Some Further Thoughts, and the BAML FMS

Human psychology is fascinating, isn’t it? How quickly has the consensus changed from Trump being a buffoon to Trump could solve secular stagnation? I mean, people should change their views if the facts dictate that they should. But the conviction that some folks maintain, despite doing a literal 180 in a week’s time, is laughable. Strategists have to pretend that they know exactly what’s going on I guess, even if they have no clue. Maybe the pretending gets into their heads. Anyway, last week is a delicious reminder that price action drives the narrative, not the other way around. Here’s a short list of things I think is true about the US political situation, regardless of the price action or the opinion flow:

· Trump is out of his depth. The executive branch is huge, and requires many hardworking, competent public servants. But he will not be able to attract very many qualified political appointees into his administration. His public persona and management style (never accepting blame or backing down) is anathema to many reasonable people who may otherwise jump at the chance for public service.

· But his party has control of Congress

· So the range of possible outcomes is wider

· But given the complexity of the world today, and the low nominal growth rates, mistakes are more expensive.

· Higher vol + negatively skewed outcome distributions is not a good combination

As a result, my assessment of the economic fundamentals has turned more bearish over the long run.

On a separate note, the BAML Fund Manager survey was interesting, even though some responses may have been returned prior to the election. Also note that the sample size has depreciated quite a bit from prior months. Here are a few charts of note:

Inflation Expectations are about the highest they’ve ever been in the 20+ years of the survey:

Historically, readings near these levels have marked highs for inflation breakevens: (early 2004, 2011)

Yield curve steepening expectations are also very elevated.

Historically, that has usually meant a continuation of the steepening already in train.

Unsurprisingly, survey participants also had unusually high expectations for higher 10y yields.

Historical readings at these levels have coincided with or preceded local highs in yields: (late 2003, early 2008, late 2010, mid 2013)

This confirms my view that we are probably closer to the beginning of the end of the rise in yields rather than the end of the beginning.

For equities, the high cash balance which has provided a backstop has fallen somewhat. It’s probably unlikely that cash balances go all the way back down to the low levels last seen in 2011, but on an absolute basis they remain high and will continue to limit the depth of any downside shocks, IMO.

Also supporting this view is the very low levels of allocation to equities:

For the USD, investors are broadly neutral on valuation, but the readings are elevated relative to the past decade. IMO, that supports my view that the USD may not appreciate a great deal more from here – certainly not as much as the 2014-2015 move.

Part of that may be due to this:

Finally, two links:

This is a very concerning read about how almost all Americans have a difficult time getting a day in court:


· whereas in 1938 about 19 percent of all federal civil cases went to trial, by 1962 that rate had declined to 11.5 percent and by 2015 it had declined to an abysmal 1.1 percent.

· over 97 percent of those charged in federal criminal cases negotiate plea bargains with the prosecution, and in the states collectively the figure is only slightly less, about 95 percent.2 In most cases, as a practical matter (and sometimes as a legally binding matter as well), the terms of the plea bargain also determine the sentence to be imposed, so there is nothing left for either a judge or a jury to decide. While the immediate result is the so-called mass incarceration in the United States that has rightly become a source of shame for our country, the effect can also be seen as just one more example of the denial of meaningful access to the courts even in the dire circumstances of a criminal case.

This is a great Chris Arnade interview on Trump supporters:

Some Clarification on Post Election Thoughts

I just wanted to clarify a few thoughts from my last note.

· To be clear, I do not think there is significant more upside for yields. I implied as much when I wrote that 2.5% for the 30y is quite reasonable. The inflation compensation component (which has moved the most) is back to fair value, (though at this stage of the cycle it tends to overshoot a bit) and real yields (which hasn’t moved all that much) are also broadly fair, in my estimation. Much of the reflationary reasons proposed so far remain conjecture. As a result, I don’t think fair value has changed all that much, though they will increase over time. Positioning and momentum are the key remaining drivers at this stage.

