Tuesday, April 25, 2017

Connecting the Dots - 4/25/17

On the heels of this weekend’s EU-supportive first round election results in France, the euro closed up by 1.35 percent in Monday’s session, with the highs from last month ~109 overtaken today in early trading. Keeping it simple – as we have with the US dollar index this year, we expect the troubled European currency to make higher highs and higher lows as it grinds its way out of a major cycle trough. 
*Click to enlarge images             

On the other shore of the exchange, the US dollar index is now flirting below long-term support extending from the July 2014 breakout, in a window we have anticipated would bring a resolution to the cyclical uptrend in the dollar. 

And while it’s still early in the week – with ample domestic and exogenous catalysts to trade through (ECB policy decision, US 1st quarter GDP, possible tax reform and a contentious debt ceiling debate), the dollar is still following long-term Treasuries leading move from the last major election results in November, corresponding with breakdowns in US Treasuries and gold and a breakout in equities and the US dollar. 
As we’ve described in previous notes, over an intermediate timeframe, the dollar has followed pivots in Treasuries by several months over the past several years, with the relative performance of US equities closely tracking the respective trend in the dollar. Along these lines – careful what you wish for President Trump, as a weaker dollar will likely see US equities underperform globally, while also a telltale for future monetary policy as the dollar has led short-term yields by several weeks.
Generally speaking, we view the EUR/USD exchange rate and the US dollar index as relative equivalent benchmarks for the dollar, as the majority of the index tracks the inverse performance between the exchange rate of the world’s two largest reserve currencies. That said, the Fed’s preferred broad dollar index also benchmarks closely with the inverse performance of the EUR/USD exchange rate. Longer-term, when normalized from the inception of the euro in electronic trading in 1999, the Fed’s broad dollar index has increasingly tightened with the inverse performance of the EUR/USD exchange rate. 

When indexed to the current cycle low in May 2011, the broad dollar index has more closely correlated with US short-term yields, although performing within a few percentage points from the other dollar benchmarks. The long and short of things, technically we tend to follow the EUR/USD exchange rate and the US dollar index, but expect a cyclical pivot lower to also be reflected by the Fed’s broad dollar index.

Not surprising in hindsight – although a testament to the times – significant pivots in the financial markets over the past year have corresponded with major political outcomes. The Brexit vote last June brought new all-time highs to long-term Treasuries and a fresh cycle high to gold and silver, before quickly reversing course in July as equities, yields and the dollar traded sharply higher out of key lows for the year. Greatly muddling causality, however, was the improving economic backdrop and outlook that forced the Fed’s hand to raise rates twice over the past 5 months.

Looking back, the outsized moves in the markets from the Brexit vote were unwound almost immediately, as the economic data broadly improved last summer – both domestically and abroad, and as Europe appeared to take the blow from Britain with no immediate systemic consequence. Although the respective breakouts and breakdowns that followed the surprise US election outcomes in November are also retracing their steps this year, the arc has been much wider as hope and sentiment springs eternal, while realized figures on the US economy continue to underwhelm.

With realistic expectations towards future monetary and fiscal policy, our working thesis has been that the economic expansion has very likely seen its best days, with the prospects for a revival of more robust growth largely tapped out. In our experience – and with a long view of history, hope floats best after the throes of a recession or economic crisis, where those in life jackets are carried on the waves of uncertainty to a more sheltered shoreline of a new cycle. The opposite is very much the case at the top, where hope will sink those left swimming far offshore, in quiet waters after a distant storm. Call me Ishmael – Minsky or Buffett, the lesson is typically the same.

Getting back to other comparative set-ups in the markets – the dollar, long-term yields and gold are also continuing to echo the cyclical pivots from 2002, where US equities began to heavily underperform globally, while commodities overall enjoyed a declining real yield market environment.

Considering the relative lofty disposition of both the dollar and US equities today, the prospective pivot presents another substantial long-term opportunity for investors, as we expect real yields to eventually break their respective cycle lows from 2011. Coming through this shift, gold offers the more conservative intermediate-term risk/reward profile, although we expect the silver:gold ratio to continue to outperform over a longer-term horizon.

And while US equities have found a very healthy bid this week – extending the retracement rally from the lows of the previous, we maintain our bearish read on the future prospects of the reflationary rally in equities and view the fresh breakdown in the dollar this week as a leading move.

Wednesday, April 12, 2017

Connecting the Dots - 4/12/17

Headed into what we anticipate 
will bring some fireworks to the currency markets this month, the US dollar index has again turned down modestly in the front half of this week. Currently trading behind a series of lower highs and lows from this past December’s cycle peak, our expectations remain for a breakdown below the index’s long-term uptrend extending from the July 2014 breakout.
* Click to enlarge images
Over the past few months we have followed last years breakdown in long-term Treasuries as a prospective leading move for the dollar, which has pointed towards a corresponding break around this April. And while it’s still early in the month, the dollar appears to be moving towards a market resolution that to-date has managed to escape dollar bears, as the index has traded within a very broad and relatively narrow range over the past 2 years.
Coming into last fall, we had noted that the US dollar index was mimicking the broad top carved by gold back in 2011 through 2013, on the flip side of the cycle where inflation had crested in 2011 and the US dollar and real yields began to materially rise. 
Since the end of 2015  where gold had set a cycle low in December as realized inflation had also begun to move out of the trough of the cycle, real yields began to crest and decline – despite the Fed’s policy shift in raising rates from ZIRP that month. 
Through Q3 of last year, this inverse symmetry within the cycle was also reflected by the mirrored moves of the financials and gold miners, whose respective performance closely corresponded with trends in the dollar, inflation and hence – the direction of real yields.

What’s happened since the US election last November, is that the financials surged with nominal yields on hopes of a more beneficial operating environment for the banks, predominantly brought on by deregulation and tax reform. Conversely, the precious metals sector initially sold-off, as greater safe-haven demand evaporated overnight as yields and the dollar rallied sharply. Although we had expected the banks to break above resistance for a spell in early fall with a corresponding retracement in the precious metals sector, the respective moves were outsized on the back of the elections newfound expectations. 

This dynamic is reflected by the significant shift in business outlooks that transpired after the US election, as economic sentiment surveys sharply diverged higher from the actual realized data on the economy. 

In fact, the spread between these so called hard and soft data series is the widest it's been over the past 2 decades. And while greater confidence can certainly positively affect downstream realized growth, eventually sentiment needs to give way to either businesses and consumers actually pulling the trigger on spending, or realizing that their respective hopes may have stepped ahead of reality. With the third longest economic expansion since 1850 already in the record books and with the US job market even below what the Fed considers as “full employment”, we’re more inclined to believe that while deregulation and tax reform can definitely improve conditions around the edges for businesses and consumers going forward, the real potential for robust growth that the recent sentiment surveys have implied has largely been tapped over the past several years.

This is why, from our perspective – which takes a very long-term view at both the nominal and real yield cycles, real yields will more likely continue to fall as the capacity for inflation outstrips underlying growth. This is contrary to how low real yield market environments have exhausted in the past, where growth explodes higher from a cycle low as inflation expectations recede from cycle highs (e.g. late 1940’s & 1970’s). Moreover, considering the relatively lofty disposition of the US dollar – which rode the wave of US outperformance over the past six years, the capacity for higher inflation and lower real yields through broad dollar weakness remains substantial.

Overall, we continue to like the prospects for gold and the precious metals sector, as we view positions as primarily a higher beta inverse play on the dollar and real yields.