“In the Bayesian framework, how much you believe something after you see the evidence depends not just on what the evidence shows, but on how much you believed it to begin with.”
That’s a more thoughtful way of stating the simple fact that preconceived notions matter – especially when it comes to data analysis and subsequent decision-making. In a very important chapter in a book I’ve been studying titled: How Not to Be Wrong: The Power of Mathematical Thinking, the author (Ellenberg) offers a succinct-yet-robust support of Bayesian inference, which itself is a core tenet of our macro research process.
On this specific subject, Ellenberg goes on to say:
“Just as the prior describes your beliefs before you see the evidence, the posterior describes your beliefs afterward.”
With respect to financial markets, one could argue that both the prior and posterior are fairly congruent – in #BeliefSystem terms, that is. Specifically, the belief that monetary easing, in all its increasingly glorious forms, is causal to the nominal growth needed to sustain and support risk asset prices is a very important prior that many investors tacitly assume.
And glorious they are. From ZIRP to NIRP, from QE to QQE, to explicit exchange rate targeting, to my personal favorite: “helicopter money”, central bankers the world over are digging deeper and deeper into their respective policy toolkits – and coming up with “the best acronyms” (Trump joke) – in order to instill one very important belief needed to keep the game going: that you can’t fight city hall.
The posterior – at least in the U.S. and specifically within the equity and credit markets – is that asset prices go up when the Fed eases, which is what Janet Yellen effectively did twice last month (once by communicating negative revisions to the FOMC’s Summary Economic Projections and Dot Plot and again two weeks later via explicitly dovish rhetoric during a lengthy speech at the Economic Club of New York).
Back to the Global Macro Grind…
Actually, no. Let’s pause for a minute to reflect upon the phrase “helicopter money”. I’m guessing most of you aren’t familiar with the hip-hop ensemble Cash Money Millionaires (from which Grammy Award winning artist Lil’ Wayne spawned), so allow me to explain. They effectively rose from the nothingness that is the slums of New Orleans to mega-fame in the early 2000s rapping mostly about money and things you could buy with money. The following is an excerpt from their 1999 hit single, “Bling Bling”:
“It’s the playa’ with the Lex[us] bubble…
Candy coated helicopter with the leather cover”
In the context of former hoodlums rapping about owning helicopters with tacky paint jobs, the phrase “helicopter money” seems a bit ridiculous, doesn’t it? If it doesn’t, now imagine a shirtless B.G. (group member) next to Janet Yellen hanging out the side of a helicopter “making it rain” with crisp twenty dollar bills.
Putting the humor of rap music videos aside, let’s revisit the #BeliefSystem in the U.S. one last time:
- 1Y Out Fed Funds Future Implied Yield, -9bps tighter MoM
- 2Y U.S. Treasury Note Yield, -13bps tighter MoM
- 10Y U.S. Treasury Bond Yield, -13bps tighter MoM
- U.S. Dollar Index, down -2.5% MoM
- S&P 500 Index, up +2.5% MoM
- Bloomberg High Yield Bond Index, up +2.1% MoM
In correlation terms, the SPX has a tight inverse correlation of -0.87 with the DXY over the past month vs. a fairly meaningful positive correlation of +0.70 over the trailing 3Y. This new data is important to evaluate in the context of updating the posterior belief highlighted above.
In that light, it is reasonable to conclude that the market has moved back into some version of the reflation-centric regime that prevailed for much of the early part of this economic expansion when monetary easing bore the greatest burden of the three principle components of relative and absolute factor exposure performance (i.e. growth, inflation and policy).
But is it reasonable to conclude that the implied directionality (i.e. dollar down, stocks up) is sustainable? Recall that a core tenet to Bayesian inference is to evaluate all relevant data in the context of prior beliefs and that the underlying prior belief underpinning reflation is that monetary easing can inflate nominal GDP growth irrespective of cyclical and secular headwinds. But how sound is that #BeliefSystem in light of the most recent evidence?
- Since December, both the ECB and BoJ have cut their respective deposit facility rates by -20bps to -0.4% and -0.1%, respectively. #NIRP
- This comes amid continued expansion in their respective balance sheets, which have increased $675B and $993B, respectively, on a YoY basis.
- The aforementioned easing has been adequately reflected in future policy rate expectations. Specifically, 2Y EUR and JPY OIS have tightened -34bps and -28bps, respectively, on a TTM peak-to-present basis.
What do these respective central banks have to show for such aggressive monetary easing?
- Not much on the growth front. Specifically, household consumption growth, industrial production growth, export growth, consumer and business confidence are now all slowing on a trending basis.
- Inflation expectations, as measured by EUR and JPY 5Y 5Y-forward inflation swaps, are trending lower as well, with the EUR measure recently hitting new all-time lows and the JPY measure recently dipping back into deflation territory for the first time since the LDP came into power in late-2012.
- With the EUR and JPY up +3.9% and +8.3% YoY vs. the USD, respectively, it’s no surprise to see that the TTM return on equity for the EuroStoxx 600 Index and TOPIX Index has compressed -196bps and -89bps, respectively. Corporate profit expectations have compressed as well, with NTM EPS for the respective indices having fallen -9% and -12.1%, respectively, on a TTM peak-to-present basis.
- In light of all the above, it’s easy to see why European and Japanese capital markets are imploding. The EuroStoxx 600 Index and TOPIX Index have crashed -20.7% and -25% from their respective 52-week closing price highs. Bank stocks are feeling the brunt of the pain amid NIRP-fueled scrutiny of their business models. Specifically, the EuroStoxx Banks Index has crashed -24.6% YTD, while the TOPIX Banks Index has crashed -22.6% from the BoJ’s 1/29 announcement of NIRP.
In light of that, I think it’s safe to conclude that “ex-U.S.” the central planning #BeliefSystem has decidedly broken down.
We’ll be discussing what we view as an elevated risk that the #BeliefSystem in the U.S. collapses over the intermediate term as it already has in Europe and Japan on our Q2 Macro Themes Call tomorrow at 11AM EST. Email for access.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 1.70-1.83% (bearish)
SPX 2020-2077 (bearish)
Nikkei 150 (bearish)
DAX 9 (bearish)
EUR/USD 1.11-1.14 (neutral)
YEN 110.19-112.95 (bullish)
Oil (WTI) 35.09-38.12 (bearish)
Gold 1 (bullish)
Keep your head on a swivel,