Trader Warns “Fear Of Being Underweight” Is Not A Compelling Narrative

Authored by Richard Breslow via Bloomberg,

Go away for a day and all of a sudden more and more people in the international arena are trying to make nice.

• The latest installment came today when German Finance Minister Olaf Scholz contemplated publicly what a joint European bank deposit facility might look like. Don’t hold your breath, but it is a step in the right direction.

• Numbers are perking up, including a strong beat for German factory orders.

• Progress on the trade dispute is apparently being made…

• …, along with a hiatus from the global fixation with Brexit.

• And the realization that China isn’t as hamstrung in providing succor to its economy as the stagflation crowd insisted.

They’re all contributing to the mood. We should enjoy it all while it lasts.

You know that the perception of things is looking up — just look at the increase in the number of central bankers who are willing to question the efficacy of negative rates. That’s an optimistic sign of less panic over the global economy and, if it persists, will likely find its way into dot plots, summaries of economic projections, speeches, and the like.

It’s not that they are making the horrible mistake of declaring “Mission Accomplished.” Rather, it’s acknowledging that many of our woes are unnecessarily self-inflicted or can better heal themselves given time and some better decisions, not with outlandish monetary policy. Take the good when you can get it.

Sometimes, optimism can be self-reinforcing. Other times, it’s just wishful thinking and things head right back into the sewer. Luck counts, too. Something the world hasn’t had a lot of. And it’s a mistake to discount the influence of political expediency, which is finally beginning to weigh on politicians everywhere. They don’t always respond with the best long-term solutions, but markets don’t mind can-kicking.

Nevertheless, upbeat is the moment’s cautious mood. Good for a trade, if nothing else.

It’s worth asking whether it will affect traders’ behavior. And it just might.

Throughout the quantitative easing and slow global growth period we’ve become accustomed to aggressively buying bonds and duration in order to sell them. There was the, correct, assumption that someone would always come along to take them from you at a better price. Negative yields weren’t an impediment to anything. Nutsy, but profitable.

In the current environment, this could get flipped and bonds sold on rallies on the expectation they can be bought back at better levels. Without overstating the case this early in the game, the absolute level of yields will begin to have some relevance in traders’ calculations.

I don’t know anyone who is extrapolating higher yields to truly “normal” levels. Far from it. And even if investors are willing to be underweight duration they still recognize the need and prudence of having fixed income figure prominently in their portfolios. But unless and until this better news period proves to be merely a temporary lull in the gloom, the bid side of the market will slowly be recognized as the soft one.

It makes perfect sense that equities have been in demand. But until you see capital investment intentions changing, it’s a gutsy thing to dismiss the influence of low yields on the portfolio allocation equation. I wonder if the mindset will begin to be more about selling the big rallies, rather than always plotting to buy the dip. They may end up looking similar on charts, but lightening up at what seem like opportune extremes might start to feel like a good idea, rather than always looking to add at better levels. Fear of being underweight may not be as compelling a narrative. Central bankers might not let slip their concern for asset bubbles, but investor flows could have more lasting effect.

As for the dollar, the real question might not yet be its absolute direction. It hasn’t exhibited the sort of impulsive behavior often shown when it is clearly on the move. It’s letting you in, no matter your bias. The issue that needs consideration is what currencies will perform best in risk-on and risk-off moments. That remains curiously ambiguous. Or, it might mean currency traders just haven’t fully signed onto the rosy scenario.