Wednesday, August 9, 2017

Connecting the Dots - 8/9/17

“Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once unthinkable dosages will almost certainly bring on unwelcomed after-effects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.” – Warren Buffett, February 2009
Looking back at the current decade – in the shadow of the global financial crisis of the previous, one topic has overwhelmingly remained in focus by policy makers, pundits and participants alike. 

Inflation: a general increase in prices and fall in the purchasing value of money.

An paradoxically, for all of the collective attention that’s been paid to the prospects of inflation, by and large, the dire warnings cast by both the brightest and most prudent in finance have appeared misplaced, as inflation has remained subdued and still below the Federal Reserve’s 2 percent long-term target more than 8 years after the final throes of the global financial crisis. 

Last week’s release of the Fed’s preferred measure of inflation – the Personal Consumption Expenditures Chain-type Price Index for June, indicated that core inflation sits at 1.5 percent, down from a high of 1.91 percent in October of last year. And although causality and correlation between inflation and the financial markets is as nuanced and complicated as any intractable problem, when it comes to the equity markets today we believe they broadly function along a binary highway where low to moderating inflation is welcomed and fundamentally expected, with higher realized inflation largely reserved for economic folklore. In essence, we’ve been driving down a seemingly one-way street for so long that participants have ignored the travel risks of oncoming traffic with higher prices. Should the dollar continued to breakdown from its cyclical high – which we believe it will, that’s precisely what will be coming our way. And like most things in life, nothing kills the mood quicker than the surprise realization that you now get less bang for your buck.  

With tomorrow's PPI and Friday’s CPI inflation reports on deck in the back half of the week, we wanted to quickly point out that the markets are now in the window where US dollar weakness – on a year-over-year performance basis, could again begin to positively affect the inflation data. 

From our perspective, the attached two charts imply (we use real yields here as it positively trends with the dollar, albeit with a several week lag) that the YOY performance of the dollar has led the move in real yields, with underlying support of the dollar's broad 3-year top serving as the fulcrum for next major move in inflation (we believe higher) and real yields (lower).   

As we pointed out at the start of summer (see Here), despite breaking down since last December, US dollar weakness was largely obscured from the inflation reports this year, primarily because on a YOY performance basis the dollar had actually trended higher through May, essentially arresting the respective moves of higher inflation and lower real yields that began in the back half of 2015 – which led the cyclical pivot higher in gold in late December of that year.

We’d speculate that if YOY weakness in the dollar fails to bump the July inflation data, it will more than likely show up next month. All things considered, it’s a good bet we see the downtrend in the data reverse course soon, which when it hits could see a more hawkish market reaction over the immediate-term  with a stronger dollar, weaker precious metals and rising yields. While over the intermediate-term we firmly expect gold and silver to break out above their respective highs from last year (with silver once again leading the way), recent strength may give way to weakness as the market considers further Fed action. 

Monday, July 24, 2017

The Breakdown Before the Breakthrough

Since our last note (see Here), the US dollar index has made its way down to the lows of last summer, currently hovering just above the Brexit upside pivot from June 24th, 2016.

Although asset trends can elicit major technical breaks from oversold conditions (i.e. crash), the more probable outcome from our perspective favors another retracement bounce, before traders can set their sights on breaking through long-term underlying support that’s confined all declines in the dollar index over the past 3 years.

Maintaining a KISS approach of lower highs and lows that has served traders well this year in the US dollar index, we would look for the highs from early July to contain a prospective bounce. This methodology also applies to the flipside of momentum for potential lows in the euro, yen and gold – with the two latter assets also likely influenced by the short-term respective trends in equities and yields. In this respect, over the near-term the Japanese yen and gold could hold up better than the euro, as we suspect the rally in equities gives back this months gains – largely supporting the uptrend in long-term Treasuries and buttressing safe haven assets like the yen and gold.

From a comparative perspective with the pattern breakdown in the dollar index that has closely resembled the complex and broad top carved in gold between 2011-2013, a near-term bounce in the dollar would develop before the index breaks through long-term underlying support later this year. Anecdotally, considering current pessimism towards the dollar, the pattern similarity should continue.
When we look back at the cyclical top in the US dollar index in 2002 that corresponded with a secular breakout in gold, the similarities extend with today in pattern and proportion, as well as from an intermarket perspective where long-term yields were at a positive correlation extreme with the dollar and turned down again with the dollar’s cyclical pivot. The net effect broke gold and the broader commodity complex out of a secular downturn, as declining real yields helped tilt the scales in commodities favor.

