Morning Notes — Position Squeeze

The Fed’s updated dot plot on Wednesday just moved closer to what markets have been signaling in OIS (overnight swaps) forward rates for months.  The Fed has essentially acknowledged the economic cycle is developing faster than they thought and they may need to act sooner than they thought. The Fed is merely acknowledging the collective intelligence of markets, which is a good thing. The Fed’s apparent pivot had investors running away from reflation trades yesterday in what looked like a crowded short-term position squeeze.  Cyclical/value and small cap equities sold off, while the Nasdaq 100 (NDX) regained leadership.  The move was confirmed in commodity and FX markets, so it shouldn’t be dismissed.

Curve: Cyclical/value equity outperformance requires yield curve steepening or at least stabilization. Bond yields and the shape of the yield curve reflect market expectations of future inflation/growth, which makes next Wednesday’s June flash PMIs the next major catalyst for bond yields, the yield curve and cyclically-sensitive equities.  PMI data is the best forward-looking major economic indicator with global composite PMI reaching a record in May.  PMI levels above 50 indicate expansion and levels below 50 indicate contraction with the distance from 50 acting as an unofficial measure of velocity.  June PMIs are expected to decelerate from last months’ record highs, but deceleration doesn’t indicate contraction.  Based on recent inflation data, the US economy would probably benefit from mild deceleration. Yesterday, the 5-year/30-year spread closed at ~121bps, which we identified as secondary technical support below ~130bps.  Bond yields are lower again today, but the 5/30 curve remains at ~121bps.  Closing levels at/above ~121bps would help support the short-term position squeeze hypothesis, making the recent pullback in cyclical/value equities an opportunity to add positioning.