If I Could Turn Back Time

So is this A-B-C or 1-2-3?   Inquiring minds want to know.  While the recent SPX rally provided quite a bit of overlap with waypoints from the downdraft, suggesting that recent weakness was indeed corrective, other indices have not.   The jury, therefore, is still out, as yesterday's price action indicated.

The slightly-below-expectation CPI print was presumably enough to raise the hackles of at least a few deflationistas, but really, in the grand scheme of things, it's merely trading water in the range of the past couple of years.




In fact, Macro Man was rather interested to observe that in the latest edition of the Financial Crisis Observatory's quarterly Cockpit publication, they identified several negative bubbles in commodity markets, as well as signs of a strong USD bubble.  Signs that the deflation scare is approaching "tabloid" status, perhaps?

Unsurprisingly, they also identified more signs of government bond bubbles than six months previously- and bear in mind that the document was released on the 1st of this month, before 10y Treasuries ripped 35 bps in one morning!  Intriguingly, the analysis found less risk in equity markets than they had at the beginning of April.   One can only presume that the bubble risks in stocks have receded further.


Source: http://www.er.ethz.ch/fco/FCO_Cockpit_October1st_2014.pdf


None of this is to be taken as gospel of course; nevertheless, it is still interesting to observe what the maths say in terms of the sustainability of price action.

Switching gears slightly, the other day while cycling Macro Man had the grave misfortune of having that wretched Cher song "If I Could Turn Back Time" stuck in his head.   How it got there, he has no idea (Cher isn't exactly in the rotation on the MM family Sonos system), and it was only by climbing a few arduous hills that he was able to extricate himself from its grip.

However, the experience got him thinking.  As many readers are no doubt aware, prior to the formation of the Federal Reserve there were more than a few instances of low inflation/outright deflation in the US economy.   This was naturally a function of the metallic monetary standards that were prevalent for much of that time, as well as the periodic financial shocks that hit the economy.  (The last of these, the Panic of 1907, was one of the raisons d'etre for the Fed's creation.)

In any event, Macro Man thought it would be fun to look at stock and bond performance during the pre-Fed era to see if there was any linkage to inflation/deflation.  He sourced data from the excellent Irrational Exuberance website, which purports to have scrubbed data going back to 1871.

He divided the data into 10 deciles sorted by annual CPI inflation, and calculated the mean equity market annual total return for each decile, as well as the standard deviations of those total returns.  He also calculated the average 10 year government bond yield, again using data provided by Professor Shiller.  The results are set out in the table below.


As you can see, deflation was much more prevalent pre-Fed than since the birth of the central bank.  Indeed, in the 43 years preceding the birth of the Fed, the average annual inflation rate was slightly negative- note that the first 5 deciles are all in negative territory.  Put another way, in the 43 years prior to the foundation of the Fed, there were 243 months of negative annual CPI inflation; in the 100 years since, there have been only 166.  There are a number of factors which explain this, not all of which are maleficent. Indeed, one could argue that transatlantic cables and the invention of the telephone and radio were the equivalents during this time frame to the latter day internet and globalization.

Regardless, the moral of the story from the table above is that equities really only showed a sensitivity to inflation at the extremes, performing poorly in times of sharply negative deflation and performing best when inflation was at its highest.   This is clearly not an experience that has been replicated in its entirety during the Federal Reserve era, when peak inflation coincided with execrable stock market performance. (The only properly nasty deflationary episode of the Fed era did, however, coincide with wretched stock performance.)

One wonders, meanwhile, whether bond investors before the Fed were primarily from Wales or New Zealand- the historical record certainly suggests that they were sheep, with yields displaying zero long-term sensitivity to the level of inflation.   Some of this may of course be a data quality issue, but man- it must have been nice to get 4% on a bond investment with inflation of -10%!

What does all of this mean for today's investor?   Quite possibly nothing.   Much as some might wish it were not so, the continued existence of the Fed is indeed a fact of life, and it is very hard indeed to see the modern financial system returning to a framework as rigid as a metallic currency standard.

Moreover, the explosion of debt across vast swathes of the world economy over the past several decades has made deflation a less savory outcome than perhaps it once was, particularly given the predilection for "zombiefication" instead of Schumpeterian creative destruction.

In any event, basing high-frequency investment decisions in the 21st century based on financial pricing in the 19th will almost certainly end in tears.  Nevertheless, it is comforting to know that a dose of disinflation, particularly one that stems from global capacity issues, does not automatically consign risk assets to a watery grave.

