Inflation Fears, Fragile Market

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The recent sell offs in the S&P 500 and U.S. Treasury markets have been tied to a narrative of increased inflation and rising interest rates.

The inflation concerns have been supported by a few surprise data-beats. Today’s ISM Non-Manufacturing Index beat the consensus of 56.2, printing a much-higher than expected 59.9. Last week, non-farm payrolls of 200k beat consensus of 160k. Also, the long-awaited increase in wages may be starting; average hourly earnings (YoY) was higher, 2.9% vs. 2.6% exp. Wednesday’s Chicago PMI came in modestly above consensus at 65.7 vs. 64.

 

ISM Prices and 10-Year: Soaring Inflation ExpectationsWhile ISM’s measure of prices paid increased to the highest level since May 2011 (keep in mind, U.S. 10 year bond yields were up near 3.50% in the Spring of 2011).  What’s driving all the bearish bond sentiment?  One major reason is found in the “growth to bold yield” disconnect.   For most of the last fifteen years, the U.S. 10 year bond yield was “tied to the hip” of manufacturing ISM prices paid.  In our view – as you can see above – the current level of ISM prices paid should be associated with U.S. Treasury bond yields 60-70bps (+0.60% to +0.70%) higher than current levels.  In recent years as inflation expectations plunged, the disconnect between ISM and 10s (Treasury bonds) widened.  Over the last month, as inflation expectations surged, these two long lost friends are spending far more time together. 

AHE Climbing; Breakout In 30 Year YieldIs increasing wage growth (finally) here? Above, Friday’s average hourly earnings beat expectations; showing 2.9% vs. the 2.6% expected. The 8:30am data release was a catalyst for the day’s bloody sell off in both bonds and stocks. The DJIA finished 666 points off; the U.S. bond selling rattled the global markets, prompting additional declines in nearly all major global indices since. Previously included in “Regime Change” . 

 

Inflation Isn’t A New Development

In addition to the data, there are supply and demand dynamics that should continue to put upward pressure on rates in 2018. The deficit is growing (at an increasing rate), and the Fed and ECB are both, for now, on course with their respective selling and decreased buying.

The mechanics of this paradigm shift in the bond market are not new, however. Most have been covered in past blog posts. The underlying symptoms have been untreated for quite some time, and the risk of an inflation-driven interest rate shock is still growing, according to some of the most powerful finance executives.

 

Finance Chiefs at Davos: “Can We Have a Soft Landing?”

One commonality in the commentary and speeches from this year’s World Economic Forum in Davos, Switzerland, was the globally-present susceptibility to an interest rate shock. Among the list of speakers to reference this apparent systemic risk was Axel Weber, of UBS, Benoît Cœuré, a member of the European Central Bank’s executive board, Ray Dalio, Bridgewater founder, and Min Zhu, the former deputy chief of the IMF and the People’s Bank of China.

 

Axel Weber

Mr. Weber, chairman of UBS and former leader of the Bundesbank, tips his hat to the central banks that have found themselves nearly 10 years into an unprecedented stimulus policy that they do not understand – an experiment with the potential to cause a sharp repricing among all asset classes globally.

According to Weber, the way monetary policy boosted the economy was through the wealth effect; by creating an environment of rising asset prices, in stocks, bonds, and real estate. This growth has been due to, and remains dependent on, low interest rates.

“At some point the inflection point will come,” he said. And when it does come, central banks will have significant challenges providing the same accommodative policy and pulling the same liquidity levers in the new political landscape.

 

Ray Dalio

Ray Dalio noted that the sensitivity to interest rate change is greater than before; “it is very high.” A surprise rise in back-end rates, even modestly, at this point in the aging cycle, could be the detriment to a market now reliant on high-duration bonds. It could abruptly end the party, and reprice all assets, generating trillions in losses.

He feels that post-QE and post-Tax Reform, the U.S. was already at capacity and near overheating, and now the weaker dollar adds “stimulus on stimulus.” When the global expansion begins to tire, the exhaustion of monetary and fiscal stimulus options leaves the system as we know it more fragile than before. If anything goes wrong, “It won’t be a pretty picture.”

VIX and 10sOn May 22, 2013, the Federal Reserve announced that it would begin tapering back their roughly $70 billion a month in bond and mortgage-backed securities program.  A series of positive economic developments in the spring of 2013 led Federal Reserve Chairman Ben Bernanke to testify to Congress on May 22, 2013, that the Fed would likely start slowing— tapering—the pace of its bond purchases later in the year, conditional upon continuing good economic news.   Similar to this week’s price action in markets, bond yields surged with equity market volatility as investors exited stocks and bonds together.  

