Tuesday, September 19, 2017

What Happens When Inflation Walks In?

If you watch and participate in markets long enough – and no, we’re not talking about, “On a long enough timeline…” – you’ll appreciate or get bitten (as we certainly have from time to time) by the sardonic irony that often becomes exposed by a market’s cycle. Consider Mohamed El-Erian’s “New Normal” market strategy, that aimed at the start of this decade to capture the anticipated outperformance of emerging over developed markets. Bear in mind that the phrase has stuck around since then, despite the fact that it was largely a narrative for a poor investment strategy.

What happened? El-Erian and Gross were prescient in inventing the term “new normal” to describe a very slow-growing global economy with heightened risks of recession, as befell much of Europe. But they were dead wrong in predicting that emerging markets would provide outsize stock returns, and they were wildly off base in their notion that developed-market stock returns would be deeply depressed. Emerging market stocks have stumbled since 2011, and emerging market bonds have lost ground this year. Meanwhile, developed-world stock markets have soared. The fund’s use of options and other techniques to hedge against “tail risk”—which essentially means insuring against extremely bad markets—has also surely cost the fund a little in performance. – Kiplinger, November 14, 2013

Not to overly pick on El-Erian here, who is typically a very thoughtful and creative macro thinker – not to mention many of his new normal predictions did prove prescient, with the very large exception of rising inflation that would have likely driven a successful investment strategy – not just a convenient catch phrase… but, ironically, it appears his timing earlier this year of calling for an end of the new normal, as selectively revisionist as they paint it, might provide a fitting bookend to the market’s wry sense of humor.

Eight years later – and instead of just getting slow growth right in a developed economy like the US, as he initially suggested in May 2009, his other two major tenets of rising inflation and rising unemployment might eventually be realized domestically in the economy’s next chapter. In fact, from our perspective it seems more likely than not.

In theory, markets should be easier to game. They’re expressed in broad sweeping moves with pronounced peaks and valleys that on paper – and in hindsight, present clear transitional signals. Buy here, sell there – what’s the big deal? The problem, however, is that timing the transitions, which are driven by inherent human behaviors, prove exceptionally challenging, especially over the short to intermediate-term and when the largest central banks are intervening in the markets on a massive global scale.

For as long as markets have functioned broadly, participants have attempted to place a quantitative framework around and over them to better understand, describe and hopefully exploit their machinations. And while it does provide some context, ultimately, they’re still driven by behavioral incentive that might best be described as non-linear and reflexive across shorter timeframes that more or less eventually conform with general equilibrium theory. The paradox is holding both the quantitative and qualitative schools of reason in mind and existing in a space seemingly governed by both free will and determinism. That said, if we weren’t wired this way, capitalism wouldn’t function as a one-way street for long (e.g. see communism). Icarus eventually flies too close to the sun, and in this alternate parable, Godot – i.e. inflation – surprises everyone and shows up.

As we alluded to in our note last month (see Here), it was a good bet that the inflation data was due to turn up again, as US dollar strength (on a year-over-year performance basis) had run its course in May. We’ve pointed out over the years that the YOY performance of the dollar has led the inflation data and we’ve closely followed the rollover in real yields (here the 10-year less CPI) since 2015, as it has positively correlated with the YOY performance of the dollar. Last week’s CPI data confirmed the expected turn, with headline CPI coming in at 1.9 percent YOY, modestly higher than the median forecast of 1.8 percent YOY for August.

So where does that leaves us going forward? Extrapolating the downtrend and YOY performance in the dollar this year, the inflation data should continue to firm in September. Moreover, the very broad 3-year top in the US dollar index has recently broken down below long-term support, which we’ve approached as a major fulcrum for the next legs in inflation (we believe higher) and real yields (lower).
Looking back at history and distilling the last time real yields had rolled over within a negative band (mid 1970’s and mid 1940’s), a pulse of inflation eventually outstrips growth, leading to a sharp spike lower in real yields. From our perspective, it is the dollar’s relative historic extreme today and the Fed’s relative constraint with raising rates that presents the largest catalyst for a continued decline in real yields. While there are some similarities with the 1970’s through the prism of real yields, there’s still greater overlap – in our opinion, with the 1940’s when the Fed and Treasury were last involved in a large-scale asset purchase program and yields were troughing within the secular long-term cycle.

