Posted in Newsclips, Samples

“Concerted Global Growth” a Thing of the Past?

  • Bloomberg – Global Growth Is Peaking—But Not Petering Out
    World growth peaking, not petering out, economists say
    What’s happening, economists say, is that the broadest period of world growth since 2010 is peaking at an elevated level, not petering out. And the driver of the expansion is shifting to a fiscally juiced U.S. economy from a slowing Europe and Japan. But they acknowledge that their forecasts of another year or more of solid economic activity have become more uncertain after a soggy start to 2018, an outbreak of trade tensions and a ratcheting up of concern over Syria. “If you had talked to me two months ago, I would have said there are upside risks,” to global growth, said Ethan Harris, head of global economics research at Bank of America Merrill Lynch in New York. “Now I’m seeing downside risks.”
  • Bloomberg – Goldman Sachs Says You Must Own Commodities in These Tense Times
    Geopolitical conflicts seen raising risk of supply disruptions
    The case for owning commodities has rarely been stronger, according to Goldman Sachs Group Inc. With raw materials rallying on escalating political tensions across the globe and economic growth remaining strong, the bank’s analysts including Jeffrey Currie doubled down on their “overweight” recommendation. They reiterated a view that commodities will yield returns of 10 percent over the next 12 months, according to an April 12 note. The Bloomberg Commodity Index is up more than 2.5 percent this week, the most in two months. Another raw materials gauge, the S&P GSCI Index, has rallied over 5 percent this week to levels last seen in 2014.
  • Summary

    Concerted economic growth is threatening to end with data misses now a global concern. We have a line in the sand at 60% of economies growing above one-year averages. A drop below (currently 67%) would sustain higher volatility and produce larger drawdowns across risk assets. 

    Comment

    The Global Citigroup Economic Surprise Index (orange line) has dropped below zero, telegraphing a continued drop by realized data changes (green line). Concerted economic growth was in its greatest form October 2016 through April 2017. 

    The bursts in economic data beats (orange line) from October 2016 through March 2017 and then again from July 2017 through December 2017 coincided with some of the strongest returns produced by developed and emerging equities, industrial metals, and energy.

    Equities have recently run into trouble while both surprises and data changes come off their fervent pace of improvement. U.S.Treasuries have stalled with the U.S. 10-year note refusing to push toward the most-discussed 3.0% threshold. 

    All in all, whether economic data changes remain above one-year averages or not will dictate returns through the end of 2018.

     

     

    The percentage of economies (35 in total) beating expectations has fallen to a paltry 31% (orange line). However, 67% of economies are still generating realized growth (i.e. data changes) above one-year averages (blue line). We have previously shown drops below 60% would sustain higher volatility and produce deeper drawdowns across risk assets. 

     

     

    On the flip side, markets are acknowledging central banks’ hawkish rhetoric by pricing in more and more tightening. The chart below shows the expected number of hikes by central banks for the next 12 months (OIS). We believe a drop below 60% of economies producing above-average data changes would cause a reduction in expected tightening just like late winter 2017.

     

     

    The next chart shows the Citigroup Economic Data Change Indices for the G10, EM, BRICs, APAC, and Latin America. Recent slowing in economic growth has been focused on the G10, especially the Eurozone. Conversely, BRICs and Latin America have found a second wind with economic data improving relative to one-year growth rates.

     

     

    We use the economic surprise and data changes above for the G10, EM, BRICs, APAC, and Latin America to forecast asset returns for the next three months. Not surprisingly, BRICs (6.5%) and emerging market (2.5%) equities are expected to produce healthy returns. The S&P 500 is expected to move sideways to modestly lower (-0.6%). 

    Commodity markets are expected to offer positive returns, but not likely to the degree expected by Goldman Sachs in the article above. Precious metals and energy top the list, followed by tepid returns by agriculture and industrial metals.

    Sovereigns like U.S. Treasuries will remain a frustrating investment as the risk-on/off dynamic continues to break down. The Federal Reserve’s heavy inflation focus (over and beyond financial stability) does not look ready to fade. 

     

Posted in Featured, Newsclips, Samples

Corporate Buyers Returning as Treasury Yields Stabilize

  • WisdomTree – If Focusing on Fundamentals, Buy the Dip in IG Credit

    After making fresh cycle lows in early February, IG credit1 spreads have widened by approximately 24 basis points (bps) over the last two months. In our view, if this was the beginning of the end for this credit cycle, we would have expected to see this move confirmed by a similar shift in high-yield (HY) credit2 spreads. Over long periods of time, IG and HY credit spreads tend to have a fairly strong correlation because credit spreads serve as a barometer of risk. When the economy is healthy, corporate bonds pose less risk of being downgraded or falling into distress. When the credit cycle is turning, spreads widen as investors sell out of risky debt. Curiously, the most recent move appears to have affected IG more than HY.

  • Citi Private Bank – Overweight US high yield despite challenging outlook

    With long-term US Treasury rates stabilizing, US investment-grade (IG) corporates were able to post their first positive month of 2018. Albeit small, IG corporate benchmarks gained 10 basis points (bp) in March, bringing year to date returns to -1.9%. Of course, the best performing components of IG last month had been the areas beaten down the most from the rise in US rates (i.e., long duration and AA/A rated issuers). While rising US yields are largely responsible for IG underperformance this year, weakness can also be attributable to rising US-China trade tensions. With the rise of global risk aversion and equity volatility, US corporate benchmark spreads have widened 25bp to 110bp. This is the largest move wider in benchmark spreads since the oil recession in 2016. Changing supply dynamics and rising hedging costs have also played a role. Though IG supply started the year slow, recent weekly volumes have been in line with 2017’s record pace. More notable has been the pick-up of issuance in longer-dated maturities, which has increased 60% versus the same period last year. Moreover, the demand from European investors has slowed, as the rising cost to hedge USD has reduced the yield pick-up from buying US corporates. This waning demand has exacerbated the underperformance, in our view.

  • Summary

    The stabilization of Treasury yields has enticed some investors back into credit markets. After a long absence, net inflows have returned for pure U.S. corporate bond ETFs. The recent bullish breakout by long term Treasuries suggests several weeks of consolidation ahead, making an opportunistic approach to credit exposure attractive. Leveraged loans have offered superior risk-adjusted returns in 2018 but may face headwinds if yields and implied volatility trend lower. 

    Comment

    We first noted U.S. ETF investors shying away from pure corporate bond exposure in late January. Only two weeks later the volatility repricing prompted record outflows from investment grade and high yield corporate bond funds. Sentiment appears to be turning after the 10-year Treasury yield fell short of the key 3% threshold.

    The chart below shows the four-week moving average of net flows for all U.S. corporate bond ETFs by type. Pure investment grade (light orange) and high yield (dark orange) funds have seen net flows turn positive this month.

     

     

    A post in late February estimated the path of U.S. 10-year Treasury note yields under a variety  of central bank stimulus scenarios. None of the scenarios, even those allowing for additional balance sheet expansion by the ECB, saw 10-year yields sustain a rise above 3%. We commented in the February post:

    All scenarios had U.S. 10-year yields grazing 3.0% to start 2018 before declining yet again. The depth of a drop in yields becomes more exacerbated in the event U.S. and Eurozone economic data growth falls back to one-year averages or below. 

    A continued period of above-average economic growth would make any rebound by U.S. Treasuries less severe. But, all scenarios indicate 3.0% could be a difficult threshold to break in 2018. A deviation from these forecasts (i.e. break above 3.0%) would indicate a new latent factor is dominating investor reactions. 

     

    Long-term Treasury yields have followed the program so far, sustaining their break below range lows. Similar bullish breakouts have seen Treasury yields trade sideways to lower over the next 2 months. Credit market investors appear to be positioning for this outcome, taking advantage of wider spreads and higher yields. 

     

     

    Some new trends are developing in credit market exposure. Most investors still expect rising short term interest rates as the Fed keeps tightening. Steadily rising LIBOR and very strong risk-adjusted performance is luring investors into bank loan ETFs. The chart below shows the 4-week average of net flows for U.S. leveraged loan funds.

     

     

    The Citi piece above suggests the outlook will continue to favor leveraged loan exposure:

    US variable rate high yield bank loans also offer an attractive complement to HY bonds. LIBOR rates are expected to rise over the next 12 months, which should continue to fuel demand for floating-rate assets. Repricing and refinancing risks remain elevated, with roughly 75% of the loan universe trading above par. However, with average LIBOR-spreads around +375bp, this implies an all-in yield around 6.0%, which is fairly comparable with US HY bonds. More important, during bouts of risk aversion, bank loans are much less volatile 

    We’ve highlighted the potential for leveraged loans to outperform in a rising rate, rising volatility environment since January. Leveraged loan outperformance over high yield bonds depends both on rising interest rates, which adjustable rate loans capitalize on, and rising implied volatility, which makes this option more valuable. The Citi piece makes another point that bank loans have delivered superior risk-adjusted returns as volatility roiled other markets. 

    The last chart shows 1-year reward to risk ratios (average daily return / standard deviation of returns) for Bloomberg Barclays total return indices for U.S. investment-grade, high yield and leveraged loans. The leveraged loan index has offered very strong risk adjusted returns since 2017, even as high yield and investment grade tumbled in early February. Stable-to-lower Treasury yields and diminished volatility would dampen performance. The big risk for leveraged loan performance is a sudden fall in Treasury yields that sees rates adjust lower. 

     

     

    Conclusion

    Stabilization in Treasury yields has credit market investors boosting their exposure again. Investment grade, high yield and leveraged loan funds are all seeing inflows as investors position for rising short term rates, stable-to-lower longer term Treasury yields and persistent volatility. Leveraged loans have delivered superior risk-adjusted returns but may face headwinds if we see volatility fall and Treasury yields move lower.