In recent years as volatility surged, long bonds (U.S. Treasuries) rallied with lower yields. Today, we’re in the early innings of a secular change in this regard, bond yields are moving HIGHER with the VIX, wow.  We have a special report on bonds and our trading thesis for 2018, pick it up here.  Previously included in “Regime Change”

 

Stagflation, or Simultaneous Sell Offs in Stocks and Bonds

The market is coping with this newfound focus on inflation in its own way— by selling off equities and treasuries. To those who joined the markets in the 21st century, this may seem to be a glitch on the screen, if the S&P falls (an increasingly rare occurrence), USTs should catch a bid, sending yields lower. But a look back to the 1970s and 80s shows us that in times when inflation concerns were higher, stocks and bonds both used to sell off in tandem.

 

Number of Times With S&P Down and the U.S. 10Y Yield Up:

3 Weeks in A Row

2010-2018: 0

2000s: 3

1990s: 3

1980s: 19

1970s: 24

 

4 Weeks in A Row

1990-2018: 0

1980s: 4

1970s: 8

Source: Deutsche Bank

 

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Regime Change

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“We believe inflation is set to finally pick up in 2018. Much of the passive and quant-side (a $1.5T shift in asset management) has become heavily invested in the “risk parity” model which involves being long equities and bonds on a risk-adjusted basis. One of the fundamental problems with this strategy is you’re effectively really long disinflation.  Sure, it’s worked very well in the post great financial crisis period, but it’s a grossly crowded trade and has all the makings of a gruesome slaughterhouse.   In this case, the risk tail is a period where equities and bonds fall together, which is not that uncommon in a late cycle inflationary environment (see 1980s and 1990s). Other than out of the money puts in rates (bonds) a big way for this crowd to hedge inflation is to increase commodity exposure.  As long-time bulls, we’re now ‘pounding the table’ bond bears for 2018.”

Bear Traps Report, January 2, 2018

Inflow of into Passive MF and ETFs

January

2018: $105B
2017: $68B
2016: $18B
2015: $22B

Bloomberg data

Many of these investors don’t realize, passive investing in bond ETFs is a colossal disinflation bet.   As the tide turns, this mad mob will rush for the exits, commodities will become the big winners relative to bonds and equities.

Hot Wages

U.S. payrolls surged by 200k in January, ahead of Street expectations for 190k. Gains were largely in the private-sector hiring (+196k). The unemployment rate remained unchanged at 4.1%.

Wage growth caught all the attention in this report, and it didn’t disappoint. Average hourly earnings rose a relatively strong 0.3% in January and accelerated to 2.9% year-over-year. That marks the fastest pace of wage gains since 2009.

ISM Prices Paid are on Fire

This week we saw hot ISM prices paid (U.S. factories expanded more than forecast in January and near the fastest pace in more than 13 years). While ISM’s measure of prices paid increased to the highest level since May 2011 (keep in mind, U.S. 10 year bond yields were up near 3.50% in the Spring of 2011).  What’s driving all the bearish bond sentiment?  One major reason is found in the “growth to bold yield” disconnect.   For most of the last fifteen years, the U.S. 10 year bond yield was “tied to the hip” of manufacturing ISM prices paid.  In our view – as you can see above – the current level of ISM prices paid should be associated with U.S. Treasury bond yields 60-70bps (+0.60% to +0.70%) higher than current levels.  In recent years as inflation expectations plunged, the disconnect between ISM and 10s (Treasury bonds) widened.  Over the last month, as inflation expectations surged, these two long lost friends are spending far more time together. 

US Equity Long Futures Positioning

2018: $405B
2017: $280B
2016: $185B
2015: $280B
2014: $240B
2013: $220B
2012: $155B
2011: $160B
2010: $150B
2009: $130B
2008: $280B
2007: $210B
2006: $180B

CFTC, GS data

Heading into February, investors have never been this long equities.  We use CFTC (positioning, measuring the crowded trade) data as an important contrarian indicator.  Over the years, as positioning wanes (2006, 2009, 2016), these are the best times to over-weight stocks.  In the bond market, the sensitivity to a rate change (in prices and wages) is greater than ever before.  It is very high, in our view the U.S. is hitting capacity constraints and risks overheating. The Trump tax cuts and spending plans are further juicing the economy at the wrong moment.  At the same time, a weaker dollar adds even more stimulus (with over $60T of GDP outside the U.S. vs. $18T inside, a weak dollar injects emerging market economies with a steroid like high).  In Davos, Axel Weber (former Bundesbank head) said: “today we’re adding stimulus on stimulus, this is after the credit channel mechanism of monetary policy shut down when interest rates collapsed to zero during the post-Lehman slump.” Quantitative easing lifted the economy through a different mechanism, by boosting financial markets – a wealth effect from gains in equities, bonds, and property.  “People have been lulled into complacency, forgetting what will happen when normal conditions return,” Weber said.  We’re now switching back on the credit and interest rate channel. We do NOT believe central bankers can effectively manage the risk path they are on.

