Friday, January 23, 2015

Going Up?

Despite arriving late to Thursday's press conference - ironically, held up by the new ECB elevator system that just wouldn't cooperate... Draghi delivered the goods. The ECB would buy over 1 trillion euros through September 2016 - or until there is a "sustained adjustment in the path of inflation". True to monetary form, the program exceeded expectations, even surprising by 20 percent the tactical "leak" of 50 billion euros/month floated just the day before. 

Well played Super Mario - well played, however;

- Will it work? 
- Will it be enough? - or, 
- Is it too late?

Considering it's Europe's first salvo fired at the QE range, it's probably wise to let the dust settle some more - although conventional wisdom yesterday echoed expectations that the program will further suppress yields. As we described in our previous note - count us skeptical of such sentiments over an intermediate time-frame (~6 months), especially considering the size of the program that was brought to the table. While there remains a widespread belief that QE helps lower yields or that the market simply front-runs this dynamic, all evidence is to the contrary when you look at what these programs achieved in the States. QE by all accounts succeeds by stimulating participants away from the safe-haven shores of the government bond market and into a concerted reach for yield in riskier assets.

Generally speaking, exceptionally low yield environments result from a lack of demand for capital. Bond yields in Europe haven't been falling over the past year because investors believed they could sell these assets to the ECB in the future at a higher cost, they've fallen because investors lacked confidence in the eurozone itself as economic conditions deteriorated and deflationary concerns emerged. We witnessed a similar dynamic during the massive deflationary squall in the financial crisis in the U.S., where investors were certainly not front-running the Fed before QE1, but parking their capital while the dust settled. Nevertheless, it's an elegant silver-lining and surely doesn't hurt the next reflexive scramble that these safe-haven assets inevitably get bid to what some consider icarus heights in the latent stage of the move. While it remains to be seen whether the ECB can achieve the same volatility and market psychology that rustled confidence and yields higher over the past six years, we do think it could help put a floor under yields globally as well as the euro over the next several months. That said, in the first shot administered in the U.S. in late 2008, the market took a few weeks to find it's footing before yields moved materially higher. We suspect a similar reaction this time around.  
When it comes to inflation, our leading proxies in gold and silver have made significant progress over the past several weeks, as the expectation gap illustrated below between durations in the Treasury market - closed with an anticipated rally in precious metals.   
While strength has been sold over the past eighteen months, coincidentally or not - gold is breaking above trend line resistance - as the ECB opens their large country kitchen. 
Although the mid-cycle bear in the 1970's was marginally more severe but only half as long, the current breakout and overall market structure is quite similar. 
Assuming the current rally has legs, the next big test should take place above $1400 as the market either accepts or rejects the first retracement level. 

A vote of confidence in shifting the inflation vane north has been the performance of the silver:gold ratio - which continues to trend higher out of a possible cyclical low. Similar to the Nasdaq:SPX ratio that marked a top for broader risk appetites in 2000, the blowoff in the silver:gold ratio in 2011 led and capped a reflationary high in commodities and tangential trends such as emerging markets. 
Another congruence with the 1970's mid-cycle retracement, is the disinflationary performance of the Gold:SPX ratio - which similar to silver outperforming gold leads a broader turn in commodities.
From a long-term perspective, we expect the gold:SPX ratio to cycle higher once more as the equity and commodity markets trade moves across the yield trough - largely motivated by inflationary trends. This would be similar to what occurred on the mirror of the long-term yield cycle from the 1930's to early 1950's. 

Wednesday, January 14, 2015

All Eyes on the ECB

- When you come to a fork in the road, take it. - Yogi
Despite finding ourselves on the right side of the tracks with European equities last year, we didn't foresee that the euro would also turn down precipitously against the U.S. dollar, as storm clouds reemerged over the Old World and rose petals fell at the feet of our own monetary handlers. Granted, this correlation was evident and strongest going into last year between the higher beta markets in Europe (e.g. Spain) and it's downtrodden currency - we just expected as deflationary conditions built on their shores, the euro would structurally be supported by such conditions. 