Posted in Featured, Newsclips, Samples

Have Surveys Become False Prophets?

Summary

Financial markets are unfortunately suffering from a circular reference due to group-think and herd mentality. We use the information and ideas from ‘the group’ as a heuristic to form our own opinions. The world has become exponentially more complicated and inter-connected, therefore to remain functional we allow the crowd to help us make decisions. Unfortunately, positioning in financial markets become polarized and surveys of the economy are of waning utility.

Comment

Responses to surveys about the economy are showing much less attachment to reality, meaning future changes in growth and/or inflation. Similarly, positioning in both risk and safe assets have become slower-moving with an ability to persist for months on end. We can partially blame passive investing, but its rising force is more a product of this herd effect than instigator. 

The chart below shows the rolling five-year average length of long and short positioning by large speculators across major investments. Net positioning from the CFTC’s Commitment of Traders report are used to produce long (bullish) and short (bearish) cycle lengths for U.S. 10-year notes, euro, pound, yen, S&P 500, and NASDAQ.

Speculators maintained bullish or bearish positioning for significantly longer periods of time heading into the financial crisis. The length of these cycles move higher from near five months to well-over 10 months by 2009. A new high in these cycle lengths was achieved in late 2017 at over 10.5 months. Speculators are operating like ocean fish in large schools, choosing long or short positioning in concert.

 

 

Surveys for economic growth and inflation are likely plagued by this same phenomenon. The advent of the internet and instantaneous news caused a sea change in the mid-to-late 1990s. We noted last week the ending of ISM Prices Paid Index as a predictive indicator near this same period.

The chart below shows U.S. soft (peach) and hard (blue) data since 1974 in the top panel with their spread in the bottom panel. The story of soft, survey-based data greatly exceeding hard, realized data has not left us. Trump’s election has generated the largest acceleration of rosy survey responses relative to actual economic conditions away from the end of a recession. 

 

 

Upbeat surveys are seemingly producing stronger equity returns than in decades past. The scatter-plot below shows 12-month changes in soft, survey data (x-axis) versus the S&P 500 broken down by period. The blue line representing 2008 – 2018 is the steepest, implying better surveys are met with higher returns than pre-crisis and much more than pre-Dotcom. 

 

 

But, we have a problem in surveys failing to accurately predict coming economic growth and inflation. The next chart shows the composite of soft, survey data (x-axis) versus hard economic data three-months ahead (y-axis). In other words, how well do surveys predict the next quarter’s realized economic growth?

Bullish surveys for the economy have seen less and less realized improvements over time. Their relationship since 2008 has been tepid at best.

 

 

Productivity remains an enigma given the many moving parts of demographics, technology, and globalization. The chart below shows the same composite of soft, survey data (x-axis) versus real output per hour year-over-year (y-axis). Positive surveys had been met with greater productivity from 1974 through 1995, but this dynamic seemingly ended with the financial crisis.

 

 

Most important for the Federal Reserve, surveys for rising prices and wages are offering little-to-no utility in forecasting realized inflation. The next set of charts show the same composite of soft, survey data (x-axis) versus headline CPI, core CPI, and average hourly earnings (AHE) three months ahead.

We would expect a parallel shift lower (meaning same slope) if the issue was simply a lower natural rate of growth. But, the slopes have dampened and/or changed their sign (positive to negative).

Core inflation and wages are refusing to chase surveys higher. The ISM, NFIB small business, and regional Fed surveys anticipating swift rises in inflation may have truly disconnected from reality. The relationship of better surveys leading to inflation existed prior to the mid-1990s, but has since faded. The Fed has professed these very surveys are favored predictors. We fear these guides may now be false prophets.

 

 

Bottom line:

  • Speculators are impaired by herd effect with long/short positioning in major asset classes lasting 10+ months. 
  • U.S. equities (S&P 500) are chasing rosy surveys of economic growth to a degree not seen in decades past.
  • Inflation has been disconnected from surveys for rising prices/wages since the mid-1990s.

Posted in Featured, Newsclips, Samples

Inflation > Financial Stability, Fed Won’t So Quickly Respond to Market Turmoil

    • Bloomberg – Tim Duy: The Fed Will Look Past This Turmoil in Markets
      Friday’s jobs report is more important for the path of interest rates than the recent drop in equities.
      The declines in equities so far are unlikely to have much impact on rate policy given the current environment where, according to the Fed, the economy sits near or beyond full employment. More important for the path of monetary policy is this week’s employment report for March. A mix of continued strong job growth, a further decline in the unemployment rate, and stronger wage growth would overshadow recent equity declines and further cement the Fed’s case for additional rate hikes.
  • Summary

    Powell and gang are expected to have muted responses to financial market turmoil, unlike their recent brethren. The rise of inflation as the Federal Reserve’s main focus over financial stability is a very important development, implying the ‘Fed put’ is likely much further away than expected.

    Comment

    The Federal Reserve remains the most hawkish since prior to the financial crisis according to official speeches. The chart below shows the spread between hawkish and dovish word counts on a rolling 25-speech basis.

     

     

    The next chart shows the count of inflation-related words in orange and financial stability-related words in blue. Financial stability, meaning words like ‘equity markets,’ ‘leverage,’ ‘volatility,’ and more, reigned supreme during the modern era of the Federal Reserve. But, inflation captured the attention of Yellen and now Powell et al since late 2015. 

    Financial stability concerns have dropped considerably since September 2016, while inflation concerns staged a swift rebound.

     

     

    The inflation versus financial stability race likely impacts the Fed’s reaction function to financial market volatility. 

    We can measure the Fed’s sensitivity to S&P 500 drawdowns using their reactions (i.e. hawkish-to-dovish leaning) found within these official speeches. The chart below shows the S&P 500’s drawdown from its highest high over the preceding 12 months on the x-axis. The percentage of Fed speeches offering hawkish rhetoric over the following three months are shown on the y-axis for the 1990 – 2006 (blue) and 2007 – current (orange) periods.

    The Fed proved significantly less sensitive to equity turmoil before the financial crisis (1990-2006), reaching an overall dovish tone only after ~30% drawdowns. Conversely, the Fed during and after the financial crisis have shown a strong tendency to calm markets with soothing dovish speeches after a mere drawdown of ~12.5%.

    We believe investors should prepare for a return to pre-crisis sensitivities, meaning the Fed will not react so quickly to equity jitters as long as growth and inflation fears brew. The post-crisis threshold of ~12.5% (or S&P 500 at 2514) could easily come and go.

     

Posted in Featured, Newsclips, Samples

Libor OIS Spread Not the Canary in the Coal Mine

Summary

Bill issuance and repatriation are offering a potentially short-term boost to the Libor / OIS spread. The onus going forward will be on inflation rebounding and economic growth remaining stable to keep the Federal Reserve from driving the target rate above the neutral rate. Markets are revealing only modest concerns, but languishing inflation and continued tightening policy would very likely boost credit/funding risks.

Comment

The U.S. Libor / OIS spread has reached its widest since May 2009 at 55.5 bps. The chart below shows this spread (red) along with U.S. three-month bills (blue) and rate hike expectations for the 12 months ahead (gray).

The rise in short-end yields on the heels of an increasing hawkish Federal Reserve has not always shown a strong connection to the Libor / OIS spread. 

 

 

This story includes many moving parts, namely bursting Treasury bill issuance and repatriation by U.S. companies of foreign holdings. The chart below shows news trends as one-year rolling z-scores (standard deviations from average) for funding stress (orange), repatriation (red), and bill issuance (green).

Anticipation of rising bill issuance and continued flows back to the U.S. from overseas are dominating the news wire. The tax plan offers incentives for repatriation, which is impacting dollar funding and shifting demand to very short-term assets.

 

 

The spread between 30 and 90-day commercial paper yields is nearing its widest post-crisis at 31.0 bps. A defensive shift has assets flowing to 30 over 90-day paper. Again, repatriation and also the hawkish bent of Powell et al are key drivers.

 

 

The chart below shows the impact of these key factors on the change in the Libor / OIS spread since November 15, 2017:

  • Financial leverage
  • FOMC rate hike expectations
  • USTs implied volatility (MOVE)
  • S&P 500 implied volatility (S&P 500)
  • Funding/credit stress (news trend)
  • Bill issuance (news trend)

These variables explain 65% of the variation in the Libor / OIS spread since 1986. Note we use the Libor / three-month bill spread as a proxy prior to 2002.

Rate hike timing is offering a very modest boost, while bill issuance, equity volatility, and funding stress dominate recent widening. We expect the impact of bill issuance to dwindle moving forward (becomes priced in), making the market’s perception of potential funding stress and volatility the key drivers. 

Fund stress has yet to rear its head with news trends quite low and high yield OAS very tight. Our theory is the Federal Reserve’s hopes for three-plus hikes in the year ahead would indeed tighten financial conditions. Inflation and wage growth failing to rebound would keep the reversal rate (or r*) near 150 – 175 bps. Taking the target rate above this range greatly boosts the probabilities both deposit/lending growth and financial leverage will contract.

For now, markets are buying the Fed’s inflation hopes, just see widening TIPS breakevens. However a failure for inflation and wages to ‘put up’ will have markets screaming ‘shut up.’ 

 

Posted in Samples

What’s Holding Back Productivity

Originally posted on December 27, 2017.  Sign up for a free trial at the bottom of this page to read our current research. 

