If This Is A Recession I Will Run Down The Street Naked*

The asterisk is because obviously there will be a recession one day the trick is to have an idea of when it could start. For me to run down the street naked, something I haven’t done since high school, a recession has to start in the next six months.

Why all the confidence? Well aside from all these pundits coming out saying there is a 100% chance that we are in a recession or that a recession will start before summer the reason is that the data doesn’t show it. You can make up indicators that don’t really make sense either in their construction or their interpretations or you can focus on one relatively narrow segment of the economy but none of that actually means we are entering a recession.

If you want to gauge the probability of a recession it might be helpful to really study the business cycle and how we enter and exit recession as well as how we do not. You then want to build a battery of models to help you interpret what is happening and what is likely to happen going forward. If you do this, and don’t focus on just one indicator, you will be far better off than what most pundits do.

One thing to look at, and maybe the most studied indicator in the history of economic indicators, is the yield spread. You can use just about any of the common spreads like the 10-2, 10-Fed Funds, 30-Fed Funds, 20-Fed Funds, etc. Anything that is definitely towards the long end of the curve and the short end of the curve should do. By the way you can do all of this in Excel using the excellent FRED plugin from the St Louis Federal Reserve.

What does the yield spread tell us? Well in general terms it is a tool that helps us gauge how tight or loose liquidity is. If the Fed wants loose monetary conditions they usually lower the Fed Funds rate and if they want tighter conditions they usually raise the Fed Funds rate. You can see this clearly in the chart below of the 20-Year yield, the Fed Funds rate, and recessions.  When the Fed wants to slow the business cycle the red line moves higher as they raise rates and when they want to spur business on they lower Fed Funds and the red line drops. Look at where we are now.

20 Year Yield and Fed Funds Rate

20 Year Yield and Fed Funds Rate

If we look at the actual spread of these two yields it might help you see what we are pointing at. You take the 20-Year yield and subtract the Fed Funds yield to get the spread. When it is moving higher we are usually expanding and when it gets almost flat or even inverted we are usually close to a recession.  Right now the spread is narrowing but it is a long ways off from being flat let alone inverted.

Yield Spread

Yield Spread

So right now it should be obvious that the Fed, despite hiking rates back in December, is still allowing business to enjoy relatively loose monetary policy. Everything from the yield spread is saying that a recession is not very likely in the near term. Before we end this however lets look at what a probit model says about the position of the yield spread.

The chart below shows the odds of a recession based on a model from Jonathan Wright at the Fed. His paper “The Yield Curve and Predicting US Recessions” shows how he built this model and how it works. In the paper there are actually two models. Model 1 is decent but Model 2 has been more accurate. What is great is that you can use both of them and then try and figure out what the yield curve and the Fed really want. Model 1 currently is saying there is a 17.91% chance of a recession while Model 2 is saying that there is a 0.05% chance of a recession.  Even if we just take an average of the two we get down to a 8.98% chance of a recession which is a far cry from a 100% chance or even a 50% chance of a recession.

Yield Curve Probit Model

Yield Curve Probit Model

Now to be fair we use far more indicators and models than just the yield spread. But here is the thing…only manufacturing is giving any real signs of stress. Every other major group of indicators is showing neutral to positive readings. Check out housing, employment, or even wages and you will see that things are actually looking pretty good.

Go immerse yourself in the data and see for yourself. In the meantime I am betting on me NOT having to run down the street naked.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

 

Are You A Contrarian Or An Idiot?

Are you a contrarian or are you an idiot? Most that claim to be the former are actually the latter.

I’m not sure why so many think that being a contrarian means that you have to fight every trend all of the time but the reality is that a successful contrarian picks their spots.  This is because most of the time the prevailing trend is the correct one and even if it is not it usually outlasts your ability to fight it. The end result is that you lose most, or all, of your money by fighting it. I don’t know about you but this has never made much sense to me.  On the other hand always going with the trend, while ensuring that you are in major moves, also means that you miss a lot of fantastic risk reward situations. Of course I have never claimed to be a contrarian or a trend follower, instead I just try and find trades with good risk and reward characteristics.

Part of my process at The Macro Trader includes a series of questions as well as a model that I have to go through before I can put on a trade. The first question is “What is the trend?” The reason being that unless my reason to go against the trend is very strong…….I should not be putting it on. Another way of saying this is I believe in going with the trend except for when I totally do not. Medium term counter trend trading, being a contrarian, is only really appropriate when you truly have a variant view on what the market should be doing and NOT when you have one or two data points that are contra to what the market is already doing.

One classic example is when you see a stock that is trading at what you think is a clearly unsustainable valuation. Is the P/E ratio really your only reason to want to short the stock? If so you might want to revisit history as it is replete with overvalued companies that got far more overvalued, or that grew our of their overvaluation and never crashed. Using this example you would want to find reasons why this valuations were not just high but unsustainable because sales were declining, debt costs were overwhelming, the sector was falling apart, and the stock was making a topping pattern.  When the weight of the evidence is pointing to a change in trend both fundamentally and technically then it might be a great time to go against it, not when you see one data point that seems out of whack.

