Some Thoughts on Cycle Length

First, a quick note. I haven’t posted many updates this year because frankly, I haven’t seen a whole lot of mispricings. My last post on in late Feb suggested getting long duration, which has worked out OK. I think rates are a bit rich currently, but the backdrop suggests more downside is likely over the rest of the summer. I actually think equities are pretty fairly priced here. Prices had ramped up ahead of fundamentals earlier this year, but it seems like the fundamentals have now caught up.

I’ve been thinking a bit about how this business cycle could play out. Historically, falling unemployment has generated rising inflationary pressures, which causes the Fed to hike enough to trigger a recession. What’s different this time is that falling unemployment has not been generating much inflation at all. The scenario being priced in by fixed income markets is that this will cause to Fed to slow or significantly shorten its hiking cycle. That’s certainly plausible to me. I don’t think anyone can rule out a scenario whereby very low unemployment rates coincide with low inflation. After all, we are already seeing it in many countries across the globe like Japan and Germany. And then there’s the chart from Haldane at the BoE that purports to go back to the 1500’s: that suggests no relationship before the industrial revolution:

But there’s another possibility, which is that unemployment will cause inflationary pressures only when unemployment is low, but then the inflation will accelerate. i.e. the slope of the Phillips curve is non-linear. Goldman recently published a study of the relationship between inflation and unemployment by metropolitan areas, which provides some support for this hypothesis.

In addition to that, there is data in US history that support this. The time periods in the early 50’s and the early 60’s exhibited both low unemployment (in blue and inverted below) and low inflation. (cpi in red) That period ultimately led to the inflationary spiral that dominated monetary developments for the subsequent decade.

Now, obviously this is not the 1960’s. We don’t have the baby boom wave coming, and rather than an inflationary oil shock, we are getting a deflationary oil shock. But the data as well as the rhetoric from the current Fed suggests that – as long as unemployment continues to fall, hikes are likely to be forth coming. In fact, that is exactly what the Fed did in the late 90’s, despite inflation that is only a bit higher than current levels. After all, the Fed doesn’t know how things will play out – whether unemployment and inflation will completely decouple, or whether some relationship still exists. So it will most like try to tread a path in the middle, that will allow it to accelerate or decelerate tightening as evidence for either case unfolds. Put differently, if unemployment is at 3.5% in a year’s time, the Fed is likely to be hiking still, even if inflation is unchanged.

The lowest unemployment reading in US history is 2.5%. If we extrapolate the trend decline in unemployment since it peaked, we could be there in 2019 – just 2 years away.

The Fed will want Fed Funds to be at least positive then on a real basis, which means 2.25% nominal. That’s another 4 hikes, or roughly 2 per year. But the risk is clearly tilted toward more hikes. The SEP median dot is near 3% for the end of 2019, with the unemployment dot basically unchanged from the last reading and core inflation at 2%. That’s pretty undemanding. And I think that because of the analysis above, the dots are sticky. Well, at least stickier than dots were in the past – simply because of the possibility of accelerating inflation.

In addition, my estimate is that 3.5% Fed Funds is highly likely to tip the economy into a recession. (a very very big) If things play out as listed here, that suggests 2020 as the potential start of the next recession.

Now – how is this useful, even if this scenario somehow plays out? Put differently, how could assets perform if this expansion extends another three years? There aren’t a lot of precedents, but here are a few thoughts:

· China’s forced rebalancing away from credit growth could be delayed until then. But the impact of a US recession on China could be yuuuuge….

· Corporate leverage ratios could make all time highs. Stock buybacks could increase until then

· I don’t think a huge equity bubble is particularly likely. The psychological pain from the past two recessions are probably going to stick around for a generation – I think if another equity bubble will happen this time, we would’ve begun the see signs already. Certainly we didn’t get an equity bubble in the 1950’s. A corporate credit bubble seems more likely to me given the massive demand for debt, the easing of covenants, and the fact that most corporate credit ex-financials did OK the last time around

· But by bubble, I mean equities may not get to levels that result in a crash. But they certainly could get to a very high plateau and stay there. A model that extrapolates 10y nominal price returns suggest that current prices embed a 2% return annually. There’s a pretty good chance that if the cycle goes to 2020, that figure goes down to zero. But that could be ~30% higher from here in price terms.

A View on Long Term Global Rates

It’s been 3 months since global yields gapped higher, and the consensus view remains quite bearish. Expectations for Fed hikes this year haven’t changed that much from the 2-3 hike range, which means the consensus seems heavily skewed toward steepeners.

I’d like to use this note to elaborate a bit about why those views may be wrong, and then go over some developed country bond markets individually. My guess is that some readers will be familiar with various components of the arguments set out below, but hopefully everyone will find an interesting piece of food for thought by the conclusion. As always, discussions and disagreements are welcome.