 

 

Summary

In this webcast, we look at the poor productivity results in the United States and over ideas for why this is not a measurement problem by the result of deep structural problems within the United States.  We break this down into five sections:
  1. Metrics That Affect Productivity
  2. Jobs Wanted, Hard To Find Skilled Labor
  3. Are We All Playing Games and Buying Stuff on Amazon During Our Work Day?
  4. Well-being’s Impact on Productivity
  5. Zombies Still on the Rise, Potentially Keeping a Lid on Productivity

Metrics That Affect Productivity

The chart below shows one-year trading ranges (max-min) for U.S. 10-year note yields in blue and the five-year average for year-over-year unit labor costs in orange. U.S. 10-year note yields have traded within a paltry 58.7 bps range between 2.04 and 2.63 percent, rivaling the tightest range since 1980 occurring in June 2014.

Growth in unit labor costs (or lack thereof) help explain the lack of fear by investors over inflation. Productivity in the U.S. is attempting to make a rebound, but recent history has been full of false starts.

 

Jobs Wanted, Hard To Find Skilled Labor

         

         

 

  • The Wall Street Journal – (July 13, 2017Videogames Might Be Keeping Young Men Out of the Workforce
    America’s young men are increasingly giving up on work in order to slay virtual aliens and fight videogame wars, new research suggests. Academics from Princeton University, the University of Chicago and the University of Rochester say there’s ample evidence that since 2000, men who would otherwise be working are instead being drawn into immersive virtual worlds, giving up paychecks in the process. What’s more, these men are reporting higher levels of happiness compared with those who work, and they’re drawing on the support of mom and dad to stay there. The paper warns these men’s absence from the labor force is likely to negatively affect their employment and earnings prospects for the rest of their lives. The paper’s authors note that 15% of younger men who weren’t students didn’t work in the prior year as of 2016, a notable increase from the 8% who didn’t work in 2000. The rise of gaming “accounts for 23 to 46 percent of the decline in market work for younger men during the 2000s,” the paper’s authors write.

 

Are We All Playing Games and Buying Stuff on Amazon During Our Work Day?
(from newsclips)

Summary

The growth of social media and online gaming are potentially having a dampening impact on productivity. Companies may be inhibiting use of social media like Facebook and Instagram during work hours, but online gaming and Amazon remain quite popular.

Comment

The next chart gets more granular by assessing popularity for what we call ‘time wasting searches’ over the prior 24 hours. All times are central. Facebook (red) is the most popular choice across the nation early morning from 5 AM CT to 7 AM CT, along with searches for the news of the day (green).

Social media like Facebook, Instagram, and Snapchat become much less sought after during work hours (gray shaded area). Many companies block the use of social media and other entertainment, but loopholes appear likely for online gaming. Search popularity for ‘games’ (orange) dominates from 8 AM to 4 PM. 

Not surprisingly, Amazon remains in steady demand from 7 AM through late night at 1 AM. 

 

The desire for social media like Facebook and Instagram upon waking up are easily identifiable in the animated map below. Darker red shading indicates greater search popularity, which peaks around 5 AM and fades as people open the doors to their place of work.
The addiction to online gaming is real with its popularity bursting during work hours (darker red). Many online games are still accessible at firms blocking specific websites like Facebook and YouTube.
Lastly, the chart below shows the popularity of news sources often used by financial market participants. Twitter and Reddit, of course, include much more than financial news and updates but are clearly heavily in use. CNBC, Bloomberg, and the Wall Street Journal see the typical early morning pop in popularity followed by slowing demand throughout the workday.
 

 

Facebook and Twitter have rapidly grown as popular destinations for news and connecting to the outside world. But, labor productivity has likely seen little to no benefit with rising the distractions of social media, online shopping, and online gaming. The dopamine boost provided by these distractions and potential time-wasters make them difficult to put away. The bigger question is are workers afforded more and more time due technological innovation or are workers taking up more and more ‘work time’ with time-wasting activities?

 

Well-being’s Impact on Productivity
(from newsclips)

  • Bloomberg Business – (July 13, 2017Yellen Says Opioid Use Is Tied to Declining Labor Participation

    Federal Reserve Chair Janet Yellen, making her most expansive remarks on an opioid epidemic that’s ravaging American communities, indicated the problem is so pervasive it is holding back the nation’s labor market. “I do think it is related to declining labor force participation among prime-age workers,” Yellen said of the opioid epidemic while answering questions during testimony before the Senate Banking Committee on Thursday. “I don’t know if it’s causal or if it’s a symptom of long-running economic maladies that have affected these communities and particularly affected workers who have seen their job opportunities decline.”

  • The Wall Street Journal – (September 7, 2017Opioid Epidemic May Be Keeping Prime-Age Americans Out of the Workforce

    New research suggests a significant portion of the post-1990s decline in labor-force participation among Americans in their prime working years could be linked to the opioid epidemic. Conducted by Princeton University economist Alan Krueger, the study found that a national increase in opioid painkiller prescriptions between 1999 and 2015 may have accounted for about 20% of the decline in workforce participation among men ages 25 to 54, and roughly 25% of the drop in prime-age female workforce participation. “The opioid epidemic and labor-force participation are now intertwined,” Mr. Krueger said. “If we are to bring a large number of people back into the labor force who have left the labor force, I think it’s important that we take serious steps to address the opioid crisis.”

 

  • The New York Times – How Social Isolation Is Killing Us
    A great paradox of our hyper-connected digital age is that we seem to be drifting apart. Increasingly, however, research confirms our deepest intuition: Human connection lies at the heart of human well-being. It’s up to all of us — doctors, patients, neighborhoods and communities — to maintain bonds where they’re fading, and create ones where they haven’t existed.

 

We turn to Google search trends within each state’s boundaries in an effort to explain differences in productivity. Search trends offer a glimpse into the biases and sentiment of each state’s population. 

For example, we gather popularity of searches for social media like ‘Facebook,’ ‘Instagram,’ and ‘Snapchat’ versus a desire for physical social interaction like ‘rotary,’ ‘clubs,’ and ‘intramural sports.’ These search trends are capable of explaining nearly 54% of the variation in relative productivity by state. 

Is it possible languishing wages and technological disruptions changing the workplace are having a damaging impact on mental and physical well-being? We appreciated Chamath Palihapitiya’s comments regarding social media altering, potentially negatively, the way we make social interactions.

The chart below shows search trends coinciding with weaker state growth when at higher popularity. Not surprisingly, opioids make this list along with mental illness and addiction. However, the increased popularity of online games and Facebook are met with lower growth.

 

 

Conversely, the higher popularity of searches for rotary and clubs are found in stronger growth states. Low popularity for social clubs is met with weaker growth.

 

 

Zombies Still on the Rise, Potentially Keeping a Lid on Productivity
(from newsclips)

What is A Zombie?

 

We looked into the rise of ‘zombies’ across the S&P 1500 by calculating the percentage of companies with EBIT-to-interest expense ratios (3-year average) below ‘1.’ We began with the current list of S&P 1500 companies, therefore history will be skewed due to survivorship bias. Similar to the BIS’ calculations above, companies must be at least ten years old.

The chart below reflects the percentage of ‘zombies’ or ‘walkers’ found within the S&P 1500. So what is to blame? Low costs of funding, inefficient allocations via ETFs, and/or low U.S. Treasury yields relative to dividend yields?

       More on Zombies Corporations herehere, and here.

 

Last week we showed low-interest rates have given way to a plethora of zombie companies unable to produce earnings over and beyond dollars paid on interest expenses. The chart below shows the percentage of companies skating by potentially due to the low costs of funding. Darker shading indicates higher percentages of zombie companies

 

 

The next chart shows the relative growth (GDP) for each state to the average. Green shading indicates above-average growth, while red indicates those states falling behind. Many of the states with greater prevalence of so-called zombies are also less productive. 

 

 

Financial media is right to point at low-interest rates helping prop up companies who would otherwise have difficulty handling the costs of funding. The chart below shows U.S. 10-year note yields versus the overall percentage of zombie companies since 2000. Lower interest rates have coincided with a much greater number of companies with interest expenses dwarfing earnings.

The perpetuation of struggling companies has potentially been a major roadblock for what has been languishing productivity.

 

 

 

Posted in Samples

Worries About Bond Market Liquidity

Originally posted on February 14, 2018.  Sign up for a free trial at the bottom of this page to read our current research. 

  • Bloomberg – Credit Markets Are Stuck Playing Game of Dealers’ Choice
    Willingness to buy debt ‘clearly being tested,’ BofA Says

    In credit markets, it’s dealers’ choice — for now. That means credit spreads are in the hands of market makers as selling pressure in investment-grade bonds refuses to fade, according to Bank of America Merrill Lynch. Dealers bought a net $1.2 billion of corporate bonds on Monday after weekly flows to high-grade funds turned negative, write a team led by Hans Mikkelsen. Record weekly outflows from iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) are a double whammy of risk aversion and diminished appetite for duration, as this product tends to hold longer-dated debt. Dealers absorbed an estimated $5 billion in investment grade bonds last week, according to Bloomberg Trace data. Up until that time, dealers were net sellers to clients and affiliates to the tune of about $6 billion in 2018.

Summary

ETF investors’ interest in pure corporate bond funds began to fade weeks ago. Now jitters that were safely confined to equities have spread to credit markets. One-way investor flows and severely constrained dealer balance sheets are precisely the scenario corporate liquidity doomsayers warned about. Continued net outflows from U.S. corporate bonds could worsen the gap between the liquidity credit investors expect and the reality the market provides. 

Comment

We first highlighted a shift in ETF investor preferences away from pure corporate bond ETFs on January 30. At that time, U.S. investment grade and high yield funds had seen three consecutive weeks of net outflows. Net outflows have accelerated since, especially among high yield funds.

