Thursday, November 9, 2017

Into the Great Wide Open

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

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

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

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

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

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

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

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

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

Thursday, October 12, 2017

Danger! Synchronized Swimming

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

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

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

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

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

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

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

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

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

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

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

Tuesday, September 19, 2017

What Happens When Inflation Walks In?

If you watch and participate in markets long enough – and no, we’re not talking about, “On a long enough timeline…” – you’ll appreciate or get bitten (as we certainly have from time to time) by the sardonic irony that often becomes exposed by a market’s cycle. Consider Mohamed El-Erian’s “New Normal” market strategy that aimed at the start of this decade to capture the anticipated outperformance of emerging over developed markets. Bear in mind that the phrase has stuck around since then, despite the fact that it was largely a narrative for a poor investment strategy.

What happened? El-Erian and Gross were prescient in inventing the term “new normal” to describe a very slow-growing global economy with heightened risks of recession, as befell much of Europe. But they were dead wrong in predicting that emerging markets would provide outsize stock returns, and they were wildly off base in their notion that developed-market stock returns would be deeply depressed. Emerging market stocks have stumbled since 2011, and emerging market bonds have lost ground this year. Meanwhile, developed-world stock markets have soared. The fund’s use of options and other techniques to hedge against “tail risk”—which essentially means insuring against extremely bad markets—has also surely cost the fund a little in performance. – Kiplinger, November 14, 2013

Not to overly pick on El-Erian here, who is typically a very thoughtful and creative macro thinker – not to mention many of his new normal predictions did prove prescient, with the very large exception of rising inflation that would have likely driven a successful investment strategy – not just a convenient catch phrase… but, ironically, it appears his timing earlier this year of calling for an end of the new normal, as selectively revisionist as they paint it, might provide a fitting bookend to the market’s wry sense of humor.

Eight years later – and instead of just getting slow growth right in a developed economy like the US, as he initially suggested in May 2009, his other two major tenets of rising inflation and rising unemployment might eventually be realized domestically in the economy’s next chapter. In fact, from our perspective it seems more likely than not.

In theory, markets should be easier to game. They’re expressed in broad sweeping moves with pronounced peaks and valleys that on paper – and in hindsight, present clear transitional signals. Buy here, sell there – what’s the big deal? The problem, however, is that timing the transitions, which are driven by inherent human behaviors, prove exceptionally challenging, especially over the short to intermediate-term and when the largest central banks are intervening in the markets on a massive global scale.

For as long as markets have functioned broadly, participants have attempted to place a quantitative framework around and over them to better understand, describe and hopefully exploit their machinations. And while it does provide some context, ultimately, they’re still driven by behavioral incentive that might best be described as non-linear and reflexive across shorter timeframes that more or less eventually conform with general equilibrium theory. The paradox is holding both the quantitative and qualitative schools of reason in mind and existing in a space seemingly governed by both free will and determinism. That said, if we weren’t wired this way, capitalism wouldn’t function as a one-way street for long (e.g. see communism). Icarus eventually flies too close to the sun, and in this alternate parable, Godot – i.e. inflation – surprises everyone and shows up.

As we alluded to in our note last month (see Here), it was a good bet that the inflation data was due to turn up again, as US dollar strength (on a year-over-year performance basis) had run its course in May. We’ve pointed out over the years that the YOY performance of the dollar has led the inflation data and we’ve closely followed the rollover in real yields (here the 10-year less CPI) since 2015, as it has positively correlated with the YOY performance of the dollar. Last week’s CPI data confirmed the expected turn, with headline CPI coming in at 1.9 percent YOY, modestly higher than the median forecast of 1.8 percent YOY for August.

So where does that leaves us going forward? Extrapolating the downtrend and YOY performance in the dollar this year, the inflation data should continue to firm in September. Moreover, the very broad 3-year top in the US dollar index has recently broken down below long-term support, which we’ve approached as a major fulcrum for the next legs in inflation (we believe higher) and real yields (lower).
Looking back at history and distilling the last time real yields had rolled over within a negative band (mid 1970’s and mid 1940’s), a pulse of inflation eventually outstrips growth, leading to a sharp spike lower in real yields. From our perspective, it is the dollar’s relative historic extreme today and the Fed’s relative constraint with raising rates that presents the largest catalyst for a continued decline in real yields. While there are some similarities with the 1970’s through the prism of real yields, there’s still greater overlap – in our opinion, with the 1940’s when the Fed and Treasury were last involved in a large-scale asset purchase program and yields were troughing within the secular long-term cycle.