Bond Yields and Equity Market Volatility, now in a Regime Change

This week, with nearly a 4% drawdown, the S&P 500 just posted its biggest (weekly) loss in two years.  If you look carefully above, we’re clearly in the middle of an important regime change. In recent years as volatility surged, long bonds (U.S. Treasuries) rallied with lower yields. Today, we’re in the early innings of a secular change in this regard, bond yields are moving HIGHER with the VIX, wow.  We have a special report on bonds and our trading thesis for 2018, pick it up here.   

As the (Bond) Bears Dance in the Night

Short interest and bearish sentiment have reached rare levels in the bond market. In U.S. Treasuries, overall short positioning is back to all-time (high) extremes reached post the 2016 Presidential election. We must remember, after periods of highly unusual positioning – interest rates typically become range bound over the short to medium term. In other words, you have to let the shorts cover. This process will put a bid under the bond market over the near term in our view. Once the large short supply has been cleansed, we can get back to a firm, bearish view on rates. We’re sticking with our 3.50 to 4.00% (in U.S. 10 year Treasuries) range target for 2018.

Lessons Always Found in the Put-Call Ratio

Hindsight is always 20/20, but it’s so interesting to note that three of the LOWEST readings (last five years) in the put-call ratio occurred as the U.S. equity market reached its January 2018 perch.  Likewise, market bottoms are often found when put-call readings are up in the 1.00 to 1.20 neighborhood (we’re not there yet – even after Friday’s market plunge).  Investors often get all “beared up” at the lows and “bulled up” at the highs, there are a lot of lessons in here.  In January, mutual fund long positioning surged in tandem with the rebound in growth to a 6-year high, as some long lost investors came back to stocks.  A look over at aggregate shorts in cash equities and ETFs – led by reductions in Technology shorts – (in January) is telling.  This was the first time tech shorts moved below the elevated range they have been in since the financial crisis.  Similar to late 1999, this outcome is a sure sign that the shorts have been carted off the field in this vicious bull market run.  Right on cue, of course, January inflows into U.S. equities surged, and are on track for the largest monthly inflow on record (we’ll get the final data next week).

U.S. Treasuries and Corporate Bonds Held Overseas

Repatriation

2017: $650B
2007: $40B

*Post tax reform, as capital comes back to the United States, a very large bond buyer might NOT be there in the same way she’s been so over the last 10 years.  We believe this is starting to contribute to the latest rate shock.  The assumption was there was “cash” held overseas, ultimately it was actually “bonds.”  Data from company SEC filings, Bloomberg and CS. 

 

Last Time Bond Yields Surged with Equity Market Volatility?

On May 22, 2013, the Federal Reserve announced that it would begin tapering back their roughly $70 billion a month in bond and mortgage-backed securities program.  A series of positive economic developments in the spring of 2013 led Federal Reserve Chairman Ben Bernanke to testify to Congress on May 22, 2013, that the Fed would likely start slowing— tapering—the pace of its bond purchases later in the year, conditional on continuing good economic news.   Similar to this week’s price action in markets, bond yields surged with equity market volatility as investors exited stocks and bonds together.  

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Inside the Mind of the Fed

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“We believe inflation is set to finally pick up in 2018. Much of the passive and quant-side (a $1.5T shift in asset management) has become heavily invested in the “risk parity” model which involves being long equities and bonds on a risk-adjusted basis. One of the fundamental problems with this strategy is you’re effectively really long disinflation.  Sure, it’s worked very well in the post great financial crisis period, but it’s a grossly crowded trade and has all the makings of a gruesome slaughterhouse.   In this case, the risk tail is a period where equities and bonds fall together, which is not that uncommon in a late cycle inflationary environment (see 1980s and 1990s). Other than out of the money puts in rates (bonds) a big way for these guys to hedge inflation is to increase commodity exposure.  As long-time bulls, we’re now ‘pounding the table’ bond bears for 2018.”

Bear Traps Report, January 2, 2018

This week’s FOMC meeting marked Janet Yellen’s final meeting as Chairwoman of the Federal Reserve.