To a certain degree, this has been borne out in the market, as the trade weighted currency has held up considerably better than the EUR/USD exchange rate - that offered up a fire sale, ignited by the juxtaposition of misguided rate hike expectations in the US and growing uncertainty towards conditions in Europe. In hindsight, the uniqueness of the currency union itself has maintained an underlying existential cohesion, when considering cross asset correlations within Europe - especially, in a world supermarket with great demand, but with far less fresh assets to choose from. Generally speaking, since the financial crisis - so goes the sentiment vane in Europe... so goes European yields, equities and the euro.
This thesis trade in Europe has magnified since the financial crisis, with different fires breaking out in every year but one. It comes with more than a bit of irony and testament to the inherent design flaws of the union, that most economists chosen antidote for Europe - a weaker euro, has only been realized in market conditions with the greatest uncertainty towards its actual survival. In the past, when the markets were finally reassured by Draghi that he would enlist whatever-it-takes to maintain the union, bond yields and the euro sharply recovered - as well as their respective equity markets. Over the past several months, the markets have reflected great skepticism of the ECB initiatives and growing concerns with the politics both inside the ECB itself and the different member countries of varying governing and economic travails. 

Coming into this year, we expected the heat to be turned up in Europe - and our equity proxy in Spain to continue wilting towards the much anticipated January 22nd ECB meeting, where Draghi may announce a large-scale quantitative easing program. For the most part, the equity markets have traveled down that path, which may present possible tactical shifts in the coming days and weeks as global markets react to what the ECB may or may not bring to the table next Thursday - as Draghi attempts to avoid what Krugman was concerned with in a preceding iteration many years before. 
"The clear and present danger is, instead, that Europe will turn Japanese: that it will slip inexorably into deflation, that by the time the central bankers finally decide to loosen up it will be too late." - Paul Krugman - The euro: beware of what you wish for - Fortune 1998

While the equity fronts in Europe and the U.S. prove less compelling along intermediate and long-term timeframes, respectively - actions by the ECB could provide a catalyst to lift yields globally - as well as the euro, which we suspect would be buttressed as it has in the past with major ECB initiatives. We say tactically, because from a long-term perspective, we still have our doubts that whenever whatever-it-takes is unveiled by the ECB, it can effectively address the structural design flaws that have continued to plague the currency union or the narrowing political realities that many countries now face. Nevertheless, we do see the plausibility that these actions could surprise and elicit a countertrend move in the bond market and continue to see constructive developments in the leading edge of such a reflationary trade; namely, in gold and silver.

Our long running comparative profiles for 10-year yields have been filling out the proportion of the patterns over the past three weeks. All things considered, we believe the lion share of the move lower in long-term yields this year is being completed, assuming Draghi steps up to the podium next week with significant action. 

TIPS look attractive on an intermediate horizon relative to nominal Treasuries, with the more aggressive reflationary trade still found in silver then gold. Similar to the commencement of QE in the U.S., gold and silver are leading the prospective pivot, with the silver:gold ratio turning up after completing a retracement commensurate with the Nasdaq:SPX ratio, circa 2000 - that we incorporated as a signature of upside exhaustion way back in April 2011

Although oil extended its decline last week beyond the 98/99' comparative reversal, we still like the prospects of the commodity itself this year, which by most extreme measures has filled out the proportions of the retracement. 

Tuesday, January 6, 2015

Why Gold May Finally Be Turning Higher

We came into last year with the idea that despite a historically low disposition at 3 percent, the 10-year yield had become stretched at a relative performance extreme. In less than two years, yields had run up over 100% above the July 2012 cycle lows around 1.4 percent. Even in context of previous rate tightening cycles, such as the one in 1994 that had caught the market offsides - the move was massive. When expressed on a logarithmic scale, the less than two year rip was the most extreme in over fifty years. 

Click to enlarge images
Not surprisingly, when viewed in this light, our expectations going into last year were for 10-year yields to retrace a significant portion of the move; hence, strategically we favored long-term Treasuries relative to U.S equities, which by most conventional metrics as well as our own variant methods - were also extended. To guide the arc of those expectations, we referenced throughout the year the complete retracement profile of the 1994/1995 rate tightening cycle - as well as an inverse reflection of the secular peak in yields from 1981 that momentum was loosely replicating on the backside of the cycle. 

