Posted in Samples, Webcasts


  • Bloomberg – Fed’s Patient-or-Preemptive Clash Looms as Inflation Misses Goal
    Former Federal Reserve Chairman Alan Greenspan, in year nine of a U.S. economic expansion, conceded in 1999 that patience was sometimes a better policy than his doctrine of preemptive interest-rate moves because “the future at times can be too opaque to penetrate.” For some Fed officials, these days look like one of those times to wait for clarity. Faith in preemption — the Greenspan-era strategy of setting of monetary policy based on forecasts to get ahead of where the economy was going — is beginning to falter among some officials. That’s because in the current expansion’s ninth year, inflation isn’t accelerating as they predicted for reasons that aren’t yet understood, even as the labor market tightens and global growth improves.


U.S. inflation expectations should continue to rebound in the event economic data surprises (beats) make a triumphant return. History suggests TIPS breakevens widen with great frequency after a period of extreme data misses.


Inflation remains the dominant topic for the Fed and market participants. The chart below shows the percentage of T.V. news coverage of the Federal Reserve including each category (inflation, uncertainty, and financial stability). However uncertainties including political and financial stability concerns are rapidly on the rise. Do not forget the Fed continues to suffer from short-term-ism.


Inflation surprises (i.e. beating economists’ estimates) in the U.S. have been very difficult to come by following the financial crisis. The chart below shows Citigroup Inflation Surprise indices for major economies with values above zero indicating beats and values below zero indicating misses.


In fact, the U.S. is at the bottom of the list of economies producing inflation surprises since 2012. Only three months (4%) have seen the U.S. inflation surprise index above zero. No wonder Brainard and some other Fed officials are leaning toward inflation running hot above 2% before further tightening. Current low levels of inflation have dragged the neutral rate lower, which we believe resides near 125-150 bps. Another hike in December and/or balance sheet reduction will very likely cause tighter financial conditions for the first time in this cycle.


So why are inflation expectations for the U.S. rebounding? We previously indicated U.S. 10-year TIPS breakevens have always widened after the U.S. Citigroup Economic Surprise index reached an extreme below -60, which occurred June 15th, 2017. Breakevens are 16 bps wider since this date.


We now look to expected moves by inflation expectations in the event the surprise index continues its rebound above zero, meaning a return to concerted data beats. The chart below shows past moves in U.S. 10-year TIPS breakevens days after the surprise index recovers from below -60 and breaks above zero.

U.S. 10-year breakevens widened 30-trading days later 78% of past instances by an average of 11.5 bps.


Posted in Newsclips, Samples

What Next From Central Banks?


At the beginning of the year, the Wall Street’s consensus was for rates to go higher. The question was  “when will 10-year yields hit 3%?”, not if.  Predictably rates have gone the other way and are lower now than the start of the year.  See the first chart below.

The next two charts show what the market expects from the Fed.  The probability of a rate hike in September is approaching zero as the market expects the Fed to announce balance sheet reductions, and not rate hikes, at this meeting. December is now less than 50% meaning a rate hike is also not expected at this meeting.

Expressed differently, see the third chart below.  Two rate hikes are already done this year (March and June).  The market only expects 0.4, or less than half a rate hike the rest of his year.  It is pricing in 1.3 rate hikes through the end of 2018.  This stands in contrast to the latest Fed “dot” chart that says 1 rate hike this year and 3 next year.  In January 2016 when the Fed dots said 4 rate hikes and the market priced in less than 2 rate hikes,  the Fed “caved” to market expectations and hiked only once in December 2016. 

Unless/until the data changes, the market expects something similar again.  Less Fed rate hikes are supportive for bond prices and help to explain lower rates.





‘Neutral’ Rate Dropping, Are Tighter Financial Conditions Finally on the Way?


  • Bloomberg – Fed Neutral Rate Estimate Drops, Lowest in Over Two Years
    The so-called neutral U.S. interest rate fell in the second quarter by the most since 2010, according to a widely-cited estimate produced by Federal Reserve economist Thomas Laubach and San Francisco Fed President John Williams. The theoretical rate known in economic circles as “r-star” — which is adjusted for inflation and would neither stimulate nor restrict an economy growing at its trend pace — declined to -0.22 percent, from 0.12 percent in the first quarter. In comparison, the Fed’s benchmark rate, adjusted for core inflation, is currently -0.35 percent, which suggests the central bank is nearly at a “neutral” monetary policy setting, according to the model.
  • Bloomberg – Fed Balance Sheet Policy May Amount to More Easing
    The structure of the bond market these days is such that there’s a good chance financial conditions will continue to loosen.

    Surely that will cause long-term yields to rise and financial conditions to finally tighten, right? Maybe not. The structure of the bond market these days is such that there’s a good chance conditions will continue to loosen, further underpinning demand for riskier assets ranging from equities to high-yield debt to emerging-market currencies. To understand why, first consider that institutions that needed very high quality securities to comply with new regulations designed to make the financial system safer have been somewhat crowded out by the Fed’s purchases. They will now have the opportunity to buy Treasuries and the resulting demand should help contain long-term yields. At the same time, officials such as New York Fed President William Dudley have hinted there will be a pause in rate hikes during the initial stages of balance-sheet normalization, which should also help support the market.


The relationships between inflation, the fed funds target rate and balance sheet suggest further tightening by the Federal Reserve should finally cause financial conditions to tighten. We suggest watching U.S. Treasury term premiums closely for real impact.


