It's A 'Turkey' Market

With Thanksgiving week rapidly approaching, I thought it was an apropos time to discuss what I am now calling a "Turkey"market.

What's a "Turkey" market? Nassim Taleb summed it up well in his 2007 book "The Black Swan."

"Consider a turkey that is fed every day. Every single feeding will firm up the bird's belief that it is the general rule of life to be fed every day by friendly members of the human race 'looking out for its best interests,' as a politician would say.

On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief."

Such is the market we live in currently.

In a market that is excessively bullish and overly complacent, investors are "willfully blind" to the relevant "risks" of excessive equity exposure. The level of bullishness, by many measures, is extremely optimistic, as this chart from Tiho Krkan (@Tihobrkan) shows.

Not surprisingly, that extreme level of bullishness has led to some of the lowest levels of volatility and cash allocations in market history.

Of course, you can't have a "Turkey" market unless you are being lulled into it with a supporting story that fits the overall narrative. The story of "it's an earnings-driven market" is one such narrative. As noted by my friend Doug Kass:

"Earnings are there to support the market. If we didn't have earnings to support the market, that would be worrying. But we have earnings."

—Mary Ann Bartels, Merrill Lynch Wealth Management

"Earnings are doing remarkably well."

—Ed Yardeni, Yardeni Research

"This is very much an earnings-driven market."

—Paul Springmeyer, U.S. Bancorp Private Wealth Management

"This is very much earnings-driven."

—Michael Shaoul, Marketfield Asset Management

"Equities have largely been driven by global liquidity, but they are now being driven by earnings."

—Kevin Boscher, Brooks Macdonald International

"Most of the market action in 2017 has been earning-driven."

—Dan Chung, Alger Management

"The action is justified because of earnings."

—James Liu, Clearnomics

In another case of "Group Stink" and contrary to the pablum we hear from many of the business media's talking heads, the U.S. stock market has not been an earnings-driven story in 2017. (I have included seven "earnings-driven" quotes above from recent interviews on CNBC, but there are literally hundreds of these interviews, all saying the same thing)

Rather, it has been a valuation-driven story, just as it was in 2016 when S&P 500 profits were up 5% and the S&P Index rose by about 11%. And going back even further, since 2012 S&P earnings have risen by 30% compared to an 80% rise in the price of the S&P lndex!

He is absolutely right, of course, as I examined in the drivers of the market rally three weeks ago.

"The chart below expands that analysis to include four measures combined: Economic growth, Top-line Sales Growth, Reported Earnings, and Corporate Profits After Tax. While quarterly data is not yet available for the 3rd quarter, officially, what is shown is the market has grown substantially faster than all other measures. Since 2014, the economy has only grown by a little less than 9%, top-line revenues by just 3% along with corporate profits after tax, and reported earnings by just 2%. All of that while asset prices have grown by 29% through Q2." 

The hallmark of a "Turkey" market really comes down to the detachment of price from valuation and the deviation of price from long-term norms. Both of these detachments are shown in the charts below.

CAPE-5 is a modified version of Dr. Robert Shiller's smoothed 10-year average. By using a 5-year average of CAPE (Cyclically Adjusted Price Earnings) ratio, it becomes more sensitive to market movements. Historically, deviations above 40% have preceded secular bear markets, while deviations exceeding -40% preceded secular bull markets.

The next chart shows the deviation of the real, inflation-adjusted S&P 500 index from the 6-year (72-month) moving average.

Not surprisingly, when the price of the index has deviated significantly from the underlying long-term moving averages, corrections and bear markets have not been too distant.

Combining the above measures (volatility, valuation, and deviation) together shows this a bit more clearly. The chart shows both 2 and 3-standard deviations above the 6-year moving average. The red circles denote periods where valuations, complacency and 3-standard deviation moves have converged. 

Of course, with cash balances low, you can't foster that kind of extension without sufficiently increasing leverage in the overall system. The expansion of margin debt is a good proxy for the "fuel" driving the bull market advance.

