The Bonds With A Draghi Tattoo

On Tuesday,  June 27th,  Super Mario said this,

“Deflationary forces have been replaced by reflationary ones.”  – Mario Draghi

And here is how global 10-year bond yields reacted,

Bonds_Draghi

The German 10-year Bund yield increased 77 percent — OK, from a low base —  and bonds across the world from Canada to Australia to the United States were tattooed.

Change In Fundamentals? 
Absolutely not!

Bond yields haven’t been trading on economic fundamentals for several years due to central bank financial represssion via quantitative easing (QE), ZIRP and NIRP.   We have been pounding the table on this point,

Lot’s of hand wringing these days about the flattening yield curve.  We still maintain our position that the signal from the bond market is significantly distorted due to the global central bank intervention (QE) into the bond markets.   See here and here

Most of what is happening with the U.S. yield curve is technical. – Global Macro Monitor,  June 22, 2017

Beach Ball Effect
The major central banks have repressed interest rates throughout the world by engineering a structural shortage of high grade sovereign bonds with their quantitative easing (QE) programs.   For example,  as we posted last week, the combined market cap of just two stocks in the U.S. — Apple and Amazon — exceeds the entire stock of U.S. Treasury notes and bonds maturing in 2027-2047 when holdings of the Federal Reserve are excluded.

Market Cap and Treasury Float

This is tantamount to holding a beach ball underwater.  You know what happens when when the ball is released.  Such as when a prominent central banker unexpectedly speaks out that the days of holding that ball underwater may be coming to an end.  We just had a little taste of that this week.

Beach Ball_Draghi

 

Conclusion
The European Central Bank tried to walk back or dilute Draghi’s comments, but bond markets are not having it.   The train has left the station and the path toward monetary normalization is, at least in rheotric, been entered into the GPS.    The next few months shall be interesting.

Though we think the “correct” or equiblrium price for interest rates on bonds is serveral hundred basis points higher — 2-3 percent real yield plus inflation —  we don’t think they get there “by way the crow flies” or in a straight line.

Several months ago,  we cited a 2012 Federal Reserve paper estimating that yields on the 5-year note should be several hundred basis points higher if not for the recycling of reserves into U.S. Treasuries by the PBOC.   The paper didn’t even take into account the impact of QE on bond and note yields,

A paper published by the Federal Reserve Board (FRB) in 2012 estimated the impact on interest rates of the capital flow recycling into the U.S. bond market,

We find that a $100 billion increase in foreign official inflows into U.S. Treasury notes and bonds lowers the 5-year yield by roughly 40 to 60 basis points in the short run. However, our VAR analysis shows that in the long-run, when we allow foreign private investors to react to the effects induced by a shock to foreign official holdings, the estimated effect is roughly -20 basis points per $100 billion. Putting these results into context, between 1995 and 2010 China acquired roughly $1.1 trillion in U.S. Treasury notes and bonds. A literal interpretation of our long-run estimates suggests that if China had not accumulated any foreign exchange reserves during this period, and therefore not acquired these $1.1 trillion in Treasuries, all else equal, the 5-year Treasury yield would have been roughly 2 percentage points higher by 2010. This effect is large enough to have implications for the effectiveness of monetary policy. – FRB

Extrapolating the above analysis to the current stock of foreign official Treasury holdings of around $4 trillion leads to nonsensical results, such as the 5-year yield should be 800 basis points higher than it is today.   Obviously, the analysis should truncate the dependent variable – 5-year note yield — and ceteris paribus (other things being equal) does not hold in the real world.  –   GMM, March 18, 2017

Deflation is an urban myth, at least it has been in the U.S., as central banks have revealed their hand to do “whatever it takes” to fight it.  Let us not conflate relative price moves with generalized deflation.

The end game will thus be an episode of ugly monetary/debt induced inflation,  in our opinion.   Not yet, however.   Timing,  my friends.

Maybe it’s time to start looking at debt fundamentals again.

 

Debt Indicators_Draghi

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The Ambiguity of Stock Value: Why It’s So Difficult to Call The Top

This is one of our favorite posts of all-time.

Thought it apropos to re-post given that everyone and their mother is trying to call the top in stocks.  It’s all about yield-seeking capital flows, my friends.   Tell us what interest rate is the tipping point which thwarts that behavior and we will tell you when the stock and credit markets top and flop.

“John Bull can stand many things, but he cannot stand  2 , 0, .5 ,11.5 , 2 percent”  – Bagehot

We are still far from the tipping point interest rate that sends the yield seekers back to their caves, in our opinion.

I just borrowed 5-year money for my daughter’s first car at 2.64 percent.  That is less than 85 basis points over the 5-year note, for a used car!

