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Greece and the rest of Europe are at a nasty impasse. Europe wants to curb its financing of ‘reforms’ that didn’t produce results, while Greece no longer wants to submit to ‘policies’ that didn’t produce results. Each side blames the other. Reciprocal animosity has intensified with each
negotiating round.

Today the odds of a deal failure are extremely high. Gone are the claims of “they would never let it happen” and “there are no legal provisions for it”. In short, Grexit has become the central case.

How bad would Grexit be?

There’s a lot we can’t know. But there’s also a lot we do know, and pretty much all of it has changed for the better. Here’s my take:

1. We’re more psychologically prepared than we were in 2010. Like with the Greek default, after talking about the prospect of Grexit for a long time, we become somewhat desensitized to the event. In markets, expectations at t-zero are hugely important;
2. We’re more financially prepared. There were no firewalls in place three years ago. Moreover, every monetary innovation was met with a German ECB resignation. Today, LTRO, ESM, QE, “Whatever it takes”, etc. are part of the landscape. And we know they worked. Draghi won. Germanic phobias lost. Not likely to be much principled pushback if Draghi needs to get aggressive with runway foam;
3. We’re more economically prepared. Growth is still the Achilles heel of the EZ, but Ireland and Portugal have made decent progress under programs, and even Spain has started to bob back to the surface. It’s not great, but it is better. Globally, the US and Japan are in a much better place, and China has repeatedly confounded the doomsayers with its own brand of muddling through;
4. Sword of Damocles has been hanging over the global economy–not just over Greece and the EZ. Removing this would be good for animal spirits globally—even though in and of itself it wouldn’t resolve Europe’s growth problems;
5. Greece, with its own currency, would finally get a path to growth. The confidence that things will get better makes even great sacrifice manageable—and IMO the much of the adjustment has already occurred. Yes, sadly, Greece would get one final gut check, but history suggests it would soon be followed by rapid growth. The alternative—financing future rounds of internal devaluation/further economic contraction—seems at best, more temporizing. Greece would also emerge with (1) its labor force competitively priced and (2) greater degrees of fiscal freedom to cushion the pain of transition;
6. EZ would emerge stronger. The heartless truth is Greece adds very little to the EZ and has subtracted a lot. It was a noble experiment, but it failed. Now we can and should own up to that.
7. Having a template for leaving the euro is a good thing, not a bad one. ‘Learning by doing’ would prove a huge help should another country decide/need to leave in the future. Of course, long-term risk premia would likely rise for certain borrowers. But is that really a bad thing as long as the ECB ensures it’s orderly? Rates are low in absolute terms, and the real constraint to lending has had more to do with balance sheets and growth prospects than the price of money.

I know it seems less than serious if we don’t furrow our brows and darkly recite things like “this has never happened before”.  And sure, in the short term markets have been leaning toward a last-second deal and would be wrong footed. Some markets have been looking tired, so it could even get rough. But when I look at Grexit I see a world in much better fundamental position to avoid the cascading systemic contagion we (rightly) feared as recently as a year ago. Now is the time to do what the system could not handle in 2010: get Greece off the toxic medication and onto a path of growth and dignity.

After a month’s worth of fake breakouts and breakdowns, the euro finally made its move over the past two weeks. Bearish euro/bullish USD sentiment, after many months of building, finally got to the point where the news flow needed to sustain the story became too high a hurdle.

So, where do we go from here?

To my eyes this, like many other medium terms swings in macro plays, is about extreme positioning and sentiment more than it is about fundamentals. Yes, the US economy has printed some disappointments. Yes, the data in the Eurozone have been less bad. Yes, market participants—rightly or wrongly—have been trudging toward the belief that Greece won’t trigger massive contagion even if it defaults and/or leaves the single currency. And yes, “fundamental” narratives that fit the price action will intensify to the extent the euro marches higher. But the truth is the cyclical drivers still favor the USD.

If you roughly buy into that view, then the question is reduced mostly to a technical one: how offsides are investors in their EURUSD positions and how much higher might an unwind take us?

So here’s the simple way a currency trader might look at EURUSD today.

Positioning/expectations are still offsides, i.e. the pain trade is higher.

The white line is the current spot rate. The blue lines are the one standard deviation lines using implied vols from end-June. The green bars are analyst projection through end June. (Note how far to the left of the white line they are.) The red curve is the probability distribution for spot outcomes at end-June based on the euro’s volatility surface.

The daily chart tells us we are bumping right up against short-term resistance.

The behavior behind resistance, of course, is the old I’ll-sell-it-when-it-gets-back-to-where-I-bought-it instinct.

