It’s been a while since I updated my views on markets, which invites humility. It usually takes a few weeks for me to get a feel for what’s really going on. I return to my analysis at a point when risk assets are on the back foot, the dollar is rallying, and bond yields are falling, though in all these cases, the moves are so far undramatic. Granted, a quick-fire 7% decline in Spoos since the end of August will have driven some Robinhood punters against the wall, but that’s hardly a surprise. Similarly, the dollar is not blowing the doors off more so than it has caught a stretched bearish position off guard. That, after all, is what currency markets do. Meanwhile in bonds; zzz. In preview; I think risk assets sell off further, the dollar has further upside, and as far as bond yields go, I think they will do more or less nothing. This is not a hill that I am willing to die on, though, One of the problems with trying to read the charts at the moment, is that base effects from the collapse during the initial phases of the Covid-19 shock are now coming into view. In other words, it’s very easy to convince yourself of the idea that the rally is running out of steam, simply by looking at trailing returns. The first chart on the next page shows that the six month stock-to-bond ratio on the S&P 500 has now made a full rebound from the collapse in March, forming a peak similar to after the rebound from the swoon in 2018, and after the initial snap-back following the selloff in early 2016. The data are inconclusive, but in any case un-troubling for investors.
Read MoreThe easiest way for U.S. bond markets to entice investors to abandon their obsession with a flattening yield curve—and whether it’ll soon invert—always was to steepen it. The spreads between 5y/10y and two-year yields have widened to 17bp and 30bp, respectively, about 10bp wider than at the end of August. More importantly, this move has occurred as a result of higher mid-to-long term yields. A few basis points don’t make a trend, but the combination of U.S. 5y and 10y bond yields pushing above 3% introduces a number of erstwhile dormant narratives into the mix. Perhaps the mythical neutral, or terminal, rate is higher than the Fed and markets think? Fed Chair Jerome Powell admitted recently that the FOMC probably doesn’t know where this rate is. This argument makes little sense in the context of the dots, which seem to imply that a policy rate of a bit over 3% in 12-to-18 months time is deemed restrictive. But it makes sense if this signal is no longer relevant for markets. The always optimistic David Zervos, the Chief Strategist for Jeffries, detects a shift at the Fed. “The most important takeaway here is that the probability of an aggressive late-cycle curve inversion has plummeted. (...) Maybe Jay goes there if we start ripping toward 3500 in spoos, but it won’t be because of the inflation or growth data.”
Read MoreOn a headline level, 2018 has started exactly as 2017 finished. Stocks are up, U.S. short term rates are up—but the dollar has traded heavy—and economic data continue to tell a story of a synchronised upturn in global growth. The bears are furious, or perhaps just confused. Hussman recently published a prepper’s guide to a hypervalued market. And value investor extraordinaire—and famed bear—Jeremy Grantham from GMO invokes the “highest-priced markets in US history,” but also proclaims that we’re now in the “melt-up phase” of the bull market. I am all for holding opposing views at the same time, but markets demand a view and a position. So which is it Mr. Grantham? Long, short, or flat? I am not holding my breath for an answer. I have long since left the extremes behind. Picture a spectrum with Hussman and GMO at one end, and the wet-behind-the-ears trader, who have never experienced a sizeable drawdown in Spoos, at the other end. Hint: You want to be somewhere in between.
Separating signal from noise is an important skill in this game, and markets currently are throwing a number of curve balls at investors. What better way to kick off 2018 than by highlighting the ones that matter.
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