The Long Bond, on a Key Technical Level

The US 10 year has already broken the trend line above.  Fed policy, strong global growth and the new kid on the block, US fiscal policy have driven the latest round of selling.  Pick up our latest Bear Traps Report for our detailed investment thesis of 2018. 

No rate hike was expected at this week’s meeting, and none came, leaving the midpoint target level at 1.375%. The next 25bp increase – up to 1.50%-1.75% from 1.25%-1.5% – will come, in all likelihood, at the March meeting with Chairman-elect Jerome Powell at the helm.

Inflation Expectations

The big news of the day (see above) came when the Fed raised near-term inflation outlook to above two percent, driving the two-year bond yield even higher, while the long end (30s) rallied, thus more flattening.

The probability of rate hikes in 2019 has doubled since the last FOMC meeting:

The thing to keep your eye on, in our opinion, is the probability of four hikes in 2018, instead of the three (the recent consensus). The Street was hawkish today before the meeting. Much of the debate comes from the Fed’s word choice on near-term risks to the economic outlook. The Fed reiterates these risks as “roughly balanced,” a nod away from Goldman Sachs’ expectations that these risks would now be just “balanced”. Chair Yellen left today as dovish as she came, and the Street is looking at the Powell team as by definition, more hawkish (more likely to pull back accommodation). 

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The probability of four or more rate hikes in 2018:

Jan 24%

Dec 5%

Nov 3%

Bloomberg data

Data-dependent, gradual raising Yellen hands the baton today over to a similarly data-dependent Powell. However, if the data (recently firming prices and slightly higher, yet still sub-2%, PCE) is allowed to speak for itself, it was reasonable to expect a hawkish tone in today’s statement.

Today’s Chicago PMI printed 65.7, soundly beating the consensus estimate of 64, yet lower than the unsustainable prior-revised 67.8. Upcoming significant data releases include Jobless Claims and Nonfarm Payrolls, on Thursday and Friday respectively.

Yellen, while ill-advised to act based on market prices has a history of mentioning “rich asset valuations”, and must be keeping her eye on the technically-overbought S&P 500, which, even with this week’s move off the highs, is up 5% YTD, or an annualized rate of 83%. NY Fed President Dudley recently expressed concern about the possibility of an “overheating” economy that appears to be stretching its cycle after the passage of tax reform.

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GDP Impact on Bonds

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“We believe inflation is set to finally pick up in 2018. Much of the passive and quant-side (a $1.5T shift in asset management) has become heavily invested in the “risk parity” model which involves being long equities and bonds on a risk-adjusted basis. One of the fundamental problems with this strategy is you’re effectively really long disinflation.  Sure, it’s worked very well in the post great financial crisis period, but it’s a grossly crowded trade and has all the makings of a gruesome slaughterhouse.   In this case, the risk tail is a period where equities and bonds fall together, which is not that uncommon in a late cycle inflationary environment (see 1980s and 1990s). Other than out of the money puts in rates (bonds) a big way for these guys to hedge inflation is to increase commodity exposure.  As long-time bulls, we’re now ‘pounding the table’ bond bears for 2018.”

Bear Traps Report, January 2, 2018

The 2.6 percent headline rate doesn’t do justice to fourth-quarter GDP where consumer spending rose a very strong 3.8 percent that reflects a 14.2 percent burst in durable spending.  Bloomberg noted Residential investment, which is another consumer-related component, rose at a very impressive 11.6 percent annualized rate. Turning to business spending, nonresidential fixed investment rose at a 6.8 percent rate which is the fourth straight mid-single digit result.

What does this mean for bonds?  We have an important note coming out, pick it up here.

Government purchases at a 3.0 percent rate, also added to GDP in the quarter.  What pulled down fourth-quarter GDP were net exports, at an annualized deficit of $652.6 billion, and inventories which rose at a slower rate than the third quarter. Looking at final sales to domestic buyers, which excludes inventories and exports, GDP comes in at a robust 4.3 percent.

Prices also showed some vigor in the quarter, with the index at 2.4 percent vs the third quarter’s 2.1 percent. This is a standout report led by the consumer that shows the economy accelerated into year-end 2017 with strong momentum going into 2018.

What are the key Takeaways?

There are both positive and negative views that can be extrapolated from today’s data.

  • The consumer savings rate fell to its lowest since November 2007, down from 3.3% to 2.6%. If it had stayed the same, Real PCE would have been 0.8% (annualized) instead of 3.8% and GDP would have been 0.6% instead of 2.6%.  Clearly, business and consumer confidence levels are nearly 2 standard deviations higher than the 1010-16 mean, thus spenders seem to be more confident dipping into savings with visions of better times ahead.
  •  The GDP came in lower than expectations, but net of hurricane-impacted inventories and exports, 4.3% is an objectively impressive number.