It’s also noteworthy that in the last two days the euro rallied, other currencies (all three buckets, risk, funding and petro) stopped following. Indeed, on Friday many of them depreciated significantly, exacerbated to some extent of the moves in US rates.

Longer-term, there is much more room for positioning/sentiment normalization

It is worth noting that the chart of oil, though not identical, is similar (oil had its retest in March whereas the euro had its in April). That oil has led the euro means it should be an excellent tell going forward

Bottom line: the likelihood is the short euro unwind is likely to go further. Typically these unwinds persist until the majority of market participants reverse their views (oil recently was an excellent example of this). And we are far from that point in the euro. But the longer term fundamentals do favor, IMO, the USD, and we have run into likely short term resistance. This increases the odds of being wrong. So, if you missed the euro move off the bottom, be patient here. Most traders haven’t given up the strong USD thesis and will likely attack any short term euro weakness. These moments should give better risk/reward entry points to take a shot at the pain trade eventually squeezing the euro higher.

I was just asked by a sell-side friend what the probability of a Grexit in the near term was and what would happen to the euro. This was my answer:

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Impossible to say when they go. Odds have to be they get a deal, but these odds have diminished with each round. My guess would be big squeeze in euro shorts were it to happen, just because of the heavy short euro positioning. Note how the increased concern over Grexit hit Eurostoxx hard (also heavily positioned) but the euro stayed bid.

We would then reverse-engineer the story “the euro is now stronger without Greece” to fit the price action. Once the squeeze is over, we would start worrying about other peripherals. Europe would have to come out with a raft of foaming-the-runway measures. They have to have some of these planned; though I can’t claim to know what they are.

In September of last year the Fed laid out in rough terms which tools it intends to use in the normalization process and the order in which it plans to use them. Of course, as has been its hallmark post-crisis and as evidenced in its most recent Minutes, the Fed has indicated it’s ready to adjust its plans as and if needed.

Nonetheless, there has been a fair amount of discussion around the Fed’s preference to begin the normalization sequence with hikes in the policy rate, as opposed to letting its balance sheet start to run off first. This post aims to lay out in simple terms why the Fed is approaching normalization in this fashion.

You have to start with where the Fed sees the risks.

The Fed is not worried about the economy overheating. True, there is a legitimate debate over the degree of slack remaining in an improving labor market. But demography, technology and globalization, in some admixture, have conspired to cloud this picture.  In fact, it has made the issue so hard to call that the Fed has effectively let the other half of its mandate, inflation, cast the deciding vote. And so far inflation continues to come out on the side of slack.

The Fed is not worried about the balance sheet or excess reserves, either. These are means to an end, not ends in and of themselves. Moreover, the risks to an enlarged balance sheet have been over-imagined at every stage of the post-crisis period, whereas the damage that higher long term rates could do to a recovery that never quite gets to liftoff is arguably very real. Again, there is simply not enough optimism in the US economy or global economy for overheating to be the preponderant risk.

What the Fed has begun to worry about is financial stability—even if not as an imminent threat. Its concerns are one part risk management, one part the ghost of crises past. FOMC members understand that financial excesses are a positive function of time. Stability sooner or later breeds instability. And the longer rates stay very low, the greater the risk they become built into the current financial architecture and baked into our extrapolations. Once you get to such a point, an eventual normalization becomes a lot riskier, in terms of both financial dislocations and economic activity.

Also, perhaps even more than the rest of us, the Fed fears a repeat of the 2013 Taper Tantrum—not to mention 1994. For this reason, it is useful to think of the Fed’s mindset here as being like that of the avalanche patrol at a ski resort. You detonate your tools in order to see if there are any avalanches out there to be triggered. You don’t know if there are any out there, but you know the longer you wait, the larger the risks grow in probability and magnitude. In essence, it’s just good risk management.

In short, if the risk is overheating, you want to influence the cost of economic borrowing. If the risk is financial stability, you want to affect the cost of leverage. In this case, the policy rate is the place to start because it controls the cost of leverage, whereas encouraging a steep yield curve by first letting the book run off adversely hits the cost of borrowing.

This is not to suggest policy rates should be the primary tool with which to manage financial stability risk. Adequate capitalization and a robust and flexible regulatory framework have to be the first lines of defense. And, it’s also true that risk appetite can at times be stubbornly insensitive to the price of money—as we saw in the 2005-07 period and as we have seen on the other end of the spectrum over the last handful of years. However, the policy rate can be used to signal, to keep us on our toes, and to help clear the slopes now so as to lower the risk of triggering a larger and potentially destabilizing avalanche later.

