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1. Current Volatility & looking out into 2025

What happened : The FED was distinctly more hawkish on inflation and more cautious on easing policy. The dot plot was significantly higher. At the same time, we saw the defeat of the bipartisan deal to avoid a government shutdown in the face of criticism from Trump and his allies

Market concerns : The sharp response from the market is an expression of concern that the FED may not be there to save the market in the face of arguably the most volatile potential fiscal policy outlook since Reagan

Multiple sources of volatility : The market will now have to contend with monetary, fiscal, trade/currency and industrial policy volatility going forward. A heady mix which requires a close eye on macro going into 2025 -- GDP, US$ and 10y/Term Premia, to mention but a few factors

So, what is Qi saying? What are the key messages coming from Qi:

Model confidence has dropped even on a short-term basis indicating a macro regime change is coming …

The chart shows how the Russell 2000 had virtually stopped worrying about credit spreads and at how far the equity risk premium for the index had dropped. A clear and complacent setup for the near uninterrupted drop over the last half month.

We know the market has bifurcated significantly over the last few years. Supernormal profits and ROIs at secular growth tech stocks have driven incredible stock returns driven principally by EPS growth though PEs are now also high on a historical range (below).

These have been concentrated in the Mag7 though we see a few new stocks enter the group (eg Broadcom recently). The size of this super group has interrupted and changed the normal “investment clock” for the major indices. However, as the move in the Russell 2000 illustrates, large parts of the market are still vulnerable to financial conditions.

2. Re-pricing the Fed

So, the gunshot reaction is the Fed is no longer the market's friend. Is there any good news from last night's policy announcements? The one possible solace is that a fair degree of the re-pricing has already happened. The chart shows Qi's Fed rate expectations factor in z-score terms. We use the 1y1y forward - spot 1y spread in SOFR swap yields to capture the markets best guess on where policy rates will be 12-24 months’ time.

A move higher in this instance captures a hawkish shift in policy expectations - as the number of cuts has been reduced (i.e. the terminal rate has moved higher), this spread steepens. It is now nearly 2.5 standard deviations above trend which is towards the top end of ranges in terms of historical moves.

For context, it was at trend as recently as mid-September. This has been an aggressive move. There are historical precedents for bigger factor shifts, but they are comparatively rare. Finally, we would observe that the Fed Funds Target Rate and 2y UST yields have now converged. A crude proxy for the market expecting a neutral Fed in the near term.

3. US Materials – an efficient China long

The latest China bounce has followed the same path as September’s with the initial excitement about a policy pivot petering out. Anecdotal evidence suggests there’s been another wave of client deleveraging, this time with US Materials in particular experiencing heavy selling.

For those who think positioning in all Chinese plays is now heavily skewed short and a lot of bad news is in the price, note the US Materials ETF XHB sits 1.2 sigma (7.8%) cheap on Qi.

In the last few months Qi's Fair Value Gap has done a good job of capturing turning points. This could be an efficient entry level for contrarians with a more constructive outlook for China & the industrial cycle.

4. Bullish bonds? Gilts offer best value

This week has seen UK wage data and inflation pick-up; a combination that has the market believing the Bank of England will be restricted to just two or three rate cuts next year. Today's MPC meeting may offer more guidance but, thus far, the market has voted with its feet hitting gilts hard.

Qi model value has been pushed higher (now 4.29% versus 4.17% at the start of the week), but the market has moved even further. 10y gilt yields are now 1.2 sigma (22bp) above macro-warranted fair value.

Strong correlation between spot yields & Qi's Fair Value Gap suggests the recent pattern has seen the "right" kind of mean reversion, i.e. for gilts to mark-to-macro rather than the other way around.

This Macrobond chart shows just how big an outlier gilts are amongst G7 government bond markets. Most of its peers sit in the middle of recent Valuation Gap ranges. US Treasuries are modestly cheap but it is the UK that offers yield to any bond bulls.

1. The FX market is risk averse

Last week we flagged how several Yen crosses were too low and risk-reward favoured a bounce in AUDJPY, NZDJPY and EURJPY. All three have bounced but remain cheap on Qi. This week the machine has turned bearish on the world's other safe haven currency, the Swiss Franc.

