Thursday, September 11, 2014

Party Hardy

With the most recent push higher in the Nikkei, Japan finds itself at a threshold opening that has rejected their equity market advances over the past three decades. Throughout the year, on both sides of the field (see Here), we have followed the momentum comparative of the Nikkei's 1987-1988 rejection and recovery. Similar to our Meridian work with the SPX that also extends from 1987, this time period as well marks the upper-pivot of the declining resistance trend, the Nikkei has strictly adhered to and been rejected by since making its historic peak in late December 1989.

In our most recent note on Japan (see Here), we had described that the Nikkei was following a similar recovery pattern that our own equity markets had taken at pivotal times - most recently in 2011. What they all had in common - with varying proportions, was that momentum was quickly restored to the upside, once the retracement decline was completed. 
From our perspective, it appears the Nikkei will loose its deflationary shackles, just in time to celebrate its twenty-fifth anniversary this Christmas. Coincidentally, it took the S&P 500 twenty-five years to the month to break above its nominal high from 1929. While the lay of the land is much different for the Nikkei and Japan today, perhaps similar to the US generation born during the Great Depression and World War II, historians will eventually refer to those brought up in Japan over the previous two decades as the "Lucky Few" as well. History repeats - often with a great sense of irony. 
With Draghi recently breaking the glass and pulling the QE fire alarm, he's attempting to startle some of Europe's markets out of their respective cyclical peaks and deflationary glide-paths we believe they have been moving towards this year. Will it work? We remain skeptical, and look towards Japan's initial efforts that broadly failed at maintaining momentum in their capital markets. As Paul McCulley aptly describes in his latest note for September (must read - see Here), it is a Hobson's choice - and one that theoretically, "should never be on the table, if the fiscal authority is willing and able to party hardy..." 

Considering the many disparate economies, players and opinions around that table today in Europe, the amount of libations needed to imbibe and maintain the festive atmosphere will likely need to be significantly larger than what was initially floated. Don't get us wrong, it was really nice to receive the invitation - it's another thing entirely when folks show up at the party. 

Sunday, September 7, 2014

Tepper Calls an Audible

We've made the case before (see Here) that for all the pomp and circumstance, Fed policy over the last three decades has done very little to deviate yields from what became a genuinely symmetrical and balanced return from the profound 1981 highs. Where they have had effect - we would argue, is around the fringe in introducing volatility to the slope of the decline, with numerous interventions and surprises as they navigated various market conditions. The chart referenced below with the 1941 to 1981 mirrored trajectory captures that story, especially when contrasted with the relative smoothness of the previous long-term cycle in the first half of the 20th century, when the Fed was still in its infancy and developing the first edition textbook of accommodation and reduction, they have continued to build upon with each passing cycle.  

On both sides of the spectrum, whether through bailouts, interventions or rate tightenings - the Fed has looked to shake the tree from time to time when the markets are deemed too complacent, accommodative or risk adverse. Coincidentally - or not, these occasions over the last thirty years have been when yields have fallen back proximate to the mirror of the cycle. Has it been beneficial? We'll save that nuanced argument for the historians, but do believe it demonstrates quite clearly the nature versus nurture aspect of the Treasury market. The Fed may find efficacy with the cattle prod at times, but the herd of the largest security market in the world will still closely follow the inherent migration pattern - one that many analysis, pundits and traders have attempted to call an audible from over the years.   

Coming into this year, we had looked for the taper-tantrum squeeze in 10-year yields to reverse from the relative extreme punctuated at the end of last year. The irony being, the collective wisdom in the market in late December and early January was wresting with how different markets would cope with a rising rate environment. Gold and gold miners were left for dead. Emerging markets were viewed as a fashion craze of the previous cycle, but unwearable in a rising rate environment.  China? "You must be crazy", we were told. Utility stocks? They'll strongly underperform. 