Back in early January I posted the charts of EEM and copper since 2003, with brief commentary. I think it is helpful to revisit those charts now, because something has changed.

Here’s the chart of Copper. It now has clearly broken down relative to where we were at the beginning of the year.

Now look at EEM. The longer-term pattern similarity is clear, but EEM has not broken down.

My guess is that it will. Here’s why:

1. The unwind in excess enthusiasm for EM and commodities has further to go. It was a 10 year run, and we are now in the 3rd year of underperformance. The unwind doesn’t have to last ten years–there are structural improvements in many of these countries and in the development of their local markets. But one look at EM corporate issuance over the past 5 years and it is easy to see there is still an enthusiasm overhang that we have to work off.
2. The fundamental factors that would staunch the outflows and attract sustainable inflows are not in place. I’ve talked about these three a lot over the past few years in conference presentations, tweets, and the occasional post, but it boils down to a growth differential vis-à-vis developed markets, the US dollar, and US rates. None of these factors is working in favor of EM now. I don’t see any signs of them changing soon, either.
3. Dem charts, doe.

Many, if not most point to the stunning decline in European bond yields as the primary factor driving US bonds over the past year. And it is true, at least anecdotally, that European interest in US bonds has picked up—especially over the last few months, as the strength in the dollar caught everyone’s eye. (After all, an annual 150bps of pickup can be wiped out in a one bad currency day, so you must have a positive view of the dollar.)

Some, with darker take, suggest the decline in absolute yields is a harbinger of bad things to come, that it’s only a matter of time before some version of the deflation and contraction much of Europe is experiencing will arrive on our shores. The precipitous decline in the price of oil since June has only reinforced this negative sentiment.

But the old and grizzled know all too well that price action does not fundamentals make, at least not always. Sometimes it’s about positioning and technicals. Sometimes it’s simple. Sometimes the bond market is not the smartest guy in the room.

Roll tape.

Here are the charts of the German 10yr bund, and the US 10yr note, respectively.

You can see that the yields in both the German bund and the US note have fallen a lot over the past year, even though the decline in the bund yield has been more dramatic and it’s absolute level much lower. In the US note there was a spike in the wake of the 2013 taper tantrum that has been largely retraced.

This is the story that most have in mind when they assert that Europe and/or a looming US growth stumble is driving bonds.

Now let’s have a look at the 2 year maturities, starting with the German schatze:

And here’s the 2 year Treasury:

Now it gets interesting.

If the US were tracking European yields for fundamental reasons, foreshadowing a drop in US demand, why would the yield on the US 2yr be trending higher, while falling and actually turning negative in Germany? (Pls excuse the scale compression on the schatze.)

And, if Europeans were interested in playing the US dollar, particularly if they thought the US cycle was improving (as the anecdote goes), shouldn’t they want to do so at the shorter end of the US curve, since duration risk in an improving economy is a big one?

In short, you can’t have the 10yr yields declining in the face of a rising 2yr yield unless you think the Fed is about to choke out an economic cycle that has barely begun. Moreover, of course, even if this were your view, you couldn’t then argue the Fed is behind the curve and its polices are too lax.

So, while you can get me to believe the European yields are some part of the story, I can’t in the face of these charts see it as a driver. What then, you might ask, could be behind the decline in US long term yields and the rise in US short term yields?

For me, it’s easy. It is the Fed. The Fed bought little in the way of short-term bonds, and what they did buy they swapped out into long-term bonds via Operation Twist. On the other hand, the Fed’s cumulative holdings of long-term bonds has become very, very large. And, if you put them together with holdings of other price insensitive UST holders, and you realize that some 70-75% (~7T of ~9T) of UST notes and bonds are held by entities that don’t care about every tick the way we do. In short, it’s about scarcity. After all, wasn’t creating a scarcity stock effect exactly how the LSAP was supposed to affect rates?

There is a lot of talk about what the fundamental inferences from the decline in commodity prices should be. FWIW, I tend to think the underperformance of commodities and emerging markets is mostly the unwind of a lot of strategic investor enthusiasm that got build up over the past twelve years, and not so much about global demand—which, with the exception of the steadily improving US, has been weak for years.

But set that all aside for a sec and just have a look at the following two charts, of copper and the ETF EEM. Whatever you think is behind their underperformance, the charts will tell you a lot about how investors think about the two assets classes; in other words, what their revealed preferences have been. It’s striking (and usefully simplifying). It may also help you develop a trading/invest view as to where you think these assets are going. Oh, and for the record: I don’t see a Ph. D. anywhere in there, either.

