Shifting Sands

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by: The Heisenberg
Summary

On Thursday, the narrative shifted a bit and it's worth taking note.

The Russia sanctions manifested themselves in surging metals prices which, combined with oil's ascent, appeared to stoke inflation fears anew.

That conjured flashbacks of February and contributed to fading equity prices into the weekend.

On Wednesday, in "Choose Your Own Adventure", I brought you some of the counterarguments to my Tuesday note for this platform on a possible pickup in cross-asset volatility.

The point of the Wednesday note was to illustrate how, in an environment characterized by competing headlines, a manic news cycle and the creeping suspicion that policymakers of all stripes know even less than we do, you can pretty much write your own narratives and, should you decide to trade on those narratives, choose your own P/L adventure.

In both linked pieces above, I talked about the inflation story and how the assumption that it will remain anchored is one of the two pillars that supports the ubiquitous "Goldilocks" narrative that implicitly underpinned the low volatility regime in 2017. That would be the low volatility regime that made it possible for every quarter of last year to witness realized volatility in the bottom quartile of the past 25 years, a stark contrast to Q1 2018, during which realized volatility was in the top quartile over the same period:

(Source: Goldman)

Well, the day after I wrote the "Choose Your Own Adventure" post, the narrative turned on a dime, in the process illustrating precisely what I was trying to convey. That shift continued on Friday.

As you're hopefully aware, the latest round of U.S. sanctions on Russia (and specifically the fallout for Rusal) have thrown the metals complex for loop. Although prices came off a bit on Friday, aluminum and nickel soared to multi-year highs this week:

(Bloomberg)

Between that, and a concurrent surge in crude (USO) catalyzed by geopolitical turmoil, the Saudis' desire to see higher prices ahead of the Aramco IPO and in order to fund ambitious government programs, and bullish inventory data from the U.S., the Bloomberg commodities index jumped to its highest since 2015:

(Bloomberg)

As an interesting aside, it's also worth noting that the ruble's recent trials and tribulations are likely bullish for Brent to the extent Russia's currency woes facilitate further cooperation between Moscow and Riyadh on production cuts.

Surging commodities prices appeared to reignite inflation concerns on Thursday and that, in turn, looks to have conspired with a selloff in gilts and bunds to push 10Y U.S. yields back above 2.90 on Thursday. The selloff continued on Friday, pushing 10Y yields (TLT) above their February inflation panic peak to their highest levels since 2014:

(Heisenberg)

On Friday, the market was also forced to cope with what seems like a poorly worded comment from Mario Draghi, who said this in statement at the IMF meetings in Washington:

Notwithstanding the latest economic indicators, which suggest that the growth cycle may have peaked, the growth momentum is expected to continue.

Draghi doesn't fumble often when it comes to communications, but that bit about "the growth cycle may have peaked" isn't great from an expectations management perspective, although it's almost certainly an accurate appraisal of the situation in Europe. You're reminded that the data has been coming in soft across the pond and you can see that pretty clearly in the following chart from BofAML:

(BofAML)

Draghi's comments came amid reports from Bloomberg that the ECB is considering waiting another month (i.e. until July) before making any kind of concrete announcement on the end of APP. That further underscores the notion that the Governing Council is getting concerned about the economic outlook in Europe.

So between renewed inflation concerns tied to commodities and the comparatively dour economic outlook conveyed by Draghi and some of the officials anonymously cited by Bloomberg, both pillars of the "Goldilocks" meme were shaken and the fallout for equities (SPY) was predictable with the U.S. rally stalling on Thursday and stocks declining materially to close the week.

What's important to note here (and this speaks to the narratives issue mentioned in the two posts linked here at the outset), is that markets seem to have abruptly pivoted to worrying about inflation again (just like they did in early February) and that shift was apparent in the curve, with 5s30s and 2s10s snapping out of an inexorable grind lower to steepen into the weekend.

To be clear, on net (i.e., when you look at the week as a whole), this was nothing dramatic, but you can see clearly in 2s10s (white line below) when things started to reverse on Thursday:

(Bloomberg)

One shouldn't overstate the case here. The long end remains well anchored and largely rangebound, and that seems likely to remain the case at least for the foreseeable future.

But what we saw on Thursday and Friday illustrates how quickly the ground can shift and really, you could make the argument that it took too long after the sanctions and the surge in crude prices for the market to take note.

As usual, there's a ton of nuance to the inflation argument and to any discussion about the curve and/or the extent to which the long end has the capacity or "desire" (assuming you can impart intent to asset prices) to selloff materially.

That said, the big picture here is relatively simple and it echoes what folks were concerned about in February. With that, I'll leave you with a quote and two charts from a BofAML note out this week:

Of course, the tighter monetary policy path in the US and the normalization of interest rates is informed by the rising inflation pressures across the economy. On the one hand, the decline in the unemployment rate will likely support a steady increase in core inflation [and] on the other hand, rising oil prices are already feeding into an increase in headline inflation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.