Wednesday, September 2, 2015

Draghi on Deck

One of the many challenges for participants today in navigating the macro-straits, is at times dismissing the conventional market wisdom for more counter-intuitive perspectives - and always keeping an open mind to where and when the respective monetary handlers may choose to intervene, regardless of one's bias or market posture. We've noted in the past that since the markets arrival at ZIRP and QE in Q4 of 2008, many long standing bedrock orthodoxies have been turned on their head, from "inflation is always and everywhere a monetary phenomenon..." - to the other bookend policy expectation that QE lowers interest rates. 

Back in 2009 and 2010, some of the most prominent minds in and around finance argued that such large scale asset purchases by the Fed risked "currency debasement and inflation" and would not achieve the Fed's objective of promoting employment. So confident with their assumptions, some of them eventually scribed a manifesto as a strongly worded open letter to then Fed chairman Bernanke (see Here) in November 2010.

Notwithstanding the fact that inflation wasn't exactly the enemy of the state during and after the crisis... LSAP's did not usher in an era of hyperinflation, but did at the outset of each program, raise inflation expectations and bolster risk appetites, that over time helped smooth the transition from the financial crisis, which ultimately became reflected in the long trend lower in the unemployment rate.


With world markets coming under significant pressure this August and with the September ECB meeting on the docket first thing tomorrow morning, the probability that President Draghi implies or takes further action in Europe has increased. Moreover, from a comparative perspective of the currency and bond markets from the last deflationary scare, there are some similarities to where the Fed surprised the markets in March 2009 with an expanded salvo of stimulus, to the tune of over twice the initial program introduced at the end of November 2008. 
While conventional wisdom is looking for a weaker euro to soothe deflationary concerns in Europe, we would argue that a broadly weaker US dollar would have greater efficacy, as it could reflexively affect inflation expectations worldwide, which in our opinion would have the widest and deepest influence on economies throughout the EU. 

In many ways, this is the flip-side of the coin we described in September 2012, as the dollar rally and the great commodity unwind were still in their respective infancies.
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Today, my work has suggested that the long-term commodity cycle has crested, growth across both the developed and emerging world economies is turning down, China is slowing rapidly - and the US dollar has found a secular low. I like to remind myself that it's much easier to rekindle economic growth across the globe, when all that is required is a large shovel, boat and a frothy marketplace. Although commodity inflation has provided the US consumer a painful transition in the pocketbook over the past decade, we likely do not fully appreciate how beneficial that same knife has smoothed the impact of our own financial stumbles - in a world more than ever financially dependent upon the health of the majority. - A Lucid Confusion
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Fast forward to today, the pain imparted on emerging economies through a strong dollar and weaker commodity prices has likely run its cyclical course. Over the next few years we expect the dollar to once again test the bottom of its long-term range, creating a rising reflationary tide that should lift most boats - including Europe's. 
Although characterizing causality in real-time is at best an educated estimate - and at worst a dead end; macro's one-way street (described here last month): long US dollar, long Treasuries and short oil - has made further progress through the turn and now appears headed towards a reflationary road. 

Even with the considerable pressures brought on the equity markets last month, Treasuries did not overshoot to the upside as they frequently have in past risk-off environments, but took further steps in completing a descending topping pattern - similar to the exhaustion of the two previous multi-year Treasury rallies. We maintain our expectations that the 10-year will test long-term overhead resistance later this year and see a weaker US dollar doing much of the heavy lifting, with regards to improving inflation expectations - both here and abroad. All things considered, we still like the longer-term prospects of hard commodities such as oil - especially relative to US equities - and view the recent reversal as a successful retest of the March lows. 

Monday, August 24, 2015

It's Different This Time... but it's Happened Before

For someone carrying a dogmatic bent of the bearish persuasion, there's always conditions somewhere that can fill the narrative. Liquidity provisions, leverage, breadth, global macro developments - the list can go on and on and there's plenty of sites that cater to these concerns or prey on participants more primal fears. Then again, cognitive biases are routinely applied on both sides of the tape, regardless of team. The truth, however, is in the long shadows cast since the financial crisis, participants are still greatly vulnerable to strong recency biases and likely to assume the worst. This is why today the most frequently cited equity market parallels are made to conditions in 2007 and 2000 - or the catastrophic declines of 1929 and 1937. When it comes to equity market analogs, its easy to invoke the ghosts that have haunted us the most. 

