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.


2 thoughts on “Recap 2015-05-12: Update

  1. Hi gmt, I found your blog recently and it is very good reading. Thanks for publishing it! I am wondering what your thoughts are on cable? I was thinking this would bounce more than eur.usd. I also tend to think sustained dollar strength will not materialise until year end.
    Also, do you have any thoughts on the Canadian, Australian and NZ property bubbles ? They seem quite overvalued and yet have not cracked despite the commodities correction and if anything appear to be going even further parabolic with reduced interest rates in these countries to reduce the macro effects of the commodities slump.

  2. Hi Sean, thanks for visiting!
    I think cable is kind of hard to read at the moment. I think the BoE is looking not only at UK data, but also at the Fed and ECB to make their policy – so things are bound to be choppy.
    I agree on dollar strength – it seems like it will go once the market fully prices in a Fed hiking within 3 months or so, it could start moving. The risk is skewed to later, of course, so we’ll see how the data plays out.
    On the property bubbles, in my experience there needs to be higher interest rates of some kind before they burst – either in the form of higher risk free rates or wider credit spreads. At this point, there isn’t an obvious catalyst. In fact, it is not obvious to me that the current levels can’t be sustained… it may be that a lot of the current pricing is related to overseas buyers. Having said that, even if they are sustainable, the high prices will be a drag on growth in the medium term, IMO.
    Interesting times…

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