Copper, from 2003:

EEM, Emerging Markets ETF, from 2003:

Here’s a podcast with my fleshed-out views. Thanks to @finansakrobat and @SardonicaX for hosting me. Lively and fun!

US – From anemic to sluggish to solid

US cycle will be protracted and moderate. Disaster myopia from the Great Recession lingers and its shadow over real-economy risk taking will be slow to fade. Structural issues too will keep growth throttled back.

The chance of recession—even in the face of external shocks—will be low until the real economy is investing, taking more risk.

It’s hard to be strategically bearish US stocks until the output gap is at a minimum closed. Bear markets typically come when cycles turn.

The spectacular oil drop causes dislocations up front, but has a long-tailed payoff if it stays below 75.

Rate scares might trigger corrections and echo taper tantrums, but won’t derail the growth trajectory.

Long-end rates will go higher when the Fed starts to let its book run off, probably late next year. The economy will be in a position to handle it when it happens.

If the yield curve inverts along the way, it may scare some, but it would be technical and transitory, not a sign of impending slowdown/recession.

Fear of stronger dollar is overblown, given closed nature of US economy. But it will weigh on sentiment and to some degree earnings.

Housing will continue to disappoint, as the epicenter of a bubble is always last to work off the excesses. Also, lots of institutional investors saddled with inventory are looking for an exit strategy.

There may be pockets of financial exhuberance but I am not worried about broad-based excesses bringing down the economy for the foreseeable future. Too many people still too fearful of the systemic risk scenario to get the “All Aboard” sentiment necessary for that degree of risk taking.

And too many people ascribe too much of the markets performance over the past few years to the Fed. This keeps many worried and has been a huge positive.

However, there will eventually be financial excesses that do damage. That’s the nature of markets in a financially globalized world. But the real economy underneath has to be vulnerable to that kind of feedback loop, and the froth in the real economy and SIFIs is not yet on the horizon.

Europe – That which is not sustainable will not be sustained

Europe can’t grow. And the hurdle to overcome demography, technological substitution and globalization is high. In the meantime, internal devaluation uber alles.

ECB QE won’t be able to turn the growth dial. QE has lost much of its shock value, sentiment is in a more neutral place relative to when US QE was rolled out, yields in EU are already low, EU banks are still clogged (and EU finance is bank-centric). I don’t even think EU sovereign QE will boost markets much. We have already seen the man behind the curtain.

I do not think structural reforms—desirable though they most certainly are—can be enough even in the abstract to return peripheral countries to the level of productivity necessary to resolve the lack of competitiveness. In practice, of course, far less in the way of structural reforms will be attempted, much less achieved.

A weaker euro won’t help much either; the imbalances are inside the EU. Externally, it is a closed economy, one that mostly exports products whose demand is fairly price inelastic (if you’re buying on price and not quality, you’d already be buying from somewhere else).

This implies that the euro will continue to depreciate, and if it is to make a meaningful contribution to EU GDP, it will have to depreciate a lot, perhaps even below the levels we saw back in 2002. It bears recalling that the trade-weighted euro has depreciated far less than EURUSD.

In the absence of growth, the centrifugal political forces that were set in motion by the crisis will only gain momentum. I expect this to be a drawn out process, but it is what will ultimately lead to a reconfiguration of membership in the single currency.

The timing in my mind is very uncertain. And this is a problem for me. Every time I see a bout of instability in Europe I will ask myself is this THE moment. This will make it hard to hold onto investment positions, because when the man bobbing in the ocean finally goes down for good, you will want to be light on risk.

Emerging Markets – Muddling through, no crisis

The fantastic 10-year run in EM started to unwind in 2012. I expect this has further to go while EM digests the rapid domestic credit expansion that drove its growth phase.

I do not expect a return to the EM crises of yesteryear, even though there may be a country or two that gets itself into policy trouble managing the transition. Unless social unrest breaks out in China (very low probability), I think the far superior initial conditions with which EM countries entered this down cycle will keep systemic EM crisis off the table.

To attract capital back into the EM asset class on a sustainable basis you will need a story with some combination of three things:

• Weakening dollar,
• Low/falling US rates, and
• A compelling growth differential story to convince investors to take that extra risk associated with EM allocations.

We are not there on any of these points—even though there may be a temptation to take a stab at EM in the beginning of the New Year, as the cumulative underperformance there has been enough to attract some mean reverters.

Commodities – Stay away

Very much like EM, commodities had a supercycle run that ended in 2012. With the prospect of rising rates in the US and a strengthening dollar, it’s hard to see when its fortunes might change.

The bottom line is that portfolio demand for commodity allocations will continue to retreat. Investors chase performance in reverse as well. Pension funds will cut back or get out, and commodity funds and specialty products will continue to unwind. Commodity investors just started in 2014 getting used to the notion that the wind is no longer at their backs.

