Bear Flattening or Steepening?
Seems so many on my feed have turned bearish risk and while I don’t think we are far away, it does seem a tad early and would like to see a bit more bond volatility and fresh triggers of inflation nervousness before turning bearish.
I’ve mentioned in my weekly preview (https://doejistar.medium.com/weekly-g8-fx-notes-2021-05-17-401e6c0eeff0) that global equity indices have retraced back to the inflection point late last week and that this area may mark the highs of a sideways market through the Summer months (coinciding with the low-volume Summer seasonality) as market awaits to see how transitory inflation will be and when we could therefore see a hawkish pivot from the Fed.
I’ve also put together some thoughts about a potential return of the USD as a result of increased bond volatility causing by rising inflation expectations (https://doejistar.medium.com/return-of-the-king-usd-386da5052da2).
Bond Volatility & Bear flattening
Returning back to this chart of inflation expectations versus bond yield and volatility, we can see sharp rises in inflation expectations was soon followed by a rise in yields and volatility, the most notable in Sep/Oct’20 and Feb/Mar’21.
This month saw another dramatic rise in inflation expectations and bond markets barely flinched looking at the Move Index. This appears tied to the bear flattening in the yield curve we have seen since the March rise.
The Move index, being the 1-month implied volatility of 2, 5, 10 and 30 year maturities, therefore being more focused on the longer end, has not resulted in a spike like we have previously seen as bonds sold off since NFP. This was not something I considered when I made my case for a return bond volatility and USD strength, but I do think the ideas around that scenario could still be in play…
Inflation & Fed inaction
Inflation expected to be even higher next month and it’s still highly questionable whether price pressures will ease over the next few months. For example — (1) sticky elements of core CPI such as Owners Equivalent Rent (OER), (2) business inventories could take time to replenish to levels that would ease supply while demand stays high, (3) inflation expectations could keep upward wage pressures in tact. The more these price pressures show little signs of abating while the Fed continues to resist notions of potentially persistent inflation and tapering, the more likely we could see another bout of volatility especially if we have more strong economic data come in.
While a bear-flattening regime is generally bad for stocks (one major reason why we can expect a sideways market in the months ahead), we have seen some re-steepening in the curve this month with volatility starting to pick up again. I prefer to see more of this as well as fresh inflation triggers while remaining mildly bullish risk on intra-day basis as I see a little more room above for equities via value themes.
Also, bear-flattening is typically good for Gold but since yields have been turning upwards we have seen the opposite recently — curve flattening with stronger Gold, steepening with weaker Gold:
With Gold reaching a technical inflection point along with the possible scenario for brief curve steepening I’ve mentioned, Gold short in addition to USD strength and a range top in equities are attractive ideas to look out for, especially if we see some strong US data. Til then, I prefer to look short USD and long Equities…