· I also should’ve clarified that I don’t think there is significant upside for equities. As noted before, many of the drivers for equities with respect to policy changes remain speculative, while the rise in long dated yields is a reality now. The likelihood of policy shifts suggests that a premium for equity prices are very reasonable. But I wrote in the summer than equities can handle a 50bp backup in yields without a problem – and 10y treasury yields already 70bps off the lows. In addition, credit markets have been much less enthused than equities. 5y Investment Grade spreads tightened just 1bp(!) on Wednesday. And finally, markets do not seem to be worrying much about the risk of a policy mistake, either at the domestic or international level. I think most would agree that those risks are higher now given the inexperience of the president-elect.

· This suggests that further rapid rises in yields here are likely to result in weakness in equity prices, which will then feed back into lower yields. This suggests that momentum across asset classes should slow.

· The fact that most of the move in US yields has been driven by the inflation compensation component rather than the real component is a key reason why the broad USD hasn’t moved all that much, IMO.

· Note also that the Fed has spent a lot of time talking about the improvement in the labor market, but the ECB has not. This is despite the fact that EU unemployment has declined by 2% from the highs already, and is now below the OECD estimate of NAIRU!

As I noted yesterday, this is probably a major reason the ECB tapering rumors are substantive. Yes, core inflation remains low, inflation expectations may be unanchored, etc, etc. But for an inflation targeting central bank, this is not something that they can ignore. The removal of ECB policy accommodation is likely to continue in fits and starts over the course of 2017, which is likely to provide support for the Euro.

Some Post-Election Thoughts

It’s a bit hard to write about markets right now given the election outcome, but I’d like to say a few things in light of the market action and the endless string of “Trump Trades” reports that are being sent around.

· No one knows what Trump wants to do. And even if that is known, no one knows what he’ll be able to do. Trump is facing not a simple Republican majority in Congress but rather a minority of ‘core’ Republicans, the Freedom caucus, and Democrats. Thus, a massive federal fiscal deficit is almost certainly going to require the buy-in of a large number of Democrats.

· Barriers to trade are a different story, since Trump does not need Congressional authority to throw up roadblocks. As a result, the moves in currency crosses vs the USD are arguably likely to be more persistent for those with a large trading relationship. Note that the roadblocks (including a currency manipulator designation) do not even need to take effect to justify these moves. The very threat is likely to restrain US companies from building factories outside the country, and dissuade foreign companies from exporting here. This suggests that the US non-petroleum trade deficit is likely to stabilize, at the very least.

· Having said that, the paradigm for US rates has abruptly changed. Treasuries are no longer seen as simply as cash like instruments, or risk off hedges. Now there is a clear downside risk via a worsening fiscal deficit, and the market is moving to price that risk premium.

· Having said that, remember that there is a limit to how high that risk premium can go. Japan has shown that the sovereign Debt/GDP ratio is much, much higher than here.

· I’ve been doing some more modeling for US rates and now believe that the fair value for nominal 30y Treasuries to be close to 2.5%.

· The selloff in fixed income is likely to accentuate inflows into equities. Most surveys suggest that investors are underweight risk assets, but there hasn’t been an impetus to reverse that given that fixed income has been performing all year. There are a few similarities to 2013 there.

· The market tone for US equities is unambiguously bullish. If a massive uncertainty shock like this AND a massive jump in treasury yields can’t send the market lower, it’s hard to imagine what will in the near term.

· Volatility spikes like what we’ve seen the past 24 hours will persist. Successful investing thus requires a combination of correct position sizing, fortitude, or ignorance.

· In my last update back in August, I said that shorting duration and being long equities is likely to work over the intermediate term. The former call has worked better than the latter, but I think those views still apply, though obviously the case for short rates is less strong now given the move.

· I also like USDCAD upside over the longer term. Regardless of what happens politically, Canada needs both lower interest rates and a weaker currency vis-à-vis its largest trade partner. Plus it is positive carry, and negatively correlated to risk assets. It’s not necessarily a fantastic trade based on an ex-ante Sharpe basis, but should work well as part of a pro-risk portfolio.