Swissy is uniformly rich to its G7 peers on Qi's models. And it's not just today's SNB decision. The SNB's aggressive 50bp rate cut helps; as does the sharp revision in their 2025 inflation forecast (from +0.6% to +0.3%). But Qi was saying the Swiss Franc was already rich to interest rate differentials even before today.

The other factor driving several CHF crosses are commodities. Copper & WTI are the top positive drivers for the three biggest FVGs (AUDCF, NZDCHF & EURCHF) so the uptick after the Chinese policy announcement have pushed Qi model value higher.
In terms of back-tests, AUDCHF has been the strongest signal - it's been in regime and this cheap to model 18x since 2009. The hit rate is 61% with a +0.7% average return. The correlation between spot and Qi FVG is strong too suggesting our Fair Value Gaps have done a good job of marking local highs and lows.

If the FX market can catch some of the equity's market "risk on" vibe, there's more downside for the Yen & Swiss Franc from here.

2. The rates market is complacent

The gunshot reaction to last month's US election was that a Trump Presidency would be inflationary and therefore bond negative. A month later the script has flipped. Bonds have rallied on a new narrative - that growth could suffer if tariffs spark a global trade war, or DOGE takes an axe to things.

Treasury yields have fallen, positioning has moved from short to long and bond volatility has collapsed. The MOVE index got close to the 2024 lows at 82.5. A break below that level hasn't been seen since early 2022, i.e. the start of the Fed's hiking cycle.

Qi uses USD swaption volatility as a proxy for the size of the Fed's balance sheet, but investors can view it as a broader liquidity measure guiding risk on / risk off sentiment. Which means the chart below showing the history of this factor in z-score terms offers a potential warning.

US rate vol is now 1.5 standard deviations below trend. It rarely spends time below -2 sigma. An early sign that interest rate volatility is falling into dangerously complacent territory.

3. Bond vol complacency raising the ante for long duration equities

We stated in our MacroHub publication this week that macro vol is currently not deemed to be a concern into year end. CDX HY credit spreads have tightened further, VIX is hitting a 13-handle and equity rate vol as measured by the MOVE index is close to its 2024 lows.

Yield curves across DM are back in positive territory i.e. term premium is making a comeback. Hence, the Central Banks will need to proceed carefully to mitigate the risks inflation expectations become unanchored.

We highlighted last week that the relative performance of longer duration stocks (biotech / non-profitable tech etc.) vs. shorter duration stocks (e.g. oil drillers with visibility on near term cashflows) would be a good barometer to judge the market sentiment to rates. That basket pair has started to underperform this week i.e. nerves are rising. It is becoming more noticeable that SPY has rallied < 1% over the month.

Another expression we think is undervalued relative to the risk of higher volatility ahead is mega cap tech over their non-profitable tech counterparts (pair at -1.75 sigma on Qi FVG). The latter faces much greater duration risk.

4. Momentum - buy the dip?

Since the election, the most popular HF longs have sharply underperformed the most popular shorts. In similar vein, the momentum style is seeing sharp underperformance. This follows a strong performance in 2024 for this style factor. Seasonally, selling pressure on the winners after a strong year is to be expected. The momentum winners are tech-heavy.

Now last week small caps were the bigger underperformers in US equities – our suspicion is that HFs who might have had to cover shorts on small caps post the election are probably done and are looking to buy back into tech winners alongside year-end de-grossing into year end. YTD, the GS most short rolling basket has rallied 26%!

As with the momentum style, the GS VIP basket is trading at a notable valuation discount to the GS most short basket on Qi. The current narrative is maybe not so much about Nvidia as it is about the likes of now Zuckerberg and Bezos also seeking to work with Trump to shape deregulation. Within Tech, the SOXX remains the industry trading at the largest discount to macro warranted fair value (-1.65 sigma).

Buying Momentum when the spot price has dipped 1.6 sigma below the Qi model price (as seen today), has proven to deliver positive returns two-thirds of the time, out of a sample of 15 trade events since 2009. See the two charts below.

5. Chinese pivot? Equities, maybe. Bonds, not yet.

Here we go again. Beijing has made positive noises about a meaningful shift in policy to support the domestic economy. As in September, the key now is implementation risk - having made positive noises, will we now see practical steps to turn rhetoric into action?

