When markets were at their abysmal low in March, it was hard to see any signs of recovery. Today it is only natural that we are bouncing off those disastrous lockdown world lows as economies re-open.
Of course demand is picking up. It has to, as April levels were unsustainable. But to go as far as suggesting that we are at the bottom and going back to January levels in a matter of months is more than just a leap of faith.
The recovery can still be intact if it is U or L shaped as the economy adjusts to the new price equilibrium. Over the last week the cyclical recovery has been the talk of the town. Cyclicals have bounced aggressively over defensives. That ratio is off its lows as value stocks have bounced 25% relative to the growth stocks. The former include energy, banks, financials and industrials while the latter includes bond proxies such as technology and utilities. Even safe assets such as gold and silver are down 4% and 10%, respectively, from their highs as the market shifts into full recovery mode and sells off the winners during the deflationary times. But is the start of a new trend or just a vicious unwind?
U.S. bond yields have been rallying aggressively over the past week. The 10-year U.S. bond yield has moved all the way up to 0.92% from lows of 0.65%. The 30-year is heading toward 1.7%, from lows of 1.25% in May. What started with a euro rally caused a breakdown in the U.S. Dollar Index (DXY), self-propagating an even higher move in cyclicals and commodities. There is a very good correlation between the level of bond yields and this cyclicals/defensives ratio. Currently it is too stretched, suggesting either bond yields rally much higher or cyclicals fall relative to market. Something has got to give.
One of the most important facts missed by the market was that as U.S. Treasury issuance picked up in May the Fed was buying less and less as its schedule showed a slowdown in asset purchases versus the aggressive rate back in March and April. This rise in yields was seen as a "recovery," but it was more a matter of less demand for the wall of paper hitting the market.
It is incredible how the market wants to fix a narrative and perceive what it wants to. No doubt this caused a massive rally in cyclical value sectors even though the fundamentals do not justify it and earnings look weaker, not stronger. This is the power of liquidity unwind that has a domino effect, causing a violent move. There was some normalization needed and sectors and stocks have moved to more normal levels from oversold levels back in April.
Oil is a great example as back in April everyone was calling for -$100 per barrel. It is incredible how back then nobody wanted to own oil and today everyone is suggesting we are going to $65 a barrel plus.
Spot price can be influenced by exogenous factors, but physical market spreads do not lie. We have moved to less of a contango but we still have oversupplied markets. The demand has not recovered to the same levels that can be seen in gasoline and distillate. If we were really in a V-shaped recovery, then distillate refining margins would not be falling. There is just too much product around.
As economies are reopening from their lows, we still have a supply excess of 10 million to 15 million barrels per day of oil. And let us not forget U.S. shale is already opening their wells, not to mention even starting to hedge some of their back-end production as prices near $45 a barrel.
Equities can get excited, but physical markets always take precedence. What do you think happens when U.S. Shale is back and OPEC+ sees their market share lost?
This Wednesday Federal Reserve Chairman Jerome Powell deliberates and it will be interesting if he talks about yield curve control. When rates move higher slowly, that can be positive for risk assets. But when they move aggressively, that is negative for cyclicals and equities as the denominator moves higher, calling for lower discounted cash flows (DCFs).
It also has harsh implications for mortgage and consumer markets. So, better be careful what you wish for as any aggressive move higher in yields that is not accompanied with the right growth is stagflation.
Powell knows this. Whether the Fed decides to buy more bonds or continue tapering will be very important for the market. All trades depend on this and the dollar. There is just one trade right now -- either you believe in a recovery and chase the cyclicals or you believe in a lower growth environment and go back to technology and bond proxies over the cyclicals.
Let's see how Chairman Powell can justify more quantitative easing (QE) and aggressive buying as jobs data have improved and asset markets are back to year-to-date highs in some cases. Too much liquidity in a system that does not know what to do with it can be a bad thing as well.