No matter how much anyone tries to deny it, this market and all asset allocation choices boils down to one big giant macro trade. We can all pretend that our funds have "real alpha" or long/short relative value diversification, but the truth of the matter is that one of the key things that has driven this market over the past few years has always been and will continue to be liquidity! Each asset class following that premise is just a levered bet on that central theme, be it equities, bonds, commodities or Bitcoin.
Throughout 1H21 the main theme in the market was one of reflation and recovery. Stocks or sectors exposed to that theme massively outperformed, namely cyclicals like energy, miners, industrials, and financials... the reflation/inflation basket. This was synonymous with U.S. 10 year bond yields rallying from lows of 0.5% to as high as 1.80% in May when the world was worried about inflation shooting away from the Fed's 2% target or higher. Since then U.S. 10 year bond yields have dropped down to 1.18% as of Tuesday. What does this mean and what is causing this violent shift in top down macro themes?
Following the Fed FOMC statement when Powell threw the towel in admitting that inflation was a lot higher than the central bank estimated, the dollar and bonds started to rally. There were hints that some members were "thinking about thinking about tapering." But what was more damaging was that over the past few weeks the global growth backdrop seemed to be taking a pause. But inflation in key consumer goods and services was still quite sticky as companies were slowly passing through higher costs to the consumer. This is a big headache for the Fed should consumer and producer prices stay elevated, as witnessed in the most recent CPI data, this means the Fed cannot taper its QE lower to temper inflation nor print more to jump start growth. In a nutshell, the Fed will be checkmated!
As bond yields dropped to as low as 1.18%, fears of deflation hit the broader market and saw all equities get hit exceptionally hard even though their drivers held up well. There was no logic as gold and silver, along with copper and oil, all got hit. Oil was the one commodity that was holding up into the OPEC+ talks but now since that had been resolved with higher baseline production going forward and no price war, it was free to adjust to what was being priced in on the "macro" side of things evidenced by its brethren copper, etc.
The media will sensationalize the move down to the Delta variant and we have seen houses like Goldman push a strong buy last week calling Brent to $100/bbl. into OPEC+ meeting only to take their price target lower today after the 9% fall on back of Delta demand hit. The sell side is constantly late to forecast the demand implications, instead it only extrapolates what has happened in the past assuming no change. The oil price move was in sync with broader asset classes pricing in this deflation backdrop. The oil price kept rallying all through 1H21 on the back of higher yields, so logic would suggest the same on the reverse.
The question to ask today is whether this move lower in U.S. bond yields is something more sinister or just a technical unwind? The Fed buying Treasury assets along with market participants covering their shorts added to this pressure. Whether it breaks the key 1.20% support in the U.S. 10 year bond yields remains to be seen. If it does, then this slowdown/deflationary cycle has more legs to it and we can see the dollar rally and commodities sell off across the board.
The violent option positioning in the S&P 500 is also to blame for the vicious day on day moves given the gamma open interest around 4300 and 4250, as dealers flip from positive to negative gamma. In layman's terms, this means that they need to sell more as market falls below a certain level and buy more if it goes back up. Perverse logic?
Asset performance this year has been about extreme positioning and any marginal hiccups to that view. Rather than chase the day on day moves, one needs to take a position on what they believe will be the next phase of the cycle. The jury is still out. You either believe inflation is here to stay or this is indeed transitory. That is the only thing that matters for all asset classes and stock selection into 2H21.
It is all one big macro trade, don't let anyone else tell you otherwise.