On Qi there are mixed messages. Macro-warranted model value for Chinese equities (FXI) lagged the September rally but led the subsequent correction. Model value is showing tentative signs of stabilising (and maybe bouncing) but there isn't an unambiguous turn higher in macro momentum just yet.

And, in the meantime, this week's rally has overshot. Model confidence has fallen below our 65% threshold which precludes a bearish signal even if we hit 1 sigma rich (currently 0.9 std dev). This too needs watching as it could possibly indicate a regime shift is unfolding.

But potentially of more significance is the behaviour of the Chinese bond market. Qi’s Short Term model value is doing a better job of explaining price action right now and it continues to fall. In fact, macro momentum is accelerating lower.

The only solace is that the market has front run this move suggesting yields have moved to price in a fair degree of the bad news already. But this is not an encouraging picture from a macro perspective – it suggests there is little sign from the bond market that the outlook for Chinese economic growth is improving.

6. Oil Stocks vs. Consumer discretionary in the US

US Oil stocks look cheap versus consumer discretionary stocks on the Qi model

The RV (using S5 indices) is trading 1.8sigma cheap in favour of oil stocks -- close to a 5-year high. Momentum is also stretched
We are at the 98th percentile in terms of valuation gap for the year and the there is a 75% correlation between the Qi fair value gap and the price of the RV, so our model has been a decent predictor over the last year

The XLY Consumer ETF has had quite the run since the summer, going from 2sigma cheap to 3.4sigma rich to the SPY -- also a 5-year high

If the recent monetary/Fx moves from China are an indicator/precursor of global easing then there may be a case for oil and commodities over consumption. The key drivers to make oil stocks outperform are stronger EU confidence and easier global financial conditions

1. Red flag on Yen strength

The bond market has moved to price in a good chance of a BoJ rate hike on December 19th. But, on Qi, the Yen has overshot versus overall macro conditions including the recent move in interest rate differentials.

The Yen screens as rich versus every one of its G7 peers on Qi. There are four models which are in regime (model confidence > 65%) and where the Fair Value Gap is greater than 1 sigma. USDJPY, EURJPY, AUDJPY and CADJPY all suggest the risk-reward favours a Yen retracement.

The profile is the same in each case. Macro-warranted model value is rising, spot has been falling & Qi has a bullish divergence pattern. EURJPY shows the pattern which is consistent for each cross.

It also shows the 1y correlation between spot price and Qi's FVG is decent. That suggests this low in the FVG could mark a local low in spot EURJPY.

Back-testing the historical efficacy of these signals shows USDJPY here is in "coin toss" territory so it's not the optimal trade expression for tactical Yen bears. But EURJPY (71% hit rate, +1.7% average return), AUDJPY (71%, +1.6%) & CADJPY (69%, +0.9%) all suggest there's decent upside to play for here.

Finally we note the Nikkei 225 was 1 sigma cheap to macro conditions at the start of the week. The FVG has subsequently narrowed but it remains below model value and the Yen features as a negative driver, i.e. a weaker Yen would provide another tailwind for Nikkei upside.

2. R2K sensitivity to HY credit spreads has dropped to zero – the easy money is over

“Long until inauguration day” and “Don’t fight the seasonals” have become common parlance in the financial media. Since the election, the highest short interest stocks have rallied almost twice as hard as the most popular VIP longs as the market jumps to the laggards vs. the mega cap techs of the universe.

The make-up of returns YTD across the major US indices reveals striking differences – 76% of the Mag 7’s 57% return ytd stems from higher earnings growth expectations; contrast that with the Russell 2000 where only 9% of the 20% return ytd stems from rising 12mth fwd EPS – 91% of the return has come from PE expansion.

The point is that easy money on Trump trades have made and are much more priced for higher nominal growth expectations vs. the 2016 setup. We should not be expecting the low vol environment of ~10 VIX in 2017 to repeat. In particular, the debate around a higher neutral rate will continue. The tails have become fatter.

Qi’s lens on the Russell 2000 warns of the risk between expectations and reality – R2K factor sensitivity to HY credit spreads has dissipated to almost zero on our model. Ordinarily, there is a large negative relationship i.e. higher spreads, weaker small caps. Back in the Spring, CDX HY spreads hit 312bps vs. 295bps today. Over the same period, the Russell 2000 has rallied 20%.

