There’s A Number That Ends This Cycle — But What Is It?

After an epic (generation-spanning at the long end) decline in interest rates, the trend has finally reversed. Which means, if history is still a reliable guide, there's a number that ends this cycle and ushers in the next recession and equities bear market. But what is it?

Here's a chart (from MishTalk) that shows the relationship between short term interest rates and economic recoveries. In cycles past the Fed has responded to building inflationary pressures by raising the Fed Funds rate, and eventually the rising cost of short-term loans either caused or coincided with the expansion's end. Note that in the past it didn't necessarily take a long, dramatic rate increase. Just a change in direction over a year or two was enough to turn growth into shrinkage.

Meanwhile at the longer end of the yield curve interest rates are jumping as well – also in response to the perception that inflation is becoming a thing again. Here's the 10-year Treasury bond yield since 2016:

This rate matters in part because it's how banks price 30-year mortgages. Already it's having a profound effect. See Mortgage rates are surging to the highest level in 7 years.

Last but not least, the relationship between short and long rates is a number, and might end up being the one we seek. The following chart shows the 10-year Treasury yield minus the 2-year Treasury yield. When it drops below zero the curve is inverted, which has historically signalled a slowdown. So the magnitude of the (apparently) coming yield curve inversion is a big deal.

The frustrating thing for investors (including short sellers) is that, as all three of these charts illustrate, there is no historically magic number that always does the trick. Rates in general have been falling over the past few decades as government financial mismanagement has required ever-easier money to keep the game going.

This means that it might not take a return to, say, the 8% Fed Funds rate of 1990 to blow up the system; a much lower rate – spread out over vastly more debt – might do the trick. Same thing with mortgages. In the healthier past a 6% rate on a 30-year mortgage was low enough to excite home buyers. Now 4.5% is pricing homes out of most Americans' reach.

So the exact number on the exact indicator that turns a steady expansion and robust bull market in a brutal bear market will only be known in retrospect. In the meantime we'll just have to pay attention and hope that the end, when it comes, provides at least a little warning.

Emerging Market Massacre Continues - Latam FX At Weakest In History

All the pesos are getting pounded - Argentine, Colombian, Chilean, and Mexican - but the 'best indicator of EM turmoil' - the Brazilian Real - is really suffering...

But the Rand is the worst...

As the Emerging Market massacre continues to accelerate... this is the worst start to a year since at least 2010...

Amid an incessantly strengthening USDollar.

And the collapse of the EM FX carry trade...

Latin American currencies just keep selling off even as commodities, the region's main exports, rise. The LACI index is at the lowest since January 2016...

And the lowest relative to emerging markets peers ever...

It's not just FX, Emerging Market Debt is suffering its worst year since at least 2012...

Bloomberg's Eric Balchunas points out more evidence of calm before EM ETF bloodbath is traders (EEM) are bailing now, and allocators (IEMG) while not yet leaving haven't added inflows at all for 20+ days straight...

Roughly translated - the professionals are dumping to retail (while we have previously noted just how exuberantly the professionals are pitching this 'dip' as a buying opportunity in EM)...

And Bloomberg's Lisa Abramowicz points out that the biggest local-currency emerging-markets ETF has lost nearly 20% of its assets since the beginning of April, dropping to $6.5 billion from $7.9 billion.

The storm before the bigger storm.

This Is A Really Strange Development

Observing the eurodollar system as I've done for so many years, you have to be prepared for curve balls thrown at you. Just when you think you've got it clocked (sometimes literally), something changes and it all gets tossed out the window.

About a month ago, the Federal Reserve reported a sharp drop of UST's in custody on behalf of foreign agents. I noted then, and remain convinced now, that was something like a collateral call. It happened the week of April 18.

Not surprisingly, the same data shows over subsequent weeks the amount of UST's in custody continued to decline sharply. The four-week total (through the week of May 9, the latest available) is about -$66 billion. That's an enormous drop, a level in the same class as other episodes where global liquidity problems were obvious.

Not only that, gold prices have been exhibiting the same repo-related tendency (crashes) dating back to that same week. Yesterday, gold fell below $1,300 for the first time since the last trading day of last year. It's the same anti-reflation/collateral deflation pattern we've become accustomed to.

