Tuesday, September 29, 2015

Connecting the Dots - 9/29/15

Whether the Fed moves later this year - sometime in 2016 or stands pat for the foreseeable future, their paint by number projections of where they foresee the fed funds rate headed are still exceedingly optimistic, in our opinion.

Over the past several years we've noted the mirrored symmetry of yields retracement return from their 1981 secular peak, with the abstract idea that the return would be roughly commensurate with the rise; a move that spanned 40 years from the trough low in long-term yields in 1941. This perspective would imply a lower for longer environment, perhaps much longer than most participants suspect.
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The relative symmetry represented in the current yield cycle is not unusual and looking back across a broad span of history, quite characteristic. The previous cycle (from trough to trough) spanned 40 years to the month (1901-1941), a period in which yields rose for 20 years followed by a 20 year decline. Unlike the current downtrend in yields that has trended to the trough with acuminating symmetry with the mirrored rise from 1941 to 1981, the previous cycle exhibited an asymmetric return below the 1901 lows, as economies pushed up against the limits and unbalances exposed and magnified during the great depression - and markets stumbled their way across the transitional divide to the next long-term growth cycle.  

Apart from a quantitative or fundamental perspective, and simply approaching what these massive debt and growth super-cycles reflect, we updated and fleshed a bit of the basic premise out in a note this March: Size Matters & Their Estimates are Still Too Damn High

The composite takeaway is: the yield trough that we currently reside in and which constitutes the divide between these overarching growth and debt cycles (e.g., the railroad, electrical and oil ages etc.), reflects a largely proportional transition with the broader cycle itself. Global economies and markets that were highly in phase (constructive interference) leading into the financial crisis, have diverged with greater policy and growth dispersions (destructive interference) once in the trough. This destructive interference, which the current market and policy environment is a microcosm of, could prevent secular trends from establishing durability and will likely present an ongoing transition for participants, as conditions globally for the next long-term growth cycle will need further time to absorb and delever the last. Some refer to these dynamics as secular stagnation, or as the man who coined the phrase some 75 years before explained;
"...passing, so to speak, over a divide which separates the great era of growth and expansion of the nineteenth century from an era which no man, unwilling to embark on pure conjecture, can yet characterize with clarity or precision. " - Alvin Hansen, Economic Progress and Declining Population Growth, 1939
While the Fed's dot plot projections continue to trend lower over the course of this year, in relation to either the retracement symmetry of the long-term cycle's trough or the comparative path from the last time (1930's and 1940's) short-term yields fell to the lower bound of the transitional divide, their estimates are still too damn high. Moreover, although the Fed Funds futures market has been notably more sanguine about the prospects of higher rates, even their more dour and less academic expectations are likely far too optimistic as well. This is where the rubber has met the road in the markets, as these relatively lofty expectations towards yields and Fed policy in the face of expansive monetary policy accommodation across much of the balance of the world, has greatly impacted world markets, most notably through the broad strength of the US dollar. 
How and when these varying expectations of posture and policy resolve in the market has been a $64,000 question over the past several years. Although general uncertainly towards the ambiguities and uniqueness of where the Fed interacts with the market has provided structural support for the US dollar - as well buttressing shorter-term yields along the curve (1-3 years); we do expect the markets to ultimately reflect conditions closer to the transitional divide of the previous cycle, which implies that the top of the range for the fed funds rate to be around 0.5 percent for an extended period of time, rather than the 3 percent median estimate of what the FOMC eventually envisions over the next few years. While we believe the Fed will marginally move off its crisis stance of ZIRP sometime over the next few months, the assumption that the global economy could absorb a move of the Fed's expected magnitude of tightening is strikingly unrealistic and largely disputed by market history.

This is where opportunity for investors lies today, as global market cycles have become dispersed in the trough of the transitional divide. From our perspective, markets that have taken the brunt of tightening through the broad sword of the US dollar (e.g. emerging markets and commodities), should find relief from those pressures as concern with future outlooks align closer with more realistic expectations. 


As a quick tangential postscript, the inverse relationship between the Nikkei and Japanese yen that we've closely followed for broader reads in the market (see Here), appears to be completing the third-act leg lower in the Nikkei. 