· For the EURUSD, barring a hiccup in Europe, new lows are likely to be limited. Beneath all the noise, Europe has been closing its output gap at a faster pace for about a year and a half now. IMO, that is one reason why the ECB is even hinting about tapering, which arguably is a much more hawkish shift than the Fed resuming its gradual hiking path. Real yield differentials in the belly of the curve has increased 60bps (!) in favor of the EUR since a year ago. The current market tone is focused on protectionism and the dollar positive effects from that, but a substantial move lower here would make a long position attractive, IMO.

As always, thoughts & responses are welcome.

It’s Time to Short the Front End

Fed credibility is really being challenged by the market. I know lots of people say the Fed has already lost credibility, etc. But I never really believed that because the Fed has only every tried to explicitly control the front end of the curve. This is the first time in a long while that the market has stopped paying attention even to that. Here is what we learned from the Fed the past couple weeks:

Esther George voted for a hike in July. In the minutes, she listed one reason for her dissent was that

· “She believed that by waiting longer to adjust the policy stance and deviating from the appropriate path to policy normalization, the Committee risked eroding the credibility of its policy communications.”

Dudley, the vice chair of the FOMC and clearly part of the leadership noted not once, but twice that market pricing of Fed policy was too dovish:

· 8/16: 10y treasury yield is pretty low given circumstances

· Bond market looks a bit stretched to me

· Market is complacent about need to gradually hike rates

· Fed Funds futures market is underpricing rate hikes

· 7/31: policy will likely need to move faster than market expects

· Market view of only one hike through 2017 ‘too complacent’

And now Fischer, the vice chair of the board, noted that:

· core PCE inflation, at 1.6 percent, is within hailing distance of 2 percent–and the core consumer price index inflation rate is currently above 2 percent

· So we are close to our targets. Not only that, the behavior of employment has been remarkably resilient.

· Employment has continued to increase, and the unemployment rate is currently close to most estimates of the natural rate.

So this means that we have one openly dissenting voter and 2 of the top 3 FOMC officials tilting toward a hike. Yet hike expectations have remained minimal. Fed Funds pricing in less than 1 hike in the next 12 months, and just one hike through Dec 2017.

Yellen is up next. It is unlikely that her views are completely opposite that of her colleagues. And she might not feel compelled to comment on near term policy on Friday. But the dichotomy between Fedspeak and market pricing is something she is clearly monitoring.

To be fair, there are a number of potential explanations for this dichotomy. They include:

1. Throughout all this, the Fed has also been talking about a lower r*. IMO, there is a very big difference between hiking a few times and a terminal rate below 3%. Both can and is likely to be true. But the market seems to only believe the latter half. It’s probable that the mental/algorithmic framework of market investors/algos tend to see Fed policy in one dimension – either dovish or hawkish.

2. There has been a substantial drag on growth from financial conditions over the past year, hitting just when the Fed first hiked. We can see that based on the dichotomy between Fed forecasts last Dec vs what has actually transpired. That effect has reversed by now, however, while market pricing has not.

3. Many participants seem to believe that the Fed will not want to risk affecting the election and moving in Sept, so the next probably date is Dec. Since we are still 4 months from the December meeting, there is probably still a fair bit of complacency

4. The bull trend in bond prices has been very strong, and long, and it does not seem threatened, at least not yet.

The market pushback against Fedspeak would be normal if the data was disappointing to the downside. But the opposite is true. As others have noted, the Bloomberg US economic surprise index has turned positive for the first time since December 2014, (That corroborates point 2 above, IMO) and are not far from levels that prevailed ahead of the Taper Tantrum in early 2013.

This is further corroborated by the fact that the industrials sector of the US stock market has broken higher. The last time that happened was also a couple months before the Taper Tantrum:

In sum, with downside limited, Fed speak hawkish and the fundamentals turning, the risk reward for shorts at the front end now seem very attractive.