As if we needed more evidence, this latest currency crisis (and it is now a crisis) spreading across the world traces its origins to the same week. The Argentine peso, for one, had been merely falling prior. Since the week of April 18, it has crashed. The same goes for others like the rupiah and real.

It's also the week when EUR turned and HKD exhibited the heaviest HKMA interventions.

We know without a doubt that something turned really bad the week of April 18, but what was it?

With the euro now trading under 1.18, I figured it was a safe bet that we'd later find out during this period since mid-April there would have been another spike in repo fails. Fails aren't necessarily a coincident indication. At several times in past eurodollar events, they have led, at others lagged. Given the surge in indicated dealer hoarding in the week prior, the week of April 11, a jump in fails at some point seemed almost guaranteed to go along with this increasing "dollar" mess.

Quite the contrary.

FRBNY reports today that there were practically no repo fails last week. The total combined ("to receive" plus "to deliver") was $22.9 billion; not $229 billion, as had become almost the baseline, but a level so low we've not seen it in the fails data for seven years going back to just before the outbreak of the 2011 crisis.

This is some pretty weird stuff. Perhaps it was a misprint or typo in the FRBNY data. While that's not impossible, it would have had to been applied to both sides ("to receive" as well as "to deliver") making it less likely. But the New York branch also reported a serious collateral de-hoarding coincident to what I'm going to call the week of no fails.

The pattern itself is not unprecedented. In 2008 as well as 2011, when some of the truly worst stuff was going on repo fails were not a pressing issue. They had in both cases preceded all that, and indicated systemic problems that were likely breaking out in that way. Again, as a coincident indication they weren't always there.

What's unique, obviously, is the scale of the decline this time around, particularly in how it is such a clear change from what's been standard operative conditions – as well as the specific period in which this has happened. The week of May 9 saw some of the biggest currency declines since the last "rising dollar" and they hit practically everyone (including to limited extent CNY).

Is this overseas capacity being asked to contribute collateral strictly to domestic participants? A one-way collateral call that offshore can't meet? It might explain the different direction reported for overseas collateral stock from what the limited view domestically (and repo fails only apply to what repo market transactions are reported by primary dealers operating in US capacities) is suggesting. There aren't a lot of answers here.

Another possibility is intervention. But who? Certainly not the Fed and not likely any of the ECB, SNB, or equivalent (BoJ and BoE would be the two most likely candidates, especially the former given TIC data). To whom? Through what channels?

As if we needed any more to investigate, it has gotten real interesting yet again.

Oil Market Flashes Warning - Prompt Brent Flips Into Contango

For the first time since September, the front-month Brent futures curve has flipped into contango suggesting notable physical supply being added (driving the front-month below the curve) - a sure sign of an oversupplied market.

Despite oil's surge to near $80 a barrel, some corners of the market that reflect the trading of actual barrels are weakening fast.

That's in part because for the coming months cheaper U.S. crude is set to flood across the Atlantic, while demand for Brent grades from traditional buyers in Asia has been muted, according to Citigroup Inc. analyst Chris Main.

Oil refiners have plenty of crude at hand right now, with unsold cargoes in north-west Europe, the Mediterranean, China, and West Africa, according to physical traders who asked not to be named discussing market movements.

As Bloomberg reports, for weeks, physical oil traders wondered whether the weakness in the physical oil market could bring down the paper -- or derivatives -- market. Add seasonal refinery maintenance and the combination has "barrels without a home, creating a prompt overhang," said Amrita Sen, chief oil analyst at Energy Aspects Ltd. in London.

As Barclays analyst Michael Cohen wrote in a report this week:

"Barring further disruptions our balances suggest a steady correction from these highs over this year and next."

"Some indicators are already not so positive. Brent time-spreads and CFDs have moved sharply lower. ICE gasoil time-spreads have also been trending lower"

And that is what is happening.

US 5Y Yields Are Higher Than Any Available 10Y Yields In The G10

Deutsche Bank has recently made fascinating observations, as showed just how much of an outlier the US yield curve has become relative to all other G10 nations: "The US 5y yield is now higher than any available 10y yield in other G10 countries."