The recent drop in the neutral interest rate or r* suggests further tightening will finally result in just that, tighter financial conditions. However, theories abound as to why balance sheet reduction will lead to further easing (second article above) akin to the past four rate hikes.

The chart below shows major financial conditions indices along with rate hikes (vertical dashed lines).



However, the estimation of thresholds like the neutral or reversal rates are quite fuzzy and difficult, especially considering the shifting dynamics of inflation.

Our own analysis sides with the determination of r* by Laubach and Williams. We stress test for contractions in deposits and lending using both varied fed funds target rates adjusted for inflation AND paces of balance sheet reduction ranging from $0 to $500 billion per year.

The chart below shows model output with each line representing an assumed pace of balance sheet reduction. The June 2017 hike suggests any pace of balance sheet reduction should lead to tighter financial conditions via contracting deposits and lending, even in the absence of further rate hikes.

U.S. Treasury term premiums have offered a reflection of the bond investor’s conviction in a low growth and inflation outlook. Barring a mistake by the Federal Reserve and declining inflation, balance sheet reduction should show up in higher term premiums.




ECB Likely the Most Watched Central Bank in 2018

  • Reuters – Fed balance sheet plan may equal three rate hikes for emerging markets
    According to calculations by IIF, one of the most authoritative trackers of global capital flows, this will slice just over $200 billion off the U.S. central bank’s balance sheet next year, assuming it keeps reinvesting some of the money for the time being. Sonja Gibbs, one of the IIF’s senior directors, also estimates that just a $65 billion drop in the Fed’s Treasury holdings would equate to a $6.5 billion to $7 billion drop in emerging market portfolio flows — bond and equity purchases by foreigners — all else being equal. “That in turn is about equal to a 25 basis point (Fed) rate hike in terms of impact,” Gibbs added.
  • The Wall Street Journal – The Great Transatlantic Bond Divergence Unwind
    The spread between U.S. and German bonds is narrowing, but this important indicator of global financial conditions has a long way to go

    Where policy goes now is key. Markets doubt how far the Fed might get with its tightening, and seem unflustered by the prospect of the central bank shrinking its balance sheet. Investors may be too relaxed, but in the absence of fiscal stimulus and inflation, much higher yields for Treasurys might be hard to achieve in the near term. The European Central Bank, meanwhile, is set to move out of emergency-policy territory. Support for low yields on German bunds is likely to diminish as the ECB starts to move gently towards an exit from its bond purchases. While policy rates are likely to remain ultra-low for a long time to come, that implies a steeper yield curve in Germany, with the central bank exerting less influence over longer-term interest rates.


Financial markets are taking in stride the Fed’s plans to begin reducing its balance sheet. The great unknown at the moment is when will other central banks join the chorus? The direction of equity returns have remained dictated by economic growth, however, insulation to negative developments and a positive beta to positive developments have very likely be provided by continued monetary stimulus across the globe.

What if economic and inflation growth were allowed to mechanically determine the impending unwinding of Fed, ECB, BoJ, and PBoC balance sheets?

The chart below shows forecasts for 2018 through 2019 based on major economic and inflation data releases.

Quick takeaways:

  • Eurozone’s recent economic improvements suggest a much lower balance sheet by the end of 2019 near $3.05T
  • US’ slower pace of gains points to a modest $0.88T reduction over the same time frame
  • Continued lack of inflation in Japan indicates the BoJ’s balance sheet could continue rising toward $5.13T
  • PBoC is expected to maintain a stable balance sheet near $4.88T



The next chart shows the same forecasts, however, stacked to indicate totals across the big four central banks. Total balance sheet assets are expected to drop from a current $19.1T to $16.6T by November 2019. In reality, a drop of $2.5T is quite marginal. Investors seemingly understand the process of ‘normalization’ will be a long one, especially in the event a recession were to hit in the coming five years.

What could make this change? Easy, inflation.



Sovereign yields have become increasingly attached to changes in total assets held by the big four central banks. The scatterplots below show 60-day log changes in total assets versus returns for U.S. and German 10 year sovereigns since 2016.

A continued rise in the BoJ’s balance sheet will likely be washed out by a reduction by the Fed. What Draghi decides for the ECB is likely most important for yields going forward. An ECB reducing assets alongside the Fed in 2018 would bring down total assets held by the big four central banks and finally drive yields higher.





U.S. Treasuries Need a Wellness Check


  • Bloomberg – Volatility Gauges Tumble to New Lows Amid Complacency Fears
    Bank of America MOVE Index closes at an all-time low on Monday
    The markets are alive with the sound of ‘zzzzzz’ as the latest trading session marks yet another another record low for volatility gauges. Bank of America’s MOVE Index, which gauges volatility in the U.S. Treasury market, has tumbled to an unprecedented 46.9 at the close of Monday’s trading session. The move means investors in the world’s largest bond market are shrugging off the potential for price swings, even as two titans of the industry up their bets on an uptick in U.S. inflation.


U.S. Treasuries are showing less and less excitement in reaction to major events since the financial crisis. Dampening volatility in economic data, inflation, and financial markets may have the same root cause, technological advances. Markets are potentially adjusting to a structural shift, much to the dismay of the financial media and analysts.


There is a laundry list of events and variables helping sink volatility in recent years. However, we have focused a lot on the rise of what we call the ‘era of ubiquitous and accessible information.’ The variability of economic data is severely low, which may be both the product of a stable economy and better means of recording its growth.

Namely, U.S. Treasuries are no longer reacting so strongly to events throughout the trading day. The chart below shows average trading ranges over five-minute intervals by U.S. 10-year note yields from 2010 to current. Note all times are central. 

