Disinflation.

Well we had better mention the Aud before we kick off. Macro great, bounce none. So we reinstated the shorts through 0.9950. But anyway, onwards..

Much has been made recently of the disinflationary trends globally together with the apparent end of the commodities super cycle which is now evident in global price indices. Please note we are using the term "disinflation" (a decrease in the rate of inflation) which should not be confused with "deflation". Now, this has been reasonably well noted by market participants, but TMM thinks that the effects are not yet well explored. Specifically, TMM thinks the decline in inflation volatility has subtle but strongly positive effects on financial asset prices and a negative effect on commodities. To that end, history may serve as a guide. The last time the US went through a period of stable inflation, whereby both headline and core (i.e. headline ex energy & food) inflation were closely coupled, was in the 1990’s:




TMM recognizes that given the backdrop today, the 90’s may seem quite different. But it’s worth noting that for this exercise, we are not comparing absolute levels. Instead, we are concerned with relative changes. In other words we are more concerned with the direction rather than the size of the move.

The Effect on Bonds is a bit tricky to measure, since Fed policy is such a big driver. But in this respect, we can use the yield curve as a very rough proxy for the yield premium on long term treasuries. And the story there seems to be one of a declining yield premium. From 1995 to 1999, the 5s30s yield curve actually flattened, even though the Fed cut rates by over 100bps. It’s quite possible that the improving budget deficit at the time may have had an effect , but the budget deficit is also improving now. All in all, this makes sense – with decreasing inflation volatility, (and by extension central bank activity) investors are likely to demand a lower premium for long dated bonds.





The Effect on Stocks is also quite positive, as they are also a long dated financial instruments. With declining inflation volatility, nominal earnings volatility can also be expected to decline, which should reduce the risk premium. There is an old 20-CPI estimate for the S&P PE ratio which has had some reasonable success over the long run. This is now suggesting that PE should be in the very high teens:




The disinflation impact on gold, however, appears to be quite bearish. The chart below shows gold in white, Fed Funds rate in Orange, CPI in Yellow, and the price of WTI crude oil in purple. Note that from the mid 90’s, the price of gold fell ~60%, even though during this period the Fed cut rates, we got a series of systemic events (LTCM, Asia crisis) AND oil prices rose. Again, the improving federal budget deficit may have also contributed back then – but that is also happening now.




In addition, there are some unique instances that are worth mentioning. Obviously disinflation gives DM central banks more room to pursue QE. But ironically, the disinflationary impact probably also makes QE less effective at generating inflation. Case in point: Headline Inflation in Japan has averaged 40bps above core inflation over the past decade. This suggests that once the inflationary impacts of the weak Yen runs its course, it will be even harder for the BoJ to achieve its 2% inflation target. The small caveat here is that the Nipponese CPI basket can actually be changed or rebased to give the appearance of higher inflation, at least temporarily. TMM expects such a change within 2 years and remember the basket being manipulated in 2006 to, believe it or not, print inflation lower (smoke and mirrors and government payments).




For Europe, current austerity targets look even more difficult to achieve, given that EMU inflation has averaged 56bps over core inflation the past decade:




So where does this leave us? Last to the party with yet another reason as to why equities will keep on going to the moon and gold through the floor? We would actually like to think we were one of the first to arrive at this current party but popped out at the end of January to get some cigarettes only to find that everyone is high by the time we return. But this is a longer term trend and as we are calling for the party to go on into the night we might as well wade in.

But how? We actually think that the chances of a melt up are still pretty high. Some of us were there in 1997-2000 and can smell exhuberance and fear. That darkest of fears, the one of missing a profit. As we have said many a time, it ain't over til 25yr olds are driving around in 3 series BMWs bragging about their portfolios. We are adding to low delta SPX calls. Gold? Well we are already short and happy to ride that into a golden sunset.

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UWO
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May 16, 2013 at 5:41 AM ×

something I don't understand: you mentioned that the disinflation trend would reduce equity risk premium; doesn't that mean the excess return on stock will be less?

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Anonymous
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May 16, 2013 at 5:58 AM ×

Good one as usual, Mr Pol.

As strong as the "it cant possibly go higher, innit" feeling can be at times, we are still quite happy with some of those LT SPY calls we have been putting on in 170-180 strikes.

