Thursday, June 16, 2016

Starring Down the Long Dark Tunnel

Like an oak slowly growing in a stand of pines, the outgrowth of sentiment extremes become visible through major market inflection points. The irony, however, is seeing them. This is because on both sides of a market cycle there is a natural tendency for conditions otherwise thought abnormal to become commonplace. As much as we try to anchor our baseline expectations with history, inevitably, paradigm creep sets in as markets and sentiment slowly become stretched beyond more rational assumptions. 

They couldn’t see the trees for the forest – until the forest caught fire.

In the late 1990’s as venture capital was seeding manic entrepreneurs with otherwise outrageous business plans, perspective was forsaken for the chance to become the next internet giant. A short time down that road, the pursuit of Amazon quickly gave way to the likes of Clickmango, your one-stop shop for all of your succulent produce desires and – well, for your many recreation flotation demands…

Fast-forward a decade later and the opposite side of the continuum, the raging fires of the financial crisis warped investors expectations into believing that a steady state of chaos would erode markets for the foreseeable future. So powerful were these kinetic events that the same anxieties still haunt participants today, even as economic conditions here in the US and abroad have little resemblance to that time and their unfounded fears over the past seven years have largely remained unrealized.

We’ve come along way when it comes to market expectations of historically low yields.  Before the financial crisis hit in 2008, the lower range for the 10-year Treasury yield was around 150 bps below at just above 3 percent. When it plunged to around 2 percent in the bowels of the financial crisis, the thought of an even deeper slide below that threshold was inconceivable – even as the threat of deflation was at its height. In fact, at that time conventional wisdom believed inflation was the next risk for the economy and markets as the Fed led the world and began applying extraordinary monetary accommodations to bridge the gap across the crisis.

Simply put, on both sides of the continuum, our collective behavior is often realized in the markets with a latent reflexive chase down a dark tunnel with an oncoming train. Today, we’d argue that participants gamble down the tunnel has been darkened by the now universally accepted exceptionally low yield market environment and that the train approaching is inflation. In this analogy, the sentiment extreme that has brought nearly half of the global government bond market to negative yields is an inverse equivalent of the speculative mania during the dotcom era that ushered in companies like Clickmango and – right before the bubble burst in 2000. One period was propelled with exuberance and the other by fear. Another distinction is that the immediate risk in the market is largely institutionally (both public – central banks & private – pensions, insurance companies and banks) held today, whereas, in 2000 retail investors became the bag holders of last resort.

With a reasonable chance that core CPI in the US will make a push above 2.5 percent later this year, who in sound mind would expect even a positive intermediate return on Treasuries, no less a longer duration note like the 10-year. But alas, the relative attraction to Treasuries here in the US where the 10-year still yields around 160 bps above German bunds is enough for most "conservative" investors. Just keep in mind that the US introduced the deflationary threat by igniting the fires in housing and is leading the way out – as the inflation data continues to suggest. As always, Fed policy has lagged on both sides of the cycle, but the notion that bonds remain attractive today because of disinflation and deflationary conditions/concerns is as reasonable as shorting them was directly in the wake of the financial crisis with fears of hyperinflation.

The reality is it's been a “Costanza” market since that time and we see no reason to believe conventional wisdom will get it right today.

George: “My life is the complete opposite of everything I want it to be. Every instinct I have in every aspect of life, be it something to wear, something to eat… It’s often wrong.”
Jerry:  ”If every instinct you have is wrong, then the opposite would have to be right.” 
                                                              - Seinfeld, "The Opposite" (1994) 

Do we expect a return to "normal" where the 10-year yields over 4 percent or the fed funds rate is materially above 2 percent? No. Expectations were pushed too high over the past two years and as seen yesterday with the Fed’s new dot-plot projections for June, have continued to drift lower as expected. Moreover – and as shown below with our comparative profile of the last time yields fell into the long-term cycle trough in the 1930’s and 1940’s, they still have a ways to go in aligning expectations with reality. 
The twist, however, is long-term yields have now been pushed to the bottom of the range by the latent reflexive move. Our best guess  and an opinion we have held since the end of 2013, is that the 10-year yield will remain range bound between 1.5 and 3 percent for the foreseeable future, as markets and economies work across the transitional divide to the next major secular growth cycle. 

With precious metals continuing to lead the move higher in the commodity sector this year and with the US dollar poised to fall further (see Here), the inflation vane continues to points higher – despite the Costanza concerns with disinflation and deflation today. All things considered (see Here), we would conservatively speculate that the 10-year yield will snap back to the return profile of the long-term cycle around 2.25 percent.     