The darkest line at the bottom shows 2017 as the least volatile, especially during major events denoted by the dashed vertical lines. For example, during Treasury auctions yields have traded in ranges roughly one-third of the years directly following the financial crisis.

Additionally, since 2012 a vast majority of trading action takes place in the first two hours (7:30 – 9:30 am) while giving way to very muted late morning and afternoon sessions.



The next chart focuses exclusively on five-minute intervals following the normal times of major economic data releases at 7:30 and 9:00 am, Treasury auctions at 12:00 pm, and Federal Reserve communications at 1:00 pm.

The trend lines show the drop in the average reaction by U.S. Treasuries. One of my children’s favorite DreamWorks’ motion pictures, Trolls, includes nasty beings called Bergens. These Bergens provide no reaction or excitement to anything shown before them. U.S. Treasuries have also become just as aloof and lethargic.

History suggests volatility is mostly a function of changes in global economic growth, inflation, and central bank action (see our model here). All three variables are lacking volatility and excitement, which should provide no surprise equity and sovereign volatility are painfully low. If economic data volatility and, likely, more importantly, inflation have made a structural shift to lower levels given technological disruptions, then this era of ultra-low volatility may persist for some time.



Posted in Newsclips, Samples

Finding Quality Labor Becoming a Significant Dilemma

  • The Wall Street Journal – Inflation Tame in June, Complicating Fed’s Rate Decision
    Officials have been expecting a pickup in prices as the economy improves, but it isn’t appearing
    Some Fed officials have expressed concern in recent weeks about pushing ahead with interest-rate increases in light of the softening inflation data. Federal Reserve Bank of Philadelphia President Patrick Harker said last month the recent slowing path of inflation gave him pause over whether the central bank should raise its benchmark interest rate for a third time this year. Overall the economy appears to be advancing at a steady but unspectacular pace. Consumer spending propelled economic growth in the second quarter, the Commerce Department reported last week. Gross domestic product, a broad measure of economic output, rose at a seasonally and inflation adjusted annual rate of 2.6%, aided by a 2.8% growth rate for consumer spending. That was up from the first quarter’s 1.9% growth pace for household outlays.


The inflation outlook for the U.S. is moderating just as the Fed is set to begin balance sheet reduction. A re-think of wage growth and inflation drivers are needed given a breakdown relative to full employment. Businesses are reporting their greatest difficulty securing quality labor in decades.


The interactive chart below provides a 12-month outlook for PCE core YoY using major economic data releases. The outlook for inflation is moderating with a modest 0 – 25 bps rise the most likely path. Probability of a bigger upside surprise in the order of 50+ bps has tumbled to a measly 10%. We have shown the Fed needs a rebound in inflation to avoid contracting deposits and lending (i.e. significantly tighter financial conditions).



However, this model, as with those run by the Fed, is only as good as the data fed into it. Wage growth remains stubbornly low even while the economy reaches full employment. We continue to believe dynamics have changed given shifts in our population and, more importantly, technology.

Performance of supercomputers are nearing the operations per second capable of simulating a human brain. Singularity, or the point at which computer power exceeds all humans, may still be decades away (so do not fear the Terminator, yet). The chart below using data from shows computers now producing a whooping 100 quadrillion floating point operations per second (FLOPS). The human brain is believed to operate at 1 exaflop or 1,000 petaflops (dashed line on chart). 



Why does this matter for wages and inflation? Artificial intelligence (A.I.), machine learning, and more are infiltrating nearly all corners of the economy. Their cost is becoming cheaper and access more widely available. Automation has clearly displaced numerous workers with companies struggling to find employees with necessary skills. 

The chart below shows the percentage of small businesses indicating quality of labor is the single most important problem. The recent spike to 19% is likely the highest in history back to 1974. We have generated estimates for this survey prior to 2008 using major economic data releases and additional survey output from the NFIB.

This dilemma of potentially diminishing quality of labor appears to keep a lid on average hourly earnings (see vertical dashed lines). Education and job re-training may not be capable of keeping pace with technological advancements.


Posted in Newsclips, Samples

Value ETFs Riding High on Small Cap Outperformance



 A quick look at large cap value equity performance so far this year suggests a challenging time for value stocks. But this is an incomplete picture and performance among smaller cap value stocks has been very strong. We note that year to date returns in value ETFs, particularly those with higher exposure to small caps, are outperforming the broad index and their large cap peers. 


A client inquiry regarding the performance of value versus growth equities in the U.S. led us to an interesting discovery. The chart below shows a clear divergence in returns this year for growth versus value equities in S&P 500. 



We typically see returns in ETFs track underlying indices fairly closely. But this appears to be a case where broad ETF definitions can give misleading impressions about performance characteristics. The next chart shows that although the faster price appreciation has driven total assets in U.S. growth ETfs higher, U.S. value ETFs have also seen year to date growth exceed 10%. 



Looking at net 20-day flows into value and growth ETFs shows surprisingly similar flows given the wide disparity in performance. We had expected to see year to date underperformance drive move value investors out of the strategy. 



Now there is enough variety in the ETF space for broad definitions like value and growth strategies to include a range of different return profiles. But there appears to be much greater variation among value ETFs than their growth focused competitors. 

The chart below shows YTD returns for all U.S. growth equity ETFs. These range from 19-28%, reasonably close to the S&P 500 Growth Index total return of 16%. 



