Sunday, October 19, 2014

Krugman Sees 37' - We Raise him 9

The expectation gap crashed close last week - with all the subtlety of an elephant standing and leaving the room. All it took was a four week tour on the weak side of positioning, to panic participants out of their misplaced policy expectations of impending rate hikes by the Fed next year - or an imminent breakdown in the government bond market. Shortly after the equity markets opened Wednesday morning, 10-year yields collapsed some 14 percent below Tuesday's close, briefly touching 1.86% - the lowest since the Fed began their fireside taper-talks in May 2013. Likewise, 5-year yields collapsed 23 percent lower at the open, briefly touching below 1.2% - before recovering 10bps by the close. 

Just a few weeks back, participants had hung their hats on the notion that the Fed would need to act sooner rather than later, as economic conditions had improved and anxieties reigned supreme over what the Fed's exit plan would entail. For the week ending September 19th, which happened to mark the top in the S&P - as well as over three and a half year highs in 2 and 5-year yields, many believed the shorter end of the Treasury market was confirming exceptions that yields were headed higher - perhaps, materially so. This opinion was shared by a rather diverse group of personalities, that broadly influenced the ballast of the market - and included;  hawks within the Fed itself, traders that continued to believe the over 30-year young bond bull was dead - as well as policy bulls that naturally saw real rates climbing as the Fed emerged triumphant from their extraordinary policy stance. 

If only they had listened to Yellen, who apparently didn't shared the same respective confidences of even the policy bulls themselves. Lower - longer. Lower  -  l  o  n  g  e  r

For better or worst, there are two essential maxims we've had embroidered and framed, in navigating the intersection of markets and policy: listen to the leader and not the follower - and check your biases at the door. This sensibility was personified on Thursday, as Federal Reserve Bank of St. Louis President, James Bullard, quickly pivoted from last months tone of removing "considerable time" at the upcoming Fed meeting - to the possibility of maintaining QE for the foreseeable future. Perhaps follower is too kind. 

Nevertheless, we don't anticipate the Fed will take up QE4 anytime soon - or tighten, which would preserve Bullard's track record of handicapping the wrong pony, no matter which race. Although latent - hence the large expectation gap, the Treasury market has now caught up to expectations, as the calls for further tightening have finally been recognized as greatly misplaced. We have argued over the past year, that for all intents and purposes, the Fed has been tightening since they first brought up the taper in May 2013. At its most basic function, quantitative easing is enacted to instill expectations - beyond were conventional policy tools could apply. When the Fed began their fireside taper-talks in May 2013, they tightened in effect through a pivot in expectations. Considering the move in yields that followed, this was largely confirmed by the market - and why we have contrasted the trend in 10-year yields throughout this year with the arc of the unexpected rate tightening cycle that began in February 1994.  
Building on the tenor of last weeks note, the similarities still resonate of a cyclical top in the US equity markets, reminiscent of the last time the government conspicuously supported the markets in like proportions through large-scale asset purchases. Not surprisingly, the 1940's were also a time period in which participants remained shell-shocked from the 1930's and maneuvered between the equity and Treasury markets, as if another depressionary and deflationary wave would unfurl when the Fed and Treasury stepped aside. When they finally did in 1946, the self-fulfilling prophesy manifested in a swift 30 percent revaluation in equities - while participants panicked and hunkered down in Treasuries expecting another chapter of the Great Depression to unfold. Sound familiar? Krugman apparently thinks so too

As the Fed looks to wind down QE later this month and with the equity markets coming under pressure once again, the natural comparative reaction is to assume the Fed will cow-tow to market pressures, as they have before; or in absence of that support - assume the worst and a downturn on par with the two previous bear markets (2007 and 2000), or as Krugman fears - a 1937-esque collapse. Broadly speaking, we don't find the same excesses available in the markets - both domestically and globally, or underlying economic conditions that are typically required to support declines of that magnitude.  Moreover, we would argue that from a comparative perspective of valuation trends in equities relative to the long-term yield cycle (see below), the bear market that began in 2007 was our 1937. The third peak from the secular high would be our 1946, which just happens to be the last time the government spoon fed the markets and the mirror of the cycle in 10-year yields. 
Over the past month as momentum in the equity markets has begun to cough out, volatility awoke from a long slumber. In doing so, the SPX completed on October 9th a 3 day series of large (1.5%) moves for the first time in over a year. Surprisingly, the definitions of this study (which was brought to our attention by the fine folks at Nautilus Capital Research) reflects a rare condition in the SPX, the likes of which have only occurred 9 times over the last 77 years - 5 of which have signaled around major equity peaks in 29', 37', 46', 00' and 07'.