The US 5y yield is now higher than any available 10y yield in other G10 countries: DB

— zerohedge (@zerohedge) May 16, 2018

The full observation, originally made by Deutsche Bank's macro strategist Alan Ruskin, was as follows:

In what is a very unusual experience, not only does the US have the highest 2y, 5y and 10y nominal and real yields in all of G10, but the US's 5y yield is now higher than any available 10y yield in other G10 countries. Even the US's nominal 3y yield (2.73%) is higher than all G10 countries' 10y yields, except Australia's 10y (2.82%).

Visually, this is shown by this sampling of G10 yield curves, in which the US is obviously the purple curve at the top:

Today Bloomberg had a similar take on this dramatic flattening of the yield curve, noting that while US 2Y TSYs offer nominally higher yields than 10Ys in Canada and Italy, US 3-Month Bills yield more than 60% of 10-Y yields across the DM space.

Needless to say, the flattening across the US curve has been astonishing.

For reference, another Deutsche Banker, Jim Reid, reminded us yesterday of the last time the 10Y was where it is now, at ~3.10%: for comparison's sake, this was back in 2011 when 2yr yields were around 0.4% and 30yr yields were around 4.3% so as Reid puts it, "today's level are a testament to how much flattening the curve has still seen in recent years as 10yrs have returned to the same level."

Meanwhile, back in 2011 10yr Bunds were also around 3% while yesterday they did climbed 3.3bps to 0.641%, "so that continues to be one of the most crazy global financial markets" in Reid's humble opinion.

The important point, according to Ruskin, is that "investors can take much more limited duration risk on US fixed income, to get the same yield as anywhere else in the G10 world."

Duration risk, related to stretching out the yield curve, is seen as a particular issue in this cycle as Central Banks exit extreme accommodation. In the US, duration risk relates particularly to a few difficult to quantify factors, including: i) an unusually large expected increase in Treasury issuance (of nearly 3% of GDP between 2017 and 2019) related to both the Fed's balance sheet reduction and the large fiscal expansion; and, ii) because the US Administration is attempting to put a stop to large official reserve buildups that are related to currency manipulation. These recycled official flows into US Treasuries, acted as 'a bond put' when the USD was weak.

And while the US yield curve is starting to move under the parameters of conventional economic forces such as treasury supply and demand, places like Europe and Japan are still toiling under an entirely different set of factors, namely central bank "jump risk" or concerns that central banks will no longer anchor the long end, causing another taper tantrum and/or VaR shock.

In the EUR area and Japan, the critical duration concerns relate to how aggressive Central Bank easing has severely distorted fundamental bond and credit value, and the uncertainties this fosters about 'jump' risk as and when they exit such distortionary policies. This exit risk particularly applies to Japan's yield curve targeting regime.

Of course, anyone who has watched the yield curve and the USD recouple in the past month - literally, ever since the PBOC cut RRR on April 16 - will know that the sharp move in rates has been matched by a similar move in the dollar.  This has manifested itself by the sharp spike in short-end yields which have led to an effective pancaking of the US Treasury yield curve: here's Ruskin:

In the past it has been remarked, how high US short-term rates and the flatness of the US yield curve has been a deterrent to hedged foreign flows into US Treasuries, most obviously from Japan.

The flip side of this is that as long as the expected USD exchange rate has shifted broadly neutral, US short-term yields are certainly high enough relative to a G10 peer group, to be extremely attractive without the need for investors to stretch out the curve and assume duration risk.

Ultimately, this boils down to a feedback loop whereby perceptions of a relatively stronger economy manifest in changes in the yield curve, which in turn leads to capital inflows, and a stronger dollar, are prompting the Fed to tighten further, creating expectations of even higher short-term rates, and even stronger inflows.

As per the above, the expected exchange rate is crucial to the US attracting unhedged bond flows that are then USD positive, and the compelling duration weighted yield advantage is one important factor tipping the scale in favor of self fulfilling positive USD expectations.

And while the feedback loop is quite effective on its own, especially with yields at other G10 economies frozen by QE or NIRP, the one catalyst that can breach it is a repricing of economic expectations. For now, the US is seen as the cleanest dirty shirt, especially after China's easing on April 17 which launched the aggressive repricing higher of the dollar and 10Y yields (maybe it was Beijing's warning shot in the ongoing Trump-Xi trade war?)