The chart below shows net 20-day outflows (weekly bars) for U.S. corporate bond ETFs by strategy. Pure investment grade corporate funds (light orange) and high yield funds (dark orange) saw a shift begin in December when 20-day inflows began to wane. Net inflows swung to net outflows in mid-January. Net 20-day outflows for high yield funds now exceed $7.4 billion. 

 

 

The corporate desk at our affiliate Arbor Research and Trading warned of deteriorating dealer willingness to support one-way flows on Friday. We highlighted their concerns in our weekly U.S. credit update on Monday:

As the week came to a close, the biggest thing to note, aside from increased volatility and spread widening, was the widening of bid/ask spreads. The liquidity that many accounts had taken for granted for almost as long as we can recall is going to be significantly reduced until the market settles down and flows become more balanced. Dealers were buying 1.38x more bonds than they were selling to clients during Friday’s session. To illustrate the point about how these client sale flows accelerated as the week progressed, dealers only bought 1.03x more bonds than they sold by the time Friday’s session came to a close.

The next chart highlights how total returns for U.S. investment grade and high yield indices continued to deteriorate after Treasuries found some footing. Sharp losses in risk markets finally triggered a bid for Treasuries just as jitters began to spread to previously tranquil credit markets. 

 

 

Despite seeing less severe net outflows, investment grade has underperformed high yield, but that isn’t unusual. The next chart shows 5-day changes in the Bloomberg Barclays U.S. Treasury total return index (x-axis) and the spread between 5-day changes in the Bloomberg Barclays U.S. high yield and investment grade indices (y-axis). This includes data back to 2009 and shows the degree of high yield outperformance is actually lower than we might expect. 

 

 

The scatter plots below show the same 5-day changes in the Treasury total return index on the x-axis and 5-day changes or the U.S. investment grade and U.S. high yield indices (y-axis). Investment grade performance has a tight linear relationship with Treasury performance and the last week’s move is right on expectations. 

While high yield has a looser correlation to Treasury performance, it also tends to see gains when Treasuries are seeing losses. The severity of net outflows in high yield is dragging down high yield performance. With dealer appetites for balance sheet risk constrained, any acceleration in investment grade outflows could knock performance out of line there. 

 

 

Conclusion

We have all been warned about the dangers of shrinking dealer balance sheets and risk appetites when investor flows become one-sided. High yield outflows are at their highest in years and rising treasury yields threaten similar outflows in investment-grade corporates. This will be the biggest test yet for how well the leaner balance sheet environment meets credit investors’ liquidity expectations. 

Posted in Newsclips, Samples

Ruh-Roh, Economic Data Beginning to Miss Expectations Across the Globe

  • Bloomberg – Dan Loeb Tells Investors to Keep Eye on ‘Rosy’ Growth Outlooks
    Dan Loeb said while he’s watching inflation and interest rates, the bigger concern is if investors are overly optimistic about earnings and economic growth. “The more pressing issue is whether the rosy assumptions that everybody has about earnings growth this year and next year will be met,” Loeb said Thursday on a conference call discussing results for Third Point Reinsurance Ltd., where he oversees investments. “I’m not saying they won’t be met, but it’s definitely something, given some of the recent economic data which tends to be noisy, we need to keep an eye on.”
  • Summary

    Economic growth remains strong across the G10, but a string of misses are raising red flags. Transitions to data misses and below-average data changes have historically been most prone to higher risk asset volatility and drawdowns. Slowing growth would pose a major problem for central banks like the ECB and BoJ contemplating an end to stimulus.

    Comment

    The chart below shows Citigroup Economic Surprise (top panel) and Data Change (bottom panel) indices for the G10, emerging markets, Latin America, and Asia Pacific. Data change indices measure actual data releases in relation to one-year average growth rates.

    Economic data surprises have greatly slowed across the G10 to begin 2018, following the lead of emerging markets. In fact, the more comprehensive global surprise index has fallen below zero, meaning more misses than upside surprises.

    The more important data change index for the G10 has yet to signal slowing realized growth rates. But, history suggests such strong growth will not last long in the event of a return to missing expectations.

     

     

    The next chart shows the percentage of economic surprises (green) and data change indices (dark yellow) that are above zero across all economies. Both percentages are retreating with only 53% of economies producing data surprises to end February 2018.

    Breaks below 50% of economies generating economic surprises and above-average realized growth have historically resulted in higher volatility and drawdowns across risk assets.

     

     

    The chart below shows a scatterplot of the percentage of surprise indices versus data change indices above zero. The size and color of each instance indicate whether or not global implied volatility rose (orange Xs) or fell (blue circles) over the ensuing three months.

    The transitions from beats to misses and ultimately below-average data changes results in the largest bursts of volatility across the globe. You will see the heavier dose of red Xs beginning just as both percentages fall below 50%. 

     

     

    The next scatterplot shows the same relationship between economic surprises and data changes, but the size and color of shading represent positive (green dots) or negative (red Xs) returns produced by the MSCI World Index over the ensuing three months.

    World equities are very susceptible to drawdowns during transitions below 50% by both metrics.

     

     

    The last chart offers median returns by asset class after the percentage of economies producing above-average data changes drops below 60%. The current percentage has fallen to 67%.
    The road becomes awfully bumpy for the S&P 500, emerging markets, developed economy equities, and U.S. high yield. Conversely, U.S. Treasuries and municipal bonds provide stable, positive returns.

     

Posted in Newsclips, Samples

Tightening Financial Conditions Will Pose a Problem for Powell

 

  • The Financial Times – ‘Powell Put’ assumption challenged as Fed chief shows hand
    Central bank chair says economic outlook has improved and is unfazed by market volatility
    In a marked departure from the more academic tone of his immediate predecessors in the Fed chair, the 65-year old signalled to Congress a willingness to look beyond bursts of volatility in financial markets and would tighten policy against a backdrop of a strengthening economy that may in due course reveal signs of overheating. The long-held view that the US central bank will temper tightening if equity and credit markets suffer bouts of turmoil is sometimes referred to as the Fed put. After years in which the Fed’s actual rate rises have failed to match its projections, investors now face the prospect that 2018 may result in the central bank not just meeting its current forecast of three rate rises, but exceeding it.

Summary

Powell may not be as deterred by falling equity markets as his predecessors, but will pay attention to broader measures of financial conditions. Our estimates for the reversal rate (or point of pain) resides near 150 bps, indicating additional hikes will continue to tighten financial conditions and hamper the Federal Reserve’s ability to fulfill hopes for at least three hikes in 2018. Rising core inflation is needed to push the reversal rate higher and keep financial conditions from tightening too quickly.

Comment

We can measure the Fed’s sensitivity to S&P 500 drawdowns using their reactions (i.e. hawkish-to-dovish leaning) found within official speeches. The chart below shows the S&P 500’s drawdown from its highest high over the preceding 12 months on the y-axis. The percentage of Fed speeches offering hawkish rhetoric over the following three months are shown on the y-axis for the 1990 – 2006 (blue) and 2007 – current (orange) periods.

The Fed proved significantly less sensitive to equity turmoil before the financial crisis (1990-2006), reaching an overall dovish tone only after ~30% drawdowns. Conversely, the Fed during and after the financial crisis have shown a strong tendency to calm markets with soothing dovish speeches after a mere drawdown of ~12.5%.

We believe investors should prepare for a return to pre-crisis sensitivities, meaning the Fed will not react so quickly to equity jitters as long as growth and inflation brew. The post-crisis threshold of ~12.5% (or S&P 500 at 2514) could easily come and go.

 

 

However, financial conditions have become less easy ever since markets priced in a 2019 hike on January 26th, 2018. The chart below offers the two most popular financial conditions indices calculated by Goldman (orange) and Bloomberg (blue). 

Bloomberg’s measure is pushing into tightening territory (above zero) not sustained since 2016. Rising Libor/OIS spreads, TIPS breakevens, and VIX are driving this index tighter.

Powell et al may not be as reactive to declining equity markets, but will certainly pay attention to a broader view of financial conditions.

 

 

The chart below breaks financial conditions into deposits/lending growth (blue) and financial leverage/volatility (red). The gray-shaded area represents equilibrium defined as +/- 1 standard deviation from long-term averages. Values above this band are contractionary, while anything below is too expansionary. 

We use these deposits/lending growth and financial leverage/volatility components to determine the Fed Funds rate capable of hindering the economy.

 

 

We began sounding the alarms in October 2017 about the December 2017 hike prompting tightening financial conditions for the first time post-crisis. Bloomberg’s index began to shed its easy bias from then on. 

The chart below shows our estimates for this ‘reversal rate’ (red line) along with the target (gray line) and Wu-Xia shadow fed funds rate (orange dots). The target rate resided below the reversal rate post-crisis until the December 2017 hike, explaining the reason financial conditions eased with each hike. However, going forward additional hikes would tap the breaks on easy financial conditions.

The saving grace for the Federal Reserve hell-bent on raising rates at least three times in 2018 would be a rebound in core inflation. PCE core was released for January 2018 at 1.5% year-over-year, failing to show a push toward the Federal Reserve’s 2% target.

 

Posted in Featured, Newsclips, Samples

U.S. Treasuries No Longer the Hedge They Once Were, Investors are Reacting

 

  • Bloomberg – With Rates on the Rise, Bond Proxy Stocks Turn Into Problem Children
    ETFs tracking dividend payers see biggest outflow since 2016
    In the years of rock-bottom interest rates, investors piled into a class of stock coveted for its consistent payouts. Now, as the Federal Reserve looks certain to raise rates at least three times this year, the group is trotted out as Exhibit A for why the nine-year bull market might be in danger. Known as bond proxies, they’re the companies that peddle soap, diapers and ready-to-eat food. While they lack the heady price returns notched by high-flying tech and bank shares, they’ve been stalwart in the ability to return cash to investors. Consumer staples, phone and utility companies have the highest dividend yields, a measure of a stock’s price relative to its payout.

