Great Chart: Gold price vs. Negative-yielding debt

Empirical researchers have demonstrated that gold has had many drivers over the past few decades, but has been mainly influenced by interest rates, inflation trends, the US Dollar, stock prices and central banks reserve policies. Baur and McDermott (2010) also shows that the precious metal plays the of a safe ‘zero-beta’ asset in periods of market stress and equity selloffs. For instance, in the last quarter of 2018, US equities (SP500) fell by 14% while the price of gold in US Dollars was up 7.6%. In the short run, participants usually look at the co-movement between gold price and real interest rate (TIPS) to define a fair value of the precious metal (gold price rises when real yields fall and vice versa).

However, gold has shown a stronger relationship with another variable in recent years: the amount of negative-yielding debt around the world. This chart shows us the striking co-movement between the two times series. After oscillating around USD 8 trillion between the beginning of 2016 and the end of 2018, the amount of negative-yielding debt doubled to nearly USD 17 trillion in the first half of 2019 amid political uncertainty and concerns over global growth, levitating gold prices from $1,280 to $1,525. However, we have noticed that investors’ concern has eased in the past two months, normalising global yields (to the upside), increasing the US 2Y10Y yield curve back to 25bps after turning negative in the end of August, therefore reducing preference for ‘safe’ assets such as bonds. The amount of debt yielding below 0% has dropped significantly since the end of August to USD 11.6 trillion this week, dragging down gold prices to $1,460. We think that market participants have overreacted to the global growth slowdown in the first half of the year and that the rise in leading indicators we have observed in the past three months (i.e. global manufacturing PMI) will continue to push preference for risk-on assets. The amount of negative-yielding debt could easily come back to its 2016-2018 8-trillion-dollar average in the following months, hence emphasising the downward pressure on gold prices. It looks like gold is set to retest the $1,350 – $1,400 support zone in the short run (which used to be its resistance zone before the 2019 rally).

Chart.  Gold price (in USD) vs. amount of negative-yielding debt (tr USD) – Source: Bloomberg, Eikon Reuters.

Gold

 

 

Great Chart: US ST Yield Curve vs. Cyclical-Defensive Stocks

Lately, the sharp revision of the US annual saving rate (up 1.6% on average since 2010) shifted growth expectations to the upside and lowered the bottom of the unemployment rate for the next few quarters. For instance, Goldman revised its GDP growth to 3% in Q4 (from 2.5% previously) and to 2% for 2019 (vs. 1.75%) and expects the unemployment rate to bottom at 3% in 2020. As a result, some investors are starting to consider that we may see more rate hikes by the Fed than currently expected. With two more hikes priced in for this year and another two to three for 2019, market participants expect the Fed Funds rate to hit [at most] 3.25% by the end of next year, which is more or less in line with the  Fed’s dot plot released at the June meeting (median projection at 3.125% for 2019).

However, we saw that the market is not expecting any more hikes post-2019, which could be interpreted as the end of the tightening cycle by US policymakers. According to the Eurodollar futures market, the December 2019 and December 2020 implied rates are trading equally at 3.06%, which suggests that the US economic outlook is expected to slow down at the end of next year. Hence, an interesting analysis is look at which sectors should perform well within the next 12 to 24 months if we stick with the scenario that economic uncertainty will increase at the end of 2019. A classic strategy looks at the Cyclical vs. the Defensive stocks. The main difference between Cyclical and Defensive stocks is their correlation to the economic cycle; Cyclical stocks tend to do well in periods of economic expansion (relative to Defensive stocks) but tend to experience more losses during recessions. According to empirical research, one of the main aspects that drive Cyclical and Defensive stocks’ performance is the beta of these stocks (also called the market risk premium). As the Defensive stocks are more resilient to an economic downturn, their beta is lower than 1 (resp. higher than 1 for Cyclical stocks).

Therefore, if we take the EuroDollar (ED) Dec19-Dec20 implied rate yield curve as our leading indicator of the business cycle, a flattening yield curve should benefit to the Defensive stocks (vs. Cyclical stocks). However, the chart below tells us a different story (Original Source: Nomura). We looked at the relationship between Cyclical-versus-Defensive sectors and the Dec19-Dec20 ED yield curve since the summer of 2008, and noticed that the two times series have been diverging for the past two years. The yield curve has constantly been flattening during that period, however Cyclical stocks have outperformed Defensive Stocks. We chose Materials, IT and Industrials sectors for the Cyclicals and HealthCare, Telecom and Utilities sectors for the Defensives (Source: Thomson Reuters Total Return Indices), and compute the ratio of the Cyclicals and Defensives new indices (find attached the file).