Naturally, as long as that "fuel" isn't ignited, leverage can remain supportive of the market's advance. However, when the reversion begins, the "fuel" that drove stocks higher will "explode" when selling forces liquidation through margin calls.

While the media continues to suggest the markets are free from risk, and investors should go ahead and "stick-their-necks-out," history shows that periods of low volatility, high valuations and deviations from long-term means has resulted in very poor outcomes.

Lastly, there has been a lot of talk about how markets have entered into a new "secular bull market" period. As I have addressed previously, I am not sure such is the case. Given the debt, demographic and deflationary backdrop, combined with the massive monetary interventions of global Central Banks, it is entirely conceivable the current advance remains part of the secular bear market that began at the turn of the century.

Only time will tell.

Regardless, whether this is a bull market rally in an ongoing bear market, OR a bull rally in a new bull market, whenever the RSI(relative strength index) on a 3-year basis has risen above 70 it has usually marked the end of the current advance. Currently, at 84, there is little doubt the market has gotten ahead of itself.

No matter how you look at it, the risk to forward returns greatly outweighs the reward presently available.

Importantly, this doesn't mean that you should "sell everything" and go hide in cash, but it does mean that being aggressively exposed to the financial markets is no longer opportune.

What is clear is that this is no longer a "bull market."

It has clearly become a "Turkey" market. Unfortunately, like Turkeys, we really have no clue where we are on the current calendar. We only know that today is much like yesterday, and the "bliss" of calm and stable markets have lulled us into extreme complacency.

You can try and fool yourself that weak earnings growth, low interest rates and high-valuations are somehow are justified. The reality is, like Turkeys, we will ultimately be sadly mistaken and learn a costly lesson.

Remember:

"Price is what you pay, Value is what you get." – Warren Buffett

"This Is A Clear Sign Of Irrational Exuberance"

The latest monthly Fund Manager Survey by Bank of America confirmed what recent market actions have already demonstrated, namely that, as BofA Chief Investment Strategist Michael Hartnett explained, there is a "big market conviction in Goldilocks leading to capitulation into risk assets" while at the same time sending Fund managers' cash levels to a 4-year low, and pushing "risk-taking" to a new all-time high, surpassing both the dot com and the 2007 bubbles.

BofA's takeaways from the survey, which polled a total of 206 panelists with $610 billion in AUM, will not come as a surprise to those who have been following this survey in recent months, and which reaffirms that while investors intimately realize how bubbly assets have become, they have no choice but to buy them.

The latest survey highlights:

It's still all about FAANG froth: the biggest market conviction is in Goldilocks (+ price action in FAANG/BAT, Bitcoin) resulting in bull capitulation; A stunning chart shows that risk-taking among Fund Managers hit an all time high in the lastest period...

...  even as cash levels grind lower despite a record high number saying equities overvalued. Indeed, as the next chart demonstrates, while the number of respondents saying equities are overvalued is at 48% - a new record high - cash levels continue to fall. Coupled with the record high number of "risk takers", Bank of America concludes that "this is a sign of irrational exuberance".

Hartnett's next observation is a carryover from the October Fund Manager Survey, namely the prevailing belief that the economy has entered a Goldilocks state. One month later, this view is now consensus.

Calling it "Consensilocks": Hartnett notes that there is an all-time high Goldilocks expectations (56% expect "high growth, low inflation"); which contrasts with tumbling bear view of secular stagnation as macro backdrop (was 88% Feb'16, now 25%); US tax reform expected to sustain or inflate Goldilocks. Just as importantly, goldilocks is now the consensus view for the global economic outlook, while the "below-trend growth/ inflation" outlook fell 9ppt to 25%, the lowest since May 11 & a total reversal from Jun'16.

