“We're in the money. We're in the money.”
Finally a couple of trades of a non-technical or statistical nature are lining up nicely.
Bad macro fundamentals, or poor execution and timing?
The recent underperformance of some macro trades, popular at the turn of the year, does not necessarily signal fundamental flaws; rather, it suggests issues with timing and execution.
The key question arises: To what extent can recent underperformance be attributed to changes in fundamental factors versus technical factors driven by crowded positioning?
Most popular macro trades of 2024
A review of prominent macro trades at the start of the year includes bullish expectations for front-end US Dollar (USD) interest rates in anticipation of further Federal Reserve rate cuts, along with long positions in the Australian Dollar (AUD) and the Japanese Yen (JPY). The Swedish Krona (SEK), conversely, was widely shorted.
A brief recap
Our analysis of the Spectra Market investors survey (see previous updates) at the year's outset led to the following conclusions:
– The discrepancy in the front-end USD rates curve pricing, relative to Federal Reserve guidance, cannot be solely attributed to optimistic inflation forecasts or heightened recession risks. It likely stems from a mix of growth and inflation expectations.
– Although we did not offer fundamental analysis on major currencies at that time or now, we noted the most popular forex trades faced adverse market technicals. Success in these trades required fundamentals to surpass already elevated expectations.
Mostly unfavourable market technicals
Quantifying the divide between fundamental and technical factors in trade underperformance is challenging. Our analysis, employing various methodologies, indicates that unfavorable market technicals accounted for 35-70% of the total underperformance in key currency pairs.
One method involved comparing the performance of consensus trades against a set of non-consensus trades driven by similar fundamentals, specifically in FX markets with overlapping currency pairs. This aimed to quantify the contribution of each currency to the recent underperformance in, say, AUD/USD.
Decomposing future Federal Reserve policy rate expectations into growth, labor market, and inflation components is notably difficult. We concluded that no single factor dominated the bullish sentiment on USD short-end rates.
Receding US recession risk explains much of it
At the year's start, Wall Street's median recession probability for 2024 was about 35%, significantly higher than the historical (unconditional) average of 15%. This 20% discrepancy implies an additional 70 basis points in Fed rate cuts, explaining more than half of the recent pricing for December 2024's implied Fed Funds rates through adjusted recession risks and inflation outlook shifts. Notably, some Wall Street banks have revised their recession forecasts for this year.
Not just confirming our priors
This analysis aims not to validate our initial hypothesis but to suggest that the recent market sentiment shift might result from exaggerated reactions to crowded positions, rather than a fundamental reevaluation of the US inflation outlook.
Also bad fundamentals
Revisiting our initial question regarding the nature of these trades' underperformance, it appears to be a combination of both fundamental and execution-related issues. However, in most cases, poor timing and execution appear to be the primary reasons for the underperformance. Exaggerated price movements likely influenced investor sentiment.
Yields down, stocks down will continue further into quarter-end
Considering all factors, the coming weeks are likely to see further declines in US Treasury yields. With US equities significantly outperforming bonds this year, a sell-off in blue-chip US stocks towards quarter-end for portfolio rebalancing between bonds and equities in the next couple of weeks seems probable. The significant performance gap between stocks and bonds may prompt earlier rebalancing trades.
In conclusion, an informed projection suggests a continued decline in US Treasury yields and a correction in US equities in the forthcoming weeks. A moderation or softening in the upcoming inflation data is likely to leave many fund managers chasing yields back down now that positions have been squared.
A broad decline in interest rates and risk assets also provides an opportunity for official Fed projections to move in lockstep with markets.
