The Macro Pulse | The Missing Piece of the Puzzle

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March 7, 2023


Rates: The Missing Piece of the Puzzle

Equities ended a volatile week higher as Friday’s Services ISM data provided a somewhat “goldilocks”🥣 picture of the US economy as the service sector continues to grow at a robust pace, coming in at 55.1 (down from 55.2 the month prior).

Perhaps more importantly, as it relates to the Fed, the prices paid sub-index edged lower to 65.6 from 67.8 and eased some of the concerns sparked earlier in the week by ISM Manufacturing PMI, which showed prices paid jumping from 44.5 to 51.3.

Adding to the positive momentum, Fed speak this past week has been somewhat balanced. Whilst maintaining the hawkish mantra that they stand ready to keep raising rates should data not show inflation clearly heading back to target, there’s also been a little more caution relative to recent market pricing. The Fed’s Bostic perhaps best captured this sentiment in saying, “slow and steady is going to be the appropriate course of action.” However, he also spoke of the lagged impact of rate hikes which should “bite through the spring” and “going at a measured pace reduces the likelihood we overshoot and damage the economy.” 

Rates reversal in the cards?

US yields subsequently reversed lower as fears of a re-acceleration in the pace of hikes eased. 10yr yields falling back below 4% at 3.95%, having tested towards 4.10% earlier in the week. Interesting to watch here, especially as, according to CFTC data, spec positioning in US treasuries is now at a record short, surpassing levels last seen in October 2018. US yields topped out shortly after that and is an important consideration here given the negative impact rising yields exerts on risk and crypto 🧐.

Interestingly too, with inflation break-evens continuing to edge higher last week (to 16-week highs), 10yr real rates (nominal adjusted for inflation), which we highlighted as important in last week’s Macro Pulse, ended the week some 14 bps lower. This is a pseudo “easing” in financial conditions and, all things equal, a continued move lower will provide a positive tailwind for risk.

US 10yr Real Rates -  reversing lower 

Dollar Reversal

Elsewhere, China continues to be a positive risk factor. Post “zero covid,” China’s factory sector grew in February at the fastest pace in over a decade with manufacturing PMI climbing to 52.6 Vs. 50.1 in Jan. 

On the one hand, this boosts global growth, which one could argue will further fan the flames of inflation. On the other hand, given how inflation has been largely a supply-side phenomenon, the further opening of supply chains is a huge positive. Indeed a UBS composite indicator of global supply chain stress currently shows the lowest level of disruption since a brief period in 2019 and before that since 2013.

Also, interesting last week was the reverse lower in USDCNH, which was a key driver for the broader dollar move lower, down 1% on the week.

Side note: ✍️ China operates a semi-fixed exchange rate, with the currency only allowed to move within a 2% daily band. When CNH is under pressure (USDCNH moving higher), the PBOC “smooth” the volatility by selling USDCNH. These intervention flows then get “recycled” to maintain a stable proportion of USD currency reserves which means buying the USD back against other currencies. The reverse is also true. When USDCNH is moving lower, the PBOC will buy USDCNH to smooth volatility and recycle by selling the USD against other currencies.

USDCNH then tends to be a big driver of the broad dollar, and so the reverse lower last week (again off of important resistance levels) was an important development to keep the lid on the dollar wrecking ball. Also worth noting, higher EU inflation is seeing the rise in German Bund yields outpace those of US treasuries which is helping to tame the dollar here.

USDCNH - reversing lower leading broader dollar

Risk conditions supportive…

Overall, broad risk conditions look supportive despite the move in US rates, which continues to be a concern and a negative driver to our markets. Friday’s reversal, however is a potentially exciting development worth watching into Non-Farm Payrolls. 

The dollar reversal is also a welcome development. Financial conditions remain “easy” (Bloomberg Financial Conditions index is higher/looser year on year despite the Fed hike cycle), and the Vix has fallen back sub 20. No undue concerns showing up in equity vol land. 

Both the Nasdaq and SPX bounced off their respective 200 DMA with the Nasdaq up 2.5% on the week and SPX up 1.9%. Despite the bearish sentiment, nothing is currently flashing warning signs for risk in the short term.
Rates are currently the missing piece of the puzzle. Should they continue to reverse lower, conditions look ripe for a push higher, which would be painful for a market that remains under-positioned risk.

Crypto FUD

However, crypto correlations with equities have fallen in recent weeks and suffered in the face of more FUD, with Silvergate’s 10K filing delay and warning that recent events could impact the bank’s ability to continue as a “going concern” weighing. Coming also on the heels of U.S Senators sending a letter to Binance demanding answers over “potentially illegal business practices,” the news appeared to trigger liquidations in BTC through the 23k support level and ETH below 1600, although the contained nature of the move and lack of subsequent volatility suggest this was a specific flow and not a broad hit to sentiment (despite the continued negative pulse of news flow)

Our flows at Paradigm whilst seeing some buyers of downside puts and bear risk reversals on the break lower in spot, quickly saw takers step in to take advantage of depressed implied vol to buy short-dated vol and topside via 28 April  BTC 26k/28k Call Spreads. We also continue to see convexity plays in both BTC and ETH via Call ratios which benefit in a higher spot/vol environment.

TLDR: The pattern of our flows hasn’t shown a material, structural shift to position for the downside, with the bias of positioning still looking for a continued move higher in spot ✍️ .

Into another big week then, with JPow giving testimony on Capitol Hill on Tuesday and the all-important Non-Farm Payrolls release on Friday. Given the rates repricing over the past month, it feels to me a high bar to out-hawk this market through words or data, but obvious caution is warranted. We said in last week’s edition of The Macro Pulse that we were “watching and waiting.” So far, with tentative signs of a rollover in rates and the dollar, we like what we’re seeing from the macro👌.

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