the Fed balance sheet unwind “has shown the most NEGATIVE sensitivity to SPX behavior YTD,” with SPX on average -0.3% the 1w PRIOR to the roll-off event / VIX +8.0%, and SPX on average -0.2% / VIX +6.6% on the 1W AFTER period. This implies that for now at least, the shrinking of the Fed’s MBS holdings remains, perversely, bullish.