All that would take for the recent move to reverse violently, would be one or more economic indicators disappointing, or Fed heads suggesting that tightening in the US has gone on too far. Until that happens, however, keep buying that USD and cut duration on the curve: after all if the difference between 2Y and 10Y paper is just ~50bps, why not?

The Greatest Financial Mismatches In History

The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only.  – John Maynard Keynes

It's time we expose a few of the greatest financial mismatches in history. At the top of my mind, due to a myriad of behavioral and cognitive hiccups, are select retail investors (you know who you are), who must come to grips with how they're handling current stock market volatility.

It's a moment of truth

Too many investors possess a hook-up mentality with stocks. Holding periods are at historic lows. According to the New York Stock Exchange's extensive database, the average holding period for stocks in 1960 was 8 years, 4 months.

As of December 2016, it was 8.3 months.

Last year's unprecedented stock market performance for the S&P 500 was the worst event for investor psyche.

I'll explain.

No doubt, it was a magical year. The market closed higher every month (first time in history). The Sharpe Ratio, or returns on the S&P relative to the risk-free (Treasury Bills) and volatility was 3.7. Since volatility was non-existent last year, risk-adjusted returns for the market were among the best I ever lived through; at least the highest in over 50 years.

Think of it like dating the most popular girl (or guy), in high school. In the beginning, you wonder how the heck it happened. Such luck! Eventually, you believe you're entitled to dating prom kings and queens in perpetuity. The problem is ego. You convince yourself the perfect prom date is the norm and begin to compare every date after to "the one." What a great way to set yourself up for failure, missed opportunities and myopia that slaughters portfolio returns (and possibly, relationships!)

In 2017, equity investors witnessed a storybook investment scenario. This year so far? Reality bites. It's not that your adviser doesn't know what he or she is doing; it's not the market doing anything out of the ordinary, either. The nature of the market is volatility, jagged edges and fractals. The sojourn, the Sunday drive in perfect weather with the top down on a newly-paved road in 2017, was an outlier. The environment you're investing through today is the norm; therefore, the problem must be the driver, the investor who doesn't realize the road conditions are back to resembling 5pm rush-hour in a downpour.

Do you experience frustration with a purchase your adviser implements or recommends if the price doesn't quickly move in your favor? Do you question every move (or lack thereof), a financial partner makes?

How often do you say to yourself – "She didn't take enough profit. Why did he buy that dog? Why isn't he or she doing anything? (Sometimes doing nothing is the best strategy, btw).

Do you constantly compare portfolio performance every quarter with a stock market index that has nothing to do with returns required to meet a personalized benchmark or long-term goal like retirement?

Ostensibly, the ugly truth is there may be a mismatch between your brain and your brain on investments. Listen, stocks aren't for everyone. Bonds can be your worst enemy. Even the highest quality bond fluctuates and can be sold at a loss before maturity. This is the year as an investor you're going to need to accept that volatility is the entrance fee to play this investment game.

According to Crestmont Research, volatility for the S&P 500 tends to average near 15%. However, volatile is well, volatile. Most periods generally fall within a band of 10% to 20% volatility with pockets of unusually high and low periods.

The space between gray lines represents four-year periods. Observe how volatility collapsed in 2017, lower than it's been in this decades-long series.

Per Crestmont:

"High or rising volatility often corresponds to declining markets; low or falling volatility is associated with good markets. Periods of low volatility are reflections of a good market, not a predictor of good markets in the future."

So, as an investor, what are the greatest financial mismatches you'll face today?

Recency Bias

Recency bias or "the imprint," as I call it, is a cognitive affliction that convinces me the trade I made last Thursday should work like it did when I placed a trade on a Thursday in 2017 when the highway was glazed smooth for max-market performance velocity. This cognitive hiccup deep in my brain makes me predisposed to recall and be seduced by incidents I've observed in the recent past.

The imprint of recent events falsely forms the foundation of everything that will occur in the present and future (at least in my head). Recency bias is a mental master and we are slaves to it. It's human. It's the habit we can't break (hey, it works for me). In my opinion, recency bias is what separates traders from long-term owners of risk assets.

When you allow volatility to deviate you from rules or a process of investing, think about Silly Putty. Remember Silly Putty? Your brain on recency bias operates much like this clammy mysterious goo.

