Thursday, February 16, 2017

Connecting the Dots - 2/16/17

Released yesterday morning, the CPI report for January indicated that prices for goods and services rose by the most in 4 years. On a year over year basis, the consumer price index rose 2.5 percent, its biggest gain in 5 years. Although equities have so far managed to shrug off any inflationary concerns to date, the rubber appears to be getting very close to meeting the proverbial road when it comes to the negative impacts of higher realized inflation  which is difficult to square in any positive light for stocks, especially the red hot financial sector, as creditors become adversely impacted through lower real yields. 

In fact, with todays CPI data, the 10-year real yield (nominal-CPI) went negative for the first time (on a downside trend) since May 2011; with the next previous occasion in November 2007  both times not exactly prudent spots to own stocks. Although the inflation data would also appear to negatively affect the performance of Treasuries going forward, we do suspect they will find some shelter, as they have in the past when equities turn down and as the economic data softens. Moreover, as shown below juxtaposed with the year-over-year growth in payrolls, real yields have often led the broader trend in the economy, with the most recent streak of decent economic data likely serving as another high-water mark on the backside of a very mature economic expansion.
With so much attention focused on the sharp spike in yields since this past summer, our counter intuitive suspicion that real yields would still continue to fall as rising inflation outstrips the reach of nominal yields, appears to be playing out. Consequently, our sustained interest in precious metals, which exhibit a strong inverse correlation with real yields, should once again outperform. 
Although it wouldn't surprise us to see the most recent pause in gold cut deeper over the near-term as the inflation data might roil more hawkish expectations with the Fed, we view the move lower in real yields as largely symptomatic of underlying fatigue in the economy  which we don't believe will leave the Fed much capacity to tighten as markets extend through the year. As such, we expect a powerful push higher in precious metals will eventually reflect the breakdown in real yields that has largely been overlooked as equities make new highs. 

The silver:gold ratio, that we follow as a barometer of risk appetites within the precious metals sector, and which in the past has led inflationary trends, is now butting up against overhead resistance from the broader retracement decline that began last summer. While our expectations remain that silver will lead and outperform within the sector, the market may need to digest the recent gains since December before breaking through overhead resistance.

Greasing the wheels and facilitating the move lower in real yields  to what we expect will break the previous lows from 2011, is 1) the US dollar that remains stretched near a cyclical high and poised to weaken; and 2) the secular trough in nominal yields, which from our read of historic long-term cycles (most recently, Here and Here) has limited upside reach. 

Over the past two years, the US dollar index has exhibited a strengthening inverse correlation with long-term Treasuries and gold (currently -0.89 and -0.90, respectively over 20 week rolling period) and naturally a positive correlation (0.90) with the 10-year yield. In fact, the last time long-term Treasuries and the dollar expressed such a strong relationship was in Q4 2001, directly before the US dollar index turned down from a cyclical peak.

From a big-picture 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 is working 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 intermarket lag (3yrs) in yields, which points towards a cyclical move lower for the dollar over the next several years.

We have also pointed out in previous notes over the past few years that over the intermediate-term the dollar has followed the structural breaks in long-term Treasuries by several weeks. Resembling the throw-over top breakdown in long-term Treasuries last summer, the US dollar index appears to be working towards a breakdown of its own along similar folds, despite the markets attention with new highs. 

Friday, February 3, 2017

Prepared to Come About

Stemming from the virtual absence of underwhelming economic data… the cumulative weight of growing confidence – as relative as it may be, continues to list US markets towards what we suspect will become another surprise “Come about!” in investors optimistic expectations towards the US economy. How much water markets may take on – or whether it becomes a capsizing Minsky moment, is another question entirely. Considering the Trump cards that could be played along the spectrum of possible outcomes (both bullish and bearish), the gap between risk and reward for nearly every type and duration of investment strategy remains profoundly wide. That being said, we remain largely risk adverse until there's greater clarity on monetary or fiscal policy, and still favor the short side of the dollar and the more safe haven positions in precious metals and long-term Treasuries, as we suspect the long run of "not bad" to mediocre grades comes to pass. The economy is surely not failing, but don't kid yourself – the bar hasn't been raised for some time.

