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There are three main threads behind the seemingly "chaotic" assets in March: Bitcoin, gold and copper, driven by abundant liquidity, interest rates, equities and gold driven by expectations of interest rate cuts, and copper and oil driven by improving demand and secondary inflation expectations. Liquidity trading may face an inflection point in the second quarter, and the logic of reflation is "rising out" is obviously preemptive, and interest rate cut transactions may gradually become the main line.
In terms of asset allocation, direction is more important than timing, which is currently similar to April-May 2019. We recommend debt before stocks, bonds are more cost-effective at present, U.S. stocks are better after facing certain twists and turns, gold has limited space after the front-running, and can intervene after a pullback, and the demand for copper and oil driven by reinflation will improve after interest rate cuts.
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Since March, the performance of global assets has been fragmented and "chaotic", and the trading logic behind it has even contradicted itself, such as copper reflecting good demand and reflation, technology stocks betting on interest rate cuts, US Treasury interest rates and gold rushing ahead of time with half-concealed interest rate cut expectations. It is not surprising that this phenomenon has occurred, and near the recent macro inflection point, the fundamentals have improved, and the expectations of reflation and interest rate cuts seem to have found their own support, but in fact, some are more short-term illusions, and some need to rely on others as a premise to rush ahead, not to mention that short-term funds and sentiment will exacerbate this divergence. After U.S. stocks, gold, bitcoin and copper rose and reached new highs, which are excessive front-running and overdraft, and which is the main line of trading, it is more important to judge the subsequent trend and asset selection.
Chart: Since March, the performance of asset prices in overseas markets has been relatively "fragmented", and the trading logic behind assets is contradictory
Source: Bloomberg, FactSet, CICC Research
After careful analysis, we believe that there are three main threads behind the recent chaotic asset performance: Bitcoin, gold and copper driven by abundant liquidity, interest rates, equities and gold driven by interest rate cut expectations, and copper and oil driven by improving demand and secondary inflation expectations. Judging from the recent performance, the liquidity expansion first drove Bitcoin to soar, and then spread to liquidity-sensitive assets such as gold and copper, so that gold began to rush to rise when interest rates have not yet fallen and interest rate cut expectations are still facing secondary inflation concerns. For example, on the basis of the logic of copper and oil supply shortages, the market expects the fundamentals to improve after the interest rate cut to drive demand and secondary inflation, but the "flaw" of this logic is that it contradicts the expectation of interest rate cuts. Looking ahead, after the confirmation of the March FOMC ("Fed rate cuts are still on the way"), we expect liquidity trading to face an inflection point ("US liquidity may be on the way"), rate cut trading is gradually becoming the main line ("Trading Strategies Before Rate Cuts"), and reflation trading is too much of a front-running. Therefore, we recommend that debt before stocks, bonds are more cost-effective at present, U.S. stocks are better after facing certain twists and turns, gold has limited space after the front-running, and can be re-intervened after the pullback, and then inflation-driven copper and oil are also in the lead, and demand will improve after interest rate cuts.
1. Liquidity trading: Liquidity-sensitive risk assets have risen sharply, but financial liquidity will face an inflection point in the second quarter
As we pointed out in "U.S. Liquidity May Be on the Horizon", the rapid release of reverse repos at the beginning of the year led to an increase in residual liquidity, which also helped to boost global risk appetite, especially for liquidity-sensitive assets. From the end of January to the beginning of March, the financial liquidity indicator (similar to bank reserves) that we constructed increased by 3.4%, almost entirely contributed by the release of reverse repos, and the Bitcoin and Nasdaq indices continued to rise sharply due to events such as the approval of the US Bitcoin spot ETF and the better-than-expected performance of US technology stocks, while gold and copper also benefited from the liquidity spread higher and significantly overbought.
Chart: The rapid release of reverse repos at the beginning of the year led to an increase in residual liquidity
Source: Bloomberg, CICC Research
Chart: From the end of January to the beginning of March, our financial liquidity indicator increased by 3.4%, almost entirely contributed by the release of reverse repos
Source: Bloomberg, CICC Research
However, this trend has since begun to reverse, with the Fed's BTFP halting and continuing to shrink its balance sheet, the slowdown or even a slight increase in the release of reverse repos, and the increase in TGA fiscal deposits all leading to a contraction of 2.2% in financial liquidity since mid-March. This change has led to a divergence in asset prices, and Bitcoin's retreat from its highs shows that liquidity is one of the leading factors in the previous surge, and ETF funds that have been flowing into Bitcoin since the beginning of this year have also turned into net outflows. Although the pullback in gold and copper was not significant on the back of interest rate cut expectations and reflation trades, they also rose and retreated, and the gains slowed down significantly.