I’m anticipating a few questions here about whether a more hawkish Fed will be bad for equities. On the contrary, I think it is still a good time to be long equities. IMO, the Fedspeak about a lower r* further supports the view that lower long term discount rates are sustainable. That is supportive for equities, because it is clearly not fully priced in.

In addition, a number of people seem to think that the ONLY reason the S&P is here is due to where yields are and/or monetary policy. Interestingly, these folks also seem to think PE multiples should be static and not move due to changes in yields. This type of contradiction is usually a sign that their model of the financial world is at least partially incorrect. By my estimates, equities remain quite cheap relative to rates products, even after adjusting for externalities, and would remain cheap even if the entire curve shifted upwards by 50bps. The valuation gap, in other words, is substantial and the worries of the investors that equities valuations are at risk if yields rise are already in the price. I continue to think equities will close out the year with a return well in the double digits.

Some thoughts on policy at the lower bound

First, a bit of market commentary. Equities are making new highs as I suggested was likely in my last note. We’ll see if it holds, but historical instances suggest reasons for optimism. I think a 5% run-up through year end is fairly likely.

I’ve noted before that global growth pessimism is quite high, and that is of course one reason yields are where they are today. But the fear of a recession, and the resulting decline in yields, seem to have actually decreased the likelihood of a recession, at least in the near term. The irony is that the better the market gets at forecasting the macro, the less likely major economic shocks occur. This suggests the business cycle may well be longer than people think. Potentially the longest expansion in history. I wouldn’t be surprised.

One argument I’ve heard often is that since central banks are out of bullets, confidence is lower / downside risk is bigger and so risk premiums should be higher. I have a fair bit of sympathy for that argument, but I also think that’s an argument that comes into play when the pricing differential between equities and rates are closer; i.e. when the Equity Risk premium is lower. It is currently already at very high levels, so it is likely that such concerns are already priced in here. A corollary to that line of thought is that people who are buying equities simply because yields are too low is stupid and do not understand the risks. But I think that’s an incomplete line of reasoning at best. The fact is, people – both institutions as well as individuals – have to decide what to buy on a daily basis. And a strategy of buying a bit more equities, even with valuations here, rather than a lot more treasuries, is hardly crazy.

OK – on to the next topic.

I’ve been mulling over how policy making is likely to evolve over the coming years, as almost all DM central banks other than the Fed has run out of bullets.

What we have seen so far is rate cuts, followed by asset swap programs. Usually a weakening in the exchange rate also occurs. But for countries with weak domestic demand, the lower discount rates does not do much for domestic growth. This means the increase in the trade balance has a larger relative effect. It also means that the effect is mostly felt by exporters and the employees of exporters, rather than everyone else. It also results in a transfer of savings into foreign countries. (especially the US)

This has been exacerbated by the fact that Japan and Germany has been using an exchange rate that has been excessively weak for years. The weak exchange rates were possible partially because of structural factors, and partially due to monetary policy. With monetary policy ineffective, the result is that the currency should adjust until excess trade balances adjust to sustainable levels. Put differently, in the absence of monetary policy effectiveness, the currency should adjust to a level where the trade balance is offset by sustainable capital flows.

Fiscal stimulus is a remaining option. But that will only occur when the electorate allows it, and there are open question on what the results would be.

A much less discussed option is regulatory easing. One reason that many households have not taken advantage of low rates is that their credit scores preclude them from borrowing. Certainly, that channel should only be used to a limited extent, but the regulatory tightness is clearly at least a part of the explanation for why low yields have not been more stimulative.

For the US:

The foreign savings in aggregate has driven longer dated US yields lower. The nominal spreads are so large in some cases that foreign entities disregard the FX risk. As an example, a Japanese entity can buy 30y treasuries at a spread of ~200bps to 30y JGBs. Over 30 years, that’s a 60% non-compounded difference that they probably think will offset any Yen strengthening.

Usually the response of an optimizing fiscal authority to very low financing costs is more borrowing. For political reasons, that has not occurred, at least not yet. But it may well happen next year.

