Well, Albert Edwards is back from his trip to Japan and guess what? He’s not sounding too optimistic on the outlook in his latest missive.
Edwards begins by recounting what we and everyone else have been talking about the better part of a month. Namely falling 10Y yields and a dollar that looks like it wants to keep falling too, last week’s ECB-engineered rally notwithstanding.
Although Edwards concedes the unassailable contention that recent action is a product of the “dovish” Fed hike and then, subsequently, the health care debacle on Capitol Hill, he also flags short covering in (previously) stretched spec positions as a likely catalyst for 10Y yields hitting their lowest levels since the day before Trump’s speech to Congress. Something we’ve flagged first for two weeks straight (see here and here).
Still – and apparently this is the point – Edwards says rates could well touch 3% (that magic threshold beyond which we get a tantrum) before the “Ice Age” continues as recession hits and the Fed is forced to reverse course on a one-way path to zero and beyond.
The dovish Fed rate hike and failure of the Trump Administration to repeal ‘Obamacare’ are thought to have stopped the so-called ‘reflation trade’ in its tracks. Both bond yields and the dollar have declined sharply in recent weeks. We remain bond bulls but we believe recent movements may have more to do with technical positioning than any fundamental-driven rally. Collapsing bank lending growth is signalling that something is amiss and the Fed should stop raising rates, but I expect rapidly rising wage inflation will push the Fed into overkill. Fed tightening cycles almost always end in recession and this time will be no exception.
One of the things you notice after doing this job for a long time is that commentators will always be able to conjure up a convincing ex post narrative to explain market moves. And so the sharp declines in both the bond yield and US dollar have been explained by the Feds dovish comments in the immediate aftermath of the March Fed rate hike, and the fear that the Trump fiscal stimulus may be threatened by the failure of congress to deliver a repeal of Obamacare. This explanation is very plausible and indeed may have been the catalyst for the initial market move, but the magnitude of the downward move in the US dollar and bond yields may also have very little to do with fundamentals, and simply have more to do with extreme market positioning.
The US CFTC publishes investor positioning data each weekend that is always worth monitoring. Breaking down the various categories of investors, market participants watch closely to see what speculators are up to. Generally they tend to be momentum traders and their positioning tends to follow price trends. But the market is aware that when huge positions (long or short) get built up this usually portends a vicious snap-back, often temporary, in the opposite direction. It is always worth monitoring this data. The unprecedented extreme short positioning built up in the US 10y Note was always likely to generate a finger-burning snapback.
In this business they say a chart saves 1,000 words and having worked on the buy side I can tell you that I found nothing more useful in the 1980s than Ed Hymans great chart books, which had lots of thick bold arrows and annotations plastered over every chart. I know there is very little point producing the large quarterly reports the sell-side still publishes. They take an awful lot of time and effort and usually end up being deleted or binned without being read. The buy side just does not have the time or inclination to read such documents. My experience of sitting with piles of sell-side research on my desk when at Bank America Investment Management is one of the key reasons why I promise my readers they will able to read each document in less than 5 minutes flat. I always do my best with my charts to illustrate my argument clearly and to break up the text. But by far and away the clearest and most interesting charts I see in the market at the moment are from the former Morgan Stanley Strategist, Gerard Minack, who still writes The Downunder Daily from Sydney, and who has now struck out as an independent.
Gerards latest thoughts are similar to my own views and so in my current Tokyo jet-lagged state, Im going to be particularly lazy this week and borrow some of his excellent charts to illustrate my points. Gerard notes how unusual it is that the recent strong US data is not accompanied by a sharp rise in bond yields (see chart below). As I said above, that is likely to have had something to do with recent extreme positioning.
You will have all seen the charts that abound showing the huge contrast between the extreme strength in the soft economic data (eg PMI, ISMs, confidence surveys, etc.) against the much more subdued hard economic data (eg GDP etc.). Some contend that the soft data will lead the hard data upwards, but it is odd that economists have not been revising their 2017 GDP estimates upwards in response to this stronger soft data.
Now maybe one reason why the GDP data has not been revised up is that economists suspect all might not be well. Some prominent observers point out that bank lending to the US corporate sector seems to have suffered some sort of seizure. It is difficult to know quite what to make of this, but it is typically associated with recession.
The Fed should have tightened a long time ago as their easy money policies had unleashed another credit frenzy. But the latest data suggests the opportunity to normalise rates may have closed. For the Fed to tighten aggressively as bank lending slumps would be most odd.
But tighten they will due to a rapid acceleration in wage inflation as high CPIs squeeze real wages in what is a tight labour market. The Fed Funds futures strip will converge further with the Fed dots (see Gerards chart below) and drive the US 10y yield towards 3%. The excellent David Rosenberg notes that 10 of the 13 post-war Fed tightening cycles have ended in recession (I think the others have ended in EM blow-ups). As the Fed kills this recovery, expect US 10y yields to visit 3% before they converge with Japan and slump well below 0%.