Expensive Assets
Yes, absolutely, all assets are incredibly expensive.  But pension funds are not going to make their nut sitting in cash waiting for them to get cheaper.   Seniors in Europe can’t eat with their interest earnings from negative rates.

Argentina floating a 100-year bond at 7 percent-ish, even after defaulting several times over the past 30 years, is definitely the warning bell of a credit bubble closer to the top.   And a contrarian call inflation is about to ignite.

The FOMO * yield and return chasing behavior of the markets  reminds us of portfolio managers running to catch the Titanic,  knowing full well the ship is going down.  They just want to enjoy the 3-day party.

How long will the party last?   O Lordy, help us.

* Fear of Missing Out

The Ambiguity of Stock Value

Professor Robert Shiller,  of Yale University,  is probably best known for his book, Irrational Exuberance, which called the top of the dot.com bubble and the second edition called the top in the housing market.  During our days on Wall Street we were big fans of Shiller’s book,  Market Volatility.

We asked him once  to visit us in our offices and the meeting took place the day after then Fed Chairman Alan Greenspan’s famous Irrational Exuberance speech in December 1996,

But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?

The professor said he was in town to meet with Greenspan who was concerned about the run-up in stock prices.  During the meeting Greenspan solicited his thoughts on why stocks were rising.  The professor answered maybe it was just “irrational exuberance” among investors.  Hmmmm….

We think Shiller’s best work was Martket Volatility and specifically the following,

The Ambiguity of Stock Value

Stock prices are likely to be among the prices that are relatively vulnerable to purely social movements because there is no accepted theory by which to understand the worth of stocks….investors have no model or at best a very incomplete model of behavior of prices, dividend, or earnings, of speculative assets.

Shiller nails it here.  Stock values are ambiguous as there are no models to determine their “true” price. Even at the macroeconomic level this is true and Greenspan addressed it in his Irrational Exuberance speech,

There is, regrettably, no simple model of the American economy that can effectively explain the levels of output, employment, and inflation. In principle, there may be some unbelievably complex set of equations that does that. But we have not been able to find them, and do not believe anyone else has either.

Consequently, we are led, of necessity, to employ ad hoc partial models and intensive informative analysis to aid in evaluating economic developments and implementing policy. There is no alternative to this, though we continuously seek to enhance our knowledge to match the ever growing complexity of the world economy.

So to it is with our job in forecasting asset values, which can only be done with “ad hoc partial models” in the ether of ambiguity.   Because prices are determined by simple buying and selling, we paraphrase Shiller in constructing our ad hoc model,

Stock prices are likely to be among the prices that are relatively determined by capital flows because there is no accepted theory by which to understand the worth of stocks.

In our experience getting ahead of the capital flows has been more profitable than buying what we believe to be a “cheap” stock or selling an “expensive” stock.

And that leads us into the next issue of perspective based on reference points, time frames, and historical bias.

Take a look at the three objects.   Two charts of the exact same market, the S&P500 over different time horizons;   and one picture.

Do you see an S&P500 that is overvalued?  Undervalued?  Oversold? About to rollover or break to new highs?   Do you see a young lady or an old hag?  It most likely depends on your confirmation bias.     Larry Summers, who will leave the White House at the New Year,  coauthored a paper in the late 1980’s stating market volatility is caused by investors and traders with different time horizons.

But, like Keynes’ beauty contest analogy, the true question to ask for 2011 is not what we see, but what we believe the market – i.e., the dominant marginal buyers – will see.  Do they  see the young lady or the old hag?

Or maybe beauty is relative, or even ambiguous,  and we have to determine which markets will be deemed the least old or the most pretty.   And that just may be the best lesson here, which we think certainly is the case for the world’s major currencies.  Dollar strength doesn’t necessary equate to the young lady!

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History’s Biggest “Butterfly Effect” Occurred On This Day

The butterfly effect is the concept that small causes can have large effects. Initially, it was used with weather prediction but later the term became a metaphor used in and out of science.

In chaos theory, the butterfly effect is the sensitive dependence on initial conditions in which a small change in one state of a deterministic nonlinear system can result in large differences in a later state. The name, coined by Edward Lorenz for the effect which had been known long before, is derived from the metaphorical example of the details of a tornado (exact time of formation, exact path taken) being influenced by minor perturbations such as the flapping of the wings of a distant butterfly several weeks earlier. Lorenz discovered the effect when he observed that runs of his weather model with initial condition data that was rounded in a seemingly inconsequential manner would fail to reproduce the results of runs with the unrounded initial condition data. A very small change in initial conditions had created a significantly different outcome.  — Wikipedia

On this day in history, June 28, 1914, the driver for Archduke Franz Ferdinand,  nephew of Emperor Franz Josef and heir to the Austro-Hungarian Empire,  made a wrong turn onto Franzjosefstrasse in Sarajevo.

