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Caution: Consumer Confidence Is A 'Cognitive Casino'

This special guest commentary was written by Peter Atwater of Financial Insyghts. This piece was originally published on March 19, 2017. 

 

Caution: Consumer Confidence Is A 'Cognitive Casino' - 03.02.2017 consumer confidence

 

The Mirage – “Consumer confidence rose in March as Americans were more satisfied than any time in 16 years with the current state of their finances and the economy, while remaining sharply divided along party lines about the outlook.”

 

Caution: Consumer Confidence Is A 'Cognitive Casino' - Financial Insyghts   March 19  2017 Commentary  2

 

That was how Bloomberg summed up Friday’s University of Michigan survey: Great, but highly partisan. While on average Americans feel good about things today, underneath the surface, eighty-seven percent of Republicans expect continued gains in the economy over the next five years, compared to just 22 percent of Democrats.


As I have offered repeatedly, when it comes to reported confidence, 2017 is 2009 in reverse.


What few took note of were these conference call comments from Michigan survey director Richard Curtin:


Consumers recognize, even Republicans recognize, that there’s lots of uncertainty about what economic policies will be passed and what the regulations will be… We have this unusual situation where we have a rise in optimism and a rise in uncertainty. (Bolded for emphasis.)


To explain the significance of this comment, I would draw your attention to this simple slide.

 

Caution: Consumer Confidence Is A 'Cognitive Casino' - Financial Insyghts   March 19  2017 Commentary  6

 

As I have offered before, confidence requires perceptions of control and certainty. While one or the other is good, both are required. Confidence is not only about how we feel about the future, it is about we see ourselves faring in that future, too. Today, per Mr. Curtin, while Republicans may have a heightened sense of control, they, along with Democrats, sense a rise in uncertainty.

 

What Mr. Curtin unknowingly revealed is something that I have been concerned about since Election Day. Republicans aren’t “confident;” they are “relieved” and now hopeful. With the arrival of the new administration, and Republicans gaining control of both the House and the Senate, Republicans feel empowered; and, as a result, they are, as Mr. Curtin put it, now “optimistic.”


While optimism accompanies confidence, the two are not at all the same. There is a vast difference between being optimistic about something happening ahead and being confident in it happening. There is hope and then there is trust.


At the risk of oversimplification, I’d offer that the mood migration that we have seen among Republicans since Election Day is not from the lower left box in the chart to the upper right box, but a shift from the lower left box to the upper left box.

 

Caution: Consumer Confidence Is A 'Cognitive Casino' - image 2

 

While Republican voters are more optimistic and feel a much greater sense of control, they are not confident. They still do not have a high sense of certainty.
On the surface this may seem like I am once again dancing with angels on the head of a pin, but the distinction matters – a lot, too.


Environments of high control and low certainty are fragile. A poker game, for example, is an environment of high control and low certainty. So, too, are stock picking and active investment management. An environment of high control and low certainty defines games of chance.


To be fair, neither we nor those measuring confidence pay much attention to the distinction between the upper left and upper right boxes. Both environments express, if not ooze, optimism. Heck, the pharmaceutical, casino and financial services industries together spend billions of dollars every year in advertising trying to convince consumers that there is no difference between the two boxes. Whether it is a drug or an investment, consumers are routinely told to ignore the potential adverse side effects arising from uncertainty.

 

This chart from Gallup, though, suggests that ignoring the potential side effects is exactly what investors and Republican voters have done since the election of Donald Trump. Consumers’ “Economic Outlook” – “optimism” – went from -21 just before the election to +15 a week ago.

 

Caution: Consumer Confidence Is A 'Cognitive Casino' - Financial Insyghts   March 19  2017 Commentary  5

 

Beyond the recent sharp decline in the black line evident in the chart above, I have two concerns with the current positioning of Republican voters in the upper left box today.


First, if the new administration has shown anything in its first days in office it is that uncertainty is the team’s normal operating environment. Stop, start, yes, no, true, false – we’ve seen more shifts in position from the Trump administration than a day-long yoga class.

 

Based on what we’ve witnessed so far, the new administration has no sense of the distinction – let alone the importance of that distinction – between the upper left and upper right boxes.

 

Rather than taking small steps that foster greater and greater certainty and build confidence over time, the new administration has thrown caution to the wind. From healthcare to financial services reform to the budget, nothing is now certain. They are, for lack of a better term, gambling with America’s future, comfortably running an administration in the upper left box.

 

Caution: Consumer Confidence Is A 'Cognitive Casino' - atwater image


While that would be worrisome on its own, the current positioning of Republicans requires that Trump’s followers keep on winning. With Republicans’ optimism entirely a function of a greater perception of control, the new administration has no choice but to do whatever-it-takes to keep that perception aloft. To put things differently, if you think things look authoritarian now, just wait until uncertainty rises.


With Republicans having been mobilized into a cognitive “casino” with the election of Donald Trump, the new administration can’t now let them lose. Even more, having just gained control, after a long time without it, Republicans aren’t going to let it go of their new found power voluntarily.

 

But whether the consequence is greater authoritarianism or increasing stridence among Republicans, the confidence of Democrats is likely to be seriously threatened. With the zero-sum thinking that exists today in the White House, there is no way the new administration is going to take a bipartisan gamble that potentially boosts Democrats’ confidence, if it in any way puts at risk Republicans’ high perception of control.

 

The net of it all suggests a probable outcome that looks like this:

 

Caution: Consumer Confidence Is A 'Cognitive Casino' - image 3

 

Republicans (in green) will remain in the upper left box, while Democrats (in red) will move further and further into the lower left box. Needless to say, not only does this all but ensure extreme political partisanship ahead, but it will seriously limit economic growth. Without certainty, no one – Republican or Democrat – will move to up and to the right. All of that “optimism” being reported by Michigan, Gallup and the NFIB won’t translate into action.


(And while it is a topic for another day, I would not underestimate the vicious cycle that is likely to develop as “underconfident” Democrats lash out at the administration, which in turns results in greater authoritarian actions resulting in further backlash…)


To be clear, if the parties were reversed and there were a Democratic administration behaving in the same manner as the new Trump administration, I would be outlining the same scenario. What I see are confidence-driven, far more than ideology-driven, behaviors. “Box position” matters.


