Behavioral Macro

Short-term calls are always tricky, but three precious metals are approaching support levels where their decline would likely accelerate if those levels/areas are breached.

As most of you know, support tends to be support because a lot of transactions have recently occurred there. The more recent, the more significant, because memory is like an exponential decay function of time. And the basic principle is people tend–in a way that is more emotional than rational–to close out risk when an asset returns to the level where they entered the position. You know, the old “I’ll sell it when it gets back to where I bought it” kind of thing.

Here’s are the 31 day charts of silver (SIZ7), platinum (PLF8), and gold (GCZ7). The support areas are very clear, especially with respect to platinum and silver.

Silver:

You can see the level in the front silver contract is 16.60. We are at 16.67 as I write this.

Platinum:

Platinum has huge support in the 915 area.

It also has important long-term support in the 900 area. Platinum has been the weakest of the precious metals for years. Here’s the five year chart below, with a red line drawn at 900. If that breaks, the next logical stop is 810.

The front platinum contract is trading at 919.4 right now.

Gold:

The critical area for front-contract gold is 1267-1270.  We’ve bounced off it twice already. The front contract is 1270.6 right now.

GDX and GDXJ, which are often leading indicators for the metal itself, have already broken their recent lows.

My guess it that it happens and we get the breaks, but from a risk management standpoint, if you don’t already have short positions and you are watching closely, it probably makes better sense to short the break rather than anticipate it (unless you are managing very large AUM). Also, if one goes, the odds of the other two following increases significantly. And if two of the three break their levels/areas, the odds that the third one is about to go are about as good as it gets in our probabilistic business. Good luck.

Currencies are about stories more than any other asset class. There are no P/Es. There is no tangible book value. Concepts like PPP and unit labor cost differentials only exert their gravitational force over the very longest of terms, especially in today’s world of capital account primacy.

The stories don’t have to be true. They don’t have to be grounded in good fundamental analysis. All they need is to be intuitively compelling to a large part of the investor base and consistent with concurrent price action. And, if the price action also happens to run against the grain of heavy positioning, then one has the makings of a powerful trade.

Right now, the odds are good that we are about to have that kind of convergence of story, price action, and positioning in bonds and the big dollar, in particular against the funding currencies.

Patterns

First, the patterns suggest the dollar is on the verge of busting a move higher.

Here’s the one-year chart of the broad USD index that I prefer to track (BBDXY):

Now look at the yen:

The Canadian dollar is not exactly a funding currency, but the one-year chart of USDCAD looks very bid:

Now have a look at precious metals. GDXJ is the best example, in my opinion. And usually precious metal stocks lead the metals themselves. GDXJ appears to be breaking down. Here’s the one-year chart:

GDX, for what it’s worth, is similarly vulnerable.

Then there’s platinum, which most of you who follow my tweets know I often use as a “tell” for precious metals. Platinum has been flirting with 900 for the last two years and continues to underperform the other precious metals. You can see this best on the 5-year chart:

Now, let’s have a look at bonds. Here I use the 10-year note on a one-year chart:

It probably looks worse on a 5-year chart:

Positioning

The bottom line here is that bonds and bond proxies are overbought and investors are structurally short dollars. In addition, a lot of hedge funds have flatteners on. Something like long 30s, short 5s. And precious metals have very few shorts.

Here is a proxy for positioning in the euro over the past 10 years, from the weekly CFTC numbers:

It’s very high.

Here are net platinum positions for small spec over the past 10 years:

And now here are small spec gold shorts:

Low and turning up.

Here’s the CFTC positioning on the 10-year note:

It’s very high and rolling over.

Now, with respect to the flattener. Have a look at the UST 5-year futures and the UST long bond futures:

The divergence is pretty stark. Now, many of the shorts in the 5-year futures reflect mortgage bond hedges, but, still, a lot of people have flatteners on. And this flattener has massive negative carry. More on this below.

Narrative

So, what’s the story and why now? First, tax cuts and repatriation. It doesn’t matter at this point whether it happens or whether it would have the desired effect. The point is right now tax cuts have momentum, and the odds of something passing are going to grow in the near term, not shrink—irrespective of whether something ultimately passes.