The lower the long end yields here, the more stimulus there is, and the more likely the Fed is to hike. (or not cut) So the implication for front end is opposite. This recent low yields is likely to nicely support the US economy in 2H, and currently provides a good entry into paid positions in the short end, IMO.

The biggest and most interesting question is what will happen in Japan:

Abe’s election win, which was big enough to support constitutional revisions, and his subsequent promise for more fiscal easing may be the start of a global trend. After all, they were the first to enact massive QE, and the first to hit easing limits. Certainly, the effectiveness of the promised stimulus will depend on how they’re structured, but that may be less important. Some similarities to FDR’s policies during the great depression probably applies. Despite stagnant topline Japanese growth, the electorate believes in Abe’s rhetoric and has given him a mandate to do whatever it takes.

The 10 trillion Yen figure that has been bandied about is roughly 2.5% of GDP. Given that Japan’s deficit for the fiscal year ending in March was 6.7%, this represents a moderate increase in additional stimulus. (remember it is the change in stimulus that matters for change in growth. A budget deficit that does not change should not change GDP) The rally in the Nikkei is certainly pricing in some optimism for the program.

A new wave of JGB issuance to fund the stimulus is also in the cards. But given that the BoJ is currently purchasing assets at a pace of ~16% of GDP per year, the 2.5% figure is not likely to make that much of a dent, especially if it is seen as a one-off. BUT, and here’s a big one, the government may commit to an increase of this size indefinitely until some goal is reached. That would be QUITE a change in policy parameters and introduce a lot of uncertainty. I don’t really know how the markets will take that over the long run, but it’s hard to see it being friendly to either JGBs or the Yen in the short term.

Barring such a (fairly risky) policy change, though, it’s not clear whether a one off fiscal stimulus should weaken the Yen all that much. In a country with declining population levels, it’s hard to make a case that the government can make any sizable investments that will increase long term growth, which means the fiscal multiplier is likely pretty low.

Other Thoughts:

· Will the EU and follow with either fiscal or regulatory easing? For the EU, the first step is seeing if some workaround is allowed to recapitalize the Italian banks. Note that the ECB (in a speech by the vice-president) has already endorsed such a path.

· Other DM central banks at ZIRP reinforces the idea that the Fed has become the world’s central bank, since it controls most of the remaining monetary levers on FX

· Does fewer active central banks suggest lower volatility going forward, or more?

· If less, this will also make it easier for the PBoC the manage a CNY depreciation.

The low P/B’s for banks is unprecedented, and have often been cited as reasons to be bearish on growth. But another take is that they have simply become socialized utilities, unable to maximize shareholder returns. And that is unlikely to change soon, since the regulators are also the central banks, many of which have run out of policy tools. Which means they do NOT want banks to shrink their balance sheets due to fear that it could tighten financial conditions at a time when they are out of bullets. This is not new information for many bank employees. In this context, banks are likely to still be active in the lending space, even with equity valuations that have historically only been seen during recessions.

2H Outlook: Here comes the squeeze

Obviously, the British referendum is dominating the headlines.  I don’t really have much to add to the narrative.  What I want to do today is discuss the broader backdrop, which I expect is likely to play out eventually regardless of the referendum outcome, since direct economic linkages to non-EU areas suggest a limited role for contagion. (Though of course that risk is skewed to the downside)



I think the big questions are:

  • Is the US employment slowdown real, and will it persist?
  • Why isn’t US growth & inflation reacting more to low yields?


US employment has undeniably slowed from year ago levels.  There is some debate as to why that is, and how much of the slowdown is noise.  My take is that this is a result of the US growth slowdown over the past 6 months.  (payrolls in white, ISM composite in orange as a proxy for growth)


Nevertheless, the last payrolls print very likely overstated the weakness in the labor market, even if payrolls growth slowed to a 1.4% annual rate (which would be the lowest since mid 2011) monthly payrolls should average 165k.  In addition, there are some divergences in various labor market indicators.  Layoffs, separations, and jobless claims remain low, but help wanted, new hires and new jobs growth has slowed.  This corroborates a picture of slowing, but still positive growth.  Historically, when that occurs in conjunction with tight monetary policy and financial conditions, the economy tips into a recession.  But in this case, financial conditions has eased significantly since earlier this year.  The implication is that unless the economy ‘tips’ soon, the easing of financial conditions is likely to support growth over the next couple quarters.  A final point to support a low likelihood of a recession:  the percentage of US adults with subprime credit scores is at the lowest level since 2005.


