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.

http://quantifiableedges.com/an-extremely-quick-move-from-a-50-day-low-to-a-50-day-high/

https://twitter.com/NautilusCap/status/741000591208525824

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)

 

Macroeconomics

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)

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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.

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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.

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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.

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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.

 

 

Rates

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.

 

 

Equities

 

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.

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  • 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.

Are we at the start of a major move higher in yields?

First, a Post Mortem on Jan 21st note:

I put out a note then that I thought it was the beginning of the bottom for risk assets. In retrospect a month and a half later, that seems to have been the right call. While not all risk assets bottomed then, many commodity and EM related assets did (BRL, ZAR) with developed market assets bottoming a bit lower and a bit later on Feb 11th. In general, buying risk assets at or below Jan 21st levels has been the right move. To me, this means that my understanding of the market narrative hasn’t been too off.

OK – on to the main idea.

Obviously, risk free yields have fallen dramatically since the end of 2013. There were a number of reasons for it, but in aggregate, I think there is a good chance that the move lower has been played out for the next few quarters, especially in the US. For simplicity, below are a number of drivers for the move lower the past few years, and reasons to believe those drivers are turning or abating:

· Easing by central banks elsewhere has been a major driver for moves in US yields, especially the long end. Well, after today, it seems like the ECB is done, at least for a couple quarters. And effectively, so is the BoJ, since they appear to be out of ammo. (how much more will 30y JGBs fall and will it matter?)

· The strength of the dollar has been exerting a significant and continuing drag on US growth since 2014, with the speed of the strengthening in 2014 front loading the effects. While the drag is likely to continue for several quarters longer, there are several mitigating points. First, the negative effects were previously underestimated. That seems to have been corrected. Secondly, even if the dollar strengthens further, but bulk of the move is already behind us. As the chart below of the trade weighted dollar shows, the dollar has already appreciated 38% from its lows, on par with the 40% strengthening in the late 90’s / early 2000’s. And even if the dollar were to repeat the early 80’s performance, (hard to see given the limitations of NIRP) we are already more than halfway.

· In conjunction with that, the US data has been stabilizing vs expectations, which suggests we may start getting some positive surprises. Citi has an aggregate economic surprise index for the G10, which has turned higher from very low levels that was last seen in 2013 that foreshadowed the ‘Taper Tantrum.’

This is also corroborated by the data flow. The Manufacturing ISM has bounced off of the 48 area and broken above the 6 month average, in a manner that is reminiscent of what happened during prior dollar bull markets in the mid 80’s and late 90’s:

· Oil prices has been driving both realized and market-implied inflation lower since 2014, and it has bottomed. (Even if we make a new low, it won’t be significantly lower than the prints we’ve seen) Realized inflation has turned up already. The last headline CPI print was +1.4% from 0% in Sept. (though given oil prices YTD, we may need to wait until 3Q to see higher prints) Inflation markets have begun to turn higher. (outside Japan anyway) 2y & 5y US breakevens are at the highest levels since last summer, though longer dated measures remain depressed. (though those are likely more affected by foreign developments)

· Credit market strains have improved significantly

· Technicals globally point to the potential for higher yields in the intermediate term:
US 10y treasury yields failed to sustain new lows and have turned higher: (chartists would call it a double bottom)

Same story for 30yr German yields:

And perhaps most interesting of all, 30y JGB’s seem to be putting in the type of price action that preceded the 2013 Taper Tantrum:

For what it’s worth, I think most of the mispricing in the US curve is in the belly. 30y levels looks only somewhat low, but given how far we’ve overshot to the downside, the likelihood of an overshoot to the topside seems more likely than not.

Thoughts on other asset classes:

For the dollar, I think it depends on the cross, as it’s arguably it’s harder to make generalization. USDJPY seems to already pricing in a rise in US yields. Against other DM currencies, higher yields are likely to be a positive for the dollar.

For equities, the picture is probably even more mixed. Earnings trends are only just beginning to stabilize, and are unlikely to grow much more than low to mid single digits by year end, with risks skewed to the downside owing to well known factors like the dollar and rising labor costs. Against that, a decrease in the credit risk premium should allow for a bit of compression in the equity risk premium as well. The upside from that source is probably capped, however, given where we are in the business cycle. Against that, volatility is unlikely to fall much, which makes the ex-ante risk/reward proposition not especially attractive.

Credit is probably the most attractively priced of the major asset classes, though the attractiveness comes primarily relative to low risk free rates. On an outright yield to worst basis, my view is that they are only somewhat cheap given the business cycle risks.

For EM, a resumption of Fed hikes and a stronger dollar probably means that investors will remain skittish, especially since for many EM’s, the structural & institutional imbalances that lead them to where they are remains unfixed.