The standard macro playbook (again, doesn’t matter if you and I think it’s right) says repatriation will give a bid to the dollar and stimulus will lead to higher UST yields, especially at the long end due to increased supply from larger deficits (plus, in this case, the Taper). Some may even speculate that a tax bill will lead to a more hawkish Fed, even though I don’t think it is that simple. So, in short, it’s easy to slap this narrative onto concurrent price action of a stronger dollar and a higher and steeper yield curve.

It is important to underscore that 6 months from now that this story could have already fallen apart and the relentless structural bid in the long end of the Treasury curve will have already reasserted itself. But I think for now the story meets the criterion of “intuitively compelling”.

That the Trump administration is about to name the next Fed chair and vice chair only adds to the story. Here there are two observations to make. One, most investors have felt for a long time that “policy rates are just too low”, and that a dovish Fed has impeded proper normalization. Virtually all of the candidates (with the possible exception of Powell) think—based on the same set of data—that the Fed should have started to normalize earlier. They also, like many investors, have anchored on a higher terminal rate than the Fed’s current leadership. And this, despite Trump’s offhand comments about being “a low rates guy”, is something investors are likely to keep in mind.

The second point is behavioral. Often when there is an “event”, like naming a new Fed chair, it forces markets to reappraise their views and positioning. In efficient markets, this should be discounted in advance. And sometimes it partially is. But, over my career, far too often somewhat random and sometimes disconnected events have this catalytic effect. Naming new leadership against the above backdrop is the kind of thing that could trigger it.

Within the currency space, I would expect the funding currencies to come under more pressure than the risk currencies, but this will depend a lot on what stocks do. If the bond move (should it materialize) be orderly and incremental, then risk assets could well do fine and risk currencies would outperform. I really think it’ll come down to the speed of a bond unwind.

And, needless to say, it might actually be a good tactical moment for bond vol, the trade that seems to be on the lips of everyone in the macro community. I personally would prefer to put on a 5s30s steepener to play this dynamic. The positioning is favorable, and it carries positively to the tune of about 5.5% annualized. Much better than bleeding theta by being long vol. (It is also not clear to me, despite all the scary charts we’ve seen on Twitter, and all the talk of the Target manager who sells vol, that the positioning is as attractive in vol space, given how many gorillas are long it.)

In short, I think the odds are good that positioning, patterns, and plausible story have converged for a directional push in currencies and bonds. And my preferred way to play it would be through shorting the funding currencies and precious metals, and through paying a steepener in 5s30s. But, as we all know, it is very easy to be wrong about these things, so don’t lose sight of your risk management.

I have a childhood friend who loves to rant and complain so much that I jokingly preface giving him good news with an apology. The market feels very much like this right now. The overwhelming sentiment is “cautious”, “we are due”, “valuations are unsustainably high”.

But the truth is our collective memory of the GFC has made sentiment a countercyclical stabilizer, stretching out both the financial risk cycle and the economic cycle. Every time we get a little confident or frothy, the scolds come out and remind us of our ‘irresponsibility’ and we all slow our roll for a little while and digest gains.

When you think the rest of the world is now going thru the same, drawn out, semi-deleveraging lower-for-longer recovery we experienced–which keeps a damper on our speed limit as well–begrudging good news could go on for a long, long time.

Credit managers have been suffering for years now. Yeah, I know that sounds strange given the run credit markets have had. But the truth is they’ve been suffering from sticker shock since 2011. “But what can I buy at these levels?” has been their constant refrain. Many have been underperforming their benchmarks and bogeys for years.

How did they fall into this trap? Start with the chart of the BBB spread over the last 15 years.

Credit managers have anchored on spread levels and yields from the strong phase of the last risk cycle, 2004-2007. Spreads then were 110-130bps. Today they are 138bps. Five-year BBB yields then were 5-6%, whereas today they are 3-3.5%. Credit managers have been forced into chasing yields lower and lower for the last 5 years.

