Back on a Familiar Horse

04/10/18 08:56AM EDT

“It promises [the government] that if you give them a dollar now, in purchasing power terms, they promise to give you something less than a dollar in one year’s time.”
—Elroy Dimson

The quote comes from a contributing author of one of the more popular books in our field: Triumph of the Optimists. In it, the authors dissect a century of investment return profiles across global regions and asset classes. 

While the book was published over 15 years ago, the three authors from London Business School still publish the “Global Investment Returns Yearbook” annually. 

Dimson’s recent comment around negative real rates in many regions was made in response to a question about global equity valuations now relative to history, and his answer is rooted in opportunity cost.

I’ll give my interpretation of his main point which is that, in many traditional equity valuation models, lower required return and discount rate assumptions justify higher multiples and valuations all else equal.

Further, looking at a long, time series view of a valuation framework without considering the opportunity cost of capital, would currently miss the point that your alternative is a negative real-yielding instrument in many parts of the world.  

And yes, we’re deep in finance academics 101; lower discount rates = higher asset values and yield-starvation. Anyone who has followed us for more than a day knows we’re not hanging on this kind of framework, but the point Dimson makes is a simple, but important one regarding leverage, valuation, and opportunity cost. 

Back on a Familiar Horse - 03.22.2018 Fed Chair cartoon NEW

Back to the Global Macro Grind

The bond bears are back on the horse this week. We wouldn’t say this preferred consensus exposure was “scared completely away.” However, some bears in the pack did hibernate for a few weeks as the ascension in nominal rates has taken a pause for two months, particularly on the back-end of the curve. 

We get the CFTC Commitments of Traders (COT) report every Friday afternoon from the Commodity Futures Trading Commission. When that data is released, we’re focusing on the net “non-commercial” futures & options open interest for a given market. Essentially this is the financial or speculative open interest taking a directional view (not always). Here are a few call-outs regarding interest rate positioning currently:

  • Consensus moved shorter of every contract linked to the treasury curve week-over-week.
  • The net short position in 5-year treasury notes is at a new record of 577K contracts which translates to Z-Score factors of -2.0x on a 1Yr window and -2.6x on a 3Yr window.
  • The net short position in 10yr contracts (326K) registers Z-Score factors of -1.9x and -1.6x on those same time windows.
  • Of that net short 577K contracts in 5Yr notes, the net short position exclusively in futures markets is 579K at CBOT (also an all-time high), so the options open interest adds 2K of incremental bullishness.
  • For more context, 579K net short is also the high in speculative open interest as a % of total open interest, and with the exception of a brief period to start 2018 (mainly due to lower trading volume over the holidays), it’s also the high in speculative net short positioning as a % of average daily trading volume (ADTV). In the financial crisis the net speculative long position was actually more extended as a % of ADTV, but on the short-side, this is the high.

The takeaway therefore, is that investors have piled in long of rates-rising despite the fact that:

  1. The clear reflation and rates-rising bias from Q1 that was apparent in other asset classes and factors (equity sector dispersion for example) was crushed by suppressed interest rate volatility.
  2. Nominal rates haven’t moved much - investors aren’t chasing ripping rates, but rather taking the other side. Longer-duration yields have in fact rolled over the last month and volatility bets around rates-rising and reflation have been crushed. 

When we refer to “muted interest rate volatility” we're referring to both realized and implied volatility. A rolling over in sovereign yields has pushed forward volatility expectations much lower, which seems to contrast a crowded directional position on interest rates. Here’s some more color on interest rate sentiment through a volatility lens:

  • The Fixed Income and Credit Volatility Indices (VXLT, VXIEF, VXHYG) are the only pocket in global macro where volatility is actually LOWER over the last 3 months. TYVIX (10yr volatility index) is up just 1% over that period.
  • Here is more context on volatility expectations with 10yr percentile readings for treasury-specific volatility indices. This is obviously the polar opposite set-up from equities:
    • TYVIX: 2.3%
    • VXTLT: 2.2%
    • VXIEF: 3.6%
  • If we verbalize a global macro screen of well over 100 tickers across asset classes, the top 5 markets with the largest declines in front-month implied volatility over the last month are Fixed Income and Credit instruments: TIP, LQD, IEF, JNK, MUB.
  • In our Chart of the Day, we show the 2017 – 2018 hand-off in volatility expectations from FICC to growth equities. Many charts exemplify this top-down trend of low relative volatility trends in fixed income and many commodities, but more specifically we are showing a rolling percentile view of implied volatility in the long-term treasury ETF (TLT) and the Nasdaq 100 Index in the chart.

Maybe equity markets have discounted higher Risk-Free-Rates in the future, a classic argument. That’s certainly what we see in CFTC net non-commercial futures & options positioning. To start the #Global Divergences section of our macro themes presentation which we rolled out last week, we show a full mosaic of coming QUAD3 and QUAD4 set-ups across major, developed-market economies. With the U.S. tracking on the border between QUAD2 and QUAD3 for Q2 of 2018, it’s important to highlight that QUAD3 is the one quadrant where fixed income yields have historically widened across the curve.

So although we have seen interest rate volatility compression associated with #reflation’s rollover or the flight to safety amidst carnage in equities (pick your narrative), there is still a growing crowd taking the other side.  

Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND views in brackets) are now:

UST 10yr Yield 2.70-2.85% (bullish)
SPX 2 (bearish)
VIX 17.22-25.23 (bullish)
RUT 1 (bearish)
NASDAQ 6 (bearish)
DAX 110 (bearish)
USD 88.75-90.51 (neutral)
EUR/USD 1.21-1.24 (neutral)
Gold 1 (bullish)
Copper 2.94-3.11 (bearish) 

Good luck out there today,

Ben Ryan
Macro Analyst

Back on a Familiar Horse - 04.10.18 EL Chart

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