Another interesting facet of this environment is that growth does not seem to be responding to low yields.  Secular stagnation has been mentioned a number of times.  The CEA just published a report noting the consistent decline in male participation rate in the labor force since the 50’s, and with the decline especially sharp for men with a high school degrees or less.  In addition, nearly 36% of primate age men not in the labor force lived in poverty.  That certainly suggests some aspects of the stagnation hypothesis are at play.


In addition, the combination of low unemployment and low inflation is unique.  The implied flattening of the Phillips curve is likely one major reason the Fed has downgraded its inflation forecasts in the dots.  I think one driver there is that mortgage availability along with high house price to income ratios has sharply blunted the real estate transmission mechanism.  With real estate prices a large portion of indirect costs in most services we consume, this has likely been a reason inflation has been contained – not just here, but globally.


A net result of that is that long term inflation expectations have fallen as fewer people expect inflation above 2.5%.  This lends credence to the view that the inflation term premium may not return to substantively positive levels anytime soon.  (Though it seems to be quite negative currently)


That segues to the topic of neutral rates, which has gotten a great deal of attention the past couple months.  Yellen devoted a fair bit of time to it at the last FOMC presser.  The vice president of the ECB also recently spoke about it.  The Fed recently published a paper estimating the neutral rate for the EU, UK and Canada.  In general, it seems that the consensus is that neutral rates are low globally as a result of various factors and do not show signs of going up anytime soon. My own take on it is that in addition to the often mentioned pressures of aging, which lowers growth, a likely additional factor is the very large non-petroleum trade imbalances in the world economy.  Specifically, the very large Chinese, German and Japanese trade balances vs the US is effectively sapping domestic consumption and raising foreign saving.  That’s a trend that seems to be ongoing, though highly unlikely to persist for very long.  In the meantime, the savings glut is not being offset (as it should) by fiscal expenditures.  The net result seems to be very low neutral real rates. (about 0.5%) Even relative to those estimates, however, current Fed policy is quite simulative. (2y real yields are roughly -0.9% currently) The offshoot of that, however, is that growth rates of 2.0% is likely above trend.  A normalized rate, say 0.5% real implies 4 hikes from here, which is likely to take the 2y to 1.75%… which is above where the 10y is currently.


The paper above also estimated neutral rates for the EU. The estimation results imply that EU real rates are currently only neutral, rather than stimulative, despite the low nominal figure.


The paper did not produce any estimates for Japan, but the BoJ tried calculating it late last year.  Like Europe, the estimated real neutral rate was negative, roughly -25bps at the 2y pt.  This suggests that at current levels, JGB yields are only neutral rather than stimulative.


Let me put that differently.  Neutral, or ‘natural’ rates in Japan is probably supposed to be negative.  Which means the current policy setting may be too tight!  Yes, I know all the arguments that negative rates causes a deflation mentality and so on.  But if you think that over the long run, yields are supposed to reflect the economy’s inflation and growth rates, then why is it wrong that Japan’s falling population (-0.5% a year over the next 10y and -0.7% over the next 30) and minimal inflation should be matched with negative nominal yields?  In fact, I think the idea that current BoJ policy is too tight is one of the reasons for the Yen strength we’ve observed this year.


To be clear, the BoJ may not be able to ease policy much here, even if it thinks policy is too tight.  In fact, it is interesting to me that so many analysts expect additional easing from the BoJ here, but none have proposed any idea that seems likely to work.  Monetizing debt will not do much, as the NY Fed has observed.