Soft commodities have faster supply responses, so, they may well do fine. But hard commodities and especially precious metals should continue to go lower in dollar terms.

Oil is a bit of a special case, if for no other reason than it has already fallen far and fast. It could well bounce. But the weaker portfolio demand for commodities and the technological substitution that will likely threaten oil long term make a sustained bounce a serious uphill endeavor.

Of course there will be many things that surprise us over the course of the year ahead. And we will have to adjust to them as they develop, but these are the grandes lignes as they appear to me on the eve of the New Year.

Mark

Bologna, Italy

December 23rd 2014

I need to say something about precious metals. I’ve been a vocal bear on them since 2011. Those who’ve subjected themselves to my blog—or worse, my Twitter account—know that. The reasons were gently laid out in a 2012 post. Less gently in subsequent ones.

The bottom line is that a pre-crisis boom in commodities lifted gold and silver—even with Fed funds at 5%. Post-crisis monetary policy then turbo-charged it, as people feared rapid inflation, renewed systemic crisis, a dollar crash, and bond vigilantes. Macro tourists lined up to pile in. Big name guys wearing money halos. ETFs and electronic futures trading for the masses poured the gasoline.

In short, they built a bubble. A bubble replete with charlatans hawking it on every medium. Just look at the chart of silver over the past 10 years.

The irony of the precious metals bubble is that it was the guys yelling ‘bubble’, bubbles of every stripe–bond, stock, credit—who sought refuge in the only asset class that was truly in a bubble. In other words, the fear of bubbles created its own bubble, trapping the bubblers. Karma really is running over dogma.

Why did the bubble pop? People progressively suspected there was a recovery, inflation wasn’t materializing, and a dollar wasn’t really going anywhere. Then, when prices started to fall, the real sellers came out. QE3 couldn’t even stop it. This was the first leg of the bubble unwind, roughly late 2012-June 2013.

Since then we’ve been consolidating, with successive bounces of lower amplitude, each time finding footing between 1200-1250. This is what technicians call a descending triangle. Odds massively favor descending triangles resolving themselves to the downside.

Last week my senses started tingling that the second leg of the bubble unwind that I’ve long awaited was on. These calls are always difficult. But I’ve been emboldened by two things. One, the price action after those tingles tended to confirm my suspicions. Second, I read the post today about RIA flows by Josh Brown over at the Reformed Broker. He said the reports showed the largest inflows last week were into gold.

Into gold? How is that bearish? First, as Josh tweeted “Flows follow price action, they don’t lead it”. Second, when the price action is bad in the face of significant inflows, it is historically a very, very bad sign.

In April 2013 I had been short gold and was vocal about it. A mutual fund executive who is a friend of mine, and with whom I regularly discuss markets and economics, said to me, “Just be careful, Mark, with your gold short. The industry is seeing meaningful inflows there.” Of course, we know what happened the following week. I don’t want to draw too tight a parallel on anything that anecdotal, but the similarity to the info in Josh’s post did jump out at me.

Now, I’m not competent enough to tell you how far down this descending triangle “measures to”. I will leave that to the expert TAs. But I do know we closed on Friday below the previous 1200 floor and on big volume.

One has to be humble when dealing with markets, but you do have to take positions. And when you do you want to take them when you think odds are overwhelmingly in your favor–Like, right here, right now.

This is supported by the fundamental side. There, we’re seeing that almost all the elements of the framework laid out in early 2012 are working against gold. If I were very bearish bonds (I’m only moderately bearish), the framework would be firing on all cylinders. In short, it looks like this: CB QE has lost its psychological punch, emerging markets have tepid income growth, the dollar is trending stronger, and USD rates can only be a headwind.

When I’m asked how far do I think gold can ultimately fall, my answer is I don’t know. I can only guess. The guess I’ve been working with is—as a minimum–a return to pre-crisis levels, based on the notion that the post-crisis investment theses have pretty much all turned out to have been wrong. (And, for the record, the statute of limitations on ‘not wrong, just early’ ran out a long time ago. By the time this is over only Peter Schiff, Zerohedge and Jim Grant will be waving their arms.)

On this basis a pre-crisis level would come out at somewhere around 700-750. Of course, bubble unwinds do overshoot, often by a lot. But the 700 area seems to me a reasonable, even conservative expectation, if the broader thesis is right.

Here’s a chart of the asset formerly known as gold. For fun, try flipping it upside-down and imagining it were a stock. Then ask yourself if you would buy it.

 

Yeah, me too.