The narrowing of sensitivities to zero has occurred in the past BUT the difference today is that credit spreads are back at their multi-year tights. The below chart shows that sensitivity since 2011 (dark blue). Alongside I show the ratio of the R2K 12mth fwd earnings yield / UST bond yield (light blue) – the message is the same – a “yellow” signal the easy money is over and those earnings expectations better start ramping up soon.

3. Long duration vs. short duration vulnerable, underplaying the risks of higher inflation vol

In the immediate aftermath of Trump’s win, the domestic agenda of deregulation, tax cuts and tariffs was deemed as stoking inflation. In recent weeks, that narrative shifted to the growth risks from DOGE cost cutting, trade wars and a potentially fading Citi economic surprise index.

That said, we should expect inflation volatility to remain elevated compared to the post GFC decade - a backdrop of stalling globalisation and heightened supply risks which are likely reinforced by Trump's policy proposals.

Given high equity valuation levels there could be an asymmetry developing - going forward there will be less of an equity tailwind from lower rates / further policy easing, whereas higher rates have the potential to deliver greater pain
So clearly, the growth / inflation mix needs to be just right otherwise bond term premia will continue to move higher. In turn, this would keep equity / bond correlations elevated i.e. higher bonds -->> lower discount rate -->> higher stocks.

The relative performance of longer duration (e.g. non-profitable tech / biotech growth etc.) vs. shorter duration stocks (e.g. oil drillers dependent on near term cashflows) will likely be a good tactical barometer to judge the reaction function to rates. The former cohort would be more vulnerable to higher rates.

In the election aftermath, long duration stocks have seen significant outperformance i.e. current market sentiment underplays the risks from higher inflation vol. Qi’s macro relational model suggests the GS basket of long duration vs. short duration stocks as sitting 2.4 sigma (~5%) above Qi model value. That valuation gap is close to the highs of the last 5yrs. Further, its high correlation to the spot price of this basket pair suggests it is offering a good mean reversion signal. The pendulum on the inflation vol debate tactically seems to have shifted too far one way…

4. Semiconductors remain the optimal AI play?

The Trump rotation theme has favoured small caps and value plays, but also coincided with a debate around the next leg of the AI trade. One theory is that semiconductors pass the baton to software stocks as the next beneficiary.

Relative to macro conditions, that thinking may have moved too far in the near term. Qi shows semiconductors are cheap outright, relative to the software sector and relative to the broader market.

SOXX screens as as 1 sigma (6.4%) cheap to aggregate macro conditions. The RV of SOXX vs. IGV sits 1.1 sigma (8.5%) below Qi’s macro-warranted model value. While the SOXX / SPY model is 1.3 sigma (10.6%) cheap to macro – chart above.

Since 2009, this FVG has only been seen on twelve occasions when the model is in regime. Using this as a +SOXX-SPY entry level produces a 92% hit rate and an average return of 3.04%. Time for semiconductors to reassert their dominance?

5. FTSE MIB vs DAX: A Europe play?

Despite all the concerns about Germany (China auto competition, energy problems), the DAX continues on its merry way making highs driven by expectations of global reflationary GDP growth and easier financial conditions. The MIB on the other hand is flatlining but is driven essentially by the same factors with one exception, the MIB wants the EURUSD to stop dropping and this sensitivity is at a high just as the EUR is close to its lows.

Looking at the RV cross MIB vs DAX we see the following:

• Solid model confidence of 78% -- the RV is being driven by macro
• A valuation gap of ~1.6sigma or 4%+ cheap to model
• Model momentum heading towards multi-year lows and should be watched
• Key drivers being EURUSD stabilisation / reversal, European confidence improving and easier financial conditions

If the EU authorities and the ECB are going to tackle the problems of the European economy with industrial and monetary policies, then this may be an interesting cross with less risk than outright plays.

1. Qi’s macro model value for SPX 12mth fwd PE in-line with spot – Rates deemed a non-issue in Trump World

The initial reaction to Trump’s win is now becoming more complex – higher rates, higher inflation expectations and stronger dollar vs. higher expectations of a US corporate friendly backdrop of de-regulation, tax cuts and America first. The price for higher valuations is a fatter downside tail if the nominal growth narrative can not be sustained.