What’s not in question – and which we take our bearings from, is that equities, yields and the US dollar have trended with investors relative expectations with the data, well before the outcome of the US election even came into focus. Looking back, this has increasingly been the case since the Fed left ZIRP in December 2015; with the most recent updraft beginning last summer after investors immediate fears with the Brexit vote went largely unfounded in the markets. And while animal spirits and narratives were certainly rekindled and reframed after the election, a positive reversion was already underway for months with respect towards participants respective expectations within the economy. Vacillating between poles of optimism and pessimism – as the index measures levels relative to consensus, we would speculate that the Citigroup US economic surprise index now reflects that expectations have largely caught up with the data, with a much greater probability that subsequent “surprises” will trend towards the negative pole. 

Moreover – and as recently described by Matthew Boesler of Bloomberg (see Here), there has been a growing gap between business and consumer confidence surveys and actual economic activity. The difference between these so called “soft” and “hard” data series has only been wider once before in 17 years of data, in February 2011. It seems reasonable to believe that the gap reflects the sharp shift in business and consumer sentiment that took place after the Republicans ran the table in November. The abstract concern being – hope springs eternal, or until reality bites. To that end, we’re more inclined to focus on the US macro environment beforehand that was predominantly characterized by lackluster year-over-year growth that was treading water at best – or decelerating from a cyclical high in a historically mature economic expansion at or near full employment.

Thursday, January 19, 2017

In Search of the New World

Although they’ve skillfully built and maneuvered their rival reputations in bond arenas worldwide, the warring kingdoms that lay siege to the Bond King throne, might just benefit from a less enlightened perspective – say, from the dark ages.

While Gundlach and Gross have a semantic squabble over the upside threshold in yields that might delineate the end of the three-decade old bull market in bonds, perhaps they should stop viewing the bond world as round and come to the apparent reality that it’s more flat than circular here in the trough of the long-term cycle.

* Click to enlarge images

In this construct, the unidirectional sovereign yield winds died – or more appropriately – transitioned, years back in 2011 and 2012. Although short-term yields and the dollar have risen in tandem as the US economic expansion led the world out of the financial crisis, long-term yields have taken a more lateral path into the trough with what we suspect will be doldrum conditions blowing east to west at best – rather than the prevailing winds we experienced out of the north for thirty years. How long the journey along this yield equator will take is anyone’s guess, but by our estimation of previous long-term cycles (most recently, Here), likely has further seas to float before the strong updrafts of the Westerlies can bring us to the higher-latitudes of a "New World".

What’s happened since the US election is that budding optimism that the ship is now sailing away from the "Old World", has helped shorter-term yields and the US dollar “breakout”, which can be viewed as a welcome shift in the economy’s tell-tails. What’s become the “Trump-rally”, led by broad buying in infrastructure and bank stocks, is a reflationary move that actually began before the election, but re-magnified with a new administration about to control both houses of Congress. The bet now is that Trump becomes Columbus and succeeds at rekindling growth on the back of fiscal stimulus and tax cuts. Yes, higher yields and inflation, but alongside stronger growth. Land ho New World - or at least one that feels like the old one of the 1950's...

However – and as we alluded to in previous notes, we believe that’s mostly wishful thinking pulled forward several years, considering the maturity of the current expansion and with the economy at or beyond full employment. While we continue to support a more commodity focused reflationary approach – spearheaded by positions in precious metals, and speculate that the US dollar will turn down again with the US led expansion, we don’t foresee the more healthy expectation that rising inflation will be accompanied with higher growth. Some might call this stagflation; we take a more pragmatic perspective in that it’s just the nature of where we sit in the long-term cycle where inflation could more easily outstrip the reach of nominal yields and growth, causing real yields to decline. 