Since this is fundamentally a Hartnett report, a mention of the Icarus rally was inevitable, and sure enough, the chief strategist points out that markets find themselves "ever closer to the sun".  The reason: cash levels among fund managers dropped to 4.4% in November from 4.7%, the lowest since Oct'13 & no longer a "buy signal" according to BofA' proprietary indicator; FMS hedge fund equity exposure at 11-year high. And while BofA's Bull & Bear indicator has risen to 7.2, but cash did not fall sharply enough - yet - to trigger 8.0 "sell" signal.

So if this is an "irrationally exuberant" bubble, the next step is clear, only the timing is uncertain. As such, BofA notes that the key correction catalysts are inflation & market structure, while the biggest FMS risk to EPS = wage inflation;

Meanwhile, there are rising fund manager concerns over "market structure" (seen as the 3rd biggest tail risk); strategies most likely to exacerbate correction: vol selling (32%), ETFs (28%), risk parity (16%).

* * *

Her are some of the more notable survey takeaways: crowded trades are #1 long Nasdaq, #2 short volatility, #3 long credit... 

    
... while "Long Nasdaq" is now the most crowded trade for the 6th time this year...

... while allocation to global equities in November rose to net 49%, the highest since Apr'15, 

... Highest Japan OW in 2-years, an epic FMS UW in UK assets, and big Nov

As a result, for any wannabe "contrarian stagflationists" out there, here are the BofA recommended trades: long UK, short Eurozone; long pharma, short banks; long utilities, short tech.

Putting it all together, here is Hartnett's conclusion: "Our conviction in winter post-tax reform risk asset correction hardens."

VIX Tops 12 As Dow Erases Yesterday's Opening Ramp Gains

Deja vu all over again?

Hold your breath for the USDJPY momo ignition in 3...2...1...

It’s Not Conspiracy Theory: It’s The Uneasy Truth About The Financial System In The U.S.

Here's a look at not just "what" is going on in the U.S. financial system, but "why" it's going on. It's as infuriating as it is truthful…

There's a reason that the Fed pursues these actions and it's not a conspiracy theory. When unlimited cash hits a limited supply of assets, whether paper or hard, this inflationary deluge boosts taxable asset values by 100-1000%, fattening the coffers of the tax collectors. 

While it's no secret that the Fed, along with all global Central Banks, are supporting their respective financial systems by capping interest rates with "QE" (also known as "money printing"), the yield on the 10-yr Treasury has risen 36 basis points in two months from 2.04% in September to 2.40% currently. There have not been any Fed rate hikes during that time period. The yield on the 2-yr Treasury has jumped from 1.26% in early September to 1.66% currently. A 40 basis point jump, 32% increase, in rates in two months.

This is not due to a "reversal" in QE. Why? Because through this past Thursday, the Fed's balance sheet has increased in size by over $7 billion since the Fed "threatened" to unwind QE starting in October. The bond market is sniffing hints of an acceleration in the general price level of goods and services, aka "inflation."

I wanted to post this comment from my blog post the other day because this person uses an expressive writing style to convey incisively the uneasy truth about the financial and economic system in the U.S.:

Bankers are moral lepers, the financial equivalent of hookers and blow. You can never get enough of the moral debauchery in that world. 

When a shit box tiny house, half the size of my man cave, goes for $50,000 less than my entire home in Reno, the end is nigh. $2,000 a square foot for a studio? What effing moron would pay that. Don't answer. We know someone did. I pity the fool.

Bitcoin 7000, DOW 23,500, studios for $550,000 are all a result of the Greenspan /Bernanke/Yellen  QEpocalypse.

The flood of faux FIAT creates the same Cantillion effect as the flood of gold and silver from the new world that inflated the values of assets in the old world and decimated those outside the ring of prosperity created by that effect.

And that was when gold and silver were real money. But do you think gold and silver can catch a break today? Nope, not a chance.

There's a reason that the Fed pursues these actions and it's not a conspiracy theory. When unlimited cash hits a limited supply of assets, whether paper or hard, this inflationary deluge boosts taxable asset values by 100-1000%, fattening the coffers of the tax collectors. No accident there.