Summary

The newly forming relationship of U.S. equity returns moving in opposition to U.S. Treasury yields is wreaking havoc on asset and sector allocations. Inflation fears are infiltrating many investment decisions in ways not seen since prior to the Dot-com bust (2000). Investors are no longer able to confidently hedge equity exposure using long-end U.S. Treasuries, causing many to lower risk exposure.

Comment

The chart below shows monthly flows for U.S. high dividend, emerging market debt, and short-term government/corporate ETFs types. Money is pouring out of high dividend and emerging market debt ETFs at a pace not seen post-crisis. Conversely, consistent inflows are being seen in short-term fixed income ETFs.

Shifting investor allocations are more a result of changing correlations and hedging concerns than U.S. Treasury yields simply rising above dividend yields offered by equities.

 

 

The chart below shows three-month changes from 2000 to current in U.S. 5-year note yields (x-axis) versus the relative performance the S&P Dividend Aristocrats Index to the S&P 500 (y-axis). We highlight the post-crisis period in red, which has been heavily dominated by rising yields resulting in underperformance by high dividend stocks. 

 

 

 

But, the sensitivity of high dividend equities to U.S. Treasury yields was very muted from 1990 to 1999 (shown below). The periods prior to 2000 were filled with much higher inflation fears, making the relationship between equities and U.S. Treasuries much less reliable. Hedging equities and/or higher dividend equities using U.S. Treasuries would not be as advantageous and potentially lead to higher risk and potential losses. The traditional 60/40 portfolios are under attack.

 

 

The rolling one-year correlation between the relative performance of high dividend stocks and U.S. 10-year note returns has been tumbling since early 2017. Investors are reacting to an ending era of higher deflation (i.e. not inflation) fears.

 

 

Additionally, investors are shifting assets between equity sectors based on the difficulty to hedge risks with safe assets. The chart below shows the rolling one-year correlation between relative equity sector performance to the S&P 500 and U.S. 10-year note returns.

Sectors like utilities, consumer staples, telecom, and real estate are all seeing correlations to U.S. 10-year note returns quicken their decline since December 2017. Not surprisingly, TIPS breakevens (i.e. inflation expectations) began to significantly widen over this same period.

All in all, investor strategies and algorithms will likely undergo a period of transition and re-writing as a new regime takes hold.

 

Posted in Newsclips, Samples

Will Shorts in U.S. High Yield ETFs Be Caught Offsides?

  • Bloomberg – Short Interest in High-Yield ETFs Hits Record
    Short interest as a percentage of shares outstanding on the $15 billion iShares iBoxx $ High Yield Corporate Bond ETF, ticker HYG, hit an all-time high of 29 percent Monday, Markit data show. Add elevated shorts on the SPDR Bloomberg Barclays High Yield Bond ETF, ticker JNK, in concert with a European counterpart, and bearish sentiment has piled up even as junk-bond spreads recover from the selloff earlier this month.  “Investors are hedging against a pop in the U.S. 10-year — a lot of guys are positioning for 3 percent or plus,” said Dave Lutz, head of ETFs at JonesTrading Institutional Services. The potential for a short squeeze looks elevated considering the funds’ indicative gross dividend yields over the next 12 months. At over 5 percent — the amount traders would have to pay lenders annually — shorting JNK is no free lunch.

Summary

Short interest in U.S. high yield ETFs is growing as the cash market continues to recover from February’s losses. We’ve discussed how some of the outflows from high yield positions have traveled to other asset classes. But it’s possible some of these outflows were kept in high yield and simply moved to cash bond positions. Investors holding expensive short positions may be caught offsides. 

Comment

The chart below shows the average short interest and average short interest ratio for several of the U.S. fixed income ETF categories. The short interest ratio is simply the total short interest divided by average daily volume, an expression of how long it might take to clear these positions. Although short interest in investment grade ETFs is also elevated, high yield funds stand alone in this measure. 

 

 

 

We’ve highlighted investors’ shift away from the pure U.S. corporate bond ETFs several times since January. Net inflows first began to dry up late last year before net outflows accelerated in the wake of the early February volatility spike. The chart below shows monthly net flows for U.S. fixed income ETFs by category. January and February saw the largest monthly net outflows on record. While investment grade ETFs have seen net outflows dissipate this week, high yield funds continue to bleed, though at a much slower pace. 

 

 

To some extent, these funds have flowed into other types of investments. On Tuesday we shared a network analysis of fund flows since February 9th showing that assets leaving high yield funds have found new homes in safer fixed income funds, value equities, emerging markets and precious metals. 

 

 

But the net outflows from corporate bond ETFs do not necessarily mean all these funds are fleeing the asset class. In discussions with high yield fund managers, we’ve come to understand that the exchange-traded funds are often used as cash management tools. Opportunistic fund managers who were sitting on excess cash may have withdrawn funds from the ETFs to buy bonds in the cash market. These would show up as outflows but with no bearish implications for high yield broadly. 

The last chart shows the Bloomberg Barclays total return indices for U.S. investment-grade and high yield indices since July 2017. Rising Treasury yields have kept investment grade bonds under pressure but high yield has snapped higher since mid-February. As time passes, it looks more and more like the surge in ETF outflows was not as bearish for credit markets as it first appeared. 

 

 

Conclusion

Some investors appear to smell blood in high yield waters and have ramped up short exposure to high yield ETFs. But different use cases for investment-grade and high yield ETFs by institutional fund managers make the signals from fund flows less clear. It’s likely that some of the surges in net outflows seen in February were opportunistic fund managers moving cash management positions in ETFs to the cash bond market. To the extent that this is true, the large short base may find themselves offsides having misread these outflows as a bearish sign for the asset class.

Posted in Featured, Newsclips, Samples

Inflation/Wages – Investors in ‘Put Up or Shut Up’ Phase

 

  • Bloomberg – From Inflation to Tax Cuts, One U.S. Report Has It All Thursday
    January spending, income data to get more attention than usual
    Early hints on how tax cuts are boosting the U.S. economy. New signs of how price pressures are flowing into a key inflation metric. An update on America’s low, low saving rate. And, above all, how consumer spending is holding up. Welcome to Thursday’s report on personal income and spending from the Commerce Department. The January figures may garner more attention than usual because they’ll cover the first month since the tax-cut legislation was signed and will provide the final reading on the Federal Reserve’s preferred price gauge before March meeting on interest rates.

Summary

Financial markets have added rate hikes as implored by the Federal Reserve and boosted inflation expectations in anticipation of rising wages. But, investors are now in the ‘put up or shut up‘ phase by demanding realized inflation and wage growth to build more inflation and hawkish action into safe and risk assets. Consumer trends have mildly softened to begin 2018, making upcoming personal spending and inflation releases critical.

Comment

Tomorrow (March 1st, 2018) could be a pivotal day for financial markets paying extra close attention to inflation and wage growth. A bummer retail sales to begin the year (less autos and gas expected at -0.2%) have many on edge. Personal income and spending data will offer the first glimpse of the tax plan’s impact on the consumer. 

The chart below shows three-month changes in Google Domestic Trends with current as blue dots, ranges since 2010 as gray dots, and the 25th/75th percentiles as orange boxes. Google Domestic Trends offer very useful insight into the biases and convictions of consumers and businesses via their Google search traffic. 

Many trends have abated since our last update in December 2017. Key takeaways:

  • Auto buying and financing have fallen below average after very strong interest to close 2017
  • Financial planning and investing have grown appreciably, even while the savings rate falls
  • Real estate has fallen below its 25th percentile
  • Non-discretionary purchases like shopping, luxury goods, and travel have slowed to begin 2018

 

 

The left panel in the chart below shows seasonally-adjusted year-over-year changes in Google search trends attributed to discretionary spending. The right panel shows the same, but for non-discretionary spending. The average growth of non-discretionary spending (red) remains above discretionary (black).

Unfortunately, growth in search trends for both discretionary and non-discretionary items are slowing since peaking mid-2016.

 

 

The leap higher in hiring and compensations plans as shown in the NFIB’s Small Business Survey has yet to become realized. We believe financial markets are awaiting realized wage and inflation growth before allowing a breakout in inflation expectations. The odds of headline CPI running above 2.5% as implied by inflation swap caps/floors (see below) remain stuck at the best seen in early 2017.
A breakout would usher in a new leg of heightening inflation fears, while a retreat would have major ramifications for U.S. Treasury yields and curve.

 

 

The chart below shows the NFIB’s Hiring Plans Index on the x-axis versus the year-over-year log change in the U.S. personal savings rate. The size and color of each instance indicate the change in year-over-year consumer spending over the following three years. Larger, darker red dots indicate consumer spending has fallen in the following three years.

The current rosy outlook for hiring coupled with a drop in the personal savings rate has historically been met with lower consumer spending.

 

 

We continue to favor over-weighting defensive sectors and municipal bonds given softening consumer trends and ‘as good as it gets’ economic growth. The last chart below shows the spread between risk-adjusted returns (three-month) for financials, technology, and consumer discretionary versus consumer staples, utilities, and real estate. 

Heightened fears of inflation and higher U.S. Treasury yields have caused a significant divergence between cyclical and non-cyclical equity sectors. Such outperformance has historically not been sustainable.

 

Posted in Newsclips, Samples

Time to Extend Duration?