If you expect the two series to convergence back together, this would imply either a sudden steepening of the yield curve or Cyclicals to underperform Defensives.

Chart: ED Dec19-Dec20 yield curve vs. Cyclical-Defensive stocks (Source: Eikon Retuers)

Sectors vs. YC.PNG

EXCEL DATA LINK ====> Sectors

Great Chart: ECB Total Assets vs. EuroStoxx50 (18M Lag) – Yearly Change

One of the main topics of the year is the central banks’ balance sheet unwind, and the potential effect it can have on asset prices. As JP Morgan (and other sell-side institutions) pointed out, if we look at the annualized monthly net bond flows, the top 4 central banks (Fed, ECB, BoE and BoJ) will switch to net sellers in October 2018 (here). BNP Paribas published an interesting chart lately of the weighted average 10-year G4 bond yield overlaid with the G4 monthly bond purchases (here); we can clearly see that the increase in the total purchases has helped to push overall 10Y yields on the downside since 2010, hence eased financial conditions and stimulated the refinancing activity. However, what will happen to LT yields now that the purchases are expected to fall in 2018?

Many market participants have argued that the constant increase in central banks’ balance sheet has levitated all asset classes, and particularly the stock market; therefore, one economic area we are watching closely during the unwind is the Euro zone. If we look back three years ago, when Mario Draghi announced the launch of the 60-billion Euro bond-buying program on January 22nd, 2015, the ECB balance sheet was totaling 2.15tr Euros and the equity market EuroStoxx50 was trading at 3,400. As of today, the central bank’s assets are north 2.3tr Euro (the ECB balance sheet surpassed the Fed’s one last summer and is now worth 4.5tr Euros), while the EuroStoxx50 Index is up a mere 200pts, currently trading at 3,600 (here). We can clearly notice that the ECB effect on European equities was non-existent. It looks like the European equity market has been a dead market over the past couple of years; the Eurostoxx 50 has been trading sideways within an 800-point range between 2,900 and 3,700 and sits at its 50% Fibonacci retracement from its mid-June-2007 peak to Feb-2009 trough.

Hence, we chose this week to overlay the yearly change in the ECB balance sheet’s total assets with the yearly change in the equity market (18-month lag). As you can see, the two times series have shown some co-movements since the Great Financial Crisis; a decrease in the ECB assets is usually associated with a negative YoY performance in the EuroStoxx50 18 months later. For instance, the ECB balance sheet yearly change switched from +60% in June 2012 to -24% in January 2014 amid early LTROs reimbursement by European banks. If we look at the lagged performance of the equity market, the yearly change in the EuroStoxx50 index went from +20% in the summer of 2012 to -18% in June 2014.

In October 2017, the ECB cut its bond-buying program to 30bn Euros a month starting January 2018 for a period of 9 months, and the market expects that the central bank will taper QE to final three months of the year. With the yearly change on the ECB assets starting its downward trend, our question is the following: will the growth and investment story in the Euro area offset the expected downturn in equities?

Chart: ECB Total Assets vs. EuroStoxx50 (18M Lag) – Yearly Change (Source: Reuters Eikon)

ECB vs Asset.png

Great Chart: Gold vs. US 5Y Real Yield

We showed in many of our charts that 2017 was the year where some of the strong correlations between assets classes broke down. We showed USDJPY vs. TOPIX (here, here), Cable (here) and EURUSD (here) vs. the 2Y and 10Y interest rate differentials, and this week we chose to overlay Gold prices with 5Y US real interest rates. As we explained it in our study on Gold (here), the relationship between Gold and US [real] rates is easy to understand. The precious metal is a non interest-bearing asset, meaning that a typical investor doesn’t get any cash-flow from owning it (unlike dividends for stocks and coupons for bonds), and has usually a storage cost associated with it. Therefore, the forward curve of the ‘currency of the last resort’ (Jeffrey Currie) is usually upward sloping, in other words Gold market is in contango, with the forward price equal to the following:

Reg.PNG

Hence, if real interest rates start to rise, a rational investor would prefer to reallocate his wealth to either US Treasuries or Treasury Inflation Protected Securities (TIPS) and receive coupons rather than keeping a long position in a commodity that has a ‘negative carry’.