Another example, and one more specific and current, is that of the yield curve. If you look at the 5-30 curve in the chart below you can see that it has been consolidating for the past two and a half months. The stubborn contrarian would say that it has bottomed and they would want to buy it as they now expect the curve to steepen.

Yield Curve 5-30 .4

Is the stubborn contrarian asking the right question here? For that matter is the stubborn contrarian asking any question here? Technically this chart shows that the 5-30 curve is in a downtrend and while it has consolidated a bit it has yet to make a higher high. Nothing in the chart is indicating the trend has changed but instead that the trend has slowed down and consolidated.

Instead we would hope that you ask yourself what is your fundamental view of the direction of the curve? Is the Fed going to hike rates in the coming months or not? What is going to happen to the 5-Yr and what is going to happen to the 30-Yr? What is consensus on this trade? How right or wrong is consensus? What is the risk/reward in either direction? And other questions like this. If you then find that your view is far enough away from consensus and that the risk/reward is good enough maybe you do go long a steepener on a breakout of the consolidation. If on the other hand you find that your view is barely out of consensus you might want to rethink your idea as more often than not the prevailing trend is correct.

Another way of looking at this that is purely technical could be to define what constitutes a change in trend. Maybe a breakout above the downward trendline as well as above the consolidation would constitute a change in trend using your rules. If so, a break in the chart below might be sufficient for you to go against the previous trend. If on the other hand you claim to only trade when the technicals match up with your fundamental view then you better actually think that the yield curve is going to be steeper in medium term than it currently is.

Yield Curve 5-30 .5

Notice how so far we have not made a judgement call on what our view of the yield curve is. Instead we have simply tried to walk you through the thought process of going against this downtrend. As discretionary global macro traders we require a strong reason as well as a good chart to get us into any trade. When it comes to going against the prevailing trend we require a lot more as we are saying that we are smarter than the market and by extension the majority of its participants.

All of this has been a long winded way of saying that going against the trend for the sake of being different is stupid. Make sure that you are being objective and that your contrarian view is both your actual view and that it is differentiated enough that it makes sense to go against the prevailing trend. Doing otherwise makes you not so much a contrarian but an idiot.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

The Most Overvalued Currency In The World*

While not quite as cool sounding as “the most interesting man in the world” the most overvalued currency could actually help you make money. Interesting doesn’t pay like over/under valuation. So what is the most overvalued currency in the G-10? If you guessed the Australian Dollar you win. Across pairs the AUD is consistently the most expensive currency and has been for a while.

Why is the AUD so overvalued? They never had a housing crash like in the US and southern Europe, they have strong natural resources, up until this year investors kept believing that China can save all, and last but not least they had the highest short term interest rates in the G-10. With high relative interest rates the AUD has been the carry trade of choice and consequently has been one of the go to “Risk On” trades since the 2008 crash. How high have rates been relative to the rest of the G-10? Below is a chart of G-10 90-day rates. (Click on chart to enlarge)

G-10 90-Day Interest Rates

Combined with the ZIRP or near ZIRP policies in most of the world the AUD has attracted a lot of money looking for yield. Of course you then have to ask is this yield safe? Judging from the slowdown in China and the drop in Australian interest rates we question the safety of this trade, of course we question anything that is considered safe.

So how overvalued is the AUD? Well using PPP-purchasing price parity as our valuation gauge here are a few charts showing how extended it really is. Our first chart is of the EUR/AUD. Here the AUD is “only” 20% overvalued.(Click on chart to enlarge)

EUR/AUD PPP

Next up is the AUD/CAD. Here you would think the relationship would be closer since the makeup of their economies is similar with commodities making up such a large part. Of course Canada is tied to the US and Australia is tied to China. Either way the AUD/CAD is overvalued to the tune of 27%.(Click on chart to enlarge)

AUD/CAD PPP

Looking at the AUD/JPY things continue to get worse as the Australian Dollar is overvalued against the Yen by 40%.(Click on chart to enlarge)

AUD/JPY PPP

Up last we have the worst case of overvaluation of the group. The AUD/USD is ridiculous for several reasons but the one we are looking at today is that it is overvalued by over 50%.(Click on chart to enlarge)

AUD/USD PPP

As you can see by the charts currencies have their share of value fluctuations but like most of finance things are rarely different and it is hard to fight reality forever. Trading currencies based on valuations is not for the impatient as it can take months and even years for things to come back in line but as evidenced by the above charts once the pendulum starts to swing the other direction it tends to carry it for some time. With China slowing down and the RBA in a rate easing cycle we think that the pendulum is ready to swing the other way.