Although the equity markets here in the US have continued to defy gravity, we suspect similar to the completion of the cyclical bull market of the mid 1940’s, its fate will be sealed when realized inflation surprises to the upside and greater uncertainty prevails with future Fed policy. Considering the recent breakdown in the dollar, Godot could show up this fall. That said, we believe the mid-to-late 1940’s still offer some behavioral perspective with the markets today, as investors – despite quickly shunning equities, did not broadly sell Treasuries in fear of inflation.
As mentioned in previous notes, in Milton Friedman and Anna Schwartz's - A Monetary History of the United States, the market climate in the 1940's was described as being so suspect of the Fed and Treasury's visible hand, that even after a 150 percent rally in the equity markets that began in 1942 - went through a recession in 1945 and exhausted around Memorial Day in 1946, participants by and large didn't trust the market or expect inflation to rise as precipitously as it did from the trough going into 1947 and 1948.

"Despite the extent to which the public and government officials were exercised about inflation, the public acted from 1946 to 1948 as if it expected deflation."  

"… An important piece of evidence in support of this view is the harbinger of yields on common stocks by comparison with bond yields. A shift in widely-held expectations toward a belief that prices are destined to rise more rapidly will tend to produce a jail in stock yields relative to bond yields because of the hedge which stocks provide against inflation. That was precisely what happened from 1950 to 1951 and again from 1955 to 1957. A shift in widely-held expectations toward a belief that prices are destined to fall instead of rise or to fall more sharply will tend to have the opposite effect - which is precisely what happened from 1946 to 1948." - Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1963

Consequently, we continue to like the long-term prospects for gold, as it has displayed a strong inverse correlation with real yields and should also benefit from the prospective safe-haven demand generated by the eventual cyclical decline in equities. All things considered, when Godot walks in – you best be wearing some. 

Friday, September 1, 2017

Macro Winds Fill Gold's Sails

While the perennial skeptics popped their heads out earlier in the week to again profess their disbelief in gold’s performance, supportive macro conditions behind the nascent and discreet bull market in precious metals continue to advance.

*Click to enlarge images

Namely, the linchpin of future inflationary pressures – the US dollar – remains heavy just below long-term support, while longer-term yields also flirt with an interim breakdown of their own below the lows from late June. Should longer-term yields continue to follow the dollar's lead, the downside range extending from the post-election breakout in November will likely be retraced. The net effect downstream will be that real yields should continue to decline, providing more favorable market conditions for non-yielding hard assets like gold to outperform.

Although contempt for gold still remains with a deep scar from the long cyclical bear market in the face of what was perceived by many as exceedingly beneficial market conditions – i.e. massive QE (a few of our takes back then  see Here, Here, Here & Here), the precious metals sector has outperformed the S&P 500 since their respective cycle lows in late Q4 2015.

Since setting another retracement low in early July, precious metals have strongly outperformed as the US dollar index made its way back down to the lows from last year. With the dollar index breaking through those lows on Monday, gold took notice and broke above its yearly range and beyond $1300/oz.
Squawking with the gold grizzlies this week have also been the downtrodden and dogmatic dollar bulls, which found fresh inspiration by the daily reversal below long-term support in the US dollar index on Tuesday. While sentiment did appear to reach a negative extreme heading into the week, that pressure valve has now been released with the dollar index still flirting below long-term support at 93.

Although technically an upside reversal again above long-term support could shift the tea-leaves in favor of a more sustained dollar rally, as we described in our previous note (see Here), the pronounced negative momentum structure in the dollar lends favor – in our opinion, that a continuation lower below long-term support will unfold.

Taking a closer (60 minute) look at our dollar/gold comparative that contrasts the current dollar move with the breakdown in gold from the flip side of the inflation cycle in April 2013, gold did initially break below long-term (weekly) support, before briefly snapping back above and setting another large bull-trap across a few sessions. If our memory serves us right (see Here), the move caught both dogmatic gold bulls and opportunistic counter-trend traders off guard right before the floor fell out. Food for thought.
Rounding out our comparative reasoning is through the lens of the cyclical turn in the dollar in 2002, which as we alluded to in our most recent note, exhibited a positive correlation extreme with long-term yields as well. Although we are less inclined to be on the lookout for new cycle lows in the 10-year yield this year, the post-election breakout range looks ripe for retracement. All things considered, the backdrop for fresh cycle highs in gold this month looks very encouraging. 