To sum it all up, optimism, not confidence, is at a 16 year high. While the stock market and surveys, like the one released by the University of Michigan on Friday, are reflecting hope, below the surface, uncertainty is building. Unless the new administration begins to takes steps to reduce growing anxiety, the bright future that consumers and investors see today will quickly evaporate.


Just like a Las Vegas casino, it will all have been a mirage.

EDITOR'S NOTE

This is a Hedgeye Guest Contributor note written by Peter Atwater, founder and president of Financial Insyghts. He previously ran JPMorgan’s asset-backed securities business. He is also the author of the book Moods and Markets (FT Press, 2012) which details how investors can improve returns by using non-market indicators of confidence. This piece does not necessarily reflect the opinion of Hedgeye.

 


Top Commodities Strategist Goes Deep On Where Gold Prices Are Headed

Editor's Note: Below is special guest commentary written by Stefan Wieler from Goldmoney

 

Top Commodities Strategist Goes Deep On Where Gold Prices Are Headed - fed gold bars

 

For the past few months, gold prices have largely followed the moves in nominal interest rates. Depending on how one analyses the correlation between gold prices and nominal interest rates (10 year US government bond yields), the correlation coefficient is anywhere near record lows and the lowest levels since data is available (1962), meaning that gold prices have recently moved almost perfectly diametrically opposed to nominal interest rates.

 

This has led some commodity analysts and some in the financial media to question the recent recovery in the gold price from USD1130/ozt to USD1230/ozt that occurred despite an increasingly more hawkish outlook for the nominal interest rates path and to proclaim that gold prices are bound to move lower as the Fed keeps raising rates.

 

However, when measured properly, regression analysis shows that gold prices are linked to real-interest rates rather than nominal rates. And sure enough, the correlation coefficient between real-interest rates and gold is currently also at very low levels.

 

Top Commodities Strategist Goes Deep On Where Gold Prices Are Headed - wieler callout image 2

 

In a rare occasion, gold prices have moved closer with nominal rates than real rates over the past months. We noticed that the link between real-interest rates and gold is often overlooked in the daily media reporting in favor of anecdotes about “flows” in the gold market (e.g. at the time of writing, the gold headline on Bloomberg is “ETF buyers see bargains as gold rally stalls on Fed view” 14 March, 2017).

 

It appears that real-interest rates, even though clearly one of the main drivers of changes in the gold prices (see: Gold Price Framework Vol. 1: Price Model, October 8, 2015), are simply not enticing enough to report on. But nominal rates seem to be, hence the increased attention lately to the record low correlation between nominal rates and gold and all the wrong conclusions that come with it.

 

We believe that the reason why gold prices have recently moved closer in line with nominal interest rates rather than real lies in the Fed’s departure from near zero interest rates. For nearly 8 years, interest rates in the US were close to zero and the Fed has bought trillions of dollars in assets.

 

As the Fed has been signaling for a while now that this period of unconventional monetary policy is coming to an end, it has sent seismic shifts through financial markets. The shifts in nominal rates are simply too large and dominate everything, hence the recent near-perfect negative correlation between gold prices and nominal rates.

 

Importantly however, there is no reason to believe that the fundamental relationship between gold and real interest rates that has existed for as long as data are available has changed. In our gold price framework we explained in detail why gold prices move with real rates and as long as gold is being regarded and used as a store ofvalue, this relationship will hold.

 

As we will explain, real interest rates are unlikely tosustainably exceed 1% in the coming years. The market's reaction to last weeks FOMC rate decision illustrates that perfectly (see Chart below). Yes the Fed raised rates another 25bps, yet real-interest rates (or to be precise, real-interest rate expectations as measured by 10-year TIPS yields) declined and gold traded almost 2% higher. Gold prices in USD made their lows the day after of the first Fed hike in December 2015 andare up almost USD200/ozt, despite Fed Funds rates being up 75bps.

 

Top Commodities Strategist Goes Deep On Where Gold Prices Are Headed - wieler chart 1

 

The Fed’s forward guidance aims at 3% terminal federal funds rate at the end for the hiking cycle (end of 2019), and taking the historical performance of both realized inflation and Treasury yields into account that means real-interest rates have only little upside.

 

In fact, we think the odds are increasingly to the contrary. The Fed can only raise rates to 3% over the next three years if the US economy doesn’t hit a roadblock on the way, but that would make the current cycle the longest period without a recession in US history.

 

If the US does enter a recession however, the Fed’s room to maneuver will be extremely small. The current record period without recession was from 1991 to 2001 that ended with the bursting of the dotcom bubble and the Fed slashing rates by 5.5%. A similarly sized rate cut (which is about the average rate cut from the Fed in a recession) would push rates to somewhere around -2.5 to -5%, depending on how much the Fed had raised rates in the first place.

 

Top Commodities Strategist Goes Deep On Where Gold Prices Are Headed - wieler callout image

 

Needless to say, real rates this negative would be extremely bullish for gold prices. In the meantime, we think gold prices will likely remain somewhat tied to nominal rates over the short run, which should offer good entry opportunities.

 

The gold sell-off in late 2016 is often attributed to a rise in interest rates. 10-year Treasury yields rose from under 1.4% in July 2016 to 1.8% shortly before the US presidential election. Subsequently, yields rose to around 2.5% at present. During this period, gold dropped from over USD 1350/ozt to USD 1240/ozt the day before the election and fell further to USD 1128/ozt before recovering back to around USD 1230ozt at the time of writing.

 

The correlation between nominal rates and gold prices is either near or at the lowest levels since data is available (1962), depending on how it is measured. This has led some financial analysts and some in the financial media to proclaim that gold prices have much more downside should interest rates rise further.

 

Top Commodities Strategist Goes Deep On Where Gold Prices Are Headed - wieler chart 2

 

In order to prove this point, a chart similar to the one in Figure 1 is typically shown in an attempt to support the argument. The chart shows the 120 day rolling correlation of the gold price and nominal interest rates (10-year treasury yields) which indeed suggests that the correlation coefficient is at the very low end.

 

However, herein lies already the first fallacy. In finance, if anything, what matters is the correlation of changes (returns), not the correlation of levels (prices). For example, in a portfolio context, the goal is to minimize portfolio volatility given portfolio return goals, thus one needs to analyze return correlations, not the correlations between prices.