You would think this might solve some fiscal woes at the local and state level by boosting tax receipts by a few hundred percent. Nope, not happening there either.

The states and cities created their own PONZI schemes with underfunded overly generous pension plans. Even a moron could get a better return in those funds but now they are out there with their begging bowls.

The County of Maui just raised it's property taxes 42% to pay for pension plan deficits. A senator from Ohio wants to use funds from treasury bonds to bail out their public pension deficits. 

As we see asset prices sky rocket, the demands from the public sector grow even faster than tax revenues and asset inflation will handle. Gresham's Law meets its Minsky Moment and none too soon.

And don't even get me started about Social Security. Just let me get mine before the whole shit show collapses.

There’s A 70% Chance Of War With North Korea

Jim just met with the Director of the CIA and the National Security Adviser, and now, Jim's estimation of war is clear. Here's what it means…

The Deeper Purpose of Trump's Asia Trip

President Trump is wrapping up his historic visit to Asia today. Trump's journey is the longest overseas trip of his presidency and the longest Asian visit of any president in 25 years.

After a stopover in Hawaii, Trump proceeded to Japan, where he met with Japanese Prime Minister Shinzō Abe, and then to South Korea where he met with President Moon Jae-in.

The capstone of the trip was Trump's arrival on Nov. 8 in Beijing for meetings with Chinese President Xi Jinping. Trump then headed for Vietnam late in the week and is concluding meetings in the Philippines today.

Much of the reporting on this trip has involved international trade, but it's a mistake to focus on that. This trip was a prewar gathering of allies (Japan and South Korea) and potential allies (China) in a last-ditch struggle to head off a hot war with North Korea, led by the reckless Kim Jong Un.

At this point, there are only four possible outcomes of the U.S.-North Korea confrontation over nuclear weapons:

1. Kim Jung Un stands down and gives up his nuclear weapons program.

2. The U.S. and China combine forces to decapitate the Kim dynasty and force regime change in North Korea.

3. Preventive attack on North Korea by the U.S. before March 20, 2018.

4. The U.S. accepts a nuclear-armed North Korea and relies on containment and deterrence to constrain its actions.

Based on public statements of U.S. officials, my recent meetings in Washington with the director of the CIA and the national security adviser and other sources, I estimate the degree distribution of those possible outcomes as follows:

• Kim stands down: 10%

• Regime change: 20%

• War: 70%

• U.S. lives with nuclear North Korea: 0%.

Trump's visits to Japan and South Korea were about leaving the door open to negotiations in the hope that Kim would stand down while also preparing for war. Trump's visit to China was about asking for assistance in regime change.

Xi is unlikely to agree to help the U.S. in this regard. This means war. Instead, Trump and Xi no doubt discussed China's "red lines" in North Korea so that a war between the U.S. and North Korea does not escalate into a war with China.

Almost none of this is fully priced in public markets, although markets seemed to be getting the message last week.

A war between the U.S. and North Korea will cause a global flight to quality assets and currencies at the expense of other asset classes.

Here are the likely market moves as the prospect of war becomes clear: Dollars, euros and Swiss francs will rally at the expense of emerging-market currencies. U.S. Treasury bonds will rally in price, pushing yields lower.

Gold will rally strongly, well past the $1,325 level, and then push higher.

Curiously, U.S. stocks may rally after an initial pullback when the shooting starts. Defense contractors, tech companies, commodities producers, utilities and energy companies should all rally. War is generally good for some sectors of the economy and may finally give the Fed the inflation it's been looking for in vain the past eight years.

The war is likely coming in a matter of months.

Investors should look at the entry points for the assets described above and position themselves accordingly now (go here to learn about an urgent opportunity in the gold market).

At a minimum, it's a good time to increase cash allocations so that you can be nimble and dodge financial bullets once the real bullets start to fly.