Just hours earlier, Franz Ferdinand narrowly escaped assassination as a bomb bounced off  his car as he and his wife,  Sophie,  traveled from the local train station to the city’s civic city.   Rather than making the wrong turn onto Franz Josef  Street, the car was supposed to travel on the river expressway allowing for a higher speed ensuring the Archduke’s safety.

Yet, somehow, the driver made a fatal mistake and tuned onto Franz Josef Street.

The 19-year-old anarchist and Serbian nationalist, Gavrilo Princip, who was part of a small group who had traveled to Sarajevo to kill the Archduke,  and a cohort of the earlier bomb thrower, was on his way home thinking the plot had failed.   He stopped for a sandwich on Franz Josef Street.

Seeing the driver of the Archduke’s car trying to back up onto the river expressway, Princi seized the opportunity and fired into the car, shooting Franz Ferdinand and Sophie at point-blank range,  killing both.

That small wrong turn,  a minor perturbation to the initial conditions, or deviation from the original plan,  set off the chain events that led to World War I.

Archduke_Jan27

Stumbling Into The Great War
Fearing Russian support of Serbia, Franz Josef would not retaliate by invading Serbia unless he was assured he had the backing of Germany.   It is uncertain as to whether the Kaiser gave Franz Josef Germany’s unequivocal support.   Russia, fearing Germany would intervene, mobilized its troops forcing Germany’s hand.

The great European powers thus stumbled into a war they didn’t want through complicated entanglements and alliances, and miscalculation.  Russia backing Serbia;  France aligned with Russia,  Germany backing the Austro-Hungarian Empire;  and Britian, who really didn’t have a dog in the fight except her economic interests, aligned with France and Russia.

Later the U.S. would enter the war due to Germany’s unrestricted submarine warfare threatening American merchant ships and the Kaiser floating the idea of an alliance with Mexico in the famous Zimmerman Telegram, which was intercepted by the British.

Of course, some will argue that Great War in Europe was inevitable

The great Prussian statesman Otto von Bismarck, the man most responsible for the unification of Germany in 1871, was quoted as saying at the end of his life that “One day the great European War will come out of some damned foolish thing in the Balkans.” It went as he predicted.  – History.com

Nevertheless,  maybe the course of history would have been different if not for that wrong turn on June 28, 1914, which created the humongous butterfly effect, which we still experience the consequences this very day.

The botched Treaty of Versailles  sowed the seeds the for World II.  The War contributed to the Russian revolution and Cold War.  The redrawing of borders in the Middle East after the War created the conditions for the instability and breakdown to tribalism the region experiences today.

A map marked with crude chinagraph-pencil in the second decade of the 20th Century shows the ambition – and folly – of the 100-year old British-French plan that helped create the modern-day Middle East.

Straight lines make uncomplicated borders. Most probably that was the reason why most of the lines that Mark Sykes, representing the British government, and Francois Georges-Picot, from the French government, agreed upon in 1916 were straight ones.  — BBC News

If Franz Ferdinand had not been murdered on this day in history,  that conflict between the Serbs and the Austro-Hungarian Empire may have been contained to just the Balkans.   Maybe.

The butterfly effect.  Think how many small events, decisions, mistakes, one small turn, or “minor perturbations” in plans have had enormous consequences in your own personal life.

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Memo To Republicans

To:         The President and Congressional Republicans

From:    Joe and Jane Sixpack

Date:     June 27, 2017

Re:         Health Care Act
_______________________________________________________________

Get over it!    America wants universal health care.

Please fix it or replace Obamacare with something better.

Your most recent plan to transfer one trillion dollars from the poor, working and middle class health care benefits to million- and billionaire tax breaks is worse than Taliban Evil. You, and the whole world, know it.

Reach across the aisle and let’s get on with it.    We need to focus on tax reform and infrastructure to get the economy moving.

Ándale!

 

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QOTD: Super Mario Speaks

“Deflationary forces have been replaced by reflationary ones.”  – Mario Draghi

Posted in ECB, Euro, Inflation/Deflation, Monetary Policy, Uncategorized | Tagged , , , | Leave a comment

The Rack Trade

Ever have a pairs (spread) trade where both sides were moving against you?  Ouch!  Been there, don’t want to do that.   Well, this is what we call the rack trade  (Kudos to Doug Skrypek for coining the term).

Rack Trade

 

You can usually find these rack trades where the fast money is way offside.   Where is that today, you ask?   Long 10-year T-Notes and short crude oil.