Loss on most was the fact that 10-year yields had surged over 80% higher in only a few short months, eclipsing the entirety of influence on long-term yields of the previous rate tightening cycle (~70%) and roughly doubling the effects of the surprise tightenings by the Fed from 1994 through February of 1995. Not surprisingly, it was a great time to buy long-term Treasuries, gold and precious metals miners, emerging market and Chinese equities and utilities.
With 10-year yields rising the most since the first week in June, bond bears started sticking their heads outside their caves last week, looking to feed and remind us once more that investing in Treasuries is akin to swimming in gasoline in a lightening storm. Emboldened by comments from Appaloosa Management's David Tepper, declaring, "It's the beginning of the end of the bond market bubble", the bond bears gain a credible ally and spokesman just as the Fed looks to shut down their country kitchen this fall - as the ECB notifies us of their own grand opening that same month. Exquisite - or desperate, timing we wonder? While Tepper's reputation and fortune have very much been built on the former, more than a tinge of the later comes to mind - with respect to the severe structural limitations of the European condition and the modest proposal the program will begin with. With that said, it is the thought that counts and we can't deny that Draghi is at the very least forging a reputation of delivering the goods - whatever they may be. 

Although we don't believe that the bond market is in a bubble per se, over the last two years we would agree that the Treasury market has been going through a transition of the beginning of the end of the move that began over 30 years ago. The main difference, is we don't expect yields to sustain a pivot higher, but remain in a long-term range roughly between 1.5 and 3.0 percent over the next several years, as the markets wrestle with normalization of monetary policy from the extraordinary measures enacted over the past five years. To that end, we defer to history and the over 70 year patterned memory of the cycle, that points to Yellen's patient refrain of lower - longer

In the obvious sense, the timing of the ECB announcement appears tailored to mitigate the swift collapse in yields that occurred at the end of the two previous QE salvos, as investors apprehensions without the Fed's training wheels and soup kitchen took over. While conventional market wisdom infers that QE helps a central bank put a cap on yields, as we mentioned earlier - the evidence in the market is very much to the contrary. QE by all accounts has successfully stimulated participants away from the safe-haven shores of Treasuries and into riskier assets.   
When the Fed started tightening first in the summer of 2004, US 10-year yields diverged higher away from Europe. As shown below in the chart between US and German yields, it wasn't until the financial crisis took hold in the back half of 2008 did the two markets once again converge. Maintaining its leadership role in dictating broader monetary policy direction, US yields fell below Europe in the fall of 2008 - as the Fed cut swiftly towards the lower bound of the fed funds rate. Reaching the bottom in December of that year, the ECB would take its time over the next five, meeting the Fed just last November. 

Propelled by the cattle prod of QE3 and the threat of the taper last spring, US 10-year yields have diverged considerably from Germany - Europe's strongest economy, as the ECB has continued to cut below where the fed funds rate currently resides. As our last bunch of QE biscuits warm, and with the ECB finally pulling a page from our own quantitative cookbook, it seems reasonable to suspect that the spread between US and Germany will begin to come in soon. The question - we suppose, is where the next convergence might take place: higher or lower than where US yields currently reside? Will US yields enjoy support extended from the new European initiative, or will nature exert its influence over the cycle and cause them to meet lower at a later date? Longer term, our money is still on the latter and from a relative performance point of view, we continue to favor long-term Treasuries relative to equities today. From our perspective, Tepper's audible will meet the same fate as the many quarterbacks who have made the call over the years. Sacked - behind the line of scrimmage. 

Tuesday, September 2, 2014

Back to School For the Euro

For lack of a better name, we call it Sunday night feeling in our house. It usually hits the kids around two or three in the afternoon and spreads with doleful interactions up the chain of command, eventually reaching its peak just before dinner. 

"I don't want to go to school tomorrow."

"I wish it was Friday."

"Where did the weekend go?"

