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.
- Click to enlarge images -

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.