(This article was first published on January 31, 2019, and is the second installment of a comprehensive report on near-term outlook on various assets classes).
US Treasury Bond Yields
In the final analysis, the short-term fate of the DXY and EEM are tied to the outlook for the performance of US Treasury bond yields over the next few weeks, primarily until early March.
Take the Treasury Cash Balance (TCB). The point is that Treasury bond yields tend to anticipate the inflows and outflows of the (TCB) by as long as two weeks. If this historical correlation holds true again this time around, bond yields should fall until late February, or even until early March.
The Treasury Cash Balance is the operational account that the U.S. Department of the Treasury has with the Federal Reserve. This account is basically equivalent to the checking accounts individuals and businesses have with their banks. Indeed, the Federal Reserve acts as the U.S. government's bank. This account takes care of expected cash payments, check clearing, and outstanding wires done by the Treasury. The balance could be also used to reduce debt or be spent on goods and services, and is kept at the Fed to earn some interest. Since late 2015 the Treasury has been purposefully holding more cash to be prepared for any major disruptions, such as a potential cyber event or a systemic event like the crisis in 2008. The TCB is first-line liquidity resource for the US financial system.
Right after the Fed announced a less aggressive tightening regime equities and bond yields went diametrically opposite each other (see chart below).
For us at PAM, the fall in yields was in response the Fed's signal that they are likely in a pause period until March. The yields are not falling because of new, overhanging threats to risk assets.
Rather, the yields were basically responding to a steepening of the yield curve (widening in the 3Y/10Y and 10Y/30Y spreads) -- and that basically pulled down the entire bond term structure (see chart below).
It is clear to Tim Kiser (my partner at PAM) and I that the coefficient correlation of bond yields and equities will now decline from positive (+) 1 to zero and eventually to negative (-)1. This may the start of a situation which I described to the PAM community about three weeks ago, when I described the highly unique coefficient correlation between stocks and bond yields (see chart below). This is what I wrote in the Market Report At The Chat on January 9, 2019:
In early October, the correlation between bond yields and equities was on the way to neutral or even the negative side when Fed Chair Jay Powell started the stock market firestorm with his "way below neutral" off-hand remark to describe the level US policy rates.
After that both yields and equities fell together to a degree unseen before, boosting the coefficient of their correlation to +1. It is still practically there, but it has moved a smidgen towards the direction of neutral. Remarkably, that was the first time that the coefficient of correlation reached +1 since 1960 (or even earlier). I was saying three weeks ago that this degree of correlation can stay there for a while, but it cannot stay there forever. And it has nowhere else to go. The correlation will soon has to turn towards zero, then to negative, and that process will take a while (see chart below).
Before the correlation reached +1, it was at -0.79 in January 2015 -- four years ago. That makes sense from a business cycle point of view -- it took half of the usual 8 year business cycle to progress from that point to where we are right now.
And it may also take four years or less for the coif. of corr. to fall into negative territory.
Think about what happens when the correlation changes. Either (1) equities will rise, and yields will fall, (2) equities will rise faster than yields, or the inverse of those two possibilities.
Given the outlook of a conciliatory Fed which is expected to pause in March and reduce the number of expected rate hikes this year, I go for possibility (2); that is, equities will rise faster than yields.
This is no academic exercise -- it is a stark suggestion that bonds may perform as well, or even outperform equities in the aggregate. This is hugely important in the way we should do asset allocation this year and beyond.
Indeed, the recent divergence in the performance of equities and bond yields has brought that analysis to the forefront. That means that equities will again become more attractive versus bonds – and that is happening even as we speak if seen against the backdrop of the Fed Model (see chart below). This model provides a simple, direct way of comparing equity and bond investments in asset allocation strategies. The Fed model postulates that stocks and long-term bonds are competing assets in the portfolios of many important investors (e.g., pension funds or insurance companies).