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Looking ahead into Q1, and Beyond

This adjusted 4.3% rate isn’t unprecedented growth, however, even in recent memory.  We saw 3% YoY in first half 2015. So, then, how sustainable is the growth? In the short term, a decreasing savings rate will boost demand. The near-term outlook is bond bearish, and it should be. Prices are rallying, savings are down, and over the next quarter or two we should see some legs on consumer demand; something that has been notably weak in recent memory. There is a reason to be optimistic into early 2018 from a consumer spending perspective, and perhaps even beyond, depending on the timeline for infrastructure spending.

Economic activity built on a foundation of lower savings, in the absence of wage growth, will eventually drag output lower.  Lower consumer savings is likely overstated; we regularly see upward revisions.

Cycle-low savings rates don’t stay low forever. Companies have shown a resilient hesitation toward raising wages. Americans are borrowing to finance their own spending and with any reasonable stall in consumer spending into 2018, our current annualized growth rate will be under significant pressure.

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Bitcoin Eating Gold Alive, for Now

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Correlation Breakdown

This week, we witnessed the largest breakdown in gold – rates (bonds) negative correlation in some time.  10s (US ten year Treasuries) – have rallied 2.39 to 2.31% with gold off 2.5%.  For a big change, its been rates DOWN, gold DOWN in recent days. In recent years, the negative correlation has been as high as 81%, but this week it’s positive.
A Powerful Negative Correlation is Reversing this Long Trend
For the last 24 months, the consistent trading pattern has been gold UP with bond yields DOWN (see the dark blue line above).  A very steadily high – negative correlation.   The latest developments are causing some disruption in the quant and macro hedge fund space, some participants are tinkering with their models to adjust for this possible regime change. 
Clients are Pointing to Bitcoin’s $250B mkt cap, Eating away at Gold
The total amount of gold above ground is 190K tonnes or $6Tr at current value. Half of that is in jewelry so left with $3Tr. Half of that is in reserves at central banks so that leaves a physical gold market size available to investors of $1.5tr (excl derivatives).  Today, total cryptos are remarkably 23% of gold liquid (physical) market capitalization.  The total value of all cryptocurrencies out is now $350bl of which bitcoin $250bl. So cryptos are 23% of physical gold available to investors now.
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Global Reflation Sparks more Rate Hikes

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Following the Federal Reserve, Bank of England, Bank of Canada – South Korea joins the rate hike party.

The Bank of Korea raised its benchmark interest rate for the first time since 2011, marking a likely turning point for Asian central banks.

Last Hiking Cycle Kicked off in 2010 in S Korea

Thursday’s decision to raise the seven-day repurchase rate to 1.5 percent was forecast by 18 of 24 analysts surveyed by Bloomberg. The rest expected the central bank to leave the rate at a record-low 1.25 percent, where it has been since June 2016.   As you can see above, markets widely anticipated this move – interest rates in China and S Korea have been on the rise for 15 months. 

 

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The Fastest Growth Economy on Earth is taking Leverage Down (Popping Asset Bubbles). What’s the Impact from China?

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De-leveraging in China kicked off this Week

They are trying to thread a very fine needle in China right now, credit risk is surging to two-year highs.

– After China’s 19th Congress meeting of political leaders in October – we’re seeing sweeping regulations focused on curbing financial risk.  New rules are appearing, many announced over the last week.   Most of the new restrictions cover China’s $15T asset management products landscape.  A colossal deleveraging is in the works.

– PBOC (China’s Central Bank)  is driving the bus through their Financial Stability Board.

Credit Risk on the Rise in China

2007-2017

This week’s fears pushed China government bond yields to a 3-year high, taking U.S.  two year Treasury bond yields north with them.

  • Very quietly, late this week the PBOC launched a $50B lifeline into their grossly leveraged banking system, the natives are growing more restless by the day.  This was the largest injection of emergency cash in the last year.

Where’s the Trade?  Pick up our latest report here:

Don’t miss our next trade idea. Get on the Bear Traps Report Today, click here

Something Big is Brewing in the Bond Market

iShares 20+ Year Treasury Bond ETF seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years.  Over the last decade, wedge breaks in the technical chart pattern of the TLT have led to large moves in interest rates.  Today. an important wedge is near a breach again, a true Bull – Bear battleground is forming (middle right above).  

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