 

But there are also mathematical reasons why measuring correlations between nominal values should be avoided.

 

In a time series, prices can be expressed as:

 

P(0), P(1), P(2)… P(N)

 

Analogously, returns can be expressed as:

 

R(1), R(2), R(3)…R(N) where R(t) = P(t)/P(t-1)-1

 

Hence prices can also be expressed as

 

P(0), P(0)x(R(1)+1)), P(0)x(R(1)+1)x(R(2)+1),…

 

From the above formula it becomes clear why measuring the correlation of prices is problematic as it weighs returns early on in the time-series higher than later returns. If prices follow a random walk and the price of an asset goes up in the first period, then the likelihood increases that at the end of the measuring period prices are higher than at the beginning of the measuring period.

 

For example, the price of a stock at the beginning of the measuring period of 30 days is USD 100 and on day 1 it goes up 10%. If prices follow a random walk for the remainder of measuring period, then the probability that prices go up or down during the remaining 29 days is the same. Hence, after day one, there is a higher likelihood that on day 30 prices will above USD100 than below USD100.

WHAT IS CORRELATION AND HOW IS IT MEASURED?

In finance, correlation is used to express the degree to which two assets move in relation to each other. In mathematical terms, correlation is defined as the covariance of two random variables divided by the product of their standard deviations.

 

corr(x,y) = cov(x,y) / (stdev(x) x stdev(y)

 

The covariance is the joint variability of two random variables and is measured as the mean value of the product of the deviations of two random variables from their respective means. The covariance of two random variables depends on the unit it is measured in (for example, the covariance of two stocks measured in cents is different than the covariance of the same stocks measured in USD).

 

Thus, the covariance is divided by the product of the standard deviation of the two random variables for normalization. As a result, the correlation coefficient of two variables falls always between -1 and 1 where 1 reflects a perfect direct linear relationship and -1 a perfect inverse linear relationship.

 

Correlation and covariance are important concepts in portfolio management. A portfolio consisting of two assets that are perfectly correlated and have the same expected return will have an expected return and volatility equal to either asset. A portfolio consisting of two assets that are perfectly negatively correlated and have the same expected return will have an expected return equal to either of the asset but with zero expected volatility.

 

A portfolio manager tries to maximize returns given a certain risk tolerance (measured by the expected volatility of the portfolio). Hence, portfolio managers try to find assets with low or negative correlations in order to optimize the expected return and volatility of the portfolio.

 

Calculating correlations of levels (prices) rather than changes (returns) thus often yields strange results. Generally, if the returns of two assets have a positive correlation, the underlying prices often have a positive correlation as well. But sometimes that is not the case. Table 1 shows an example where the correlation of prices and returns yields a very different result. Further, in our experience, correlations of values are much more likely to take extreme values (close to -1 / +1).

 

Top Commodities Strategist Goes Deep On Where Gold Prices Are Headed - wieler chart 3

 

Outside portfolio optimization, financial research analysts may use correlation analysis to show the degree by how much two variables are related. However, there are limitations to the significance of correlation analysis. The correlation coefficient gives no information about cause and effect. Correlation does not imply causation. More importantly, the correlation coefficient also does not allow to predict one value fromthe other.

 

Which method should be used then to show the relationship between interest rates and gold prices, the correlation coefficient of values or that of changes? The short answer is: likely neither. If the goal is to predict gold prices (or changes in gold prices) based on expectations for interest rates, a correlation analysis is of no help. Instead, a regression analysis with gold as the dependent variable may be used to develop a gold price model.

 

We have done that extensively and you can read up on the results in our gold price framework. However, if one simply wants to show whether there is a relationship between interest rates and gold prices, we think measuring the correlation of the changes is appropriate. After all, what one wants to show is whether gold prices tend to go up or to go down when interest rates fall or rise.

AND CHANGES IN GOLD PRICES

The 120 day rolling correlation of the generic 10-year treasury yield and gold is plotted in figure 2 below. As one can see, the correlation of the changes is not as volatile as the correlation of levels and less likely to reach extreme values.

 

This is actually more helpful, as it tells us that gold prices tend to be negatively correlated to changes in interest rates most of the time. It does however say nothing about the causality, whether interest rates drive gold prices or gold prices drive interest rates, or, whether both are driven by something entirely different. It thus also does not allow one to predict changes in the gold price based on changes in interest rates, even though that seems the plausible causality.

 

Assuming interest rates do drive gold prices, does a positive correlation mean that rising interest rates sometimes lead to rising gold prices? Not necessarily. The correlation only measures how the two variables behave over the measured period. A multivariate regression analysis is necessary to get a better understanding of the underlying drivers of the gold price.

 

The gold price could be affected by other drivers as well. In fact, in our gold price framework note we found that changes in longer-dated energy prices and central bank policies such as quantitative easing (QE) are equally important drivers and there are periods where these drivers undergo large shifts which dominates the gold price.

 

Top Commodities Strategist Goes Deep On Where Gold Prices Are Headed - wieler chart 4

 

What can we learn then from analyzing the correlation between changes in interest rates and changes in gold prices? The very low correlation recently between the two tells us that gold prices and interest rates have been moving almost in tandem (reciprocal) over the past few months. However, we cannot simply conclude from this observation that with rising interest rates, gold prices will decline further.

REAL-INTEREST RATES RATHER THAN NOMINAL RATES DRIVE GOLD PRICES

 

Which brings us to the second misconception in the argument that gold prices will move lower as rates rise. In our gold price framework note, we identified real-interest rates as the driver for gold prices rather than nominal rates. Real interest rates are nominal interest rates minus inflation expectations. It is the expected real yield of a 10-year Treasury note.

 

Real-interest rates drive the demand for money (and thus gold) which is why there is a strong link between real interest rates and gold. Because nominal interest rates are one part of real interest rates (and inflation expectations the other), gold prices can move with changes in nominal rates when inflation expectations are stable.

 

This might give the appearance that gold prices are simply driven by changes in nominal rates when in fact they move with real-interest rates. We highlighted before why correlation analysis is most of the time an inadequate statistical tool if the goal is to find the underlying price drivers of an asset.