Last week, the SPX broke below its 200-day moving average for the first time in 476 days. As presented in another study by Nautilus, this is the 7th longest consecutive streak in over 100 years, sharing the mantle with the three peaks in 29', 37' and 46'.

Overall, we find that the two studies reflect the expectation gap that just closed and a market environment sputtering from benevolent and complacent conditions, that one could argue has been greatly supported by the active and visible hand of the Fed. Taken in context with our previous work, we continue to find the historic parallels with the 1940's compelling and worthy of further contrast. As is the case with all comparative reasoning, we primarily use the work to generate a strategic outlook of what might lie ahead - based on similar market conditions in the past. It is rarely a refined and discriminative inference, but very much a composite sketch between quantitative and qualitative conditions. That said, below is a comparative momentum and performance study normalized between the cyclical peak in 1946 and the current high in the SPX on September 18th. Based on this study, the equity markets would retrace the decline over the next few weeks, before resuming the downtrend in November.   
This retracement perspective is supported by the work of our friends over at EidoSearch, which provides quantitative expectation analysis - based on a comprehensive numerical search engine of historical market data. What makes EidoSearch unique, is that it utilizes innovative signal processing and classification technologies of the dedicated pattern itself, to generate quantitative forward looking projected ranges.
Based on the current trend in the SPX that began with the high set on September 18th and using a minimum pattern similarity of .85, the search found 89 similar instances (since 1980 in the SPX) - with the index up two thirds of the time over the next month with an average return of 1.8%. 
All things considered, while we remain bearish on the SPX's intermediate-term prospects, we find further room to run for the retracement rally that began in the SPX last week.

Monday, October 13, 2014

How Very Wet This Water Is...

In the illustrious wisdom of Don Rumsfeld - there are known knowns

The cheap thrills of a Halloween horror flick. The ecstatic squeals from your four year old on Christmas morning. The pleasures of indoor plumbing... And along those lines: Stocks drop - when the Fed turns the spigot off.   

As telegraphed as it has been since the Fed first embarked and outlined the taper last December, the equity and Treasury markets are currently expressing similar reflexes, that had developed on the two previous occasions where the Fed stepped away from policy accommodations in 2010 and 2011. Throw in the perennial spoiler that is the dysfunctional body politic we call Europe, and viola - it's Groundhogs Day all over again. 

Granted, this was largely expected - a known known, if you will. So obvious in fact, that many participants might have dismissed caution going into this fall, with a bit of the old market reasoning - that what's obvious to the public is obviously wrong. The problem, however, is that we find the current situation more mercantile and less motivated by game theory, per se, when it comes to the structural support extended in the equity markets today. The simple fact remains: since January 2009, all of the equity market gains have taken place during the weeks in which the Fed purchased 
Treasury bonds and mortgages - and conversely, the stock market has declined during the weeks in which it has not. While we would certainly agree the market functions and is weighed with a complicated and at times non-linear calculus - or that correlation doesn't always determine causation;  we'd speculate you're either a pollyanna or just playing advocate for the devil himself, to believe that Fed policy over the past five years, has not materially affected higher valuations in the equity markets. Needless to say, both of those opinions are rarely in short supply these days, either around the markets or in the media.

Notwithstanding the convoluted dye traces or reflexive feedback from the structural transmission mechanism itself, just look at who has been the single largest purchasers of stocks today: corporations buying their own secret sauce.  Where did that capital come from? Predominantly, from investors that were driven by monetary policy out of the safe haven harbors of the Treasury market and into a concerted reach for yield in the corporate debt markets - that inevitably becomes leveraged into equities through buybacks. Back in March 2011 (see Here), we described this
Dow 20,000
dynamic as moving "the credit bubble from real estate speculation over to the corporate ledger side of business." - adding,  "Is that a healthier bubble? Probably. Will that put a strong bid under the market going forward over the next few years? Probably." Penned under the auspicious, if not tongue-in-cheek headline, of Dow 20,000, the markets have come close to living up to that hyperbole. 
With that said, corporations have historically displayed the same deftness of individual investors, with all the prevalence's to buy high - or stand like a deer in headlights when the equity markets turn south. Not surprisingly,  contrarian thought appears to have no place in the gilded halls of corporate finance. What happens when the QE spigot turns off? As the demand/supply balances shift in the markets and equities come under pressure from (fill in the blank), market participants swiftly turn back to Treasuries and buttress negative feedback pressures in the equity markets. 