It's not that, to borrow from C from C (where is he/she by the way), you'd have to pry it from our cold, dead hands (since in all fairness, what started as "limited risk" is now not so low delta anymore). But we really really like them. The bear lady doth protest too much methinks.

A tangent point: more than the 25y old buying Teslas with their $TSLA profits, the party will be over when we see the Fed-doomists commit seppuku at the Beard's altar.

Disinflation, collapsing deficits and SPY/GLD up, up, up is the super pain trade for that crowd. They've had their day in the sun, but our gut feeling is, there is still quite a bit of capitulation to occur on those fancy Weimar-proof portfolios.

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Anonymous
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May 16, 2013 at 8:02 AM ×

It's interesting that you should mention that Japan wouldn't achieve inflation long term. But I wonder what the full implications are, if their CB really goes all in and pushes Yen down further. Possibility for a black swan type of mass capital flight and currency collapse? Soros thinks this is a possibility.

Or will they give up? That would doom Japan into eternal deficits and no way out. Implications for Japan's bonds? It's hard to not wonder if even a modest increase in interest rates would trigger a dislocation when combined with weakening Yen.

These are extreme scenarios, but I think worth considering.

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Orthodox
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May 16, 2013 at 10:47 AM ×

Remember the 1990s was a temporary decline in inflation thanks to the fall of communism, then the Asian Crisis and Russian default. More of that is coming if this trend plays out because the U.S. dollar will go vertical. At the end of this party, U.S. debt relative to global GDP is going to be much, much higher.

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GMS
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May 16, 2013 at 2:08 PM ×

UWO - a reduction in risk premium means a higher present value but lower returns after that. So in a sense, the idea is that the price of the bond will increase, but then the yield to maturity after the price increase.

Anon @ 8:02, re: the black swan capital flight, that is certainly possible, but judging from the portfolio flows data and asset prices, we are still quite some ways away. Having said that, if USDJPY gets close to 120, options on that tail will probably be worth buying.

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Anonymous
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May 16, 2013 at 5:03 PM ×

Any thoughts here on shorting Jap bonds?

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Leftback
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May 16, 2013 at 5:11 PM ×

You have been busy, Mr Pol! Nice analysis. One has to keep busy during these long weeks of watching 25 y-o traders go long TSLA, and what better way than with a fine collection of charts?

Gold's collapse of late has been sending a very coherent message, along with the miners and those struggling BRIC equities as every HF manager bailed out of EEM and GDX and into Netflix and Build-A-Bear. The message of global disinflation.

So anyone who hung on to the Weimar portfolio of long commodities and short Treasuries has had their posterior presented to them with a ribbon tied round it. We simply haven't seen inflation in the US at all, b/c the USD has risen steadily, much to the chagrin of the "Dollar Collapse" crowd.

Now, LB has been meaning to write on the T word. Not Tesla, but Tapering. The question du jour is, has the FED really achieved anything concrete with QE infinity other than supporting the sales commissions at Greenwich Tesla and Lamborghini dealers? Employment indicators such as JOLTS are not terribly encouraging. This policy isn't helping everyday US citizens. Bernanke would have done better walking down the streets handing out Benjamins (see what I did there?).

One wonders at what point even the FED will balk at subsidizing the "models and bottles" lifestyle of 25 y-o Margin Man. There is a very real form of Moral Hazard associated with this market that is every bit as repellent to everyday Americans as were the bank bailouts.

We are not shorting this market (and we are long quite a lot of European equities and a bit of washed out emerging markets), although here and there we have traded XHB and FB from the short side for a quick hit. But we remain very cautious, not least because of the universal exuberance and bear-baiting now being exhibited in the financial media. Nothing goes up in a straight line.

Here in our bunker we are tuned in to the very real possibility that the Fed will use a jawboning campaign to signal some modest tapering of QE in the summer. The June meeting looms as the obvious fulcrum about which policy might eventually pivot. Recent WSJ leaks from Hilsenrath and comments by Plosser represent, we think, initial attempts by the FED to test the market's reaction to an actual announcement.