The universe of U.S. value ETF returns has a much wider dispersion, and much less resemblance to the S&P 500 Value Index. Year to date returns range from 18-37%, well above the 4.9% return of the index. Most of the variation is explained by exposure to small caps. The best performing funds focus on small caps or value sector of the Russell 2000. 

Still, the fact that none of these ETFs are within 12% of the total return for a widely used, if large cap specific, benchmark value index illustrates how widely performance can vary within a defined space. The outperformance of small cap value ETFs is helping maintain investor interest in value ETFs even as larger cap value stocks are under-performing. 



The underperformance of large cap value stocks does not paint a complete picture of the value space in U.S. equities. Small cap value stocks are outperforming and helping drive superior performance in the value ETF space. Given the high concentration of stock market performance in a handful of large cap technology names, the strong performance of small cap value may offer some under-appreciated diversification opportunities. 


Posted in Newsclips, Samples

The Rise Of Emerging Markets

  • The Financial Times – Seven charts that show how the developed world is losing its edge

    What is happening to the world economy? Here are some answers, in seven charts. They reveal a world undergoing profound changes. The most important transformation of recent decades has been the declining weight of the high-income countries in global economic activity. The “great divergence” of the 19th and early 20th centuries, when today’s high-income economies leapt ahead of the rest of the world in terms of wealth and power, has gone into remarkably rapid reverse. Where once there was divergence, we now see a “great convergence”. Yet it is also a limited convergence. The change is all about the rise of Asia and, most importantly, of China.


The interactive charts below offer a look at the rise of emerging market economies on the world stage. The first chart shows that, while the U.S. still accounts for the largest portion of world GDP, China is quickly closing in.

The second chart shows that, on a regional basis, East Asia & the Pacific actually account for a larger share of world GDP than Europe and North America.

Finally, the last chart shows a breakdown of contribution to world GDP based on income groups. High income economies still account for over 60% of world GDP.



Posted in Charts of the Week, Samples

A decent year in stocks.  As the table below shows, the stock market is having a decent year.


Large cap stocks leading the way.  As the next chart shows, large cap stocks (blue) are leading the way as small cap stocks (red) lag badly.



Market Cap weighted beats equal weight.  Another way to show that large capitalized stocks are powering the overall market higher is the next chart.  It shows the S&P 500 stocks market cap weighted (blue) and equal-weighted (orange).  It is unusual for market cap to outperform equal weight by this degree.



Growth beats value.  The chart below shows the S&P 500 pure growth (orange) and pure value (blue).  “Pure” means the S&P 500 universe is out into one of these two groups.  Growth is dominated by large capitalization technology stocks (i.e., FAANMG) which explain why pure growth is handily outperforming.




The best and worst sectors.  The S&P 500 has 11 sectors.  The two best (info tech and healthcare) and the two worst (energy and telecom) are shown below.



The most positive and negative influences on the S&P 500.  The S&P also has 11 “x” sector indices.  These are indices that exclude a specific sector.  We show the two best and worst x-sectors below.

This is useful as it shows how much a sector influences the overall S&P 500 (by subtracting the “x sector from the overall S&P 500 in blue).  So x-energy is up 12.93% versus 11.05% for the overall S&P 500.  This means that the energy sector dragged down the overall S&P 500 1.88%.  Conversely, x-info tech is up 8.76% against 11.05% for the overall S&P 500.  This means the info tech sector has pushed up the overall S&P 500 2.29%. 



Interactive Chart 

The interactive chart below can be used to view the total returns for any or all of the 34 indexes provided under the “select an index” dropdown menu. The date range can be adjusted at the bottom of the chart.


Posted in Charts of the Week, Samples

Bitcoin continues to fascinate observers and frustrate some owners with its exceptionally high volatility in recent weeks. Now back above $2000, Bitcoin has fought off two sharp declines since the end of May. 

One contributor to higher volatility is the dramatic fall in volume after the regulatory intervention by the Peoples Bank of China. See the second tab in the story point below. Volume fell by more than 90% and has not recovered. 

If you click to the third tab you can see the share of volume by currency. The USD has been slowly gaining share since the intervention but the CNY still accounts for the 2nd largest share of volume followed by EUR and JPY. 


Click for static images of the price, volume by currency and volume share charts. 
Posted in Charts of the Week, Samples

The chart below shows various tenors of interest rates since the initial FOMC hike on December 17, 2015. 10-year yields are almost exactly where they were prior to this hike. 30-year yields are actually lower over this time period.

At the same time, yields on the short end of the curve have marched much higher. A look at 3-month T-bills shows yields have shot up 84 basis points.

The flattening of the yield curve was a topic of a recent Conference Call.


Posted in Charts of the Week, Samples

The Federal Funds market is showing no signs of reviving.  The Fed still targets the federal fund’s rate. They do this by using tools like fixed rate reverse repos and Interest on Excess Reserves (IOER).  This suggests they think it will return some day.  But as the chart below shows, this market’s volume is still down 90% from its peak and still bumping around a 40 year low.  It is showing no signs of reviving.  Should the Fed consider abandoning this target for another interest rate benchmark?

Posted in Charts of the Week, Samples


Measuring Political Risk.  The Economist Intelligent Unit compiles Political Risk measures for 132 countries at last count.  The next chart shows the 10 countries with the lowest political risk.  Pretty standard stuff (Denmark then Luxembourg are the lowest).


The next chart shows the 10 countries with the highest political risk.  Britain is on this list! Right above it is the Congo and Iraq.  Right below it is Cambodia and El Salvador.

