If everyone is thinking alike, then somebody isn’t thinking
If everyone is thinking alike, then somebody isn’t thinking
–General George Patton
There are a few things that come to mind when looking at this week’s markets. Strangely enough, General George Patton is one of them. For those who don’t know, Patton was a famous, controversial, and profane leader of the Third Army in World War II. Though I am not given to using military analogies, I often think of a tactic that I believe is attributed to Patton, which is this: At the front lines your fighting force will be involved in the most brutal fighting and incur heavy casualties, causing both sides to deploy more resources. However, if you’ve committed to taking losses, once you break through the front, your forces can swiftly and easily take vast amounts of territory because the resources of the enemy have been expended.* That is what happened to the US stock market this week. (And other markets as well). Throughout all of 2015 and into the start of 2016, “the Front” was 2100 to 2140 on the SPX. In the summer post-Brexit, the Front moved a bit north, to 2160/2190. This week the market vaulted 3% higher after the Italian referendum, on heavy volume. The warnings from Soros, Druckenmiller, Gross, Gundlach and even Icahn (who seems pretty fluid in his views) were steamrolled by the Trump tanks, meeting little resistance after the big battle. I am not suggesting that the above investing stars were caught out by the moves, (they are where they are because they adapt to changing conditions), but I am suggesting that the resources of short sellers were expended at the front, and resistance behind enemy lines is sparse. As a friend of mine says, “You can be bearish. Just don’t be short.”
The other thing that this market makes me think about is 1987. A chart from 1985 to 89 is below, showing SPX in blue and the ten year yield in white.
Note that when SPX broke through the front in 1986 at around 255, it quickly gained about 20% in Q1 of 1987 to a bit over 300 and then added further gains to around 340 going into October, when the market crashed. (So the rally from 250 to 340 was a gain of 35% in a year. In our current case, 2160 x 1.35 is 2916, or… NEW PROJECTION!!! DOW 25000!!!). It’s interesting to note than in the beginning of 1987, the dollar index was right about where it is now, just below 102. However, in 1986 going into 1987 the dollar was on a fast train south, as opposed to rallying in the current case. History rhymes. There are a few additional interesting similarities. First, there was concern about trade: “The announcement of a larger-than-expected trade deficit came on October 14, 1987. In response, Treasury Secretary James Baker got tough with U.S. trading partners, specifically Germany. Baker’s message… was “if you don’t lower rates, we’re going to lower the dollar and you’re going to have export problems.” A threat regarding trade from a high-level official. Probably couldn’t happen with this new buttoned-down and low key Trump administration….right? How’s this from the President-elect: ‘China is not a market economy … they haven’t played by the rules, and they know it’s time that they’re going to start.” Second, in October 1987, Iran hit a couple of American owned supertankers with silkworm missiles. Third, and this is where our story dovetails with the interest rate markets, yields were marching higher. From the beginning of 1987 to October, the ten year yield went from around 7% to 10%. Whoa, now those were some rates! However, our current ten year yield has risen by a similar magnitude, from 1.60% to 2.40%, i.e. 1.5x the starting rate. Does it make a difference? Not yet, but given the huge debt levels in the current situation, it’s worth bearing in mind.
CHINA
A couple of charts on China below. The first is the US 2/10 treasury spread vs the Chinese ten year yield. Correlated. However, the rise in China’s ten year yield doesn’t seem to be stopping weakness in the renminbi, as shown on the next chart.
This chart includes Chinese reserves (white), the inverse of CNY (red) and, again, the Chinese ten year yield (green). Reserves continue to slide as China tries to stem the decline in the currency related to capital outflows. Capital is fleeing because of structural problems, which will likely be exacerbated by trade issues with the US. Which, in turn causes selling of reserves comprised of US treasuries. Which causes additional pressure on US rates, which stifles US economic growth. Which Trump can blame on China… I’m sort of joking about this self-reinforcing loop scenario. Sort of.
ECB
Really this week was about the ECB, which extended QE, though at a slower pace after March 2017, and expanded eligible securities which can be bought in shorter maturities. The result was steeper curves everywhere, and new highs in long end rates. For example, the German 2/10 spread rose over 10 bps to 111.8. US 2/10 rose to a new high just over 133. Even Japan’s ten year went to a new recent high of 5.6 bps, and the 10/30 spread in Japan went to 65 bps (highest since March). The banks loved it. Italian bank shares rose over 12% this week. US banks were up over 5%. Goldman has launched 33% in a month! “What’s good for General Motors (oops, I mean Goldman Sachs) is good for America.” ** Of course, the dollar index closed at the high of the week as the euro threatens to test 105.
This week it’s the US Fed’s turn. A hike is priced, with January Fed Funds trading 9936.0. The only drama is related to forward looking statements. Last time the statement said, “The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace…” It added, “Near term risks to the economic outlook appear roughly balanced.” And, “…the actual path of the FF rate will depend on the economic outlook as informed by incoming data.” GRADUAL and DATA DEPENDENT. Maintain course. Any chance that financial stability concerns are voiced with respect to inflated asset prices? I doubt it. Another Patton quote: “No good decision was ever made in a swivel chair.”
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I will be out of town this week and therefore not recommending trades. However, note that in euro$’s, Friday is midcurve option expiration. Back month Eurodollars (greens back) settled at new lows for the move. Given relatively low straddle levels, there are cheap ways of playing for a contrarian bounce.
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| 12/2/2016 | 12/9/2016 | chg | |
| UST 2Y | 110.4 | 113.3 | 2.9 |
| UST 5Y | 182.6 | 188.6 | 6.0 |
| UST 10Y | 238.7 | 246.6 | 7.9 |
| UST 30Y | 305.9 | 315.7 | 9.8 |
| GERM 2Y | -73.5 | -75.3 | -1.8 |
| GERM 10Y | 28.1 | 36.5 | 8.4 |
| EURO$ H7/H8 | 44.5 | 48.5 | 4.0 |
| EURO$ H8/H9 | 42.5 | 44.5 | 2.0 |
| EUR | 106.68 | 105.63 | -1.05 |
| CRUDE (1st cont) | 51.68 | 51.50 | -0.18 |
| SPX | 2191.95 | 2259.53 | 67.58 |
| VIX | 14.12 | 11.75 | -2.37 |
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https://www.goodreads.com/author/quotes/370054.George_S_Patton_Jr_
*I couldn’t find an exact reference to the tactic, but I did find this quote: “Our basic plan of operation is to advance and to keep on advancing regardless of whether we have to go over, under, or through the enemy. “
http://www.history.com/news/10-things-you-may-not-know-about-george-patton
https://en.wikipedia.org/wiki/Black_Monday_(1987)
https://www.federalreserve.gov/pubs/feds/2007/200713/200713pap.pdf
