By Kacper Brzezniak
Every year, starting around November, investment banks (and fund managers) begin to drip out their outlooks for currencies, rates, economies, you name it, for the following year.
The consensus has been largely wrong for the past four or five years; those multiple rate hikes never came, the bond market is still alive and we never got that roaring inflation.
Historically, you tend to get at least some divergence in views. For example, in 2014 everyone hated US Treasuries but predicted a mix of FX, equity and commodity moves. What made the ‘top 2017’ trades so striking was that almost everyone was saying the same thing, across every asset class.
Below, I outline the 2017 consensus in two parts: first, the consensus narrative, and second, the consensus trades that banks are suggesting. So far, it has been a terrible start for many of them. Will the consensus be wrong yet again this year?
The consensus narrative
The Great Trumpflation
Here is the story that everyone will be very familiar with.
Trump will assume the presidency, and immediately set up massive infrastructure projects, as well as cutting taxes for companies and individuals. To do this, the US will need to borrow large amounts and, despite the Republican Party’s opposition to high government borrowing, and the coming debt ceiling limit, Trump’s additional measures will easily pass. This strategy will create jobs (for Americans only) and boost disposable incomes. This, combined with some protectionism, will probably boost inflation in the US, while the massive increases in GDP mean policies will pay for themselves (they just will). In reaction to this new dynamic, the Federal Reserve will now become more aggressive in monetary policy, hiking two to three times a year.
Fiscal expansion, more borrowing, higher inflation and higher rates mean higher bond yields. At the same time, higher rates and monetary policy divergence also mean a stronger US dollar.
Meanwhile, the reflation theme transcends the entire globe as higher oil and commodities, combined with magic, drive inflation towards target levels.
The limits of monetary policy
Central bankers, having experimented with quantitative easing (QE) and negative rates, have realised that their policies do not work and carry other negative side-effects – they reduce bank profitability and increase inequality, to name just two. Encouraged by politicians, central bankers have then given up and are passing the baton to politicians, who will embark on massive fiscal stimulus to support economies.
The most popular trades*
- Short US Treasuries, and short G10 Fixed Income in general
- Long USD – versus JPY, EUR and CNY (or a CNY proxy like KRW)
- Long oil
- Risk on (long equities, credit etc.)
The problem with the consensus narrative
- How did Donald Trump’s policies become so positive in the eyes of the market? Prior to Trump’s victory, investors were divided in terms of what it meant for financial markets, where if anything it was expected to cause a risk off move. It feels like the ‘Trumpflation’ narrative was used to explain market movements, which then morphed into a driver of markets.
- If economic policy was as easy as just lowering taxes and increasing government spending, wouldn’t everyone have already done this? Actually Japan has been doing this for decades, with little to show for it.
- Will Trump even be able to get many of his ideas through? If he does, won’t it take years for the economy to benefit from infrastructure spending, and besides, wouldn’t infrastructure spending ultimately be deflationary? Won’t protectionist policies ultimately harm global trade, and hence growth?
- The lesson of the past few years is that global bond yield levels have increasingly been influenced by the European Central Bank’s (ECB) policies. Has much changed in Europe? Core inflation remains very low and countries are limited by EU fiscal rules on increasing spending; QE may continue for quite some time.
- Even with a significant pickup in US infrastructure spending, commodity prices will continue to be dictated by policies in China.
- Risk assets are already looking fully priced, e.g. credit spreads around 18-month tights, equity indices around record highs. The bar is high.
Performance of the top trades so far this year
Now sometimes the consensus can be right, and even if not, can very much be logical. The message however is to be careful, especially when, like this year, this consensus is so broad and related very much to the same themes. Some of the numbers so far look ugly. For example, since their high levels in December:
- USDJPY is 5.1% lower
- 10y Treasury yields are about 30bp lower*.
Broadly speaking, many of the 'Trump' trades have reversed somewhat over the past week, but we are still a long way off pre-Trump levels. The consensus, however, remains broadly unchanged.
Positioning remains extreme, suggesting significant potential for more unwinds
Here are a few charts that should worry the consensus. Based on these measures, ‘Trumpflation’ is one of the biggest speculative bubbles that financial markets have ever seen.
*This is no recommendation or solicitation to buy or sell any particular security.
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