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RBC: Two Things Are Behind Today's Rally

According to RBC’s cross-asset strategist, Charlie McElligott, two things are behind today’s (painfully volumeless) market rally: i) a return of “policy divergence”, following yesterday’s hawkish announcements by the Fed (“up to 4 hikes”) offset by dovish hints by the ECB, which in turn is powering the dollar higher, and ii) OPEC “deal extension speculation” pushing oil prices higher. The result: the general reflation trade is back on.

Here are the full details from McElligott who writes that “Risk Is Rallying On The Return of “Policy Divergence” and Higher Crude”

“Major key” alert (H/T DJ Khaled) as a return of ‘policy DIVERGENCE’ powers ‘higher Dollar’ and OPEC deal extension talk powers ‘higher crude’—in turn driving risk-assets to best levels of the week. 

  • As anticipated in the 3/16 ““RBC Big Picture: FED CREATES MORE ROPE TO HANG THEMSELVES WITH,” the Fed’s doves are rolling-out ‘hawkish,’ with 4 hikes in ’17 a real option. 
  • Juxtapose this with ECB ‘source’ story yesterday (‘taken aback’ by mkt hawkishness and thus looking to reiterate ‘easy’ policy), while today we saw a massive messaging campaign from Nowotny, Praet and Knot all ‘walking-back’ hike expectations with dovish language.
  • Add-in the weak German March Inflation print (1.5% vs est 1.9% and Feb’s 2.2%) and we see Bunds rallying today.
  • This “hawkish Fed, dovish ECB” dynamic is a complete “round-trip” back to where we were just prior to the Fed—a return to “policy DIVERGENCE” and away from the two-week old “policy CONVERGENCE” narrative which has been driving the USD-unwind / weakness. 
  • As a reminder, “ Fed / R.O.W. policy divergence” has been “THE” driver of higher USD regime over the past 2.5 years, over which the DXY has appreciated 25%.
  • With this ‘hawkish Fed / dovish ECB’ scenario, the USD is experiencing ‘signs of life.’  In turn, this could in fact reinvigorate ‘US domestic reflation’ trades which had been on life-support or unwound outright over the prior weeks / months.
  • Equities thematic ‘reflation’ plays have too been reawakened this week within the broad market rally—but note that it is possible this is simply representative of significant mean reversion’ strategy deployment into month- and quarter- end rebalancing flows (as opposed to ‘sticky’ money rotating back ‘into’ trade). 
  • The first week of April will then be critical to monitor for follow-through in said ‘cyclical beta’ / ‘inflation’ / ‘value’ / ‘small cap’ thematic equities trades, or whether we see a return to the ‘havens’ trade that dictated performance YTD (‘secular growers’ like mega-cap tech and classic ‘defensive’ sectors).
  • “Paging Dr. Obvious,” but even more important with ‘reflation’ theme will be crude oil’s direction.  As I’ve said for eons-now, we are beginning to see the ‘roll-off’ of the ‘energy base effect’ (as evidenced by the aforementioned German inflation data, where the ‘energy’ component declined from 7.2% in Feb to 5.1% in March YoY). 
  • As has been the case for two years, higher inflation expectations (via higher crude) are MISSION-CRITICAL for higher risk assets (S&P, HY and EM).  Today’s Kuwait / OPEC ‘support extending cuts’ headlines are a positive start, as we need higher crude to keep inflation walking higher (note: breakevens and 5y5y infl remain ‘stuck’).
  • In conjunction with US GDP and Personal Consumption both revised higher this morning, we are seeing all three ‘macro factor’ boxes being positively ‘checked’ for the SPX—higher ‘global growth,’ ‘inflation expectations’ and ‘global real rates’ all at once.
  • As such, the Quant Insight short-term (83d) model is almost back at a ‘predictive’ macro regime (62% R^2) after collapsing earlier this month (down to 9%)—meaning, the SPX price movements are now largely ‘explainable’ again.  It seems clear to me that the macro regime breakdown was heavily correlated to the crowded positioning and ensuing price ‘shakeouts’ in crude- and USD- longs.
  • Now, the SPX ‘volatility signal’ window is about to close when R^2 passes back above 65% imminently (likely tomorrow).  S&P eminis traded -3.0% ‘peak to trough’ from the generation of the signal noted on the 13th, to the highs made the 17th, to the lows made Monday of this week, which speaks to 1) ‘buy the dip’ in Spooz / ‘sell the rip’ in Vol “alpha generating muscle-memory” still firmly intact with traders, but also 2) the forever-shrinking ‘half-lives’ of macro drawdowns, as so much tactical money is ‘loaded’ for such opportunities.
  • The largest threat then for risky-assets it seems is a swing back to ‘tighter financial conditions’ concerns via higher USD and US rates, on account of any “policy error / policy divergence” scenario accelerating.  In meantime, higher nominal rates and higher Dollar due to ongoing better data / revisions continue to be palatable.

How are traders reacting  to today’s news? With a return of the original reflation trade.



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