Over the next several sessions, we will be looking for an upside reversal in the Nikkei that should modulate the correlation relationship with the yen, away from the inverse extreme that has existed since Abenomics was first floated in the fall of 2012. As such, we like both positions going forward into Q4.

Friday, September 18, 2015

Gold Takes its Cue

She came, she saw she passed. After confining herself to radio silence for the better part of two months, chairwoman Yellen yesterday lit the fire and wafted the signal: the Fed would stand pat on raising interest rates. Moreover, there was a less than hawkish tone delivered towards the intermediate-term outlook both in the communique and the nearly hour long press conference that followed, that broke the back of the dollar as well as the swell in short-term interest rates that had been cresting higher into the September meeting. The long and short of things, the initial relief rally in equities quickly fizzled, the yen and gold found another foothold and real yields declined. 

Gold, which had been trapped over the past few years between a strengthening dollar and rising real yields and squeezed recently by expectations of further tightening, took solace in yesterday's news. While we had liked the position in either scenario because we felt the dollar and real yields already reflected lofty expectation to more contemporary tightening cycles, the news cleared the way for gold to stretch its legs in a market environment that should broadly support the reversal. 

As shown below in Figure 1 between gold (inverse) and 10-year real yields; similar to the market dynamics at the top in gold that was stretched across a broad negative divergence with real yields, the trough for gold has been carved lower over the past two years with a positive divergence with lower highs in real yields. Going forward, we expect a weakening dollar to once again pull real yields lower, which should go a long way in rejuvenating gold - as well as the broader commodity complex. 

Figure 1
In the wake of the September pass, the similar performance pattern that we've followed throughout the year with gold's secular low in 1999, appears to have successfully retested the lows from this summer and is now climbing the stairs out of the basement on the wings of less hawkish expectations. 
Figure 1
 One and two year fractals with the 1999 secular low.  
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Trending with gold through broad dollar weakness, the yen has led the way higher as expected. With volatility increasing in the wake of yesterday's decision, we included updates of the yen and Nikkei series from Monday's note (see Here) - as well as an exploded view of the anticipated next leg lower in the Nikkei that appears underway.

Over the past few years we have leaned on the Nikkei and yen at times of elevated volatility for broader reads in the markets. This is primarily because of the yen and Nikkei's tight inverse correlation that has been in place since Abenomics was first floated in November 2012. As we commented on in previous notes, we are looking for the correlation extreme between the Nikkei and yen to thaw, in a manner similar to the reversal in Q1 2009. The difference of course being, that the trends today between the Nikkei and yen are inverse to that time (Figures 3-4). That said, we expect a similar outcome from the correlation extreme that also takes a reflationary path for both assets (Figure 6). 
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Tuesday, September 15, 2015

Great Expectations

There’s an old saying, "If you have no expectations, you'll never be disappointed.” Some might even suggest it's universal wisdom – a tenet that neither leads one astray nor fools with randomness. And while the long reflection of the more than six year bull run in equities benevolently nurtured a Zen approach towards risk (i.e. don't think, just buy), the past year has introduced a challenge to that dogma, as the Fed stepped away from quantitative easing and looked to further normalize monetary policy through posture, now perhaps practice. The end result, has lengthened the expectation phase for this policy cycle, commensurate with the extraordinary span of ZIRP. As such, the ambiguity – either intended or not, has muddled the macro waters for participants to gauge conditions of where they are actually swimming.

When it comes to the US dollar, this prolonged and fuzzy chapter in the face of easing across much of the developed and emergent world, cleared the airspace for the buck and real yields to take flight in; which has already tightened financial conditions – in our opinion, with even greater capacity than what the Fed could/will engender with marginally raising the fed funds rate off ZIRP over the next year. 

Here's Morgan Stanley in August characterizing an impact of a stronger dollar:

The role of the USD in financial conditions is also significant. We find that a 1-month 1% increase in the nominal trade-weighted exchange value of the USD versus major currencies would add roughly 0.14 points to the Chicago Fed's adjusted financial conditions index, indicative of substantially tighter financial conditions. To put it in perspective, a 10bp widening of the 2-year/3-month Treasury yield spread would have an equivalent impact on financial conditions. 