"There Are Too Many Warning Signs": Why One Trader Thinks Stocks Are Set To Slide In The Coming Days

Stock markets look set to continue to slide in the days ahead.

There are too many small warning signs building up at a vulnerable time for markets. Just because a 3% correction hasn't happened for a long time doesn't mean that one isn't possible. Quite to the contrary, it suggests there are a lot of complacent longs that may over-react to a pullback.

It's also important to emphasize the proviso that the three pillars of the secular bull market remain solid: growth, earnings and liquidity. There's no obvious reason to turn structurally bearish, but that's not the same as thinking that every dip needs to be bought instantly.

After a tremendous year of gains, the S&P 500 is particularly vulnerable to profit-taking as Thanksgiving Day and the looming debt-ceiling issue provide further complications to the implementation of a potential tax reform package.

China has been the engine of global growth, but Monday's disappointing credit data will make investors nervous that the much greater policy focus will now be on deleveraging - and that will weigh on Asia broadly.

Japan has been a bellwether for the most recent equity gains, but last week's volatile hiccup and subsequent price action look very bearish technically. After a parabolic gain the past two months, a pullback here would only be a healthy consolidation in the grand scheme of things.

European equities are leading the correction already, while U.K. stocks will remain under pressure from domestic politics and Brexit talks.

At this time of year, there are plenty of traders who'll only need a nudge to take 2017's profit and move to the sidelines. In contrast, there's a dearth of reasons for fresh bulls to join in now.

Sometimes in markets you don't need one headline catalyst to shift sentiment. Equity markets fall just because there are more marginal sellers than buyers.

One Trader Warns "To Ignore All Around You Is Playing With Fire"

Something changed in the last week or so. Several markets that had hitherto been unstoppable examples of central bank recklessness dominating rational thinking suddenly 'stopped'. Of course this is seen by many asset-gatherers and commission-takers as 'a pause that refreshes' but what if it's not? As former fund manager Richard Breslow warns, "you'd better believe things can change on a dime," and we suspect they just did...

Via Bloomberg,

I freely admit that I have a lower threshold for finding things funny at 3 AM than later in the day. But after laughing out loud over this line in a story, I actually thought it may contain some real wisdom. Especially, because there are so many alternate explanations of why various asset prices trade where and in the fashion they do.

The Nikkei 225 posted its biggest drop in seven months, as investors found no new reasons to buy after driving benchmarks to their highest in a quarter century.

You are starting to hear more and more people writing the rest of this year off, because of course, volatility is low and nothing will change. Markets are locked into tight ranges that presumably will break out on cue come January. If I knew that, I'd be trading up a storm in late December. 

So many people are off and running forecasting just what to expect next year. It's not worth dwelling on the obvious folly of claiming to have a solid handle on what's coming down the pike. Especially when it's broken down by quarters. 

I read one today that laid out what to expect the currencies of the CE3 nations to do by the end of 2019. Read that while thinking about what the world looked like two years ago. 

Forecasts do have their legitimate purposes, and at this distance are reasonably harmless. But unless you are strictly in day-trading mode for the duration, don't fool yourself that what you have on now can be set to auto-pilot through year-end. 

Over the span of just a few days, the Nikkei has gone from impulsively moving higher to providing a perfect technical set-up for those wishing to short it while controlling their risk. Who could ask for anything more? And it didn't take some cataclysmic event. My theory is that local traders may have quickly reconsidered all this buying in light of learning how much of it was from overseas. And just how good a Japanese stock-picker are you? 

But it's not just Japanese stocks. The whole mood of the day changed during the last half hour of the Japanese trading day. People are overly blase because they've gotten used to manic mood swings signifying nothing. However sometimes from little contagions, mighty maelstroms grow. 

Chinese money supply and credit numbers were clear misses, today. Not a problem: special factors and claims of opacity will keep this at the level of interesting debate for now. With enormous influence on how all those forecasts will pan out. 