The reason is understandable, Brexit.  But Britain with a higher risk that Cambodia?  Similar to the Congo?  We would argue this rating is more about the “intellectuals” at The Economist making a political statement about their disapproval of Brexit more than an honest assessment of Britain’s actual political risk.




Using the interactive chart below, you can view the political risk for any country over any period you choose.



How safe is Trump?  The bettors are giving him much better than a 50% probability of stay in office until the end of next year.





Click for static images of the President’s ratings comparison, President’s ratings over time and how Trump compares to past approval ratings


Posted in Charts of the Week, Samples

The blue line below shows a 50-day moving average of the total trading volume in actual high-yield bonds as measured by TRACE. In the 50 days ending July 19, $7.66B of high yield bonds traded on an average day.

The green line shows the 50-day average of the total dollar volume (price multiplied by shares) for the 25 largest high-yield ETFs. HYG accounts for roughly two-thirds of this total. In the 50 days ending July 19, $1.56B of high-yield ETFs traded on an average day.

The red line, which shows the ratio of the green line to the blue line, shows the ETF market is currently 20% the size of the underlying cash market.

This is how one-fifth of the high-yield market now trades.



By contrast. the chart below shows the same metric for investment grade.  Only 4% of investment grade market trading is driven by ETFs. Other than high yield, this is a large number when compared to other ETF sectors.  It shows how dominant high yield is relative to its underlying cash market.


Posted in Charts of the Week, Samples

 The black market rate of Venezuela’s currency continues to collapse resulting in hyperinflation and a worsening situation in the country.  Note that in the last year the black market rate went from 1,010 Bolivars to buy a dollar to 8,481 Bolivars today.  A drop of 88%.


At this rate of currency depreciation over the last year, prices in Venezuela would need to rise 833% in the last year to keep pace with inflation.  This is not happening with wages.  But, as the next chart shows, the Venezuelan stock market is keeping pace with this hyperinflation rate (for now).  It went up by 970% in the last year (blue) leading to a 27% currency adjusted rate (red now).  Venezuela’s stock market has 15 liquid stocks with Mercantil Servicios Financieros, C.A. and Banco Provincial, S.A. account for 85% of their stock market’s capitalization.  Mercantil Servicios is a junk rated credit and Banco Provincial is no longer rated.

Posted in Newsclips, Samples

U.S. Dollar Decline Looking Over-Extended

  • Financial Times – Dollar sinks on failure of healthcare reform
    US currency hits 10-month low as hopes fade for Trump economic stimulus
    The dollar has been a barometer of prospects for the Trump administration’s efforts to enact pro-growth policies of tax cuts and fiscal stimulus. As the administration has become bogged down in the past six months handling healthcare reform and dealing with the Russia scandal, the reserve currency has steadily retreated. Lacklustre economic data, notably a weaker tone for inflation and retail sales for June, have prompted the bond market to reduce the likelihood of further interest rate increases from the US Federal Reserve.

  • Wall Street Journal – Why a Weaker Dollar Is a Source of Market Strength
    The dollar is down. But that is good news for markets

    The WSJ Dollar Index has now unwound the boost it got from the election of Donald Trump in November, and is down about 6.5% this year. The greenback’s key counterpart, the euro, is up close to 10% in 2017. Early Tuesday, the euro rose above $1.15 for the first time since May 2016, reaching the top of the range it has been in since the start of 2015 under the influence of monetary-policy divergence between Europe and the U.S. The transformation in the dollar and euro’s relative fortunes in 2017 has been remarkable. The focus at the start of the year was on the U.S. Federal Reserve and its efforts to raise interest rates; now the European Central Bank has stolen the spotlight as it tacks gently away from ultraloose policy settings.

  • Wall Street Journal – Dollar Doldrums Mean Easier Money
    The Goldman Sachs Financial Conditions Index, a widely-watched gauge, was at its lowest since late 2014 this week. The lower the index, the looser the flow of money, based on factors like bond yields and the value of the dollar against its peers. Much of that is the result of a falling greenback. The WSJ Dollar Index, a measure of the U.S. currency against 16 others, is down 6.5% since the end of last year. The index was down another 0.6% Tuesday morning at its lowest level since October, before the presidential election spurred a big surge in the dollar.


Expectations for sustained weakening by the U.S. dollar seem to be fashionable lately. And there are many reasons why this could be the case. We discussed some of them yesterday as they related to potential tailwinds for emerging markets. But there are signs the dollar’s latest decline is over-extended, short-term outlook aside. The potential for sustained dollar weakness, which would mean persistently loose financial conditions, may complicate the Fed’s plans. 


Despite agreeing that medium-to-long-term influences point toward persistent U.S. dollar weakness, we see two signs that the short-term outlook is brightening. The first is a simple momentum indicator we use to highlight overbought and oversold conditions. The chart below shows oversold conditions (indicator below -0.5) beginning to appear. 



The second is that our 20-day forecast model is beginning to lean bullish for the dollar. The model estimates the probability that the Bloomberg U.S. Dollar Index will close higher in 20 days. The recent dollar selloff has seen this probability climb to 76.8%. You can read more about the model here

It’s important to note that the latest decline accelerated as the markets tried to gauge political consequences of a defeat to GOP-led health care reform. Deteriorating political risks would be well outside the scope of the model, which considers changes in changes in the yield curve, relative performance of global equities, global risk indices, economic data and gold. The volatile political environment in the U.S. is a risk fact for dollar weakness to continue or even worsen. 