* As a postscript reminder to ourselves - remarks composed with this degree of hubris often age poorly. 

Thursday, August 24, 2017

Connecting the Dots - 8/24/17

With traders setting their sights and ears to what Fed Chairwoman Yellen and ECB President Draghi might say or exclude in their respective Jackson Hole speeches tomorrow, the US dollar index – primarily influenced by the exchange rate of the world’s two largest reserve currencies – has made its way back down to long-term support after consolidating the steep move lower that began at the start of the year. 

As the July inflation data was largely uneventful, another window has opened over the next few weeks to break the respective ranges in gold (up) and the dollar (down). Over the near-term we wouldn’t be surprised if the markets took a slightly more hawkish tone subsequent to Yellen and Draghi’s speeches tomorrow, if only because the palpable dovish leanings going in may not be further nurtured. At the end of the day, Yellen knows it’s easier to walk back policy expectations than to ratchet them up. In the absence of new data or an exogenous influence, we would speculate the symposium is largely a non-event, where a relatively tighter ECB is counterbalanced by a less hawkish Fed. 

That said, the elephant(s) in the room remains the contentious relationship between the President and his own party, as the very real threat of a government shut-down and debt default greatly threatens the last remaining prize of the President's legislative agenda this year: an overhaul of the nations tax system. Naturally, as the legislative deadline approaches this fall these tensions should come to a head.

*Click to enlarge images*

Generally speaking, from a basic technical perspective the downtrend in the US dollar index this year has been defined by characteristic “lower lows” and “lower highs”, typical of a significant momentum unwind with diminishing relative strength imprints as the move unfurls. Overall, we expect the pattern to continue as underlying long-term support is eventually breached, which should register positive relative strength divergences before a more tradable low is reached. 

Among the few touchstones we’ve benchmarked against this year to estimate the dollar’s prospective trend, we’ve contrasted the breakdown in gold in 2013, which also displayed a diminishing momentum signature as it broke underlying support from its broad top range. Notwithstanding our appreciation of the inverse symmetry to the cycle today – in which gold has been rejuvenated as the dollar weakens, the technical similarities have remained prescient for the dollar index as well.
Since utilizing at the start of the year our intermarket leading comparative with long-term Treasuries that accurately pointed towards where the dollar would loose trend line support in April (see Here), we have also contrasted with the cyclical pivot in the dollar in 2002 for more long-term projections  as well as a prospective road map for long-term yields, the euro and gold. 

Our interpretation at the end of Q1 (see Here) was that the dollar was set to follow Treasuries breakdown lead with the last lagged pivot (~5-6 months) of the cycle, which should mark a pattern break (between LT Treasuries and the USDX) as the dollar turns cyclically lower without a corresponding leading move in Treasuries. In hindsight, those expectations appear well founded to-date, as the dollar and long-term yields have behaved quite similar to their respective breakdowns in 2002, where long-term yields reached a positive correlation extreme with the dollar and turned down again with the dollar's cyclical pivot.

From a big-picture cyclical perspective, we’ve pointed out in the past that the dollar has followed major upside exhaustion extremes in long-term yields by 2 to 3 years. The 9/81’ secular high in yields was followed by a secular high in the US dollar index in 2/85’ (monthly). The upside exhaustion in yields in 1/00’ was followed by the cyclical high in the dollar index in 1/02’.

Structurally speaking, the pattern in yields has been to test the previous interim low after the exhaustion high, followed by a sharp secondary move that is rejected below the previous extreme. 

Today, the 10-year yield has worked through the secondary pivot below the previous exhaustion extreme of ~3 percent in 12/13’. Our expectation remains that the US dollar index is following again the long cyclical intermarket lag (3yrs) in yields, which points towards a continuation move lower for the dollar over the next several years.

Similar to how the US dollar index led the subsequent breakdown in yields in the back half of 2002, a fresh break of long-term support in the dollar could bring a retest of long-term yields lows from last summer. 

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.