On a separate topic, one of the many interesting trends we’ve seen over the past few years is the combination of more money in passive strategies, but also active managers underperforming more. At first glance this appears to be counterintuitive, since one would think that less active management would imply more opportunities to add alpha. A potential explanation is that the market has gotten more efficient, and in general the opportunity to generate alpha has fallen. The below post would seem to support that hypothesis. In general, and unsurprisingly, most easy and/or simple quantitative strategies are no longer working:

http://blog.alphaarchitect.com/2016/02/11/dual-momentum-on-individual-stocks-wow/

The Markets are sending Central Banks a Message

What’s Going On

EU Banks were over levered going into the EU crisis. The ECB has forced them to delever and build up capital, even as they faced rising loan defaults and market headwinds. While most of the loan defaults are behind them, the banks’ plans to get to regulatory-mandated levels of capital makes assumptions of large increases in retained earnings.

Over the past year, a combination of QE and negative rates has flattened the yield curve substantially. The flattening has in turn resulted in substantial lower interest rate margins for the banks. In turn, this means lower expected earnings for the banks.

For the least profitable and weakest banks, this combination of low capital and lower future earnings has resulted in solvency concerns.

Since Deustche is a large bank, this very quickly turned into systemic concerns.

Systemic solvency concerns, as anyone who worked through the last recession knows, is everything.

Likely Effects in the Future

Weak Bank equity valuations will likely exert a drag on economic growth over time.

Generally speaking, banks need to increase or at least keep stable their net loan books.

Nominal GDP = Money Supply * Velocity

By keeping its loan book stable, banks can at least keep the Money Supply variable stable. That is one reason why historically it has been unusual to see NGDP grow with an extended period of contracting money supply.

When bank equity valuations are cheap, banks are incentivized to delever and buy back equity and / or debt, rather than make loans.

Here are some charts that show this. This shows the US bank index Price to book in white vs Commercial and Industrial Loans outstanding in Orange. Note how dips in value below 1.0 has historically preceded declines in C&I Loans outstanding.

This one is for Europe. Non-Financial Corporate Loans outstanding is in Orange.

The message from bank shareholders seems to be clear: stop the easing.

There is a big difference between liquidity concerns, solvency concerns, and profitability concerns. The order of importance is respective.

· At this point, liquidity concerns for senior unsecured debt is fairly minimal given ECB policy.

· Solvency concerns a bit higher, but is mitigated by lots of factors: a trigger on CoCo bonds would be supportive for solvency, and Germany and other EU countries in general are much better placed to inject capital. Yields are negative for them, after all!

· Profitability concerns are pretty big. The chart below shows the index price on top vs trailing 12m Earnings Per Share on the bottom. Despite the easy monetary conditions and the decrease in oil prices, EU banks have not really been able to sustain positive earnings over a 5 quarter period until recently:

Bank Solvency Concerns can take on a life of its own.

This shouldn’t be news to old market hands. The credit worthiness of a bank is to a large extent an article of faith by its creditors. Especially for large, opaque concerns like Deutsche, no one really knows the full extent of the risks. That is why solvency concerns can very quickly lead to a drying up of funding by creditors and an eventual liquidity crisis, which is what kills banks.

Having said that, given sufficient liquidity and time, these effects can stabilize. For banks that have sufficiently long and stable liquidity, they can buy back debt and/or equity. Even if RoE is zero, buying back debt below par and equity below book is accretive to earnings and valuation. But again, this is something that will take some time and/or action from policy makers.

I think credit spreads have also been getting impacted prior to this episode, but not in the way one’d think.

I’ve noted in the past that the Yield to Worst for investment grade credit has been broadly stable. However, there has been a sharp decline in treasury yields. The net effect is the credit spreads have widened by quite a bit. As the chart below illustrates, 30y credit spreads has hit levels not seen since mid 2009, even as the credit Yield to Worst has been stable:

Delving into the decline in treasury yields further, the decline has been mostly driven by the inflation compensation component. (in White below, with real yield in orange) Since the June highs in the nominal yield, the vast majority of the decline has been driven by the breakeven leg:

The interesting thing is that breakevens seem to have dropped even beyond levels implied by oil forwards: (not that 30y breakevens should be tracking oil price that closely anyway, but I digress)

A major additional factor is the policy rates overseas. The Fed has a measure of term premium for the 10y that has dropped sharply since the crisis. This term premium is strongly inversely correlated to the yield differential between US treasuries and global bonds elsewhere. The chart below illustrates: term premium is in white, and the US 10y yield differential between a basket of German, Japanese, and UK 10y yields is in orange and inverted.