Although we are less inclined to presume long-term yields will materially break below the lows from last year as they did coming into 2003, we still believe there is much greater upside reach for the current inflationary trend – than the Fed’s capacity to raise rates. This is largely because we expect the current expansion will diminish the Fed’s appetite to tighten as it continues to mature. All things considered, real yields should continue to decline, even if the downside range of long-term Treasury yields is limited.

Looking back at our month-over-month comparative from the secular peak in the 10-year yield, the relative symmetry of the decline continues with yields basically at their respective mirror of the mid 1940’s. While the linear regression of the current retracement is tracking shallower than the secular build from the previous cycle low in the 1940’s, over the next year we see a declining dollar eventually capping the downside in nominal yields as realized inflation begins to surprise again to the upside.

Thursday, July 6, 2017

What's "Up" With Gold?

The dollar continues to weaken, yet gold finds no incentive to rally. 
What gives?

Fundamentally, in the basic real yield equation (nominal yields less inflation) – that arguably is the main long-term driver of the price of gold, the year-over-year inflation figures have underwhelmed of late. 

This is primarily because despite breaking down again from the highs last December, on a year-over-year performance basis the dollar has actually trended higher, essentially arresting the respective moves of higher inflation and lower real yields that began in the back half of 2015 – and which led the cyclical pivot higher in gold in late December of that year. 

Big-picture-wise, the dollar has remained largely range bound over the past 2½ years. However, it's the dollar's relative performance (YOY) trend that has wagged inflation and the direction of real yields. Until the dollar can break below the lows of last summer and fracture the very broad top that’s extended the range since 2015, both gold and the prospects for higher inflation/lower real yields will remain range bound as well. This perspective also applies to the numerating side of the real yield equation, as long-term yields – despite weakening again this year, are significantly higher than where they were a year before. 

That said, the positive long-term development for gold is that although prices have recently been impacted by more hawkish policy expectations abroad – dragging US nominal and real yields higher, the dollar index has taken the next step lower beneath last November’s ephemeral post election breakout, with long-term support extending from the over  year range directly below. 

Our expectations remain that the cyclical bull market in the dollar is over, and a breakdown below long-term support will rejuvenate the move higher in gold – as well as the next leg lower in real yields. From our perspective, it is the dollar's relative historic extreme that presents the largest catalyst for a continued move lower in real yields and a resumption of the bull market in gold. 
The US dollar index continues to mimic gold's pattern breakdown from it's broad top carved across Q2 2011 to Q1 2013. Although gold will likely remain range bound this summer until long-term support is broken in the dollar, we'd speculate that as the dollar makes its way back to the lows from last summer, gold will regain a foothold as the retracement rally in yields also runs its course. 

Sunday, June 11, 2017

Connecting the Dots - 6/11/17

Finding support around last November’s lows, weakness in the US dollar paused last week with various dollar benchmarks now displaying full retracements of the post US election rally. 

*Click to enlarge images

While it wouldn’t surprise us to see recent support extended before the Fed decision Wednesday as the dollar’s oversold condition eases, we foresee two additional moves lower unfolding this year – the first over the near-term as the dollar index slips back against the lows from last year – and a larger second break as support from the broad top extended over the past two years is finally broken.

Coming into last fall we had noted that the US dollar index was mimicking the broad top carved by gold back in 2011 through 2013 – where it traded on the flip side of the cycle as inflation crested in 2011 and the US dollar and real yields began to materially rise out of their cycle lows. 
Despite the post election rally to new highs in the US dollar index last December, the complex and broad pattern displayed in both tops has been quite similar. 
Just as the suggestion and enactment of QE3 in September 2012 encouraged a bull trap in the precious metal sector on misplaced beliefs of renewed inflationary pressures, the broad based reflationary rally that began last year and was further fortified after the election on renewed expectations of stronger growth and higher nominal and real yields, triggered a short-lived breakout in the US dollar.  


As we have shown over the years, the dollar's performance has been one of the primary driving forces behind the direction of real yields, with gold naturally closely tracking the inverse performance of both. 
When real yields began to move out of the cycle lows in 2011, a bear market in precious metals and commodities began to take hold, as the opportunity costs for holding non-interest bearing hard assets became less attractive while disinflationary pressures began to strengthen.