With a year of daylight between that extreme, yields are still following both retracement profiles - with 10-year yields just today feathering the panic lows from last October. While respective retracements in both Treasuries and equities may manifest over the short-term, strategically speaking, we continue to favor Treasuries - considering that the U.S. equity markets remained relatively buoyant last year. 
What has been more difficult to handicap is the large differential in performance between durations in the Treasury market, with shorter durations greatly supported by expectations that a more conventional tightening cycle would eventually transpire, as well as the influence of ZIRP - which has muddled the waters from a comparative perspective. Over the past few months we have noted the significant spread in performance between 5 and 10 year yields, as a literal expectation gap in the market has continued to grow. 
Generally speaking, this market mentality also maintained pressure on assets such as precious metals and emerging markets throughout last year, as traders waited for a second shoe to drop with further tightening delineated by the Fed. Our general take has been that the lion share of tightening - both through the posture and then completion of the taper, has already been completed. From our perspective, pivoting on a policy that actively and passively supported the markets to the tune of over 4 Trillion in net assets purchased, is the closest thing you will find to materially "tightening" at this point in the cycle. Actions and expectations are all relative, which is easily lost in this market - especially with the Fed at ZIRP for over six years. We fleshed some of these thoughts out in The World According to ZIRP last October. If and when the Fed eventually gets a window to cut the ribbon and take us off ZIRP, the move will likely be exceedingly modest and ceremonial at best. That said, we continue to be far less confident that even a modest rate hike arrives sooner rather than later and still expect that the equity markets will continue to normalize with current policy (i.e. QE free) - which for better or worst will broadly influence expectations of future policy. 

Needless to say, market conditions are anything but conventional these days, although we do believe that gold - a leading market, has made its peace with policy first as well as digested the overshot from misguided inflation expectations that slammed shut in 2011. Over the past year we've posted a version of the chart below that showed gold relative to 10-year yields was at a level commensurate with significant lows in the past. And while 10-year yields played the part last year, the large expectation gap - that is captured below in red in the shorter end of the Treasury market, held gold in place - until now. Gold appears to be finally breaking out of its broad base as the extreme correlation drop between durations that began with the taper in December 2013 exhausts. As we pointed out last year, this same dynamic - to a lesser degree, manifested with the previous tightening cycle that began in June 2004. Once the policy shift was digested, gold broke out of its much smaller consolidation range and correlations were reestablished in the Treasury market. 
Interestingly, the two other occasions where the Treasury market dropped out of tune with respect to durations and gold was during the 1970's bull market, where the dynamic with the Fed was the polar opposite of how it reacts with policy shifts today - as well as in the Treasury market. Back then, when the Fed raised rates - gold rallied. When the Fed eased - gold corrected.  As such, gold trended with the relative performance between 5 and 10-year yields. 

That said, we continue to see the closest parallel with a broader cycle continuation period - such as the mid-cycle retracement in the 1970's, that shook the tree strongly before another set of branches completed the larger move. While the saplings in this cycle have taken their sweet time to germinate over the past year, we like the long-term prospects for the sector - especially relative to the U.S. equity markets. 

Tuesday, December 30, 2014

Fill'er Up

The powerful disinflationary trend that has broadly benefitted equities at the expense of commodities - and which was set in motion in early Q2 2011 with a major low in the U.S. dollar, has been expressing in various iterations the tell-tale signs of a major blow-off move in the back half of this year. 

What started off in silver and gold - and which we believe exhausted first in the precious metals sector; then bled into the oil market - where the move has overshot most downside expectations. As we described in our note from two weeks back (see Here), oil was capitulating in a similar fashion to the low that was completed at the end of 1998 - that became the blowoff peak of the disinflationary trend between equities and oil. We believe a comparable reversal could manifest heading into next year, and similar to our affinity with precious metals - we very much like oil here. 

Monday, December 22, 2014

Taking off in the Rain

The famous and infamous Joe Granville once duly observed, "Remember, if it's obvious to the public - it's obviously wrong." Just a few years later - and with more than a tinge of irony, he failed to recognize his own wisdom as the U.S. equity markets quietly filled their tanks on the tarmac of one of the greatest bull markets in history. 