  • Bloomberg – King Cash Threatens the Reign of Credit Markets From U.S. to Europe
    Higher rates on U.S. risk-free curb appeal of high grade: Citi

    Investors reaching for yield are now finding it’s less of a stretch. Global credit markets are on the cusp of a post-crisis regime shift as higher rates on short-dated U.S. Treasuries challenge the investment case for high-grade corporate bonds — on both sides of the Atlantic. Consider this: The Vanguard short-term corporate bond exchange-traded fund, which holds U.S. investment grade debt with a maturity of less than five years, now has an indicated dividend yield only 0.54 percentage point above that of the three-month Treasury bill. That represents a tiny pickup compared with a whopping 2 percentage points in early 2017.

  • Morningstar – Bond Market Activity Returns to Normal
    Although credit spreads in the corporate bond markets widened slightly at the end of last week, activity across the fixed-income markets was generally back to normal after a wild ride in early February. Changes in interest rates and credit spreads were muted, and the decrease in volatility led to a reopening of the window to the new issue marketplace. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) widened 2 basis points to end the week at +100. In the high-yield market, the average spread of the BofA Merrill Lynch High Yield Master Index also widened slightly, by 8 basis points to +358.

Summary

Long running fears of higher rates have had many investors taking shelter in shorter duration credits. That has been beneficial so far in 2018 as Treasury yields finally moved materially higher. But higher yields and wider spreads may be appealing enough for some credit market investors to begin extending duration. 

Comment

The chart below shows why the short duration trade has been favored by those expecting rates to move higher. The panels show year-to-date total return (y-axis) by duration (x-axis) for each sector, excluding utilities, in the Bloomberg Barclays industrial index. We limited this to issues of $750 million or larger.

Investors who hunkered down at the short end of the curve have been spared the worst of the total return losses so far this year. There are some exceptions among energy and communications where rising oil prices and M&A activity are driving performance. But for the most part, the benefits of shorter duration have offset the lost yield. 


 

Spread performance is telling a different story, however, and perhaps illustrating some shifting preferences among credit investors. The next chart shows the 1-month change in spread to benchmark Treasury (y-axis) versus duration (x-axis) for each of the sectors above. The trend lines help highlight how spreads have been more resilient and even tightened farther out the curve.

This preference for longer duration has been especially strong for basic materials, communications, technology and financials. Longer duration financial issues are sparse, which likely fuels some of this premium. 

 

 

The combination of sharply wider spreads for medium duration bonds and our expectation for falling Treasury yields over the next month might entice some buyers to begin extending duration a bit. The last chart shows spread to benchmark Treasuries by duration for four of the sectors which have seen the most spread widening in short-to-medium duration issues. Shading indicates the 1-month change in spread for each issue, with shades of orange showing larger widening moves. Those looking to pick up yield might find some value in consumer and energy sectors without having to stray too far out the curve. 

 

 

Conclusion

On the heels of the sharp rise in Treasury yields and a shakeout in investment grade corporate bonds, opportunistic investors may have found some reasons to move out the curve. We’ve seen preference for longer duration in utilities and investment grade credits in general in recent weeks. Here we showed longer duration spread performance has been superior over the past month. Even with central banks expected to continue pushing short term rates higher, the outlook for Treasuries is brighter for the next month. This might be enough to entice more investors to move away from the short duration stance. 

Posted in Newsclips, Samples

Headwinds for Leveraged Loans

  • Barron’s – After the High-Yield Storm, Calm Returns to Market

    In recent years, investors’ interest in loans has surged, in anticipation of interest rates climbing. There are a few reasons for that possibly not working as intended. Many were issued with rate “floors,” to provide a minimum payment. That means rate increases won’t show up until that threshold has been breached. Loans are perceived to be safer than bonds because they are higher in the capital structure. But growing demand has allowed issuers to sell their loans with looser and looser covenants—promises to help protect investors when an issuer’s management is dancing around trying to avoid default, eroding some of that security. ETFs that buy leveraged loans have generated returns this year, while the two most popular high-yield bond ETFs have lost money. The PowerShares Senior Loan Portfolio (BKLN) has gained 1%, and the SPDR Blackstone/GSO Senior Loan ETF (SRLN) has gained 0.9%. That compares with losses of 0.6% for the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), and 0.8% for the SPDR Bloomberg Barclays High Yield Bond ETF (JNK). The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), a popular high-grade bond ETF, has lost 3.3%.

  • Summary

    Leveraged loans have had a moment in the sun as high yield stumbled earlier this month. It will be more difficult for leveraged loans to sustain this outperformance going forward. This would require additional gains in implied volatility, especially if Treasury yields fall. 

     

    Comment

    The potential for leveraged loans to finally outperform high yield has been a theme of ours this year. The chart below shows total returns for the Bloomberg Barclays U.S. High Yield and Credit Suisse U.S. Leveraged Loan indices since July 2017. Loans proved far more resilient than their fixed-rate peers in high yield bonds during the February downdraft. They were also spared the massive outflows the high yield bond ETFs saw.

     

     

    The scatterplot below shows quarterly (66-day) changes in the Bloomberg Barclay’s U.S. Treasury Total Return Index (x-axis) and the difference between the total returns for U.S. leveraged loans and high yield. The shading reflects the quarterly change in Treasury implied volatility (MOVE Index).

    Leveraged loans see their widest outperformance over high yield with both rising Treasury yields and rising implied volatility. Almost any rebound in Treasuries favors high yield outperformance. But falling yields are accompanied by still-rising implied volatility, leveraged loans may still sustain their recent outperformance. This is a lower probability outcome though. The stage is set for high yield to regain ground on leveraged loans if Treasuries rebound.

     

     

Posted in Featured, Newsclips, Samples

Defensive Sectors and Munis Likely Outperformers

  • Bloomberg – Inflation Worrywarts Just Ought to Calm Down
    The Fed isn’t rattled by a little rise in jobs and wages. That’s what it’s been seeking for years.
    Are interest rates headed higher? Sure, but that was always going to be the case. The Fed’s own projections in December told us that. In 2017, unlike the previous two years, the Fed did exactly what it said it would do: raise rates three times and begin the process of reducing the bloat in its balance sheet that resulted from a decade of stimulative bond-buying. You would never know that either, from public discourse. Intriguingly, the minutes show some musing that the corporate tax cuts signed by President Donald Trump may actually weaken inflation. The idea is that lower tax rates might encourage some firms to simply cut prices. We’ll have to keep an eye on that one.
  • Summary

    The world’s major economies are seeing a slowing pace of positive economic data and inflation changes. Similar past instances favor equity and high yield investors over-weight defensive sectors like healthcare, consumer staples, and utilities. Additionally, municipal bonds are again on the radar as a potentially stable performer in the months ahead.

    Comment

    The chart below shows current Citigroup Economic Data Change Indices by economy. Central banks and risk assets have enjoyed the tailwinds of a majority of economies producing data releases above one-year average growth rates.

    The Eurozone remains the star performer, while commodity-heavy economies like Canada and Australia are struggling.

     

     

    The next set of charts offer metrics measuring economic data releases, surprises, and inflation growth across the globe:

    • Top panel = % of the world’s economies growing above average
    • Middle panel = % of economies producing data surprises
    • Bottom panel = growth index of headline and core inflation releases (above zero indicates above one-year average growth rates)

    The percentage of economies producing above-average data is rolling over (69%) after peaking in August 2017. However a very healthy 77% of economies are still producing data surprises on whole.

    But, inflation momentum enjoyed from mid-2016 through 2017 has significantly slowed with our World Inflation Growth Index falling toward zero. This is not the result of falling inflation readings, but a failure of inflation to continue driving higher over the past quarter.

    Inflation expectations (i.e. market-based) are diverging with this inflation index. In other words, investors are believing inflation growth rates will rebound and stay above averages (zero).

     

     

    The next chart focuses on the percentage of economies producing above one-year average growth rates. The vertical dotted lines mark significant breaks below 60%, which have been followed by swiftly deteriorating data across the globe in the months and quarters to follow. We are watching extremely closely for whether or not the current 69% makes this significant break below 60%.

     

     

    The chart below shows the average returns by asset class after the percentage of economies growing above one-year averages fell below 60%.

    All but emerging market equities produced tepid returns over the following quarter. However emerging markets, developed equities ex-US, and U.S. high yield all quickly ran into trouble the following quarter.

    We continue to note the calm, steady performance of municipal bonds within such studies. Municipal bonds generate a 3% return over this six-month window, clearly besting the S&P 500 on a risk-adjusted basis.

     

     

    The last chart shows equity sector returns following these same instances. Not surprisingly, healthcare, utilities, and consumer staples (i.e. defensive sectors) produce higher returns under significantly less volatility.

    All in all, equity and high yield investors should benefit from overweighting these lower beta, less cyclical sectors.

     

Posted in Newsclips, Samples

Worries About Bond Market Liquidity

  • Bloomberg – Credit Markets Are Stuck Playing Game of Dealers’ Choice
    Willingness to buy debt ‘clearly being tested,’ BofA Says

    In credit markets, it’s dealers’ choice — for now. That means credit spreads are in the hands of market makers as selling pressure in investment-grade bonds refuses to fade, according to Bank of America Merrill Lynch. Dealers bought a net $1.2 billion of corporate bonds on Monday after weekly flows to high-grade funds turned negative, write a team led by Hans Mikkelsen. Record weekly outflows from iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) are a double whammy of risk aversion and diminished appetite for duration, as this product tends to hold longer-dated debt. Dealers absorbed an estimated $5 billion in investment grade bonds last week, according to Bloomberg Trace data. Up until that time, dealers were net sellers to clients and affiliates to the tune of about $6 billion in 2018.

