Monday, September 29, 2014

The Inverse Symmetry of Market Reflexivity

We follow precious metals, not as harbingers of financial armageddon or even geopolitical unrest, but primarily as a leading proxy of the commodity markets - that we feel provides the most nuanced view of which way the inflation vane is pointing today and possibly headed tomorrow. 

There is an ambiguity associated with precious metals relative value and causative motivations, that extends in part from their archaic beginnings - to legacy as the cornerstone in the previous monetary system. Because of this history, the sector has maintained a large congregation of fervent believers, that see gold and silver as the ultimate currency and backstop of fiscal and monetary responsibility. As a result of this heightened market psychology, they tend to be the most sensitive to expectations and can lead broader moves in the commodity sector and inflation expectations downstream. 

Back in the spring of 2011, we viewed precious metals - specifically silver, as testament to the exceedingly frothy and misguided expectations that many participants associated with inflation at that time (see Here). Where a one-way street for commodities and the dollar was assumed, we saw a dangerously lopsided market with all the hallmarks of exhaustion and absent of any real evidence, that the structural transmission mechanism of QE merited the rise in inflation expectations, that many participants held and/or feared. 

Generally speaking, we maintained this perspective as the downside pivots in precious metals and commodities unfolded, and incorporated a market posture around the thesis until late in the second quarter of last year. At that time, we felt that market conditions in the US dollar and yields had shifted and were no longer favorably behind the great unwind in metals and commodities. Moreover, sentiment had strongly capitulated, positioning was at bearish extremes and market structure was presenting clear signatures of downside exhaustion - e.g. waterfall declines.


Since then, the sector has rallied and receded three times over, most recently pressured lower by an exceptional move in the US dollar - the likes of which (11 week consecutive rally) have not been seen since the dollar was floated by Nixon in August of 1971. In hindsight, our expectations in precious metals, commodities and ultimately inflation - have been off the mark (i.e. wrong), predominantly because we initially assumed the respective trends would pivot swiftly out of their respective lows from last year. Forever the humbler of mice and men, market conditions have pandered to both sides of the field - the bulls most recently, and have rewarded mercenary traders with healthy swings to exploit, as the respective moves in both yields and currencies have worked to define the range.

So with the sector once again in tatters and circling the drain from last year's lows, does the recent breakdown in metals mark the start of another leg lower for commodities and inflation - or just another interim low in what has become an ever broadening range?

Like all speculative moves, they either eventually find some fundamental traction or exhaust when an external catalyst exposes that sentiment, positioning and the underlying market psychology had become dangerously lopsided and misplaced. This was the case in 2011 when a weak dollar was a foregone conclusion and inflation expectations had reached a fever pitch. Seemingly out of left field, the death of Osama bin Laden pricked the speculative run in silver (see Here), which also marketed the top for the broader commodity sector. 

Inflation expectations - just like asset prices, can rise and fall with strong reflexive feedback tendencies. Look no further than the recent past to see where the currency markets have magnified the moves in the commodity markets and inflation expectations around the world. With hindsight 20/20, from a fundamental perspective did it make much sense that inflation expectations surged as the financial crisis began? With global demand cratering - did the market fundamentally merit $140/barrel oil? One could make the argument that reflexivity greatly impacts trends at the trough of the cycle, where the velocity of money declines and where speculation can have a disproportionate influence on fundamental expectations. That being said, it can cut both ways - which once could argue has contributed recently to magnifying the moves in the currency markets, the downturn in commodities - as well as inflation expectations. Considering the US is poised to end what we perceive became disinflationary policy and where the balance of the world's largest central banks look to stimulate their own economies and inflation expectations, does a continuation of the broader disinflationary trend that began in 2011 on the back of the US dollar hold much water today?

We don't believe so - and find similar market conditions in both sentiment and positioning, that were present at the June 2013 lows in precious metals and which are inverse to the underlying market psychology that was present at the top of the cycle in 2011. Moreover, with commercial short positions in the US dollar the largest on record and with bullish speculative sentiment pined at the top of the range, the tinder doesn't get much drier should a match get thrown. The same could be said on the opposite side of the exchange for our commodity proxies in gold and silver as well as the euro. From an anecdotal perspective, you also find parallel despondency towards gold that was present last June from both producers and pundits alike.
From a basic technical perspective, the damage ended last week for both gold and silver around trend line support that extends from November 2001 in gold and March 2003 for silver. 
Considering current market extremes in both sentiment and positioning, the impetus for a further breakdown below support would likely prove ephemeral. Moreover, momentum is still expressing a positive divergence on both a weekly and monthly time frame in both metals.
Over the past two weeks silver broke down below last year's daily and weekly low and found support between the exhaustion gap of the 1980 blow-off top and trend line support extending from 2003. Similar to the weekly low registered in the first week of July (2013) where managed money started covering their expansive short positions, current shorts began covering last week - with an approximately 50% larger aggregate position than what at the time was a historic extreme last year. 