The Fed Model compares the difference between the stock market earnings (dividend) yield and the ten-year Treasury bond yield. The equity dividend yield is the price-to-earnings ratio of the S&P 500 based on expected operating earnings in the coming 12 months. In essence, the Fed’s model asks, “why would anyone buy a 10yr bond with a yield of 2.69%, when they could get a stock with a 6.97% earning return?” At this point, with the yield gap of circa 428 basis points, equities remain the better investment vehicle relative to the 10yr bond at present.
There has been some objections to the Fed Model in that we cannot compare a real variable (earnings yield) with a nominal variable (bond yield). This has been resolved by deflating the Fed Model with the US CPI (red line in the chart above).
Sustained outperformance of equities has always been accompanied by the widening of Treasury yield spreads (steepening of the yield curve) at the back-end, as the longer end of the curve is abandoned by many investors, and who opt for better-performing equities (or shorter duration bonds). This is apparent in the chart above.
The current steepening of the yield curve in the back-end is further accentuated by the shift of foreign central banks from long end Treasuries to short-end Treasuries. Central banks are hedge funds that think extra long-term. If indications of a growth recession show the possibility of that event within three years, foreign central banks will flock to the short end of Treasuries. That is already happening – central banks have been loading up on short-term US Treasuries at the expense of bonds and notes (see chart below).
Being long the Treasury spreads (benefiting from spread widening) is a very profitable and very efficient investment, especially so from a Sharpe Ratio point of view. You remove most of the market beta, and it also is very capital-efficient to hold these trades for a long time (which is how you make money). And the steepening occurs just BEFORE a recession, and extend well AFTER a recession, even without the illustration provided by the Fed Model (see chart below).
So we now see the validity of the second alternative that I was talking about several weeks ago. Equities will likely rise in 2019, and yields will, too. But yields will rise at a less fast rate. That is what the Fed Model is implying, and that could also be seen in the eventuality of coefficient correlation between bonds and equities moving from positive (+)1 to neutral, and then to negative (-)1, as well. That is how you asset allocators out there should position your investment strategies.
Equity mini futures have likely bottomed on December 24, and so the "great correction" is likely over. The market is now on the way to complete the fifth wave of our first impulsive rally since last month’s low. That completes the rally sequence and should be followed by a large (50 pct or more) correction of the upside gains.
In coming to these conclusions, we have been guided by various systemic liquidity models, from the G-5 central bank balance sheets (which determine the broad trends of risk assets) to term (money) market rates, which provide the variability provided by high-frequency turns in those data. PAM has been showing mostly liquidity models derived from Fed and Treasury policy liquidity inflows and outflows. We added a few more tools in our kit – I have been working on the impact of Fed SOMA transactions, and the consequent effect those transactions have on term (money) market rates. The changes in those term rates in turn affect the evolution of equities after a certain distributed time lag (see chart below).
The term market rates are the first line liquidity flows for the US shadow banking. This sector has outsized impact on risk asset prices because this is where the funds for purchasing/selling assets come from or go to. The chart above is a rough aggregation of the disparate impacts of these instruments; as is normal, the individual effect of each term rate varies, sometime significantly.
What the liquidity model suggests is that the current rally will soon peter out, and a so-called “test of the low” will take place thereafter. The chart below illustrates what we expect to happen. EWP schema suggests one more rally to complete the intraday five wave sequence, then we could expect a correction to take place. That correction could happen as early as next week.
The ensuing correction may be THE correction which sets off a 50 pct retracement. Or it could be followed by one more rally before THE 50 pct correction that we are expecting. For now, we go for a top then a 50 pct correction. The commonality between these two EWP schematics is a decline anyway, so prep up for a top soon, followed by a (probably) significant decline. Mr. Kiser has been reminding me not to overstay on the long side, as a 50 pct decline is a much bigger risk in the near-term, anyway.
Some investors are already antsy about this rally, but a few more days rally is still required to complete the impulsive five-wave upside sequence.
WTI, Brent Oil and Gasoline
Oil prices will likely responding to the firmer tone in equities. RBoB was recently falling due to Hedge Funds piling into short gasoline-long WTI or Brent trades. But if equities rise further as we expect, then oil and gasoline should also rise. We are also looking for a new top in WTI and Brent. RBOB should retest its recent top, but unlikely to make a higher high.