Chart: Bitcoin's retreat from its highs shows that liquidity is one of the dominant factors in the previous rally
Source: Bloomberg, CICC Research
Chart: ETF funds that have been flowing into Bitcoin since the beginning of this year have also turned into net outflows
Source: Bloomberg, CICC Research
Chart: The liquidity diffusion effect once drove gold to be overbought, and the RSI point approached 85
Source: Bloomberg, CICC Research
Chart: Copper futures are clearly overbought, with the RSI overbought climbing to 75 at one point
Source: Bloomberg, CICC Research
Looking ahead, we expect an inflection point in US financial liquidity in Q2, which in turn will further impact underlying assets. Based on the Treasury Bond issuance plan, the pace of the Fed's balance sheet reduction, and changes in fiscal deposits, we estimate that financial liquidity may turn into a contraction in the second quarter until the Fed slows down its balance sheet reduction in June to hedge some of the pressures ("U.S. Liquidity May Reach an Inflection Point"). This will further put some pressure on bitcoin, US technology stocks, and even gold and copper. We estimate that the contraction of financial liquidity may bring about a drawdown of about 8% to US stocks, and the Nasdaq is more sensitive.
Chart: Major U.S. financial institutions are currently using about $0.48 trillion per day of reverse repos on the Fed's books
Source: Bloomberg, CICC Research
Chart: We estimate that financial liquidity is likely to turn contractionary in Q2 until the Fed slows its balance sheet reduction in June to hedge some of the pressure
Source: Bloomberg, CICC Research
Second, the reflation trade: the logic of commodities "rising out" is obviously ahead of the curve, and the improvement in demand will wait for the credit to expand after the interest rate cut
In addition to directly benefiting from the liquidity expansion, commodities such as copper, oil and gold are also trading expectations of reflation and improved demand, coinciding with supply disruptions from crude oil and copper production cuts, and U.S. inflation continued to beat expectations in January-February, all of which gave more support to this trade, and the net position of copper CFTC contracts increased sharply after turning net long in early March.
However, this transaction faces two problems: first, the seemingly strong demand and inflation in January and February are the result of the rapid decline in 6-7 interest rate cuts in the previous interest rate trade, and have now been corrected; From the demand side, the new orders sub-items of the U.S. manufacturing industry, which reflect demand, are still falling, and the certainty of the real estate and investment side will be repaired after the interest rate cut begins, and the improvement in existing home sales in February reflects the transactions in the past two months, that is, the lagged result of the rapid decline in interest rates in the previous period driving down lending rates. From the supply side, the inventory and inventory-to-sales ratio of U.S. manufacturers has continued to decline since October 2022, and crude oil inventories are also at a low level, but the price increase of low inventories alone is not sustainable, and demand still comes first.
Chart: 6-7 interest rate cuts in January-February rate trading fell rapidly, driving mortgage interest rates downward
Source: Wind, Bloomberg, CICC Research
Chart: The improvement in existing home sales in February is the lagged result of the rapid decline in interest rates in the previous two months, which led to a decline in lending rates
Source: Haver, CICC Research
Chart: Low U.S. crude inventories combined with extended OPEC+ production cuts led to higher crude prices
Source: EIA, CICC Research
Chart: U.S. manufacturers' primary metals inventories and stock-to-sales ratios have been declining since October 2022
Source: Haver, CICC Research
From a first-principles perspective, credit expansion is the key to driving improved demand. Under the bipartisan game in this year's election year, it may be difficult for the US government to further expand its finances. The CBO recently lowered its fiscal deficit forecast for this year from 5.8% to 5.3%, a contraction of 1 percentage point from 6.3% last year, and the financing costs of both the corporate and household sectors are higher than their respective investment returns, and it is difficult to significantly increase leverage. Therefore, if the Fed wants to restart credit expansion, it is a prerequisite for the Fed to start a cycle of interest rate cuts and reduce the cost of financing, so skipping the rate cut and directly trading the improvement in demand and reflation in advance is a clear preemption ("Where is the US Credit Cycle?").
Chart: The CBO recently lowered its fiscal deficit forecast for this year to 5.3% from 5.8%, a contraction of 1 percentage point from 6.3% last year
Source: Haver, CICC Research
Chart: In a bipartisan election year, the U.S. government's fiscal deficit pulse is likely to shrink compared to last year
Source: Haver, CICC Research
Chart: Both the corporate and residential sectors have higher financing costs than their respective ROIs, and it is difficult to leverage significantly
Source: Federal Reserve, FDIC, Haver, CICC Research
3. Interest rate cut trade: It will gradually become the main line of trading until the interest rate cut is cashed in the middle of the year
There are still some misunderstandings in the market about this round of interest rate cuts, either believing that there is no need to cut interest rates now, or defaulting to a sharp rate cut once it starts, neither of which may be inevitable, and simple traditional experience does not apply. Compared with the normal interest rate cut cycle in order to cope with the sharp downward pressure on the economy, this interest rate cut is more to solve the current situation of the continuous and deep inversion of the interest rate curve, otherwise financial institutions will continue to "lose blood", so the start of interest rate cuts does not need to be premised on a sharp weakening of economic data, and the opening does not mean that interest rates will continue to be cut sharply.