From a qualitative perspective, both metals have weathered the explosive US dollar rally comparatively well. Unlike conditions in the first half of last year where both yields and the dollar worked in tandem against the sector, yields have stair stepped lower since May while the dollar became the outlier influence. 
In a note at the end of May, we had updated our commentary on different symmetries - both mirrored and inverse, that had developed along varying time frames in 10-year yields (see Here). Essentially, trends were being replicated - from the mirrored symmetry of the long-term cycle, to its inverse structure that yields have been following over the past four years. 

Additionally, mirrored relationships have also maintained form between long-term yields/gold and equities/gold. With yields acting as the common denominator, inverse symmetries have translated with similar complexity and breadth from the top of the cycle in gold miners to what has become an equally expansive inverse reflection in the hardest hit corner of the sector. 

Behold, the inverse symmetry of market reflexivity. 

Monday, September 22, 2014

Dollar Hollers - What does it say?

Paul Tudor Jones, once fittingly observed, "Fundamentals might be good for the first third or first 50 or 60 percent of a move, but the last third of a great bull market is typically a blow-off, whereas the mania runs wild and prices go parabolic... There is no training, classroom or otherwise, that can prepare for trading the last third of a move, whether it's the end of a bull market or the end of a bear market."

In today's policy driven system, where fundamentals have been melded and supplanted by the hand of the Fed, the relative outperformance by our own monetary authorities has not only buttressed US equity markets relative to the world, but also the dollar. This dynamic has been in place since the embers of the US financial crisis, blew across the pond in the summer of 2008 and ignited a firestorm around the world that fall. Despite our clear culpability in setting the world ablaze, in another counterintuitive twist of fate, we had a head start of working and digging the fire lines, that eventually brought the economic disaster under control - first. The "new normal", posited directly following the financial crisis, looked a whole lot like the old normal from the late 1990's.
*Charts updated through Friday's close

With the US dollar index now flirting with the topside of its long-term range, a break above might imply that the move was not the last third - but a new game altogether. Considering the juxtaposition of the Fed withdrawing its fire brigade as the rest of the world turns up their hoses - how likely does that seem? 
At face value - and from an "old school' fundamental perspective, quite likely. However, as we alluded to before, since the financial crisis, the doctrines that have instigated the reach for yield and differential of capital flows towards the US, have been framed relative to what the balance of the worlds major central banks were doing to support their own economies. With the ECB now finding religion and the Chinese seemingly not far behind, the shear stresses that have engendered a positive skew in the US equity markets and dollar, should diminish as the Fed walks away. Moreover, we find it noteworthy that the conventional wisdom in the euro today now echoes the expectations from earlier in the cycle for the dollar: that the currency would be pressured lower by Fed policy. 

From a broader macro point of view, it appears more likely that the dollar is completing "the last third of the move", rather than a return to conditions of the late 1990's that an upside range break would imply. 

Friday, September 19, 2014

An Expectation Gap

Ignoring what Yellen continues to emphasize as her intentions to leave rates lower - longer, participants once again focused their attention Wednesday on the updated dot-plot projections, that implied some Fed officials may have turned towards a more aggressive policy path over the next two years. This hawkish bias was confirmed in the market, as 10-year yields rose to ~ 2.6% and 5-year inflation breakevens collapsed to just under 1.72%. Where the rubber met the road - real rates rose; causing the financials and US dollar to surge, commodity currencies to collapse and precious metals to weaken. 

Similar to the reaction of the taper-tantrum last year, the ballast of the market continues to not believe that Yellen will err on the side of caution and maintain the status quo, implicitly encouraging inflation to perk before even considering raising rates. Here lies the large expectation gap in the market - and one we expect will capitulate towards the Chairwoman's underlying directive. As Jon Hilsenrath pointed out this week, the old market adage, "Don't fight the fed", should really be "Don't fight what the Fed says" - this time around the block. This dynamic is contrary to how participants reacted to the last time inflation was troughing during the financial crisis, when traders expectations were greatly in line with the Fed - as they both jumped hand and hand into the trenches. Today, there exists a large hawkish skew in expectations - predominantly swollen by the uncertainty surrounding the Fed's exit plan and the leftover and misplaced biases of previous rate tightening cycles. While we continue to believe participants are putting the cart before the horse when it comes to raising rates and inflation expectations, we have clearly remained offsides over the past quarter in anticipating the timing and catalyst of such a paradoxical resolution. 