The British are coming! The British are coming! The British are coming!

With the Brexit vote on tap for next Thursday, we see a resolution for the markets heightened anxieties and not a revolution to leave the EU. Over the past few weeks, concerns have snowballed that Britain will choose to leave. Our best guesstimate is they're widely off the mark, and expect a strong snap-back reaction to develop in the markets next week. Broad brush, over the short-term this would likely be bullish for equities and bearish for bonds and gold.

Taking a speculative swing with potentially longer-term opportunities, we cautiously like the prospects for higher beta equity markets over the short-term, such as Spain's IBEX. Moreover, our momentum comparative that we've followed over the past three years for the IBEX points towards an interim low, with the possibility that its cyclical decline has run its course. With the euro finding a foothold in today's session, we like the iShares MSCI Spain ETF - EWP, that would also benefit from a stronger euro. For potential longer-term investors, the ETF pays a hefty 4.25 percent dividend.  

The US dollar index, which we had expected to retrace lower coming into June, continues to flirt with the bottom of the range (~93) of the broad top it has traded in over the past two years. Should the vote in Britain fail next week, we'd expect the euro to find strength and the US dollar index to weaken. Our dollar index comparative from 2009 also points towards further weakness and a breakdown below support of its broad top. 
Although gold may have reached another interim high this week, we are still long-term bulls on both gold and silver and point towards further weakness in the dollar in tempering their potential retracement declines. Moreover, the silver-gold ratio's rare positive momentum cross remains broadly bullish towards the reflationary trend that gold had led initially this past December. Should the trend in inflation step higher through the end of the year, we expect silver will continue to outperform.

Thursday, June 2, 2016

The Long & Short of it...

Long-term Treasuries are throwing caution to the wind this week - or more appropriately, seeding caution to the wind, with strong follow-up strength into tomorrow morning's US jobs report. And as much as anticipating a short-term prospective catalyst is a murky Game of Unknowns endeavor to trade on, we still like the risk profile over the intermediate-term from the short side of long-term Treasuries.

As outlined in a note a few weeks back (see Here), long-term Treasuries have been trading in a broad descending range from their February highs that in the past has presaged a subsequent trend shift lower. Coupled with our historical study of how a similar disinflationary market environment exhausted and reversed course, the jobs report appears near a coincident comparative pivot. 

From our perspective, a short in long-term Treasuries (30 Year or iShares 20+ Year Treasury ETF - TLT) is asymmetrically defined by the upside risk (<2%) above the previous highs this February and a prospective breakdown below support extending from the lows from late December 2013. While we don't trade futures, we do like the ProShares UltraShort 20+ Year Treasury ETF - TBT, that is again revisiting levels around $35.60.

Wednesday, May 25, 2016

All Dressed Up with Nowhere to Go

In difficult times, fashion is always outrageous 
Elsa Shiaparelli

Trenched for severe weather, we’ve all donned the thick wooly coat at times. Oversized and tailored for the apocalypse, bear fur goes on easy – it’s taking it off that’s the hard part. With more than seven years of daylight from the throes of the financial crisis, past traumas still haunt perceptions, through scars both phantom and felt.
“The economy will surely be swept away by a tidal wave of corporate default” Albert Edwards 
Fool me once shame on you, fool me three times, well – that’s a trend.  Despite the incessant clarion calls from the deflationist’s camp that the waters are once again lapping at the levees, we see a more pragmatic outcome developing, one that turns the capital tide from our shores to theirs, on the back of a weaker US dollar and rising inflation expectations. “Theirs” – referring to those economies hardest hit over the past several years as the dollar became motivated by the apparent policy differential as the Fed slowly crept towards normalizing policy from their then leading crisis stance during the financial crisis. And while the hand wringing of a strong dollar has begun in earnest again as the Fed postures their next move, we continue to believe that the buck’s ship has sailed and is running downwind from its cycle high last year.

Jesting aside, these remain difficult times to navigate for investors and we understand why many believe that the table is set for another global crisis. Should the US dollar rekindle lasting momentum to the upside, we just might agree. But what we speculate they miss is the silver lining in greater market disequilibriums across the world in the wake of the financial crisis, that should help buttress growth and inflation expectations going forward as the US dollar comes off a cyclical high. While global growth certainly won’t benefit as robustly from the harmonic expansions of yesteryear, the collective capacity to turn down is mitigated as well, as we trudge across the transitional divide (see Here) to the next secular growth cycle. 