From the perspective of the cyclical direction, as long as there is no re-increase in leverage by various sectors, it is difficult for the demand side to have the risk of re-acceleration, and the direction of overall growth and inflation is also downward, so the improvement of US demand and the risk of secondary inflation must be based on the premise of the start of interest rate cuts ("A Detailed Explanation of the Financing Costs and Burdens of Chinese and American Sectors"). We estimate that inflation is still likely to fall back to 3% by the middle of the year, so it is still possible to start cutting interest rates in the middle of the year, and it can also avoid the interference of the third quarter election to the greatest extent.
Chart: The market is currently pricing in three rate cuts this year
Source: Bloomberg, CICC Research
Chart: We estimate that inflation could still fall back to around 3% by mid-year
Source: Bloomberg, CICC Research
At the March FOMC meeting, the Fed kept the dot plot unchanged for three rate cuts ("Fed rate cuts are still on the way"), so as long as there is no supply-side inflation and other unexpected disruptions in the future, the rate cut trade will gradually become the main line of trading. Bonds are more cost-effective, and we expect the 10-year Treasury rate to fall from 4.3% to 3.5-3.8%, while gold and Treasury bonds have a similar logic, but the premise is limited after the front-running, at $2,100-2,200 per ounce, and U.S. stocks will intervene after volatility. However, due to the limited magnitude of the rate cut, we do not think the window for the rate cut trade will be too long, and one or two rate cuts between now and the end of the rate cut are basically over.
4. How will the follow-up evolve: 2019 or 1995?
As we have repeatedly emphasized since our November outlook (Global Markets Outlook 2024: The Unavoidable Cycle), the experience of 2019 is more relevant for this cycle, given the fundamentals of the current soft landing and the policy response to prevent interest rate cuts.
The downward pressure on the U.S. economy in 2019 was also limited, so the Fed only made three brief "precautionary rate cuts" in July and September, and the U.S. economy then moved into a new cycle, driven by the start of the real estate cycle. In this context, although the long-end U.S. bond interest rate has "turned back and run" many times before the rate cut, its downward trend has continued until the first interest rate cut in July before bottoming out, so the short-term repetition is insignificant in the face of the general direction, and the direction is more important than the time point, which is also the current stage, similar to April-May 2019. After the start of the interest rate cut, short-term bonds continued to decline with the interest rate cut, but the long-end U.S. bonds basically bottomed out and began to rise due to the gradual improvement of growth expectations, and gold peaked, so it is not meaningful to chase up U.S. bonds and gold after the interest rate cut starts. After the U.S. stock market fluctuated sideways, it gradually rose again under the impetus of the numerator. After a brief weakening of the US dollar, the overall strength is likely to be on the 102-106 side.
1995 is a stronger example ("How the 1994 Rapid Rate Hike Averted a Recession?"). At that time, the rate cut cycle was also short-lived, and the two rate cuts were six months apart (the first rate cut in July 1995, and the second rate cut in December 1995 due to the pressure of fiscal contraction due to the government's two shutdowns). What's more, at that time, driven by the industrial trend of the Internet revolution, U.S. stocks barely pulled back and continued to rise sharply. The U.S. dollar is also strong overall, and gold only has a phased opportunity in the early stage of interest rate cuts.
Chart: Based on the experience of 2019, US Treasuries and gold have not yet finished trading, and they will not basically end until one or two interest rate cuts, and US stocks continued to rise sharply in 1995, driven by the industrial trend of the Internet revolution
Source: Bloomberg, FactSet, CICC Research
Chart: We estimate that US financial liquidity is likely to turn to the downside in Q2
Source: Bloomberg, CICC Research
Chart: U.S. Treasury interest rate path and pivot estimates
Source: Bloomberg, CICC Research
Chart: We estimate that the reasonable range of gold is 2100~2200 US dollars / ounce
Source: Bloomberg, CICC Research
Chart: The US dollar may remain volatile, with a point of 102~106
Source: Bloomberg, CICC Research
Article source:
This article is excerpted from: "Stocks and Bonds Rise in Bulk Together, Who Is "Wrong"?March 18~24, 2024
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