Inflation Watch: Yields Have Now Broken a 20-Year Trendline

If you want to make money investing, you first need to understand the structure of the asset classes in our current financial system,

Everyone likes to go bonkers over stocks, but the reality is that the stock market is in fact one of the smallest and least liquid markets on the planet. All told, US stocks are roughly $26 trillion in market cap.

By way of contrast, the US debt markets (Treasuries, corporate, municipal, local, etc.) is well north of $60 trillion.

And the currency markets (which cannot be accurately measured because every trade involves a currency pair) trades over $5 trillion per day.

Put simply, currencies are the "smartest" money, followed by bonds, and then finally stocks. So when a seismic change takes place, currencies and bonds pick up on it LONG before stocks do.

With that in mind consider that the $USD is collapsing, having gone almost straight down for 12 months.

Now consider that the US Treasury bond market, is falling in price, resulting in yields spiking above their 20-year downtrend.

BOTH of these assets are forecasting the same thing: INFLATION.

Inflation forces the $USD DOWN and bond yields UP.

This country will trigger ‘the great unwind’

Markets could unravel if dollar falls below ¥107

Japan is the catalyst that could bring the record-setting bull market for stocks across
the globe to a screeching halt: surprise monetary tightening in Japan could be the 
trigger that finally upend what has been an protracted and unrelenting global rally 
for assets considered risky. 

'This could be far more important than the Fed. A lot of major trends start with Japan.
 People don't focus on Japan enough 

While most investors are busy eyeing rate increases in the U.S. and tapering by the
European Central Bank in the eurozone, Edwards says they should also watch
developments in the world's third-largest economy, Japan, where corporate 
profits are surging and inflation has picked up.

"We've been looking for surprises and one thing that can catch us out is if the 
Bank of Japan starts tightening. If it actually follows the Fed and the ECB and 
announces some sort of tapering," he said, speaking at SocGen's annual strategy 
conference in London on Tuesday.

"This could be far more important than the Fed. A lot of major trends start with
Japan. People don't focus on Japan enough in my view," he added.

Investors already on Tuesday got a taste of how BOJ tightening can rattle the markets.
The central bank said it would buy less of its long-dated bonds, sparking speculation
Gov. Haruhiko Kuroda could back away from its ultraloose monetary policy as early 
as this year. 

The surprise announcement sent global bond markets into spin on Tuesday. 
The yield on 10-year U.S. Treasury notes TMUBMUSD10Y, +0.91%  jumped above 2.5%
to its highest since March and the 30-year bond yieldTMUBMUSD30Y, +0.08%  logged
 its biggest one-day jump since Dec. 19. 

Some strategists, however, argue that the recent news was more a technical than philosophical
shift by the central bank. The BOJ has for years been among the most accommodative central 
banks in the world and as recent as December reaffirmed its commitment to aggressive qualitative
and quantitative-easing program, also known as QQE. With inflation stubbornly running below
the BOJ's 2% annual target, the central bank has since early 2016 kept interest rates in negative
territory and even introduced a 0%-target for its 10-year government bond yields to avoid deflation. 

The determined efforts by the BOJ to boost consumer prices have turned investors against the
yen USDJPY, +0.37% with data from the Commodity Futures Trading Commission showing an 
extreme bearishness toward the Japanese currency. However, downbeat investors on the yen
could be caught flat-footed if inflation starts to pick up, prompting the BOJ to halt easing efforts,
Edwards warned. Core inflation in the country has bottomed, as the following chart illustrates, 
while more than 60% of households now expect inflation rather than deflation, he pointed out.

"What happens if the BOJ tightens instead of weakens as everyone is positioned for? What if 
the yen strengthens and [the dollar] breaks through ¥107? That would be a major surprise," 
Edwards said. "If you are looking for something as a trigger for the great unwind, 
this could be it." The yen USDJPY, +0.37%  already started to soar this week. The dollar 
traded around ¥111.82 on Wednesday, compared with above ¥113 at the beginning 
of the week. The last time the dollar traded below ¥107 was in November 2016.

Price to Sales Ratio for S&P 500 Surpasses 2000 Tech Bubble Peak

At the individual investor level there is certainly a lot of excitement heading into the new year. AAII said Bulls rose to 59.8 from 52.7 last week. That is the highest level since December 2010. Bears are nowhere to be found, falling to 15.6 from 20.6 and that is the least amount since November 2014 by .5 pt. Another drop by more than .5 pt would put the bears at the smallest amount since July 2005.

Many don't care much for this sentiment indicator because it is so volatile but when it gets to an extreme like it is today, we must take note that the bullish sentiment is certainly euphoric. This comes as the weekly II data has never had a weekly stretch this long of Bulls above 60 in its 50-year history. 

BULL/BEAR SPREAD IN AAII

Along with the excitement with global growth and equities, the US 2 yr yield is at a fresh 9 1/2 yr high at 1.96%. This rise in yields and ebullience in market sentiment comes along with the price to sales ratio in the S&P 500 that is now above its March 2000 peak. 

PRICE to SALES RATIO S&P 500

Ahead of the US services PMI from Markit today, we saw a slew of them overseas. The private sector weighted Caixin services index rose 2 pts to 53.9. New orders rose to the best since May 2015 while job growth was little changed and "moderate." Price pressures continued to build: "Average input costs faced by service companies in China increased at a solid and accelerated rate in December. Furthermore, the rate of inflation was the quickest since February 2013. Raw materials, transportation and salaries were all cited as having gone up in price in the latest survey period."