What they’ve been overlooking is the risk free rate. The 5 year risk free rate averaged around 4% from 2004-2007, and now we are at 1.8%. If you look at how much risk-free yield (opportunity cost) you are giving up to collect extra spread, it becomes obvious that a spread of 138bps is far, far cheaper when the risk free rate is at 1.8% than when it is 4%. Spread-to-spread comparisons just don’t make sense. Yet that’s what we keep hearing. It’s kind of shocking, really, how many professional managers–especially those with a lot of experience, paradoxically–have been blinded to this simple but powerful consideration.

The TL;DR: Credit markets aren’t as rich as you might have thought, and in any event, the credit cycle is likely to end around the time the economic cycle in the US turns, irrespective of valuations.

The forward points on BRL and MXN show, approximately, a 6% breakeven depreciation over the next 12 months. Or, in other word, 6% carry. If you believe emerging markets are in the early phases of the same kind of slow, muddle-through recovery we have seen in the US and increasingly Europe, it is hard to imagine spot underperforming the forwards as a longer-term investment proposition. This is the phase of the global risk cycle where the desire for returns is very high but the forward-looking scope for returns in the US market appears limited.

It also looks to me as though there is still tons of scope for further “normalization” from the unwind of the EM bear market.

NB: This blog is currently unlocked. It will convert to locked, accessible to @BehavioralMacro subscribers through PremoSocial, in the near future.

Up until recently oil stocks have been about playing/gaming some type of normalization from the 2014-15 crash. Mostly, repeated attempts at knife catching. Over this past month or two it seems investors are finally looking a little beyond this and starting to price in the secular challenges facing global oil supply & demand.

1. Electric car dominance is no longer a question of “if”.
2. The fuel intensity of global growth continues to decline, as emerging economies catch up with the well-established trends in the advanced ones.
3. Extraction technologies have become vastly more productive and less expensive.

From an investment standpoint, this is a headwind—whether the price of oil is rising or not. If the price of oil were to rise, no doubt oil stocks would also, just probably with a lower beta to it. It makes the sector a much less attractive risk-reward proposition, despite how beaten up it has been.

NB: This blog is currently unlocked. It will convert to locked, accessible to  @BehavioralMacro subscribers through PremoSocial, in the near future.

I’m trying something new.

I’ve been looking for months for a better way to share my core competency: global macro investing and trading. My public twitter account and blog no longer reward my effort the way they did when I started tweeting, disincentivizing thoughtful output. And I’ve got tons to say about patterns, narratives, correlations, investor reaction functions, position sizing tricks, portfolio construction, managing mental capital, fundamentals, etc. I live for this game.

So, I was pretty happy when I stumbled onto Premo, the brainchild of the folks at the Bespoke Investment Group. Through Premo’s new platform, I have set up a private, subscription-based Twitter account, @BehavioralMacro, and expect to add to it a locked blog in the near future. It will be all global macro, all the time. And for those of you who’ve followed me on my public Twitter feed, @mark_dow, you know what I mean when I say all the time. There will be no dog pics, no cat pics, no politics, and no puns, either. The focus will be exclusively on reading market trends, patterns and sharing my macro trading/investing processes.

Becoming a follower is easy. Once you subscribe at my @BehavorialMacro profile page on Premo, it’s done. You’re immediately added as a new follower. You can cancel the subscription at any time on Premo as well. Couldn’t be easier. I’ve already been posting to the new feed for over a week, so you should be able to get a sense of what I want to accomplish right away. Most of it will be about process. Some of it will be actionable, but the focus will not be on specific trade recommendations or a blow-by-blow of what I am doing with my portfolios. It will be about sharing my tricks, techniques and frameworks for reading markets and managing global macro risk.

DMs will be open, and I’m going to use the feed to engage as much as possible.

The subscription will be set at $30 a month—at least at the outset. Targeting institutional investors would allow me to charge considerably more, but it would then not be accessible to motivated individuals who want to piggyback on my experience to get up the learning curve faster. If I were to price it too low, I would be basically giving it away to a market segment that could and should pay more. From preliminary discussions, I suspect the price is more likely to be adjusted up rather than down, and, at some point, I may want to cap the number of followers, but it’s really too early to say for sure. I want to be responsive to how things unfold. I hope you bear with me through the trial and error.