The problem, however, is - it's different this time.

No, not that kind of - different this time. Rather, the disconnect that's existed for years from ZIRP and QE - between the markets and the underlying economy, lends itself to even rarer historic comparison - and this applies to everything from Fed tightening cycles, to recessions and inverted yield curves, but also to future equity market returns and the data miners that like to dig in between. It's dangerous to the extent that it could break long standing conventional market wisdom on both sides of the field, which in the end could leave participants and strategists wondering which way is up and how to position a portfolio, with few historic parallels to draw from. The bulls would be hoodwinked by waiting for the typical bear market catalysts (i.e. a downturn in the economy and inverted yield curve) and the bears would eventually bite off more than they can chew by following the aforementioned market cycles with expectations of a 50 percent or more market decline. 


Like most things, we believe the truth will eventually be found somewhere in the middle and feel both outcomes are unlikely today because of what ZIRP and QE provided the economy and markets.  All things considered, we still find the closest market and policy parallels to the previous trough of the long-term yield cycle of the mid to late 1940's, where the Fed began normalizing policy after providing extraordinary support through the Treasury markets between 1942 and 1946.

- Click to enlarge images - 


In Milton Friedman and Anna Schwartz's - A Monetary History of the United States, the market climate in the 1940's was described as being so suspect of the Fed and Treasury's visible hand, that even after a 150 percent rally in the equity markets that began in 1942 - went through a recession in 1945 and exhausted around Memorial Day in 1946; participants by and large didn't trust the market or expect inflation to rise as precipitously as it did from the trough going into 1947 and 1948.
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"Despite the extent to which the public and government officials were exercised about inflation, the public acted from 1946 to 1948 as if it expected deflation."  
"An important piece of evidence in support of this view is the harbinger of yields on common stocks by comparison with bond yields. A shift in widely-held expectations toward a belief that prices are destined to rise more rapidly will tend to produce a jail in stock yields relative to bond yields because of the hedge which stocks provide against inflation. That was precisely what happened from 1950 to 1951 and again from 1955 to 1957. A shift in widely-held expectations toward a belief that prices are destined to fall instead of rise or to fall more sharply will tend to have the opposite effect - which is precisely what happened from 1946 to 1948." - Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1963
Today, as investors grapple with the more esoteric nature of monetary policy enacted in the trough of the long-term yield cycle, we believe a similar fate awaits the equity, commodity and Treasury markets as the Fed looks to further normalize policy. On one hand, the stalwart strength extended to the equity markets on the back of the Fed's extraordinary policy support - and which to a large degree suppressed equity yields and commodity prices, is likely in the markets rearview mirror. On the other hand, those policies should go a long way towards smoothing the transition in the economy as it works its way across the transitional divide between growth cycles. The net effect, we believe, should allow the US consumer and households greater traction in the economy (i.e inflation), even while US equity prices decline from what we perceive to be a valuation ceiling extended by ZIRP and QE and which ultimately should buttress the Treasury markets - as it did in the 1940's, as many market participants feared the worst and took shelter in bonds.

A few weeks back at the end of July (see Here), we found the equity markets precariously situated going into the back half of summer and into the much anticipated September Fed meeting.
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A potential equity market set-up from our often cited 1946 cyclical top, may be finally getting ready to "set the hook", as participants brace for a future rate hike from the Fed this fall. Should the historical guideposts prove prescient, downside support in the equity markets will fail over the coming weeks, opening the door to the first material correction in US equities since the summer of 2011.  
Assuming the correction materializes, whether the Fed choses to act in September - subsequent to a market development such as this, obviously remains contingent on the magnitude of a potential dislocation and its broader kinetic impact in the markets. That said, based on our research of the long-term yield cycle (see Here & Figures 4-6), we have always believed that the Fed's latitude to tighten would ultimately be limited by developments in the market and the economy's capacity to carry the burden of higher rates (seeHere). 
Cyclically speaking, from a top down view of the long-term yield cycle (Figure 1) - as well as the reach of equity market valuations (which we've argued are greatly driven by rates disposition within the cycle), we have approached the 1946 cyclical peak in equities as the closest market and policy environment with today. From a historical perspective, the trough of the long-term yield cycle in the mid to late 1940's, where the Fed began to normalize policy after extraordinary support was extended in the market with significant Treasury purchases by the Fed between 1942 and 1946 - remains this cycle's mirror equivalent.  
As such, since the Fed began to normalize policy through the taper last year, we have panned the longer-term prospects of the US equity markets and largely viewed them pushing up against another valuation ceiling, similar to what transpired in 1946 (Figure 2) as accommodative policy support was removed.  
While a potential downside pivot will invariably make its own distinct path (Figure 3), from our perspective, the risks of such a decline have not diminished and now appear to be preemptively butting up against the Fed's starters gun - that may or may not go off.  
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While we would once again emphasize that markets will invariably make their own distinct path - as they have this time around; over the long run we expect market conditions between bond and stock yields to return to where they perennially resided for over a century, until the previous long-term growth cycle kicked into high gear as the 1950's came to a close.


