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.
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.
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.
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.