As other commentators have pointed out, the media are almost certainly wrong about the reaction to such a tapering announcement. "Bond meltdown" is the most common prediction. In fact, although there might be a knee-jerk move of 20-30 bps at the long end of the curve, we expect that this would be reversed very promptly as fixed income investors retrace their move back down the risk curve, just as the whole risk-on move in the bond market was telegraphed and supported by the Fed's QE infinity intervention.

Just as FED interventions have been front run in Treasuries and FX trading in the past, the tapering has likely already been partially anticipated. This can be most clearly seen in DX marching to 84 even as the US economy snoozes along at 1-2%. The asset classes most likely to suffer will be equities, mortgage backeds and high yield (including dodgy sovereign bonds). Spreads are too tight, and the FED is likely already concerned about this. Those equities that have not formed part of the 2013 bubble will likely be little affected, while the VHB (very high beta) crowd will see some pain. A lot of pain, perhaps to be experienced in the unwinding of certain trades most closely resembling parabolae and the Flight of Icarus.

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Leftback
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May 16, 2013 at 5:35 PM ×

The jawboning about tapering has begun, and the rules of central banking stipulate that any such jawboning be done by proxies:

IMF Jawboning

Plosser Jawboning

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Leftback
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May 16, 2013 at 9:24 PM ×

It's probably superfluous to mention that several sectors are currently at extremely overbought levels. It would not be a surprise to see some of these sectors retrace in the next few days. Here are the nice coloured charts from Bespoke:

S&P Sector Trading Ranges

We have made some modest bets against certain segments of the consumer discretionary sector. Trees don't grow to the sky. Especially if the guys from the Fed keep on talking about starting up the chain saws in the background.......

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abee crombie
admin
May 17, 2013 at 1:33 AM ×

Nice post and I agree we are not seeing the exuberance of a top in equities and the pe could certainly go higher given where rates and inflation is. However I dont think the equity top will end with models and bottles leading mba grads and investors off a cliff. More like my income starved mother buying nestle bc of the yield. This is a yield hog market not a momo field growth type ( which has some reflexive responses to juice growth) that said equity dividends are a bit rich and multiples for those issuers are high but not to the extent I get excited about shorting. They do not however realistically take into account the low world wide growth.

So I guess that means equities keep going up.but the yield hogs will see their reckoning soon I think. Maybe in the fall. Global growth is pinning a lot of spoos earnings. If that starts to fall I think the market will initially overlook it but then realize hey my dividend isn't so guaranteed afterall.

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Nico G
admin
May 17, 2013 at 6:27 AM ×

trading is much easier this side of the Atlantic - European indexes can't ignore bad data the way US does so shorting here for multi-week correction is much easier

i alerted you when EUropean equities got a bid during last correction. signaling the bounce to come well, there is now a stronge divergence at the top and this signals an imminent correction

expiry today should mark a local top, pretty much like April expiry marked the last bottom.

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May 17, 2013 at 11:41 AM ×

1999: "Until 25 year olds are driving 3 series BMWs and talking about their equity portfolios"

2014: "Until 25 year olds are driving Tesla's bought using proceeds of the Tesla equity they bought and telling everyone about it."

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Anonymous
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May 17, 2013 at 12:10 PM ×

The only thing that is ignored here is currency role. Right now, USD can definitely play a spoil sport for global markets if it keeps on showing strength. one should not ignore bcd nexus (bonds, currency and derivatives) and that is showing real disturbing signs now.

Its difficult to believe that market top has to happen only when there is real craziness.. It can happen otherwise while surprising all bulls who are expecting mania requirement to fulfill.

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Nico G
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May 17, 2013 at 2:00 PM ×

Anon thanks for writing some sense into this madness. After 20 years in this business i am amazed the psychology at tops has not changed. It will never change. In 2006 club bouncers in Miami were bragging about their condo flipping, some had netted seven figure profits.. and i'd think 'does anyone remember 2000 at all'.

Rewind. In early 2000 i was in Tahiti and truck drivers from France were staying in a $800 a night resort bragging about the money they made on Cisco, Akamai etc

It did not bother them at all than Naz was absolutely vertical on the chart, it did not bother them that the yield curve had just inverted.

2013 Tesla = 1999 Cisco. Right now day traders' exploits on Tesla are all over the press.

"Pretty much any trade you entered, if you held it long enough, you made money," wrote some triumphant Tesla punter of a housewife today. $10bn valuation? Buy first, worry later.

