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. 
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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. 
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"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. 

Wednesday, November 30, 2016

Connecting the Dots - 11/30/16

Despite the enduring enthusiasm in equities since the US presidential election, we continue to follow the proxy pivots in gold that has broadly led the trend in equities by approximately 4 weeks over the past 2 years. Should the relationship persist, we would guesstimate a pivot lower in equities approaches over the coming week. And while the S&P 500 has fully benefited from the unbridled capital outflows from Treasuries and safe haven assets that helped inspire fresh all-time highs across most indexes over the past 2 weeks, emerging market equities remain in lock step with gold’s leading structure that points towards another leg down after the current retracement rally exhausts. 
 
That said, it would not surprise us to see US equities underperform (on a relative performance basis to EEM) on the downside, as we expect similar to last year’s dynamics going into and after the December Fed meeting, another sell-the-news reaction in the dollar manifests. A good leading indication that the dollar rally has run its course would be for gold and silver to find their respective lows over the coming week or so as the equity markets begin to turn down. We indicated below the two previous examples over the past two years of where a similar dynamic had developed. 
 

The US dollar index has again broken above 100 for the fourth time in the past two years, which has closely correlated with cresting rate hike expectations of the Fed. The last time the CME Group’s Fed Fund Futures probability for this December meeting rose above 90 percent was the first week in January of this year – before global market pressures significantly reduced expectations, which very likely had a negative feedback effect on the near-term outlook for growth and hence the economic data downstream in the following months. Despite participants mood in yields and rate hikes pivoting 180 degrees since the lows in July and some marquee money managers becoming increasingly more bullish on US economic growth in the wake of a Trump victory, US markets are still at the mercy of a fragile global equilibrium that is invariably adversely affected by a much stronger US dollar and tighter financial conditions worldwide – not to mention a domestic economic expansion already historically long in the tooth. 

Consequently, we tend to defer to much longer-term perspectives on yields and growth that despite what the interim rally might suggest, continues to point towards a lower-for-longer market environment well into the next decade. 
While we do expect the current weakness in Treasuries to extend into early next year and that yields would be more supported than the dollar over the coming years as we foresee the uptrend in inflation continuing, both markets are confined by a much broader construct that we believe is not yet under a more secular persuasion or has digested and crossed the transitional divide to the next major growth cycle. This long-term outlook remains for equities as well, as 2200 on the S&P 500 was our secondary target back in January, if the market found support at the Meridian – as it did a few weeks later. And although it wasn't our base case scenario back then, we still hold the respective extremes (both bullish and bearish) as outlier probabilities, with now considerable less upside opportunity today from a long-term historical perspective.
Expecting US growth will now resume a trajectory last seen during the halcyon days of the 1990’s, or that yields on the 10-year will again rise above 4 percent, is putting the cart well out in front of this horse, regardless of whether it was the Fed – or now Trump, holding out the carrot or waiving a large stick. Less we forget, we've been whacked plenty and have eaten trillions of bushels of carrots over the past decade with little to show for it in terms of growth. Sticks and carrots may have helped repair it, but only time will heal these wounds.

Although the US equity markets have enjoyed recent strength since the election, the honeymoon appears to be ending and we expect the new members of the bull brigade to have their gilded growth thesis tested as the equity markets could again become the sharp tip of the sword prodding at the sides of the Fed next year.

Monday, November 14, 2016

Clear & Present Danger

While the list of US money managers pivoting bullish last week on the US economy and equity markets reads like a who's who list of hedge fund titans, the broader reflationary trend that had displayed cracks in its foundation last month (see Here), once again began to quake and break down.

The main forces at work cleaving performance within the markets were longer-term Treasury yields and the US dollar, the impacts of which were mostly absorbed by US equities to date while emerging market stocks, precious metals and commodities took the full impact of a much stronger dollar and surging Treasury yields. 

What's interesting and perhaps lost or largely ignored over the short-term, is that although many strategists and managers now see an intermediate-term catalyst for US equities and a rejuvenation of inflationary forces here in the US  emerging market stocks that had significantly outperformed within the wider reflationary trend this year, now face a clear and present danger as yields break materially higher and as the dollar targets its highs from last year. 

Our comparative with the 1987 breakdown in long-term Treasuries would indicate a near-term low is imminent of a first leg down within a broader ABC corrective decline. We estimate this pattern would work out to an eventual target for the 30-year Treasury bond of around 140 next year.
Considering the recent intermarket developments, we continue to like the protection of a short position in EEM, that is still loosely following the breakdown of the reflationary outperformance of US equities in late 1987. For more on our thought process behind this position, see Here. While we never expect history to repeat in perfect cadence or proportion, intermediate-term support was broken last week that from our perspective points to further declines.
This negative outlook also applies to oil, that continues to follow the inverse performance of the dollar, which is now targeting its highs from last year. 
Although US equities came up a bit short in open market trading of our corrective decline target of around 2050-2060 in the S&P 500, we still think it warrants following the leading pivots in gold that now suggests another leg lower is approaching.