Setting aside the short-term outlook for a moment, the potential for persistent U.S. dollar weakness will complicate discussions within the FOMC as they progress toward balance sheet normalization and consider further rate hikes in 2017. We have discussed how financial conditions do not necessarily tighten as the Fed is raising interest rates. And we’ve also discussed how uncertainty and financial stability concerns tend to accompany tighter financial conditions. But the second Wall Street Journal story above illustrates another point. 

The chart below from the Wall Street Journal story clearly shows just how influential the U.S. dollar weakness has been in driving financial conditions lower (looser). The potential for sustained dollar weakness means a potential medium-to-long-term bias for looser financial conditions. As we’ve mentioned before, New York Fed President William Dudley has promoted the Goldman Sachs Financial Conditions index within the Fed as a means to gauge policy effectiveness. We’ve noted that the influence of the stock market may be problematic if the Fed misses other signals like the yield curve. If the weaker dollar is clouding the signal in the index, the Fed risks tightening too quickly.



This is precisely the opposite challenge they faced as they marched toward the final tapering in late 2014 and the first rate hike in 2015. Both instances saw markets build a massive premium into the U.S. dollar as the Fed was the only central bank tightening policy. There is potential for this premium to be unwound as the Fed begins to slow its pace of tightening and other central banks converge on tighter policy stances. The Fed may be happy to see economic tailwinds from a weaker U.S dollar given recent weakness in economic data. But weighing these offsetting influences will make for complicated discussions and tricky communications in the months ahead. 


Despite valid reasons to expect persistent U.S. dollar weakness, we see some signs that this latest decline is getting over-extended. Firming expectations for more dollar declines are driving positioning across many assets, especially emerging markets. A near-term correction isn’t likely to derail medium-to-longer-term dollar weakening. An eventual return to dollar weakness, or continued dollar weakness despite oversold conditions, will complicate the Fed’s discussions about further tightening this year. 

Posted in Newsclips, Samples

The Market vs. The Fed Update

  • The Daily Reckoning – Jim Rickards: The Fed Has Hit the ‘Pause’ Button

    No rate hikes are coming at the July, September or November Fed FOMC meetings. The earliest rate hike might be at the December 13, 2017 FOMC meeting, but even that has a less than 50% probability as of today. I’ll update those probabilities using my proprietary models in the weeks and months ahead. The white flag of surrender came in two public comments by two of the only four FOMC members whose opinions really count. The four voting members of the FOMC worth listening to are Janet Yellen, Stan Fischer, Bill Dudley and Lael Brainard.


The market has 1.5 hikes priced in through the end of 2018 with no more hikes expected this year. The Fed’s June update to its Summary of Economic Projections predicted 1 more hike this year and three next year. The market and the Fed are once again on different pages. Go with the market as it has a better track record.


The Fed last updated their Summary of Economic Projections at the June FOMC meeting with an expectation for one more rate hike by the end of 2017 and an additional three by the end of 2018. This would leave the targeted funds rate at 1.375% as 2017 comes to a close and 2.125% by the end of 2018.



But, as the chart below shows, the market is not pricing in another hike this year. The odds of a hike at the September meeting are just 10% while the odds of a December hike are 42%.



Expressed another way, the market has 0.4 more hikes priced in for this year while the Fed expects one more hike. By the end of 2018, the market expects 1.5 more hikes while the Fed expects a total of four.

Posted in Newsclips, Samples

Market Not Convinced The Trump Trade Is Dead

  • Bloomberg View – Komal Sri Kumar: How Trump Could Puncture the Equity Bubble
    A delay in stimulus measures and the rise in global trade tensions could deflate valuations.

    Donald Trump’s appeal last November was linked to two factors. Both are now putting the valuation bubble in equities at risk. The first factor was his emphasis on stimulus — tax reform, infrastructure spending and fewer regulations — that has pushed markets to higher and higher levels. The new administration was targeting at least 3 percent annual growth in real gross domestic product, well in excess of levels that the U.S. economy has experienced since the financial crisis.  The second component of the Trump campaign presented the U.S. trade deficit as a sign that the country was being treated unfairly by its trading partners. The remedy was to impose higher tariffs on imports, with China and Mexico mentioned as specific targets. Fear that the trade restrictions the candidate threatened during the campaign would dominate the incipient administration was the reason U.S. equity futures plunged during the hours immediately after the election results were known. Retaliation by trading partners to new tariffs would have slowed global economic growth and demand, resulting in a headwind for equities.

  • The Wall Street Journal – The Last Market Still Betting on Trump

    Still, the market’s high valuation in the face of declining earnings growth and a tepid U.S. economy means some of the rally was likely driven by policy expectations. More than half of the respondents to a survey of nearly 1,100 clients conducted by Cornerstone Macro last month said they expected Congress to pass a significant tax bill before the 2018 midterm elections. The question to ask, says Cornerstone’s Andy Laperriere, is what would happen to stocks if all investors gave up on a tax cut? The answer: They would probably go down.


The Trump trade has three parts; healthcare reform, tax cuts and a business friendly environment. Healthcare reform is on life support, but not totally dead. Expectations are tax cuts, especially corporate tax cuts, can still happen. The massive reduction in regulatory activity is viewed as a big positive for markets. Sum it up and the Trump trade, or at least the hope of the Trump trade, will continue to be a tailwind for markets.


As we noted last month, the U.S. is experiencing an unprecedented drop in regulatory activity. This is in part due to Trump’s pro-business agenda.


In addition, the betting markets are not convinced that healthcare and tax reform are dead. As the next chart shows, the betting markets barely budged on yesterday’s news that Republicans were abandoning the current bill. Bettors have been giving less than a 50% chance of healthcare reform since May and have placed the odds near 20% in recent weeks. 