Whether it's the food for the kids or a glass of wine for mom and dad, the apathy is slowly swallowed and accepted by the time dinner is through. With the end of summer officially crossed this Labor Day weekend with a final crawl up the Garden State Parkway, we find ourselves sitting with a severe case of Sunday night feeling - here this Monday evening. Adding to our general indifference, we also find the markets situated with a mixed bag of performances through the summer months that leaves more questions than answers from both a tactical and strategic point of view. Granted, the markets are rarely an easy read or a fat pitch down the center of the plate, but the continued shift and loosening in inter-market correlations have muddled the waters considerably and allowed ebullient markets to remain buoyant as greater uncertainty abounds. Yes, uncertainty. In our experience, the old Wall Street adage that markets hate uncertainty, is about as accurate as your data is safe in the cloud... Perhaps a better truism would be: a market that stays in motion remains in motion - of course, until everyone is certain it will remain in motion. Let's just call it the Minsky coefficient. 

Looking back at the summer through July and August, we've experienced enough cross currents and strange bedfellows of performance pairs to collectively leave certainty in short supply. Just to name a few: Strong dollar - strong emerging markets and Chinese equities; strong dollar - strong bond market; strong bond market - weak yen; weak small caps - strong Nasdaq; strong bond market - weak precious metals; weak gold - firm gold miners. From a cross asset point of view, one of the primary outlier influences over the summer appears to have been at the hands of a weak euro. For all of our cynicism directed at the ECB and Draghi this spring, the currency markets pivoted sharply thereafter, cutting the euro over 4 percent through July and August. This in turn placed a strong bid beneath the US dollar index which maintained pressures on the commodity markets that weaken throughout the better part of summer. 

That being said, the same market dynamics in which traders lean on the perception that the only clear path for the euro is lower - because of what the ECB can and will bring to the table, are even 
more stretched than where they were historically at the beginning of summer. To that end, gross short euro positions are in spitting distance of the record set in July 2012, when the actual fate of the currency union was very much in doubt. Furthermore, when you factor in the futures positioning of both the euro and the dollar, a rather extreme picture is brought to light (Courtesy of Nordea Markets savvy currency strategist Aurelija Augulyte and Reuters Ecowin). When it comes to the euro, certainty is certainly not in short supply these days.

At the end of the day we still believe the euro is primarily motivated and supported in the long-term by strong deflationary forces - compounded by its flawed structure, which at times present real existential catalysts for the markets to react on. In this sense the euro is unique, although we still look towards the Japanese yen of yesteryear for guideposts in the road and similarities in burgeoning deflationary trends. In the summer of 2012 when Draghi threw down the gauntlet and declared whatever it takes, those existential concerns were addressed and the euro pivoted sharply higher. With Draghi once again stepping up to the podium this week with hints and hopes of more or less whatever it takes greatly factored into positioning, we can't help but feel the euro's outlier influence in the markets this summer is drawing to a close. From our perspective, we don't expect that Draghi will get off this easy with Europe's considerable deflationary concerns. Japan certainly didn't - and they only had one economy and political system to navigate. It's back to school and reality for the euro.

Thursday, August 21, 2014

Breaking the Banks & Finding Gold

Since finding a low in the first week of August, the S&P 500 hasn't wasted much time, closing positive in seven sessions out of nine and narrowing the gap from its 27th record close this year - way back on July 24th. With Yellen flying into Jackson Hole this week to enjoy some good old fashion Rooseveltian eco-tourism, the point spreads have come in considerably for those betting on number 28. Data mining the mountain some more, over the past seven years with the inspiring majesty of the Tetons in the background, stocks have rallied on what the Fed Chair has to say. 

That being said, we remain skeptical that the equity markets can maintain their historic streak and continue to see strains developing in the leading financial sector, which appears to be butting up against the harsh realities of a flattened yield curve and the narrowing margins of net interest income. As we had commented on leading through the decline at the start of the month, the S&P 500 was breaking down along similar folds with the retracement decline this past January. Taking a shallower fall this time around the block - and despite the perceived bid that that Yellen may extend, we do expect a divergent outcome with the sustained recovery that the equity markets had enjoyed earlier in the year. Apparent in the followup study below with the financial sector, the banks relative to the broader market have been making their way down the stairs with 10-year yields. This is in stark contrast to how the banks had led the broader market higher since the fourth quarter lows in 2011.   
As one door closes another cracks open, and we continue to favor the precious metals sector - led by their respective and misfit miners. The common denominator - or hinge, being 10-year yields. As gold and silver relative to yields complete what has become a very broad and symmetrical base from the relative extreme punctuated at the end of last year, the likelihood of an asymmetric return is echoed in the preceding pattern of the financials and similarities in the magnitude of the miners decline over the past few years relative to their denominating spot prices.   