*  *  *
It was the summer of 1982 and the U.S. was still reeling from the harsh tonic prescribed by the then disdained - but tenacious, Fed Chairman of a one, Paul A. Volcker. With the US economy falling into a recession in the summer of 1981 and with 10-year Treasury yields still hovering over 13%, investors relative optimism towards the economy and financial markets resonated deep concerns over the possible direction of interest rates and the fledgling recovery. It was stormy at Wall Street and Main - and the sun hadn't been seen in weeks.  

Vartanig G. Vartan, a New York Times business reporter at the time, gathered the following comments from investors on August 6 and 7, 1982. 
-  "One big worry of money managers revolves around the economic recovery,' said Robert Grossman of Cantor, Fitzgerald & Company, an investment banking firm. 'In 16 years in this business, I've never seen so many people holding onto cash." 
-  "I detect increasing pessimism among people who are normally optimistic,' stated Theodore H. Halligan, an institutional salesman with Piper, Jaffray & Hopwood Inc. 'What are they worried about? The budget deficit, a lack of conviction that interest rates will stay down, a possible new crisis in the banking system. Now there is an added stress. The corporate investment committees that hire money managers are putting pressure on them to perform. Jobs are no longer safe. So we're seeing more funds being switched out of stocks and into bonds."
-  "Today's drop in the Dow confirms that we're in a bear market,' said Edward P. Nicoski, technical analyst for Piper, Jaffray & Hopwood Inc. in Minneapolis, 'and it looks like we're going lower."
The following session, the equity markets 
made an intraday generational lowEmbodying the prevailing sentiment, the most powerful pundit of the times told investors on August 16, 1982, that the recent move higher was a "folly" and "bull trap" and that "rising stock prices were like balloons that were about to burst". Unbeknownst to Joe Granville, the only balloon bursting that day was his larger than life reputation - as he remained mostly offsides or bearish for the better part of the next two decades.

*  *  *
Under the onus of introducing and carrying out another round of anticipated reforms, Xi Jinping assumed the presidency in China in March 2013. At the time, many analysts and economists viewed the situation in China as particularly grim - considering its legacy of robust growth over the past three decades that were driven by enormous investment within China and which appeared to be loosing momentum at a rapid rate. The catch phrase of the moment, an economic rebalancing, became synonymous with a great reckoning - with the implied understanding that China could be headed for a crash with considerable unknown consequence. As Paul Krugman bluntly proposed that summer, "...the only question now is just how bad the crash will be.   

In our opinion, what the popular perspective failed to grasp was that the reforms were not about economics per se, but primarily driven by rooting out corruption that had infiltrated all levels of government - and which was a prerequisite to ensuring and maximizing future growth as the economy transitioned to a more mature footing. In essence, where the Chinese saw opportunity - the west feared economic instability. 

Back in January, as concerns over the Chinese banking system were brought to focus after the Industrial & Commercial Bank of China refused to compensate investors in a troubled trust, we drew up a weak cartoon (see Here) that depicted what we believed was an overreaction by the west that played on these fears and cognitive biases. Although we won't dispute that future growth in China will likely be considerably less robust than what it was over the past three decades - or that investment excesses weren't evident; we do believe the binary implications inferred with the economic rebalancing hypothesis are misplaced and or exaggerated. Cynics will undoubtedly think otherwise, but while the prescriptions for their afflicted economies are quite different, the tough love provided by Volcker in 1981 and 1982 is similar to the anti-corruption campaign by Xi Jinping over the past two years. Both strangled the market for a spell and set the stage for the next phase in their respective economies.

Since the summer of 2013 (see Here), we have looked back at the summer of 1982 in the U.S. as a possible contrarian template of what might transpire in Chinese markets over the next few years. And while the comparative liftoff was delayed as President Xi Jinping chose to govern rather than stimulate over the past year, we believe the impression of the pattern holds true when considering the future prospects of China and their equity markets. Like the S&P 500 that exploded 40% in the back half of 1982, the Shanghai Composite is up over 46% this year - with nearly the entire rally manifesting since July. 
Considering the size of the breakout that developed over a very short timeframe, it's not surprising that the index suffered on December 9th its largest loss since 2009. Moreover, it wouldn't surprise us to see greater volatility and similar churn develop over the next few weeks as the market further digests and consolidates the move. 
As always, Stay Frosty - and we wish you and your family a wonderful holiday season and a healthy and peaceful New Year. 

- Photo courtesy of Pedro Moura Pinheiro