Although the equity markets here in the US have continued to defy gravity, we suspect similar to the completion of the cyclical bull market of the mid 1940’s, its fate will be sealed when realized inflation surprises to the upside and greater uncertainty prevails with future Fed policy. Considering the recent breakdown in the dollar, Godot could show up this fall. That said, we believe the mid-to-late 1940’s still offer some behavioral perspective with the markets today, as investors – despite quickly shunning equities, did not broadly sell Treasuries in fear of inflation.
As mentioned in previous notes, in Milton Friedman and Anna Schwartz's - A Monetary History of the United States, the market climate in the 1940's was described as being so suspect of the Fed and Treasury's visible hand, that even after a 150 percent rally in the equity markets that began in 1942 - went through a recession in 1945 and exhausted around Memorial Day in 1946, participants by and large didn't trust the market or expect inflation to rise as precipitously as it did from the trough going into 1947 and 1948.

"Despite the extent to which the public and government officials were exercised about inflation, the public acted from 1946 to 1948 as if it expected deflation."  

"… An important piece of evidence in support of this view is the harbinger of yields on common stocks by comparison with bond yields. A shift in widely-held expectations toward a belief that prices are destined to rise more rapidly will tend to produce a jail in stock yields relative to bond yields because of the hedge which stocks provide against inflation. That was precisely what happened from 1950 to 1951 and again from 1955 to 1957. A shift in widely-held expectations toward a belief that prices are destined to fall instead of rise or to fall more sharply will tend to have the opposite effect - which is precisely what happened from 1946 to 1948." - Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1963

Consequently, we continue to like the long-term prospects for gold, as it has displayed a strong inverse correlation with real yields and should also benefit from the prospective safe-haven demand generated by the eventual cyclical decline in equities. All things considered, when Godot walks in – you best be wearing some. 

Friday, September 1, 2017

Macro Winds Fill Gold's Sails

While the perennial skeptics popped their heads out earlier in the week to again profess their disbelief in gold’s performance, supportive macro conditions behind the nascent and discreet bull market in precious metals continue to advance.

*Click to enlarge images

Namely, the linchpin of future inflationary pressures – the US dollar – remains heavy just below long-term support, while longer-term yields also flirt with an interim breakdown of their own below the lows from late June. Should longer-term yields continue to follow the dollar's lead, the downside range extending from the post-election breakout in November will likely be retraced. The net effect downstream will be that real yields should continue to decline, providing more favorable market conditions for non-yielding hard assets like gold to outperform.

Although contempt for gold still remains with a deep scar from the long cyclical bear market in the face of what was perceived by many as exceedingly beneficial market conditions – i.e. massive QE (a few of our takes back then  see Here, Here, Here & Here), the precious metals sector has outperformed the S&P 500 since their respective cycle lows in late Q4 2015.

Since setting another retracement low in early July, precious metals have strongly outperformed as the US dollar index made its way back down to the lows from last year. With the dollar index breaking through those lows on Monday, gold took notice and broke above its yearly range and beyond $1300/oz.
Squawking with the gold grizzlies this week have also been the downtrodden and dogmatic dollar bulls, which found fresh inspiration by the daily reversal below long-term support in the US dollar index on Tuesday. While sentiment did appear to reach a negative extreme heading into the week, that pressure valve has now been released with the dollar index still flirting below long-term support at 93.

Although technically an upside reversal again above long-term support could shift the tea-leaves in favor of a more sustained dollar rally, as we described in our previous note (see Here), the pronounced negative momentum structure in the dollar lends favor – in our opinion, that a continuation lower below long-term support will unfold.

Taking a closer (60 minute) look at our dollar/gold comparative that contrasts the current dollar move with the breakdown in gold from the flip side of the inflation cycle in April 2013, gold did initially break below long-term (weekly) support, before briefly snapping back above and setting another large bull-trap across a few sessions. If our memory serves us right (see Here), the move caught both dogmatic gold bulls and opportunistic counter-trend traders off guard right before the floor fell out. Food for thought.
Rounding out our comparative reasoning is through the lens of the cyclical turn in the dollar in 2002, which as we alluded to in our most recent note, exhibited a positive correlation extreme with long-term yields as well. Although we are less inclined to be on the lookout for new cycle lows in the 10-year yield this year, the post-election breakout range looks ripe for retracement. All things considered, the backdrop for fresh cycle highs in gold this month looks very encouraging. 

