Forget the February 5 VIX eruption: there is another critical shift that is taking place right now, and which matters far more to the US and global economy and capital markets. According to Citigroup, the most important transformation at the start of 2018, has little to do with the move in volatility, which is merely a symptom of underlying causes, and everything to do with the transition away from “Goldilocks” and to “Reflation”, a moment in the cycle which Citi calls pivotal.
And so, if we are indeed at a pivotal point, transitioning from goldilocks to reflation, from low to somewhat higher inflation, from low to higher yields and from post crisis to broadening expansion, how far could markets move?
In a note released by Citi’s cross-asset group, the bank answers and while it diligently caveats that “these are not Citi house views” – which usually tend to be worthless anyway, and instead represent “four crazy market targets”, the bank’s best and brightest explicitly warn that we could see “10y UST yields at 4.5%+, EUR at 1.40, JPY at 95, oil at $95-100 and US HY credit 650-700bp over USTs as tail risks.”
Here are the details on these “far from Citi house view” targets that might be possible under some circumstances, a caution which Citi further urges to “please take the health warning seriously. These are not Citi house views but may still present a danger to your wealth.“
10y UST yield to 4.5% (+)
Given the current (not all completed) base formations in 10y USTs, if 10y yields breach 3% technicians will call for medium to long term targets well above 4% with the 2012-2016 double bottom (if confirmed) signaling 4.5%+.
4.5% yields were last seen in November 2007. Could they go there again? Many analysts will argue this is impossible given debt loads, lower savings rates, lower R*, secular stagnation and a plethora of other, often ex-post, arguments for lower yields.
But, assuming yields break 3% decisively this year, the base in yields will have taken seven years to complete so the target needs only be hit by say mid-2025. And the same economists who will now say it’s impossible to go above 4% were also saying in 2007 that a move from 5% to 2% was impossible when technicians made that call from the top of the channel.
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2. EUR/$ to 1.40, $/JPY to 95
Citi makes the case for not merely a cyclical lower $ but a more structural one too. For now, the bank’s targets on the downside have been fairly conservative not least because it has been fighting the “higher Fed rates = higher $” crowd. But if the $ is really back in a ten year bear market, Citi says that it should at least consider more bearish $ targets long term. And so it does:
For EUR, we think 1.28 offers immediate resistance as the connection to the EUR/$ downtrend since the GFC. But longer term, we are still struck by the similarity in the price action over the 1992-2001-2004 EUR cycle and the current one. First a highly volatile topping process, then a sharp fall followed by a two year basing period and then a rally. Overlays of these suggest EUR could reach 1.40 in 2019.
And this is what the euro’s “crazy” move to 1.40 would look like:
As for $/JPY, recent price action has breached the whole Abenomics uptrend. Technically speaking, at a minimum this opens up the chances of 100 again but the low end target really becomes 95 or below. Note: citi assumes that BoJ YCC policy would have to be modified or scrapped along the way for this to be achieved.
Also worth noting: these targets would leave EUR/JPY almost unchanged. Citi explains: “EUR at 1.40 and JPY at 95 would imply some appreciation in real effective exchange rates. This would be relatively small if all other currencies keep pace and it’s only a $ move of around 14% with trade weights for $ of 14% in EUR TWI and 17% in JPY TWI respectively. On the more likely assumption that $ depreciation is resisted by some EM countries to some degree, REERs will move higher but not to levels that seem excessive.”
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3. Oil to $95-100
Citi house forecasts are for lower oil prices in 2018H2, essentially driven by higher US supply. Brent is forecast to $50/bl or a bit lower by early 2019.
While this makes sense if one assumes that OPEC supply is more or less unchanged, with geopolitics in the Middle East still uncertain, the broad base in oil prices over 2014-2017 might signal a pull back to the Citi target first followed by renewed strength in later years, maybe back to $95-100 again. There are a number of political scenarios where this would be possible (some discussed on this website recently). But unexpectedly higher oil prices might be one reason that yields also breach current expected ranges.
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4. Credit Re-Pricing. US HY to USTs +650-700bp
Finally, we go back to what many consider Citi’s biggest strength: credit. Here, the bank’s models have long shown credit spreads to be tight to underlying fundamentals. If we are in a strong growth but higher yield environment, the reach for yield dynamic that has driven yields hugely below model fair value levels will likely reverse, especially in the context of reduced Central Bank accommodation (tapering/ tightening where we both corporate and sovereign spreads become more volatile), a topic discussed in depth overnight by Deutsche Bank’s Aleksandar Kocic.
So in terms of soft targets, Citi writes that while its model fair value is currently a spread of 567bp, having traded rich by more than one sigma, we may next see the reverse happen, and HY switches to the cheap end of the range in this environment, somewhere around 683bps. It goes without saying that such a blow out in HY spreads would send thunderous shockwaves across global equities.