 

With that in mind, figure 3 shows that the correlation coefficient between real-interest rates and gold is much more stable over time and is almost always lower (and barely ever positive) when compared to the correlation coefficient between nominal rates and gold, consistent with our findings that real-interest rates are one of the main drivers for gold prices.

 

Top Commodities Strategist Goes Deep On Where Gold Prices Are Headed - wieler chart 5

 

Interestingly though, the correlation between changes in gold and nominal rates has recently fallen substantially below the correlation between real-interest rates and gold, which is rare. In other words gold prices have been largely following the move in nominal rates.

 

We believe the reason for this lies in the Fed’s perceived departure from close to eight years of near zero interest rates and the potential reversal of trillions of asset purchases conducted under multiple quantitative easing programs, creating seismic shifts in financial markets.

 

The shifts in nominal rates are simply too large and dominate everything at present, hence the recent near perfect negative correlation between gold prices and nominal rates. The reason why the correlation between real-interest rates and gold has been somewhat lagging is that inflation expectations (measured as breakeven inflation from TIPS yields) has been moving higher since the election as well.

 

Part of that might reflect the markets’ view that future inflation might be higher as a result of the White House infrastructure spending plans. But inflation generally has been on the rise, which can’t be attributed to any of President Trump’s nascent polices (which have not even been decided yet).

 

But other than for nominal rates, where the impact was almost instantaneous, inflation expectations are only gradually moving higher. By now, inflation has almost caught up and real-interest rates are back to around 50bps. Gold prices did recover a bit, but not to the same extent. We think gold is still trading more off nominal rates than real-rates at this point.

 

What does that mean for the future? The fact that gold prices are driven by nominal interest rather than real rates is in our view a temporary phenomenon that came with the shift in market perceptions about the forward Fed interest rate path and will not last over the long run. In the end, as long as gold is regarded and used as a store ofvalue, gold prices will eventually reflect real-interest rates.

THE FORWARD PATH OF REAL-INTEREST RATES

What is the most likely forward path for real interest rates? Again, real-interest rates are nominal rates – inflation. So let’s look at the nominal rate side first. Nominal interest rates have been in a clear upward trend for a while now with the Fed determined to gradually raise rates for several years. The Fed itself has a forecast for terminal rates at 3% longer term (2020 and beyond).

 

What can we expect for bond yields in such a scenario? In our recent report (The Gold Sell-off: How far might it go?, December 2, 2016) we showed that bond yields are above Fed funds rates at the bottom of the cycle, but the two tend to converge at the peak of the cycle, see Figure 4).

 

Top Commodities Strategist Goes Deep On Where Gold Prices Are Headed - wieler chart 6

 

This suggest that the 2% differential between 10-year nominal rates and the Fed funds rate is unlikely to persist as the Fed keeps raising rates. As a result, the yield on 10-year Treasury will most likely not be substantially above 3% at the end of the Fed hiking cycle, even if the Fed gets to raise rates continuously over the coming years.

WHAT ABOUT INFLATION?

Inflation has been accelerating and this is reflected in inflation expectations as well. More specifically, CPI inflation in February has reached 2.7% year-over-year (from 1% in 2016 and below zero in 2015) while 5-year breakeven inflation expectations embedded in TIPS yields recently topped 2% (from a low of 1.25% in mid-2016).

 

In our view this was largely responsible for the market reaction (USD sold off and gold rallied) post-FOMC rate announcement. The market had expected that the Fed would present a much more hawkish forward guidance in light of the recent uptick in price inflation.

 

Yet the FOMCs dot plot (the expectations of individual FOMC members in regards to the Fed rate path) was almost unchanged from the December meeting, reflecting that the Fed does not believe the macroeconomic environment has materially changed. In that context it is also important to notice that the FED has a history of letting inflation exceed the target of 2% in a hiking cycle (see Figure 5).

 

Top Commodities Strategist Goes Deep On Where Gold Prices Are Headed - wieler chart 7

 

For that, it is important to understand the different measures of inflation provided by government agencies. The two main inflation measures are personal consumer expenditure (PCE) and consumer price index (CPI). The main difference between PCE and CPI is the weightings of the various components. The CPI is based on a survey of what households are buying while the PCE is based on surveys of what businesses are selling.

 

The coverage of the two measures also differs, the CPI only covers out-of-pocket expenditures on goods and services purchased. Expenditures that are not paid directly (employer provided insurance for example) are excluded from the CPI but included in the PCE. In addition, the PCE assumes that consumers substitute for cheaper goods when the price of an item in the basket becomes more expensive.

 

Both measures come in two main flavors, headline and core. Headline measures all prices in the basket while core excludes food and energy. While naturally what really matters for consumers is headline (as they do eat and drive), food and energy prices tend to be more volatile and so the argument goes that core inflation is a better trend indicator where inflation is going (by omitting the noise).

 

Importantly, the Fed focuses on core PCE in regards to its inflation target of 2%. However, the headline CPI issued to adjust social security payments as well as the principal of Treasury inflation protected securities (TIPS).

 

In our gold price framework note we found that TIPS yields can be used to measure actual real-interest rate expectations. Figure 5 thus suggests that not only does the Fed seem comfortable letting core PCE exceed the 2% target during a hiking cycle (a view that has been reinforced by the latest FOMC meeting outcome), headline CPI (which is what drives gold prices) tends to come in substantially higher.

 

Following the end of the convertibility of the USD to gold in 1971, headline CPI exceeded core PCE by 0.8%per year. This increased to 1% over the past 10 years. Hence even with a 2% inflation target (and some regional Fed presidents are already advocating for a higher target), actual headline inflation will likely increase the target rate substantially in the current hiking cycle.

 

Therefore, even in the best case scenario, where the US economy continues to improve for years to come, allowing the Fed to gradually raise rates over the next four years to around 3%, realized real-rates at the end of the hiking cycle will likely be close to zero percent.

 

And because the Fed is unlikely to raise rates further if the inflation target of 2% cannot be met, this implies that real-interest rates should not go much over 1% even in the ‘Goldilocks’ scenario where the US economy does not encounter any slowdown or recession over the coming years.