That still leaves the tactical issues of how to navigate the end of QE and the possible onset of rate hikes.   Old Diamond Jim Brady, Jay Cooke, and Cornelius Vanderbilt never had to deal with these sorts of issues.    If only we could turn back time....




Previous
Next Post »

36 comments

Click here for comments
theta
admin
October 23, 2014 at 8:56 AM ×

"One wonders, meanwhile, whether bond investors before the Fed were primarily from Wales or New Zealand- the historical record certainly suggests that they were sheep, with yields displaying zero long-term sensitivity to the level of inflation. Some of this may of course be a data quality issue, but man- it must have been nice to get 4% on a bond investment with inflation of -10%!"

Gold standard may explain this. There's an element of credit risk in those bond yields, whereas today there isn't any by design. Modern day equivalent is Greek bond yields. You can have 9% yields with 2% deflation, why don't you buy? ;)

Reply
avatar
Anonymous
admin
October 23, 2014 at 9:00 AM ×

Many of us have been haunted by our recollection of free markets since ZIRP and QE were firmly established.

Whilst it is currently fashionable to suggest that the US is in fact not in a liquidity trap and hence the removal of QE will herald a return to normalization, why would anyone bet against the Fed once more becoming a credible institution.

I mean seriously, when Bullard gets on the wires after a few weeks of poor S&P performance to carp on about QE4, we know what he is trying to achieve.

If 10's are back sub 2% after the 29th will people really be advocating a long position in equities ?

Reply
avatar
Nico G
admin
October 23, 2014 at 10:26 AM ×

"I know it's crazy but I felt physically better when I knew the ECB had started actually buying covered bonds on Monday," said David Stubbs, a global strategist at J.P. Morgan in London.

Reply
avatar
Anonymous
admin
October 23, 2014 at 10:34 AM ×

Bond investors?
Sure we have pension regulations forcing the blind buying of worthless (in the end) government paper; we also have short sighted banks earning the spread along the curve and a few punters hoping they won't be the ones left standing at the end of the musical chairs game....


I think a true benchmark of faith in the eventual success or demise of the great experiment (aka QE) is the scale giving us a clue about the appetite for private assets i.e. equities.

I recommend "The economics of inflation - A study of currency depreciation in post war germany" by Costantino Bresciani Turroni.
It's a good roadmap of what we will live in slow motion in the coming years.
Equities : eventually to DA MOON (with a few hiccups along the way)
Gold: surprisingly slow to start, but when it does...oh boy!

Reply
avatar
Polemic
admin
October 23, 2014 at 11:08 AM ×

I think the most stunning point from that table is how bond yields basically flat line 3.5-4% throughout it all.

another witness in the case against over analysing potential fed moves when playing the bond markets?

Reply
avatar
Leftback
admin
October 23, 2014 at 3:11 PM ×

Is that a cannon you're pointing at me, or are you just pleased to see me?

Reply
avatar
Leftback
admin
October 23, 2014 at 3:29 PM ×

LB has a suspicion that Bullard's real purpose was to curtail the parabolic run of the USD, and that he achieved his aim with the QE4 talk. DX having another run at 86 here, and the Carry Monkey is back on board, so it looks like Mr Shorty will be in a world of hurt today and tomorrow.

We decided to be vol sellers yesterday, that drop had certainly sucked in a lot of punters to buy protection. SPX 1965 is now in Mr Market's sights. Today and Monday are the last POMO days, then like Derek Jeter they will be retired but not forgotten.

In fixed income, we may have to squeeze a little more fear out of the system before receiving rates becomes attractive again. Not there yet.

Europe data wasn't half bad today, but as Mr T suggested here, the decent US data trumped. Still, EURUSD does look like a bottom might be in.

Event-driven macro ahead, with the ECB stress tests and the Brazilian elections looming. We think that the rumour has already been sold and it might be time to buy the news. Place your bets...

No Santa rally in Spoos, not for this punter's money. Sideways action until we see the US data weaken again, and the bond market will likely lead the way as usual.

Reply
avatar
CV
admin
October 23, 2014 at 3:56 PM ×

"No Santa rally in Spoos, not for this punter's money."

Aww, come on LB ... live a little ;). Fair point on the bond market though, you have had a decent hand here this year, so I suppose the good'ol 10y will tell us when to move.

