Recap 2015-06-18: Some Thoughts


The FOMC was dovish as expected, but the effects have mostly impacted the belly of the curve. Long dated yields remain higher.

I’ve previously noted that sentiment was unusually pessimistic, and so the removal of near term FOMC uncertainty seems to have allowed the S&P to begin rallying. I think the rally has a good chance of extending for a few weeks. In addition to the sentiment backdrop, earnings estimates may start picking up soon as well.

As most readers know, the weakness in earnings has mostly been due to the Energy sector. Below is a chart of the average 12m change in 1y ahead EPS estimates by various groups. As the chart shows, the non-commodities sectors have been fairly resilient.

Unsurprisingly, the Energy sector EPS is fairly highly correlated to trailing measures of oil prices. Below is the rolling 2qtr median (with extrapolations out a few weeks) vs EPS estimates:

The point is that given the likely small uptick in expected Energy sector earnings, along with dropping out of base effects, the YoY change in Energy earnings estimates are likely to pick up over the next couple months.

This suggests that rising earnings is likely to once again start helping SPX performance over that time frame. The effects, however, are likely to be fairly mild until late in the year.

In addition, with the backup in yields, the supply dynamics for US credit may be changing soon. Blackrock noted that the US IG issuance since March has been double the average rate of the prior 4 years.

The majority of this seems to be related to M&A.

With the backup in global yields since March, there should be a slowdown in those activities, and hence issuance. That may allow long dated spreads to stabilize and eventually compress. The compression of credit risk premia is likely to also support equity prices.

Separately, the moves in EUR yields continue to be a key driver of EUR asset prices. 30y EUR swap yields are now 30bps higher than where they closed on the day QE was announced. The 2003 BoJ analog suggests that the broader sell off may be over for a bit, volatility not withstanding. Nevertheless, the effects on EUR assets has been powerful. That is likely to continue until it becomes more clear that we’ve past a local high for yields.

The EUR charts are looking… bullish. Momentum had turned by April, but the rising wedge suggests a potential break through 1.15 resistance. Through there, the next level of serious resistance doesn’t come into play until ~1.20.

Like the EUR, almost all of the Eurostoxx outperformance vs the SPX following the ECB meeting announcing QE has been unwound. The burden for outperformance remains on rising earnings. IMO, at current levels it’s not obvious that EU equities are cheap vs SPX even after adjusting for the better EPS growth over the next couple quarters. One possibility is that the (eventual) outperformance may not come until late this year.

Finally, I though this article from the WSJ was VERY interesting:

Prime Minister Shinzo Abe is expected to unveil a plan to balance Japan’s budget in five years, a move that underscores Tokyo’s resolve to improve its deficit-ridden finances even as it continues to pursue costly economic-stimulus programs. In a draft plan to be released early next week, Mr. Abe is expected to reiterate his long-held goal of eliminating a deficit in the government’s primary balance—the difference between tax revenues and government spending minus debt-servicing costs—as a step toward reducing the country’s debt burden, according to government officials.

This is a big deal because now it appears that Japanese fiscal policy makers is backing away from easing. In conjunction with Kuroda’s statements on the Yen, it appears that both fiscal and monetary policy makers in Japan expects to gradually wind down stimulus going forward.

Recap 2015-06-12: Europe now vs Japan a decade ago, SPX upside next few weeks


I’ve written in the past that the current EU bond market price action has many similarities to that of the Japanese bond market in the early 2000’s. The chart below shows the German 2s30s curve (blue) vs the Japanese 2s30s curve starting in 2002. (red) I used the 2s30s curve instead of outright yields because we need to adjust for the fact that the ECB has cut rates into negative territory:

I’ve noted in the past that perhaps the comparisons are of limited value because of the differences in the economic back drop. The more I’ve thought about it, however, the more I think that the similarities are bigger than I originally realized. For example, the EU unemployment rate (white) topped out at 12.1%, whereas the Japanese UER (orange) topped out at 5.5%. While the difference looks massive at first glance, I didn’t take into account the difference in the measurement of the data, i.e. who qualifies as unemployed. If we look at the change in the UER instead, the picture looks much more alike. By 2002, Japanese UER rose had risen by 3.5 percentage points from the 1992 lows, where as the EU UER, currently at 11.2%, is up 3.9 percentage points from the 2008 lows:

Of course, no historical analog is exactly alike. In 2002, the global economy was coming out of a recession. But it’s interesting to note that even US interest rates now seem to compare well with then. Here is a chart of the Fed Funds rate now (blue) vs then, (red) with futures-implied levels included:

And here is the overlay of the US 10y yields:

Of course, the axes are different between now and then, reflecting the different levels of growth and inflation, but the resemblances are quite remarkable, at least to me. These resemblances made me dig a bit further.

A simple comparison of the Real Trade Weighted currency levels between Europe now and Japan then initially shows low correlation until recently:

But a look at the longer term picture shows more similarities. The trade weighted EUR peaked in 2008, fell for 4 years, bounced, then resumed falling. The trade weighted Yen peaked in 1995, fell for 3 years, bounced, then resumed falling.

The point is that in the case of the Yen, further depreciation on a trade weighted basis did not occur until 2005, about two years after the BoJ initiated QE and well after the Fed started hiking. Note that this occurred even as the Fed’s hiking path is projected to be roughly comparable to the path then. The take away for the EUR, in other words, is that the further depreciation that is very widely expected may not be coming for several quarters. Specifically, the start of Fed hikes may not cause the EUR to immediately depreciate as is widely assumed.

It’s a bit harder to get a read on how the Eurostoxx will perform using this analog. One reason is that the global economy was in a recession in 2002, which obviously had a large effect on how Japanese equities performed. Japanese equities also started with zero or negative earnings. Differences in the moves in the currency between now and then obviously also has an effect on earnings. There really isn’t a good way to reconcile all these differences, so what I did was rebase the indicies to 12/31/14 and 3/3/03, respectively.

Now, because Japanese equities benefited from a global recovery, one could argue that Japanese corporate earnings benefited more than what could be expected for EU equities this time. EU equities, after all, are already up 65% from the May 2012 closing low. So perhaps the Equities analog is not particularly informative in this case. Readers are welcome to judge for themselves.

Separately, based on sentiment measures, the S&P looks ready to rally. The AAII survey reported that just 20% of respondents were bullish this week, which is very pessimistic reading indeed. In fact, in the past 10 years, the reading has only been lower 4 times. Unsurprisingly, this level of pessimism has historically preceded decent rallies over the subsequent weeks:

This dovetails with my comments earlier this week. Equity market pessimism, a potentially dovish Fed, and economic data that is starting to improve vs expectations. They are all fuel for a risk rally.

Anecdotally, GS notes that calls are quite attractively priced here as well:

Recap 2015-06-10: FCI, Historical Analog


One of the things that have been unusual about recent market moves is that credit spreads has not been tightening with the move up in global risk free yields. Here is a chart of the US long term BBB yield vs the 30yr Treasury yield. Note that unlike what happened during the Taper Tantrum, where credit spreads were broadly stable or even tightened, over the past 6 months, spreads have unambiguously widened.

Now this type of behavior is not uncommon heading into recessions, after the Fed has already tightened. But that is not the case here – very few macro indicators suggest such a risk is yet on the horizon.

This widening in spreads has been a surprise to the consensus, which has broadly expected the usual pattern of credit yields being broadly stable in treasury sell offs. When combined with the fact that equity prices has not appreciated much, the result is that financial conditions (there are many ways to measure it – I used the Chicago Fed measure below) has tightened to unusually restrictive levels. In fact, these levels are usually only seen just ahead of recessions & slowdowns, and coincident with local highs in treasury yields:

Now, you may ask, does it really matter? Or worded differently: does the Fed care?