With the Fed's preferred measure of the dollar (broad index) gaining more than 15 percent over the past 12 months and the DXY trade-weighted index cresting in March over 20 percent higher, financial conditions have tightened swiftly. Considering the dollar's reserve status throughout the world and the more than 9 trillion in credit outstanding outside the US, the impact has been especially severe overseas. Moreover, taking into account the move higher in real yields from the initial suggestion of an end zone for QE by Bernanke in May 2013, through the completion of the taper last October, markets have reflected tighter financial conditions for some time. 

We know in past cycles – and characteristic of markets forward discounting dynamics, the dollar strengthens during the expectation phase of tightening and typically begins to weaken directly before as markets become confident that the Fed will move. Commonly understood by traders as buy the rumor – sell the news, we've playfully suggested it’s become, buy the hype – sell the bluff. The bluff of course being, the posture and expectations shaped from more conventional tightening cycles, would have stronger influence within the financial markets, than the actual structural significance of a quarter point hike – or less. Granted, this is par for course with the Fed and monetary policy over the past 6 years, where the behavioral reflex inferred was arguably as or more important than the structural transmission mechanisms themselves. 

That said, having their cake and eating it too has proved difficult for the Fed. While the US equity markets had enjoyed the warm gentle breeze of disinflationary conditions over the past several years;  a consequence of elongating the expectation phase of the next pivot in posture or policy, engendered a vacuum in the currency markets that supported and strengthened the dollar – and which ultimately has worked against their goal of achieving a 2 percent inflation target.

Just recently, Stanley Fischer– Vice Chairman of the Fed, remarked on the dollar's sizeable impact on inflation and the economy in his Jackson Hole speech this August.
In the first instance, as already noted, core inflation can to some extent be influenced by oil prices. However, a larger effect comes from changes in the exchange value of the dollar, and the rise in the dollar over the past year is an important reason inflation has remained low (chart 4). A higher value of the dollar passes through to lower import prices, which hold down U.S. inflation both because imports make up part of final consumption, and because lower prices for imported components hold down business costs more generally. In addition, a rise in the dollar restrains the growth of aggregate demand and overall economic activity, and so has some effect on inflation through that more indirect channel.3  

To get a sense of the timing and magnitude of these exchange rate effects, chart 5 shows dynamic simulations of a 10 percent real dollar appreciation, based on one of the models we maintain at the Federal Reserve.4 The estimated pass-through from import prices to consumer price inflation occurs relatively quickly, with effects becoming evident within a quarter and the bulk of the overall effect occurring within one year. By contrast, the portion of the dollar effects on inflation that work through the channel of overall economic activity occurs with considerable lags. In the model shown here, the appreciation has its largest effect on gross domestic product (GDP) growth in the second year after the shock. Thus, it is plausible to think that the rise in the dollar over the past year would restrain growth of real GDP through 2016 and perhaps into 2017 as well. The rise in the dollar since last summer, of about 17 percent in nominal terms, with its associated declines in non-oil import prices, could plausibly be holding down core inflation quite noticeably this year. - U.S. Inflation Developments, Stanley Fischer

Weighing into the inflation/policy debate this past Friday, Kenneth Rogoff, the esteemed professor of economics and public policy at Harvard, questioned the logic surrounding the growing idea that the Fed's liftoff from ZIRP will be a one-off event. Concerned with the lack of inflation and arguing the Fed should wait to raise until they see the whites of inflation’s eyes, the idea of lifting rates just to prove they can, doesn't seem to be worth the risk for Rogoff.  

"What is the logic of doing it, also?" he said in response to a question on the merits of a rate hike followed by a long pause. "It's very asymmetric. If we see inflation, they can start raising rates, and if you go in the wrong direction, it's harder to do something about it."

"The models have not been very good for a long, long time since the financial crisis, and why you would want to rely on that and not be more on seeing inflation I don't understand," said Rogoff. "After your models have been so off for so long- your ship's been thrown around in a storm and you don't know where you are when you land- you kind of want to see the inflation more than usual."

The danger in signaling a long pause, or potentially having to reserve a hike soon thereafter, is that it fosters unnecessary uncertainty, the professor asserted.  