Circling back to more Rumsfeldian wisdom, a known unknown, was what effects the ECB could have on the US markets as the Fed walked away. Just a few weeks back the music was playing sweetly - the mood was festive. There was a cadence being carried between the Fed and the ECB, that at first blush implied the party could continue - and it was the beginning of the end of the bond market bubble. Sell bonds, they said... Over the past week, between the disappointments with the ECB meeting and the recent candid, but disheartening, comments from Draghi seemingly directed at Germany - the path of least resistance in equities has been lower, with the Treasury market receiving the broadest support. In some ways the political and market conditions in Europe is reminiscent of our own reluctant embrace of the Fed's extraordinary measures introduced at the end of 2008, but only really brought up to potent efficacy, deep into battle and pushed to the markets breaking limits. The question remains - will the German's still be atheists in a foxhole. Gun to their heads - we doubt it, but certainly wouldn't handicap how close they come to pulling or stumbling on that trigger. Will the DAX below 9,000, 8,000 or 6,000 bring them eye to eye with Draghi?

Over the past several months we have drawn parallels to both the equity and Treasury markets of the 1940's and believe the current market environment rhymes much closer with this time period, than the more recent Fed tightening regimes we continue to see referenced on a weekly basis or the two most recent bear markets that respectively began in 2000 and 2007. On one hand, we are reminded that this isn't the 1970's, where long-term yields rose rapidly with inflation expectations; and this isn't the pre-ZIRP periods of the 1980's, 90's - or even this centuries first decade, which enjoyed a fed funds rate that could maneuver on both sides of the road. This is a place we have playfully referred to as Esoterica - an unfamiliar territory for several participant generations, that we have found the closest parallels with the mirror of the long-term yield environment of the mid 1940's. 
Another significant condition comparable with the 1940's, is the Fed and Treasury actively intervened and bought market securities in somewhat similar proportions (debt/GDP), between the cyclical low in equities in 1942 and the cyclical peak in 1946. Reminiscent of the current lackluster fundamental backdrop that has diverged over recent years from the stoic strength of the equity markets, the massive bond buying program in the 1940's had a much stronger correlation to the capital markets it directly affected, than the macro climate that most economists appraise.
What happened when the government ended their extraordinary support through direct purchases of market securities? Similar to the reactions at the end of QE1 and QE2, the market swiftly revalued to the new demand/supply dynamics and shifts in monetary policy expectations. 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 rather analogous. 
Nevertheless, just as participants have put the cart before the horse when it comes to expectations of the Fed raising rates next year, we would caution that looking for an equity market slide 10 to 30 percent lower, would likely take a more circuitous path, than last weeks action might imply. While we continue to favor long-term Treasuries relative to equities, on a short-term time horizon, the equity markets are significantly stretched to the downside - and conversely, long-term Treasuries are significantly overbought. 
That being said, small caps continue to receive the brunt of the sell-off in the US, as nervous capital has climbed up the stairs from the higher beta corners, to the relative safety in large cap stocks. Comparatively speaking, while QE3 has run longer than the preceding programs, small caps have loosely followed the distribution pattern following the end of QE2. Namely, once the market rejected new highs in July, the subsequent secondary attempts and failures, served as further confirmation that the underlying market character and psychology has changed. A notable contrast with today, is that correlation conditions across markets in 2011 were near historic extremes going into August, as support gave way across indexes and asset classes - as traders ran for the exits in unison. While we would expect correlations between markets to tighten with further weakness, the conditions that helped give way to the cascade structures in 2011 are currently not present. 
As a parting thought, we find commodities relative to equities at their most compelling valuations over the past two decades. On one hand, if the worst case deflationary fears that have recently gripped the markets find further traction, historically speaking - commodities should outperform equities on a relative basis. Conversely, if those fears have been overblown - as we believe they have, commodities should rebound sharply, both relative to equities and on an absolute basis - as the recent strength of the US dollar unwinds. To a large extent, this win/win macro scenario is reflected in the chart below, that shows the equity markets relative to commodities retesting the secular top from around the new Millennium, with a pronounced negative RSI divergence - that in the past has marked a trend change in the asset relationship.