Regarding tax reform, bettors still place 51% odds on a cut to corporate tax rates. The odds the individual tax rate will be cut stand closer to 36%.



Posted in Newsclips, Samples

U.S. Banking Sector Lagging Despite Steeper Curve

  • Wall Street Journal – Bank Earnings Are Coming: Five Things to Watch
    Calm markets, the Fed and lighter lending are among the factors seen influencing second-quarter results
    The Federal Reserve’s decision to raise short-term interest rates in June, the fourth rate increase since December 2015, should boost banks’ lending income. The rates banks charge on credit cards, home equity lines of credit and other types of loans vary depending on the Fed’s target. Those higher yields will help push net-interest income at the median big U.S. bank up by 6.2% in the second quarter, according to analysts at RBC Capital Markets.


Recent steepening in the U.S. Treasury curve offers a brighter outlook for financials and especially regional banks, yet regional banks have lagged despite heavy inflows into the sector. Further steepening in the treasury curve could see regional banks outperform. 


As the chart in the health care block above shows, despite strong inflows in July, financials continue to underperform at only +5.2% for the year. We noted through the second quarter that U.S. bank equities looked vulnerable to further flattening in the Treasury curve. Interest rates were already well below forecasts and expectations for net interest margins were still tied to a steeper curve. Bank investors were granted some relief as the Treasury curve steepened over the past month. The chart above shows the U.S. 2y10y spread has steepened almost 20 bps since June 14. 

It appears that regional bank investors may now be too pessimistic about the outlook for net interest margins. The next chart shows 20 day change in the U.S. 2y10y spread (x axis) and U.S. regional bank total returns (y axis). The latest point is marked. Bank total returns are flat over the past 20 days even as the 2y10y steepened 17 bps. But past steepening moves greater than this have been heavily skewed toward stronger total returns for regional bank equities. 




ETF investors are flooding into financials despite continued under-performance. One potential headwind for the banking sector specifically has diminished as the Treasury curve steepened in the past month. Now regional bank investors appear wary of accepting the brighter outlook for profitability. We expect net interest margins to be in focus during earnings. Regional banks could be poised to outperform in the near term if the curve continues to steepen. 

Posted in Newsclips, Samples

The Fed’s Got a Fever and the Only Prescription is More Inflation

  • Bloomberg – The Study Europe’s Rate-Setters Should Read
    A new paper shows why the longer rates stay low, the fewer benefits they bring.
    A key argument for hurrying up with a monetary tightening is that negative rates have hurt bank profitability, restricting lenders’ ability to give credit to families and firms. But is it really the case? How low can interest rates go before they become a drag on the economy? A new way of thinking about this problem comes from a working paper by Markus Brunnermeier and Yann Koby at Princeton University. The two scholars believe there is a “reversal interest rate” below which a central bank prompts lenders to cut back on their lending, instead of increasing it. This boundary creeps up over time, setting a limit to how long central banks should keep interest rates low.
  • Bloomberg – The Fed Needs a Better Inflation Target
    A higher goal, with more public support, would benefit the central bank and the economy.
    Today, a group of economists published a letter urging the U.S. Federal Reserve to consider a monumental change in policy: raising its target for inflation above the current 2 percent.

    I signed the letter. Here’s why.

    The inflation target helps define how much stimulus the Fed can deliver when it lowers interest rates to zero (a boundary below which the central bank has been unwilling to go). In a higher-inflation environment, a nominal fed funds rate of zero results in a lower real, net-of-anticipated-inflation rate — the rate that economists typically see as most relevant for consumer and business decisions. If, for example, people expect inflation to be 3 percent, then a zero nominal rate translates into a negative 3 percent real rate — a full percentage point lower than the Fed could achieve if expected inflation were 2 percent.


We have two opposing perspectives in the articles above concerning further monetary stimulus. The ‘reversal rate’ suggests interest rate cuts can move from an accommodative to contractionary impact on lending. The research indicates balance sheet expansion increases this so called reversal rate, meaning interest rate cuts could more quickly become ineffective. In contrast, Kocherlakota continues his support for easier policy by signing a letter with fellow economists urging the Federal Reserve to increase its inflation target.

Who’s right? Unfortunately, the camp calling for continued accommodative policy has a difficult battle showing its ability to foster improved lending and ultimately economic/inflation growth. However, both perspectives appear to have value. We will explain.

The chart below shows two important components of financial conditions: 1) deposits and lending growth (orange line) and 2) leverage and volatility in the financial system (green line). Lower levels indicate expansion, while higher levels contraction. 

Financial leverage remains as elevated as ever and coupled with ultra-low volatility in market returns. Conversely, growth in deposits and lending has steadily retreated post-Great Recession to near average levels. We define values below the shaded green band as too expansionary and values above too contractionary. The Federal Reserve should likely aim for these financials conditions to remain near average (zero).



Prior to the Great Recession the changes in the fed funds rate led to better conditions (i.e. growth) for deposits and lending. The scatterplot below shows six-month changes in the funds rate versus changes in our composite of deposit and lending growth six months forward. More cuts (moving left in chart) were matched with accommodative conditions.


But this all changed post-Great Recession. Further easing actions were surprisingly often followed by diminishing growth in deposits and lending. Confusingly, recent hikes have had balanced-to-accommodative impact. We see some evidence of this ‘reversal rate’ suggesting cuts beyond a certain level can become contractionary. Is a rise in rates toward this ‘reversal rate’ actually good for the economy?



