The Inflation Hedge Trade Appears to Be Reversing
Speculators, both human and bots, as well as portfolio managers have been relentlessly employing a "sell Treasuries and buy crude oil" strategy to hedge inflation. As a result, the negative correlation between these two assets has been wildly persistent.
Over the previous 180 trading days, oil and the 10-Year Note have settled in the opposite direction 91% of the time. Further, the trend has encouraged overcrowded trades and complacency regarding popular opinion.
For full disclosure, I have been early in calling for this trade to reverse itself; I am convinced that my timing is off rather than my premise being off the market. That said, I don't have a crystal ball to guide me.
This is what I am seeing that tells me the inflation trade is overstretched and due for a reversion to the mean (crude oil appears to have kicked off the move Tuesday morning).
#1 - The weekly crude oil chart depicts a four-wave rally with divergence in the RSI.
In recent years, that pattern has proven to be the "last hurrah" of the rally before a sharp decline.
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Chart Source: QST
#2 - When crude oil fundamentals are the loudest and the story is the most compelling, is usually when the trend changes.
When commodity markets went "online" in the early 2000s it opened the door for retail traders to get in on the action. Since then, we have seen exaggerated boom and bust cycles.
In 2007, the analysts were convinced we were running out of oil causing the market to bid prices to $150.00 per barrel. A year later, the financial crisis convinced the masses we were looking at "lower for longer" oil prices.
In more recent years we have gone from supply gluts and OPEC+ price wars to a green energy revolution that deterred investment in new extraction. In each of these cases, when the trend seems the strongest and a reversal of that move felt hopeless, is when prices rolled over.
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Chart Source: QST
#3 - Is there anybody left to sell Treasuries?
Although we all like to talk about market fundamentals and technical analysis, the reality is price discovery is most influenced by how many buyers there are vs. how many sellers there are, and how motivated they are to chase prices.
We can't imagine anyone with a bearish view in Treasuries who hasn't taken action through either selling speculative shorts in the futures market or (TLT) or reduced or eliminated Treasury exposure in their investment portfolio. In other words, regardless of fundamentals, we might simply run out of sellers.
And don't forget, the Fed is still buying!
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Chart Source: QST
#4 - The spread between oil and the 30-year bond is likely unsustainable.
In the past, we have seen mean reversion in these assets when they are trading with an extreme negative correlation.
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Chart Source: QST
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At the time of publication, Garner was long 10-year note futures.
There is a substantial risk in trading options and futures. Doing so may not be suitable for everyone.