I’m excited about this new experiment. It should allow me to better share my skill set. The platform looks cool. I hope you’ll give it a try. To join, you can subscribe below:

https://premosocial.com/BehavioralMacro

I know everyone likes EM. I know it has had a great run the last 18 months. I know the Fed is reducing its balance sheet.

But consider this:

1. EM had a prolonged bear market, and large allocators
   are always slow to get back in after a cyclical bear. Expressing bullishness
   and acting on it can be very separate things.
2. The EM cyclical bull is on—albeit much in the same muddle-thru way we saw in the advanced economies. Expect ‘slower for longer’. It was a global credit boom, and we are experiencing a global, asynchronous, muddle-thru recovery.
3. This is not your father’s Emerging Markets. It’s well past time to give up on the
   generational blowup he bought his beach house with.
4. Other major central banks are far earlier in their monetary tightening cycles than the Fed is—and the Fed (and markets) have just penciled in a lower terminal federal funds rate—again.
5. This is very bearish the dollar—ergo bullish EM. Moreover, the other factor holding back EM bullishness has been the fear of what higher US rates might do to the asset class. This fear too has lessened considerably.
6. Others have been unwilling to chase and have been ‘waiting for a pullback’. Well, we just had one and it was so shallow and fleeting (common at the beginning of bull cycle) that few got the chance to wet their beaks. And, to quote from the Trader’s Bible: “They’re panicking out there right now, I can feel it”.
7. EM indices all over the world are breaking out to new highs (pick one).
8. The dollar (to my eye) seems to have made a blow off top in the wake of the US election (red circle). Lots of scope for depreciation.

   

9. Long term EM currency charts suggest massive room for further appreciation. Here are a couple from our backyard (they also have tons of carry):
   

   

   

10. European rates are now rising faster than US rates. If this really is the moment where markets recognize that Fed normalization is closer to its end and ECB normalization is just starting, this is likely to persist.
    

    If the above is at all correct, this is a very, very bullish set up for EM—despite the EM bull being 18 months in. And, if you know how this game works, you realize how hard and counter-intuitive that is to say. And it also means that the pain for those who have missed the EM train is only going to increase. In other advertisements, please checktout cosmetic dentist pick.

The Great Financial Crisis shook a lot of trees and made many economists/investors/traders go back and question first principles—at least it should have.

Here’s a quick list of Things We Should Have Learned by Now:

1. Potential growth in developed economies is lower than it was before the GFC. And policy can’t do as much about it—whatever your policy inclinations—as we’d like to think.
2. The interest rate sensitivity of economic activity is far less than was believed to be the case.
3. Printing money can cause inflation, but doesn’t always. Asking what are the conditions under which it is likely to, and if those conditions obtain, is the smart question.
4. The economic channel of monetary policy and financial channel of monetary policy have to be thought through jointly and separately, and often have very different requirements and equilibrating dynamics.
5. Oil matters less. It didn’t help the consumer as much as forecast when it fell, and didn’t hurt GDP as much as others suggested, either. Oil intensity of GDP or share of consumption basket is far lower than the levels most observers—consciously or unconsciously—had anchored on.
6. The overall commodity intensity of output has declined significantly and will continue to do so. It is in some sense the very definition of technological advancement.
7. Commodity markets (IDK about softs) are driven in the first instance by speculation, which regularly overwhelms fundamentals.
8. Inflation/wage impulse per increment of GDP has been systematically lower than thought. And transitory shocks are often, well, transitory.
9. EM has structurally changed —for the better.
10. Government intervention is a necessary evil in a financial crisis. What’s desirable isn’t always feasible. Path dependency is dominant. And circuit-breaking the self-reinforcing downward spiral of panic is essential.
11. The bond market—in both shape and level—has been telling us very little about US economic prospects/activity. However, short-term changes do inform us as to the prevailing narrative.
12. Economics should be used for diagnostic purposes, not predictive ones.
13. Very few investors/traders can disentangle their political preferences from their economic analyses. Systematic traders, disciplined risk managers, and passive investors have a big advantage in this regard.
14. The Mexican peso is not a petro-currency; Mexico imports more petroleum products than it exports.
15. Brazilian growth is driven primarily by domestic credit, not commodity exports.