The Weekly Fix

Welcome to the Weekly Fix, the newsletter that isn't complaining about a Fed that took pre-emptive action to ward off inflation and also wants to take pre-emptive action to allay a downturn. – Luke Kawa, Cross-Asset Reporter

R.I.P. Everything Rally

20/20 Hindsight Capital here: As soon as negative-yielding European junk bonds made it to the front page, the "everything rally" across asset classes had to come to an end.

The irony is that to keep the cross-asset narrative intact – global activity is gloomy but not dire, and central banks are coming to the rescue to ensure it doesn't get worse – it's the longer-term risk-free sovereign bonds that have borne the brunt of the adjustment process, not European high-yield companies whose debt is trading with yields below zero.

This week has seen the beginnings of duration risk, rather than credit risk, falling out of favor in the marketplace. It's the bonds, not the corporates, that have been the issue.

Between firmer than expected U.S. job growth and core CPI inflation and a pop in French industrial production, both American and German 10-year yields have risen nearly 20 basis points since last Friday. If the world isn't falling apart but central banks are still easing, there's a limit to how much longer-term yields should fall. The probability attached to tail risk scenarios involving a return to the zero lower bound in the U.S., and the potential for deflationary spirals, ought to diminish.

With the market pricing at least one Fed cut coming soon and other major central banks expected to add accommodation in coming months, this dynamic brings to mind a tweet from macro trader Jeremy Wilkinson-Smith:

"Central banks held on for 6-9 months of crappy data to stop out at the Low!! Ohhh I know that feeling all too well."

Or, put differently, a note from RBC's Tom Porcelli:

"Right now the Fed is cutting when growth prospects are nowhere near weak and Fed funds is close to neutral. Theoretically, risk assets should love this setup. In fact let us re-state that: in practice, risk assets should absolutely love this setup."

A look at forward curves suggest the world's preeminent long-term, risk-free asset – Treasuries – is expected to continue to be among the first casualties of the end of the everything rally.

The so-called twist steepener (two year bonds rallying while the 10-year sells off) is still firmly entrenched as an anticipated trend for the year ahead. It's "supposed" to be driven more by the bear side, which is a shift from when we last discussed this phenomenon: that points towards less Fed easing over the short term, and enhanced faith in the outlook for global activity.

Equity bulls ought to be thrilled by the idea that U.S. stocks can hit fresh records even amid a reversal in the tumbling long-term yields that had been juicing valuations.

This dynamic, if sustained, allows for good economic news to be good news for risk assets (so long as earnings hold up, too!). It helps that central banks, namely the Fed, are perceived to be slightly data-independent at this juncture; poised to boost stimulus no matter what. As such, it's notable that this phenomenon appeared on the heels of good data from outside the U.S. coupled with Powell cementing the Fed's commitment to ease this week.

"I think it is extremely important that equities are rallying with the 10 year Treasury yield ticking higher," wrote Peter Tchir, head of macro strategy at Academy Securities, in a note on Thursday. "We have been in a cycle where rate expectations and stocks were highly correlated and were not getting many 'risk-on' days. Today is 'risk-on'."

It's clear that if there's a macro factor that's weighing on U.S. stocks, it's the dollar, not yields. This is a triumph of levels over rate of change: the greenback is much closer to cycle highs –that is, pain levels – than longer-term U.S. yields.

Something that may keep a lid on the selloff in long end bonds: market participants surveyed by the New York Fed in the immediate aftermath of Powell's "act as appropriate" remarks in early June say the federal funds rate will average 2% over the next decade – completely erasing the "Trump bump" in the wake of the 2016 U.S. election. Market participants' assessment of how short rates will unfold has proved a fairly reliable upper bound for where the 10-year yield will trade in the history of this survey – at least before 2018.

There's more proof in the global price action:

The European periphery – especially Italy – is enjoying spread compression relative to Bunds and seeing high demand for new issues. Emerging Europe has negative yields.

And Citi's Michael Anderson, who has espoused a cautious tone on U.S. junk bonds of late, isn't willing to stand in front of what appears to be a runaway train.

"High yield investors seem very eager to jump into the rate rally with both feet," he writes. "Who can blame them?"

Powell Puts America and the World First

Bloomberg's Steve Matthews perfectly distills the actionable insight from the Fed Chair's testimony before Congress into one headline:

Powell Had One Last Chance to Go Against Rate Cut and He Didn't

If anything, the opposite occurred. Powell's testimony, in which he stressed that the cooling global economy posed downside risks to U.S. activity and admitted that policy may have been too tight almost perfectly offset the decline in Fed easing odds after the robust June non-farm payrolls report.

While market pricing suggests a 50 basis point cut could be in the cards, it's tough to find evidence besides pricing that would support this outcome. A half a percentage point reduction would entail that the most dovish member in June – St. Louis Fed chief James Bullard, who has repeatedly since said easing of that magnitude isn't needed now – becomes less dovish than the median voter by month's end. A tall order to say the least.

Nonetheless, some firms including Morgan Stanley think that's what we'll be getting at the end of the month.

Bloomberg's Matthew Boesler gives us the best reason to suspect a bigger ease might be warranted: more than a 25-basis point rate cut is needed to turn Fed policy from restrictive to accommodative: in real terms, the policy rate is well about the median long-term dot.

Minutes from the June meeting made clear why an ease is in the cards: the danger is coming from outside the house. The number of Fed officials indicating the risks to growth and inflation are tilted to the downside surged, the mirror image of tumbling gauges of manufacturing activity in the U.S. and globally.

The potential positive spillovers from a Fed ease are becoming apparent. EM central bankers – importantly, China – can cut as well with reduced fear of capital flight.

The resilience in the dollar relative to developed-market currencies and softness against developing-market economies since Powell opened the door to easing in early June has propelled JPMorgan's index of EM local debt to its highest level in over a year, revived carry trade appeal even amid idiosyncratic adverse episodes, and crushed measures of implied volatility in developing markets.

Shifting Winds

While we're no fans of the Great Man theory of history – or attempts to apply that to financial markets – we'd be remiss not to note two shifts from strategists renowned for their consistency and track records.

HSBC's Steven Major, a famed bond bull, has refused to change his Treasury forecast to chase the rally. Even when the 10-year broke below 2%, he stuck to his guns that it would end the year at 2.1%.

This week, he made the case that the floor may be in for bund yields, maintaining a -20 basis point target for 2019.

"Rate cuts are in the price, inflation forwards have never been so low and relative value is no longer compelling," Major concludes.

And then there's Jefferies chief market strategist David Zervos. A longtime champion of the "spoos and blues" strategy, he's recently moved to cash in his gains.

Granted, there are a couple of mitigating factors here: Zervos sold the 3000 strike S&P 500 calls to fund protection in the form of a put spread earlier this year, capping his upside in equities around current levels unless he restructured the trade. The second might be more important: he's currently relaxing in a Tuscan villa and would prefer to have his slate clean while doing so.

Zervos followed up after Powell's testimony reiterating his stance:

"I'll end today by noting that even with Jay's exceptionally dovish testimony, spoos are right around 3000 and cash 10s are right around 2%. There were no major market breakouts, and as such it appears we were largely priced for his extra level of dovishness. That leaves me quite comfortable with this newfound position on the risk sidelines after the blistering first half of the year in spoos and blues."