I think the answer is: probably. The FOMC centrists have noted repeatedly that they are concerned about the risks to financial asset prices (and knockon effects on the real economy) following the first hike. Given how tight financial conditions (and reportedly low fixed income liquidity) are currently, one would think that would influence FOMC thinking. And this is all before the recent weak data is taken into account.

There is a rough historical analog to rates movements the past few years. The Treasury price action following the Savings & Loan crisis resulted in a sharp fall in treasury yields, a Fed ‘mistake tightening’ cycle in 1994, which was then subsequently unwound. The movements in the long end over that period and now bear many similarities, but the comparison from late 1993-1997 (in red) and now (in blue) are somewhat eye-catching:

It appears that back in 1996, equity prices were broadly range bound until it became apparent that yields had topped by 3Q. After that, it was off to the races. The analog to the 2015 price action is below:

In aggregate, it may be that like in 1996, financial markets are waiting for financial conditions (proxied by this global bond sell off) to stabilize. Credit spreads and other risk premia may not tighten until then.

Having said that, we may be nearing that point. I’ve already noted that historically, financial conditions at these tights have coincided with local tops in treasury yields. Ultimately, it will still be the data that will drive the Fed’s decision for lift off. But note that the last Fed guidance ‘ease’ was in March. Data since then has continued to disappoint, even as Fed Funds pricing has been range bound. (BBG US economic surprise index in white, the Dec 2015 Fed Funds Futures implied yield in orange) This suggests that the current market pricing of a 25bp move up in the effective Fed Funds rate by Dec is fairly reasonable:

Given that consensus expectations for Fed Funds in 4Q is 70bps, a SEP next week pointing to a Dec or later lift off is likely to be supportive for treasury prices, and potentially credit and equities as well.

Recap 2015-06-03: My Take from Here


The big question remains: when and at what level will US growth pick up?

A few weeks ago, I noted that the amount the US economic data has disappointed vs expectations was unusually wide, and that the dichotomy would begin to converge soon. So far, (as is usually the case) it’s been expectations that have moved. 2Q growth expectations has already dropped sharply, to 2.65% from 3.1%. Given that the 8 quarter average is 2.5%, expectations are probably no longer overly optimistic.

With the benefit of hindsight, it appears reasonably clear now that the strong bounce that many expected following the weak Q1 will not be materializing, as consumers save, rather than spend, their ‘oil tax cut.’ All else equal, this should delay the Fed’s hiking schedule somewhat, though the Fed will likely hold off on signaling as such until the data is more conclusive. We’ve only seen data for the first half of 2Q, after all. Having said that, note that the US economic data surprise index has already begun to turn up, though from very low levels.

As the immediate effects of the oil and dollar move on earnings fade over time, we are likely to see better earnings expectations as well. Citi notes that 9 out of 10 S&P 500 sectors showing EPS revisions to the upside thus far in May. To me, this is probably a more timely indicator for when the Fed goes. Earnings, after all, provide the room for additional hiring and spending. Another way to put this is that not only is S&P momentum likely to pick up in the next month or two, such a pickup is probably a prerequisite for Fed hikes.

Note that that the data surprise and equity sentiment seasonality bear some similarity to last year. Historically, US data weakness has tended to last around two quarters and trough around late 2Q. This year we may see a repeat of that:

The seasonal trough also seems to apply to equity sentiment. (Proxied by the AAII Bulls-Bears difference in the chart below)

In fact, note that equity sentiment (proxied by the 9 week moving average of the AAII Bulls-Bears differential) is now roughly at the lows of last year:

Given all that, it shouldn’t be a surprise if S&P price action roughly follows last year’s pattern as well:

In rates space, EU fixed income remains a major driver. There are clearly a number of trapped longs. (Was it just a couple of months ago that people were projecting 0% yield on Buxl??) But valuation indicators suggest we are nearing ‘neutral’ levels. First, long dated EUR real yields have bounced back sharply from an implausibly low -100bps to just below zero, which was where they were at the height of the EU crisis. While one could make the case that they are still too low, this is no longer an obvious call, given the size of the EU output gap. Moreover, as a precedent, the US 30y real yield also traded around zero from late 2011 through early 2013.

