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. 

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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.

Thursday, May 11, 2017

A Crowded House

“The one who follows the crowd will usually get no further than the crowd. The one who walks alone, is likely to find himself in places no one has ever been.”         – Albert Einstein

When it comes to the financial markets there’s as much madness in crowds as there is wisdom. Granted, most times the trend is your friend and easiest passage, that is – until it’s not. Successfully navigating the shoals of this dynamic shift is forever the challenge for professional money managers. Tact to early and spill the wind and you run the risk of aimlessly drifting out to sea. Stay the course through the inevitable storm and you danger the lives of the passengers and perhaps sink the ship. 

Writing for Bloomberg View this past February, Noah Smith aptly described the subtleties of crowd psychology when applied to finance.

Why are crowds sometimes wise and sometimes mad? Social scientists already have a rough idea of the general answer to that question. Crowd wisdom works because people’s mistakes are haphazard and uncorrelated. Everyone’s guess is a combination of signal and noise -- we have some idea of the real weight of a cow, or the real value of a stock, but we also have our own wrong ideas and preconceptions and irrationalities. But because my errors aren’t the same as yours, when you and I combine our guesses, the true knowledge shines through while the random errors tend to cancel out.

But when the people in a crowd communicate, their mistakes are no longer uncorrelated. When one person’s misjudgments influence another person’s thinking, the errors can snowball and wreck the whole forecast. Any number of studies confirms the general principle -- once people start talking and arguing and persuading each other, crowds turn into herds, and the magic disappears. – The Wisdom and Madness of Crowds

These societal tensions are also neatly distilled by Soros’s theory of reflexivity, where a distinction is made between the objective and subjective aspects of reality and the feedback loops that materially influences and affects both sides. The subjective refers to what takes place in our minds, the objective represents what takes place in external reality. Soros suggests that when it comes to the financial markets, the fundamental value of an asset is always being weighed by our collective and subjective reasoning. In essence, our perception of an asset literally shapes its worth, which in turn can further influence our expectations – often times reinforcing a feedback cycle. At the crux of the theory is the belief that inevitably a distortion and divergence from realistic valuation manifests, which Soros looks to exploit at different points along the behavioral continuum.

Where we’re going with this – if you haven’t already guessed… is that we have a strong suspicion that the wisdom of crowds today in stocks has created enough distortion from reality that it makes sense to walk away from it. Whether it’s the belief that US equities are under a more secular persuasion higher – which from our perspective is strongly rebuked by our historical understanding of the long-term yield/valuation cycle; or that parts of the world, namely Europe, represents great opportunity relative to US markets  the fallacies of our collective assumptions have been reflexively interacting, resulting with arguably the second highest valuation for US stocks in history and a gathering of investors now in Europe that appear to have quickly forgotten the real structural challenges still within the EU and that perennial asset unwinds have very long tails across very long timeframes.

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Last June, we took a look at Spain’s IBEX, which appeared to point towards an interim low with the possibility that its cyclical decline had run its course. With a little less than a year from that observation and with a more than 45 percent rally in the IBEX from the post Brexit lows of late June, the window to buy into the reflexive rally appears to be closed. In fact, when contrasted with the historic perennial unwind of the Nikkei that we’ve followed and utilized for guidance in Europe over the past 4 years, the IBEX’s swift retracement rally has already met the comparative highs of the Nikkei in late March 2000. The retracement level represents both a long-term technical and sentiment hinge, as a potential higher high of the IBEX’s broad inverse head and shoulders would be a bullish long-term development, reinforcing the markets reflexive tendencies already in play. 
That said – and why we incorporate historic comparative trends as guideposts in the road, we’re more inclined to view the rally as advanced with a greater possibility that the more bullish assumptions made of Europe have been predicated on false hopes. Considering the recent collapse of the gap between "soft" and "hard" data here in the US, hope certainly wasn't in short supply. Is it enough to keep the cycle going? We wouldn't bet on it. 

