Sunday, December 10, 2017

Instant Gratification's Gonna Get You

Sans the ever wilder world of bitcoin – more of the same since last month’s note, as spreads between short and long-term Treasuries continue to narrow, with 2’s and 10’s earlier last week at their tightest levels since the previous equity market peak in October 2007.

That said – and contrary to the market environment in Q4 2007 where spreads had been widening for several months as both short and long-term Treasury yields fell, but shorter-term yields fell faster – the curve today has continued to flatten as shorter-term yields have climbed and “outperformed” the long-end, greatly buoyed by staunch confidence of another rate hike by the Fed this week and tepid expectations towards rising inflationary pressures next year.

The cyclical disinflationary gravy train that began in Q4 2011 as the US dollar and real yields carved out their respective cyclical lows, has handsomely rewarded both equity and credit investors alike, at the expense of more inflationary driven assets – like commodities. And while there are many that believe that a secular move higher in equities began in 2013 as indexes broke out above their previous 2007 cycle highs, that observation appears mostly biased by simple technical disposition and ignorant of a wider historical perspective and understanding of the long-term yield/growth cycle – we believe essential to even considering more lasting secular persuasions.

The long and short of things – which appears entirely personified in the speculative microcosm of bitcoin mania these days: trade it while it lasts, but don’t be fooled by price alone. Valuations anchor all returns in the long run, and that rope between expectations and reality is exceptionally long and extraordinarily taut today.

Besides the unconventional and extraordinary monetary policy approaches applied in the markets since the global financial crisis, expectations continue to be muddled by the massive scale of the long-term yield and growth supercycle that we believe ultimately exerts the greatest influence on the respective equity and commodity sub-cycles over the long-term. Simply put, investors need to balance expectations by also viewing the overarching cycle through a market historian’s wide-angle lens, rather than just a weatherman’s radar display of current market conditions.

Granted, much easier said than done, as prudence typically takes a back seat to the ever pressing consequence of the fear of missing out. Heck, what’s a measly 20 percent return, when your kid’s teacher bought some crypto last week and doubled his “investment” – just because his nephew bought a bitcoin financed Bimmer on a cheap ticket punched in June? As if Millennials weren’t disliked enough already, returns in their preferred investment vehicle over the past year rival equities over the entirety of the more than 35+ year secular bull market. From a speculative point of view, there’s never been anything like it – and it’s happening right now. Chew on that.

Getting back to a more stodgy and puritan landscape… When you look back at the span of the broader long-term yield cycle, you'll find it was a period in history that encompasses 70+ years of remarkable growth, the last 35+ of which were traveled with increasingly benevolent credit conditions, in which the US has enjoyed elevated equity market valuations on the back of a proportionately massive secular downdraft in yields. Historically speaking, the significant investments and advancements in the world economy that took place directly after World War II, helped drive growth, inflation and eventually yields to such Icarus heights – that countries, central banks, corporations and individuals have enjoyed the voluminous book-end benefits of a declining rate environment for well over 35 years. This in a nutshell built the long road to the top of the equity market cycle on the back of ever cheapening credit and ever more accommodative monetary policy.

Interestingly, the relative symmetry represented in the current yield cycle is not unusual and quite characteristic when you look back at several hundred years of market history. 
* Click to enlarge images
The previous cycle (from trough to trough) spanned 40 years to the month; a period in which yields rose for 20 years – followed by a 20 year decline. Unlike the current downtrend in yields that has trended to the trough with increasingly more symmetry with the mirrored rise in yields from 1941 to 1981, the previous cycle exhibited an asymmetric return below the 1901 lows, as economies pushed up against the limits and unbalances exposed and magnified during the great depression - and markets stumbled their way across the transitional divide to the next major growth cycle.