 

As of today, the US economy has had 92 months of no (official) recession. That is less than 30 months short of the record 121 month period between 1991 and 2001, which ended with the bursting of the dotcom bubble and forced the Fed to lower interest rates by 5.5%. If the Fed really gets another recession-free three years in which to raise rates to their forecasted 3%, it would mark a new record.

 

Top Commodities Strategist Goes Deep On Where Gold Prices Are Headed - wieler chart 8

 

But if we are not so lucky, then both nominal and real-interest rates will inevitably decline again. Because the Fed has just a very small buffer left (currently 0.875%), we would most likely see more unconventional monetary policy including quite possibly negative interest rates (NIRP) and more quantitative easing (QE). Whatever the Fed does deploy, expect real-interest rates to reach new lows (real-interests rates fell below -0.9% in 2012), which would likely push gold sharply higher in USD terms.

 

But even without a recession, real-interest rates simply don’t have much upside. At 3-4% nominal yields with 2% inflation, realized real rates would be around 1-2% at their peaks (currently 0.6%). That means even if the Fed has three more years to raise rates before we see another recession, the ensuing easing (the Fed slashes nominal rates by around 5% on average) would push real-interest rates to new lows around -3-4%, with inflation anchored at 2%.

 

In other words, we think real-interest rate expectations have already peaked in early 2016. Over the short run, gold prices might continue to trade closer in line with nominal rates, which means as the Fed is hiking and the market believes it will continue to do so, gold might face some headwinds. But we believe gold prices will eventually trade more in line with real-interest rates again, which implies that any further sell-off will prove unsustainable over the medium to long term.

EDITOR'S NOTE

This is a Hedgeye Guest Contributor research note written by Stefan Wieler for Goldmoney Insights. Wieler was previously a senior commodity strategist at Goldman Sachs. This piece does not necessarily reflect the opinion of Hedgeye.


Cliggott: Here's the $64,000 Question Right Now

Editor's Note: Below is a Guest Contributor note written by our friend Doug Cliggott. Cliggott is a former U.S. equity strategist at Credit Suisse and chief investment strategist at J.P. Morgan. He is currently a lecturer in the Economics Department at UMass Amherst. 

Cliggott: Here's the $64,000 Question Right Now - Bull and bear extra cartoon

 

On markets...

 

My views on bonds haven't changed a whole lot from six months ago. But I was wrong on 2017 earnings ... I thought they would be down quite a bit this year, but it does not look that way now.  Profit growth has turned positive. 

 

1) I think the 10-year yield is heading higher.

 

Why? Faster inflation caused by rising unit labor costs.  

 

Non-farm productivity growth remains dismal:  0.2% in 2016, following 0.9% in 2015 and 0.8% in 2014.  With hourly compensation growing at 2.9%, BLS reports unit labor costs rose 2.6% in 2016, up from 2.0% in 2015.  A  2.5% 10-year yield seems unsustainable when unit labor costs are rising at 2.6%. 

 

Non-residential fixed investment remained stagnant in 2016, even as after-tax cash flow edged up, so it is hard to see what will push productivity growth higher in the near-term.  The focus of corporate America remains returning cash to shareholders rather than investing in the future.  

 

Share buybacks and dividend payments equaled 53% of cash flow in the non-financial corporate sector in 2016 -- that compares with a 35-year average of 34%. {This is based on Fed data, Cliggott calculation from Table F.103 in the Z1 release - new Fed website looks pretty cool, btw}

 

Meanwhile, cap ex by non-financial corporations equaled 73% of cash flow in 2016 -- that compares with a 35-year average of 84%.  The two numbers combined {shareholder payments of 53% + cap ex of 73%} still looks high relative to the long-term average combined total of the two -- 34% +53% = 117%.

 

So if US corporates slow their borrowing for some reason {higher rates?}, my guess is cutting cap ex will come before cutting payments to shareholders.

 

2) Most LEI's around the world bottomed last summer - including the U.S. 

 

That was a big surprise to me. This data tends to fit well with the U.S. corporate profit cycle.  Hence my change in view on 2107 profit growth.

 

I guess now the $64,000 question is -- Is this the beginning of a new cycle or "noise" on the way down?  I honestly don't know ... but given leverage levels and interest rate trends I am VERY SKEPTICAL that this is the beginning of a new credit / profit cycle. 

 

So my guess is renting {with a short-term lease} rather than owning US equities makes the most sense at this stage. I would note that the IWM hasn't made any net progress in three months ... and the next OECD LEI data release is April 10th!


Are You Prepared For The End Of The Bond Bubble?

This special guest commentary was written by Daniel Lacalle

 

Are You Prepared For The End Of The Bond Bubble? - z lacalle

 

The biggest bubble in financial history is about to end.

 

With rate hikes, a stronger dollar and the return of inflation, bond inflows are normalizing, sell-off in negative yield fixed incme continues, and real rates increase despite central planners’ financial repression. High-yield bond funds saw their biggest outflows since December 2014 last week, as investors withdrew $5.7bn, according to EPFR Global.

 

Meanwhile, the total value of negative-yielding sovereign bonds fell to $8.6 trillion as of March 1 from $9.1 trillion at the end of 2016.

 

Three factors are helping the burst of the bond bubble:

 

  1. The price of oil falling to three-month lows on the evidence of the ineffectiveness of OPEC cuts, a record increase in inventories and a stronger dollar is helping to reduce the thirst for high-yield.
  2. A strong “America First” policy needs a stronger US dollar. The US economy benefits from a strong dollar and rising rates, not the other way around. Believing that the US needs to weaken its currency is a fallacy repeated by mainstream economists. The US exports are relatively small, about 13% of its GDP, and its citizens have 80% of their wealth in deposits. The new administration knows it. They are their voters. The only ones that benefit from a weak dollar and low rates are bubbles, indebted and inefficient sectors. If a rise in rates of 0.25% negatively impacts a part of the economy, after more than 600 rate cuts, it means that such part of the economy is unsustainable. Increasing rates is essential to limit the exponential growth of bubbles and excesses.
  3. The European Central Bank. The placebo effect of ECB policy has already passed. With more than € 1.3 trillion in excess liquidity and a dangerous environment where economic agents have become “used” to unsustainable rates to perpetuate low productivity sectors, it is inevitable that the central bank will begin to unwind its Monetary laughing gas sooner rather than later.

