David Woo, global head of rates and currencies research at BofA Merrill Lynch, suggests the next “pain trade” is betting on Treasuries.
On the other hand, Woo’s counterpart at Société Générale, global head of rates and FX strategy Vincent Chaigneau, says the next pain trade is betting against Treasuries.
The “pain trade” refers to a crowded trade that goes in the wrong direction, causing more damage to more portfolios than any other trade — so it can’t really be both long Treasuries and short Treasuries at the same time.
But both are using the phrase to support their respective calls on where the market is going next: BAML is currently advising clients to short Treasuries, and SocGen is advising just the opposite.
“Our discussions with clients suggest that many market players, perhaps too many, want to be short here,” says Chaigneau. “That may be the pain trade just now, in an environment where inflation continues to surprise to the downside (U.S. CPI for September reported at just 1.2% yoy, with core up only 0.1% mum, EMU HICP at just 0.7% yoy in October) and growth remains soft.”
In other words, Chaigneau thinks Treasuries are going to continue to rally, catching the majority (which wants to be short, according to the SocGen strategist) flat-footed.
Chaigneau says the team remains “cautiously bullish on U.S. Treasuries, with yields likely drifting down 10-20 [basis points] over coming weeks.”
Woo, on the other hand, argues that the “pain trade” is in the other direction — investors long Treasuries will experience the most hurt — supporting BAML’s short-Treasuries call initiated October 25.
“The September FOMC meeting and the October government shutdown precipitated a big shift in the consensus over the tapering timetable, leading to a major repricing of markets over the past six weeks,” says Woo, referring to the rally in the Treasury market since September 18, when the Fed unexpectedly refrained from tapering down its quantitative easing program.
“This seems to have finally run its course,” he writes. “Where are we now? Where are we going next? What is the next pain trade?”
Woo is looking at forward exchange-rate volatility curves, which he says “
allow us to gauge more precisely when the market expects tapering to start.”
“The fact that the forward curve of [1-month] AUD/USD volatility peaks four months from now (near the level of [1-month] volatility just before the September FOMC meeting) leaves little doubt that March is the market’s new central scenario for the start of tapering,” says Woo.
The BAML strategist believes that because of this new consensus in the market that tapering doesn’t begin before March, investors are piling into carry trades — which do well in environments of low interest-rate volatility and happen to be what SocGen has been recommending to clients lately.
Woo says Friday’s October nonfarm payrolls report “could put this consensus and carry trades to test.”
“If the market was too confident about September tapering six weeks ago, it may be too confident about March tapering now,” he writes. “This is why we like running short rates, long USD and long volatility positions going into Friday.”