Further muddling the waters has been the more aggressive policy and posturing by the ECB in response to persistently low inflation in the eurozone. These actions have encouraged and maintained downside momentum in the euro, which has re-engaged the value trap like conditions for commodities - as the disinflationary trend in the US has once again rebooted on the back of a surging dollar. While the circularity of conditions is enough to make even Rust Cohle smile, the feedback loop has maintained trend in the equity markets with all the smoothness of a Madoff return - basking under the fair weather conditions of moderating inflation. Conversely, this has caused various reflationary assets (i.e. precious metals, commodities, commodity currencies, emerging markets) to stall out for a third time over the past year - as participants inflation expectations have broadly fallen. All things considered, we believe those biases are once again misplaced and find the same relative value that has remained attractive over the past year, in corners such as precious metals and their respective miners, the Australian dollar and emerging market and Chinese equities. 

Thursday, September 11, 2014

Party Hardy

With the most recent push higher in the Nikkei, Japan finds itself at a threshold opening that has rejected their equity market advances over the past three decades. Throughout the year, on both sides of the field (see Here), we have followed the momentum comparative of the Nikkei's 1987-1988 rejection and recovery. Similar to our Meridian work with the SPX that also extends from 1987, this time period as well marks the upper-pivot of the declining resistance trend, the Nikkei has strictly adhered to and been rejected by since making its historic peak in late December 1989.

In our most recent note on Japan (see Here), we had described that the Nikkei was following a similar recovery pattern that our own equity markets had taken at pivotal times - most recently in 2011. What they all had in common - with varying proportions, was that momentum was quickly restored to the upside, once the retracement decline was completed. 
From our perspective, it appears the Nikkei will loose its deflationary shackles, just in time to celebrate its twenty-fifth anniversary this Christmas. Coincidentally, it took the S&P 500 twenty-five years to the month to break above its nominal high from 1929. While the lay of the land is much different for the Nikkei and Japan today, perhaps similar to the US generation born during the Great Depression and World War II, historians will eventually refer to those brought up in Japan over the previous two decades as the "Lucky Few" as well. History repeats - often with a great sense of irony. 
With Draghi recently breaking the glass and pulling the QE fire alarm, he's attempting to startle some of Europe's markets out of their respective cyclical peaks and deflationary glide-paths we believe they have been moving towards this year. Will it work? We remain skeptical, and look towards Japan's initial efforts that broadly failed at maintaining momentum in their capital markets. As Paul McCulley aptly describes in his latest note for September (must read - see Here), it is a Hobson's choice - and one that theoretically, "should never be on the table, if the fiscal authority is willing and able to party hardy..." 

Considering the many disparate economies, players and opinions around that table today in Europe, the amount of libations needed to imbibe and maintain the festive atmosphere will likely need to be significantly larger than what was initially floated. Don't get us wrong, it was really nice to receive the invitation - it's another thing entirely when folks show up at the party. 


Sunday, September 7, 2014

Tepper Calls an Audible

We've made the case before (see Here) that for all the pomp and circumstance, Fed policy over the last three decades has done very little to deviate yields from what became a genuinely symmetrical and balanced return from the profound 1981 highs. Where they have had effect - we would argue, is around the fringe in introducing volatility to the slope of the decline, with numerous interventions and surprises as they navigated various market conditions. The chart referenced below with the 1941 to 1981 mirrored trajectory captures that story, especially when contrasted with the relative smoothness of the previous long-term cycle in the first half of the 20th century, when the Fed was still in its infancy and developing the first edition textbook of accommodation and reduction, they have continued to build upon with each passing cycle.  

On both sides of the spectrum, whether through bailouts, interventions or rate tightenings - the Fed has looked to shake the tree from time to time when the markets are deemed too complacent, accommodative or risk adverse. Coincidentally - or not, these occasions over the last thirty years have been when yields have fallen back proximate to the mirror of the cycle. Has it been beneficial? We'll save that nuanced argument for the historians, but do believe it demonstrates quite clearly the nature versus nurture aspect of the Treasury market. The Fed may find efficacy with the cattle prod at times, but the herd of the largest security market in the world will still closely follow the inherent migration pattern - one that many analysis, pundits and traders have attempted to call an audible from over the years.   