The EURUSD could be interesting. A major part of the washout in the EUR has been driven by portfolio flows and if they come back, it could be happy-rally time for a few months in Eurozone assets. Eventually of course, reality will take over and it will all turn pear-shaped, but not yet I think.

Claus

Reply
avatar
Leftback
admin
October 23, 2014 at 4:34 PM ×

Since the GFC, we usually only have had ONLY one thing going pear-shaped at a time, and for the time being it's been EMs and commodities. Europe will get its turn again at some point, but it's not the obvious pink flamingo at the moment (cough: US).

Reply
avatar
Leftback
admin
October 23, 2014 at 4:58 PM ×

Magazine cover indicator. Go long EURUSD?

Economic Dead Parrot

Reply
avatar
Polemic
admin
October 23, 2014 at 5:12 PM ×

Brilliant LB , well spotted. I must get on and light the beacons and spread the word ..ECONOMIST COVER ALERT !! DING DING

Reply
avatar
Mr. T
admin
October 23, 2014 at 5:46 PM ×

UNP is a great case study for the fed - their business is going gangbusters, their customers are getting squeezed from capacity problems, profits are good and still capex is muted relative to historical spend, having real impact on the ability of their customers - industrial America, to move products. The fed has no problems seeing transmission problems in finance - the need to get banks to lend being integral to the economy as a whole. But how to get UNP et al to redirect some of their buyback+div into capex to unclog the rail congestion everyone is complaining about? Is this because of too much consolidation creating cartels with not enough incentive to compete? Is it because management does not believe in the recovery enough to invest? Last q capex was $1158 vs $1272 spent on capex+div with an increase in debt of ~$650.

Given the amount of time spent studying the transmission mechanisms in financial sector, and the amount of policy targeting it, it's surprising to me that more time is not spent trying to affect mgmt capex decisions. I'm not suggesting there is anything inherently wrong with UNP choices, but that if the goal is to incentivize growth creation something is wrong. Should buybacks be less tax efficient? Accelerated depreciation schedules? Given the current landscape I cant see how a corp-targeted QE4 would change the situation - it would only result in higher leverages in the capital structure.

Reply
avatar
abee crombie
admin
October 23, 2014 at 5:50 PM ×

Interesting historical comments MM

Jim Grant has been making the point for many years about the difference between debt deflation (ala Irving Fischer) and price deflation (ala lower everyday price at Wal Mart). Academics and CB's staff seem to have a hard time dissenting the two and it has led to the current hysteria over deflation.

Its also interesting to note that there are many different types of inflation, asset inflation, CPI inflation (which is based on a basket not all of us would feel is representative) and the ex Food and Energy Inflation which apparently doesnt count, and of course the two big ones, Wage inflation and Inflation Expectations.

On the latter it seems CB's will pretty much do anything to see a little (but not too much) of wage and expectations increase with little regard to the other types of inflation. Add in a global labour force, 2 tiered technology workforce and overcapacity in China and the dynamics seem pretty hard for most to grasp, myself included.

Gold isnt coming back as the center of the system (although it role in stabilizing imbalances is simplistic and purse, the ajdustments are something no government today will accept) but I think it might still play a role in investors portfolio. Wheather that means gold will be higher next year for now, who knows, but in 20 years I would expect that the yellow metal keeps up with general asset prices and ALSO provides a decent hedge against CB mistakes.

Reply
avatar
Polemic
admin
October 23, 2014 at 6:45 PM ×

Mr T - I am glad that you suggest that the blockage is no longer with the banks but with big corporates. The next down he chain. I fully agree.
I think the venom and retribution that has so far been held only for bankers is moving downwards to encompass large corporate in general.

I am looking forward to the same stimuli through regulation and punishment to hit the huge balance sheets of large corporates and hopefully the same threats and cap to board pay. I see the chairman of Tesco is walking of with £10m. That should be enough to light the peasant fires!

Reply
avatar
Anonymous
admin
October 23, 2014 at 7:04 PM ×

Apple are a prime example. They suck money out of the system when discretionary spend goes on apps, iTunes etc. 500 bln or whatever they have sitting in an untaxed bank account. Borrow for stock buybacks. I've no problem with them operating in the most efficient way possible but, the money suck is where a big problem lies for the economy.

Reply
avatar
Leftback
admin
October 23, 2014 at 7:58 PM ×

A very sore bottom for Mr Shorty today, as the SPX train has just pulled into 1960 station.... the 1960-1965 and then 1980 area would represent the last major technical hurdles ahead of Mr Market here.

