Thursday, June 11, 2015

Breaking Away

With the 10-year yield breaking away from the top of its 2015 range, Treasury yields continue to push higher with all the bravado of an Italian cutter racing in Bloomington. Technically, the 10-year remains on course towards challenging long-term overhead resistance, which we expect will come in                     ~ 2.65% - after retracing and digesting the large moves over the past few weeks.

Bloomington bravado? 

Considering that the average age of traders today on Wall Street (30) would place their birthdays six years after the classic coming of age film, the reference may fall on deaf ears as this Millennial class also looks to graduate to a higher education. 

Then again, in many ways this speaks to a recurrent theme from us over the past year of the complexity for today's participants in understanding and visualizing where the markets have been and where they may be headed. As much as today's stockjocks and bond boys and girls were in diapers or their parents imaginations during previous rising rate environments, the insights and wisdom imparted from even the previous generations experience may prove incomplete. 

Although the shift in Fed policy has our complete attention and respect, we have found the more obvious comparative insights to most tightening cycles over the past fifty years less correspondent. The obvious being, that the Fed has stepped away from actively supporting the markets and is progressing towards further normalizing policy. Granted, "normalizing" is a strange characterization in a dynamic system. Certainly, what was considered normal in recent tightening cycles that were not tethered to ZIRP for an extended period or accompanied with QE, isn't all that normal this time around. 

While you'll find that many contemporary tightening cycles share certain insight similarities with how rising yields affected the performance between different markets and sectors, our own deference towards a wider scope of history with a more top down read of the long-term yield cycle, also strongly resonates with a lesser known period of the 1940's - sandwiched between the traumas of the Great Depression and the 1951 Treasury-Fed Accord. 

This melded perspective of both old and new, impressions our expectations that 1) the tightening - if and when it arrives, will be minimal, and 2) considering yields disposition in the trough of the long-term cycle, we believe real yields will ultimately fall as the capacity of inflation today could easily exceed the reach of nominal yields.  

As described in previous notes, the mid 1940's shared a structural similarity to the trough of the current long-term yield cycle, which is also reflected in comparable cyclical moves in the equity and commodity markets since equities set a secular valuation high over fifteen years ago. Moreover, there are parallels extend in policy and practice, as the 1940's were the last time the Fed conspicuously supported and bought Treasuries in like magnitude - to prop up the financial system as markets and participants recovered from the long tail of the Great Depression and the colossal price tag of World War II. 

That said, it wasn't entirely a free lunch, as ultimately there were latent effects from the historic liquidity provisions extended by the Fed and the inevitable psychological shift away from such support that impacted participant expectations. 

Through the balance of the late 1940's, the equity markets in the US primarily treaded water with a ~20 to 25 percent nominal cut below the cyclical high set in May 1946 - directly after the Fed's historic balance sheet expansion had peaked. Over the next four years, the financial markets struggled through adjusting to new policy and paradoxical market conditions, as strong pulses of inflation worked their way through the system, while participants remained concerned that another deflationary leg of the Great Depression would unfold. 

Today, as the Fed creeps further towards normalizing policy, we expect that yields will remain supported, as the disinflationary trend that reflexively fed back and buttressed the bid in equities since the back half of 2011 - dissipates. Our best guesstimate is that as inflation finds traction, it will translate with accompanying cyclical pivots in the dollar and commodities - which we believe has already begun to unfold from the relative performance extreme witnessed in the US dollar index this March.
Following up on a reflationary study we've contrasted throughout the year, the SPX:Oil ratio continues to remain under pressure, supporting our expectations that oil should outperform US equities, as the strong disinflationary trend that began in 2011 exhausts.
We continue to closely follow the SPX:Oil ratio through a comparative prism of the two major exhaustion pivots (1986 & 1999) that make up the asymmetrical disinflationary/reflationary construct that the ratio represents. 

Although both timeframes reflect market environments where oil strongly performed from its Q1 cycle low through the balance of the year, there were notable differences in the magnitude of the moves (1999/WTI+138% vs. 1986/WTI+70%), relating to policy and inflation/growth expectations - which greatly determined the direction of yields through the year. 

In 1986, yields troughed as the Fed moved to further ease the fed funds rate as the economy slowed, completing its last rate cut by the end of August and moving to marginally tighten policy by the end of December. 
Conversely, in 1999 yields led and rose with oil throughout the year, as the Fed began in late June to tighten policy - eventually contributing to pricking the equity market cycle less than one year later. 

As described in previous notes, while the current relationship between oil and yields is tighter than both periods, we find greater similarities with 1999 - both with respect to Fed policy posture and the respective cyclical trends in the equity and commodity markets. Moreover, current market conditions reflect the potential for a more long-term downtrend in the SPX:Oil ratio - which we expect would translate with a "shoulder" on the asymmetric pattern now in place.  
Interestingly, from an intermarket currency perspective, there are significant differences between 1999 and today - which we believe if left standing would strengthen the case that a broad based rebound in commodities and inflation was unfolding.

The most glaring difference is that in 1999 yields led the turn - tightly correlated with the dollar, as oil followed the pivot 10 weeks later with a lag.  
Today, the opposite dynamic is true, with the move higher in yields in late January - inverse to the recent pivot lower in the dollar.
This has also been translated downstream with a lag, with the euro and oil remaining tightly correlated from their cycle lows in early march.
Consequently, the 1999 10-year yield/oil chart resembles the 10-year yield/euro chart today. Should the comparative pattern hold prescience, yields over the coming weeks will retrace and flag as the euro takes its turn breaking away. This perspective would dovetail with our work in the relative extreme noted in the US dollar index, which continues to loosely follow the symmetrical secular pivot from the index in 1985.