"You're trying to create some certainty about what your path is, to have a reaction function people understand," Rogoff said. – Ken Rogoff Slams One of the Most Popoular Theories for What the Fed Should Do Next, Bloomberg

What we'd argue that Rogoff is missing today (that Fischer gets, see Here) with respect to policy at the zero-bound, is the significance of the signal itself to the markets (as small as it may be), which greatly influences confidence and consequently, inflation expectations. From a behavioral point of view, QE and ZIRP have not been considered a positive station for the markets for some time; rather much the opposite – a confirmation in the belief that the economy still requires further external support. From a market perspective, maintaining current policy is in and of itself – disinflationary. Notwithstanding the tepid measure of inflation over the past year – which as we contend is more a consequence of the currency markets and the drawn out and ambiguous expectations of this policy cycle; the underlying conditions in the economy – from near full employment to robust business and construction spending  at the very least supports further normalizing policy and posture from a crisis stance.

As counterintuitive as it may sound, but in-line with the coriolis-like effect on expectations and outcomes for this cycle (i.e gold, silver and commodities round-trip across ZIRP and QE), we'd argue financial conditions will loosen (i.e. real rates decline) over time as the Fed either finally marginally moves off ZIRP next week or provides greater clarity of policy going forward. Whichever the case, we believe the magnitude of the rate hike will be exceedingly modest – and consequently, the dollar's decline from the relative performance extreme will have greater positive impact on the global economy and inflation expectations, than a governor on growth of higher nominal yields.

For a few of our own Great Expectations, see Here.  

Monday, September 14, 2015

Connecting the Dots - 9/14/15

As traders stroll and stumble into another marque event at the Fed this week, we thought we would do a quick follow-up on a few markets we continue to keep close tabs on. 

- Presented in no particular order from previous notes.

The US dollar index continues to chip lower, loosely following the breakdown from the 1985 secular high. Similar to the market reflex in yields following the suggestion and commencement of the taper that drove the 10-year yield to a relative performance extreme in late 2013 - and traders to infer a continuation of like-conditions throughout much of 2014 (see Here); the move in the dollar over the past year has been equally severe with convictions of further strength, just as strong. Although event risk from the four largest central banks (Fed, ECB, BOJ & PBOC) remains high coming into the fall, we still expect the dollar to step lower over time as greater clarity on policy encourages listing positioning to sell the news. For more recent thoughts on the dollar, see Here

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Coming into the Fed decision Thursday, gold is testing the lows from this summer's swoon, similar to the performance pattern of the secular low achieved subsequent to the first rate hike in June 1999. At $1100/oz, we like gold - rate hikes and all. For recent thoughts on gold, see Here
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With the recent breakdown in global equity markets, the Japanese yen recaptured and now sits on its nearly 30 year trend line support. Over the course of this year, we have waited for the negative correlation extreme that has been in place over the past three years between the Nikkei and yen to reverse course (Figure 11) - and continue to like the Nikkei's longer-term prospects. Nevertheless, we suspected the shift would come with greater strain on equities; similar (but inverse, Figures 12-13) to how the negative correlation extreme between the Nikkei and yen resolved in 2009. As such, we have approached a position in the yen as a hedge to any equity exposure in Japan. Per the 2009 comparative (Figure 13) pattern, the Nikkei would have another minor leg down, before recapturing upside momentum into 2016. 
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Bonds continue to make the turn lower, similar to the reversal pattern of the previous multi-year Treasury rallies (Figure 16). Although we're skeptical of a sustained downturn, we still don't like the near to intermediate-term prospects for Treasuries and expect dollar weakness and euro strength to support the trend. For more recent thoughts on Treasuries, see Here
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Despite oil taking its time in plumbing the lows, we still like its long-term prospects relative to US equities and see commodities in general as an asset class outperforming the SPX - as the Fed further normalizes policy. Comparatively speaking, the severe relative strength condition coming into 2015, was in hindsight (see Here), an early indication that the decline in oil would take the better part of the year to fill out (Figure 22).
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Although the Shanghai Composite continues to get lambasted by the media for China's heavy handed response to its swoon, similar to our long-term outlook on Japan, we expect a resumption in the fourth quarter of its outperformance over the SPX into the end of the year. That said, we will continue to keep a close eye on the SPX relative to the Meridian trend line (~1774 for September), to help better shape our long-term expectations for US equities (see Here).

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