I think one of the major things folks miss when they project rates going back to some historical average is that they do not take into account the fact that past economic outcomes were burnished as a result of falling rates. Sounds trivial, but it doesn’t seem to be broadly incorporated into expectations of asset returns. To be more concrete: US growth is currently what it is because of the continuous decline in US yields since the end of 2013. For growth to persist at current levels AND yields to move significantly higher would require a huge source of growth from some other sector of the economy. That would be bigly!

The Philadelphia Fed has a quarterly survey asking economists their expectations. One of them is their expectations for the nominal return on 10yr treasury bonds. Now, perhaps it’s not a surprise that actual 10yr Treasury yields have been lower than the average survey response. But it is worth noting that since 2000, the difference between the market rate and expectations averaged 130bps. Talk about bias!

To be fair, many of the models that economists use (especially at central banks) have embedded features that allows for past interest rates to affect equilibrium estimates. That is one reason why the FOMC’s estimate of long run Fed Funds rate has been consistently falling for the past several years. But unfortunately, it seems not many folks fully adjust their views to real world outcomes!


This is probably the easiest one. Consensus forecasts for 10y JGB yields in a year’s time is just 11 bps, basically unchanged from current levels. And the reasoning the pretty clear. Japanese inflation has hovered around zero for the past two decades despite multiple efforts by the BoJ to raise it. The vast majority of the variation in core CPI inflation after adjusting for taxes has simply been a function of the Yen:

This is already reasonably well accepted by market participants, which is why the various discussions around the BoJ potentially raising the 10bp cap on JGB yields isn’t all that credible. Even the most hawkish member of the BoJ has warned against it. So barring either a break in the two decade long relationship above, or a change in the BoJ mandate away from positive inflation targeting, JGB yields look likely to continue trading in this range for the foreseeable future.


…is a mess. Nothing new there. Most of the noise around Europe seems to be on French politics right now, but I think it’s just a distraction from the bigger problem. Which is that the Italian sovereign bond yields are unsustainable without purchases by the ECB.

Italian government interest payments alone have been stable at around 4%-5% of GDP over the past decade despite both the 30% jump in debt/GDP and the slowdown in nominal GDP growth. That’s been the case only because of ECB purchases, which has pushed 7y BTP yields from ~4.5% a decade ago to just ~1.6% now. Even with that however, interest payments at 4% of GDP are unsustainable with nominal GDP at less than 2%:

The current debt distribution according to Bloomberg is front loaded, with an average maturity of 6.7 years and a weighted average coupon of 3.36%.

With current BTP yields well below the average weighted coupon, and given that we know the debt maturity profile, we can make an estimate of how long it will take for interest payments to fall to sustainable levels. I’m going to define sustainable at 3% of GDP, which is giving Italy the benefit of the doubt given that nominal Italian GDP growth has printed above 2% YoY just once in the past 5 years. We’ll also assume that the primary deficit balances the interest payments such that the debt to GDP ratio stays stable at 135%. If we assume that the BTP curve holds constant, and the maturity profile is held constant, and nominal GDP is stable at 2%, interest payments as a percent of nominal GDP will evolve as follows:

Now: 3.36% avg coupon * 1.35 debt/GDP = 4.5%

2018: 2.97 * 1.35 = 4.0%

2019: 2.73 * 1.35 = 3.7%

2020: 2.51 * 1.35 = 3.4%

2021: 2.37 * 1.35 = 3.2%

2022: 2.23 * 1.35 = 3.0%

Put differently, if we optimistically assume BTP yields do not rise much more from here, growth and inflation remains at current levels (i.e. no more growth shocks), and debt/GDP remains stable, it will take another 5 years before interest payments fall to a plausibly sustainable level. It seems quite unlikely that the ECB will be able to step away from buying BTPs until we are close to that level.

In addition, consider the fact that the “mark to market” level for interest payments as a percent of GDP, which I define as Debt/GDP * 7y yields, cannot stay more than 1% above nominal GDP growth for very long without yields jumping higher. That’s because such a move would result in a self-reinforcing spiral akin to what we saw during the EU crisis. Higher yields => worsening fiscal picture => higher yields. With sustainable nominal GDP likely not much higher than 2%, this probably means around 3% or so, which on 135% debt/GDP implies a ceiling of ~2.25% on 7y BTPs.

To me, this means that the ECB will have to keep 7y BTPs yields not much above 2.0% until at least 2021. It’s very hard to see that happening without some sort of QE program.