From a big picture outlook of the markets current disposition within the trough of the yield and growth supercycle (i.e. 1940’s trough to today), we would argue the inflation vane these days is less influenced by growth than the direction of the US dollar, which significantly strengthened as the US led the world out of the financial crisis in 2009 and has largely remained range bound for the past two years as the expansion matured and the ECB and other major central banks followed the Fed's lead. Until the growth cues of stabilizing and rising yields materialize for a considerable period, the notion of a more secular continuation of a stronger US dollar and higher real yields is as misplaced as expectations for sustained GDP growth above 3 percent per year. 

This dynamic was evident as real rates made a lower cycle high in 2015 and began rolling over, despite a surging US dollar that was primarily driven by global monetary policy differentials with the Fed. What was basically missing from the higher real yield equation at that point in the cycle was rising nominal yields tied to stronger US growth, conditions largely improbable in a mature economic expansion already under the influence of extraordinary policy accommodations for more than 7 years. 



Consequently, the most likely outcome from our perspective is that real yields – at the very least – test their cycle lows from 2011, akin to the sharply negative real yield market environments of the 1940's and 1970's.




Although the Fed will likely move to raise the fed funds rate a quarter point higher this week, waning growth and an economy likely at or beyond full employment puts the Fed in a difficult situation going forward, one that realistically doesn’t favor a more hawkish and sustained tightening cycle. As the currency and credit markets often lead policy shifts by the Fed by several months, yields – and more recently the dollar, have weakened ahead of the end of the current tightening cycle. 

Moreover – and picking up on some thoughts in our last note (see Here) in May, should the Fed raise rates again this week, the fed funds rate will be very close or actually invert with 1-yr Treasury yields, a condition realized at the very end of the last tightening cycle in June 2006. 


All things considered, we remain bullish on gold, which should continue to find considerable upside motivation as rate hikes by the Fed come to an end and the dollar breaks down further from its cyclical high. Similar to the move in long-term Treasury yields last year, we expect the dollar index to eventually weaken to the trough of its long-term downtrend, which should provide ample motivation for gold and real yields to test their respective cycle highs and lows. 

From a near-term perspective, the three previous rate hikes have closely marked retracement lows in gold, with the initial rate hike in December 2015 setting the bear market cycle low (daily close) the next session.



Wednesday, May 24, 2017

Connecting the Dots - 5/24/17

Despite holding both the experience and capacity to understand the complexities of the forest, in a post global financial crisis world, when markets head south and loose traction the Fed’s focus narrows to effectively the trees and any brush directly in view. In this respect, they have feared the forest for the trees – for quite some time.

This mentality has supported the longevity of the current economic expansion (3rd longest since 1850), as the Fed has taken a very active and accommodative approach since the financial crisis exhausted with enabling a benevolent market environment for businesses to rebuild and expand within. Consequently, they have more frequently than not erred on the side of extreme caution – predominantly from a reaction perspective to possible outbreaks of brushfire in the markets, while pushing back more hawkish expectations that to-date has avoided “pricking” the business cycle (see perhaps June).

Greatly contributing to the Fed’s fear of destabilizing the economy has been the relative tepid pace of the expansion, which historically would have seen real GDP growth north of 3 percent – a condition completely absent from the data this cycle, despite the unemployment rate in April matching the lows from the previous expansion in the mid-2000s. And although these conditions are likely more normal than not (i.e. within the context of our collective disposition within the trough of the long-term yield and growth super cycle), the sensitivity displayed on the part of the Fed over the past several years may see the current economic expansion die primarily from old age and exhaustion – rather than the characteristic and eventually toxic exuberance more typical of the two previous cycles.


We’ve noted over the past year that Treasuries were the first market to peak in July and breakdown in November, which from a leading intermarket perspective pointed towards a potential breakdown for the US dollar index this spring. 

Over an intermediate-term timeframe the dollar index has followed the structural pivots in long-term Treasuries by several weeks over the past several years, with the relative performance of US equities closely tracking the respective trend in the dollar. Right on schedule and true to form, the US dollar index broke down last month similar to the throw-over top reversal in long-term Treasuries last year.  
Should the dollar breakdown continue, the uptrend in short-term yields that began in November 2014 – subsequent to the dollar breakout in July and the end of the Fed's taper in October of that year – is likely near the top of the cycle. Moreover, despite the support extended by the current uptrend in the fed funds rate; future rate hike expectations in June (78.5% CME FedWatch) or the growing pressure to further normalize the Fed's balance sheet, a leading intermarket relationship is firmly in retracement.    
One could make the analogy that similar to how an elderly patient’s circulatory system weakens before exhaustion, markets have been going through a sequenced transition since last summer. As such, over the long-term we continue to favor counter-cyclical assets like gold that should outperform as the dollar and equities retreat from a cyclical high.