With the ECB and BoJ not able or willing to do much more, currency movements  will be increasingly driven by the Fed and economic fundamentals.  Since both the EU and Japan have current account surpluses vs the US, that means the Fed needs to tighten policy just to keep the crosses in place.


With respect to China, I find it interesting that the recent jump in credit/money creation has had a minimal impact on growth. The chart below shows CNY M1 growth in white vs real GDP growth in orange, and the ratio of the two in the lower panel.  M1 growth has been at a rate not seen since the great recession – and the lack of an uptick in growth the past couple quarters is striking.


With growth no longer responding to credit creation, an eventual slowdown seems inevitable.


I noted last August that China is likely to try to depreciate its trade weighted currency by about 20% over a few years.  The CFETS index has already depreciated by ~7% on a nominal basis since it was published in November, or roughly 12% annualized. With the growth backdrop, a continuation of trend seems likely, but the probability of the weaker currency supporting domestic growth is low given both China’s size as well as the limited appetite for more trade deals by the G7 electorate.




I listed a number of reasons that argue for lower yields above.  But there may be one more reason for yields to  be low, which is that risk free assets have become increasingly negatively correlated to equities.  It makes sense that insurance costs money, and on that logic, the better treasuries function as insurance for an equity book, the richer the price is likely to be.


Despite that, and despite the other fundamental reasons I listed above, I still think yields are too low.  I think current yields have already discounted many of these effects, and in any case it’s not clear how those factors will shift over time.  I.e. will the negative correlation actually persist in the US?  Or are current levels an artifact of the oil sell off?  Could correlation move towards zero as inflation picks up?


What is clear, however, is that inflation forwards seem unlikely to be realized.  1y Inflation  swaps are currently just 2.0%, and the 1y1y forward is just 1.5%.  That’s with core CPI at 2.2% currently.  In fact, the lowest core CPI print over the past 5 years is 1.6%.  A sub 1.5% outcome only seems likely in the event of a recession.


Furthermore, a sharp further decline in yields here is likely to be self-defeating.   Currently, 30y mortgages are ~15bps above the 2012 lows.  If mortgage rates were to make new lows on the back of Brexit, Fed, overseas buying, whatever, and holds there for a bit, there will likely be a decent response from the housing sector in the form of a refi surge / housing price increase.


Finally, spec positioning in futures suggest long bond futures positioning is quite stretched to the long side.





IMO, the backdrop I presented above is a good backdrop to get long equities after or potentially just before the British referendum. Now obviously, a Brexit vote is likely to coincide with a risk off.   And obviously there are headline risks around the US election.  But if we look through that, I think a brighter picture emerges.


  • As I noted earlier, given the easing in financial conditions earlier this year, growth is likely to turn up from here.
  • Higher year over year inflation is already baked in
  • Earnings expectations is likely to pick up as well.  In fact, they have already started moving up – the 3m chg have hit the highest levels since last summer
  • Current valuations vs fixed income are the most attractive they’ve been in a year.  S&P dividend yield at 2.2%, vs 30y swap at 2.0%.
  • Sentiment & positioning is still bearish.  But it is beginning to turn.  A break to new highs is likely to drive quite a squeeze. The chart below shows the results of the most recent BAML survey.  Equities weighting is at levels last seen in 2011 and 2012.


  • On account of the easing in financial conditions and the passing of inflation & currency shocks, recession risk over the next 12 months is reduced.  If the economy was fragile enough to tip into a recession, the shocks over the past 12 months should’ve done it.


I’m aware of the various argument for an upcoming recession and/or bear market.  Little available slack in the labor market, profit margins have peaked, Fed is tightening, etc.  The fact is, however, that the reason why recessions have historically followed those factors is due to tightening fed policy / financial conditions.  The Fed’s reaction function this time is quite different.  Which means the lag between those indicators and the next recession is likely longer than usual also.