Summary

ETF investors’ interest in pure corporate bond funds began to fade weeks ago. Now jitters that were safely confined to equities have spread to credit markets. One-way investor flows and severely constrained dealer balance sheets are precisely the scenario corporate liquidity doomsayers warned about. Continued net outflows from U.S. corporate bonds could worsen the gap between the liquidity credit investors expect and the reality the market provides. 

Comment

We first highlighted a shift in ETF investor preferences away from pure corporate bond ETFs on January 30. At that time, U.S. investment grade and high yield funds had seen three consecutive weeks of net outflows. Net outflows have accelerated since, especially among high yield funds.

The chart below shows net 20-day outflows (weekly bars) for U.S. corporate bond ETFs by strategy. Pure investment grade corporate funds (light orange) and high yield funds (dark orange) saw a shift begin in December when 20-day inflows began to wane. Net inflows swung to net outflows in mid-January. Net 20-day outflows for high yield funds now exceed $7.4 billion. 

 

 

The corporate desk at our affiliate Arbor Research and Trading warned of deteriorating dealer willingness to support one-way flows on Friday. We highlighted their concerns in our weekly U.S. credit update on Monday:

As the week came to a close, the biggest thing to note, aside from increased volatility and spread widening, was the widening of bid/ask spreads. The liquidity that many accounts had taken for granted for almost as long as we can recall is going to be significantly reduced until the market settles down and flows become more balanced. Dealers were buying 1.38x more bonds than they were selling to clients during Friday’s session. To illustrate the point about how these client sale flows accelerated as the week progressed, dealers only bought 1.03x more bonds than they sold by the time Friday’s session came to a close.

The next chart highlights how total returns for U.S. investment grade and high yield indices continued to deteriorate after Treasuries found some footing. Sharp losses in risk markets finally triggered a bid for Treasuries just as jitters began to spread to previously tranquil credit markets. 

 

 

Despite seeing less severe net outflows, investment grade has underperformed high yield, but that isn’t unusual. The next chart shows 5-day changes in the Bloomberg Barclays U.S. Treasury total return index (x-axis) and the spread between 5-day changes in the Bloomberg Barclays U.S. high yield and investment grade indices (y-axis). This includes data back to 2009 and shows the degree of high yield outperformance is actually lower than we might expect. 

 

 

The scatter plots below show the same 5-day changes in the Treasury total return index on the x-axis and 5-day changes or the U.S. investment grade and U.S. high yield indices (y-axis). Investment grade performance has a tight linear relationship with Treasury performance and the last week’s move is right on expectations. 

While high yield has a looser correlation to Treasury performance, it also tends to see gains when Treasuries are seeing losses. The severity of net outflows in high yield is dragging down high yield performance. With dealer appetites for balance sheet risk constrained, any acceleration in investment grade outflows could knock performance out of line there. 

 

 

Conclusion

We have all been warned about the dangers of shrinking dealer balance sheets and risk appetites when investor flows become one-sided. High yield outflows are at their highest in years and rising treasury yields threaten similar outflows in investment-grade corporates. This will be the biggest test yet for how well the leaner balance sheet environment meets credit investors’ liquidity expectations. 

Posted in Featured, Newsclips, Samples

Inflation, Central Banks Inducing Higher Volatility, Which is Normal

 

  • The Wall Street Journal – A Warning Sign Behind the Market Swings
    The economy is still abnormally dependent on low interest rates and richly priced assets
    Don’t worry about stock-market volatility: It is perfectly normal. Do worry about how stocks got so high to start with because it is evidence of an economy still abnormally dependent on low interest rates and richly priced assets. The 2,271-point drop in the Dow Jones Industrial Average in the week through Monday, a decline of 9%, didn’t even meet the usual 10% threshold for a correction. Tuesday’s 567-point rebound didn’t make the top-500 daily increases by percentage. Wednesday’s 509-point swing between high and low was positively humdrum, with the Dow closing down 19 points, or 0.1%, at 24893.35. Even more reassuring, the volatility is being driven by the most banal of reasons: worries about inflation and interest rates.
  • The Wall Street Journal – Stocks Changed, But Bonds Still Sound the Same
    Why trouble for stocks won’t be a boon for bonds this time
    Those are exactly the forces—combined with technical concerns about greater supply of bonds as the U.S. expands its budget deficit, and central banks cut back on stimulus—that have driven bond yields higher and favored stocks in the past year. Unless the economic outlook deteriorates, or central banks show signs of concern about market moves and hint at softening their stance, there seems to be little reason for bonds to rally. Selloffs in the past few years in the bond market have been characterized as “tantrums,” and the lack of inflationary pressures has meant they have reversed. But this time the move is more fundamentally driven, and thus has more staying power. That is the mark of a dip that shouldn’t be bought.

Summary

The volatility of U.S. equities rocketed higher in February but has thus far been mostly an isolated event away from U.S. Treasuries, foreign equities, and currencies. But, increasing inflation and the coinciding boost in tightening expectations will create higher volatility as normal. In particular, rate hike timing is on the verge of inducing volatility across all asset classes.

Comment

The chart below shows the VIX (log scale) in the top panel and the multiple or leverage needed to maintain 15% annualized volatility for a portfolio of 60% equities and 40% U.S. Treasuries. The average annualized volatility since 1970 of a 60/40 portfolio is 15%. 

Historically, regime shifts to rising volatility occur when this leverage ratio exceeds 1.5, which just occurred in mid-December 2017. Extreme comfortability of investors in a low volatility, inflation environment cannot last forever. Based on this metric, investors will change their behavior in anticipation of heightening risks.

 

 

We can explain implied volatility across major asset classes using the following:

  • Economic Data Changes – G10 and Emerging Markets
  • Economic Data Surprises – G10 and Emerging Markets
  • Inflation Expectations – Inflation breakevens across major economies
  • Pace of Rate Hikes – 12-month expectations for the Fed, ECB, and BoE

These variables are capable of explaining 80+% (r^2) of the variation in implied volatility of the S&P 500, DAX, U.S. Treasuries, foreign exchange, gold, and emerging markets.

The chart below shows estimates (blue line) for the VIX along with model residuals (actual – estimate) in the bottom panel. The dramatic equity selloff in February 2018 produced the largest deviation from estimates in history back to 2004. These estimates will not pick up on unexpected events like geopolitical risks, but do efficiently match volatility induced by economic growth, inflation, and rate hike timing.

 

 

The next set of histograms offer the distribution of differences between actual implied volatility and model estimates. The left panel shows the VIX’s most recent residuals as clear ‘off-the-chart’ outliers. The middle and right panels show emerging market currencies and the MOVE Index falling mostly in line with expectations. This same dynamic plays out with gold, foreign exchange, and foreign equities. The excessive jump in S&P 500 volatility has been mostly an isolated event.

 

 

But, do not place the blame of increased volatility on the fall-out from VIX-related ETFs. Rising volatility across asset classes will be normal given rising inflation and tightening expectations.

The next set of charts show the impact of the average number of rate hikes expected by the Fed, ECB, and BoE on each asset class’s implied volatility. Currently, an average of 1.9 hikes are expected and will likely grow given Carney’s comments this morning for raising rates “somewhat sooner, and to a somewhat greater extent.” Markets were only pricing in a total of 1.4 hikes in the 12-months ahead by the BoE, therefore there is plenty of catching up to Carney’s three hikes in 2018.

Volatility appreciably rises (red bars) across all asset classes when the Fed, ECB, and BoE show an average pace of hikes above 2.0 (see the dotted red line). Simply expecting an average of 3.0 hikes would increase the VIX by 5.0 and MOVE by nearly 20.

Markets will view an acceleration of rate hike timing as the beginning of a major battle against impending inflation. The more inflation expectations rise, the more parties (i.e. asset classes) are thrust into this war.

 

 

On the flip side, the charts below show the impact of economic surprise volatility on implied volatility by asset classes. Economic surprises remain few and far between with a current standard deviation of economic surprises across major economies at 2.8. More erratic economic data is needed to provide another boost to volatility. We do note the MOVE (USTs) and emerging markets would be first impacted.

 

Posted in Featured, Newsclips, Samples

U.S. Treasury Yields Most Reliant on Inflation Since Pre-crisis

 

  • The Financial Times – Someone is wrong on the internet, wages and the stock market edition
    Considering how the markets had been doing in the few months leading up to the BLS survey, it is not surprising that investment bankers and traders would have been recording large average pay increases. The FT recently had stories about how 2018 was shaping up to be a banner year for both IPOs and M&A. It would certainly be ironic if financiers convinced themselves to sell stocks because of a single data release, which had been distorted by their own aggressive pay packets, which in turn were based on a market melt-up partly justified by the stability of inflation…

Summary

Inflation and wage growth are showing nearly their largest contributions to U.S. Treasury yields since the financial crisis. We have just witnessed how sensitive equity markets are to rising inflation and rising tightening expectations. The U.S. Treasury market has not responded in kind but requires realized inflation/wage gains to avoid a return to lower yields (i.e. removal of inflation premiums).

Comment

We discussed the growth in wages last week

A big beat by average hourly earnings (2.9% vs 2.6% est) is appearing to validate the jump in U.S. Treasury yields across the curve. Recent yield curve steepening is coming by way of rising rate hike timing and inflation expectations. But, we need at least another month of wage growth considering the drop in average hours worked (34.3) and supervisory and technology-focused jobs accruing the greatest gains. 