Recall earlier this year, the fast money had record shorts in the T-Note at 2.60 percent and record longs in crude oil at $50-55 bbl..   Betting against that crowd would have made you a lot of money.

Notes and bonds are down today, which we would attribute to Mario Draghi’s comments that deflation is dead and QE is on its way out the door in Europe.

As the economy continues to recover, a constant policy stance will become more accommodative, and the central bank can accompany the recovery by adjusting the parameters of its policy instruments — not in order to tighten the policy stance, but to keep it broadly unchanged. – Mario Draghi,  June 27

We have always held that, with exception of a few times/risks during the post crisis period, deflation, or fear of deflation, has been an urban myth and not rational.  Rents and healthcare costs, probably the two largest components of the consumer basket have skyrocketed since 2009.   The “real” real wage has probably declined more than measured thus contributing  to the punk economic growth.

The U.S. economy is far from rolling over, though it has slowed a bit,  and most of the move in the bonds has been technical — the massive short covering over the past few months and the structural shortage generated by global QE leading to a very inelastic supply curve of Treasury notes and bonds.   Traders gaming negative economic news can thus generate outsized moves in bond yields.

We love how some argue inflation expectations have come down.   Inflation expectations are measured off a distorted bond yield!  Talk about circular logic.

Crude oil is moving higher today, maybe because of the White House’s bellicose announcement on Syria last night,  but we suspect short covering.   The Middle East is blowing up and Syria is probably the biggest and most dangerous quagmire we have ever seen.  Russian and U.S. fighter jets fighting for air space.  Iranians lobbing missiles into Syria.  And the U.S. keeps getting in deeper and deeper.

Always dangerous to attribute short-term moves to fundamentals as most are just noise and re-positioning of the fast money crowd.

There you have it.  The rack trade, torturing the fast money crowd today.

T-Note_Jan27Crude_Jan27.png

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US Sector ETF Performance – June 23

ETF_DayETF_WeekETF_MonthETF_QETF_YTD

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Global Risk Monitor – June 23

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The Incredible Shrinking Relative Float of Treasury Bonds

Lot’s of hand wringing these days about the flattening yield curve.  We still maintain our position that the signal from the bond market is significantly distorted due to the global central bank intervention (QE) into the bond markets.   See here and here.

Most of what is happening with the U.S. yield curve is technical.  Sure,  traders can get a wild hair up their arse,  believing the economy is slowing and try and game duration by punting in the cash or futures markets.  Given the small relative float of the U.S. Treasury bond market, however,  it doesn’t take much buying to move yields.  In the words of economists,  the supply curve of outstanding Treasuries is very inelastic.

This is illustrated in the following chart.   The combined market cap of just Apple and Amazon at today’s close is larger than the entire the float of outstanding Treasury notes and bonds that mature from 2027-2027.  We define float (US$1.16 trillion)  as total Treasury securities (2027-2047) outstanding (US$1.73 trillion) less Fed holdings (US$575 billion).

Market Cap and Treasury Float

Now consider you started the year with, say, a hypothetical $3 billion portfolio of Amazon, Apple, and Treasury notes and bonds, each with a 33.3 percent weighting.

Given the rise of Apple and Amazon stock prices just this year, the current under weight in your Treasury position relative to the start of year would force an additional purchase of US$226 million of bonds to get back to the 33.33 percent weighting.   The allocation effect of a stock bull market or bubble on the bond markets can be a powerful source of demand.

This is a classic case of a positive feedback loop between two markets.  The allocation effect and the increased demand for bonds lowers the interest rate making stocks fundamentally more attractive as the rate to discount corporate cash flows declines.  This drives up stock prices ergo another allocation effect on bonds.

Here’s to hoping that in the next decade we, and the policy makers, don’t look back at this period with regret realizing we got the signal from the yield curve entirely wrong.  In hindsight, it is always so obvious.

Posted in Uncategorized | 23 Comments

Dubai’s Robotic Police Force

Wow!  When is the last time you met a cop that spoke nine languages?

Robocop

On Wednesday, May 24, Dubai will launch a new police robot that marks the first phase of the integration of robots into the police force. This modified version of the REEM robot (Designed by PAL robotics and unveiled in 2011) is capable of feeding video to a command center, forwarding reported crimes to police, settling fines, facial recognition, and speaking nine languages. It will operate at most malls and tourist attractions.

Dubai hopes robots will constitute 25 percent of its police force by 2030, with the next stage being to use them as receptionists in police stations. Brigadier Khalid Nasser Alrazooqi, General Director of Dubai Police’s Smart Services Department, told CNN that they eventually want to release a “fully-functional robot that can work as [a] normal police officer.” — WEF, May 2017

Robots_June22.png

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