So the Federal Reserve’s steadfast committal to interest rate hikes may be the better path barring a significant shift in economic data. However the added pace of tightening created by balance sheet reduction may be better connected to a higher inflation threshold as suggested by Kocherlakota.

The chart below shows the impact of year-over-year balance sheet reduction on deposits and lending during varying rates of inflation. We are aiming to show the likelihood of the Fed going too far (i.e. mistake) when tightening. This model uses changes in major economic data releases to determine probabilities of balance sheet reduction forcing our composite of deposits and lending to exceed +1 standard deviation from the long-term average (above green band in the first chart above). For the probabilities below we have held constant current rates of economic growth and assumed a pace of hikes at 50 bps per year.

Current core inflation near 1.9% year-over-year (CPI ex-food and energy) shows the Fed has a higher probability of causing a contraction in deposits and lending at nearly any pace of balance sheet reduction. Inflation running above 2.2% indicates a better environment with lower probabilities of contraction.





The Fed will be taking a gamble with continued rate hikes in hopes economic growth remains stable and inflation rises. Losing this bet would likely force the U.S. Treasury yield curve flatter and flatter while demand remains high for longer-dated issues. We have recently shown the yield curve is on the precipice of flattening to quite unfavorable levels for banks and other financials. In this scenario, the Fed like Chistopher Walkin has a fever and the only prescription is ‘more inflation.’

Next Wednesday (June 14) we will see May’s CPI. We continue to believe inflation remains paramount to job growth as we reach full employment. 

Posted in Samples, Webcasts



In our latest webinar, Peter Forbes expands on the financial sector and yield curve

Similar to the block below about the financial sector and yield curve, ETF investors may still be optimistic enough about deregulation to look past the darkening outlook for net interest margins. But the combination of a hawkish Fed and a weakening economic outlook could be enough to shake the lingering confidence of bank ETF investors. The 2y10y spread has another 10 bps to the 2016 lows near 75 bps. A retest of those lows may be a moment of truth for the financial sector. 


  • Financial Times – Bank shares hit as Treasury yield curve flattens
    Net interest margins for financials been depressed for an extended period
    An important measure for US bank profitability plumbed an eight-month low on Tuesday, pressuring the shares of lenders and highlighting doubts in the bond market over the prospect of an acceleration in the economy and inflation this year. The difference in yield between two and 10-year Treasury notes narrowed 2.5 basis points to 84.99 bps, the lowest level since October 3, according to Bloomberg data. This closely watched relationship climbed to a post-election high of 135.5bp in late December, predicated on President Donald Trump’s pro-growth policies boosting inflation and sparking higher interest rates in the future.


Many ETF investors are clinging to elevated post-election expectations for the financial sector despite the worrisome flattening in the yield curve. In the wake of the November election, banking ETFs saw total assets surge by $4.5 billion. Through a mix of poor performance and more recently, steady but limited outflows, assets have fallen $2 billion from the March 1 peak. A substantial amount of the post-election flows have remained in financials despite souring conditions. 



ETF investors who were among the first to jump aboard the post-election rally are still in the money. The chart below shows the average cumulative return for banking ETFs since the election is +17.6%. Nearly anyone else who invested in banking ETFs since November is seeing performance suffer. 



And importantly, investor performance and bonuses are not measured using “Trump to-date” returns. The chart below shows year-to-date total returns for the broad S&P 500, S&P 500 Bank index and S&P 500 Regional Bank index. Regional banks which are more exposed to net interest margins are under-performing the broad market by almost 11%. 




Similar to the block above about the financial sector and yield curve, ETF investors may still be optimistic enough about deregulation to look past the darkening outlook for net interest margins. But the combination of a hawkish Fed and a weakening economic outlook could be enough to shake the lingering confidence of bank ETF investors. The 2y10y spread has another 10 bps to the 2016 lows near 75 bps. A retest of those lows may be a moment of truth for the financial sector. 

Posted in Newsclips, Samples

Discussing The Six Stocks Leading This Rally


Net Positions – Why Are Six Stocks Leading This Rally?
In this Net Positions, Jim Bianco takes a look at the six stocks leading the rally.


There is not a single clean metric to show if the stock market’s returns are concentrated in a few stocks. That is why we use several charts above to show the S&P 500’s gains this year are the most concentrated since the tech bubble of 1995 to 2000.  

To illustrate, a portfolio holding 86% cash and a market weighting of the six FAANMG stocks in the other 14% would be up 2.60% this year. Many fully invested, highly diversified funds have done worse.

2017 investment committee meetings can be condensed into two topics:

  • What to do with FAANMG stocks as a group
  • What to do with the other 494 stocks in the S&P 500 as a group

Simply put, managers will have a very tough time outperforming the market unless they are correctly positioned in the FAANMG stocks. While this simplifies investment meetings, managers are essentially living and dying by these six stocks.

  • Bloomberg View – A Few Big Stocks Don’t Tell the Whole Market Story
    Investor nervousness over concentrated gains in the markets is nothing new. The FANG stocks — Facebook, Amazon, Netflix and Google — accounted for a large part of the S&P 500 gains in 2015, as well. AQR’s Cliff Asness looked at the impact of individual stocks on the S&P 500 from 1994 to 2014 and compared those results to the 2015 FANG-driven market. Asness showed what the impact on overall market performance would have been if you removed the best performing stocks each year
Again, as noted above, there is no single statistic that measures the concentration of returns. This story uses a different set of statistics and comes to a different conclusion.