As you can see it on the chart, Gold prices (in US Dollars) and the 5Y TIPS real yield have shown some strong co-movements over the past 5 years, until the summer of 2017 when the two times series diverged. If we would follow recent moves on the market, the late surge in Gold prices (currently trading at 1,340 $/ounce) would imply a 50 to 60 bps decrease in US real interest rates (note that if we regress the change in Gold prices on the change in the 5Y real yield using weekly data since 2013, we find that a 1% increase in real yields lead to an 8.7% depreciation in Gold prices). And lower real rates would either come from higher inflation expectations or lower nominal interest rates. With the 5Y5Y forward inflation swap currently trading at 2.11% and up 30bps over the past 6 months, core inflation and core PCE YoY rates at 1.8% and 1.5% slightly moving to the upside, and oil prices still trending higher with WTI front month contract trading at $64.5, there is room for higher inflation prints coming ahead. However, if the two curves were to converge in the short term, the [sharp] move would come from either [lower] Gold prices or [lower] Treasury rates.

Our view is that the divergence will persist in the beginning of 2018, with inflation remaining steady / slightly increasing and US interest rates failing to break new highs on the long end of the curve (5Y and 10Y). The main reason for that is that we think market’s confidence on the Fed’s 4 or plus hikes will slow down in the coming months on the back of lower-than expected fundamental, depriving the yield curve from steepening too much.

Chart: Gold prices vs. US 5Y TIPS (inv.) (Source: Reuters Eikon) 

WeeklyGold.PNG

 

Great Chart: SP500 vs. US 2Y10Y Yield Curve

Historically, research has shown that the difference between long-term and short-term interest rates (‘Yield Curve’ or ‘Time Spread’) has shown some significant negative relationship with subsequent real economic activity in the United States, with a lead of about four to six quarters. Hence, with the current low levels of the US yield curves (2Y10Y or 5Y30Y), we chose today this week to overlay the 2Y10Y yield curve with the SP500.

If we say that low yield curves tend to predict recessions, then the question now relies on quantifying a low level of the yield curve. We hear from many analysts that the current levels are very low, however if we look back at 40 years of data, the US yield curve levels are not that far away from their long-term averages. For instance, the 2Y10Y and 5Y30Y slopes are currently trading at 51bps and 53bps, while their LT averages stand at 95bps and 82bps, respectively (see here). One main reason why yield curves have been crashing over the past few months is mainly due to an increase in the front-end of the US curve on a back of a shift in expectations of monetary policy. The US 2Y interest rate is now trading at 1.96%, its highest level since September 2008. On the other hand, the 10Y yield stands at 2.46%, has been ranging between 2% and 2.6% over the past year and is up 110bps from its historical low of 1.36% reached in July 2016.

The chart below shows the importance that even if the yield curve turns negative in the US, the equity market has still upside potential in the following months. In our first observation, the 2Y10Y time spread went negative in February 2000, while the SP500 continued its rally and reached a peak in September the same year. In the second one, the yield curve inverted in June 2006 (if we ignore the Jan-Mar 2006 episode) while equities continued to rise for more than a year, peaked in October 2007, and the US plunged into the Great Depression in December 2007.

We don’t think that the current levels of the yield curves are actually alarming for the US economy and we may see a potential floor in the first quarter of this year as we believe that market participants’ (over)excitement on the Fed potential hikes will ease in the medium term. The probability of 4 or more hikes has soared to 12.1%, which pushed the front end of the US curve on the upside and explains the sharp flattening we saw in 2017 (from 1.27% to 0.5%). However, if we look at the EuroDollar futures market, the December 2018 contract currently trades at 97.81, suggesting that investors are pricing in a ST interest rate of 2.19% by the end of the year (see here). This analysis also confirms our bearish view on the US Dollar for 2018 (especially against the Euro).

Chart: SP500 (yellow, rhs) vs. US 2Y10Y Yield Curve (Source: Reuters Eikon)

Yield Curve.PNG

Great Chart: Cable vs. 2Y UK – US IR Differential

As for EURUSD and the 10Y interest rate (IR) spread (here) or for USDJPY versus the equity market (TOPIX, see here), the same interesting divergence has been occurring between Cable and the 2Y IR differential. We mentioned in many of our posts that the interest rate differential (either short term 2Y or long term 10Y) has been considered as one of the main drivers of a currency pair for a long time. For instance, in our BEER FX Model, we used the terms-of-trades, inflation and the 10-year interest rates differentials for our cross-sectional study, using the US Dollar as the base country and currency (see post here).