Moreover, we continue to view the Fed's expectation of raising rates several times a year through 2019 as wildly unrealistic – as well as the markets underlying fears of the 1970’s, where to kill inflation took the mythical axe of Tall Paul Volker and a fed funds rate of 20 percent. This isn’t the 1970’s where yields continued to surge higher, but inflation still had greater reach and more pernicious momentum. Today, we would speculate that a spike in inflation would be more ephemeral and provide a bookend to an equity market cycle that took flight as disinflationary pressures brought yields and growth into the trough of the long-term cycle. 

As mentioned in previous notes, over the past few months gold has again been strengthening its negative correlation with the US dollar. Although the relationship is trending towards an extreme, gold now expresses a positive divergence with the most recent highs in the US dollar index, relative to the dollar's previous highs in December 2015. 

While the correction in precious metals was steep through Q4 of last year, we view them in hindsight as a successful test of the 2015 cycle lows and expect a full retracement and continuation of the young bull market in precious metals. Similar to the market environment headed into 2002, we expect favorable conditions in the currency and Treasury markets that should help propel precious metals to fresh cycle highs. 

Wednesday, January 4, 2017

Connecting the Dots - 1/4/17

No rest for the weary – or the wicked, as the New Year gets quickly to the point with a few key economic data plots this week. Coming through last quarter, the data extended a decisively more upbeat turn that became apparent last summer shortly after Britain’s Brexit vote failed to immediately usher in a broad economic slowdown that was widely feared with such an outcome.

Correlating with this turn in the data last summer was a pivot in the dollar and yields, which greatly impacted the safe haven uptrends in precious metals and Treasuries that had enjoyed significant rallies in the front half of 2016. Further supporting the moves were the gathering expectations that the Fed was poised to raise rates in the back half of the year, if the data maintained its positive tone – which was realized at their December meeting.

For the moment, macro trends appear to be trading off of a more binary calculus that positive economic data will support the dollar and equity market rallies and limit the upside reach in gold and Treasuries. Basically, if market participants believe that the economic uptrend has further room to run and that the prospective benevolent policies of a new US administration will help extend these expectations, the future looks much brighter in 2017 than where you sat a year before.

However, if you believe – as we do, that the data basically just rebounded from overtly bearish expectations that came to pass in the first half of 2016 and that the perceived breakouts in equities and the dollar will retrace yet again with the data this year, than 2017 presents a continuation of a very broad market cycle top that has much greater risks on the downside for the dueling bull markets in equities and the dollar. From our perspective, the “Trump effect” is nothing less than ironic, considering the cycle has greatly been distinguished by a US led cyclical uptrend that began when some of the brightest minds on the Street were expecting a “new normal” to emerge after the financial crisis that saw the US taking a back seat to emerging economies, namely China. A renewed belief in US hegemony would have been timely back then – when the S&P 500 was a third of its current market capitalization and the US dollar was nearly 30 percent weaker than it enjoys today. But alas, the market often wryly winks without prejudice at both the ignorant and the experienced at market turns.

Although the economic data may take some time to again disappoint over the coming weeks and months, the expectations of a new administration revamping US manufacturing and unleashing untapped potential in the economy this year – hence lifting most boats, appears even less realistic than the previous notion that the considerable downturn in US manufacturing that began in 2014 would take the broader economy into recession over the past two years.

The reality is non-manufacturing’s share of GDP is roughly five-and-a-half times larger than manufacturing is in the US and that will certainly not change overnight – regardless of how aggressive the incoming administration is. Moreover, the heighted risk on demand by protectionist policies that Trump continues to threaten would likely more than offset the potential benefits of tax breaks and looser regulations on prospective supply within the US manufacturing sector.

Yesterday, we received the ISM manufacturing index that exceeded forecasts, as manufacturing executives remain largely upbeat headed into 2017. With the ISM non-manufacturing index slated to be released tomorrow, it will be interesting to see if they share the same upbeat sentiment of manufactures or if the rebound that began in the back half of last year has mostly run its course. Taking a long-term perspective on the series, juxtaposed against the trend in nonfarm payrolls – we suspect the latter is increasingly more likely as we work through the first half of the year. 

