Market Thinking

making sense of the narrative

Traders go full deflation trade

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Having held up remarkably well during the first full month of the Corona Virus pan(dem)ic, equity and high yield bond markets took a tumble this week as a combination of technical buying of US Treasuries – pushing long bond yields to all time lows – and renewed efforts by leveraged traders to push a deflation trade based around slowing global trade triggered some forced selling. The weak US data last Friday and the weekend news of the spread of the virus to Europe, notably Italy, combined as the rationale for selling and uncertainty was further fueled by so called experts pronouncing on the ‘possibility’ of millions dying. As previously noted, for context, the total deaths worldwide from the virus – which is about to head into its third month – are still less than a quarter of the average annual death toll from ‘ordinary’ flu that is recorded every year in the United States alone. At the moment however, we are in that phase Eisenhower referred to as having nothing to fear but fear itself.

The latest bout of ‘risk aversion’ began last Friday when the economic impact of China being on lock-down showed up in the latest US PMI numbers. As previously discussed, the PMI is a widely used (and widely mis-used) indicator beloved of macro traders. A poor reading, rather like the equally (mis)used Non Farm Payrolls data, tends to produce a standard playbook of ‘sell risk assets and buy bonds’. And so it proved last Friday. Interestingly this looks like it was helped along by some market mechanics to do with our old friends the Taiwanese insurance companies hedging their Formosa Bonds. Formosa bonds are a phenomenon we discussed late last year as a different sort of risk – principally the unhedged currency ‘bet’ the Taiwanese insurers are running buying US Corporate bonds in an onshore ETF. This still remains a concern but last week at least the situation was driving yields lower not higher. With some record issuance last week of ultra long (i.e.40 year) corporate bonds in Taiwan for the likes of AT&T, Verizon and Citi, the hedging of fixed rates into variable caused a flattening at the long end of the yield curve, exaggerating the flight to quality/safety, deflation trade that the noise traders were busy putting on.

On Monday’s US opening the macro traders clearly doubled down, selling anything ‘growth’ and buying bonds and bond proxies. Have a look again at the macro trade we discussed last week – gold v copper and TLT – this time with the PMI (inverted) added on.

We have seen this pattern before of course, although it was associated with trade wars rather than the virus and it is worth remembering that a sharp squeeze in bonds can quickly reverse, as can the associated trades.

We like to look at markets through factor characteristics and in late August and early September last year we saw not only a sudden unwind of a squeeze in bonds, but a sharp reversal in fortunes between momentum and value, as captured by the chart, which shows the Global Value ETF from Blackrock relative to the global momentum equivalent. After a long period of under-performance, value rallied sharply in q4. This year however has seen the long momentum/short value trade go back on, increasingly aggressively, and while that appeared to be topping out last week, it has now broken up and gone through the previous high, doubtless triggering technical trading. Other factors such as size (small and mid cap) have been hit in a similar fashion, as to some extent interestingly has quality. Low volatility and momentum meanwhile continue to be back in the dominant positions they previously enjoyed.

Momentum versus Value – deflation trade back on

For now then, the virus continues to drive uncertainty and the traders continue to push low volatility and long bond trades. Our dynamic asset allocation is also following this, waiting for the time to move back into value and small mid cap as well as high yield. But for now, the momentum remains, with momentum.

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