* As a postscript reminder to ourselves - remarks composed with this degree of hubris often age poorly. 

Thursday, August 24, 2017

Connecting the Dots - 8/24/17

With traders setting their sights and ears to what Fed Chairwoman Yellen and ECB President Draghi might say or exclude in their respective Jackson Hole speeches tomorrow, the US dollar index – primarily influenced by the exchange rate of the world’s two largest reserve currencies – has made its way back down to long-term support after consolidating the steep move lower that began at the start of the year. 

As the July inflation data was largely uneventful, another window has opened over the next few weeks to break the respective ranges in gold (up) and the dollar (down). Over the near-term we wouldn’t be surprised if the markets took a slightly more hawkish tone subsequent to Yellen and Draghi’s speeches tomorrow, if only because the palpable dovish leanings going in may not be further nurtured. At the end of the day, Yellen knows it’s easier to walk back policy expectations than to ratchet them up. In the absence of new data or an exogenous influence, we would speculate the symposium is largely a non-event, where a relatively tighter ECB is counterbalanced by a less hawkish Fed. 

That said, the elephant(s) in the room remains the contentious relationship between the President and his own party, as the very real threat of a government shut-down and debt default greatly threatens the last remaining prize of the President's legislative agenda this year: an overhaul of the nations tax system. Naturally, as the legislative deadline approaches this fall these tensions should come to a head.

*Click to enlarge images*

Generally speaking, from a basic technical perspective the downtrend in the US dollar index this year has been defined by characteristic “lower lows” and “lower highs”, typical of a significant momentum unwind with diminishing relative strength imprints as the move unfurls. Overall, we expect the pattern to continue as underlying long-term support is eventually breached, which should register positive relative strength divergences before a more tradable low is reached. 

Among the few touchstones we’ve benchmarked against this year to estimate the dollar’s prospective trend, we’ve contrasted the breakdown in gold in 2013, which also displayed a diminishing momentum signature as it broke underlying support from its broad top range. Notwithstanding our appreciation of the inverse symmetry to the cycle today – in which gold has been rejuvenated as the dollar weakens, the technical similarities have remained prescient for the dollar index as well.
Since utilizing at the start of the year our intermarket leading comparative with long-term Treasuries that accurately pointed towards where the dollar would loose trend line support in April (see Here), we have also contrasted with the cyclical pivot in the dollar in 2002 for more long-term projections  as well as a prospective road map for long-term yields, the euro and gold. 

Our interpretation at the end of Q1 (see Here) was that the dollar was set to follow Treasuries breakdown lead with the last lagged pivot (~5-6 months) of the cycle, which should mark a pattern break (between LT Treasuries and the USDX) as the dollar turns cyclically lower without a corresponding leading move in Treasuries. In hindsight, those expectations appear well founded to-date, as the dollar and long-term yields have behaved quite similar to their respective breakdowns in 2002, where long-term yields reached a positive correlation extreme with the dollar and turned down again with the dollar's cyclical pivot.

From a big-picture cyclical perspective, we’ve pointed out in the past that the dollar has followed major upside exhaustion extremes in long-term yields by 2 to 3 years. The 9/81’ secular high in yields was followed by a secular high in the US dollar index in 2/85’ (monthly). The upside exhaustion in yields in 1/00’ was followed by the cyclical high in the dollar index in 1/02’.

Structurally speaking, the pattern in yields has been to test the previous interim low after the exhaustion high, followed by a sharp secondary move that is rejected below the previous extreme. 

Today, the 10-year yield has worked through the secondary pivot below the previous exhaustion extreme of ~3 percent in 12/13’. Our expectation remains that the US dollar index is following again the long cyclical intermarket lag (3yrs) in yields, which points towards a continuation move lower for the dollar over the next several years.

Similar to how the US dollar index led the subsequent breakdown in yields in the back half of 2002, a fresh break of long-term support in the dollar could bring a retest of long-term yields lows from last summer.