Consistent with our divergent expectations in the equity markets previous retracement patterns, tensions are building up in the precious metals sector to breakout above overhead resistance of their respective interim highs. 

Saturday, August 16, 2014

A Scheduled Departure in Yields

Although we would never dispute that markets often pivot on external catalysts, as we noted recently (see Here) - they often are just instigators of larger forces at play. For every time that a market perceives to be largely driven by breaking news or geopolitical events, we could reference fifty other occasions in which a similar development had no material influence. 

From our perspective, yesterday was a perfect example in which an exogenous event in Ukraine, motivated pre-existing conditions in the Treasury markets. Based on our comparative analysis of 10-year yields developed months before (see Here), the current breakdown truly comes as no surprise. In fact - it arrived right on schedule.  
A similar research approach has been prescient with tangential trends, as depicted below with our work with the TIPS bond fund the past January (see Here), which highlighted both the pivot and proportional recovery path the asset has followed. 
Headed into next week, the asset class relationship that we have favored over the course of this year, namely, long-term Treasuries relative to equities (TLT:SPX) - is at a potential breakout point. As shown below in a similar dynamic that developed after the markets began to normalize to structural and psychological conditions in the wake of QEII, the current set-up is feathering the hinge line of the retracement highs from this past May. Back then, it was the instigating factors of Europe's sovereign debt crisis and our own issues at home, emanating from a contentious Congress that led to a debt downgrade from Standard & Poor's that August.  

Should yields continue to breakdown further with equities next week, we can guess the nature of what the headlines might read. That being said, we continue to believe there are larger forces at play, just as there were in 2011 as the Fed first attempted to wind down QE - and in the mid 1940's when the Fed ended their extraordinary support of the Treasury markets.   

Thursday, August 14, 2014

Past Performance Does Not Guarantee Future Results

We've all read the distilled disclaimer above a thousand times before. And yet, with full frontal cognizance of its universal truth, we ignore the warning for the sake of the still waters of current market conditions and our behavioral predisposition to follow. Follow leaders, trends - follow performance. It's a hardwired survival trait built into all of us, and generally speaking - exposes our achilles heel at times, when it comes to bends in the road and future expectations.

Speaking of which, we see that another large investment bank recently chimed in with long-term forecasts out to 2018 of divergent returns between equities and bonds. Seeing a 6 percent annualized total return in the S&P 500 compared to a 1% annualized gain for the benchmark 10-year Treasury note, the forecast assumes the Fed begins raising rates as soon as the middle of next year - with a 4 percent ceiling by 2018. Citing the same rate increase playbook referenced ad nauseam (94', 99' and 04' cycles) this year, we think it would behoove their expectations to heed the standard disclaimer mentioned above, as well as a wider breadth of market history that rhymes much closer with the current mix of market conditions present in equities, bonds and commodities - against the backdrop of extraordinary monetary policies extended over the past five years  (cough, cough - the 1940's). Taking this into account, the dynamic of divergent returns would vanish as we would cut their forecast for the total return in the S&P 500 in half and more than double the annualized gain noted for the benchmark 10-year Treasury note. 

Befitting of the paradox of both our capacity to collectively follow and ignore, participants appear to receive an almost daily dose of insight and reason from our Madam Chairwoman, who continuously reminds us that rates will stay lower - looonger. Besides the fact that long-term yields continue to move against  a more contemporary conventional wisdom, what does Yellen consider that the rest of the Street choses to ignore? Hint - recent past performance does not guarantee future results? We think so, and expect that as these benevolent market conditions come to pass, the Street will change their tone and karaoke tune as well. 

