Thursday, February 4, 2016

Legends of the Fall

A man will sometimes devote all his life to the development of one part of his body - the wishbone.  -Robert Frost

It wasn't that long ago that anyone could walk into their local community bank and purchase a one-year certificate of deposit with a risk free return of around 5 percent. In the late 1980's that same CD would have yielded more than 9 percent. Less than a decade before in 1981 - nearly 18 percent! For equity market investors today, the thought of an 18 percent return for the year would certainly turn heads, regardless of its risk profile. But wishful thinking is one thing - reality is another. 

Just as pensioners and savers have been led ignorant to these historical downtrends and hence gripe in disbelief as yields have fallen into the trough of the long-term yield cycle, the Fed has promulgated an expectation of eventually raising rates to levels of yesteryear like Lazarus from the dead. 
- Click to enlarge images -
The only problem, however, is while they’ve expressed a clear capacity for intervention and a knack for plotting dots, it's the divine influence they sorely lack in the face of market history. In absence of the second coming, we unfortunately don't expect yields on CD's to return much more than they have over the past several years, as global economies and markets work across the transitional divide of the long-term yield trough and markets come to grip with the next phase of lower for longer.
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 has implied a lower for longer environment, perhaps much longer than most participants suspect.
The relative symmetry represented in the current yield cycle is not unusual and looking back several hundred years, 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.

From our perspective, the yield trough that markets currently reside in and which constitutes the divide between these overarching growth and debt cycles, will eventually reflect a largely proportional transition with the broader cycle itself. Meaning, the massive relative symmetry in yields expressed over the past 75 years (much more when considering previous cycles), would imply a greater probability that today’s historically low range could extend well into the next decade. 

Why is this so important for future expectations in the US dollar?

While the Fed's dot plot projections continue to trend lower, in relation to either current economic conditions; the retracement symmetry of the long-term cycle's trough or the comparative path from the last time short-term yields fell to the lower bound of the transitional divide - their estimates are still exceedingly unrealistic. Although we agree that from a signal point of view to the markets the Fed acted accordingly in modestly coming off of its crisis stance of ZIRP, their quarterly updates of forward guidance through wishful dot plot projections, caused significant tightening to US and global markets - predominantly through the broad sword of the US dollar. 
David Beckworth had a nice chart this week (see above and read, Here) that showed how the move in the dollar coincided with the rise in fed-funds future rate expectations in Q2 2014. As mentioned in previous notes (most recently, Here), we know in past cycles – and characteristic of markets forward discounting dynamics, the dollar strengthens during the expectation phase of tightening (buy the rumor) and typically begins to weaken as markets become confident that the Fed will move (sell the news). For the dollar in this cycle, we’ve referred to it as - buy the hype/sell the bluff. The bluff being: the posture and expectations shaped from comparisons to more conventional tightening cycles would ultimately have stronger influence within the markets, than the actual structural significance of a fractional hike. Moreover, the ambiguous and prolonged nature of this cycle’s expectation phase - in the face of multiple large easing initiatives around the world, allowed participants an abnormally large and fertile window to build assumptions and positions in the US dollar; regardless, that the Fed would likely never achieve the same reach as they have in more recent tightenings. 
This is one of the main reasons we’ve carried a bearish long-term outlook towards the dollar, as we’ve viewed the rally as predominantly built around misplaced expectations from Fed posturing, rather than more underlying structural support - such as a secular move higher in yields or growth that would also likely sustain a more lasting move in the dollar as well. It is also why we have viewed the large reflex and retracement in yields in response to the taper in 2013 as the leading move for the dollar, as the Fed advanced into the next phase of normalizing policy from an extraordinary position. 
Our best guess over the past year has been that the dollar would ultimately crack upon the weight of the move itself (on the markets) or the Fed calling its own bluff when it came to future rate hikes. And while the old market adage certainly comes to mind that markets can remain irrational longer than you (and companies - i.e. commodity producers) can remain solvent, the dollar appears to be finally breaking down; in part from recent and pragmatic Fed-speak - as well as the knock-on effects from the relative performance extreme of the dollar on economies and markets over the past two years.

While we expect it will be a tougher slog for fixed income and most developed equity markets over the next phase, for commodity investors that have been hurt by the strong US dollar, a cyclical upturn appears to be unfolding - led by the move higher in gold that coincided directly after the rate hike in December.