Monday, October 6, 2014

On the Dark Side of the Dollar

Further shamed by the US dollar's recent advance, the Inflationistas - circa 2010, were paraded out on stage last week, shackled to their failed beliefs that the policy accommodations initiated during the financial crisis would rue the day. Considering the conceit for which many had expressed that opinion at the time and general reluctance to reflect on what went wrong today, it comes as no surprise that the Statler and Waldorf's of the world are now relishing a tender schadenfreude sirloin, that has been marinating slowly for years. 

Having said that - and picking up on the socionomic theme in our last note, the degree of confidence by the policy advocates today practically matches the swagger the Inflationistas embodied in the Spring of 2011. If the markets have taught us anything over the years is that those with the loudest cheers and sneers typically mark a turning point in correlation with those beliefs. The performance overlap with any given dogma - especially inflation expectations, cycles like the moon. Full, slowly transitions to crescent - and then back to new. Nevertheless, we remain on the dark side of the moon, in constellations such as precious metals and have watched the long victory trot enter what we suspect will be it's final turn. 

Echoing the inverse market psychology and pulling the disinflationary tide, has been the Herculean strength of the US dollar, that extended its record streak to 12 consecutive higher weekly closes - to the boisterous belly laughs of the policy wonks. Conspicuously, this show of strength has resurrected the mantle in the market and the media, as - King Dollar, with the obvious understanding that it's dominance has only just begun. My have we come a long way from the new moon of the dollar cycle low in late April of 2011, where many of the same players and pundits openly declared the dollar crisis in full swing and just getting started. Back then, the mood in the markets were decisively dimmer, from both the usual suspects - to the ominous warnings from leaders in the private sector that the US consumer would soon face "serious" inflation in the months ahead. 
"Except for fuel costs, US consumers haven't seen much in the way of inflation for almost a decade, so a broad-based increase in prices will be unprecedented in recent memory" - Bill Simon, then CEO of Walmart - Walmart CEO Bill Simon Expects Inflation - USA Today 4/1/2011
A few weeks later the dollar bottomed, commodities topped and the waning crescent of inflation expectations began making its way to where it now presides - on the dark side of the dollar. Coincidentally, it was also a 10% move (lower) in the US dollar index in 2011 that engendered the runaway inflation hysteria and parabolic moves in assets such as silver. Of course today one could argue that the same market structure and psychology can be found in the dollar itself this time around. 

Monday, September 29, 2014

The Inverse Symmetry of Market Reflexivity

We follow precious metals, not as harbingers of financial armageddon or even geopolitical unrest, but primarily as a leading proxy of the commodity markets - that we feel provides the most nuanced view of which way the inflation vane is pointing today and possibly headed tomorrow. 

There is an ambiguity associated with precious metals relative value and causative motivations, that extends in part from their archaic beginnings - to legacy as the cornerstone in the previous monetary system. Because of this history, the sector has maintained a large congregation of fervent believers, that see gold and silver as the ultimate currency and backstop of fiscal and monetary responsibility. As a result of this heightened market psychology, they tend to be the most sensitive to expectations and can lead broader moves in the commodity sector and inflation expectations downstream. 

Back in the spring of 2011, we viewed precious metals - specifically silver, as testament to the exceedingly frothy and misguided expectations that many participants associated with inflation at that time (see Here). Where a one-way street for commodities and the dollar was assumed, we saw a dangerously lopsided market with all the hallmarks of exhaustion and absent of any real evidence, that the structural transmission mechanism of QE merited the rise in inflation expectations, that many participants held and/or feared. 

Generally speaking, we maintained this perspective as the downside pivots in precious metals and commodities unfolded, and incorporated a market posture around the thesis until late in the second quarter of last year. At that time, we felt that market conditions in the US dollar and yields had shifted and were no longer favorably behind the great unwind in metals and commodities. Moreover, sentiment had strongly capitulated, positioning was at bearish extremes and market structure was presenting clear signatures of downside exhaustion - e.g. waterfall declines.