Comparatively, the secular peak in yields in 1981 was over three times as steep as the previous secular peak in 1921 – and the broader span from trough to trough of the current move (1941 - today) will likely be over twice the previous cycles length (1901-1941'). Consequently, the massive range and structure of the current long-term yield/growth cycle represents the enormous scale that market participants should balance their more long-term and secular expectations within. 
Believing that the broader system will normalize and reboot to the next long-term cycle without a prolonged period of transition (i.e. secular stagnation - we like transitional divide) – even proportional and commensurate with the previous trough – is unfounded even along the irrational continuum markets often walk out on. In this respect – and as was the case across the previous transitional divide in the 1930’s and 1940’s, look for alternating periods of outperformance between equities and commodities extending well into the next decade, before a more secular move higher begins beneath growth, yields and equities.
The main takeaway for us, is that although equity markets have extended far offshore to relative valuation extremes today, the anchor of the broader long-term yield and growth supercycle will eventually pull returns lower as economies move further away from the easy credit conditions and accommodative monetary policy approaches that have greatly defined the current disinflationary sub-cycle since 2011. Considering the major influences of US dollar strength and extraordinary monetary policy accommodations that have gradually receded over the past few years, the disinflationary tradewinds that have greatly supported equities – but were headwinds for commodities, will eventually dissipate entirely in the current doldrums (i.e. goldilocks conditions) the markets remain in. Filling the void will be either rising inflation – deflation, or relatively brief cycles of both. We suspect we’ll see the former stretch its legs further, before the latter threatens yet another return. That said, we’re reminded this isn’t the summit of the yield/growth cycle of the 1970’s were inflation had ample fuel to burn – but likely the middle of the trough, where outbreaks of inflation burn fast and bright before exhausting whatever oxygen remains in the economy.


With November’s CPI report coinciding for release with the December Fed meeting announcement Wednesday afternoon, markets will be provided ample catalyst and reaction to trade between. Gold, which has remained mostly under pressure since its late summer high, has found major tradable lows shortly after the two previous December rate hikes in 2015 and 2016. It traded out of a bear market cycle low in December 2015 – directly after the Fed’s initial rate hike off ZIRP; and successfully defended that low the following December as the Fed hiked once more. Should the CPI report come in hotter than expected, look for gold to test underlying trend line support ~ 1215, before reversing course into the end of the year.

Generally speaking, gold has continued to trade higher – even as the Fed has raised rates four times over the past two years, predominantly because real yields have continued to fall as the dollar’s cyclical bull market turns down. In this regard, the dollar’s year-over-year performance trend has continued to decline this month, which would indicate that real yields should follow suit, largely supporting the cyclical uptrend in gold that began two years ago.

Overall, we continue to watch the slow battleship turn in the US dollar, with the fundamental belief that similar to the trend in long-term yields, the dollar will also work its way back down to the trough of its long-term range, coinciding with another cyclical move higher for gold and commodities in general.

Thursday, November 9, 2017

Into the Great Wide Open

Traders looking for a steeper yield curve continue to see spreads come in as confidence builds for another rate hike by the Fed next month, while weak convictions persist towards rising inflationary pressures next year. This week, the combination of expectations saw the spread between the 2 and 10-year Treasury yields at its narrowest since November 2007.

Although causation may lie in the eyes of it’s beholder, it does at the very least suggest that collective wisdom believes future inflation will remain subdued, despite a continued tightening in the US labor market, a baker’s trillion in global QE accrued within the system since November 2007 – and a US dollar likely on the backside of it’s cyclical peak.

Nevertheless – and regardless of motivation, the tightening of spreads between shorter and longer-term Treasuries that really began as the Fed floated, then enacted the taper in December 2013, appears to be as stretched as this year’s move in equities to another historic valuation extreme. When the dust settles after the next inevitable pivot, will long-term yields rise faster than the short-end of the curve – because the reach of inflation is greater than the Fed’s capacity to tighten, or will the long-end steepen simply because short-term yields fall faster as rate hike expectations recede? In either case: an economy becoming too hot or an economy turning down – and even a combination of both (i.e. stagflation), gold is positioned to outperform as the benevolent conditions against which the equity markets have advanced with begin to diminish. 

While on an absolute basis it was the pivot lower in real yields at the end of 2015 that drove the cyclical turn higher in gold (inverted here), on a relative performance perspective we will be looking for Treasury spreads to widen as longer-term yields "outperform" the short-end of the curve. As shown below, the relative performance of the 10-year versus the 5-year yield has trended closely with the performance of gold relative to the S&P 500.
Similar to following the yield curve for greater bearings in the market, over the years in previous notes we’ve commented on the relative performance trend in Treasury yields as a more discrete indication of the Fed’s policy shifts away from the extraordinary easing initiatives that began during the global financial crisis and were built-out in several phases in its wake. Because of the more unconventional and esoteric nature of these policies that were enacted in large part because of the inherent limitations of ZIRP, we’ve followed the relative performance trend between the 5 and 10-year Treasury yields as indication of the markets expectation shift that first transpired with the taper tantrum in May 2013. We chose to highlight and contrast the relative performance between 5 and 10-year yields, as we felt the shorter durations of the market had been disproportionally influenced by ZIRP and the Fed.