Although the economic data through the balance of year may run antithetic of the Fed's mandate on inflation, we view that risk - as we believe Yellen does, in shades of gray. The reality in the economy is that a strong pulse of inflation would eventually self-correct trajectory under its own weight - and without further tightening in Fed policy. This isn't the 1970's, where the Fed chased inflation with yields that had been rising for over two decades and where the saplings of globalization began to grow exponentially in the stand. No, we currently reside in the old growth trough of the long-term yield cycle, where generally speaking - the threat of perennial inflation is limited by more than 30 years of inertia on the downside of the cycle. Frankly, we are a bit surprised that this fundamental difference isn't considered more often and that the extremes of the 1970's are contrast for concern, instead of where yields currently sit and the extensive historical record which depicts that the trough - like Yellen, is lower for longer. Will there be spikes of inflation as pressures builds up from time to time under varying conditions. Certainly, but in the recent past and the parallels we noted in the 1940's - they all were ephemeral conditions.

Coming into the home stretch of the year we expect the current pulse of inflation to continue higher as the Fed walks away and foresee the chirping hawk choir grow louder and more emboldened with each reassurance by Yellen that she'll stand pat longer with lower. From our perspective, the double edge sword that Yellen needs to gingerly step between is a damned if she does and damned if she doesn't mentality with tightening, since the risk becomes that rising inflation could hit the brakes in the economy for her, reinforcing the belief that the Fed was foolishly behind the curve. At the same time, if they raise rates too soon the scenario laid out below could have the same outcome - but perhaps even sooner.  
- The nightmare scenario she wants to avoid is hiking rates only to see financial markets and the economy take such a hit that she has to backtrack. Until the Fed has gotten rates up from the current level near zero to more normal levels, it would have little room to respond if the economy threatened to head into another recession. - Reuters 8/12/14
All things considered, we tend to agree with Pimco's Paul McCulley that believes "behind the curve" is precisely where the Fed wants to be - for now. Trading more time for inflation risk - that we would argue poses a less long-term threat than many of the hawks continue to posture as severe. With that said and as pragmatic participants, this dynamic should bolster a rising interest in the precious metals sector and commodities - that should benefit from inflationary tendencies and a broad distrust of the Fed as they navigate another difficult policy chapter. 

1994, 1999 - 2004. What do they all have in common besides rate tightening cycles ? A broad respect and lionization by participants of Fed policy and their Maestro that conducted the show. Does that sound like today? While we do find great utility in thoughtful comparative reasoning when it comes to market cycles - the fact remains that past performance never guarantees future results. Especially, when the comparisons are so far off the mark. 

Sunday, August 10, 2014

These Go To Eleven

With geopolitical tensions continuing to escalate, there's a tendency by participants and pundits alike to fit the headlines to the tape. 


While these events have certainly not hurt demand, the respective trends in both Treasuries and gold have been in place all year and under what we believe are more endogenous and cyclical motivations - than event driven reflexes at the whim of Putin, Hamas or Israel. From our perspective, the same holds true with the recent cracks in the US equity markets, which we view as an obvious - but latent reaction, to the
Fed slowly ending their extraordinary policy support this fall. As we see things, the markets will continue to adjust to the visible hand of the Fed, whom to the shock and distrust of most ran an open and heavily subsidized kitchen over the past five years and has been equally public and transparent about shutting it down. As obvious as that may be, ignoring the significance of their influence at these pivotal points in time, would be overlooking the performance in the US markets over the past five years and believing with 20/20 hindsight that the Fed's quite visible hand didn't play the commanding role. 