Of course, the ECB is not allowed to buy only BTPs. It will have to buy bunds as well, which is already a problem due to scarcity. I think the market has been sniffing this story out the past couple months, and one reason why 2y German yields have dropped to new lows even as 2y yields elsewhere have been stable. Here is a chart of the spread between an average of French, Spanish, and Italian 2y yields vs German 2y yields:

After converging to a range around 35bps or so, spreads have moved back to ~70bps, a level not seen since the end of 2013. In fact, 70bps was a key resistance level that marked the beginning of the EU crisis back in 2010. This 70bps level is a line in the sand, in my opinion. If spreads break above it, we will see periphery spreads widen out until the QE tapering is reversed.

United States

The impact of the items I listed earlier is likely impacting the US market the most via the term premium. The term premium is defined as the compensation that investors require for bearing the risk that short term Treasury yields do not evolve as they expected. The most well known measure is the ACM estimate, which the NY Fed has discussed. Currently, the ACM 10y term premium estimate is around zero, which is quite low relative to history. A common theme that many bond bearish articles have discussed is that the term premium could revert back to longer term averages, which is in the neighborhood of 1.5%.

However, a closer look at the term premium shows that it’s actually highly correlated to the spread premium of US treasuries relative to the rest of the world. The chart below plots the 10y ACM term premium in white, and the yield difference between 10y treasuries and a basket of 10y bunds, gilts and JGBs in orange and inverted. As the chart shows, the higher the yield advantage treasuries offer relative to the rest of the world, the lower the term premium. Which makes sense!

The implication then, is that if both the BoJ and the ECB are not able to allow yields in their countries to move much higher, the spread between treasury yields and the rest of the world is not likely to tighten. Which suggests that the risk is not that the US term premium could rise, but that they could fall further!

There are many other factors that affect yields that I haven’t discussed here, but I think it the analysis above presents a compelling argument that the top for US yields is likely to be quite a bit lower than consensus expectations.


Market tone in Fixed Income is very bullish currently. In the past few weeks, we’ve had:

1. a more hawkish than expected Yellen,

2. strong, above consensus inflation prints

3. strong, above consensus growth prints, which means the economic surprise index hit the highest level in almost 5 years:

4. strong data globally, with the Citi G10 economic surprise index at levels not seen since 2010(!)

5. strong performance in risk assets

And yet long term yields have not moved higher! Literally, we’ve had almost everything a bond bear could ask for, and yet US yield are lower YTD and looks ready to break below support that has held since Dec:

If yields can’t go higher on good news… what will? In my last note in early Dec, I suggested getting some exposure to duration via selling out of the money puts on 30y treasuries. I think it’s time to upgrade that view to building duration outright.

Trade Ideas for 2017

Before we get to the ideas, a quick note on my predictions and ideas from the past year. Overall, it’s been a decent year for my calls. Part of that is due to the major swings in asset prices over the course of the year. Here were my key calls and subsequent market price action: (I used SPX as the proxy for risk assets and 5y Treasury yields as a proxy for risk free rates)

On 10/22/2015, I wrote ‘It’s time to be Neutral or Short Risk.’ (assets) That proceeded a 13% drop over the subsequent 3.5 months:

On 1/21/2016, I wrote ‘It’s time to start building exposure to risk assets.’ That was a bit before the ultimate low (which I acknowledged was likely at the time), but was subsequently followed by a double digit gain over the subsequent 3 months:

On 6/23/2016 I wrote ‘Here comes the Squeeze,’ where I noted that equities were likely to rally regardless of the Brexit referendum outcome.

On 8/22/2016, I wrote ‘It’s time to short the front end,’ where I argued that it was time to bet on higher rates:

To sum up, most of the intra-year calls have worked out, though it seems I was a bit early on all of them.

My 2016 ideas all showed nice profits at mid year, but have retraced much of their gains over the past month.

· Short CHF vs JPY worked pretty well. Regular readers will recall that I proposed taking profits when the cross was at 106 mid-year.

1. 12/11/15 level for 12m fwd: 123.84

2. Current Spot: 112.22

3. PL = +8.4%

· Short AUD vs USD. This trade hit a 5% profit within a month of initiation, but gave it all back. The PBoC easing starting in late 2015 was the main factor that knock the trade into a loss.

1. 12/11/15 level for 12m fwd: 0.7073

2. Current Spot: 0.7460

3. PL = -3%

· US 5s30s Flattener. This trade was up +35bps by the end of Aug, when I’d suggested potentially booking profits. Since I proposed going short duration, the trade has gone back to flat.

1. 12/11/15 level for 1yfwd 5s30s in swaps: 0.742

2. Current Spot: 0.726

3. PL = +1.5 bps.

Thoughts about the Current Macro Environment: (This will provide some context for the 2017 trade ideas)

The global economic & inflation rebound has some more room to go. The current economic momentum and some leading indicators suggests another quarter or two. The deflation / recession mindset that was in place for much of last year is now a good base against which the economic cycle can extend. EM balance sheets are now fairly healthy, (though potentially at risk if the USD strengthens a lot more) and FX levels undemanding.