PAM will wait for resolution of the equity very short term outlook before adding overhedge to long oil equity exposures. Nonetheless, the oil sector has plenty of idiosyncratic, fundamental to worry about in the near-term. And if equities top out soon (next week, say), oil and oil equity prices should peak as well.
That said, there are some good news from the energy sector today.
The January OPEC survey indicates that output from the 11 OPEC members with supply reduction targets fell by 740,000 bpd from December, while total OPEC output dropped by 890,000 bpd.
But it is now a battle between diminishing OPEC output and increasing US oil inventories. On top of that product and inventory fundamentals are still a huge headwind for oil prices.
Nonetheless, if yields rise further, alongside equities, then the short term outlook for oil prices should be more benign, better than what is being illustrated by gasoline prices at this point. WTI has been very resilient, and if yields and equities do the fifth wave which we believe would be done, then WTI oil may even make it to $57.00. But as PAM member drtodor points out, that may be a good place to start shorting the stuff.
If yields and equities do the expected major, Wave 2-type of bottoming-out process, then oil will likely retrace up to 50 pct or more of its recent gains. That grim outlook has some support from worsening product fundamentals, which are the reason why gasoline price was being hammered lately – gasoline inventories are building significantly (see chart below).
That poses continued risk for gasoline prices, as an end to the gasoline inventory build is still at least 7 weeks in the future.
And US oil inventory builds will become very large quickly soon, and will keep that trajectory for at least the next 8 more weeks, or longer. Oil inventories mimic the inflection points of US gasoline inventories, after an 8 week lag (see chart below),
And so even if gasoline builds will stop soon, oil inventory builds are just starting -- and will be a feature in the weekly EIA inventory reports over the next 7 to 8 weeks. So there are plenty of fundamental reasons for oil prices to go back down, and do a technical "retest the previous low."
E&P and Oil Refiners equities
Nonetheless, we have had some good news from the E&P sector.
ConocoPhillips COP.N, the world's largest independent oil producer, reported a surge in quarterly adjusted profit on Thursday, helped by higher production and realized prices for its crude.
Baker Hughes BHGE.N, General Electric Co's GE.N oilfield services arm, posted an 85 percent jump in adjusted quarterly profit on Thursday, boosted by surging demand for its services.
Royal Dutch Shell RDSa.L said to would stick to spending discipline this year after 2018 profits jumped by more than a third to $21.4 billion, their highest since 2014. The Anglo-Dutch oil company also reported a sharp rise in cash generation.
The major E&Ps tend to be also very sensitive to US oil and petroleum consumption trends, after a short lag. US oil/petroleum consumption has been rising over the past 6 months and EIA forecasts rising trends well into late Q3 2019 (see chart above). The EIA forecasts (and actual data) are already indicating rising oil and oil equities up to late Q2 2019, but may see a peak in late Q3. Conversely, oil prices and oil equities could come under pressure in Q4 -- unless EIA forecasts change.
So much for the "lack of oil demand growth" meme of the hedge funds, which goes diametrically opposite to what the EIA has been forecasting.
I've modeled US gasoline consumption and gasoline stocking trends and although the gasoline builds may end sometime soon, gasoline consumption won't pick up until the middle of March (see chart above)
The path of the E&Ps may not be a straight line, therefore, and that is why we are open to the idea of a large (up to 50 pct) correction of the recent rally in both oil and E&P price data set.
See the fluctuations of the red line (VLO) in the chart above.
It is better this way -- try to protect yourself from the message of fundamentals, rather than be swayed by newsflow or by prognostications that denigrate the capability of the EIA in forecasting oil demand growth.
The EIA has been at it for many, many years and do not have agenda. All writers at Seeking Alpha (including myself), and at OIPrice.com for that matter (or oil bloggers) have agenda to flog. I stick with the data provided by the professional statisticians and geophysicists at the EIA (and have done so for more than four decades). I could try to replicate their effort, but why try to reinvent the wheel, when someone is actually doing a respectable job at it today?
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Disclosure: I am/we are long OIL, EQUITIES, DXY, PMS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.