Since then, the sector has rallied and receded three times over, most recently pressured lower by an exceptional move in the US dollar - the likes of which (11 week consecutive rally) have not been seen since the dollar was floated by Nixon in August of 1971. In hindsight, our expectations in precious metals, commodities and ultimately inflation - have been off the mark (i.e. wrong), predominantly because we initially assumed the respective trends would pivot swiftly out of their respective lows from last year. Forever the humbler of mice and men, market conditions have pandered to both sides of the field - the bulls most recently, and have rewarded mercenary traders with healthy swings to exploit, as the respective moves in both yields and currencies have worked to define the range.

So with the sector once again in tatters and circling the drain from last year's lows, does the recent breakdown in metals mark the start of another leg lower for commodities and inflation - or just another interim low in what has become an ever broadening range?

Like all speculative moves, they either eventually find some fundamental traction or exhaust when an external catalyst exposes that sentiment, positioning and the underlying market psychology had become dangerously lopsided and misplaced. This was the case in 2011 when a weak dollar was a foregone conclusion and inflation expectations had reached a fever pitch. Seemingly out of left field, the death of Osama bin Laden pricked the speculative run in silver (see Here), which also marketed the top for the broader commodity sector. 

Inflation expectations - just like asset prices, can rise and fall with strong reflexive feedback tendencies. Look no further than the recent past to see where the currency markets have magnified the moves in the commodity markets and inflation expectations around the world. With hindsight 20/20, from a fundamental perspective did it make much sense that inflation expectations surged as the financial crisis began? With global demand cratering - did the market fundamentally merit $140/barrel oil? One could make the argument that reflexivity greatly impacts trends at the trough of the cycle, where the velocity of money declines and where speculation can have a disproportionate influence on fundamental expectations. That being said, it can cut both ways - which once could argue has contributed recently to magnifying the moves in the currency markets, the downturn in commodities - as well as inflation expectations. Considering the US is poised to end what we perceive became disinflationary policy and where the balance of the world's largest central banks look to stimulate their own economies and inflation expectations, does a continuation of the broader disinflationary trend that began in 2011 on the back of the US dollar hold much water today?

We don't believe so - and find similar market conditions in both sentiment and positioning, that were present at the June 2013 lows in precious metals and which are inverse to the underlying market psychology that was present at the top of the cycle in 2011. Moreover, with commercial short positions in the US dollar the largest on record and with bullish speculative sentiment pined at the top of the range, the tinder doesn't get much drier should a match get thrown. The same could be said on the opposite side of the exchange for our commodity proxies in gold and silver as well as the euro. From an anecdotal perspective, you also find parallel despondency towards gold that was present last June from both producers and pundits alike.
From a basic technical perspective, the damage ended last week for both gold and silver around trend line support that extends from November 2001 in gold and March 2003 for silver. 
Considering current market extremes in both sentiment and positioning, the impetus for a further breakdown below support would likely prove ephemeral. Moreover, momentum is still expressing a positive divergence on both a weekly and monthly time frame in both metals.
Over the past two weeks silver broke down below last year's daily and weekly low and found support between the exhaustion gap of the 1980 blow-off top and trend line support extending from 2003. Similar to the weekly low registered in the first week of July (2013) where managed money started covering their expansive short positions, current shorts began covering last week - with an approximately 50% larger aggregate position than what at the time was a historic extreme last year. 

From a qualitative perspective, both metals have weathered the explosive US dollar rally comparatively well. Unlike conditions in the first half of last year where both yields and the dollar worked in tandem against the sector, yields have stair stepped lower since May while the dollar became the outlier influence. 
In a note at the end of May, we had updated our commentary on different symmetries - both mirrored and inverse, that had developed along varying time frames in 10-year yields (see Here). Essentially, trends were being replicated - from the mirrored symmetry of the long-term cycle, to its inverse structure that yields have been following over the past four years. 

Additionally, mirrored relationships have also maintained form between long-term yields/gold and equities/gold. With yields acting as the common denominator, inverse symmetries have translated with similar complexity and breadth from the top of the cycle in gold miners to what has become an equally expansive inverse reflection in the hardest hit corner of the sector. 

Behold, the inverse symmetry of market reflexivity. 

Monday, September 22, 2014

Dollar Hollers - What does it say?