As the equity markets sold-off at the end of January (see Here), we noted that for just the fourth time in the last fifty years, the S&P 500 yielded more than 10-year Treasuries. 
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If one was to mine the data, in the three previous occasions where this had occurred, equities rallied sharply over the short-term and strongly performed over the next year - quickly closing the aberration that represented a particular extreme between these two markets. 
  • June 1962: +14% 06/27/62 - 08/22/62 (1-year performance + 32%)
  • November 2008: +24% 11/20/08 - 01/06/09 (1-year performance +35%)
  • August 2011: +9% 08/09/11 - 08/31/11 52 (1-year performance  +25%)
That said, we would strongly caution anyone looking for similar returns or bolstering their respective equity biases with this fourth occurrence. From our perspective, the fourth time may be the charm as these two massive trends pass quietly in the night, ending an epoch that first set sail in 1959 as Treasury yields began their long and steep journey to a secular peak in 1981.
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With the hook now set in equities and for just the fifth time in the last fifty years - but second time since January: the S&P 500 once again yields more than the 10-year Treasuries. From our perspective, the brevity between these signals should be a warning shot for those data miners looking for more contemporary context of longer-term bullish significance. While the SPX rallied 6 percent over the following month through March, these markets will continue signaling through this long-term passage, as we suspect any retracements to be even shallower this time around, as these two immense ships pass quietly in the night. 

Tuesday, August 18, 2015

Macro's One-way Street

I live on a one-way street that's also a dead end. I'm not sure how I got there.  - Stephen Wright

Despite the incessant clarion calls by the deflationists that the dominant macro trade: long US dollar, long Treasuries and short oil - will extend indefinitely; the bend in the road in Q1 and the familiar patterned streetscapes, continue to point towards an approaching U-turn in this one-way street. 

Long-term Treasuries appear poised for a downside reversal - and are completing a similar descending topping pattern, evident in the two previous multi-year Treasury rallies. We maintain our expectations that the 10-year yield will challenge overhead resistance around 2.65 percent later this year and see the US dollar index following suit lower - which should provide an exit for commodities from the dead end street they've remained in since Q2 2011.  

Thursday, August 6, 2015

The Wizard of Odds for the US $

When it comes to currencies, the laws of Newtonian physics still appear to hold the greatest influence over participants long-term expectations. That is, the belief that a currency in motion will stay in motion, unless acted upon by an external force. For veteran currency traders of the 70's, 80's and 90's, trends were often measured in years, rather than weeks and months, with the basic understanding that the fundamental forces behind the trend were not ephemeral conditions - but long lasting, reinforcing and with great inertias to overcome. 

Today, these same sentiments have been resurrected in participants expectations towards the US dollar, which from a range of benchmarks and weightings has been trending higher from a cycle low over the past 4 (trade weighted - broad index) to 7 years (dollar index - USDX). That said, when you compare and contrast the bull markets of the past to the current dollar rally, it just doesn't quite measure up for some, who nostalgically harken back to those markets of old, of where yields were several hundred basis points higher, the Fed comfortably drove policy on both sides of the road and the Maestro was still, well - the Maestro.

 -Toto, I've a feeling we're not in Kansas anymore. 