 

That dollar strength and US rate hikes, reinforced by the Trump administration’s capital repatriation policy, is exactly what the country needs if it really wants to “make America great again.” If you destroy the middle class with financial repression, you will not only lose its political support, but the policy will not work either.

 

Strong dollar, normalized rates and repatriation of capital create the vacuum effect. Higher demand for dollars is triggered and the attractiveness of low yield bonds outside the US is reduced.

 

… In Europe, we are not prepared for the bond bubble to deflate.

 

The vacuum effect can mean a loss of up to a $100 billion just from repatriations. If the top five technology companies repatriated half of their cash back to the US, it would mean more than $240 billion leaving the rest of the world and returning to the US.

 

But, moreover, rate hikes make it less attractive for investors to buy bonds from European and emerging countries.

 

At the moment, growth prospects in the Eurozone, and the US-European inflation differential keep the flow of investment in the European Union because in real terms it still offers a decent mix of risk and profitability. But the Eurozone has a problem when governments have to refinance more than a trillion euros and have become used to spending elsewhere the “savings” in interest expenses achieved due to artificially low rates.

 

Are You Prepared For The End Of The Bond Bubble? - z uno

 

Those savings have already been spent, and when rates rise, and it will happen, many countries do not seem to be sufficiently prepared. Same with many companies. The rise in inflation and rates, which has given some breathing air to banks, holds another side of the coin. Non-performing loans have not been adequately cleaned, and remain above 900 billion euro in the European financial system. Banks do not have enough capital cushion to undertake the deep provisions that would entail cleaning up such a hole and have relied on the recovery to try to sell these loans. The improvement in NIM (net income margin) coming from inflation and a rate increase does not compensate for the increase in NPLs and their provisions. A rate hike of 0.25% means an increase in NIMs of 17% for Eurozone banks, but the clean-up of NPLs would completely wipe out that benefit.

 

The European Central Bank should analyze the risk of fragility. Because it has not been reduced.

 

Europe continues to suffer from three factors: Industrial overcapacity, high indebtedness and excessive weight in the economy of low productivity sectors.

 

These sectors -industrial conglomerates, construction- have absorbed most of the new credit. The ECB and governments were too obsessed with increasing credit to the economy to worry about where that credit was going to. When Eurozone economies and companies are afraid of the impact of a hike of just 0.25%, it means we have a problem – really big.

 

Do you have a business? Are you prepared to pay 1-2% more for your financing in the next five years? Yes? Congratulations. You have nothing to worry about.

 

Do you have a variable rate mortgage? Are you prepared to pay a few hundred euros more per year in the next few years? Yes? You have no problem.

 

Do you have a country where net financing needs are going to continue to fall as rates rise? Yes? Congratulations, you are fine.

 

Do you think that the ECB will have to keep or lower rates because everyone is so entrapped that it needs to be more dovish? I wish you luck.

 

Are You Prepared For The End Of The Bond Bubble? - bubble cartoon 09.09.2014

 

The big mistake of central banks has been to create bubbles, then deny them, and afterward try to perpetuate them with the same policy that created the initial problem. Lowering rates and increasing liquidity has been the only policy.

 

Now central banks face a new US administration that sees currency wars and beggar-thy-neighbor policies as what they are, assaults on the middle class. Financial repression did not work in the past, and failing to adapt economies to normalized rates is dangerous.

 

Investors should really pay attention because real and nominal losses are more than evident in bond portfolios.

EDITOR'S NOTE

This is a Hedgeye Guest Contributor note written by economist Daniel Lacalle. He previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is CIO of Tressis Gestion and author of Life In The Financial MarketsThe Energy World Is Flat and the forthcoming Escape from the Central Bank Trap.


Putin's Other Bromance

This guest commentary was written by Rich Blake of Wikistrat

 

Putin's Other Bromance - putin image

 

While Russia has carved itself a permanent spot in the American news cycle, the context is almost always with respect to United States election meddling, or, alternatively, the conflict in Syria. In recent weeks, Vladimir Putin’s alleged penchant for having dissidents poisoned has gotten a little attention too.

 

Still, it could be argued that myriad other more complicated but no less important storylines concerning Russia deserve more play. One example: renewed relations between Russia and Egypt.

 

What started a few years ago as a bolt-from-the-blue bear hug has quietly morphed into a tender slow dance – joint military exercises in the Med, arms deals, tourism partnerships – oh and did we mention Russia plans to build a nuclear plant in Egypt?

Something to Watch Very Closely

What this burgeoning alliance mean for the region, and for the rest of the world, remains to be seen. To assess the relationship's ramifications, Wikistrat, the world's first crowdsourced geopolitical intelligence consultancy, held a short online engagement exercise hotwiring the brains of a dozen experts on Egyptian and Russian politics/security/economies via a series of questions and cross-analysis.

 

One key question tackled by the working group: Can Russia replace Saudi Arabia as the main financial backer of Egypt? The answer seems more likely to be NO.

 

But it's still a situation on which to keep a close eye, especially with America's current foreign policy in a disrupted state not unlike a brand new chemistry set that's been opened on Christmas morning: jostled around and emptied out on to floor.

 

Putin's Other Bromance - us egypt russia callout

 

During the 1950s and '60s, the Soviet Union and Egypt were sort of kindred spirits with a shared disdain for dominant Western powers. But then came the early 1970s and the rise of Anwar Sadat who embraced the U.S. After a long sour patch, this pair of geopolitical misfits is giving it another go.

 

It's as if the drummer and bass player from a classic rock band decided to record some new material together following a long hiatus – even as their lead guitarist and singer soldier on together playing the old stuff – in other words, Russia and Egypt may find it complicated, if not impossible, to rekindle what may never have been there to begin with.

 

Or to take the analogy further, and in a more twisted direction – think two ex-lovers, one of whom is crafty and manipulative, the other, emotionally unstable, who move into a fixer-upper together, although the project is overwhelming and both of them are broke and off their meds. What could go wrong?

What's Behind the Russia-Egypt Bromance

Russia saw an opening to revive relations with Egypt after the latter country alienated Gulf state sponsors i.e. Saudi Arabia by supporting Assad's crackdown on Sunni Islamists. Saudi Arabia surely expected its ties with Egypt's president, Abdel Fattah al-Sisi, were bound in iron cement after the Kingdom supported the 2013 Egyptian military coup that put Sisi's government in power – and chilled relations between Egypt and the U.S.