Wage growth and prices paid forecasts from regional Fed surveys are their most rosy post-crisis. Below we show indices compiling these numerous surveys. Wage growth, in particular, is breaking out in the wake of stronger supervisor wage growth, minimum wage bumps, and corporate tax cuts. We have argued higher wages are of course a very positive dynamic, but the markets and the economy will move on to demand greater consumer spending to follow

 

 

Options markets via inflation swap caps/floors are showing swiftly rising odds headline inflation will run over 2% year-over-year. The chart below shows these odds by maturity with all but 2-years producing above 1/1 odds. 

 

 

Most notably, investors are waving goodbye to the long nightmare of deflationary fears. The chart below shows the odds headline CPI runs above 1.5% for the defined time period. The 30-year outlook spiked to its highest post-crisis on January 30th, 2018.

 

 

The next chart shows the contribution of expectations to nominal U.S. 10-year note yields since 2010:

  • Inflation – News trends for ‘higher inflation’
  • Wages & Prices – Composite of regional Fed wage/price forecasts
  • WTI Crude Oil – 3-month forward
  • Soft, Survey Data – Citigroup Soft Economic Data Change Index
  • FOMC Rate Hike Timing – Morgan Stanley’s Pace of Rate Hikes for FOMC
  • Global Balance Sheet Growth – 6-month change in Fed, ECB, BoE, and PBOC total assets

*Intercept (or mean) of 2.36%

Inflation (red) and wages/price forecasts (orange) are offering their highest contributions since May 2011. Additionally, the pace of tightening by the Fed (dark teal) is beginning to pressure yields higher for the first time since mid-2015.

All in all, inflationary fears are impacting Treasury yields by nearly the greatest degree since the crisis. Matthew C. Klein’s question of whether or not wage gains trickle down from supervisors and technology jobs is THE issue for both U.S. Treasury yields and risk asset volatility. We find no coincidence the inflation expectation breakouts shown above and an additional rate hike added to 2019 were met with a dramatic burst in equity volatility (i.e. VIX). Again, volatility follows a simple equation using economic growth, inflation, and rate hike timing.

 

 

Lastly, higher volatility and still-elevated inflation expectations leave room for further U.S. Treasury curve steepening. Our last update producing steepening forecasts on January 22nd have mostly come to fruition.

We have expanded the lookback used to train these models to pre-crisis, while also adding the MOVE index and bank stocks’ relative performance to the S&P 500. A deeper look back and consideration of risks have dampened the outlook for steepening. The 2-year 10-year has the potential to steepen just above 80 bps.

The long-term flattening trend is likely still intact barring a more significant drawdown across equity markets. We will be watching these models closely to see when curve forecasts potentially roll back over toward flattening.

 

 

Posted in Featured, Newsclips, Samples

Welcome Back, Volatility! Financial Conditions Primed to Tighten

  • Tim Duy’s Fed Watch – Moving Pieces
    If as I suspect much of what we are seeing in the economy is a cyclical readjustment, then long term yields will likely reach more resistance soon while short term yields will continue to be pressured by Fed rate hikes this year and beyond. If the Fed turns hawkish here they will likely accelerate the inversion of the yield curve and the end of the expansion (this could be the ultimate impact of the tax cuts – a short run boost to a mature cycle that moves forward the recession). If a more secular realignment is underway, long (and short) rates have more room to rise. It is reasonable to be unable to differentiate between these two outcomes as this juncture.
  • The Financial Times – Anatomy of the escalating bond bear market
    With term premia now back to ‘normal’ bonds look better underpinned
    In summary, the bond bear market has so far been due to a normalisation of bond term premia, especially the inflation risk premium. With term premia now back to “normal”, bonds look better underpinned than in the recent past. If the bond bear market is to be extended much further on a sustainable basis, something new needs to go wrong in the global economy.
  • Summary

    Volatility-sensitive equity strategies are suffering in the wake of heightened inflation fears and a pulling in of rate hike expectations. We do not foresee a protracted drawdown given strong earnings and economic growth, but the metrics influencing volatility are signalling greater risks and tighter financial conditions. All in all, these are the times active management should prosper.

    Comment

    The S&P 500’s drawdown of 3.9% is putting intense focus on volatility-sensitive strategies like option writing and risk parity. The chart below shows mean reversion as the most damaged strategy (-7.1%) after the parabolic rally into the end of January 2018, while put option writing on the S&P 500 (-1.6%), mutual funds shorting volatility (-2.0%), and risk parity (-3.7%) are playing catch-up.

     

     

    We have stressed risk assets’ recent shift away from a positive correlation relative to inflation expectations for the first time in over a decade. Investors are leaving behind the belief of ‘low inflation forever,’ which we have extensively shown using options on inflation (caps/floors)

    The chart below shows six-month correlations between daily returns by U.S. equity strategies versus U.S. 10-year TIPS breakevens. The S&P 500’s positive relationship to inflation (blue line) is quickly fading with implied volatility (VIX) already signaling an abrupt shift from the post-crisis environment.

    Volatility-sensitive strategies like put option writing (orange), risk parity (blue), and mean reversion (gray) are ending their favorable symbiotic relationship with inflation at a faster rate than the S&P 500. The dotted vertical line marks when CPI (core) year-over-year dipped below 2.0%, signaling the beginning of heightened deflationary fears. Notably, risk parity strategies, which we understand vary greatly, are showing negative correlation to inflation akin to pre-2003.

     

     

    The chart below shows the aftermath of past instances when the VIX and U.S. 10-year TIPS breakevens became positively correlated under similar conditions to 2018. We have shortened the correlation window to 90 days and filtered for instances when TIPS breakevens had widened at least 20 bps and nominal yields rose at least 35 bps over the past three months. In other words, we are searching for environments when inflation induced a rise in U.S. Treasury yields.

    The three other instances in January 2000, March 2005, and June 2015 occurred within 6 to 12 months following the beginning of tightening cycles. Note we include balance sheet flow using the Wu-Xia shadow rate when assessing the June 2015 instance.

    Historically, U.S. 10-year note yields promptly declined, flattening the yield curve over the following 100 trading days. The S&P 500 saw mixed, sideways trading action. Can the inflation train continue chugging along or will risk-off conditions begin like past instances? We would view a continued rise in yields bucking these historical instances as confirmation of heightened inflation fears.

     

     

    Market volatility abides by a simple equation including economic growth, inflation, and expectations for central bank tightening. There is no coincidence equities grumbled and peaked when markets began pricing in greater than 2.5 hikes over the next twelve months on January 26th, 2018. In addition, we have seen a swift addition of a 2019 hike, potentially pulling closer rate hikes as Davies suggests in his article above. 

    The chart below shows expectations for the number of hikes by the FOMC over the next one (blue) and two (yellow) years. The bottom panel shows the spread or the number of anticipated hikes in the 2nd year ahead. Markets began pricing in a 2019 hike on January 29th, the very day the S&P 500 began its descent.

     

     

    The neutral rate may not be increasing, but a faster pace of ‘getting there’ is spooking markets. We continue to rely on the concept of the ‘reversal rate,’ which measures the fed funds rate capable of causing a contraction in deposits, lending, and leverage. 

    The chart below shows our estimates for the reversal rate (red line) along with the target (gray line) and Wu-Xia shadow fed funds rate (orange dots). The target rate resided below the reversal rate post-crisis until the December 2017 hike, allowing financial conditions to remain ultra-easy. However, going forward hikes could tap the breaks on easy financial conditions.

    All in all, continued tightening would likely slow growth, but not necessarily lead to a protracted drawdown by risk assets. A strong economic backdrop world-wide and hints of wage growth are not the makings of a bear equity market. The end result would be a return to higher volatility and risks, a condition active management would greatly enjoy.

     

Posted in Featured, Newsclips, Samples

Curve and Inflation Expectations are Dictating Central Bank Policy

Summary

The Federal Reserve is ending Yellen’s term with a hawkish bias, but also a lack of confidence in their forecasts for inflation and wage growth. Market-based measures of inflation are finally percolating, meaning the Fed may ultimately lean more on the market’s outlook than their own going forward.

Comment

Yellen is clearly handing over a hawkish Federal Reserve to Powell. The chart below shows the spread between hawkish and dovish words found within official Federal Reserve speeches since 2005.
 

 

Unfortunately, confidence is near post-crisis lows while inflation has been the hot topic ever since Yellen et al lobbied for the first hike in December 2015. The chart below shows the rolling sum of words concerning “inflation” in the top panel and “confidence” in the bottom panel.

A complete re-think of models used to forecast inflation and wage growth were fervently discussed by not only markets, but many Fed officials. Persistently sub-2.0% core inflation has pushed numerous officials to consider new models (away from the Phillips curve) and alternative targets.

 

 

The next chart shows the percentage of “confident” words relative to “inflation.” Past bursts in confidence after declining core inflation (top panel) in 2002 and 2009 were short-lived, likely leaving a lasting impact on the psyche of Fed officials. 

Inflation expectations as determined by TIPS breakevens have rebounded significantly, which may boost the Fed’s confidence in the months to come.

 

 

The pace of tightening expected by financial markets has jumped to over 2.5 hikes in 2018, just shy of the Fed’s estimated three hikes. Not only are TIPS breakevens widening, but nominal U.S. 10-year notes have reached their cheapest relative to 5-year notes and 30-year bonds. 

The top panel shows the U.S. 5y10y30y butterfly spread and the bottom panel the average pace of rate hikes for the next 12 months by the Fed, ECB, and BoE. The 10-year’s relative value is directly tied to global rate hike timing with an r^2 of 0.78.

The markets’ perspective on rate hikes via butterfly spreads like below and TIPS breakevens may be the most critical drivers of central bank policy moving forward. If the Federal Reserve is questioning their own models, then market-based measures will likely carry greater weight.