In May 2013 the Fed began to telegraph their intentions to begin a tapering later that year of the massive monthly QE program, which caused short-term yields to surge relative to the long-end of the curve; conditions greatly similar to the build-up of the Fed’s previous tightening cycle that began in June 2004. Generally speaking, yields along the shorter end of the market tend to either "outperform" or "underperform" longer-term yields as the Fed moves between tightening or easing monetary policy. Naturally, when the Fed tightens, shorter-term yields outperform – and vice versa as they ease. 

*Contrary to the previous chart shown, the chart below uses the inverse series (5yr:10yr & SPX:Gold) as they have historically trended with the Fed funds rate. 
In January 2004, the Fed first telegraphed to the market by removing the phrase that rates would remain low for a “considerable period”. By the end of June of that year, the Fed had begun to gradually raise rates. Less than two years later in February 2006, the relative performance differential between 5 and 10-year yields had reached its peak four months before the end of the rate tightening cycle later that June.

The uniqueness of the current Fed tightening cycle – which we had noted at the time, is that the majority of tightening actually took place during the expectation and tapering period away from QE, rather than the second phase that we’ve currently been in since December 2015 of actual rate hikes. This makes sense as the “tightening” was enacted on a greater relative perspective to already historically extraordinarily accommodative policies, rather than more material interest rate hikes typical of conventional tightening cycles. 

Moreover, by some measures conditions were the tightest a few weeks after the initial rate hike in December 2015 and have steadily fallen even as the Fed has further raised the funds rate – as displayed by the Chicago Fed National Financial Conditions Index that hit a more than 20 year low this month. Not surprisingly, gold relative to equities has loosely trended with the index. 

All things considered – which should also take into account a historic perspective of the last time yields were this low (spot the outlier below), it's a decent bet that the spread between short and long-term Treasury yields will widen – and with it a greater outperformance in gold

Thursday, October 12, 2017

Danger! Synchronized Swimming

As traders prepare to receive September’s CPI numbers tomorrow, markets are digesting the leading PPI report released this morning that indicated that the producer price index rose 0.4% in September, matching the rise in the median forecast. Although the Fed and traders will undoubtedly take greater signal from tomorrow’s CPI data, with participants – both doves and hawks – now closely tracking any whereabouts of inflation, markets are vulnerable to influence as equities, bonds and gold initially stepped lower after the inflation report, with the dollar finding a modest bid on soundings of rising price pressures.

Granted, deciphering and assigning causation across such an immediate timeframe is more chance than skill, it will undoubtedly become the $64,000 question across a much longer timeframe, if our suspicion that inflation rises faster than the pace of rate hikes is realized. While the immediate influence on gold and the US dollar is more tail than dog – as the data is obviously viewed in the prism of a rearview mirror, the longer-term impacts on equities and bonds has yet to be felt.

As mentioned in previous notes, we believe that the equity markets are most vulnerable to surprise price pressures when already historically lofty valuations become squeezed. From our perspective, the intermediate-term impacts on Treasuries is the hardest to gauge today, although we suspect they will eventually be supported (relative to stocks) by the Fed’s limited capacity to tighten and the Pavlovian demand from misplaced perennial concerns with the perceived greater deflationary threat. Moreover, although the data may strengthen any hawkish resolve in the immediate term towards future rate hikes this year, ultimately, rising US inflation should have a deleterious effect on dollar exchange rates, as the Fed is likely limited by a maturing expansion against a global backdrop where policy differentials with other large central banks like the ECB are now just beginning to tighten. Simply put, we’re on the flipside of the cycle, whereas in 2014, policy differentials greatly supported a stronger dollar.

That said, from a counterintuitive perspective, investor’s ears should perk up with the latest buzz-phrase now circulating around the markets of “synchronized global growth”. 
"The economic expansion is about as synchronized as it gets." - Michael Gapen, Barclays Capital Chief US Economist 
While there are certainly policy differentials in place affecting the relative performances across global markets, over the past year the tide of growth has risen broadly, harmonizing global growth for the first time since directly after the global financial crisis in 2010. After many years of disparate growth tracts, where some economies were expanding while others contracted, most countries – including advanced, emerging and developing economies – have experienced strong synchronized growth since the back half of 2016.