Anyway, the point is that it seems like monetary policy overseas has also been a contributory factor to the pricing of treasury yields, which impacts US credit spreads, which in turns has implications across the capital stack, and a key driver of equity performance this year.

Credit spreads are so far having a limited impact on the economy, due to past bank deleveraging and regulatory prudence. This is supported by the recently released results from the Fed’s Senior Loan officer survey, which showed that despite the sharp widening in corporate credit spreads, only a small percentage of banks tightened credit to corporate borrowers on net, roughly unchanged from 3Q. Obviously, we shouldn’t expect this divergence to persist forever, but it does suggest that the new regulatory policies has been successful in insulating banks from market volatility somewhat.

Further Out

The goal of QE is to decrease yield, lift risk assets and weaken the currency.

Since 3m OIS swaps have declined below -10bps and 0bps in Europe and Japan respectively, exactly the opposite has happened. In Europe, since 3m OIS swaps (orange) declined below 10bpsin early April, the EUR (white) is higher vs the dollar, bank shares (purple) has gotten annihilated, and even the average of 30y EUR sovereign bond yields, (yellow) the asset the ECB is buying directly, is higher in yield.

The story is the same in Japan. Since the BoJ cut, the Yen (white) is 6 figures stronger vs the dollar, the Topix bank index (yellow) is 20% lower, and even 30y JGB yields (green) are higher post cut!

My hope is that the ECB and BoJ have started to recognize these issues, and are beginning to consider ways to mitigate them. At the very least, the pace of deterioration in bank shares the past few weeks will have gotten their attention. A bit of stability in oil prices should also help inflation stabilize and reduce the desire for further easing.

A pullback by these central banks from further easing will help both bank prices as well as treasury yields rise. This in turn is likely to be supportive (or less unsupportive) for lending, while the higher Treasury yields allow the EUR and JPY to weaken. Paradoxically, a shift away from dovishness by those central banks is likely to be risk positive. Because as many of us have intuitively understood, negative rates are not stimulative on net.

It’s time to start building exposure to risk assets

Back in late October, I published a note entitled “It’s Time to be Neutral or Short Risk”

I now think that current market levels and conditions warrant getting long. My reasoning is as follows:

Oil prices have been a major driver for other assets, primarily via second round effects. So let’s start there.

First, speculative positions in Oil are now very low, back to 2009 levels:

Second, the ~26 level on oil is a very long term support resistance level that stretches back several decades:

Third, $20 or so is the current cash cost of producing shale oil, which means that even if prices get there, they are unlikely to be at that level for long. As such, this means downside is capped.

Finally, Oil has had a seasonal tendency to bottom around now:

In addition, investment grade credit, which lead the way lower, has been broadly stable on an outright yield basis, though spreads have widened as risk free yields have fallen.

In high yield space, the spread (Barclay’s HY OAS below) has hit levels not far from the very worst levels of 2011:

The fundamentals for the economy also remain decent, though not robust. Earnings ex-energy are still growing. Employment is still growing, though likely to slow a bit in the months ahead. Retail sales still strong. Credit conditions easy. Even in China, the policy easing we’ve seen over the past 4 months will start to bear fruit soon – allowing for at least some stabilization in the data. The Philly Fed has bounced, which suggests that ISM manufacturing could do the same:

It is also worth noting that while the negative effects of lower oil prices are front loaded, the positive effects play out over a longer period of time. Per FTA, current oil expenditures as a percentage of world GDP has dropped at a pace not seen since the mid 1980’s:

Back then, world GDP in USD terms subsequently rose strongly over the next 5 years:

Here is a related chart from Deustche Bank:

Fear, as proxied by cash levels from the BAML survey, are already as high as highs from 2011 / 2012:

And the price action has been bad enough to have triggered technical selling on the breach below the ~1880 area. But note that a break below, followed by a rally above the close would bring a lot of chart driven short covering. The break has probably been bad enough to flush out most of the remaining ‘weak hands.’

Supporting that hypothesis is the fact that futures volume yesterday was about ~4mm contracts, a level that has historically coincided with near term lows:

The bottom will take some time to form. Volatility will need to fall to bring buyers back in. But I do believe that we are at the beginning of the end rather than the end of the beginning.

In interest rates space, investor expectations are now very gloomy indeed. Citi distributed a survey yesterday to its rates clients, and reported that 3/4th of respondents expect a terminal Fed Funds rate at or below 1% this cycle. (!) A stabilization (and possible bounce) in oil and associate risk assets, in conjunction with improving data, will allow inflation breakevens to reprice substantially. In the inflation swap market, 5y5y forward inflation is through the 2008 lows: (caveats apply given the market, but the point applies regardless. 30 TIPS breakevens are ate 1.5%)