 

That Sisi turned his back on the Kingdom's proxy wars (in Syria, Yemen and Iraq) with Iran, while expressing an all-options-open foreign policy not in lockstep with Riyadh's, was an even more monumental development than a U.S.-Egypt rift and cleared the stage for Russia to swoop in with candy and flowers in the form of an offer to help Egypt with its nuclear program. 

 

Just when you thought the region couldn't be any more fragile you find new tensions, and new rivals; a gas leak inside a gunpowder making facility housed in the windowless basement of a firetrap. Or put in even scarier terms – a Russian-built nuclear reactor in the heart of the Middle East.

 

Egypt and Russia began to strengthen their cooperation in the aftermath the 2013 coup (paid for by Saudi Arabia) but this saga, while not new, has been underfollowed.

 

Increasingly aligned regional interests and a sense of mutual respect between Sisi and Putin has led to increased military cooperation, Egyptian purchases of Russian arms and an increase in economic cooperation, mainly in the energy sector. Last September, Egypt went as far as to back a Russian proposal on the Syrian crisis in the UNSC, full-well knowing it would lead to tensions with Saudi Arabia, its most crucial regional ally; or at least it was.

What's the smart money say...

The Wikistrat exercise – experts trading views, contributing answers and analysis to several key questions in a sort of pop-up think tank – had at least one key finding and it should come as (seemingly) good news for those followers of geopolitical tinder boxes and/or Lifetime network movies: Russia can never take the place of Egypt’s main strategic allies.

 

Wikistrat analysts believe that despite a genuine desire by both leaders to enhance bilateral relations, Russia will not be able, or willing, to replace Saudi Arabia and the Gulf States as Egypt’s main financial backer; nor will it be able to substitute the U.S as its main strategic partner. Said one contributor following the thought exercise: “Egypt's relationship with Russia is quite shallow and lacks serious depth."

 

The more recent upturn in relations with Russia is primarily a function of the deterioration of bilateral relations with the U.S. and the beginning of hedging behavior during a period of turbulence and isolation, the analyst added.

 

"Russia cannot and will not replace the financial support provided to Egypt by the United State and the Gulf.”

 

More reasons to not panic: Military cooperation seems likely to be limited to arms purchases of Egypt from Russia, military drills, and perhaps some (again, limited) cooperation in areas of common strategic interest. This could include Libya - where Egypt and Russia both support Khalifa Haftar’s Libyan National Army. The majority of Wikistrat's analysts believe that the plan to set up a Russian military base on Egyptian soil will not materialize, and that Russia will not directly intervene to help the Egyptian regime confront its own security threats.

 

However, and this could be categorized as worrisome, there is significant potential avenue for continued cooperation: Egypt badly needs foreign investment in its awakening energy sector.

 

Russia could benefit from Egypt’s energy resources and in the long term could finally lock-in Southern Europe to Russian suppliers of natural gas. In December 2016, the Russian energy firm Rosneft bought 30% of the stake in Egypt’s major gas field, Zohr, from Italy’s Eni. Additionally, Russia plans to build Egypt’s first nuclear plant in Dabaa.

 

How likely is that Dabaa plant (gulp), you might be asking? Of 12 Wikistrat analysts, 11 agreed; YES it is likely to materialize. 

EDITOR'S NOTE

This is a Hedgeye Guest Contributor piece written by Rich Blake a veteran financial journalist and the former head of content at the Investor Intelligence Network. Blake is now a contributing analyst at Wikistrat, the world's first crowdsourced geopolitical intelligence consultancy with over 3,000 subject-matter experts.


Investors Have Begun to Smell a Rat In the Bond Market

This guest commentary was written by "Fed Up" author Danielle DiMartino Booth. Make sure to watch her recent conversation with Hedgeye CEO Keith McCullough.

 

Of all virtues to which we must ultimately aspire, forgiveness demands the most of our souls. In our naivety, we may fancy ourselves man or woman enough to absolve those who have wronged us. But far too often, we find our pool of grace has run dry. So deeply burdened are we by our emotions that grace to us is lost.

 

How many of us have the strength of resolve to let bygones be gone for good? Those of the cloth recognize the damage self-inflicted scars sear into our souls as they seek to guide us through life’s most difficult journeys. They pray for our deliverance from a painful inner turmoil and with it the peace only forgiveness can convey.

 

None who have ever heard Don Henley’s "The Heart of the Matter" could be blamed for thinking divine inspiration itself came down from the heavens to spawn those longing lyrics. But it isn’t just the words that scorch their way into your memory, it’s Henley’s tone, the raw pain that pierces every time you’re caught off guard by the mournful ballad released in 1989.

 

 

Henley sings of our feeble struggle as no other, grasping for our collective release in humility. “The more I know, the less I understand. All the things I thought I’d figured out, I have to learn again.” In the end, Henley hands down the cruelest of convictions: If you truly want to vanquish your demons, you must find the strength within to forgive.

 

Astute policymakers might be saying a few prayers of their own on fixed income investors’ behalves. The explosion in corporate bond issuance since credit markets unfroze in the aftermath of the financial crisis is nothing short of epic. Some issuers have been emboldened by the cheap cost of credit associated with their sturdy credit ratings.

 

Those with less than stellar credit have been prodded by equally emboldened investors gasping for yield as they would an oasis in a desert. Forgiveness, it would seem, will be required of bond holders, possibly sooner than most of us imagine.

 

Investors Have Begun to Smell a Rat In the Bond Market - dimartino banks

 

For whatever reason, we remain in a world acutely focused on credit ratings. It’s as if the mortgage market never ballooned to massive proportions and imploded under its own weight. In eerie echoes of the subprime mania, investors indulge on the comfort food of pristine credit ratings despite what’s staring them in the face – a credit market that’s become so obese as to threaten its own cardiac moment.

 

It may take you by surprise, but the U.S. corporate bond market has more than doubled in the space of eight years. Consider that at year end 2008, high yield and investment grade bonds plus leveraged loans equaled $3.5 trillion. Today we’re staring down the barrel of an $8.1 trillion market.

The age-old question is, and remains:  Does size matter?

