"Time to SELL bonds; cyclicals vs. defensives - extreme signals; the message of the yield curve; & why gold isn't about geopolitics"

Below is a round-up of Longview related views/research & trade ideas – the intention is to publish this most Fridays, updating key themes and highlighting key pieces of (often contrarian) research. Feedback, as always, is appreciated. Equally just ‘unsubscribe’ at the bottom if you don’t want to receive the email.

Time to SELL Bonds?

US bond prices have moved sharply higher in March (+2.1% so far this month on US bond futures). Month to date, that represents their strongest monthly return since 2016 (albeit with one remaining trading day in the month). With that yields have, of course, moved notably lower, breaking below recent support levels at around 2.50 – 2.60% yield. From the close on the first trading day of this month yields have fallen by 37bps (i.e. from 2.76% to 2.39% at last night’s close).

As we laid out in our ‘Longview on Friday’, 8^th March (see HERE), a move to/towards a 10 year yield of 2.20% is/was our central case scenario*. That was based on: i) our interpretation of the US mini cycle (see HERE); ii) some expectation of giveback in risk assets in March, or just some sideways trading; & iii) the positioning of our bond trading models.

Much, although probably not all, of that has now played out. Most notably the bond trading models are mostly now back on SELL (including FIGs 1 & 1b – the market timing and market positioning models), while equity market sector rotation has been swift. As such, positioning is now increasingly looking extreme. That is, defensives, on a variety of models, are overbought and over-owned and it’s time to start moving into cyclical sectors of the global stock market.

FIG 1: US bond futures market timing model vs. US 10 year bond futures price

*NB although in the very long term, in our view, bonds are now in a multi decade bear market – see this piece from 2012 & 2016 (available HERE & HERE).

Added to that, in recent weeks, central banks across the globe have been following the Fed’s lead and rapidly changing their outlook with respect to monetary policy. This week, the RBNZ left rates on hold but said a weak external environment meant its next move was more likely to be a cut (RTRS). Money markets have priced in a cut in Australia this year (and possibly a second). In Malaysia, rate cut calls are growing louder as inflation has turned negative, while in Japan policymakers debated further stimulus amid concerns over waning global demand (see the minutes from the Bank of Japan’s March meeting). South Korea is also reported to be “a new and unexpected member of the club of potential rate cutters” LINK.

Interest rate futures markets are, as is often the case, ahead of the central banks. US fed fund futures, for example, are pricing in cuts of 29.5bps in 2019 and 31.5bps in 2020 (FIG 1a). This is, of course, a very dramatic shift from the start of Q4 2018, when interest rate futures were pricing in over 50bps of hikes in 2019 (as a whole).

FIG 1a: US Fed funds futures ‘interest rate’ expectations in the rest of 2019 and in 2020

FIG 1b: Net speculative LONG/SHORT positions (US 10 year bond futures) vs. US 10 year bond futures price

Sector implications and positioning

Importantly the behaviour of bonds remains a key driver/determinant of relative sector performance. When bond yields trend lower, defensive sectors outperform cyclical ones. When yields trend higher, the opposite typically occurs (FIG 1c). As such, correctly forecasting bond yield direction is critical for forecasting relative sector performance. 

That point is illustrated by FIG 1c below. This chart shows the performance of US bond yields plotted against the relative performance of cyclicals versus defensives (i.e. a basket of equal weighted global cyclical sectors versus a basket of equal weighted defensive sectors). Over the course of this bull market/economic cycle, the correlation between the two has been high.

FIG 1c: US 10 year bond yields vs. relative performance of global defensive vs cyclical sectors

Consistent with that relationship, the relative performance of financials versus utilities correlates well with our bond market timing model.

BUY signals on bonds in early 2017, and then again in early 2018 (N.B. the market timing model is inverted), worked well as multi month BUY signals on the utilities sector relative to financials (FIG 1d), as well as for the consumer staples sector (also relative to financials - FIG 1e). All three sectors are known for their correlation with bond yields.

With our bond market timing model now generating a SELL signal on bonds, it increasingly makes sense to shift out of defensive sectors and into cyclical sectors (including industrials, financials and energy/materials). That sentiment is consistent with the shift in monetary policy from many/most of the world’s major central banks (as highlighted above).

If, therefore, our US mini cycle thesis and our expectation of a turn in the Chinese credit cycle are correct, then the US yield curve should steepen later this year. With that, cyclical sectors should outperform.

FIG 1d: Market timing model (US 10 year bond) vs. relative performance financials against utilities

FIG 1e: Market timing model (US 10 year bond) vs. relative performance financials against consumer staples

While the bond market timing indicator typically works on a multi month (6 month or so) timeframe, other shorter term indicators are generating a consistent message.