Consider the market conditions. The brain attaches to recent news, preconceived notions or the financial pundit commentary comic-of-the-day and believes these conditions will not change. To sidestep this bias, at Clarity and RIA we adhere to rules, a process to add or subtract portfolio positions.

Unfortunately, rules do not prevent market losses. Rules are there to manage risk in long-term portfolio allocations.

Losses are to be minimized but if you're in the stock market you're gonna experience losses. They are inevitable. It's what you do (or don't do), in the face of those losses that define you. And if you're making those decisions based on imprinting or Silly Putty thinking, you are not cognitively equipped to own stocks.

Hindsight Bias

When you question your adviser's every trade or the big ones you personally missed, you're suffering from hindsight bias. Hindsight bias is deception. You falsely believe the actual outcome had to be the only outcome when in fact an infinite number of outcomes had as equal a chance. It's the ego run amok. An overestimation of an ability to predict the future.

The market in the short-term is full of surprises. A financial partner doesn't possess a crystal ball. For example, to keep my own hindsight bias under control, I never take credit for an investment that works gainfully for a client. The market must be respected. Investors, pros or not, must remain humble and in infinite awe of Mr. Market. A winning trade in the short term is luck or good timing. Nothing more.

With that being said, stock investing is difficult. Unlike the pervasive, cancerous dogma communicated by money managers like Ken Fisher who boldly states that in the long-run, stocks are safer than cash, stocks are not less risky the longer you hold them. Unfortunately, academic research that contradicts the Wall Street machine rarely filters down to retail investors. One such analysis is entitled "On The Risk Of Stocks In The Long Run," by prolific author Zvi Bodie, the Norman and Adele Barron Professor of Management at Boston University.

I had a once-in-a-lifetime opportunity to break bread with Dr. Bodie recently in Nashville and spend quality time picking his brain. I'm grateful for his thoughts. He expressed lightheartedly how his retail books don't get much attention although the textbook Financial Economics co-written with Robert C. Merton and David L. Cleeton is the one of choice in many university programs.

In a joking manner, he calls Wharton School professor and author of the seminal tome "Stocks for the Long Run,"Jeremy Siegel his "nemesis." He mentions his goal is to help "everyday" people invest, understand personal finance and be wary of the financial industry's entrenched stories about long-term stock performance. He's a man after my own heart. He'll be interviewed on the Real Investment Hour in early June.

In the study, he busts the conventional wisdom that riskiness of stocks diminishes with the length of one's time horizon. The basis of Wall Street's counter-argument is the observation that the longer the time horizon, the smaller the probability of a shortfall. Therefore, stocks are less risky the longer they're held. In Ken Fisher's opinion, stocks are less risky than the risk-free rate of interest (or cash) in the long run. Well, then it should be plausible for the cost of insuring against earning less than the risk-free rate of interest to decline as the length of the investment horizon increases.

Dr. Bodie contends the probability of a shortfall is a flawed measure of risk because it completely ignores how large the potential shortfall might be. Sound familiar? It should. We write of this dilemma frequently here on the blog. Using the probability of a shortfall as the measure of risk, no distinction is made between a loss of 20% or a loss of 99%.

If it were true that stocks are less risky in the long run, it should portend to a lower cost to insure against that risk the longer the holding period. The opposite is true. Dr. Bodie uses modern option pricing methodology i.e., put options to validate the truth.

Using a simplified form of the Black-Scholes formula, he outlines how the cost of insurance rises with time. For a one-year horizon, the cost is 8% of the investment. For a 10-year horizon it is 25%, for a 50-year time frame, the cost is 52%.

As the length of horizon increases without limit, the cost of insuring against loss approaches 100% of the investment. The longer you hold stocks the greater a chance of encountering tail risk. That's the bottom line (or your bottom is eventually on the line).

Short-term, emotions can destroy portfolios; long term, it's the ever-present possibility of tail risks or "Black Swans."I know. Tail risks like market bubbles and financial crises don't come along often. However, only one is required to blow financial plans out of the water.

An investor (if he or she decides to take on the responsibility), must follow rules to manage risk of long-term positions that include taking profits or an outright reduction to stock allocations. It's never an "all-or-none" premise. Those who wholesale enter and exit markets based on "gut" feelings or are convinced the stocks have reached a top or bottom and act upon those convictions are best to avoid the stock market altogether.

