Everyone is trying to understand the nuances of central bank communications – indeed, this has been a decades long pastime. In recent years, the parsing of communications was for signs of how much more extraordinary the stimulus would be. As 2017 plods along, the parsing is now for signs of not just whether the times of extraordinary stimulus are coming to an end (which is where the ECB is) but also how quickly the accommodation will be removed (the Federal Reserve).
Investors are quite right to ask whether the change from extraordinary stimulus to policy normalisation is important for markets. With valuations stretched (boy, are we being kind here!), investors are also quite right to ask where the growth is going to come from to justify those lofty valuations.
Last week, Mario Draghi made some changes to the language in his regular statement accompanying the ECB meeting. ECB staff also nudged up their GDP and inflation forecasts and there is a general sense that the downside risks are diminishing. A bland assessment would be that this was no more than a “mark to market” as the recent cyclical upswing has generated better growth and headline inflation is back at target, even if core inflation is not. A more nuanced assessment may be that Draghi continues to tiptoe away from the extraordinary policies of recent years and that this will become more evident by year end as QE will be reduced further going into 2018. The debate will surely begin at some point on raising interest rates; at least the deposit rate that sits at minus 40 basis points.
Next week, the Federal Reserve will most likely raise interest rates again. The key question will be whether they indicate a modestly faster pace of policy tightening and whether they are actively discussing reducing the balance sheet. There has definitely been a more hawkish bias to the Fed since the US election. Some are arguing that this is as it should be as they risk falling further behind the curve as inflation picks up and fiscal policy will surely kick in later this year. Others seem to be more wary, suggesting that growth will not be as strong as the optimists hope, inflation has mostly been an energy event and a more hawkish Fed risks creating a policy error.
So where do we sit? Well, let’s look at a couple of charts of bond yields.
Chart 1 shows the German 5 year Government bond yield. We said several times in the second half of last year that negative yields on bonds was absolutely insane. It goes against every principal of free markets. Looking at this chart, it very much appears to us that the period of insanity is coming to an end. Although the yield on the German 5 year is still negative to the tune of -0.30%, this surely has to start rising at some point from what looks like a multi-month base as the ECB tiptoes towards the exit.
Chart 1 – The German 5 year Government bond yield
Rising bond yields are not necessarily a bad thing. If growth remains at or above trend and the output gap closes, then rising bond yields can be viewed as a good thing. However, Draghi will be very keen to see yields rise slowly rather than quickly as he wants to avoid market dislocations at almost any cost. Hence, we along with everyone else expect any removal of accommodation to be very measured. The question therefore is whether investors will play ball.
Will investors sit holding negative yielding bonds as the ECB takes away the punch bowl? For the time being, there is a ready buyer in the form of the ECB still hoovering up EUR60 billion of bonds each month (as of April). It is possible that Europe is a little different from the US during the normalisation process, in at least two ways. First, the ECB is shuffling towards the exit having helped push trillions of bonds into negative yield. US bonds never went negative and although the normalisation process has been reasonably smooth so far in the US, they never started with so many bonds priced with a negative yield. Second, the US normalisation process started with global money printing at a record level as both the ECB and BoJ went into overdrive. With the rate of global QE now declining from record levels, the normalisation for Europe may not be so smooth.
Over to the US, we see the picture as finely balanced in the short term. Chart 2 shows the US 10 year Government bond yield, which has basically been in a sideways range for about 3 months, bounded by 2.30% on the low side and 2.60% on the high side. There are many commentators suggesting that the 35 year bond bull market (falling yields) is now over, and therefore it is simply a matter of time before the 2.60% resistance is overcome. Indeed, many of these commentators believe that a break above the 3% or so level confirms the end of the secular bull market.
Chart 2 – The US 10 year Government bond yield
Surely with the policies being promoted by the new administration, growth and/or inflation are set to rise which, alongside a more hawkish Fed, almost guarantees demonstrably higher yields in the US. And as with Germany, higher yields should actually be seen as a good sign as we should be celebrating growth. Again, as with Europe, gently rising yields are not necessarily a problem, but sharply higher yields could create some market dislocation that the Fed will be keen to avoid.
In short, central bankers are very keen to build on the narrative that downside risks have mostly disappeared and that they are normalising policy from a position of strength. Part of that narrative will be that for years the central banks shouldered the burden of stimulating the economy whilst politicians sat back and did mostly nothing. Therefore, with growth initiatives back on the agenda (in the US at least, not so much in Europe as far as we can see), the time is right to normalise and haven’t they done a great job in both saving the world during the crisis and guiding us during the healing stage of the recovery process.
But here’s the crux. Growth has to be sufficient to generate the cash flows to support current asset prices as central banks remove accommodation. Will the Fed become too hawkish and create a policy error?