Global cyclical indicators are now close to the peak levels seen from late 2013 – late 2014. (below chart is from GS)

With G8 unemployment now near multi-decade lows, it is questionable how much the acceleration can continue.

The biggest long term risk remains rapidly tightening monetary policy. By my estimates, US policy rates above 3% would be enough to trigger a recession. We’re obviously still a ways from that, but by the end of 2017, we could be almost halfway there. In contrast with the low odds of recession near term, I think the odds of a US recession during 2019-2021 period is quite high. How quickly policy actually tightens, however, will be dependent on the evolution of fiscal policy and inflation. That’s one reason I’m hesitant about making any longer term bets on the belly of the curve.

I don’t think there’s that much upside left for equities, at least on a risk adjusted basis. On my models, they are already trading rich, but that may well be justified due to the corporate tax cuts that Trump has talked about. GS noted that a reduction in effective corporate taxes by ~10% could increase EPS by ~15% or so. That certainly justifies some sort of premium, but further gains on that front will require some legislative details. DM yields and equity valuations are roughly in balance here, so a further rise in yields will be a significant headwind for equities, though rising earnings will provide some offset.

Nevertheless, it is key to recognize that there is more uncertainty now about the appropriate risk free discount rate than at any time since the end of 2013. This key input that goes into essentially every asset valuation model presents a key source of uncertainty that lowers the conviction on any calls one can make. Note that this uncertainty is also being reflected in vol space, as rates and FX vol are both quite high compared to the past 5 years.

2017 trade ideas:

Sell puts on 30y Treasuries at ~3.5% yield (roughly 150 on the ultra contracts)

There is a limited amount of upside for 30y yields from here. The global savings glut and wealth inequality is not going away. No president is going to move us out of the new normal. As global momentum slows at some point next year, those views will be talked about again. In addition, implied vol for US rates is on the high side. Currently, 3m puts are ~1’20 bid, or ~88bps of notional. On an annualized basis, that is roughly 3.5%. I think you are supposed to get long 30y treasuries at that yield, if not sooner, and get longer if the opportunity arises. As I mentioned, I am strongly convinced that policy rates in excess of 3% is likely to trigger a recession, so 3.5% is a good level to lean against.

In addition, per JPM, various positioning metrics suggests that Treasury shorts are now fairly crowded.

On the other hand, it seems unlikely that we will see the highs for yields until at least the end of the year or even inauguration. There is simply too much uncertainty and current yields are not quite high enough to justify the risks. In addition, with economic and inflation momentum on the rise, risks are still biased to the upside. As a result, selling puts provides a reasonable alternative, IMO.

Long US Leveraged Loans outright or HY on duration hedged basis

Though clearing levels for risk free rates are in question, credit spread levels are easier to call. Credit spreads are ~3.6% for loans, and ~3.7% for HY CDX. Given that near term economic risks are low, neither are unreasonably tight given expected defaults and is likely to provide a decent source of vol-adjusted carry. The higher total yield is not a problem – interest coverage ratios remains healthy. (per GS – see chart)

This is a fairly consensus call. Having said that, it is important to be mindful of where we are in the business cycle, and that credit spreads are only somewhat attractive. In other words, it’s not the time to load up on illiquid bonds!


After the 1998-2007 oil boom, Canada is suffering from a mild form of dutch disease, IMO. Despite the 25% depreciation in the real effective exchange rate since 2007, the current account deficit remains quite poor at -3.5% of GDP. Over the past 40 years, the only other two periods of such sustained current account deficits saw large depreciations that continued until the deficit was corrected. I think that’s a pretty good template this time around also.

In addition, the trade has the added bonus of being positive carry, and negatively correlated to risk assets.

The biggest pushback on this is that oil is likely to rally, which has historically meant CAD strength. In this respect, it is important to recall that the US is now a major oil exporter – in fact, the net US petroleum trade balance is almost flat, levels not seen since 2002.

Long S&P vs Russell

Higher real rates are negative for small caps relative to large caps. The current levels are already extrapolating a jump in growth:

There’s certainly a bit more room for small caps to outperform, but they seem more likely to mean revert – either due to growth mean reverting or a tightening Fed.

On a final note of clarification, these are not necessarily trades that anyone should hold blindly for the year. But I do think that they provide some interesting risk/reward tradeoffs over a longer time frame that at least will provide some food for thought for readers. As always, thoughts and disagreements are welcome. Good luck and best wishes for a profitable and educational 2017!

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.