Blain: "The Bond Spike Confirms The End Of Experimental Monetary-Policy Rally"

"Fools ignore complexity. Pragmatists suffer it. Geniuses remove it."

What we got in markets this fine and dandy morning? The clue might be in the weather. Blue skies over London, and the forecast is for a great weekend. Compare and contrast with the snow and storms of just 2 months ago. The outlook is fine – so why is everyone so bleak about market prospects?

Perhaps it's the sheer complexity of all the awful bad news in geopolitics, rates, flows and all the other what-evers that drive market sentiment? Treasury yields (the 10-year US bond rate) have decisively breached 3%, spiking all the way up to 3.11% this morning - triggering terror across global stocks according to the news wires, although a glance out the window suggests stock jobbers ain't hurling themselves lemming-like from the 19th floor… yet. Still... we live in hope.

The problem is bad news sells. When did you last read a headline about everything being just peachy? You didn't. Sure there are worries out there. Recent economic data has been disappointing – which is hardly surprising when you consider just how much economies were disrupted by the miserable winter. It feels the global growth macro engine has stalled – but hey-ho, the sun is literally shinning this morning. We've seen divergence and dissonance in the synchronicity global growth vibe, but a few bum notes shouldn't stop the concert!

The bottom line is we're in a period of correction. Negative sentiment has been fanned because so many investors are out their comfort zones, for instance: if you bought into EM debt in search of the stellar returns that dried up in investment grade, you are probably nursing severe bruises - meaning you are bound to be negative. Meanwhile, you might miss that distressed sovereign specialist Michael Hasenstab of Franklin Templeton just took a massive $2.25 bln bet on Argentina, buying new Peso debt.. Ask yourself: what does he know that recent yield tourists into Latin America don't? (The answer - I would hazard.. is lots.)

Then there is Italy. what's ever not to worry about when it comes to Italian politics! 10-year Italy bond yields have risen 25% since early May, and if you really think 2.09% is the right yield, I'll sell you as much as you want. Sure, its got everyone worried about the EU, how the ECB will react, and all that stuff about how Italy will become a rotten core of Europe with a quasi Lire destabilising the Euro. Or maybe not: Italy has been, is and will always be... Italy. Get over it. My best advice on Italian politics is worry not.. the Italians don't seem to mind.. In fact, play the likely over-reactions...

And as for US bond yields spiking to 3.11%. Yawn… 3% bond yields are still far south of the 5% normalised rate we saw prior the Global Financial Crisis (GFC) of 2008. Slightly higher, but still historically low, interest rates will shake out a few weaker over-levered firms, put the fear of god into yield tourists, but will also stimulate other return driven sectors – not least financials!

What we are seeing is shift. 

The bond spike confirms it's the end of the long-term secular 30-year bond bull market, but also the end of the post GFC experimental monetary-policy driven rally. Bond yields will go higher. Get over it. Reassess where other markets are going – take a look at oil prices, up 30% since Feb. Stocks aren't showing direction yet – but it's clear the VIX shock back in Feb has calmed much of the froth, and our chartists agree that while we may see a continued range pattern for a while, its as likely the next big move will be higher. 

Sorry if all the above sounds a bit upbeat. I shall no-doubt return to my resolutely bearish mood by this time next week. 

Meanwhile, I've spent the last few days traveling, including a very informative one day aviation conference arranged by Doric – the largest independent aircraft lessor. They assembled a superb roster of speakers to address many of the key aspects of aviation finance including valuations and transparency. But, perhaps the key "wake up and smell the coffee" moment was a very effective on-stage interview with the CFO of Finnair who reminded us of the complexity of all major businesses – when asked about threats, she responded with the example of new clean fuel regulations on shipping.

The new regulations will require ships to either use cleaner fuel or fix scrubbers from 2020. Presently, most ships use raw oil sludge/bunker fuel to power dirty engines. In just a few years, they'll need refined fuel, or to spend millions retro-fitting. You can't magic up new global refining resources overnight – and a shortage of fuel could drive Jet fuel higher as it competes for scarce capacity. The cost of fuel is a major driver of airline profits and costs.

Real Complexity – it's a topic worth spending some time thinking about! Forget the noise about politics, and seek out the real factors driving markets.