Tangent to the markets adjustments to transparency on both sides of the field is the realization that the Fed has conducted policy over the past five years from the mystical plane beyond ZIRP. At its basest level, we have argued (see Here) quantitative easing is about instilling expectations in the market, both from a structural and psychological perspective - beyond where conventional policy tools could apply. When the Fed began their fireside taper-talks last May, they tightened in effect through a pivot in expectations. On the Spinal Tap policy continuum that goes beyond the norm - they took the bold step and turned the volume down. Considering the move in 10-year yields that followed, this was largely confirmed by the market - and why we have contrasted the trend in yields throughout this year with the arc of the unexpected rate tightening cycle in 1994 and 1995 that capsized the bond market and reset expectations.  
Generally speaking, we've approached the broader macro picture in the US equity markets from the top down bearings of the long-term 10-year yield cycle and the proportional trends of Shiller's P/E ratio - which we have described in previous notes (see Here) as sharing close parallels with the cyclical peak in equities in 1946. Although the trend in equities did extend further than we anticipated at the start of the year, similar market and policy conditions still exist that hold strong congruencies with this historic time period. This perspective remains supported by:
  • The long-term yield backdrop - which we would argue primarily drives the boat from a valuation and asset cycle point of view and is similar to the range in yields witnessed in the mid 1940's. Yields currently reside on the mirrored return of the 80 year cycle - which would extends the range (~1.5-3.0%) of this extremely low yield environment further out than is currently considered.  
  • The current disposition of Shiller's P/E - which our trend analysis would indicate has a low probability of exceeding the proximate and previous cyclical peak in 2007.
  • Similarities in extraordinary measures in monetary policy between today and the 1940's - which saw the Fed purchase and hold all available short-term U.S. Treasuries and virtually all long-term U.S. Treasuries. We expect a similar outcome in the markets to the normalization of current monetary policy, which from our perspective would likely push an actual rate tightening cycle further out than is currently considered.
  • Similarities in equity market performance since the Fed started visibly supporting the markets at the previous cycle lows in 1942 and 2009. Although the composite duration in policy support extended from the Fed has been longer today, it was intermittently halted on two occasions over the past five years. Taking into account these pauses between QE salvos, comparisons between the two equity market cycles are commensurate.   
  • The pivot higher in the commodity markets this year, which was also dramatically evident when the Fed pivoted from its outright purchase of securities in the market at the end of 45' and extended the commodity cycle to its cyclical high in 51'. Generally speaking, we view the bid in the precious metals sector this year as the leading edge for the broader commodity space and find efficacy in the Fed's policy pivot - which signaled to the markets a trend change in inflation expectations.
Just as the policy shifts by the Fed in the mid 1940's sparked the unique conditions in which long-term yields declined with a rejuvenation in commodities and inflation (see Here), a similar dynamic has developed since last December in precious metals, commodities and those reflationary assets closely associated with their respective performance trends. 

While there are parallels to the wind down of QEII in how long-term Treasuries relative to equities have performed this year, the biggest difference in our opinion - and one we cite as indication of effective demand with policy, is the fact that gold and the broader commodity complex based and pivoted out of a cyclical low last December when the Fed moved to taper. This was largely contrarian to what most participants believed would occur as the Fed walks away. From our perspective and as we had noted last year before the initial taper, these developments ring true if policy accommodations were being withdrawn a final time - and if underlying conditions were in place to sustain reflationary forces.  

These set-ups are greatly divergent from what was present in 2011 as the Fed ramped - then wound down QEII. Back then, the commodity sector - led by silver and gold, had surged higher on the misplaced notion that inflation would rue the day because monetary policy was far too accommodative.  The harsh reality was soon proctored by the markets which saw those assets closely tied to inflation expectations peak in the wake of QEII and begin a long disinflationary downturn and wide underperformance to the S&P 500.

Today, as the markets work through the structural and psychological frictions of a normalization with monetary policy, demand for long-term Treasuries should remain supported - as well as reflationary trends in precious metals, commodities, emerging markets and Chinese equities. With that said and as noted throughout the year, there has been a lagged sequence out of these assets cyclical pivots and respective interim highs and lows. 

In our opinion, the biggest development recently - besides the cracks developing in the equity markets, is the further breakdown in 10-year yields, which should release the next leg higher in gold and draw the broader commodity complex out of an interim low. At the same time, a declining yield environment should present a strong headwind for the financial sector - that up until this spring had led the broader market higher.  All said, ramifications by a zealous audience to a Fed willing to turn the music down. It's still loud out there - but it's not 11.