These retracements can be a real bitch.... the 50% and 61.8% fibs have already been left in the dust.

Reply
avatar
Anonymous
admin
October 23, 2014 at 10:18 PM ×

Traders back to heavily net short the 10-year Treasury. Goldman is also still recommending clients short US notes...

http://imgur.com/fYNsLsL

Reply
avatar
Polemic
admin
October 23, 2014 at 10:34 PM ×

Heard today in the Ursine Club on Pall Mall.

"Waiter? Bring me another resistance, this ones broken"

Reply
avatar
Anonymous
admin
October 24, 2014 at 1:01 AM ×

Russia’s economy, the sanctions, and especially finance, with Putin’s advisor & other Russian economics & finance experts:

Sergey Glazyev (S.G)

Khazin Mikhail Leonidovich (M.L)

Vladimir Yuryevich Levchenko (V.Y)

It’s 1hr 20mins, fairly technical and detailed.

https://www.youtube.com/watch?feature=player_embedded&v=CH4Pcgoi3eE

Reply
avatar
Anonymous
admin
October 24, 2014 at 9:04 AM ×

C Says
The V is in so now we get the choppy disagreement has last time shorts meet latecomers recovering their dating do.
Dare say most gaps in equity opened down have been filled more or less.

Reply
avatar
Anonymous
admin
October 24, 2014 at 9:05 AM ×

C Says
The V is in so now we get the choppy disagreement has last time shorts meet latecomers recovering their dating do.
Dare say most gaps in equity opened down have been filled more or less.

Reply
avatar
Anonymous
admin
October 24, 2014 at 9:05 AM ×

Or daring do even yogi.

Reply
avatar
Anonymous
admin
October 24, 2014 at 1:36 PM ×

C Says,
I get the suoer quick liquidation and it's even quicker recovery ,I do. Zero to do with anything ,but fast twitch muscles ,and those in question are not between the ears if they are pushed for holding purposes. I say that because the standout for me this earnings season is just how many of the big blues known as Buffets moats, are in trouble. Most of this stuff would in the past have been the place to go for defensive moves against broader overpricing issues. This time they don't fulfil that criteria unless one is blind. The world is changing and some of them have not changed with it fast enough.

Reply
avatar
Anonymous
admin
October 24, 2014 at 3:24 PM ×

good stuff:

http://traderfeed.blogspot.com/2014/10/what-is-different-about-this-market.html

Reply
avatar
abee crombie
admin
October 24, 2014 at 3:40 PM ×

Mr T, going back to your point about how do you get companies to spend (and demand for loans, so banks can lend aside for buybacks and divi recaps) it is all about top line growth, and to a lesser extent capacity utilization, IMO

If CEO's see improving top line growth, they will invest, otherwise they are happy to sit and buyback stock to increase EPS. DRAM and Airlines are a perfect example again of industries that were once known as hyper cyclical but now seem to be much more conservative in their spending. There is no irrational exuberance by those companies CEO's quite the contrary they are all about maximizing margins now.

Software is one of the few places where talent and money still flows with little regard to margins/ profitability (biotech, clean tech are others). But the rewards from animal spirits in those markets go to mostly well educated and richer ppl anyways, so it doesnt help the bottom class and they just spend it on million dollar NYC/Miami/Malibu apartments with little effect on the economy overall

All the asset price inflation stays within a fairly well defined segment of the population. It doesnt trickle down.

Reply
avatar
Leftback
admin
October 24, 2014 at 4:31 PM ×

Punters still in love with the US recovery and the USD rally might want to consider today's new home sales data, complete with downward revisions going back to May, and gaze upon the chart of the XHB. If housing is indeed the engine of the recovery, why is this one of the most bearish charts you can find?

While not in the camp that expects and eagerly anticipates another 2008-style Big One, LB is moderately bearish Spoos, but much more bearish DX. We think that once the world views the soft and soggy reality beneath the US Emperor's suit of new clothes, investors will rotate out of US growth stories and into (emerging) markets that offer better value, higher yields and more genuine growth stories. This will also revive a host of dollar hedging strategies that have been left for dead by the side of the road "with a spike right though my head..."

On the topic of the Greenback, when Yellen says "we are not selling any bonds", what she really means is "we are not selling any bonds, and there is no effing way I can raise rates, so don't go getting asshole long USD here, because that would slow the US economy".

