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US equity sector sensitivity to inflation expectations – March 31st

At the margin, sensitivity to inflation has fallen. Back in March, a one standard deviation increase in inflation expectations saw 4 sectors benefit (outperform the S&P500) by 2% plus. Today it’s only two models that display such sensitivity.

The sector split remains broadly the same – energy & financials are the greatest beneficiaries from reflation.

The biggest change comes in macro valuations. Both XLF & KBE are modestly rich to SPY. Energy (XLE & XOP) now screen as almost one sigma cheap versus the broader market.

On the Qi web platform, two tabs side-by-side enable clients to switch between the macro picture & the trend outlook. A quantitative way to align macro valuation & trend signals, giving clients the opportunity to see when an asset is:

Sometimes the message from macro will conflict with the trend & momentum picture. But, when aligned, users have a powerful signal combining two of the critical dynamics driving any investment decision.

That has already weighed on the Turkish Lira but it is striking that TRY features four times in the chart below which shows the ten biggest Fair Value Gaps across all Qi’s fx models. In all four, the Lira screens as rich to macro fair value.

Both USDTRY & EURTRY are around one sigma (circa 5.0%) cheap to macro fair value. Versus safe havens the Yen & Swiss Franc, the Lira is around 0.5 sigma rich.

The former two back-test well. Buying USDTRY at a -1 sigma FVG when in regime has, since 2009, produced a 78.6% hit rate for an average return of 3.1%. The equivalent numbers for EURTRY are 70.6% & +0.5%.

President Erdogan would note that in each model, Developed Market bonds feature as a top driver & lower UST yields, Bunds yields etc are consistent with higher Dollar, Euro. Arguably though this speaks more to a quality dynamic.

China stress & crude oil are also prominent drivers. Risk off is Lira negative. Domestic Turkish monetary policy aside, the suggestion is TRY is vulnerable here if you believe markets face a deterioration in risk appetite.

The collapse in bond yields since March has been well documented. But, as the chart below shows, the move in 10y real rates is starting to look significant. European real yields in particular are now 3 standard deviations below trend – a level only seen on a handful of occasions over the last 10 years plus.

The signal from the bond market would appear to be that inflation is indeed transitory & growth concerns are escalating. What are the implications?

Real rates do not look attractive from a long term valuation perspective. They have seen significant inflows of late but TIPS & BUNDei’s especially are not necessarily the best inflation hedges right here, right now.

Real yield differentials are the key driver of EURUSD & the move above helps explain the downward pressure on the Euro over May-July. Euro bears need to be on alert for any potential mean reversion.

Screening European equities for sensitivity to EUR real rates reveals it only a modest driver at both the index & sector level. At the margin, peripheral rather than core indices are the most sensitive; while Travel & Leisure plus Banks are the sectors that want real rates higher.

FX markets will be a popular way to play this & interest rate differentials could emerge as a key driver of currencies. Except rate differentials aren’t always the primary driver of FX. The first step is to quantify where & when they are the dominant engine for FX markets.

Qi’s G10 fx models include rate differentials at three points along the yield curve. 1y1y & 2y2y differentials are pure plays on relative Central Bank rate expectations.

The third is the 5y5y cross market spread. This captures market perceptions of the terminal rate in each country.

In the chart, red (faded) dots capture models that are in (outside) a macro regime. The y-axis shows where the interest rate differential bucket ranks as a driver versus the other variables in the model’s factor set.

If a model is in regime & rate differentials are the number one driver, that FX cross represents an efficient trading expression for any views on the respective Central Banks’ policy stance.

A simple blanket approach does not work. The RBNZ is perceived as hawkish but while NZDJPY & NZDCHF are sensitive to rate differentials, NZDUSD & NZDCAD are not in regime.

Neither is USDCAD. EURUSD is all about real yields not nominal rate differentials. Respective yield curve shape is more important than rate differentials for USDJPY.

Having identified where rates matter, tomorrow we will add a valuation overlay into the mix.