Coming into this year, we had looked for the taper-tantrum squeeze in 10-year yields to reverse from the relative extreme punctuated at the end of last year. The irony being, the collective wisdom in the market in late December and early January was wresting with how different markets would cope with a rising rate environment. Gold and gold miners were left for dead. Emerging markets were viewed as a fashion craze of the previous cycle, but unwearable in a rising rate environment.  China? "You must be crazy", we were told. Utility stocks? They'll strongly underperform. 

Loss on most was the fact that 10-year yields had surged over 80% higher in only a few short months, eclipsing the entirety of influence on long-term yields of the previous rate tightening cycle (~70%) and roughly doubling the effects of the surprise tightenings by the Fed from 1994 through February of 1995. Not surprisingly, it was a great time to buy long-term Treasuries, gold and precious metals miners, emerging market and Chinese equities and utilities.
With 10-year yields rising the most since the first week in June, bond bears started sticking their heads outside their caves last week, looking to feed and remind us once more that investing in Treasuries is akin to swimming in gasoline in a lightening storm. Emboldened by comments from Appaloosa Management's David Tepper, declaring, "It's the beginning of the end of the bond market bubble", the bond bears gain a credible ally and spokesman just as the Fed looks to shut down their country kitchen this fall - as the ECB notifies us of their own grand opening that same month. Exquisite - or desperate, timing we wonder? While Tepper's reputation and fortune have very much been built on the former, more than a tinge of the later comes to mind - with respect to the severe structural limitations of the European condition and the modest proposal the program will begin with. With that said, it is the thought that counts and we can't deny that Draghi is at the very least forging a reputation of delivering the goods - whatever they may be. 

Although we don't believe that the bond market is in a bubble per se, over the last two years we would agree that the Treasury market has been going through a transition of the beginning of the end of the move that began over 30 years ago. The main difference, is we don't expect yields to sustain a pivot higher, but remain in a long-term range roughly between 1.5 and 3.0 percent over the next several years, as the markets wrestle with normalization of monetary policy from the extraordinary measures enacted over the past five years. To that end, we defer to history and the over 70 year patterned memory of the cycle, that points to Yellen's patient refrain of lower - longer

In the obvious sense, the timing of the ECB announcement appears tailored to mitigate the swift collapse in yields that occurred at the end of the two previous QE salvos, as investors apprehensions without the Fed's training wheels and soup kitchen took over. While conventional market wisdom infers that QE helps a central bank put a cap on yields, as we mentioned earlier - the evidence in the market is very much to the contrary. QE by all accounts has successfully stimulated participants away from the safe-haven shores of Treasuries and into riskier assets.   
When the Fed started tightening first in the summer of 2004, US 10-year yields diverged higher away from Europe. As shown below in the chart between US and German yields, it wasn't until the financial crisis took hold in the back half of 2008 did the two markets once again converge. Maintaining its leadership role in dictating broader monetary policy direction, US yields fell below Europe in the fall of 2008 - as the Fed cut swiftly towards the lower bound of the fed funds rate. Reaching the bottom in December of that year, the ECB would take its time over the next five, meeting the Fed just last November. 

Propelled by the cattle prod of QE3 and the threat of the taper last spring, US 10-year yields have diverged considerably from Germany - Europe's strongest economy, as the ECB has continued to cut below where the fed funds rate currently resides. As our last bunch of QE biscuits warm, and with the ECB finally pulling a page from our own quantitative cookbook, it seems reasonable to suspect that the spread between US and Germany will begin to come in soon. The question - we suppose, is where the next convergence might take place: higher or lower than where US yields currently reside? Will US yields enjoy support extended from the new European initiative, or will nature exert its influence over the cycle and cause them to meet lower at a later date? Longer term, our money is still on the latter and from a relative performance point of view, we continue to favor long-term Treasuries relative to equities today. From our perspective, Tepper's audible will meet the same fate as the many quarterbacks who have made the call over the years. Sacked - behind the line of scrimmage. 

Tuesday, September 2, 2014

Back to School For the Euro

For lack of a better name, we call it Sunday night feeling in our house. It usually hits the kids around two or three in the afternoon and spreads with doleful interactions up the chain of command, eventually reaching its peak just before dinner. 

"I don't want to go to school tomorrow."

"I wish it was Friday."

"Where did the weekend go?"