Punters are so lucky to see 1650 SPX traded against a world (a wall) of pain and yet this is not enough.

Regardless of valuations or macro they want to see another 30% gone hyperbolic yeah that would be the condition to sell. At 2000 spx analysts would probably upgrade target to say, an extra 15% vertical 'for the road'.

'We need proper madness, there ain't proper madness yet we need everyone and their pet iguana to brag about stocks again then we can call it a bubble, then we can sell the top"

Could it be that simple. I would be intellectually dumbfounded if market goes up after today's expiry (and it will hurt my European shorts, too).

Does anyone remember 2008? Does anyone remember Apple at $700, when they moved their target to $1000. Does anyone remember gold at $1900 when they moved their target to $3000'.

those obsessive blogosphere darlings have been trashed. Someone tell why US indices are different today

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Anonymous
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May 17, 2013 at 8:22 PM ×

Why Nico? Because as Dalio said in February, there's a shitload of cash out there that got bored of watching Ben et al. thumb their noses.

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Anonymous
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May 17, 2013 at 8:52 PM ×

We may be thick but we dont get the 1999/2007 comps.

Where is the leverage? Where are the armies of IBs floating pets.com IPOs and 15x leveraged basket of financials yielding 4bp?

We have our own reservations with the rally. Hence our preference for options vs outright, but this notion that going up = bubble is a bit disrespectful to the beauty pageant of stupid investments we did witness at the 00 and 07 tops.

Skepticism also cannot get in the way of one still having to do his job. Not to get Chuck Prince on you, but regardless of what you think is "right", why not insure against the pain trade if the cost is limited? There is no special prize for intellectually elegant position.

Ask yourself this (on top of Anon/Dalio's point above): of those 1700 SPX points, how much is cash on hand? How does this compare to those two previous valuation peaks?

Anyway, it takes two sides I guess.

- DD

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Anonymous
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May 17, 2013 at 9:22 PM ×

btw, C from C's (them again) theme of smallcaps over megacaps is going to be quite something in the Q2/Q3 earnings round if USD continues its little run higher

DD

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Leftback
admin
May 17, 2013 at 9:26 PM ×

Watch out. Blokes really are putting all their wonga into shares of Tesla. It usually goes pear-shaped very soon after this kind of story appears:

Betting It All on Tesla

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Anonymous
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May 18, 2013 at 8:50 AM ×

Its almost certain that bernake policies has worked in favour of averting Japanse kinda deflation but comparing this time with 90's would not be fruitful.

If market top is not based on euphoria, then we believe that the correction won't be waterfall kinda panicky like 08, 00's.

Showing models and hence proved is obviously revealing the book. But under short to medium , sky-high complacency
is unignorable for us followed by european elections and then bernanke possible exit (not only from policies but from Fed too).


http://www.huffingtonpost.com/2013/04/23/bernanke-miss-conference-departure-speculation_n_3137797.html

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Anonymous
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May 19, 2013 at 11:34 PM ×

Everyone's still too concerned, cautious and skeptical for us to be anywhere near 'The Top'. At this point even if the markets were to panic and drop 10 - 15% in the short term I believe prices would recover within a month or two. So many have missed this run up which is obvious when you look at average hedge fund returns over the last few quarters desperation to make up for this is another factor that will support this bull...

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Anonymous
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May 20, 2013 at 11:34 AM ×

All the talk that euphoria is needed for market top gets me thinking that the market will do whatever hurts the most people so naturally the obvious top would be when euphoria exists. But I seem to read everywhere that buying the dip will be the best opportunity to get into the bull market. so what if the euphoria isn't associated with the top and instead is associated with buying the dip. As ANON 8:50AM says, the market could gradually fall in a fashion nothing like the sharp sell off dips we have been conditioned to expect and thus trapping all these dip buyers at higher levels.

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Anonymous
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May 20, 2013 at 3:46 PM ×

I don't think its right to look for obvious psychological parallels to '00 or even '07 as some kind of tell as to if everyone is all in. 2000 happened at the tail end of what, a 17 year bull market? At this point I think we are just not going to see the widespread euphoria, even at SPX2000.

I think the time spent looking for signs of public intoxication with equities is better spent looking for catalysts for credit to go boom, like JGB var's blowing up.

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