Was that the "Gong"?

TMM "Note to self": USD/JPY will remain difficult. DO NOT TOUCH. We are out of that one as the mood turned "carry off" in general. The EUR/GBP we will hang on to.

TMM must admit that, as optimists on the US economy and having taken a constructive view of equities this year, they have found today's post very difficult to write. This is because after a pretty good earnings season (where revenues posted their largest upside surprise since Q4 2004) equities still look pretty cheap on their valuation models and have been remarkably resilient in the face of several idiosyncratic shocks this year. While Q1 growth data disappointed to the downside, certain survey and supply side data were suggesting a reacceleration to around 3.6% annualised GDP going into H2. Indeed, today's post was - until yesterday - going to be about how TMM were coming around to the view that the bond market was overpricing the risks to growth (based upon a combination of arithmetic and forward real rates) and that they were getting to close to pulling the trigger and going short Treasuries. But yesterday's Non-Manufacturing ISM data have them wondering if the "Gong" has just been rung...

In an eerily similar manner to 2010, the US data has begun to roll over, with Non-Manufacturing ISM adding to the list of Philly Fed, the Global PMI and Jobless Claims. As above, TMM's GDP model (see chart below, white line vs. actual GDP - pink line) had been, until recently, pointing to growth in the 3.6-3.7% annualised region. However, the most recent survey data have led to a dramatic reversal, with the model now consistent with annualised growth of just 1.6%. Now, the model not even close to perfect (it does not include household or government consumption inputs, for simplicity), and certainly, it is possible to argue that the most recent data may be the product of statistical factors related to a late Easter, but it is hard to ignore the fact that a trend in the data has emerged and it is increasingly looking like the US is once again growing sub-trend, widening the output gap further.

Regular readers will be familiar with the below chart of Economist 2011 GDP consensus expectations lagged two weeks (white line) vs. the 5y5y forward real rate (orange). Obviously, both have been moving lower over the past month, with the bond market seemingly settling at just below 2.8%, while analysts have settled on 2.9%. Plugging in 1.8% for Q1, that would suggest in order to match the economists' yearly 2.9% figure, that GDP would need to be growing at an annualised 3.2% for the rest of year and a mere 3% under the bond market's pricing of growth. Until yesterday, TMM thought that was not a big hurdle and that the time to short Treasuries was near. However, if the model prediction of 1.6% is plugged in, that would require H2 annualised growth of around 4% (or 3.9% under the bond market metric), which is a significantly higher hurdle. TMM are increasingly concerned that markets may be sleepwalking into a growth scare...

...particularly ahead of tomorrow's Payroll report, about which TMM's model (see chart below, orange line) reckons economists are overly optimistic in looking for a 200k private jobs increase vs. 110k on our model.

The trouble for markets, and growth expectations, is that real rates have fallen a great deal in past couple of months, such that the 5y5y forward real rate is now plumbing levels usually seen prior to a Fed easing. Under this prism, it is hard for nominal yields to fall much further unless either inflation breakevens fall and/or the Fed eases further...

Oh dear... we said it... could this be the time that the "Gong" rang for QE3?

Or rather, the time the "Bell Tolled" for Equities and risk assets more broadly?

The below chart shows 10yr yields (white line), 5y5y breakevens (orange line) and 5y5y real rates (yellow line). In 2010, real rates initially fell in response to slowing data but then gradually dragged breakevens lower as well to the point that a growth scare morphed into a deflation scare. Sure, real rates can go a little lower, but TMM suspect that with commodities being given the short shrift that it will be breakevens that take leadership.

In short, TMM have found this a very difficult post to write upon the backdrop of their, up to now, optimistic views of growth. However, given positioning in EMFX and equities, a demonstrable turn in the macro data and little room for the bond market to cushion these growth downgrades that we are at an important inflexion point. TMM believe that either the data has to rebound sharpish, or else talk of QE3 is likely to intensify in the coming months. TMM are struggling to believe that they are writing these words...

It is a shame, as we had hoped that the US would tough it through to the point where they became competitive enough to re-compete against the new world, which is all the more frustrating as that cavalry may well be coming to the rescue in the shape of the stories in the FT today on US competitiveness re: China and Siemens' concerns re: Brazil hint that that structurally the way companies think may be changing. But will they be in time to make it a Waterloo rather than an Alamo.