From our perspective - and represented by the Fed's arduous task of administrating policy from ZIRP and within the trough of the long-term yield cycle, the conditions in the economy that were reflected in the markets of the 70's, 80's and 90's - are not remotely similar with today or have the potential reach and trend capacity that was fundamentally set in motion and sustained by the rise and fall in yields, from their secular icarus heights of the early 1980's.    
Nevertheless, the availability heuristic afforded by the two previous bull markets in the dollar, have become the benchmarks for pundits and analysts to measure up against today. Just this week we saw a piece from BlackRock contemplating that the move in the dollar may just be getting started.
"Since the 1970s when the Bretton Woods fixed-currency regime ended and currencies began floating, a typical dollar rally has lasted roughly six to seven years. The increase in the dollar we’ve seen so far this year is muted compared with the strong dollar episodes of the early 1980s and late 1990s. The dollar’s recent rally may just be getting started." - Why the Dollar's Strength Can Continue - BlackRock Blog
Although anythings possible - and admittedly the bulls continue to hold the fort and battle for now, we feel it would behoove such lofty expectations to approach the dollar with the aforementioned long-term intermarket cycles in mind. Moreover, from a performance point-of-view, the magnitude and pace of gains over the past year is in fact rare and more representative of culminating blowoff extremes - rather than the early headwaters of a longer trend.  
This impression is also depicted in the long-term chart of the US dollar index, which we've speculated was pushed to a relative performance extreme in March, arguably last witnessed at its secular peak in February 1985. Although the dollar appears to be testing those highs this summer, we maintain our expectations that similar to the relative performance extreme in longer-term yields going into 2014, momentum in the dollar will once again roll-over and ultimately test the bottom of its long-term range, as the limits of the virtuous disinflationary trend is confined by the broader structure of the long-term yield cycle.  
  
The Re-test
As much as the media has presented the fundamental supply side on oil over the past year, you would be hard pressed to read as much on its inherent denominating calculus from the currency markets that appears far more consequential to the price of oil over the near-term. 

It's the dollar, stupid. 
Notwithstanding the actions in Japan that only reinforced conditions in the currency and commodity markets over the past three years; our general belief is the two largest reserve currencies in the world have been wagged by the divergent policy paths between the US and Europe, which contributed to the strong disinflationary tailwind that initially took hold in 2011 when the ECB raised its refinancing rate twice to 1.5 percent - while the US maintained a zero interest rate policy, subsequently buttressed by additional rounds of quantitative easing. With the ECB finally finding religion and cutting rates below the US for the first time in a decade - as well as pulling up to the alter of QE in March, the torque in the currency markets from the differentials in policy paths should continue to back off.
And while a retest of a markets lows can be a nerve-racking experience to buy into, we still like oil's long-term prospects - especially relative to the US equity markets, where we expect the euro and inflation expectations to rise through the balance of year as the Fed stumbles to the starting gate, the ECB maintains course and Japan pulls back from further suppressing the yen.   

Tuesday, July 28, 2015

Traders - Take your Marks

A potential equity market set-up from our often cited 1946 cyclical top, may be finally getting ready to "set the hook", as participants brace for a future rate hike from the Fed this fall. Should the historical guideposts prove prescient, downside support in the equity markets will fail over the coming weeks, opening the door to the first material correction in US equities since the summer of 2011. 

Assuming the correction materializes, whether the Fed choses to act in September - subsequent to a market development such as this, obviously remains contingent on the magnitude of a potential dislocation and its broader kinetic impact in the markets. That said, based on our research of the long-term yield cycle (see Here & Figures 4-6), we have always believed that the Fed's latitude to tighten would ultimately be limited by developments in the market and the economy's capacity to carry the burden of higher rates (see Here).

Cyclically speaking, from a top down view of the long-term yield cycle (Figure 1) - as well as the reach of equity market valuations (which we've argued are greatly driven by rates disposition within the cycle), we have approached the 1946 cyclical peak in equities as the closest market and policy environment with today. From a historical perspective, the trough of the long-term yield cycle in the mid to late 1940's, where the Fed began to normalize policy after extraordinary support was extended in the market with significant Treasury purchases by the Fed between 1942 and 1946 - remains this cycle's mirror equivalent. 

As such, since the Fed began to normalize policy through the taper last year, we have panned the longer-term prospects of the US equity markets and largely viewed them pushing up against another valuation ceiling, similar to what transpired in 1946 (Figure 2) as accommodative policy support was removed. 

While a potential downside pivot will invariably make its own distinct path (Figure 3), from our perspective, the risks of such a decline have not diminished and now appear to be preemptively butting up against the Fed's starters gun - that may or may not go off.
Figure 1
Figure 2
Figure 3
Figure 4
Figure 5
Figure 6