Now, ask yourself, for more immediate import, what a beat or miss from Wednesday's U.S. CPI has the potential to do? Is anyone watching the Middle-East? What does your portfolio look like at $45/barrel versus $70?

Commentators look at the surface numbers and declare everything in Europe to be great. Best numbers in many years. Utterly forgetting, not understanding, or not caring that some of the disaggregated numbers are dangerous. 

Lost generations have voting patterns that don't fit what top-line numbers would suggest. Next year's problem? Maybe. But like the Nikkei today, things can change, and quickly.

But Breslow sums it up perfectly as slowly but surely reality is peeking its head out from under the central bank boot of repression:

We live in interesting times. Better as well as bad. To ignore all around you is playing with fire...

Goldman Discovers Something Odd: Stock Moves Are Increasing Even As Index Moves Are Decreasing

One wouldn't know it by looking at the moves in equity indexes, but this earnings season has been unusually volatile for stocks, which however has yet to translate into bigger moves at the macro level. That is the bizarre observation made by Goldman's derivatives strategist John Marshall (whose team grew by one when ex-Deutsche Banker Rocky Fishman joined recently).

As Goldman shows in the chart below, while earnings day moves have increased in the US and globally, and stock dispersion generally has jumped to the highest since the Trump election, index moves have been the smallest in years. Goldman believes this is further evidence "of increased uncertainty in the equity market."

Quantifying the delta between the two vol indicators, Goldman writes that over the past two weeks, the SPX has moved an average of 0.17% per day (1-standard deviation BELOW its 3-year average), while looking under the hood at the stocks in the S&P 500 the standard deviation of returns has been 1.8% on average (1-standard deviations ABOVE its 3-year average). As an indication of just how much turblience there is below the surface, earnings day moves are 4.2x average daily moves for US stocks (3.6x for European and 2.3x for Asian) in this earnings season so far.

Using the charts below, Goldman shows the earnings day absolute move in stocks relative to the non-earnings days 1 month before and after. This includes data through November 9, 2017 for the current quarter. Earnings day moves are above average levels relative to the past decade, while non-earnings days have had lower volatility.

What does this bifurcated volatility pattern mean? According to Goldman, "this as evidence that fundamental uncertainty is rising (stock moves on earnings days) while general macro fears have fallen (stock moves on non-earnings days)." In practical terms, and based on the relationship of index volatility and the standard deviation of S&P 500 stock returns over the past 15 years, Marshall writes that he would expect "the SPX to be moving 90bps per day rather than the current 17bps. This implies realized volatility above 15%." Of course, that may not be possible (or allowed by central banks) because as noted in the recent past, the beta of VIX spot has exploded to -19, which means that even a mere 90bps down day in the S&P could launch a self-reinforcing vol cascade which crushes the millions of vol sellers, unleashing a another sharp correction, or worse.

Goldman's conclusion:

A rise in single stock volatility is generally associated with a decline in equity returns. Based on the relationship between the standard deviation of S&P 500 stock returns and forward returns in the SPX over the past 15 years (controlling for index returns and index volatility), this elevated level of stock volatility would suggest a decline in the SPX of 0.8% over the next two weeks +/- 1.5%.

Alas, that observations is completely meaningless as due to the margin of error, the market can rise by 0.7% and Goldman can still claim it was right.

In any case, Goldman ends on a cautious note and warns that "while we do not believe this alone is a compelling reason to sell the market today (or buy VIX), we believe it is a trend worth monitoring closely."

Into the Great Wide Open

Traders looking for a steeper yield curve continue to see spreads come

in as confidence builds for another rate hike by the Fed next month,

while weak convictions persist towards rising inflationary 

pressures next year. This week, the combination of expectations

saw the spread between the 2 and 10-year Treasury yields at its

narrowest since November 2007. Although causation may lie

in the eyes of it's beholder, it does at the very least suggest that 

collective wisdom believes future inflation will remain subdued,

despite a continued tightening in the US labor market, a baker's

trillion in global QE accrued within the system since November

2007 – and a US dollar likely on the backside of it's cyclical peak.