However, Qi suggests the 12mth fwd PE today is warranted by macro. The below chart show the S&P500 12mth fwd PE through the lens of Qi’s macro-relational model. The rise in model value to ~22x 12mth fwd PE has reflected the compression in vol and credit spreads alongside a positive sensitivity to inflation expectations. Meanwhile, sensitivity to real rates remains small – there is less worry about rates. These observations highlight that markets are giving Trump the benefit of the doubt. The baseline is that markets can take advantage of positive seasonals into year end.

Big picture, as long as the rate market does not break down (and we note that the 5y5y USD forward inflation swap is back to where it was pre-election), equities will try to stick to the script into year end. Lending credence to this view is that Qi’s model momentum for the UST 10yr yield is waning, with a ST / LT model value now of between 4.3%-4.4%.

2. Trump tariffs hurt the Euro – but which cross?
The chart below shows Qi’s long term models for EUR FX developed market crosses – the Fair Value Gap plus each pair’s sensitivity to interest rate differentials.

EURUSD is the standout. It has the biggest Fair Value Gap sitting 1.7 sigma or 2.4% cheap to aggregate macro conditions.
And it is also the most sensitive cross to interest rate differentials – current patterns show, all else equal, a one standard deviation shift lower in European yields across the curve (relative to US yields), drags EURUSD 0.7% lower.
This suggests a lot of the relative dovishness of the ECB (higher-for-longer from the Fed) is priced into EURUSD at these levels. Back-tests over the last 15yrs aren’t great but, over the last year, the correlation between spot EURUSD & Qi’s FVG is 84%.
That suggests the mean reversion more recently has happened via the fx market correcting back to Qi model value. At a minimum, even with significant headwinds over the medium to long term, these aren’t great entry levels for EUR downside bets.

3. Take Profits in KRE Outperformance
In the election aftermath, Financials have been among the best performing sectors – a thesis based on a combination of a steeper yield curve, financial de-regulation and M&A tailwinds. Screening Qi across the US sector universe, the RV pair of KRE vs. SPY is a stand out at +1 sigma (+5.5%) rich to Qi model value. As can be seen in the chart below, the Qi fair value gap exhibits a good correlation to spot price – on the last few occasions where the value gap exceeded 1 sigma, it was an opportune time to take profits.

As cited, KRE outperformance would like to see a steeper 5s30s, and stronger Dollar. However, as highlighted in this note Dollar strength may see some respite - EURUSD is cheap to model, USDCNH is rich to model and model price momentum for USDJPY has been waning. Meanwhile10yr UST yields average a short term / long term model value of ~4.4% - model value momentum seems to have stalled here also (reflecting drift lower in inflation expectations / drift wider in credit spreads).

4. Time for respite in Value? Energy will struggle unless geopolitical risk premia rises further
Value has outperformed the broader market through this month. Commentators have highlighted that history suggests Republican wins are associated with Value outperformance. Indeed, Financials and Energy have been among the strongest performing sectors post the election.

Scanning Qi’s models across the risk premia landscape, Value is the standout. RPV (Invesco S&P500 Pure Value ETF) vs. RSP (Invesco S&P500 Equity Weight ETF) is +0.9 sigma rich to Qi model value on both ST and LT models.
The below chart shows the strong relationship between the Qi FVG and spot price of this pair. The current level would advocate curtailing a bias to Value. The last few occasions the FVG hit > 1 sigma, it was a time to be fading the styles relative to the broader market.

Note the size of divergence between Energy stocks and oil is unusual – see the first chart below. If there is little reason to think that oil will rally to close the gap, Energy will likely find it tough going. The sector is the most rich on Qi’s US sector models, on both ST and LT time horizons. See the second chart below.

5. Internationally, Nifty offering value should dollar strength wane
The Nifty 50 Index has seen a 10% correction from its September highs and currently hovering around its 200d MA. Qi’s long term model, where macro explanatory power has been rising over the last month, shows the index now ~4% cheap to Qi model value – in sigma terms -0.8 sigma. Qi model value over the last week is shown tentative signs of stabilisation.

Among the largest upside drivers for the Nifty through Qi’s lens are lower US inflation expectations and a weaker trade-weighted dollar. Indeed, scanning the major indices, internationally it is one of the bigger beneficiaries if dollar strength was to wane. See the first chart below.

Running backtest to see the efficacy of going long at the current FVG reveals a 60% trade win ratio. The caveat is that dollar strength must wane.