*-We deal primarily in G-10 currencies. AUD is not the most overvalued currency on the planet, but is the most overvalued currency in the industrialized world.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-In our model portfolio we are short the AUD

Take a $1 trial of The Macro Trader to receive unbiased actionable research

The Futility of Buzz Lightyear and QE to Infinity and Beyond

We have all seen a chart similar to the one below of the effects of QE on the stock market.  When the Fed is buying the market moves higher and when it sells it helps the market move lower.  Of course what we have all noticed, well everyone except for Buzz Lightyear at the Fed, is that each successive buy program has led to a smaller and smaller rise in the market.  So the question is with a zero interest rate policy and with an additional and infinite buy program in place, at what point do we decide that maybe it is alright to fight the Fed?  The more we look at it the more we think that their stance is sufficiently weakened that shorting may soon be, and indeed may already be, a viable option.

Looking at the situation from a smaller time frame the results are basically the same.  Here is a table showing how Fed buy days compare against sell days as well as all days for the SP500.  As you can see the out performance was fairly consistent since the end of August 2005.  If you bought the market at the open on the day of a POMO buy and sold at the close you outperformed by a wide margin.  If you held for 10 days you still were winning.

When we go to the latest finished action of operation twist however we can see that, like the large chart above shows, the effects of Fed buying have been drastically diminished.  Buy days still outperform the SP500 by a small margin but does not fare so well against the sell days.  Wen you take it out to 10 days the out performance is almost non-existent showing that Fed buying is not what it used to be.

All of this combined with out slowdown/recession forecast gives us more and more reason to look for shorting opportunities.  If we are entering an earnings led recession and the Fed’s efforts are falling on investors with less and less force than it is getting closer and closer to being safe to fight Buzz Lightyear Bernanke and the Fed.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-In our model portfolio we are long TLT.

Take a $1 trial of The Macro Trader to receive unbiased actionable research

A Case For Buying Treasuries

The majority of investors seem to hate them and the rest are shorting them. While at some point shorting bonds will be a huge trade we think that the timing is still a ways off for the end of the 31-Year bond bull. So what do bonds have going for them? Well the most obvious and yet what seems to be the most overlooked is the simple trend. Looking at the chart below you should ask yourself how many times have investors been convinced that rates were too low? (click on chart below to enlarge)

30-Year Treasury Yield

Aside from the trend we have the current situation with GDP growth of only 1.7% which is very slow for a so-called recovery, especially one that is five years along. In addition we have very slow growth globally as Europe continues to blow up and we keep seeing estimates for China drop every month or two. We have very slow global growth and this is showing in very low inflation data. Yes, the central banks led by Helicopter Ben are juicing the system, hell I hear Ben is dressing up as Buzz Lightyear for Halloween so he can say “QE to infinity and beyond” but the fact is that despite their best efforts inflation remains muted.

In a world of extremely slow growth and chronically low inflation we would expect Treasuries to do well and lo and behold they have. Since QE1 was announced November 25th 2008 we have seen 30-Yr yields drop from 3.632% to 2.988% and the 10-Yr dropped from 3.092% all the way to 1.811%. If this does not make it obvious that QE alone does not cause the bond market to crash then nothing will. No, until we see stronger growth and a large pick up with inflation we expect fundamental picture to remain decent to strong for Treasuries.

Now of course we are going to get some people saying “but bonds are up too much” our natural response would be something like WTF? but our more reasoned response would be compared to what? Bonds have been up “too much” for the last 20 years. Who would have ever thought that 5% 30-Yr interest rates would sound high? Rates are low but they are a long ways from 0% which would indicate that they have room to go lower. That said what does the technical picture look for bonds? In the chart below we have our intermediate term 30-Yr Reversion to the Mean (RTM) chart. While the RTM chart isn’t saying load the boat it is also not saying run for the hills as it is instead giving us an almost perfectly neutral reading which indicates that bonds have plenty of room to go up or down before reaching anything near an oversold/overbought point. (click on chart to enlarge)

30-Yr Treasury RTM

Finally, at least for now, is the sentiment picture. We all know that volatility is one of the most mean reverting series in all of finance. In the chart below we have the Treasury MOVE index vs the 30-Yr yield and then we have overlaid the 30-Yr yield with an inverse scale. We inverted it so it is a better visual as to what happens to bond prices when the MOVE index is so low. As you can see when Treasury volatility is really low it is usually a time to be buying bonds and when it is high is when you should be selling. Well right now we are hovering close to the lows of the past five years indicating that bonds could take off at any time. (click on chart to enlarge)

So is going long bonds the new trade of the century? Nope not by a long shot. Still that doesn’t meant that there isn’t a case to be made for being long. The economic fundamentals are in place, unless you think we are the cusp of a huge growth spree. The technical picture is saying that while its not a perfect buy there is plenty of room to run. Finally sentiment/volatility are saying that the time in at hand for a renewed move higher in Treasury bonds. Obviously we could be wrong but the risk reward is there.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-In our model portfolio we are long TLT, AGG, and FLAT.

Take a $1 trial of The Macro Trader to receive unbiased actionable research