Crowded Trades Are Crowded For The Same Reason – “Everyone's Betting To Extremes On Reflation”

Original post

Authored by Jeffrey Snider via Alhambra Investment Partners,

No matter where one looks, there is extreme positioning in all the key markets. Each one is pulled further and further toward “reflation”, too, or in the case of the euro this “falling dollar” consistent with that idea. The world is betting big on it finally coming true, the “globally synchronized growth” to this point of pure myth.

If there is such a thing as don’t fight the Fed, these indications are that the slogan is being taken to heart in a way that hadn’t been until now. Is that a good thing, or bad thing?

Before trying to answer, it’s worth noting what seems to have changed at least in the market mind (if there is such a thing).

Prior to last year, “rate hikes” and the balance sheet runoff were more theory than reality; future events to ignore as monetary officials continuously embarrassed themselves. In 2015, the one in December was a complete disaster. Even in 2016, there were more questions than answers, mainly whether or not FOMC or ECB officials were straight incompetent.

Their competency hasn’t yet been established one way or the other, so what’s really different is that the market has realized officials no longer care whether or not they are. They’ve found some nerve and resolve, largely because downside risks just “disappeared.” Without them, given how much time has passed now (more than a decade), they better start getting out of the “stimulus” business lest they further prove they don’t actually stimulate.

It’s this difference, I believe, that is being worked out in these markets as extreme positions but not extreme prices. The two are not necessarily the same, though it may seem that way.

Start with crude oil. Money managers are again record long WTI. They are betting heavily on economic growth, thus supply and demand fundamentals for the physical commodity. Absent any liquidity shocks, that would be consistent with the FOMC outline toward the next few years.

Yet, despite massive long interest in the futures market, the price of oil has been restrained.

It’s a strange departure from even three and four years ago where MGRS always set the price. Yes, oil prices have been rising but not nearly as fast or to the degree one would expect given this crucial futures market segment.

That’s because on the other side have appeared, out of nowhere, swap dealers.

As long as MGRS are now, DLRS are even shorter. Some of that is straight liquidity, meaning how DLRS merely mirror MGRS in taking the other side of their trade.

It has become more than that, though, where some of the shorts in DLRS are actual shorts. Though we may not know how many or by how much (or how intensely), it’s an argument about the Fed’s competence played out in two very different extremes. The net result is, so far, a tepid rise in oil prices rather than an inflationary spike.

That’s the kind of disparity we find in other markets, too.

The so-called falling dollar is another one of these no-brainers where the Fed must have it right. What’s driving the dollar exchange particularly in any dollar index is largely the European currency. In futures markets, specs are record long the euro – by a lot.

The last time they were even close to this level was late May 2007. The euro would keep rising through July 2008, but futures investors particularly on the spec side were growing more cautious about that continued rise, or falling dollar, for very good reason.

As with WTI, this extreme long position doesn’t fit the scale of USD/EUR. In that respect, the euro is left like every other currency in the world (with the exception of China and CNY, which is to say not everyone has a Hong Kong they can abuse to gain altitude for their currency) where it was pummeled 2014-16 but only partially rebounded 2016-18 despite outwardly enormous traded enthusiasm.

Everyone’s long the euro on the Fed’s side, but the euro is still down. Why?

In UST futures, too, specs are at record shorts betting on inflation and rising policy rates – even if they know the Fed doesn’t really know why.

And still the 10-year UST yield is underneath 3% rather than already surging well past that level and trading perhaps closer to 4% by now.

Everyone’s betting to extremes on “reflation”, yet prices aren’t moving like it. We should never expect a one-to-one relationship, of course, but still there’s something missing here in all these facets.

I think the answer is apprehension, or at least reticence to more completely embrace the narrative. Specs may be onboard to the nth degree, but these markets overall sure aren’t. And why would they be? We’ve seen this movie before, three times. We know how it ends.

Betting on the fallibility of extreme specs may seem like an opportunity too much to pass up. After all, we’ve been hearing about all these good “reflation” things in the real economy for several years and still the boom is more rhetorical than substance.

Nobody has a crystal ball, which is why markets deal in probabilities. The probability that the Fed might be right this time isn’t zero, which is why given their 2017-18 determination it can seem like the safer bet – for some. As to the rest, well, nothing ever goes in a straight line. The past two weeks have been a reminder that the downside still lurks, the crowded trades all crowded for the same reasons.