With nonfarm payrolls set to be released this Friday, the markets will have further catalyst to trade on, one we continue to believe favors the short side of the dollar over time, which is again strengthening its inverse correlation with gold as well as Treasuries.
Looking for a continuation of the extreme release higher in yields, consensus expectations have now pivoted 180 degrees from the July lows. Technically – as well as from an intermarket perspective with the US dollar index, the markets set-up quite similar to the early 2002 pivots in the dollar and yields, which propelled both nominal and real yields to new cycle lows. 
Despite current market expectations that express building confidence in the US economy, we continue to believe – based on our own research of both the nominal and real long-term cycles, that new lows are more likely than the beginning of a new secular growth trend. Moreover, the relative symmetry of the retracement decline in nominal yields from the secular high in 1981 is actually marginally trending even shallower than the trough of the previous cycle in the 1940's. 

As such – and despite the considerable retracement declines in precious metals  in the back half of last year, we continue to like their long-term prospects in what we believe will be a lower real yield market environment, longer than most still suspect.

Thursday, December 15, 2016

Sugar Plum Fairies

Rattling an already skittish government bond market, Chair Yellen delivered another seasonal interest rate hike with seemingly greater resolution that the New Year will be tighter than the last… The Fed's holiday wishes had all the usual hawkish trappings we've seen from time to time when the data aligns, with greater confidences in the economy that not one – but three, separate rate hikes could be delivered next year. Not surprisingly, the expedited path sent the dollar and shorter-term yields screaming, the net effect of which hit hardest at emerging market debt and equities as well as gold  that had already lost its luster since the US presidential election last month.

Of course cynics and trends be damned, as many – ourselves included, have tasted a respective macro victory over the past few years only to find it to be more ephemeral than satisfying. Generally speaking, trending markets became increasingly range bound with the transitional illusion that a more lasting pivot was closer than it actually was – or perhaps is. Essentially, markets became more or less a fractal expression of the Fed’s own collective range of confidence with enacting policy. The question today is has that calculus changed and will the Fed or Trump be able to maintain a breakout – or even an illusion of one, as who’s to say where reflexive expectations become reality.  

While the strength in the dollar this quarter has certainly given pause to our own expectations of a cyclical move south, we continue to look through the wide-angle lens of a more long-term prism on the dollar and yields that we have argued points towards another reversion to the mean of both the Fed’s own confidence in enacting policy as well as the respective long-term downtrends in the dollar and yields. Overall, although it certainly has not been a crisp pivot lower for the dollar, we are again reminded it is the trough of the very long-term cycle, which as history depicts pivots with less volatility than the sharp reversals witnessed at secular highs – e.g. yields 1981, dollar 1985. 

"It's like deja vu all over again," said Yogi.  

The day after the December Fed meeting where a major policy shift was enacted has presented a tradable low in gold over the past few years. The chart below was one we had followed from the 2015 rate hike, with strikingly similar conditions in sentiment to last December. Note the strengthening inverse correlation with the dollar. 

US equities have made the outlier breakout move with the dollar. We don't have confidence in either and suspect they follow gold's lead lower as emerging markets have begun to break down this week.   
The move lower in long-term Treasuries has been relentless, now eclipsing the bloodbath of the 1987 breakdown. Although our long-term chart of the 30-year bond impressions a prospective move to ~140, we would speculate the risk/reward shifts long for investors today around these levels. 
Granted, looking back at previous cyclical highs in the dollar index has been as useful to-date as the Fed's own dot plot projections, we still firmly believe that lower-for-longer will ultimately prevail in both yields and the dollar and that the relative and absolute performance of both previous major cyclical bull markets in the dollar augurs that there's much greater room on the downside for opportunity in investors longer-term investment theses. And although gold and silver have taken it on the chin in recent weeks, we still approach them as volatile proxies for commodities that should have another day in the sun as the dollar weakens on a more lasting trajectory.