Whereas, in 2007 most of the largest developed and emergent economies where all cresting at the same time (i.e. constructive interference), today there’s much greater dispersion in growth tracks between developed and emerging markets, in part, because of the policy differentials set in motion during and after the financial crisis.

Whether it was cyclical happenstance or by design, these differentials have naturally affected economies primarily through the currency markets, with the US dollar exerting the greatest influence over the past two years, as the Fed gradually removed their extraordinary policy accommodations introduced and emulated during and after the financial crisis. As the dust settled, the net effect from this atypical and drawn-out process manifested with significant positioning and newfound strength in the dollar, arguably as extreme as the US Dollar Index exhibited at its secular peak in 1985. And while the deflationists have viewed dollar strength as the natural consequence of our collective and impending debt-ageddon, we view things more pragmatically as these market disequilibriums will invariably trend with greater cyclical frequency, as central banks modulate policy from extraordinary postures in the trough of the long-term yield cycle. 

From our point of view, the biggest secular trend these days is the drawn-out structure of the long-term yield and growth troughs, that will likely continue to try both investors and pundits patience and play-books when contrasted with the past several decades of economic growth and corresponding market performance. That said, we find the phrase "secular stagnation" a bit misleading, as it infers a more negative tilt towards future expectations, rather than the reality of where the US and global economy sit in the long-term growth cycle. Semantically speaking, we prefer "transitional divide", as it reflects the matured state of the economy  a natural condition, rather than a more pernicious economic malaise that many associate with secular stagnation. 

Essentially, stagnation is in the eyes of the beholder – considering the greatest threat to the global economy came during the financial crisis when the composite contraction was magnified significantly by the alignment of our respective economic cycles. Since then, shorter-term reflationary and disinflationary subcycles have waxed and waned  but overall, the broader deflationary threat to the global economy has receded since the height of the financial crisis. And while the most recent disinflationary cycle mimicked market conditions representative of deflation (i.e. declining prices/stronger dollar), we primarily view this as a currency effect manifested from the Fed's leading role in normalizing policy, which pushed the dollar and positioning to a relative performance extreme last year. As such – and assuming that the US dollar has crested, we continue to look to fade latent disinflationary conditions in the market, as we expect the pendulum will build on the reflationary trend already established this year.


Despite recent strength in the dollar that was largely anticipated this month (see Here), we expect the buy the hype (the taper) and sell the news (rate hike) reaction to win out, even as the Fed looks to another modest rate hike this summer. All things considered, while the thought of a rate hike might impression the dollar over the short-term, we find the wider macro view still broadly bearish over the long-term.
Notwithstanding the relative structural symmetry leading into the yield trough, comparatively speaking, the dollar's move from Q2 2014 exhibited the performance extreme that in the past (1985 and 2009) marked exhaustion reversals.
Although much broader in timeframe today, using the dollar index's reversal profile from 2009 as our guide, the current retracement bounce developed along similar lines.  
Following the fractures in the dollar this year, long-term Treasuries continue to trade in a broad topping structure, that may point towards a significant breakdown over the coming weeks (see Here). 
Despite some that believe a modest rate hike would elicit another move higher in the dollar, we suspect the opposite will unfold as the deflationary cookbook that saw bonds, commodities and currencies reach relative performance extremes  completes the broad reversal that began last year.  
Not surprisingly, gold, which had led the broader reflationary trend since the initial rate hike last December, has retraced the entire move from earlier this month. Should the dollar begin to weaken again, we suspect that similar to the resumption of the uptrend in July 2009, gold will find support around current levels. Over the past several weeks, the inverse correlation between gold and the US dollar has begun to tighten again, which we expect will be bullish for gold and commodities in general. 

Thursday, May 12, 2016

The Next Market to Break Might Not be Stocks

After watching some markets develop over the past week, we thought it warranted a few thoughts on a possible outlier outcome in Treasuries over the next several weeks.

Since Treasuries made their respective highs in mid February, we held an intermediate-term outlook that yields could drift higher through the spring, before exogenous market pressures again arose pushing participants back into the safe haven shores of long-term Treasuries. Overall, yields have drifted above their respective lows from February, albeit modestly, and in a flagging and diminishing range from the highs in early March.

Figure 1
While the backdrop for long-term Treasuries has largely remained a benevolent place for investors this year, the markets have again traded in a descending range from their February highs, which in the past has presaged a subsequent trend shift lower. Taken in context with the broad range that long-term Treasuries have remained in since their momentum highs back in January 2015, a potential break below support extending from their late December 2013 lows – could accelerate downside pressures and markedly extend our outlook for a rising yield environment beyond Q2.  