Nevertheless – and regardless of motivation, the tightening of

spreads between shorter and longer-term Treasuries that really

began as the Fed floated, then enacted the taper in December

2013, appears to be as stretched as this year's move in equities

to another historic valuation extreme. When the dust settles

after the next inevitable pivot, will long-term yields rise faster

than the short-end of the curve – because the reach of inflation

is greater than the Fed's capacity to tighten, or will the long-end

steepen simply because short-term yields fall faster as rate hike

expectations recede? In either case: an economy becoming too

hot or an economy turning down – and even a combination of both

(i.e. stagflation), gold is positioned to outperform as the benevolent

conditions against which the equity markets have advanced with

begin to diminish.

While on an absolute basis it was the pivot lower in real yields

at the end of 2015 that drove the cyclical turn higher in gold

(inverted here), on a relative performance perspective

we will be looking for Treasury spreads to widen as longer-term

yields "outperform" the short-end of the curve. As shown below,

the relative performance of the 10-year versus the 5-year yield

has trended closely with the performance of gold relative to the

S&P 500.

Similar to following the yield curve for greater bearings in the

market, over the years in previous notes we've commented on

the relative performance trend in Treasury yields as a more

discrete indication of the Fed's policy shifts away from

the extraordinary easing initiatives that began during the

global financial crisis and were built-out in several phases

in its wake. Because of the more unconventional and esoteric

nature of these policies that were enacted in large part because

of the inherent limitations of ZIRP, we've followed the 

relative performance trend between the 5 and 10-year

Treasury yields as indication of the markets expectation

shift that first transpired with the taper tantrum in May 2013.

We chose to highlight and contrast the relative performance

between 5 and 10-year yields, as we felt the shorter durations

of the market had been disproportionally influenced by 

ZIRP and the Fed. 

In May 2013 the Fed began to telegraph their intentions to begin

a tapering later that year of the massive monthly QE program,

which caused short-term yields to surge relative to the long-end

of the curve; conditions greatly similar to the build-up of the

Fed's previous tightening cycle that began in June 2004.

Generally speaking, yields along the shorter end of the market

tend to either "outperform" or "underperform" longer-term

yields as the Fed moves between tightening or easing monetary

policy. Naturally, when the Fed tightens, shorter-term yields

outperform – and vice versa as they ease.

*Contrary to the previous chart shown, the chart below uses

the inverse series (5yr:10yr; SPX:Gold) as they have

historically trended with the Fed funds rate.

In January 2004, the Fed first telegraphed to the market by

removing the phrase that rates would remain low for a

"considerable period". By the end of June of that year, 

the Fed had begun to gradually raise rates. Less than

two years later in February 2006, the relative performance

differential between 5 and 10-year yields had reached its peak

four months before the end of the rate tightening cycle later

that June. 

The uniqueness of the current Fed tightening cycle – which

we had noted at the time, is that the majority of tightening

actually took place during the expectation and tapering 

period away from QE, rather than the second phase that

we've currently been in since December 2015 of actual

rate hikes. This makes sense as the "tightening" was enacted 

on a greater relative perspective to already historically

extraordinarily accommodative policies, rather than more

material interest rate hikes typical of conventional tightening

cycles. 

Moreover, by some measures conditions were the tightest

a few weeks after the initial rate hike in December 2015

and have steadily fallen even as the Fed has further raised 

the funds rate – as displayed by the Chicago Fed National

Financial Conditions Index that hit a more than 20 year

low this month. Not surprisingly, gold relative to equities

has loosely trended with the index. 

All things considered – which should also take into account

a historic perspective of the last time yields were this low

(spot the outlier below), it's a decent bet that the spread 

between short and long-term Treasury yields will widen

– and with it a greater outperformance in gold.