This is a quick post this morning because it is rainy and I am grumpy and feel like complaining.
Over the weekend I saw a post from a major market news website. I don’t want to name the website, because what they wrote was embarrassingly obtuse. I wouldn’t like it if someone cited my blog when I write something obtuse, so I won’t link to theirs. Consider it professional courtesy.
Here is what they wrote: “The global bond selloff was blamed largely on fears the European Central Bank and the Bank of Japan will eventually run out of bonds to buy.”
At this point, time yourself to see how long it takes you to figure out what’s wrong with that sentence. Score yourself with this table:
1 second or less: Congratulations! You have excellent common sense.
2-30 seconds: You have good common sense but maybe spend too much time around markets.
31-2 minutes: You are smart enough to figure this out, but you watch too much financial TV.
Over 2 minutes: You can be a Wall Street economist!
“I don’t see anything wrong” : You can write for the blog in question.
I could give an answer key, but in the interest of ranting let me present instead an analogy:
In a certain town there is a grocery store, whose proprietor sells apples for 50 cents. One day, a man walks in, flags down the proprietor, and says, “Hello kind sir. I see you have apples for sale. I would like to buy your apples. You see, I have bought all of the apples in this state, and in the surrounding state. I have bought every apple in this town. In fact, I have bought almost all of this year’s harvest. So, I’d like to buy your apples because I have money to buy apples and you have the only apples left.”
The proprietor responds, “Great! I will sell them to you for a nickel each!”
Because, you see, since the apple buyer has just about run out of apples to buy, the price of apples should fall. Right? Well, that’s exactly the point the blog made about bonds: because investors fear the ECB and BOJ will eventually run out of bonds to buy, bond prices fell. If there are really investors out there who think that when the supply of something declines, its price will fall…please introduce me to them, because I’d like to trade with them.
The fact that global central banks continue to buy bonds is the single, best reason to think that yields may not rise. In normal times, bond yields would be rising right now to reflect the fact that inflation is rising, just about everywhere we measure inflation (maybe not in Japan – core inflation in Japan was rising thanks to more-rapid money growth, but when the BOJ lowered rates into negative territory it lowered money velocity and may have squashed the recent rise). But if central banks are buying every bond they can, then prices are more likely to stay high and yields low – even in places like the US where the central bank is not currently buying bonds, because a paucity of Japanese and European bonds tends to increase the demand for US bonds. The risk to the bulls is actually that central banks stop buying bonds.
Maybe that is the weird reasoning that the blog in question was employing: once there are no bonds, central banks will have to stop buying them. And when the central banks stop buying bonds, their prices should fall. Ergo, when there are no bonds to buy the prices should fall. Sure, that makes sense!
Here is an interesting chart that might suggest flows into oil markets.
Or perhaps it suggests something else. But I put together the chart below (data sourced from Bloomberg) because it seemed to me as if recently crude oil – and other energy markets, but I am focusing on Crude – has been having a nice little spike in the middle of the morning. Often, these have seemed inexplicable to me; other times (like yesterday) there was ostensibly news but it was not immediately obvious that the news was oil-supportive.
This chart shows a composite trading day for June NYMEX Crude Oil futures for the last 20 days. You can see that it appears I am not imagining it: on average, Crude has been rallying about 30 cents per day, beginning about 9:00ET.
I thought this might be flattered by the DOE weekly release, which is at 10:30ET on Wednesdays. So I removed those days and the relationship is still clear (although it makes the rise from 3am to 9am look relatively more important).
I don’t know exactly what this means, but it has “felt” to the old trader in me that the market was tending to gap in that time frame and this seems to confirm the visceral sense. It doesn’t necessarily mean my other gut feeling, that this might represent systematic daily allocations – perhaps to energy or broad commodity ETFs? Or OTC products? Or both? – is correct, however.
If posting on December 22nd was a bad idea, imagine how stupid it is to post on December 23rd?
But I noticed something unusual and thought to point it out. Yesterday, I observed that the data has generally been weakening, and while some commentators are optimistic on the outlook for 2016 I am not one of them. Actually, it appears that perhaps commentators as a whole are not only too optimistic now, but have been too optimistic all year.
