Wednesday, May 18, 2011

I Spy More Pain (ISM Pain)

Yesterday's bounce in many markets led to surprise in the TMM camp. Not surprise over the bounce occurring (the Soothsayer signals in many USD crosses signaled an end to the run yesterday) but we were more surprised at the amount of pain and woe being expressed by many on the street, as it wasn’t THAT big a bounce. To TMM the corpses of some overexcited new uberbears is good news as it leaves the market more balanced, yet still pretty close to recent lows. This is supportive of our thesis that yesterday's move was just the "R" of our JSTFR play of the past couple of weeks. Hopefully we can get back to the basics now that the panic noise has diminished.

TMM's basics, as expressed here recently, are that both Global and US growth are slowing and still like the idea of JSTFR in Equities while continuing to favour the bull flattener in USTs. But today, we thought they'd take a closer look at the inputs to their ISM model, why it appears to have diverged from the actual numbers over the past year and the outlook moving into the summer. The below chart shows ISM (red line) vs. TMM's ISM model (blue line). Over the past year, this overshot to the downside during last summer's double-dip scare, something TMM believe to be the result of the very large shifts in the global inventory cycle (something we will take a closer look at below), but directionally - if not in actual level terms - the model is clearly pointing to another drop off in industrial production.

The two main variables in TMM's ISM model aim to describe short term inventory cycle-driven factors (see chart below, blue line) and proxy "true" end demand (red line) in terms of raw materials needed for investment in infrastructure. As TMM noted above, the inventory cycle has been very volatile over the past few years, making it very difficult to see the wood for the trees in terms of how the recovery has been progressing, which is why TMM are particularly interested that the end demand variable in their model. And this component has largely settled around sub-trend growth levels, seen either during recessions or mid-cycle slowdowns (c.f. - 1995/96, 2004/5). Now TMM are not anticipating a recession, because a lot of things need to go wrong for such an outturn, but it seems increasingly likely that that growth will slow further over the coming months and that consensus economist expectations for Q2 and Q3 GDP of 3.3% annualised rates have some way to fall...

...which in the context of historic equity performance when the model is these levels (see chart below, SPX YoY% - red line), suggests to TMM that Spooz continue to look vulnerable over the next couple of months, especially given the scarred memories of this time last year for many a trader.

In TMM's experience, growth slowdowns usually morph into growth scares (in recent years morphing further into deflation scares) so we think the curve is likely to continue bull-flattening, with 10yr notes headed to 2.9%. TMM's mates at Nomura rightly point out that given specs are positioned in steepeners and primary dealers are short the belly of the curve that a nasty position squeeze could develop here.

Oh yeah, and Bill is still short.


Anonymous said...

2-10s flattner or 5-30y steepner ... which has best risk reward here ya think?

lead components of PMIs ie new order turning down fast too.

Anonymous said...

agreed on the 2.9% bottom on Tnotes, albeit less convinced that the current rally has enough legs to reach it as it is now "consensus" number. Not entirely sure if I can agree with Nomura on positioning, the mkt seems to sell off in Asia and then rally back in Europe/US. Looks more like specs trying to establish shorts and then get turned around by wall of buying from dealers and CTAs. I guess a lot of ppl shorted the curve in anticipation of QE2 end and now got squeezed out.

Anonymous said...

equity monkeys will only care if earnings start missing..

nice post though... the divergence of late in the Fixed income markets and equities is really interesting. At some point you would think it will resolve itself

Leftback said...

LB will take the 5-30y steepner, this is the last day that FRBNY is buying back the long bond until June 1.

Nomura have been extremely rational and definitely among the best in the business at forecasting Treasury market in the last 2-3 years. George Goncalves is always worth a listen when he is on BBG, and is invariably significantly more accurate than.... (fill in the name of your favorite fixed income tools here). It's hard to say how much of the risk aversion is related to Europe and temporary in nature, but the fact is that buyers definitely did not go away. Yet.

Fixed income is obviously going at risk from any sign of a tepidly reheating economy, but the earliest indications of such a warming would likely be in the next jobs reports (June 1-3), which gives us another two weeks to reach TMM's bottom on the 10y. Chances are Bill is going to receive a bit more of the Cold Steel/Red Hot Poker?