Furthermore, the differential between US and EU 30y yields are now roughly back to the range prevailing in 4Q last year, before the hysteria around the ECB QE became feverish:

I’ve long held the view that the fair level for US 30y yields is roughly 3%. With yields not far from there, there isn’t much value in a significant position here from my point of view.

Having said that, it will certainly take time and additional volatility for the market to find the appropriate clearing level for EUR yields. This is very likely to add vol to EURUSD. This, in turn, is likely to add volatility to all USD crosses. That would be mitigated if other central banks eased further, but the appetite for that appears quite low at this juncture. For example, additional easing by the BoJ seems unlikely. The risk/reward trade off for them at these levels of asset prices is poor, as is the political appetite. While the BoJ continues to desire a weaker Yen over the long run, they will depend on Fed hikes to cheapen the currency further, and seem happy to sit on their hands in the interim. This is the playbook for other CB’s this year, such as the RBA. That is another reason the USD may be range bound until the Fed begins to hike. As a result, I don’t think it will be a fun summer, or even a fun autumn for USD bulls, even as they will be proven right over the longer run.

Other Thoughts:

  • EU earnings expectations are improving at the fastest rate since 2010. That has helped mitigate the negative impact of the move in yields.
  • MIB (Italian equities) are unusually rich here and likely to underperform its peers.
  • Long dated USD IG credit spreads look unusually wide and hence interesting

Recap 2015-05-12: Update


A number of my longer term expectations were realized the past couple weeks. I have written at length about all these topics, so I’ll just be brief here:

  • Long dated EUR bonds will sell off despite the ECB QE program.
  • US 30y yields hit 3%, my long standing estimate of fair value
  • EU equities has significant exposure to EU duration
  • Risk Parity performance will wane sharply going forward
  • EUR is likely to bounce towards 1.15

To be fair, many of these are occurring somewhat later than I’d expected. I’m reminded of a quote by an MIT economist Rudiger Dornbusch: “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” Anyway, this seems like a good time to reassess the market picture for the second third of the year. Unlike my recent pieces, I don’t have an overarching theme here, so I’ll just present my thoughts on an itemized basis.

Yields are still well below fair value in Europe, but they’re not low enough that shorting is phenomenally attractive, especially if it’s adjusted for the likely volatility. The lack of liquidity that characterized this move up in yields the past few weeks is also likely to exacerbate moves on the way down. In addition, EU yields are now already higher than the levels prevailing just before the January ECB meeting, which suggests that the QE ‘surprise’ effect has already been removed from the price. Having said that, in my experience asset prices tend to fluctuate around fair value a bit like a pendulum. Given how far the mispricing has gone to the downside for yields, they may well overshoot more than expected to the upside. This applies to the US bond market as well. Movements in oil prices are likely to continue to play a role.

The duration risk in EU equities remains quite pertinent. While earnings expectations have finally picked up in a real way, there hasn’t been enough time for that growth to actually occur yet. Until that happens, I expect EU equity prices to continue to exhibit correlation to long dated EU bond prices.

The duration risk for US equities is lower, but another sizable backup in real yields from here could be problematic. Because US earnings are not expected to pickup until several quarters from now, that duration risk will be around for a while. Having said that, the long term charts continue to show the S&P in a bullish triangle formation that should be resolved by mid-June. The backdrop for US equities has been pretty difficult the past few quarters: a negative GDP print, a sharp drop in earnings expectations, a central bank that is discussing tightening, significant outperformance of foreign counterparts. Yet index prices have remained fairly resilient. With the waning of those headwinds, perhaps some more upside may be forthcoming. My macro models suggest that both expected EPS and PE will probably rise further through year end.

FTSE100 looks likely to underperform vs the US & Europe given valuation differences.

