Thursday, January 19, 2017

In Search of the New World

Although they’ve skillfully built and maneuvered their rival reputations in bond arenas worldwide, the warring kingdoms that lay siege to the Bond King throne, might just benefit from a less enlightened perspective – say, from the dark ages.

While Gundlach and Gross have a semantic squabble over the upside threshold in yields that might delineate the end of the three-decade old bull market in bonds, perhaps they should stop viewing the bond world as round and come to the apparent reality that it’s more flat than circular here in the trough of the long-term cycle.

* Click to enlarge images

In this construct, the unidirectional sovereign yield winds died – or more appropriately – transitioned, years back in 2011 and 2012. Although short-term yields and the dollar have risen in tandem as the US economic expansion led the world out of the financial crisis, long-term yields have taken a more lateral path into the trough with what we suspect will be doldrum conditions blowing east to west at best – rather than the prevailing winds we experienced out of the north for thirty years. How long the journey along this yield equator will take is anyone’s guess, but by our estimation of previous long-term cycles (most recently, Here), likely has further seas to float before the strong updrafts of the Westerlies can bring us to the higher-latitudes of a "New World".

What’s happened since the US election is that budding optimism that the ship is now sailing away from the "Old World", has helped shorter-term yields and the US dollar “breakout”, which can be viewed as a welcome shift in the economy’s tell-tails. What’s become the “Trump-rally”, led by broad buying in infrastructure and bank stocks, is a reflationary move that actually began before the election, but re-magnified with a new administration about to control both houses of Congress. The bet now is that Trump becomes Columbus and succeeds at rekindling growth on the back of fiscal stimulus and tax cuts. Yes, higher yields and inflation, but alongside stronger growth. Land ho New World - or at least one that feels like the old one of the 1950's...

However – and as we alluded to in previous notes, we believe that’s mostly wishful thinking pulled forward several years, considering the maturity of the current expansion and with the economy at or beyond full employment. While we continue to support a more commodity focused reflationary approach – spearheaded by positions in precious metals, and speculate that the US dollar will turn down again with the US led expansion, we don’t foresee the more healthy expectation that rising inflation will be accompanied with higher growth. Some might call this stagflation; we take a more pragmatic perspective in that it’s just the nature of where we sit in the long-term cycle where inflation could more easily outstrip the reach of nominal yields and growth, causing real yields to decline. 

Moreover, we continue to view the Fed's expectation of raising rates several times a year through 2019 as wildly unrealistic – as well as the markets underlying fears of the 1970’s, where to kill inflation took the mythical axe of Tall Paul Volker and a fed funds rate of 20 percent. This isn’t the 1970’s where yields continued to surge higher, but inflation still had greater reach and more pernicious momentum. Today, we would speculate that a spike in inflation would be more ephemeral and provide a bookend to an equity market cycle that took flight as disinflationary pressures brought yields and growth into the trough of the long-term cycle. 

As mentioned in previous notes, over the past few months gold has again been strengthening its negative correlation with the US dollar. Although the relationship is trending towards an extreme, gold now expresses a positive divergence with the most recent highs in the US dollar index, relative to the dollar's previous highs in December 2015. 

While the correction in precious metals was steep through Q4 of last year, we view them in hindsight as a successful test of the 2015 cycle lows and expect a full retracement and continuation of the young bull market in precious metals. Similar to the market environment headed into 2002, we expect favorable conditions in the currency and Treasury markets that should help propel precious metals to fresh cycle highs. 

Wednesday, January 4, 2017

Connecting the Dots - 1/4/17

No rest for the weary – or the wicked, as the New Year gets quickly to the point with a few key economic data plots this week. Coming through last quarter, the data extended a decisively more upbeat turn that became apparent last summer shortly after Britain’s Brexit vote failed to immediately usher in a broad economic slowdown that was widely feared with such an outcome.

Correlating with this turn in the data last summer was a pivot in the dollar and yields, which greatly impacted the safe haven uptrends in precious metals and Treasuries that had enjoyed significant rallies in the front half of 2016. Further supporting the moves were the gathering expectations that the Fed was poised to raise rates in the back half of the year, if the data maintained its positive tone – which was realized at their December meeting.

For the moment, macro trends appear to be trading off of a more binary calculus that positive economic data will support the dollar and equity market rallies and limit the upside reach in gold and Treasuries. Basically, if market participants believe that the economic uptrend has further room to run and that the prospective benevolent policies of a new US administration will help extend these expectations, the future looks much brighter in 2017 than where you sat a year before.

However, if you believe – as we do, that the data basically just rebounded from overtly bearish expectations that came to pass in the first half of 2016 and that the perceived breakouts in equities and the dollar will retrace yet again with the data this year, than 2017 presents a continuation of a very broad market cycle top that has much greater risks on the downside for the dueling bull markets in equities and the dollar. From our perspective, the “Trump effect” is nothing less than ironic, considering the cycle has greatly been distinguished by a US led cyclical uptrend that began when some of the brightest minds on the Street were expecting a “new normal” to emerge after the financial crisis that saw the US taking a back seat to emerging economies, namely China. A renewed belief in US hegemony would have been timely back then – when the S&P 500 was a third of its current market capitalization and the US dollar was nearly 30 percent weaker than it enjoys today. But alas, the market often wryly winks without prejudice at both the ignorant and the experienced at market turns.

Although the economic data may take some time to again disappoint over the coming weeks and months, the expectations of a new administration revamping US manufacturing and unleashing untapped potential in the economy this year – hence lifting most boats, appears even less realistic than the previous notion that the considerable downturn in US manufacturing that began in 2014 would take the broader economy into recession over the past two years.

The reality is non-manufacturing’s share of GDP is roughly five-and-a-half times larger than manufacturing is in the US and that will certainly not change overnight – regardless of how aggressive the incoming administration is. Moreover, the heighted risk on demand by protectionist policies that Trump continues to threaten would likely more than offset the potential benefits of tax breaks and looser regulations on prospective supply within the US manufacturing sector.

Yesterday, we received the ISM manufacturing index that exceeded forecasts, as manufacturing executives remain largely upbeat headed into 2017. With the ISM non-manufacturing index slated to be released tomorrow, it will be interesting to see if they share the same upbeat sentiment of manufactures or if the rebound that began in the back half of last year has mostly run its course. Taking a long-term perspective on the series, juxtaposed against the trend in nonfarm payrolls – we suspect the latter is increasingly more likely as we work through the first half of the year. 

With nonfarm payrolls set to be released this Friday, the markets will have further catalyst to trade on, one we continue to believe favors the short side of the dollar over time, which is again strengthening its inverse correlation with gold as well as Treasuries.
Looking for a continuation of the extreme release higher in yields, consensus expectations have now pivoted 180 degrees from the July lows. Technically – as well as from an intermarket perspective with the US dollar index, the markets set-up quite similar to the early 2002 pivots in the dollar and yields, which propelled both nominal and real yields to new cycle lows. 
Despite current market expectations that express building confidence in the US economy, we continue to believe – based on our own research of both the nominal and real long-term cycles, that new lows are more likely than the beginning of a new secular growth trend. Moreover, the relative symmetry of the retracement decline in nominal yields from the secular high in 1981 is actually marginally trending even shallower than the trough of the previous cycle in the 1940's. 

As such – and despite the considerable retracement declines in precious metals  in the back half of last year, we continue to like their long-term prospects in what we believe will be a lower real yield market environment, longer than most still suspect.