At face value, unified growth across the world is a strong and positive tailwind, especially when so many developed economies have experienced historically sluggish expansions. Essentially amplifying and buttressing different countries respective economies, the net effect has undoubtedly driven the rally over the past year across global equity markets, despite the perceived and headline risks associated with significant issues like Brexit, rising protectionism and gasp – nuclear war. And while Trump is doing his best to take credit for the rally in stocks since the election, the reality is his hand has played little to no part in propelling it and we’re likely just witnessing the culmination of moves set in place at the start of the decade.

Some years back we described our concerns with a similar condition that arose globally at the end of the previous cycle. We recall listening to an economist in the summer of 2006 wax poetic about how the 66 largest economies in the world were enjoying a historic and synchronized expansion. Naturally, his takeaway was broadly bullish - implying a sturdy and broad foundation was extended beneath the markets. While that was true for the moment, his observation of the cycle resonated with us in a very different way. If everyone was expanding on the same growth wave, the inevitable contraction would be magnified.

These same wave principals are taught in your high school physics class as a phenomenon known as constructive interference. When two waves become in phase, they form a new wave with an amplitude equal to the sum of their individual amplitudes. Conversely, when two waves of identical wavelength are out of phase, they cancel each other out completely. Often, it's a combination of varying degrees of both destructive and constructive interference that determines the composite structure of the new wave - or in this analogy, the aggregate cycle of the largest economies in the world that had become highly synchronized. Needless to say, our greatest fears were realized just two years later as momentum was translated and magnified sharply lower during the financial crisis. We presented these thoughts back in 2011 in something we playfully called the Constructive Interference Theory (see Here).

One could make the counterintuitive argument today that the current bull market in stocks here in the US (the second longest on record) has been greatly helped along by the economic and policy dispersion around the globe that followed in the wake of the financial crisis. Although growth domestically has been historically lackluster, the varying economic conditions and policy approaches throughout the world fostered a composite not-too-hot/not-too-cold scenario, which kept at bay the more destructive concerns of inflation that were levied by many following the Fed’s extraordinary policy approach to the crisis. Because of a more coordinated, yet structurally out of phase global policy response since the crisis, the performance baton has been passed with no one region or economy largely upsetting the global apple cart and no one capable of overheating it – because of the varying economic paths taken. With global growth again becoming increasingly in-synch, the vulnerabilities become far greater to experiencing conditions on both sides of the spectrum – all the while as pundits today begin writing the obituary for secular stagnation.

Picking up on some thoughts in our last note (see Here), tomorrow's CPI report should continue the trend higher, as the dollar's year-over-year performance trend has closely led the CPI data (expressed here through the 10-year real yield), which would point towards further advances – notwithstanding the impacts from this summer's devastating hurricane season. Although the dollar index has bounced since the early September low – and a "hot" report might rekindle the retracement move higher in the immediate term, we expect the cyclical shift lower that began this year to once again exert itself and take the next leg down. 

Generally speaking, a weaker dollar should continue to exert pressure on real yields, as we believe the Fed's reach is ultimately limited by an economy in the late stages of a mature expansion. Overall, this should continue to be supportive of gold.
Taking a peak around the globe at our higher beta proxy for Europe, Spain's IBEX retraced more than 10 percent since setting a high this May. At that time we had noted that the more than 45 percent rally in the IBEX (from the post Brexit lows less than a year) looked extended (see Here). Quickly forgetting the real structural challenges still present within the EU or that perennial asset unwinds have very long tails across very long timeframes... conventional wisdom had now turned and viewed Europe as a great opportunity relative to US markets. Sizing up the IBEX relative to the historic Nikkei comparative that we've followed and utilized for guidance in Europe over the past 4 years, the swift retracement rally had met the comparative highs of the Nikkei in late March 2000. From a basic technical perspective, the retracement level simply represents a long-term technical hinge, as a potential higher high would greatly reestablish a bullish long-term trend. To date, the level was rejected in May. 
Speaking of higher highs, Japan's Nikkei this week is flirting with its highs from the summer of 2015. Although it hasn't broken out like US markets, similar to the S&P 500's test of the long-term trend line from the 1987 high, the Nikkei has rallied sharply since the lows in early 2016. 

Although both markets look constructive from a purely long-term technical point of view – we know that from a valuation perspective they are both historically stretched and vulnerable to breaking below support in a more protracted downturn.
Moreover, from a trend perspective we're inclined to view the retest of support in the yen as more long-term bullish. And although both the yen and the Nikkei have recently traded together away from the negative correlation extreme seen throughout 2014 and 2015, on an absolute basis we would prefer the prospects of the yen. 

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.