Paul Tudor Jones, once fittingly observed, "Fundamentals might be good for the first third or first 50 or 60 percent of a move, but the last third of a great bull market is typically a blow-off, whereas the mania runs wild and prices go parabolic... There is no training, classroom or otherwise, that can prepare for trading the last third of a move, whether it's the end of a bull market or the end of a bear market."

In today's policy driven system, where fundamentals have been melded and supplanted by the hand of the Fed, the relative outperformance by our own monetary authorities has not only buttressed US equity markets relative to the world, but also the dollar. This dynamic has been in place since the embers of the US financial crisis, blew across the pond in the summer of 2008 and ignited a firestorm around the world that fall. Despite our clear culpability in setting the world ablaze, in another counterintuitive twist of fate, we had a head start of working and digging the fire lines, that eventually brought the economic disaster under control - first. The "new normal", posited directly following the financial crisis, looked a whole lot like the old normal from the late 1990's.
*Charts updated through Friday's close

With the US dollar index now flirting with the topside of its long-term range, a break above might imply that the move was not the last third - but a new game altogether. Considering the juxtaposition of the Fed withdrawing its fire brigade as the rest of the world turns up their hoses - how likely does that seem? 
At face value - and from an "old school' fundamental perspective, quite likely. However, as we alluded to before, since the financial crisis, the doctrines that have instigated the reach for yield and differential of capital flows towards the US, have been framed relative to what the balance of the worlds major central banks were doing to support their own economies. With the ECB now finding religion and the Chinese seemingly not far behind, the shear stresses that have engendered a positive skew in the US equity markets and dollar, should diminish as the Fed walks away. Moreover, we find it noteworthy that the conventional wisdom in the euro today now echoes the expectations from earlier in the cycle for the dollar: that the currency would be pressured lower by Fed policy. 

From a broader macro point of view, it appears more likely that the dollar is completing "the last third of the move", rather than a return to conditions of the late 1990's that an upside range break would imply. 

Friday, September 19, 2014

An Expectation Gap

Ignoring what Yellen continues to emphasize as her intentions to leave rates lower - longer, participants once again focused their attention Wednesday on the updated dot-plot projections, that implied some Fed officials may have turned towards a more aggressive policy path over the next two years. This hawkish bias was confirmed in the market, as 10-year yields rose to ~ 2.6% and 5-year inflation breakevens collapsed to just under 1.72%. Where the rubber met the road - real rates rose; causing the financials and US dollar to surge, commodity currencies to collapse and precious metals to weaken. 

Similar to the reaction of the taper-tantrum last year, the ballast of the market continues to not believe that Yellen will err on the side of caution and maintain the status quo, implicitly encouraging inflation to perk before even considering raising rates. Here lies the large expectation gap in the market - and one we expect will capitulate towards the Chairwoman's underlying directive. As Jon Hilsenrath pointed out this week, the old market adage, "Don't fight the fed", should really be "Don't fight what the Fed says" - this time around the block. This dynamic is contrary to how participants reacted to the last time inflation was troughing during the financial crisis, when traders expectations were greatly in line with the Fed - as they both jumped hand and hand into the trenches. Today, there exists a large hawkish skew in expectations - predominantly swollen by the uncertainty surrounding the Fed's exit plan and the leftover and misplaced biases of previous rate tightening cycles. While we continue to believe participants are putting the cart before the horse when it comes to raising rates and inflation expectations, we have clearly remained offsides over the past quarter in anticipating the timing and catalyst of such a paradoxical resolution. 

Further muddling the waters has been the more aggressive policy and posturing by the ECB in response to persistently low inflation in the eurozone. These actions have encouraged and maintained downside momentum in the euro, which has re-engaged the value trap like conditions for commodities - as the disinflationary trend in the US has once again rebooted on the back of a surging dollar. While the circularity of conditions is enough to make even Rust Cohle smile, the feedback loop has maintained trend in the equity markets with all the smoothness of a Madoff return - basking under the fair weather conditions of moderating inflation. Conversely, this has caused various reflationary assets (i.e. precious metals, commodities, commodity currencies, emerging markets) to stall out for a third time over the past year - as participants inflation expectations have broadly fallen. All things considered, we believe those biases are once again misplaced and find the same relative value that has remained attractive over the past year, in corners such as precious metals and their respective miners, the Australian dollar and emerging market and Chinese equities. 

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.