Before you get too swept up in the prospects for a squeeze higher in equities into year-end, don’t forget that the confluence of bullish technicals which have variously conspired to ignite a powerful rally of the late October lows are playing out against a backdrop of tightening financial conditions.

That’s the message from Nomura’s Charlie McElligott, whose recent notes have revolved around the dynamics that have helped the S&P log four sessions of >1% gains since October 29.

Those dynamics, you’re reminded, entail hedge funds and asset managers being forced to buy after low-ticking their exposure on October 29, just prior to the rally that saw stocks close out an otherwise abysmal month with the best two-day gain since February. Those fundamental investors were caught flat-footed just as the systematic crowd (e.g., CTAs) and macro funds started to re-risk. That, McElligott argues, catalyzed a grab for exposure. To wit, from a note out Wednesday:

The “fundamental” active Equities universe then has essentially become a source of synthetic “short gamma” in the market, as with any rally in stocks, said performance-burned funds effectively “get shorter” the higher Equities travel, in turn contributing to these violent bear market rallies on “up” days, with funds grabbing exposure “dynamically hedging” futures on said move.

Between that, expectations for further systematic re-risking and buybacks, there’s scope for a tactical rally into year-end. That thesis was echoed this week by JPMorgan’s Marko Kolanovic.

But again, McElligott doesn’t think you should lose track of the larger, overarching narrative.

“Even with this +8.3% rally off last week’s lows to yesterday’s SPX highs, DO NOT be mistaken—we remain immersed within the ‘financial conditions tightening tantrum’ end-of-cycle phase”, Charlie writes on Friday, adding that “U.S. 5Y real yields sit at highs since early 2009, corporate credit Baa-10Y yield spread is 45bps wider off early February levels and the 90-day commercial paper-3m T-Bill spread has nearly tripled to +27bps since early September levels”.

(Bloomberg)

That, McElligott says, should be viewed in the context of the bear market in crude, 1Y UST breakevens the narrowest since October 2015 and ongoing troubles for late-cycle “coal mine canaries” (e.g., Homebuilders and Autos), which he reminds you are still singing.

(Nomura, Bloomberg)

He goes on to flag renewed flattening in the curve, and reiterates what we noted on Thursday after the Fed decision. “EDZ8Z9 is again up to 50bps of implied hikes in 2019 after trading down to 39bps two weeks ago, especially alongside the recent four-year seasonality trend which has seen a flatter bias in the November/December timeframe”, Charlie writes.

(Bloomberg)

Finally, McElligott reiterates that the biggest risk is still the “rogue inflation print” which would catalyze a “lights-out” trade. To wit:

What remains my largest concern with regards to the “pull forward” of the “end-of-cycle” trade into an outright “risk off” one (which I currently believe is a 1Q-2Q19 phenomenon, after either the March or June hikes)?  A rogue inflation print to the upside, which to me is the “lights-out” trade as the Fed is thus cornered into accelerating the tightening pace, then likely drives a negative market response per “policy error” / “tightening into a slowdown” capitulation from the last of the “late-cycle expansion” holdouts in risky-assets.

In that context, you’re reminded that private sector wages and salaries accelerated at 3.1% in Q3, the fastest pace since 2008 and also that if there’s no breakthrough on trade when Trump meets Xi at the G-20, the U.S. is expected to move ahead with tariffs on the remainder of Chinese imports. That will drive up consumer prices in the U.S., raising the risk that the Fed is forced into a policy mistake by ongoing inflation pressure.