Unfortunately, we still have far too few details about the new policies from the new US administration. The benefits from some of their likely policies are obvious and to be welcomed; some not so much. However, it does appear that implementing these policies will take longer than originally suggested and there remains some debate about key campaign promises on trade for example. Our point here is that an awful lot of good news is now priced into equity and credit markets in terms of future growth, and if the growth is not forthcoming in the foreseeable future AND the Fed is more hawkish, this should become a problem for investors.
So, in bond land, the reaction to whatever the Fed says and does next week will be extremely important. If yields break above the 2.6% area on the 10 year, then we expect yields to rise towards 3%. This will pressure bond yields higher globally. However, a more measured Fed could see yields remain range bound. For our part, we are going for a more measured Fed and yields remaining range bound; although we will not stand in the way of a breakout if one were to occur – flexibility is key here.
As for other assets, last week we suggested that equities and credit are priced for perfection. What has piqued our interest this past week is the near 10% decline in the price of oil (alongside declines in other key commodities) and a modest widening in credit spreads. We think that these moves may be an indication that a more corrective period may soon be upon us for risky assets and a more nuanced look at the “market internals” would support this view.
The oil price decline is interesting to us not so much as a sign that something is immediately wrong with the global economy, but more as an example of what can go wrong when a trade becomes extremely crowded and then price moves against the crowd. Chart 3 shows the price of WTI oil and the net positions held by speculators in the futures market. As can be seen, the huge price decline between late 2014 and early last year coincided with a large reduction in speculators net long positions, as should be expected. Since the low a year or so ago, speculators have increased their net long position dramatically, especially around and after the OPEC production cuts announced late last year. As of two weeks ago, the net speculative long was at a record, some way above the previous record in late 2014 just prior to a 70% price decline.
Now we are not suggesting prices have to decline 70%, but what we are trying to illustrate is that price can decline rapidly when the market is wrong-footed like oil was last week. As noted, other industrial commodities like Copper and Iron Ore have seen quite large price declines in the last couple of weeks. Either we have just seen a clearing out of weak positions in commodities, and prices will stabilise and recover. Or, these price moves are suggestive of some trouble in the global reflation trade.
Chart 3 – WTI Oil and Net Speculative Positioning
Having shown credit spreads last week, we will simply note that spreads did widen out last week. This may be a function of the oil price decline and nothing more – oil is a very large sector in the credit market and certainly influenced the credit spread movements between 2014 and today. However, we see now that the retail sector is becoming quite stressed in the US, and when more than one sector is influencing the whole market, perhaps we should start taking note especially with credit spreads at historically narrow levels.
Within the equity market itself, we see the “internals” as on a weakening bias here. The number of declining stocks has been above those advancing in the last couple of weeks, and there is now a large negative divergence between prices (S&P 500, which is 8% above its own 200 day moving average) and the percentage of stocks in the index above their own 200 day moving average, as shown in chart 4 below. As we’ve said many times, divergences do not guaranteed a change in trend, but they are nearly always apparent at trend changes.
Chart 4 – The S&P 500 with percentage of stocks above their own 200 day moving average
Just one more chart this week, and this shows the S&P 500 on a weekly basis back to 2012 with a trading envelope (40 week average +/- 9%) and in the lower panel the Fed’s balance sheet. We would highlight how the index is now trading at the outer reach of the upper boundary of the trading envelope. This not only shows that the S&P 500 is overbought compared to a reasonable “technical” indicator of value. Furthermore, the S&P has not been this overbought (on this technical approach) since the end of 2013 when the Fed QE was at its greatest.
So, at the current juncture, the market is overbought but rather than running the printing press at warp speed, the Fed is now removing accommodation. Perhaps the other way to look at this is that in 2013/14 the market could remain overbought so long as the Fed was printing money. Now, the market is just as overbought but on the hope for economic reflation. Well, the reflation had better show some signs of turning up quite soon to support the current market level.
Chart 5 – S&P 500 Weekly with trading envelope and Fed Balance Sheet
To try and wrap things up here. We are in the crosshairs of a handover from central bank support to fiscal support. The US Federal Reserve is further down the road (having never got so entrenched in extreme policies like negative rates) and the bond market yields there reflect both that and the proposed growth friendly policies of the new administration. In Europe, there is no pro-growth plan from the politicians (yet?) but the ECB is tiptoeing towards the exit because the cyclical picture has improved of late (perhaps the improvement is more cyclical than structural and boosted by low energy prices?). This normalisation has been pretty smooth so far, but is not guaranteed to remain so. The market reaction to next week’s Fed utterances is important.
At the same time, the pro-growth initiatives in the US may well be fully priced in short term, with some signs that momentum and market breadth are deteriorating. We would suggest that, at a minimum, this is not a great time to be buying equities. At a minimum, we suspect a period of consolidation is not far away. However, as outlined many times in the past, there are reasons to believe that we are due a cyclical bear market in risk assets, in which case now would be a great time to be selling out of both equities and credit, and allocating to other assets that are not correlated and offer better liquidity and diversification characteristics.
Stewart Richardson
RMG Wealth Management
