“The Federal Reserve has an official commitment to two different policies. One is to prevent inflation from getting too high. The second is to maintain high employment… the European Central Bank has only the first. It has no commitment to keep employment up.” ― Noam Chomsky
“A small group of people, they raise the price of oil and the whole world will suffer from this.” ― Ahmed Zaki Yamani, minister in OPEC for 25 years
A Mix of Macro Charts
In this week’s piece we share three macro charts that we hope will provide readers with an insight on how various risks are priced in markets by a seeming disparate range of instruments and indicators.
Short-Term Rates and the Yield Curve
The above chart is of the de-trended 3-month Treasury bill rate (inverted) ― de-trended by subtracting the 10-year moving average from the bill rate ― versus the US Treasury 10-year and 3-month yield curve. The chart dates from 1962 till today, suggesting that the de-trended 3-month Treasury bill rate contains information about the direction of the yield curve.
The two-time series have a correlation of -0.77 with an r-squared of 59 per cent.
(The dashed lines on the above chart are the average de-trended bill rate and levels one standard deviation above and below the average.)
The relation between the de-trended bill rate and the yield curve indicates a strong tendency of interest rates to mean revert. The wider the gap between the current de-trended bill rate and its long-term average, the stronger the markets expectation of mean-reversion. For example, the de-trended bill rate being one standard deviation above (below) its average generally serves as a guide post to position for a yield curve steepening (flattening / inversion). (The time series is inverted, so above the average means visually below on the chart.)
The de-trended bill rate recently reached one standard deviation above its long-term average and has since turned down, suggesting that fixed income investors position for a yield curve steepening, as opposed to a direct long or short position at either end of the curve.
Equity market investors can play a steepening yield curve by being long financials.
The Golden Period of Risk-Parity and 60/40 Allocations
The above chart is the 6-month rolling US stocks-to-bond correlation and the 6-month rolling average of the annual rate of inflation, as measured by the consumer price index.
The relationship demonstrates (1) how the capital markets price in inflation and (2) the correlation between stocks and bonds is not static. The implication of the latter is that bond allocations do not always serve as a suitable diversifier for equity allocations. Rather, it is the prevailing market regime that determines the efficacy of bond allocations to lower draw downs and portfolio level volatility during equity market sell-offs.
Capital markets price in inflation ― outside financial crises when the safe haven demand for bonds can overwhelm implicit inflation expectations ― through an adjustment of the correlation between stocks and bonds. During the period from 1965 through to 1997, when inflation expectations experienced large swings, the stock-to-bond correlation was almost consistently positive. That is, changes in inflation expectations drove both stock and bond returns and during periods of equity market weakness bond allocations did not make up the difference. For example, in the sub-period between 1973 and 1981, during which there was a negative supply shock from the OPEC oil export embargo, multiple recessions, high unemployment rates and high inflation, equity market weakness coincided with a poor bond market performance.
To re-iterate the point again, it is market regime that determines whether Treasury bonds are a “wonderful hedge” or a “terrible investment”. Moreover, we can from the chart above why the last decade and a half has been a golden period for risky parity strategies and 60/40 allocations ― stock-to-bond correlations have been and remained at or close to 100-year lows.
The question then is, how does one determine market regime?
Market regime is just another way of saying inflation expectations. Rising inflation expectations equate to rising stock-to-bond correlations. Retreating inflation expectations translate to declining stock-to-bond correlations. By extension, something touched upon last week, the combination of stable, that is expectations of more of the same, and low-levels of inflation makes for the optimal investment environment.
Continuing to bet on more of the same when stock-to-bond correlations have been at 100-year lows for a prolonged period is surely asking for trouble. All the more, with political movements the world over nudging the global economy from being driven by negative and positive demands shocks to becoming one that will be driven by positive and negative supply shocks, a market regime change seems inevitable.
Demand shocks, either positive or negative, do not move the Phillips curve; supply shocks, however, shift it in and out. When the Phillips curve shifts in response to a negative supply shock, nominal bonds exacerbate losses suffered in equity markets. For example, an adverse supply shock in the form of the oil embargo by the OPEC in 1973 shifted the Phillips curve by increasing both production and distribution costs of almost all industries and led to losses for both equity and bond market investors.
That is why we think investors need to consider instruments other than bonds to hedge equity allocations. The Japanese yen, precious metals, Treasury Inflation-Protected Securities (TIPS), oil and energy stocks are some of the viable options. It is likely that there are others.
Why do we keep insisting on oil and energy stocks? Well because oil is the most obvious negative supply shock we can conceive of in the event of an Elizabeth Warren or Bernie Sanders presidency. Both Democratic presidential contenders have proposed to ban fracking altogether.
Europe Sovereign Risk Model
The above chart is the ratio of gold, in euros, to the Euro Area all shares index versus the differential between 10-year government bond yields of the ‘fragile’ European economies and Germany. (For the latter we use the average of the yields on Spanish, Portuguese and Italian 10-year bonds and subtract from it the yield on 10-year German bonds.)
The two series are a means of measuring sovereign, or break up, risk in Europe. Rising ratios imply rising sovereign risks and a rush towards the safe havens of gold and German debt. Recently, with gold having rallied and some form of Brexit related agreement forming, the two time series have diverged. The yield differentials indicate a declining risk premium while the gold-to-shares ratio indicates a rising risk premium.
We think the two series should start to converge with European stock markets continuing to head higher.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.