Hence, if you look back over the past few years, there is a significant co-movement between the two times series. As you know, the ST 2Y IR differential reflects the expected announcements from either UK or US policymakers concerning the future path of the target IR set by the central bank. For instance, between summer 2013 (when Governor Carney took office at the BoE) and summer 2014, the 2Y IR differential went up from 0 to 45bps on the back of strong UK fundamentals (fastest growing economy in G7 in 2014) and market participants starting to price in a rate hike as early as Q4 2014 or Q1 2015 according to the short-sterling futures contract (see July 2014 update). The increase of both the 2Y IR differential and the short-sterling futures implied rate brought Cable to its highest level since October 2008 at 1.72 in July 2014. However, both trends reversed that summer with the US Dollar waking up from its LT coma and the UK starting to show some weaknesses in its fundamentals. At that time, we entered a 2Y+ Cable bear market, and if we omit the pound ‘flash crash’ in early October 2016 and set the low at 1.20, Cable experienced a 30-percent depreciation. Therefore, this fall moved the British pound from being a slightly overvalued currency to a clearly undervalued currency if we look at some broad measures such as the real effective exchange rate (REER). According to the REER, the Pound is 15% far away from its 23Y LT average (GBP REER).

If we look at the last quarter of 2017, despite a 50bps drop in the 2Y differential (currently trading at -1.44%), Cable found support slightly below its 100D SMA each time and the pair has shown strong momentum since the beginning of the year. We believe that the strong decrease in the IR differential lately comes from an (over) confident market pricing in three Fed hikes next year (probability of 4 or more rate hikes stands at 9% in 2018). However, we think that this current excitement may slow down in Q1 2018, hence readjust the IR differentials, which is going to be positive for the British pound against the greenback. In our view, the 1.40 level seems reasonable for Cable in the medium term (1-3M), which corresponds to the 38.2% Fibonacci retracement of the 1.20 – 1.72 range.

Chart: GBPUSD vs. 2Y IR differential (blue line, rhs) Source: Reuters Eikon

Cablevs2Y.PNG

Monetary Policy Coordination: From Global Easing to Global ‘Tightening’

Abstract: An interesting series of central-bank announcements over the past semester confirmed our view of a global central banking monetary policy coordination. The first two major players that hinted in a speech that the central bank might slow down their asset purchases were the ECB and the BoJ; but more recently we heard hawkish comments coming from the BoC, RBA and even the BoE. In this article, we first review the quantitative tightening (or the Fed balance sheet reduction program), followed by some comments on the current situation in the other major central banks combined with an FX analysis.

Link ==> US Dollar Analysis 2

Introducing the 3D challenge – Debt, Demographics and Disruption (with a US case study)

Abstract: As a response to the Financial Crisis of 2008, central banks have been running persistent loose monetary policies (NIRP and aggressive asset purchase programs) in order to generate some growth and inflation. Even though the measures chosen by policymakers mainly came from the burst in the housing market (US and Europe), developed economies have also been cornered with another long-term big issue: the 3D problem – Debt, Demographics and Disruption. Demographics reveal a dramatic aging of the developed world’s population (‘Baby Boom effect’), which has been playing a role in the desire of consumers to save more than actually spend. In addition, the long-term solvency of public and private plans has also been a growing concerns across the developed nations, adding pressure on current workers to increase their amount of savings based on a shift in expectations of higher taxes to sustain the secular change in demographics. The effect of an increase in savings have been one of the main factors of a decrease in inflation expectations across the world in addition to a sluggish growth, forcing policymakers to maintain a loose monetary policy, cutting rates to even negative territory and diversifying the asset purchase programs (corporate bonds, ETF and Real estate). The slowdown of inflation, and even deflation for some countries, is an issue for developed nations as it increases the country’s debt in real terms, putting the country under pressure and questioning its long run sustainability.

We then look at the US economy for our case study on the 3D problem. Our analysis is composed of three sections: in the first one we quickly review US demographics challenge, then in the second section we present the US Federal and Household debt, and in the third part we introduce Disruption in different sectors of the US economy.

Link ==> 3D Problem

Rising US corporate default rates during a tightening monetary policy cycle

In this study, we mainly focus on the refinancing issues that US [non-financial] companies will face within the next five years as a lot of corporations are trading at a distressed price (or yield) due to the lack of global growth and low commodity prices. In the first session, we review the US credit market structure. Then, the second session introduces a two-state Markov switching model (Hamilton, 1989), followed by a presentation of the paper Corporate bond default risk: a 150-year perspective (Giesecke & al., 2011), a study that uses a set of macroeconomic and financial variables to forecast default rates in the US. In the third Section, we comment the potential change in the explanatory variables since 2009 and we discuss a solution to avoid a new clustered default event over the next five years.

Link ==> Studies on Corporate Defaults