Finally, there are several similarities to late 90’s here, after the Fed was dovish after oil & EM shocks.  Imagine the narrative when the S&P makes new highs, and managers are underweight equities, and 10y is still below 1.75%.  What do you think they will do?  Bonds are arguably already in bubble territory.  Why can’t equities be also? (Yes, the Fed did note that forward p/e ratios are well above their 30y median.  But then Greenspan did speak about ‘irrational exuberance’ in stock prices… in 1996.  And if you have other concerns that risk taking is blunted – apparently someone is hovering up leverage loans)



Current Thoughts

It’s been a while since my last note, so I thought I’d make an update. Broadly speaking, not a great deal has changed over the past couple months.

On Rates:

In my last note, I suggested the possibility of a move higher in yields. Clearly that has been wrong so far. Yields have not moved higher, although it has not made new lows, at least not yet. My view remains the same, but the timetable is delayed. The current backdrop suggested a somewhat subdued Q2 for the US economy, with a pickup in 2H. Current market pricing continues to present a very low risk premium for the possibility of Fed hikes. By 4Q, with the labor market at full employment and headline CPI & core PCE just a bit below 2%, I think it will be difficult for the Fed to avoid hiking this year, barring a major shock. Once the Fed hikes once, it will be hard for the market to avoid discounting further hikes, which means the current market pricing of just 2 hikes through the end of 2017 will look quite low. This could be a catalyst for a move higher.

One reason for the current low level of interest rates appears to be market fear of persistent disinflation. Fwd starting inflation swaps look interesting. 1y1y is at just 1.6%, with core CPI @ 2.1% last. In fact, the lowest core CPI print since mid 2011 was 1.6%. Real yields are also low, with 2y real swap yields currently at -75bps, near the levels in May 2015. So it’s quite clear that inflation & term premiums are both very depressed, contributing to the low level of rates currently. IMO, this is the main reason yields were not able to break lower this year – current pricing is difficult to justify barring a shock.

On Equities:

Positioning and sentiment are both quite negative, which suggest limited downside here. For example, the most recent BAML survey showed the lowest allocation to equities since Feb, and before that mid-2012. The average cash balance is also back to 2012 levels. The rolling 5 week outflow from equity funds was the highest since August 2011. AAII sentiment is also quite bearish.

Of course, limited downside doesn’t mean imminent upside in this environment. With earnings growth still weak, a continuation of the range bound environment seems the most likely, at least until later in the year. After that, earnings growth should start to pickup a bit, but this will be offset by risks from Fed tightening and politics. With the skew currently quite elevated, selling puts seems to be a superior expression of a long bias here.

The market seems to be focusing on the CNY again. The chart below plots USDCNH (inverted, white) vs SPX.

You can see why the market may be concerned, but it’s worth recalling that the backdrop now vs January or last August is very different. Both expectations and positioning were much more bullish then, even though credit markets were tightening and growth & inflation expectations were falling. A sharp correction in equities here on the back of the CNY move is likely a good fade, IMO.

On FX:

CNY is getting back on people’s radars, as I noted earlier. In addition, it’s worth noting that that CFETS RMB index has now fallen 6% since it was published 6 months ago, meaning that the PBoC is managing a 12% annualized FX depreciation, even as the 12 month rolling trade balance is hitting new highs. This is not a sustainable trend.

IMO, it is not a coincidence that Brexit and Trump have been gaining in popularity the same year. In the two DM countries with the worst trade balances. I think that this is at least partly driven by workers who have been displaced by trade. Yes, much of those workers’ jobs have been displaced by technology rather than trade, but the fact is that they are sick of politicians not even trying to do anything about it. These voices became apparent with the Tea Party wave at the turn of the decade and are unlikely to fade away until they are addressed. To me, Anti-Trade & protectionist policies are likely only a matter of time, regardless of who winds up getting elected. This is likely positive for USD, GBP, at least in the longer run, and obviously quite bad for equities in Germany & Japan.

Finally, a quick update from a recent visit to China. Faith in policy makers continue, despite equity market turbulence last year. In general, optimism remains high, in contrast to opinions of Westerners.