Whether it's the food for the kids or a glass of wine for mom and dad, the apathy is slowly swallowed and accepted by the time dinner is through. With the end of summer officially crossed this Labor Day weekend with a final crawl up the Garden State Parkway, we find ourselves sitting with a severe case of Sunday night feeling - here this Monday evening. Adding to our general indifference, we also find the markets situated with a mixed bag of performances through the summer months that leaves more questions than answers from both a tactical and strategic point of view. Granted, the markets are rarely an easy read or a fat pitch down the center of the plate, but the continued shift and loosening in inter-market correlations have muddled the waters considerably and allowed ebullient markets to remain buoyant as greater uncertainty abounds. Yes, uncertainty. In our experience, the old Wall Street adage that markets hate uncertainty, is about as accurate as your data is safe in the cloud... Perhaps a better truism would be: a market that stays in motion remains in motion - of course, until everyone is certain it will remain in motion. Let's just call it the Minsky coefficient. 

Looking back at the summer through July and August, we've experienced enough cross currents and strange bedfellows of performance pairs to collectively leave certainty in short supply. Just to name a few: Strong dollar - strong emerging markets and Chinese equities; strong dollar - strong bond market; strong bond market - weak yen; weak small caps - strong Nasdaq; strong bond market - weak precious metals; weak gold - firm gold miners. From a cross asset point of view, one of the primary outlier influences over the summer appears to have been at the hands of a weak euro. For all of our cynicism directed at the ECB and Draghi this spring, the currency markets pivoted sharply thereafter, cutting the euro over 4 percent through July and August. This in turn placed a strong bid beneath the US dollar index which maintained pressures on the commodity markets that weaken throughout the better part of summer. 

That being said, the same market dynamics in which traders lean on the perception that the only clear path for the euro is lower - because of what the ECB can and will bring to the table, are even 
more stretched than where they were historically at the beginning of summer. To that end, gross short euro positions are in spitting distance of the record set in July 2012, when the actual fate of the currency union was very much in doubt. Furthermore, when you factor in the futures positioning of both the euro and the dollar, a rather extreme picture is brought to light (Courtesy of Nordea Markets savvy currency strategist Aurelija Augulyte and Reuters Ecowin). When it comes to the euro, certainty is certainly not in short supply these days.

At the end of the day we still believe the euro is primarily motivated and supported in the long-term by strong deflationary forces - compounded by its flawed structure, which at times present real existential catalysts for the markets to react on. In this sense the euro is unique, although we still look towards the Japanese yen of yesteryear for guideposts in the road and similarities in burgeoning deflationary trends. In the summer of 2012 when Draghi threw down the gauntlet and declared whatever it takes, those existential concerns were addressed and the euro pivoted sharply higher. With Draghi once again stepping up to the podium this week with hints and hopes of more or less whatever it takes greatly factored into positioning, we can't help but feel the euro's outlier influence in the markets this summer is drawing to a close. From our perspective, we don't expect that Draghi will get off this easy with Europe's considerable deflationary concerns. Japan certainly didn't - and they only had one economy and political system to navigate. It's back to school and reality for the euro.

Thursday, August 21, 2014

Breaking the Banks & Finding Gold

Since finding a low in the first week of August, the S&P 500 hasn't wasted much time, closing positive in seven sessions out of nine and narrowing the gap from its 27th record close this year - way back on July 24th. With Yellen flying into Jackson Hole this week to enjoy some good old fashion Rooseveltian eco-tourism, the point spreads have come in considerably for those betting on number 28. Data mining the mountain some more, over the past seven years with the inspiring majesty of the Tetons in the background, stocks have rallied on what the Fed Chair has to say. 

That being said, we remain skeptical that the equity markets can maintain their historic streak and continue to see strains developing in the leading financial sector, which appears to be butting up against the harsh realities of a flattened yield curve and the narrowing margins of net interest income. As we had commented on leading through the decline at the start of the month, the S&P 500 was breaking down along similar folds with the retracement decline this past January. Taking a shallower fall this time around the block - and despite the perceived bid that that Yellen may extend, we do expect a divergent outcome with the sustained recovery that the equity markets had enjoyed earlier in the year. Apparent in the followup study below with the financial sector, the banks relative to the broader market have been making their way down the stairs with 10-year yields. This is in stark contrast to how the banks had led the broader market higher since the fourth quarter lows in 2011.   
As one door closes another cracks open, and we continue to favor the precious metals sector - led by their respective and misfit miners. The common denominator - or hinge, being 10-year yields. As gold and silver relative to yields complete what has become a very broad and symmetrical base from the relative extreme punctuated at the end of last year, the likelihood of an asymmetric return is echoed in the preceding pattern of the financials and similarities in the magnitude of the miners decline over the past few years relative to their denominating spot prices.   


Consistent with our divergent expectations in the equity markets previous retracement patterns, tensions are building up in the precious metals sector to breakout above overhead resistance of their respective interim highs.