Be Careful What You Wish For

Just like the sideshow huckster who convinces you to have a go at knocking over the milk bottles, the Bank of England's own Carney lured the punters in, separated them from their cash, and sent them on their way empty-handed.  By offering the limpest possible validation of the market's rate-hike pricing, Sideshow Mark helped spur the largest one-day rally in the June 15 short sterling contract since last September (when the Federal Reserve's own Ben "Barker" Bernanke amazed crowds with his "vanishing taper" trick.)



Although Macro Man was correct to be wary of the UK rates trade, his preferred trading vehicle, EUR/GBP, wasn't exactly a bed of roses, either.   While yesterday's rally was actually quite modest, the chart put in an outside reversal day, which would appear to augur a deeper correction in the works.  Who knew that Austin Powers was such a prescient market analyst....

The rip-snorting rally in UK rates percolated into other markets, and one could almost see towels being thrown as both eurodollars and Treasuries ripped back towards (and in some cases, through) their highs of the year...despite a considerably higher than expected PPI.

Now, this apparently incessant rally must be causing an awful lot of head-scratching, and for sure it came out of left field based on the expectations from last December.    However, at some point it is worth looking at the market's reflection in Occam's Razor,  searching for the simplest possible explanation to fit the facts.  In this case, the market consensus forecast now expects Q1 GDP to be revised down into negative territory.  Yes, this has been significantly caused by the adverse winter weather, thus allowing the PhD community to blithely wave it away.

However, the bond market appears to be taking it at face value, especially in light of the disappointing trajectory of retail sales in April.  The currency market appears to be taking it at face value, given the wretched performance of consensus dollar longs for much of the year.  Even equities, as noted previously in this space, have abandoned growth stocks, apparently taking the weak output data at face value.

                                                               Growth vs. Value

To be sure, and slightly to Macro Man's chagrin, the headline SPX has not followed along (though other indices, particularly the Russell, have.)  At the risk of beating a dead horse, it is worth noting once again that while the consensus forecast for 2014 US growth has dropped, this is merely a base effect resulting from the abysmal Q1 reading.   The forecast profile (at least as reported by the Bloomberg consensus) over the next several quarters is unchanged, other than to upgrade Q2 as a "payback" quarter.  Attention, Lazy Sunbathers: the weather is getting warmer!

Today sees the release of US CPI, which reflects the current excuse du jour for the Fed to pursue its repressive monetary policies.   Of course, there is relatively little evidence that ZIRP/QE/Woodfordite mumbo-jumbo actually spurs business activity (though perhaps Sideshow Mark would observe that the UK's resurgence coincided with his arrival...)  Instead, the Fed prefers to talk about the "portfolio channel" effect, wherein markets are relieved of their 'riskless' assets and forced to extend out the risk curve to generate investment returns.

Although the Fed, noted savants of financial excess, have observed frothy conditions in farmland and leveraged loans, they seem A-OK with equity prices.   Indeed, Ben Bernanke wrote glowingly of the beneficent impact of pumping equities in the aftermath of QE2 three and a half years ago.  The irony is that the Fed now wants to get inflation up...and inflation is more or less the worst possible thing for the transmission of the portfolio channel effect.

Although the analysis below is hardly groundbreaking, sometimes it is worthwhile to take a step back and check your foundations.   Simply put, the performance of US equities when CPI inflation is below 2% is far, far better than during any other inflation bucket.   Equity performance when inflation is on a 2 handle is better than when it is higher.   Equity performance when inflation is between 3% and 5% is better than when it is above 5%.  The buckets in the chart below were chosen fairly arbitrarily, but they are broadly comparable in size and illustrate the point well enough.

Monthly data since 1960.   Does not include dividends

If you want a good explanation of why stocks have seemed so bullet-proof for so long, this isn't a half-bad start.   The FOMC, of course, want to push things from the most favourable quartile to somewhere else.   The implicit assumption, naturally, is that it will be economic growth that spurs inflation higher, and so all will be right with the world.  Whether that belief proves to be founded remains to be seen.  Somehow, Macro Man cannot help thinking that the Fed should be careful what they wish for, because they just might get it.


Previous
Next Post »

7 comments

Click here for comments
Anonymous
admin
May 15, 2014 at 12:41 PM ×

Nice post. So instead of using outright equities as my classic inflation hedge, I should be buying some of those newly listed US dvd futures or even deep otm long dated DEDZ calls to protect purchasing power?

Reply
avatar
Anonymous
admin
May 15, 2014 at 1:46 PM ×

C Says
We started with a sell in the small caps ,but we've now got a sell going in the Uk250. It's fairly typical for the large caps to be last dominoe.
Anyone really want the large cap indices at these highs, be my guest they are all yours.

Reply
avatar
Leftback
admin
May 15, 2014 at 4:20 PM ×

Remember how strong US data was supposed to drive UST10Y rates to the moon? Another large group of bond shorts were completely (toasted/ squeezed/ subjected to Cold Steel/ insert your own favorite metaphor here involving rear entry) this morning, an event almost predictable from the extreme positioning of futures traders.

Strong data in the US, big bond buying. Who knew? "Be Careful What You Wish For" indeed. For the media morons, especially our friends @CNBC, who are plaintively asking "why is the market behaving his way?", we know that your tiny minds have always struggled with the bond market. Perhaps your brains are too clogged full of monetarist theory, the principle of American exceptionalism and other forms of neo-con political ideology to be able to parse the price information in the historical record. So here is a little primer from Uncle LB to help you.

It works like this, kids, when Fedspeak says this: "we might commence QE" it is a signal to front-run the Fed by buying USTs; "we will commence QE now" is a signal to move out of USTs and out along the risk curve, vacating Ts for the new buyer (the Fed); "we might end QE at some point" is a signal to sell any remaining USTs; while "QE is ending imminently, it really is" is a signal to exit risky assets and move back down the risk curve to the safety of USTs.

I realize most of you @CNBC weren't in the top 10% of the class, but is this really so hard to understand? It was all very nicely explained for the Meeja by Tony Crescenzi of PIMCO a few years back, and repeated here on a regular basis by many sage observers.

Reply
avatar
Leftback
admin
May 15, 2014 at 5:57 PM ×

Don't look now, Macro, but after the insanity of last week (when we saw Italy trading only 30-40 bps wide of US), BTPs are offered today, 10y up +16 bps today, this trade being the flip side of the bid in gilts and bunds. Could some of the UST buying also be a reflection of a new Risk Off move in Yoorp?

Reply
avatar
rossco
admin
May 16, 2014 at 12:33 AM ×

With respect to the performance of US equities under various states of inflation, what would be interesting is to divide the <2 sub set into <1 and >1<2

I think it would show that at sub 1% inflation US equities have almost never performed well and greater than 1 is the sweetspot.

Reply
avatar
Macro Man
admin
May 16, 2014 at 12:45 AM ×

This is the wrong dataset for that study, as there have only been 15 months of <1% inflation since 1960- most of which came in 2009. Actually, the return/risk ratio of those 15 months is just above 1- better than that of the 1-1.9% cohort.

Obviously, extending the study to the 1930's would change the results dramatically.

Reply
avatar
rossco
admin
May 16, 2014 at 11:01 PM ×

back in my box then , thanks

Reply
avatar