BARX – Macro Update – A time for reflection, not a point of inflection: FXWW

From the FXWW Chatroom: Two weeks ago, on February 2, a US employment report showing rising wages started a sell-off in risk assets. We think it is now broadly understood that most of the drop since then was driven by trading in volatility-related strategies. We refer not just to volatility ETNs, but also to target-volatility funds. This sell-off was ultimately technical in nature. Fundamental concerns about higher inflation leading to a more rapid fed tightening cycle might have been an initial spark, but they did not feed the bigger move.

To dispel any lingering doubt, we cite several pieces of evidence. First, the assets that would be expected to rally on stronger US inflation did not; commodity prices, for example, fell and have now declined by more than the drop in US equities in February. Second, bond proxies in the US stock market should have underperformed; they did not. Third, fed funds futures would have moved to price in a greater likelihood of more fed hikes this year. They did the opposite, taking their cue from the equity move. Fourth, while VIX went from 13 to 37 between January 29 and February 5, rate vol (we use 1y*10y bp vol) barely budged in that period. It rose from 69 bp/y to 74 bp/y, far below the 90 bp/y it moved last year when 10-year yields rose just above 2.6%.

So the evidence suggests the drop was driven primarily by trading from volatility strategies. In a bullish signal for markets, our equity derivative team thinks that most of the exposure that drove hedging and selling has now been unwound. In particular, they point out that target volatility strategies ($500bn AUM), which aim for a particular level of portfolio volatility by dynamically rebalancing between risky and riskless assets funds, were responsible for perhaps over $200bn of selling, but having mostly de-leveraged may now have very little more to do. Risk parity funds were the other widely cited source of volatility, but we think this is overstated. These funds are smaller and have a lower allocation to equities versus bonds than widely thought, and the do n0t change these very rapidly.

But even if the recent sell-off unfurled amid hedging and outright selling from volatility investors, the seed of the correction was the US employment report, which showed accelerating wage inflation. A stronger-than-expected US CPI print this week has strengthened this narrative.

We understand why investors are concerned. The US economy is growing well above trend, the unemployment rate is close to all-time lows, and we just passed fiscal stimulus through not only the tax cut but also via the recent budget deal. The case for a benign path for policy rates rests in no small part on well-behaved wage growth and inflation.

The theme running through our economic analysis in the three regions with the tightest labor markets – the US, Germany, and Japan – is that evidence of the kind of wage gains that would force an inflation shock and tighter policy is still very thin. Michael Gapen (US Economics), argues that the wage gains shown in the US employment report were limited to supervisory workers. Gains for production and non-supervisory workers, who account for 85% of the index, were much lower. In Germany, Thomas Wieladek, points out that the read-across from the wage settlement reached between the largest labor union and industry is that German unit labor costs will probably rise only 1.5% this year (less than the ECB’s target of 2% inflation). More broadly, Fabio Fois (European Economics) argues that European employment has shifted from manufacturing to services, but most of these jobs have been low-productivity/low-paid positions that do not lead to wage bargaining pressure, despite increasingly stretched labor market conditions. Perhaps surprisingly, Japan stands apart here. We think the upcoming ‘Shunto’ wage negotiations could lead to a 2.5% increase in wages. This would be the sharpest acceleration in twenty years.
We think we are still in an unusual cycle – of decent growth and tight labor markets, but well-behaved inflation and wage gains – and the latest data are not enough to make us think we are returning to a “normal” one anytime soon. In early 2014, then-Chair Yellen said that a good time to start hiking rates would be when average hourly nominal earnings were running at 3-3.5% for six months in a row. The latest print, which seeded the sell-off, was only 2.9%. Similarly, some investors worried about this week’s core CPI print of 1.8%. But core CPI averaged 2.2% across much of 2016, and the recent print was partly driven by several ‘one-offs’. The average Fed hiking cycle lifts rates at an average pace of 10 hikes (of 25bp) per year over 18 months. During the previous cycle, the fed funds rate topped out at 5.25%. In this one, the average pace has been 2-3 hikes per year. Markets are debating between three and four hikes this year, with a likely endpoint of 3% or less. This remains an incredibly benign pace of policy normalization by historical standards.

Is there a next ‘shoe to drop’? So far, most asset classes outside of US equities and volatility have been relatively well behaved. Recent moves in FX markets smack of risk-limit motivated reduction of longs, rather than more fundamentally driven risk aversion. Emerging market strategist Bruno Velloso points out that none of the conditions that typically foreshadow a sell-off in EM credit is present.

It seems to us that equity investors are focused on the catalyst coming from the bond market. We are not so sure. Rajiv Setia and team point out that even with firmer wages, US yields are unlikely to rise much further. This is a function of demographics and low term premia and, on a shorter-term basis, neutral to short positioning. But low yields are also a function of a stabilizer mechanism at work: “long-term Treasuries still outperform in response to any sharp declines in equity markets,” even if stock/bond negative correlations have weakened somewhat.

Instead, we recommend keeping an eye on the US high yield credit market, which is at risk from a dynamic that is somewhat analogous to what unraveled the US stock market. Specifically, about a fifth of the US high yield is owned by retail investors. Historically, sharply higher yields have led to outflows from high yield funds. At the kinds of low spread levels we are at today, these episodes have led to negative total returns, often with knock-on effects in other markets such as equities. There is some nascent evidence for this dynamic already: though US investment grade outperformed equities on a beta-adjusted basis, high yield underperformed. We do not think credit conditions have tightened enough to have a fundamental effect on high yield companies. But to the extent that broader corrections have often originated in this market, US high yield fund flows are worth watching.

For now, we believe that the technical correction in the markets over the past two weeks has likely run its course, while the inflation fundamentals simply suggest a slow grind higher, rather than an inflexion point towards much higher inflation and much tighter Fed policy.

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