1. Renewables – a Cheap Hedge for a Harris Victory

Harris would be expected to continue and expand on Biden’s climate policies, prioritising investments in the renewable energy sector. With this in mind, we note that the performance of ICLN (Global Clean Energy ETF) has closely tracked the RCP Harris betting odds – see the first chart below.

However, Qi’s model for ICLN shows the sector now trading at a 1.7 sigma discount to model value. Model explanatory power has been falling into October because our standard model does not factor in the recent excitement around Trump and his policies. With that said, consider the chart below – this is the largest discount ICLN has been vs. Qi’s model value for some time. Only 3 times since 2009 has it been at this discount. 2 of those 3 occasions were buying opportunities.

2. Back End of Rates now an Open Risk – Winners & Losers

A Republican sweep risks resulting in higher deficits and a pickup in inflation, hitting fixed income even harder than we have seen in recent weeks. Even under a Harris victory, there is almost no prospect of any deficit reduction plan. In other words, the back end of rates now seems like an open risk. Longer term treasury yields broke out of a forty-year downtrend in 2021 and show no sign of returning anytime soon. Bond vol represented by the MOVE index and proxied by CB QT Expectations in our models has ramped higher into October.

The equity market would posit that the backup in bond yields is more of a reflation trade. However, Qi’s model would suggest the move in rates is more about inflation fears than growth hopes.

With this in mind, the first chart below shows sector sensitivities to real rates based on our multi-month relational model alongside the spot vs. model fair value gap. We note that Tech (SOXX, XLK) and Energy (IEZ, XOP, XLE) are not perturbed by higher real rates and are still deemed cheap to Qi model. In contrast, homebuilders / real estate (ITB, XHB, IYR), Retail (XRT), Small Caps (IWM) and gold miners (GDX) would be hurt by further rises in real rates AND are trading rich to Qi model.
The second chart plots those sensitivities to both real rates and rate vol – a similar picture emerges.

3. Higher bond yields globally – does that make sense?

Last week we noted it’s been unusual for US Treasury yields to trade above Qi’s macro-warranted model value in 2024.

At the time, the Fair Value Gap was a modest +0.5 sigma. This week’s 4.33% yield high equated to a +0.9 sigma FVG. Close, but not quite sufficient to trigger an official bullish signal on Qi. What is equally striking is the fact that this has been a global move.

The magnitude of recent yield moves differ across countries, but the bearish repricing has been universal. Yet the consensus is that the European growth outlook for example is significantly more challenged than in the US.

So, should dip buyers in bonds focus on opportunities away from US Treasuries?

The chart uses the Macrobond platform to show Qi Fair Value Gaps across 10y yields in several different countries, plus the 1y historical percentiles of those FVGs.

The standout are 10y gilt yields which are now 1.8 sigma (25bp) above Qi model value. That’s an extreme relative to recent history & clearly reflects market fears following the UK budget.

Bunds also stand out – now 1.2 sigma (17bp) cheap to macro at a time when most are bearish economic growth and this results season is seeing forward 12mth earnings roll over aggressively.

4. Small Caps Increasingly Vulnerable to a Strong Dollar:

The Dollar has become the biggest negative driver of both Qi’s SPY and IWM models. QQQ has become indifferent. See the snapshot below showing the % change for a 1 standard deviation move higher in the dollar.

While the caveat is all 3 model explanatory powers are rolling over, anyone believing in a rotation out of tech into small caps, needs to know that IWM is increasingly vulnerable to a strong $ (& screens as 0.7 sigma rich).

5. Equal-Weighted Consumer Discretionary (RSPD) – Too Much Good News Priced In?

Among the largest FVGs we see at the sector level is for equal-weighted consumer discretionary (RSPD). This ETF includes the likes of Amazon, Tesla but maintains an equal weight across all holdings (quarterly rebalance). The recent excitement around Trump beneficiaries like Tesla and General Motors (not dependent on China for EV batteries) is understandable, but this equal-weighted version tries to adjust for that.

According to Qi’s model, RSPD wants stronger global GDP growth (the largest driver in aggregate), a steeper 5s30s curve (would prefer to see short term rate cuts), a weaker dollar and lower real rates. See the snapshot below.

However, the last month has seen Qi model value flat-line, leaving the FVG extended at +1.3 sigma.