The Citi Economic Surprise Index is an interesting data series that measures how data releases have generally compared to economists’ prior expectations. When data is coming in weaker than expected, it declines; when data is coming in stronger than expected, it rises. This doesn’t necessarily mean that it declines when the economy is weakening, just when the data is surprising on the downside. I’ve always had trouble figuring out just how to use this information, because of that. Is the indicator rising because conditions are getting better, or just because economists are morose? Is it falling because conditions are getting worse, or because economists are too optimistic? Hard to tell.
With that said, here is what the indicator has done over the last three years (source: Bloomberg).
Nothing to see here, right? Well take a look at this! The table below shows the proportion of the time, by year (since the index was created in 2003), that the index was above zero.
Now that, as they would say on Mythbusters, is a result. I have no idea what it means, that economic data has been consistently undershooting expectations all year so that the index has been negative 92% of the time. The second-worst outcome was 2008, but that was clearly a situation in which the economy was getting worse lots faster than economists anticipated.
I am inclined to think that this represents the optimism that economists seem to have that the Fed’s move to tighten policy reflects a response to actual underlying strength. I should add that I believe this is an unfounded, irrational, and borderline psychotic optimism given the historical prognosticative powers of the Federal Reserve…but if that is indeed what is happening then the optimism that these same economists have about the number of rate hikes we will see in 2016 is probably misplaced.
In an excellent (and free!) daily email I receive, the Daily Shot, I ran across a chart that touched off my quant BS alert.
This chart is from here, and is obviously a few years out-of-date, but that isn’t the problem. The problem is that the chart suggests that gold prices rise 5.5% every year. If you buy gold in January, at an index value of 100, and hold it through the flat part of January-June, then you reap the 5% rally in the second half of the year.
No wonder people love gold! You can get a 10% annual return simply by buying in July and selling in December!
The problem is that this is not the way you should do a seasonal chart. It has not be detrended. We detrend data because that way, we can express the expected return for any given day as (the normal expected return) plus (the seasonal component). This is valuable because, as analysts, we might have a general forecast for gold but we will want to adjust that forecast to a holding period return based on a seasonal pattern. This is very important, for example, with TIPS yields and breakevens, because inflation itself is highly seasonal.
Now, the seasonal chart done correctly still suggests that the best time to own gold is in the second half of the year, but it no longer suggests that owning gold is an automatic winner. (It is a separate argument whether we can reject the null hypothesis of zero seasonality altogether, but that’s not my point here).
Frankly, I would also use real prices rather than nominal prices, since it is much easier to make a statement about the expected real return to gold (roughly zero over time, although it may be more or less than that based on current valuation metrics) than it is to make a statement about the expected nominal return to gold, since the latter includes an embedded assumption about the inflation rate, which I would prefer to strip out. And I would also include data from the 1970s.
“When in the Course of human events it becomes necessary for one people to dissolve the political bands which have connected them with another and to assume among the powers of the earth, the separate and equal station to which the Laws of Nature and of Nature’s God entitle them, a decent respect to the opinions of mankind requires that they should declare the causes which impel them to the separation.
“We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness. — That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed, — That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness.”
Greece has voted ‘no.’ It should not surprise us that this has happened. The only surprise is that it took this long for “one people to dissolve the political bands which have connected them with another.”
This is an interesting chart I think. It shows the spot CPI swap curve (that is, expected 1y inflation, expected 2y compounded inflation, expected 3y compounded inflation), which is very, very steep at the moment because of the plunge in oil. It also shows the CPI swap curve one year forward (that is, expected inflation for 1y, starting in 1y; expected inflation for 2y, starting in 1y; expected inflation for 3y, starting in 1y – in other words, what the spot curve is expected to look like one year from today). The x-axis is the number of years from now.
Basically, after this oil crash passes through the system, the market thinks inflation will be exactly at 2% (a bit lower than the Fed’s target, adjusting for the difference between CPI and PCE, but still amazingly flat) for 6-7 years, and then rise to the heady level of 2.10-2.15% basically forever.
That demonstrates an amazing confidence in the Fed’s power. Since inflation tails are longest to the high side, this is equivalent to pricing either no chance of an inflation tail, or that the Fed will consistently miss on the low side by just about exactly the same amount, and that amount happens to be equal to the value of the tail more or less.
But what is really interesting to me is simply how the wild spot curve translates so cleanly to the forward curve, at the moment.