Considering fund flows this year that have overwhelmingly remained out of equities and into bonds (see Here), a major breakdown in Treasuries could result in another rotation back into equities. That said, at this point in the cycle we're more comfortable speculating on the short-side of Treasuries here, rather than a derivative bet on this potential outcome.

Figure 2
One historical period that we have been following for possible insights is the market environment headed into the spring of 1987, where investors had pushed long-term Treasuries significantly higher over the previous two years on the back of a sluggish global economy and a collapse in oil prices. It wasn’t until the global economy stabilized and oil prices began moving higher that the Fed began to raise rates in April 1987. This shift, following several years of disinflationary market conditions that had greatly buttressed the trend in Treasuries – came to an abrupt end that spring. Headed into October, the price on the 30-year Treasury bond had fallen by over 20 percent.

Although we would never hold a position with commensurate expectations to an outlier outcome such as the bond crash in 1987, the levels of pessimism prevalent today regarding the state of the US and global economy could provide ample contrarian tinder should they largely go unfounded. Despite panning the prospects for equities here in the US and belief that monetary policy helped inflate stock valuations above their more fundamental underpinnings – we don’t buy into the deflationary thesis that sees the US and global economy sinking into another recession based on a more pernicious economic malaise.

As such  and considering the current set-up in long-term Treasuries going into Q3, we are now on the lookout for prices to test and break below support (Figure 1) extending from the late December 2013 lows. Should this occur, we'd speculate that prices could fall back to long-term trend line support extending from the 1987 crash low. In the five previous occasions that long-term bonds exhausted with a momentum extreme (as based on RSI - Figure 3), they eventually found support at this rising trend line. From our perspective, the current set-up that holds structural and momentum similarities with the broad top in bonds in 1986 and 1987, warrants taking a swing on the short-side of the field. 
Figure 3
Figure 4
Figure 5
Figure 6
Figure 7

Tuesday, May 3, 2016

Connecting the Dots - 5/3/16


After treading water through much of April, the US dollar index took another step lower last week after the BOJ declined to fire another salvo of stimulus at the markets – rocketing the yen higher by over 5 percent for the week. Taking their cue from the currency markets, hard commodities also rallied sharply to new highs for the year, with gold, silver and oil each tacking on ~ 5 percent for the week. 

Doing what they do best, markets successfully cut against the grain of the now apparent consensus expectation that the reflationary rally was due for a pause. Nonetheless, the rising tide that had lifted most boats since mid February did begin to recede, namely, in the equity markets that enjoyed a wider breadth of performance since the commodity markets found what we believe was a cyclical low.

US Dollar

While we remain steadfast long-term bears on the dollar and believe the majority of the move over the past two years will eventually get unwound, over the short-term we're more inclined to speculate the recent leg lower in the dollar index over the past week will be retraced, with the yen appearing most vulnerable to newfound dollar strength. That said, keep in mind the bigger picture headwinds working on the dollar both at home and abroad, that remain long-term bearish -in our opinion. Considering the recent move lower, we have adjusted our outlook for a more moderate retracement target in the US dollar index back to ~ 94.50.  


Since breaking below last year's low in February, the 10-year yield has bounced between ~ 2.0 and 1.7 percent. Over the intermediate-term we continue to believe that yields will drift higher, perhaps extending the range up to ~ 2.2 percent. Moreover, we see greater upside risk in European markets, with a target of ~ 0.6 percent for Germany's 10-year yield.


What's interesting to note is that despite oil's massive rally since February, it has yet to realize a move above the highs (~50/barrel WTI) from last fall. Collectively, both precious and industrial metals indexes – as well as the agricultural commodity index have all achieved this benchmark. Considering the lag from the lows in oil, it wouldn't surprise us to see the rally extend above 50 before consolidating. 

Taking their cue from dollar, gold and silver surprised to the upside last month, resolving higher from their respective consolidation ranges. Moreover, silver strongly outperformed gold, fulfilling the positive momentum signal evident in its long-term ratio since the end of last year. 

Overall, this is broadly bullish towards silver and should delineate the beginning of a new cycle for precious metals. In the past, the silver:gold ratio has led benchmarks of inflation – as evident with the lag in the Fed's preferred measure of the core PCE index. Should the relationship continue, core PCE would make a new cycle low over the coming months, which would likely alleviate pressures on the Fed to again raise rates.
Similar to the firmness in the dollar going into June 2009 that allowed another consolidation decline in precious metals, the current market may work off the shoulder trend lines that extend from last summer's highs.