Mirror Mirror On The Wall: Is The Reflation Trade About To Fall?

 

On Friday, Grant Williams announced he was working on a new presentation and asked the twitter-verse what they thought the craziest chart in the world was.

If you haven’t read the responses, I highly recommend that you do. There are a lot of really great charts (although Bitcoin is not one of them, give it a few more years folks). Of course, being somewhat of a reflation trade fanatic, I threw out a rather expected response.

I also forgot to add one very important component to this trade which is for speculators and hedge funds to be very long US stocks and short volatility, but we’ll get to this bit later.

 

Arguably the most overextended, and most talked about leg of this trade is the speculative long oil position. In 2017, we’ve seen speculators add to their net long position by about 200,000 contracts.

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With oil below its 200d ma (dark blue line) and at its lowest point this year, even without counting the cost of rolling these positions over, AT LEAST 40% of these contracts are in the red.

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Students of history will recall that the last time speculative positioning was this extreme oil tumbled over 70% in the following year. During this time (2014), Hedge Funds and speculators operated under the false assumption that OPEC had their back.

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Once again, OPEC has warned the US shale and more importantly the speculators that OPEC does not have their back.

The poor fundamentals supporting higher oil prices only gets worse from here. US oil inventory is at a post WWII record high.

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Meanwhile, US gasoline demand has also been “unexpectedly” soft.

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At the same time, US shale producers currently holding an extreme short futures position making them well prepared for a downturn in oil prices.

 

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On top of being well positioned for a downturn, US shale breakeven prices have collapsed in the last two years.

In order to cripple the growth of the US shale industry we’ll need to see oil prices below $40 for a prolonged period of time. That’s not exactly music to the ears of these record long speculators…

Which brings me to the crux of my argument: If the price of oil continues to fall, hedge funds and speculators will take incredible losses. These losses will begin to weigh on their other positions which they also have levered themselves to the hilt on and force them to unwind these positions as well. Taking into account that the fundamentals supporting their extreme positioning have continued to deteriorate, any potential unwind could become incredibly violent as the markets return to reality.

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In the past month I’ve written counter arguments for two of the reflation trade positions (long US dollar and long US stock market) and given that oil base effects have played a key role in driving inflation higher I believe we are about to see a tremendous amount of pressure applied to yet another one of these speculative positions, short bonds.

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Recall that oil prices bottomed in February 2016. With base effects firmly behind us, and the price of oil set to head lower, we could see oil quickly go from an inflationary pressure to a deflationary one.

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And if we give the recent rise in rates a historical perspective, we find that we are at the top of a 30+ year channel… and people make fun of me for betting against an 8 year trend.

I couldn’t have said the following better myself.

AND YET this is the exact opposite positioning that we see from hedge funds and speculators, who are not only short bonds but extremely long stocks!

Since my bearish post on US equities, the technical deterioration of the US stock market has only gotten worse.

Investor appetite for junk bonds appears to be waning.

At a very key juncture I might add.

Insiders are running in terror from the market.

But don’t worry, hedge funds aren’t alone in their foxholes, retail investors have finally joined the party.

So much for the most hated bull market in history. Retail have responded to higher prices and Donald’s rhetoric. They’ve heard that Donald Trump is going to enact some super stimulus and tax cuts that would transform the US economy into a soaring eagle that shoots laser beams out of its eye sockets.

Of course, the reason retail investors are in the stock market has nothing to do with the underlying fundamentals of the actual reflation trade or US economic health for that matter. I hate to sound like a broken record but here is a quote from The Reflation Trade:

“But investors have become so accustomed to the US driving the global credit cycle that they have missed the origin of the reflation trade. The dollar, commodities and inflation have all risen together for the first time in over a decade which has left investors scrambling for a narrative to explain this paradox. Fortunately, the recent US presidential election has provided just that. Despite the “coincidence” of commodities bottoming with China’s economy in February of last year, investors have latched on whole heartily to the “Trumpflation” narrative. Or to use another analogy, investors have entered the Jade City, but they have become distracted by the Giant Green Floating Head.”

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If we examine the underlying health of the US economy, we find it is quite weak. Despite this Trumpflation narrative, loan growth over the past two months has actually been negative.

Consumer lending standards are tightening.

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3-month LIBOR continues to hit post crisis highs.

And even with the tremendous growth we’ve seen in US shale, the US economy has continued to slow. Going from 1.9% in Q4 to just 1.3% in Q1.

The accelerating growth in employment we’ve seen, although enough to spook the Fed into hiking, has diverged dramatically from the underlying fundamentals of GDP growth.

And yes, let’s not forget the Fed is prepared to hike interest rates for the 2nd time in just 3 months. This dramatic tightening has put a great deal of pressure on China’s slowing economy.

 

And to top off this cluster fuck of speculative positioning, it is important to note that the VIX has been sold shorter than Tyrion Lannister.

Fortunately as we all know, a Lannister always pays his debts.

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Or just watch and wait for oil volatility to spread to other asset classes.

So while hedge funds and speculators are watching Trump for false bull signals, they are missing the underlying weakness. To make matters worse, investors and speculators have not been this positioned for a move in the global economy since the world was supposed to end in 2009.

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666 becomes 999 which some how becomes 1999 but wait the year zero didn’t actually start till the year 10, which makes the year of the devil 2009!

OK bad Arnold Schwarzenegger movie references aside (I’m optimistic to think that 3 people will get that reference), my point is that investors are levered to the hilt in almost all the wrong places: Long dollar, long commodities, long US equities, short volatility and short US bonds.

Until now, these levered positions were a powder keg in search of a spark. If the price of oil continues to fall we could witness a forced unwind of these extremely levered speculative positions which would come at a time when the market is incredibly fragile and the Fed has been uncharacteristically hawkish.

 


DISCLAIMER: This blog is the diary of a twenty something millennial who has never stepped foot inside a wall street bank. He has not taken an economic or business course since high school (for which he is immensely proud of) and has been long gold since 2012 (which he is not so proud of). In short his opinions and experiences make him uniquely unqualified to give advice. This blog post is NOT advice to buy or sell securities. He may have positions in the aforementioned trades/securities. He may change his opinion the instant the post is published. In short, what follows is pure fiction based loosely in the reality of the ever shifting narrative of the markets. These posts are meant for enjoyment and self reflection and nothing else. So ENJOY and REFLECT! 

One thought on “Mirror Mirror On The Wall: Is The Reflation Trade About To Fall?

  1. Pingback: What’s piqued my interest? 3 stories that will get tongues wagging in markets. – macromusingsfrom10000ft

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