 

Ask yourself, did size matter as it pertained to the mortgage market way back in 2006, when it peaked in size at $13 trillion? (That was rhetorical in the event you weren’t on Planet Earth at the advent of all modern times’ meltdowns.) Still, it’s the why behind the growth of any given market that matters most. In the case of both markets, the credit rating agencies have helped investors sleep at night, a fact that might now keep you up at night.

 

First, a disclaimer. Of course, speculative grade debt is riskier than its investment grade brethren. The vast majority of investors in the go-go junk market know this and are hopefully buckled up as such, especially if a true rate-hiking cycle is about to test their mettle – more on this later.

 

Still, it’s the blind abandon with which issuance has risen among investment grade (IG) issuers that should, but has yet to, give supposedly conservative investors pause. Consider that in 2011, a (then) record $741 billion was sold into the IG market. As an endless encore, in every single year that followed, issuance has shattered the prior 12-month record. 

 

Last year alone witnessed $1.28 trillion in issuance. As for all the rate hike anxiety permeating the airwaves, 2017 also appears to be in it to win it — $254 billion was sold in the first two months of the year, $20 billion more than the same period in 2016. Investors might soon have to call upon Archimedes’ concept of exponentiation to sufficiently capture how very large the numbers have become.

 

You might wonder how the health of the corporate bond market is faring as it bulks up. As Bloomberg reported last week, you’d have to time travel back to 2002 to get back to the last time IG issuers were carrying more debt vis-à-vis their profits. The sticking point is leverage ratios tend to peak as an economy is just emerging from recession, as companies’ revenue streams hit their nadir.

 

Today, though, as we’ve been told in tsk-tsk fashion, the economy is at the precipice of an accelerating trend. That’s a good thing as companies have sold a heck of a lot more debt than their profit growth justifies, leaving their rainy-day cash to cover their massive, mounting obligations at the lowest levels since 2009.

Debt: The Good, the Bad and the Ugly

The good news is that on the surface, the chances of a hiccup appear to have diminished. According to credit rating agency Standard & Poor’s (S&P), 2016 ended on a relatively better low note: Some 68 global IG issuers were at risk of being downgraded speculative grade, five fewer than the last time the data were compiled at the end of the third quarter.

 

S&P refers to these envelope-pushing issuers as ‘potential fallen angels,’ with ratings at the cusp of crossing over into junk-land. Though you might be thinking one notch on a ratings scale is just that – one measly notch – crossing that line in the sand makes a huge difference for borrowing costs. The yield ‘spread’ above Treasuries paid by junk issuers is typically about double that of what IG issuers pay.

 

The not so good news is that the universe of potential fallen angels remains at historically high levels. The latest read of 68 potential fallen angels is identical to what it was last summer and appreciably higher than as recently as 2015’s first quarter when 42 issuers were at risk of downgrade to spec grade. Moreover, the divide that began to open between potential rising stars – those with the potential to be upgraded into the IG sphere – and potential fallen angels remains at the current cycle’s wides.

 

Perhaps most worrisome is the sector at the greatest risk of downgrades — that is, financials. Years ago, a high yield strategist remarked that declining commodities prices would take their toll in two waves – first, the actual commodities producers, and second, the financials who banked them as the initial commodities cycle became super-sized in magnitude. Bank balance sheets are highly susceptible to a nasty contagion effect.

 

And yet, here we sit watching those oil prices Janet Yellen lectured us would be at ‘transitory’ lows (several years ago) decline anew. God help us if crude’s latest swoon presages a broader downturn. Precisely because leverage is rising among IG borrowers, economic growth literally has to hang in there.

 

If growth even slows, or worse, contracts, all this ballyhooed record issuance among IG issuers will devolve into unprecedented levels of potential-to-actual fallen angels. It will be as if the heavens have opened up as their wings burn and they tumble back to earth.

 

Of course, downgrades don’t necessarily denote defaults. The Start of the Matter may nevertheless require forgiveness in some form as refinancing needs are also now at record levels and must be met. If the Federal Reserve does not intervene, markets are likely to revert back to pure price discovery mechanisms; they will be brutally agnostic to the rate environment to say nothing of the economic backdrop.

Investors have begun to smell a rat

IG exchange-traded funds (ETFs) have slid more in price compared to their high yield ETF peers since the surprise U.S. election that set rates rising. But unlike junk’s magnificent rebound since then, IG has yet to stage a return rebound.

 

It all comes down to refinancing risk. According to S&P’s competition down the block, Moody’s, the refinancing needs of both IG and spec grade issuers will hit record levels over the next five years.

 

Spec grade issuers’ five-years-out refinancing needs have officially crossed the trillion-dollar threshold. Some $1.06 trillion will come due between now and 2021, up from $947 billion in last year’s refinancing risk study and double what they were ten years ago. In the event you’re concerned spec risk has been overly downplayed in this missive, rest assured, the same dynamics that propel record fallen angel levels will be the mother of all default-rate cycle accelerants. File that one away in the ‘actual forgiveness’ to come file.

 

As for the IG space, $944 billion comes due in the five years through 2021. But here’s the kicker – the need to roll over debt is going to come on much more quickly for IG. Maturities are roughly evenly distributed over the next five years as opposed to the needs in spec grade, whose rollover risk gains speed and crescendos in 2021 with a record $402 billion in refinancing coming due.

 

Is that why junk is trading more richly than IG? The yield at which spec trades vs. its Treasury equivalent has only been wider 13 percent of the time over the past 17 years (2007 should provide you comfort because…?). IG on the other hand has traded this ‘tightly’ in only 25 percent of the times records have been kept.

 

Would the start of the matter – the prospects for debt forgiveness and debilitating defaults – be threatening so were it not for central bankers’ meddling ways in markets designed to determine their own damn prices? The ashes will indeed scatter. They will let us know.

EDITOR'S NOTE

This is a Hedgeye Guest Contributor piece written by Danielle DiMartino Booth. DiMartino Booth spent nine years as a Senior Financial Analyst with the Federal Reserve of Dallas under Dallas Federal Reserve President Richard W. Fisher. Her brand new book “Fed Up” explains why the current Federal Reserve system is due for a serious revamp. DiMartino Booth currently runs Money Strong, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.


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