The intent of CBs is a) to keep rates low and b) to try to pin FX into ranges that can then be tweaked occasionally to prevent deflation in one area or another. Hence DX is going to be constrained between 75 and 90 for years and years ahead, EURUSD between 1,20 and 1,40 etc...

Reply
avatar
Mr. T
admin
October 24, 2014 at 5:52 PM ×

We think that once the world views the soft and soggy reality beneath the US Emperor's suit of new clothes, investors will rotate out of US growth stories and into (emerging) markets that offer better value, higher yields and more genuine growth stories.

But isn't the DX trade based not so much on who is soft and soggy but who is softer and soggier? Europe is really in a mess, and its not clear at all at least to this punter what will get them out. At least in the US there are bright spots.

I think the long dollar trades will continue to work. Outside of some mean reversion bets there are not really catalysts I see for eur,gbp,yen strength, but the catalysts for weakness are numerous.

It might be a crowded trade but I'm nibbling short some ED and ZN's as well. The risk of some kind of 1987 washout and dramatic flight to safety seems to have come and gone. (Sorry Nico) Baseline here is US stays slow and steady, decoupling hypothesis comes back. Too much vol in spoos to make directional bets.

Lastly about XHB and housing in general I think its overwatched, last cycles catalyst, etc. Housing goes through long periods of nothing, and its not the engine of growth its hyped up as. The real US growth engines are energy, startups, ag etc. Plus there is some interesting research out on the correlation of student loan debt to home ownership - basically previous generations of buyers would get out of college and be able to afford a home + pay off student debt, whereas now an increasing number are barely able to pay off the student debt. (And no, the answer here is not lower mortgage rates...). I think the point is that there are some real secular headwinds housing is fighting against.



Reply
avatar
Anonymous
admin
October 24, 2014 at 6:22 PM ×

C Says,
"But isn't the DX trade based not so much on who is soft and soggy but who is softer and soggier?"
Exactement, mon ami!!
Which is why LB is wrong and Yellen will not win this race.

Reply
avatar
Anonymous
admin
October 24, 2014 at 7:16 PM ×

What Mr. T said is definitely correct, however aren't those factors already "priced in"? I do not have a good measurement, but it looks like that theme had been around for several months now.

LB's prediction on the US weak data is still too early to tell. Probably the picture is clearer by the end of this year.

Reply
avatar
Anonymous
admin
October 24, 2014 at 7:29 PM ×

C Says,
Perhaps one should not be looking at the past few months ,but the future years? Then some consolidation from the past few months looks rational in terms of expecting continuation.
I do of course acknowledge the 5 minute macro world we live in.

Reply
avatar
Leftback
admin
October 24, 2014 at 8:33 PM ×

"What Mr. T said is definitely correct, however aren't those factors already "priced in"?"

This is in fact my point, and the EURUSD chart might just be beginning to show that others agree with me. This is another of those infamous TWINE ("The world is not ending") trades. Btw, if anyone thinks there will be big negative surprises in the ECB bank stress tests, then I have a small European principality to sell you.

Reply
avatar
Polemic
admin
October 24, 2014 at 8:41 PM ×

Agree LB, having flagrantly nicked your point on The Economist Cover and made it my own (in the way so celebrated on X-factor .." you just took that song and made it and made it your own" which does beg the question about copywriter theft but anyway)...

Anyway having nicked it and made it my own I wrote a load of gumph around it that basically ended up saying "BUY EURUSD". The post can be found at the other place.

Reply
avatar
Anonymous
admin
October 25, 2014 at 8:27 PM ×

Has anyone considered that the drop in oil prices and commodities was an "engineered" event, timed to coincide with the end of QE and POMO's?

Reply
avatar
Anonymous
admin
October 26, 2014 at 1:20 AM ×

Oil. Go back to June. Any newsflow on ISIS or Ukraine was sold. Libya civil war, fighting near Libyan oil fields, rockey struck some tanker? Oil sold. I'm talking about as the news happened. Back when supply was tight and any newsflow came on Iran, Libya or Syria it was an easy dollar upside. First attack on Baji refinery in Iraq? Sold.

Reply
avatar
Nico G
admin
October 26, 2014 at 6:30 PM ×

yeah they tried so hard to avoid a 'Israel on Iran' $148 kingdom of fear that they ended up pressing the other way.

Reply
avatar
Nico G
admin
October 27, 2014 at 6:22 AM ×

meanwhile.. RUB 42

tut tut

Reply
avatar