The USD correction is still ongoing. My 1.15 target on the EUR is the minimum – I wouldn’t be surprised to see it hit 1.20. There just isn’t a catalyst for further USD strength in the near term. The data has not bounced back like the Fed has expected yet, and until that happens for a sustained period of time, the FOMC will be on hold and hikes will continue to get pushed out. In aggregate, I wouldn’t be surprised if the USD rally didn’t resume until the fall.

I don’t know when the Fed’s going to hike – but I do think that it doesn’t matter that much with respect to long term asset prices. (I think that Fed hikes will be a positive for corporate profits, at least initially.) Much more important are the terminal level and the pace of hikes. Both have been revised lower (or slower) in the SEP, a trend that I think will continue. My best guess for the terminal rate is ~3.5%, give or take 50bps depending on economic momentum.

On Greece, I’ll just repeat what I’ve said before. I have no idea what will happen, but given that the market has had 5 years now to prepare for this, the probability that a Grexit or whatever affects the markets in a significant way is quite low.

On Oil, it seems like everyone who writes or talks about it has no idea. To be fair, I don’t have many ideas either. Production everywhere has surprised to the upside, so analysts have been bearish, yet prices are now up 13% for the year and near their highs for the year. Speculative positioning has turned from extremely short to only marginally short by my estimates. Thus, barring another shift in the marginal cost of production, one possibility is that we are near the middle of a new range here. The 1y, 1y fwd strip is currently at $65.

Recap 2015-04-30: ERP in the EU vs the US

I noted previously (3/5 to be exact) that one of the reasons I have been less bullish on EU equities over the longer run (as compared to the US) is that much of the move YTD has been due only to the excessively low EUR risk free rates. That was a factor that came into play yesterday, as both EU equities and fixed income sold off in tandem: (Eurostoxx in white, EUR 30y swap rates in orange and inverted)

A natural question following that is: why did EU equities get hit by higher yields this time, while US stocks escaped unscathed in 2013? A key reason is that Europe has a higher Equity Risk Premium than the US. A higher ERP that is entirely justified. Rather than expound on all the different potential reasons, many of which has been explored by others in the past, I’ll just list some bullet points:

  • Widely different economies and one central bank means that on a per country basis, policy is never optimal. See footnote 1.
  • The ECB’s mandate that ONLY encompasses the AVERAGE inflation, (which lags the economic cycle) across all the countries of the Eurozone, (which often have widely disparate data) means that the ECB is much more likely to act too late. This results in larger cyclical peaks and troughs and greater macro volatility, which typically results in higher risk premiums for longer dated, pro-cyclical assets. It is not an accident that they hiked in 2010… and eased in 2015. Both actions are likely to be categorized by historians as policy moves that were incorrect, IMO.
  • The combination of the Maastricht Treaty debt limitations and the ECB’s inflation-only mandate means that both fiscal AND monetary policy ability to support growth in a timely fashion is impaired.
  • Different politics, different laws and different courts of law means significant hurdles & friction for optimal capital deployment including M&A.
  • The amount of EUR debt held by EU insurance companies, and the rigidity of EU laws for insurers, restricts the portfolio rebalancing channel. I.e. it limits the ability of EU investors to move away from fixed income into equities. See footnote 2.

Readers will note that one implication of the ERP differential is that monetary policy in Europe has a more limited room to be effective on equities than in the US. My view is that we are basically at that limit already. By my estimates, a +10bp rise in the long term EU discount rate, without a change in the forward earnings estimates, would result in a ~1.6% decline in the Eurostoxx index, ceteris paribus.

Speaking of EU yields, I noted on 3/16 that the German yield curve matches up pretty well to the Japanese curve in 2002-03. That analog seems to be working pretty well YTD:

Having said that, I do think that this analog will only take us so far. The ECB has backed itself into a corner of sorts, and to turn in the towel after only 3 months would probably be seen within the institution as being very damaging for its credibility. IMO, the recent volatility has been the result of a combination of heavy issuance and speculative positioning, combined with poor liquidity conditions. (Which of course itself heavily exacerbated by QE) In aggregate, the price action in Buxl looks corrective. The downward trend in yields has been ongoing for years now – it will take time for the trend to reverse. But recent price action certainly suggests that this is the beginning of the end rather than the end of the beginning.