Hong Kong's PMI rose .8 pt to 51.5 but Singapore's fell by 3.3 pts. India's got back above 50 at 50.9 from 48.5.

The final read on Eurozone services was about the same as the preliminary at 56.6 which brings the manufacturing and services composite index at 58.1, the highest since early 2011. Ireland was a particular outperformer. On the inflation side for services, "Input price pressures increased in December, with the rate of cost inflation the highest for 6 1/2 years. Part of the rise was passed on to clients in the form of higher service charges. However, the pace of output price inflation eased for the first time in 6 months. Increases in charges were signalled in almost all of the nations covered, the exception being Italy."

The UK services PMI improved a touch to 54.2 from 53.8 but new orders and employment fell. Inflation pressures remained intense: "service providers indicated another marked increase in their average prices charged, which was overwhelmingly linked to strong cost pressures. Survey respondents signalled the fastest rise in operating expenses for 3 months, reflecting higher transportation costs, staff salaries and utility bills in December." Bond yields are moving higher in the UK with the 2 yr in particular back above .50%.

Fed's Dudley Is Worried About "Elevated Asset Prices", Sees "Real Risk" Of US Overheating, Hard Landing

In today's most anticipated Fed speech, outgoing NY Fed president Bill Dudley delivered keynote remarks at a SIFMA event in New York, titled "The Outlook for the US Economy in 2018 and Beyond", in which he warned bluntly that the prospect of U.S. economic overheating "is a real risk over the next few years" and cautioned that one area he is "slightly worried about is financial market asset valuations, which I would characterize as elevated."

But before algos read too much into it and decide to sell on yet another "irrational exuberance" moment, the head of the most important regional Fed immediately hedged that even a "significant" market drop would not have the "destructive impact" we saw a decade ago, to wit: 

I am also less worried because the financial system today is much more resilient and robust than it was a decade ago. Thus, even if financial asset prices were to decline significantly—which presumably would occur if the economic outlook were to deteriorate—I don't think such declines would have the destructive impact we saw a decade ago.

Is he right? We will let readers decide...

He then reverted back to rates, saying that "I will continue to advocate for gradually removing monetary policy accommodation. As I see it, the case for doing so remains strong."

The reason for that is the same one Bank of America highlighted earlier: namely that "financial conditions today are easier than when we started to remove monetary policy accommodation." Which is precisely what Goldman warned nearly a year ago, when it said that it appeared that Yellen had lost control of the market.

As BofA recently noted, "the current backdrop feels very reminiscent of the Greenspan era of 2004-2006. Back then US interest rates rose 17 times. Yet, financial conditions remained loose and interest rate volatility fell to very low levels precisely because Fed monetary tightening was so predictable and patient: rates generally rose by 25bp at each meeting." 

Sure enough, to Dudley, "this suggests that the Federal Reserve may have to press harder on the brakes at some point over the next few years. If that happens, the risk of a hard landing will increase."

Dudley wasn't done, and realizing he has little to lose by telling the truth, now that he is on his way out, said that "the second risk is the long-term fiscal position of the United States." I.e. US debt.

Still, he said that "the economy is likely to continue to grow at an above-trend pace, which should lead to a tighter labor market and faster wage growth." and anticipated the tight labor market would generate wage gains and price inflation. Even if inflation does not reach objective, "that might not be a serious problem" as long as the economy "were to continue to perform well in other respects."

He continues to expect inflation to return to target over the medium term, and transitory factors to move through the inflation data. "I would be much more concerned if low inflation outcomes were contributing to a decline in inflation expectations."

He anticipated that the economy "will be getting an extra boost in 2018 and 2019 from the recently enacted tax legislation" which could lead to overheating. In which case, it would be necessary for the Fed to "press harder on the brakes" and that "while the recently passed Tax Cuts and Jobs Act of 2017 likely will provide additional support to growth over the near term, it will come at a cost."

He added that the tax packed "will increase the nation's longer-term fiscal burden, which is already facing other pressures, such as higher debt service costs and entitlement spending as the baby-boom generation retires."

Stocks, predictably, have not responded one bit to Dudley's surprisingly blunt warning.

* * *

Separately, Dudley echoed the Fed's recent mantra that the flattening yield curve is not a worrisome sign, upgrade his GDP growth view for 2018 from 2.5% to 2.75%, and said that he sees inflation rising to target in the medium term whil unemployment falls below 4%.

"We should expect the yield curve to be flatter than normal in the current environment."

Naturally, Dudley did not see a recession signal at present, and reassured his audience that the "financial system today is much more resilient and robust than it was a decade ago."

To sum up Dudley's statement:

I am optimistic about the near-term economic outlook and the likelihood that the FOMC will be able to make progress this year in pushing inflation up toward its 2 percent objective. The economy has considerable forward momentum, monetary policy is still accommodative, financial conditions are easy, and fiscal policy is set to provide a boost. But, there are some significant storm clouds over the longer term. If the labor market tightens much further, it will be harder to slow the economy to a sustainable pace, avoiding overheating and an eventual economic downturn. Another important issue is the need to get the country's fiscal house in order for the long run. The longer that task is deferred, the greater the risk for financial markets and the economy, and the harder it will be for the Federal Reserve to keep the economy on an even keel.