So, having very skillfully negotiated the Spring "soft patch", TMM, the question for you now is: with very low rates and lower commodity prices than a month ago presumably leading to a moderation or unwind of US inflationary trends, is it going to be "Full Steam Ahead" for the USS Economy or "All Stop" in the summer shipping lanes? Another leg up for equities seems possible before too long, once the sell-off in energy ends, no?

Jim said...

I disagree on inflation, the trap has already been set with many nations the US runs a deficit with seeing their currencies up 5% or more YTD. Further, oil at 98 is still very expensive. Comments on the 2.9% on T notes don't seem to take into account the lack of buying given China has been a net seller for 5 months and Japan now has problems of their own plus end of QE & decline in demand from Fed. Investors could "fly to safety" in the event of a growth scare but that would make them bond monkeys, wouldn't it?

Anonymous said...

The US bond market at these prices and with QE concluding to a reinvestment basis needs a major risk off wave. Without that those yields have only one way to go..UP.
So whether they ay have alittle further to go is academic to me because the risk reward is simply no longer wirth it at current levels.

Anonymous said...

uhmmm ... amongst other things bond yields move as a function of growth an inflation expectations ... in other words nominal gdp ... QE2 ending reduces inflation expectations and hence nominal gdp ... bad for risky assets, good for bonds.

supply-demand leading to a determination of yields out to 5years is innacurate... that's mostly expectations of rate policy.

fiscal problems on one hand, QE2 ending is effectively a tightening measures which is why in conjunction to a super special repo market, implies 5-30y will steepen as per above at least over the course of the summer.

Leftback said...

Anon @ 5:53. Correct, I believe. The front end is a reflection of rate policy expectations, hence not changing any time soon. The group of observers now prepared to contemplate a Japanese scenario of long-term ZIRP does seem to be growing.

The long end is more sensitive to inflation concerns and marginal changes in supply. Congrats to all who caught the recent bull flattener, but the risk:reward now looks poor.

Mark Thyme said...

Leftback and Anon 5:53, there's also the teeny tiny matter of where global real yields might be heading (I'm not sure if this is risk premium or global demand for long run funding relative to supply). Anyway Russell Napier pointed out that the end of QE is coming at a time when EM central banks are tighening liquidity and that EM liquidity has been a primary source of downward pressure on yields.

It could be that the end of QE recycling through EM economies takes some of the inflationary heat off these central banks, but I suspect their wage-price inflationary cycle has kicked off and will keep going as long as people in these countries have access to easy credit. And they're finding tricky ways of doing just that--like the Chinese copper scams. Anyway, EM central banks may be hoping that they don't need to do much more, but as wages keep going up, they could well be forced to slam on the brakes.

That would hit global growth (good for long end of the Treasury market) but would also hit demand for massive U.S. govt issuance (bad for long end of the Treasury market).

If it means falling EM trade surpluses that could be good for US manufacturers (import substitution) and thus good for economic growth and government finances (lower issuance) but real yields would rise to reflect domestic investment growth demand. Or it could mean global aggregate demand is being crushed and therefore is bad for people but good for bonds.

Sorry, I'm just trying to think things through on somebody else's blog. I'll stop now that I've reached a firm conclusion that I have no idea what's likely to happen.

Anonymous said...

anon at 2:26pm

i also find it interesting that tsy yeilds have rallied so much relative to the level of equities since april. I see this as a replication of last year when the same happened after tsys saw the data turning more quickly than stocks. However Tsys are at a much lower yield relative to stocks than last year, and as some have mentioned, don't exactly look cheap here. So is it not better to sell equities than buy tsys (outright or synthetically through flatteners)

FX said...

Was that ISM cousin that fell out of bed today, don't have to be bear nor bull to enjoy that one folks!

Jim said...

Mark Thyme - Nice analysis. Anon 5:53pm - My comment was probably too long term focused for the previous discussion but in my opinion, yields are always based on supply/demand. What drives that supply and demand is where expectations for inflation, growth, etc, come in. The treasury has a report with a great chart of the tremendous growth of emerging market holders of USTs from 1994. Its hard to look at that chart and the compression in yields since then, and draw a conclusion that secular supply/demand shifts can't impact yields - at least in my opinion.