Tuesday, April 25, 2017

Connecting the Dots - 4/25/17

On the heels of this weekend’s EU-supportive first round election results in France, the euro closed up by 1.35 percent in Monday’s session, with the highs from last month ~109 overtaken today in early trading. Keeping it simple – as we have with the US dollar index this year, we expect the troubled European currency to make higher highs and higher lows as it grinds its way out of a major cycle trough. 
*Click to enlarge images             

On the other shore of the exchange, the US dollar index is now flirting below long-term support extending from the July 2014 breakout, in a window we have anticipated would bring a resolution to the cyclical uptrend in the dollar. 

And while it’s still early in the week – with ample domestic and exogenous catalysts to trade through (ECB policy decision, US 1st quarter GDP, possible tax reform and a contentious debt ceiling debate), the dollar is still following long-term Treasuries leading move from the last major election results in November, corresponding with breakdowns in US Treasuries and gold and a breakout in equities and the US dollar. 
As we’ve described in previous notes, over an intermediate timeframe, the dollar has followed pivots in Treasuries by several months over the past several years, with the relative performance of US equities closely tracking the respective trend in the dollar. Along these lines – careful what you wish for President Trump, as a weaker dollar will likely see US equities underperform globally, while also a telltale for future monetary policy as the dollar has led short-term yields by several weeks.
Generally speaking, we view the EUR/USD exchange rate and the US dollar index as relative equivalent benchmarks for the dollar, as the majority of the index tracks the inverse performance between the exchange rate of the world’s two largest reserve currencies. That said, the Fed’s preferred broad dollar index also benchmarks closely with the inverse performance of the EUR/USD exchange rate. Longer-term, when normalized from the inception of the euro in electronic trading in 1999, the Fed’s broad dollar index has increasingly tightened with the inverse performance of the EUR/USD exchange rate. 

When indexed to the current cycle low in May 2011, the broad dollar index has more closely correlated with US short-term yields, although performing within a few percentage points from the other dollar benchmarks. The long and short of things, technically we tend to follow the EUR/USD exchange rate and the US dollar index, but expect a cyclical pivot lower to also be reflected by the Fed’s broad dollar index.

Not surprising in hindsight – although a testament to the times – significant pivots in the financial markets over the past year have corresponded with major political outcomes. The Brexit vote last June brought new all-time highs to long-term Treasuries and a fresh cycle high to gold and silver, before quickly reversing course in July as equities, yields and the dollar traded sharply higher out of key lows for the year. Greatly muddling causality, however, was the improving economic backdrop and outlook that forced the Fed’s hand to raise rates twice over the past 5 months.

Looking back, the outsized moves in the markets from the Brexit vote were unwound almost immediately, as the economic data broadly improved last summer – both domestically and abroad, and as Europe appeared to take the blow from Britain with no immediate systemic consequence. Although the respective breakouts and breakdowns that followed the surprise US election outcomes in November are also retracing their steps this year, the arc has been much wider as hope and sentiment springs eternal, while realized figures on the US economy continue to underwhelm.

With realistic expectations towards future monetary and fiscal policy, our working thesis has been that the economic expansion has very likely seen its best days, with the prospects for a revival of more robust growth largely tapped out. In our experience – and with a long view of history, hope floats best after the throes of a recession or economic crisis, where those in life jackets are carried on the waves of uncertainty to a more sheltered shoreline of a new cycle. The opposite is very much the case at the top, where hope will sink those left swimming far offshore, in quiet waters after a distant storm. Call me Ishmael – Minsky or Buffett, the lesson is typically the same.

Getting back to other comparative set-ups in the markets – the dollar, long-term yields and gold are also continuing to echo the cyclical pivots from 2002, where US equities began to heavily underperform globally, while commodities overall enjoyed a declining real yield market environment.

Considering the relative lofty disposition of both the dollar and US equities today, the prospective pivot presents another substantial long-term opportunity for investors, as we expect real yields to eventually break their respective cycle lows from 2011. Coming through this shift, gold offers the more conservative intermediate-term risk/reward profile, although we expect the silver:gold ratio to continue to outperform over a longer-term horizon.

And while US equities have found a very healthy bid this week – extending the retracement rally from the lows of the previous, we maintain our bearish read on the future prospects of the reflationary rally in equities and view the fresh breakdown in the dollar this week as a leading move.