Speaking of corrective price action, I noted back on 3/23 that the 1.15 area is a likely corrective target for EUR. I think that is still the case. In fact, note that without an actual Fed hike, there are no obvious catalysts that are likely to push EURUSD to new lows. As a result, we should not be surprised to see the cross range bound over the next couple quarters.


1) Disparities in EU unemployment:

From JPM Private Bank:

2) Composition of EUR debt investors from Citi:

Recap 2015-04-22: My Take


The weak US data in 1Q has been unusually surprising. The Bloomberg measure of surprises, for example, is at the most negative level since the Lehman recession:

The drivers seem to be a result of both the data as well as the resilience of analyst estimates. Clearly, the US economy is feeling the front loaded effects of the move in oil and the dollar. However, analyst estimates has remained broadly sanguine, with many expecting a bounce back in 2Q. The chart below illustrates how despite the sharp drop off in 1Q growth estimates (white line) 2Q estimates has actually ticked up. (orange)

The wide spread consensus expectation of a strong rebound means that the data needs to hit expectations. And given where we are in 2Q, that needs to start happening soon.

Asset prices have already moved in response to the weak 1Q data. As economic surprises (orange) fell in late Dec and accelerated in Feb and March, treasury yields (white) fell, and equities (yellow) and the dollar (green) consolidated.

In other words, data over the next few weeks are likely to be quite important. If the recent string of data disappointments continue, analysts as well as the Fed are likely to need to reassess their growth projections. In particular, they are likely to need to reassess the impact of the dollar. The US economy is actually relatively closed, but its exposure to global trade has been increasing over the years, just like those of other DM countries. Dudley on Monday said that

While I am relatively optimistic about the growth outlook for 2015, I also must acknowledge that there are some significant downside risks. In particular, the roughly 15 percent appreciation of the exchange value of the dollar since mid-2014 is making U.S. exports more expensive and imports more competitive. My staff’s analysis concludes that an appreciation of this magnitude would, all else equal, reduce growth of real GDP by about 0.6 percentage point over this year. Some of the recent softness in indicators of manufacturing activity is likely a reflection of this development.

Given that US growth has been averaging 2.3%, the 0.6% figure is quite substantive. In addition, an upward revision of the ‘beta’ of the dollar on US growth is important because expectations for further dollar strength are widespread. Such a revision would thus have a compounded effect on expectations for US growth & monetary policy.

Furthermore, note that there is probably a reasonable basis for such a revision. All macro models use historical data as a basis for estimates. GMO recently published a white paper noting that domestic sales of EAFE (non-US developed market) country corporations have continued to fall since the recession, also that trend may have stabilized as of 2012:

In other words, it is quite possible that the continued globalization of corporate profits (which leads investment & hiring intentions) has not yet been fully incorporated into analyst models.

Having said that, however, most of the charts support analyst optimism. The S&P is in the middle of a textbook bullish wedge that looks likely to be resolved soon. The last such occurrence was a year ago:

US 30y yields’ downward momentum appears to be flagging, with yields unable to re-break support at 2.5%. Like the S&P chart, we are likely to get some sort of formation break soon, either up or down. There are some similarities to 2012 here also.

The Dollar is consolidating above long term support / resistance.

Finally, Gold appears to be consolidating before a push lower. If yields and the dollar move higher, such a move would not be surprising.

In fact, short gold may be one of the better proxies to express a short interest rate view. Since the curve is in contango, carry is positive. (rather than negative in most expressions) In addition, an end to global central bank easing is in sight. Finally, the sharp drop in commodity prices globally the past few quarters means the marginal cost of production has likely fallen dramatically.