ETF fund flows into cyclical sectors have fallen sharply in recent weeks, such that the indicator is now generating a short term BUY signal (FIG 1f)…....

FIG 1f: ETF fund flows into cyclical sectors (materials, industrials & financials, $mn/day) vs. CME S&P materials sector futures index

……while our global sector risk appetite model, having generated a strong SELL signal in late January/early February (i.e. a few weeks early), has worked its way lower and is now back on BUY (FIG 1g).

This model draws upon daily price movements from over 60 global sectors (i.e. Bloomberg defined sectors). For each trading session we draw risk curves using those global sectors and determine the global appetite for risk in this part of the global financial markets. The swift move lower from high strong SELL levels in early February to BUY levels currently, reflects the sector rotation within the global equity market (i.e. the shift into lower volatility defensive sectors and out of higher volatility cyclical sectors).

FIG 1g: Global sector risk appetite model vs. S&P1200

….consistent with those messages, financials are also oversold relative to utilities (FIG 1h)…..

FIG 1h: Global ‘financials relative to utilities’ technical scoring system vs. relative performance

Extract from Longview Letter No. 122: "The End is Nigh (just not yet)"

The list of things to worry about is growing. Last week, the market’s interest was piqued by the inversion of the yield curve (using 10 year less 3 month yields). This is the first inversion in this cycle. Below we assess its efficacy, timeliness and usefulness as a recession warning signal (along with the efficacy of the steepness of 10s2s and 30s10s). 

In addition to that inversion, the lengthening list of concerns includes: i) the first warning signal from our liquidity indicator since just prior to the last recession; ii) a rising likelihood of recession in Australia, Canada (see forthcoming research) and the Euro zone (see qtrly asset allocation no 37, 14^th March: "Eurozone: The new Japan"); iii) the behaviour of bond yields; and iv) signs of dwindling confidence amongst US consumers about the future. Pls see Longview on Friday, 1^st March 2019: "What are the risks?", for further analysis of those concerns.

Fig A: Longview US (economic) Recession Indicator vs. GDP growth (inverted)

How good and timely is the yield curve as an indicator?

In the tables and sections below, we have analysed the efficacy of three measures of yield curve steepness. These are typically the most widely followed measures of the curve’s steepness. Those three are: i) The steepness of the 10 year less 3 month yields; ii) the steepness of the 10 year less 2 year yields; & iii) the steepness of the 30 less 10 year yields.

Table 1: Yield Curve Inversion Signals & Recession Dates

*2nd ‘double dip’ recession of early 1980s

Source: Longview Economics

See HERE for detail…

Extract from Commodity Fundamentals Report: “GOLD – Geopolitics doesn’t matter much (if at all)”    

Global geopolitical tensions have escalated in recent years: the US – China relationship has become increasingly fraught as China has sought to grow its global political influence* and the US, under Trump, has pushed back. Elsewhere, populism remains on the rise in Europe with extreme parties on both the left and right side of the political spectrum increasing their share of the votes. As an expression of that, the UK & EU continue to struggle to conclude a Brexit deal. Russia, meanwhile, continues to meddle in Western affairs (whether elections or assassinations on British soil) while seeking to absorb small territories on its border with Eastern Europe.

Possibly reflecting that rise in global tensions, central banks have markedly increased gold buying. Russian holdings, for example, have been increasing since 2006, with that rate of growth having increased sharply since 2015. Likewise, Chinese stockpiles have been growing since the early-2000s (see fig B).

Fig B: Russian & Chinese gold holdings (tonnes) vs. gold price (USD/oz)

* (Italy, for example, recently became the first G7 member to join China’s Belt & Road initiative)

Unsurprisingly, gold bugs use that narrative (i.e. of renewed central bank buying) as another reason to be bullish on gold (e.g. see the LBMA Precious Metals Forecast Survey 2019**). The key question, then, is whether they are right, i.e. will increased geopolitical tension and concomitant central bank buying of gold significantly change the supply & demand balance and drive the gold price higher? Or, put another way, what is the price outlook and what’s likely to drive it?

See HERE for detail…

Have a great weekend.

Kind regards,

Longview

Longview Research Recently Published

This week:

Longview Letter No. 122, 29^th Mar 2019:

"The End is Nigh (just not yet) a.k.a. The Efficacy of yield curve inversions (and the message of other signals)" – see HERE

Commodity Fundamentals Report No. 92, 27th Mar 2019:

"GOLD: Geopolitics doesn't matter much (if at all)" – see HERE

Weekly Market Positioning Update, 25^th Mar 2019:

"Currency positioning: EM vs. DM"

Last week:

LV on Friday, 22^nd Mar 2019:

"Brexit: The (attractive) risk reward of UK assets" – see HERE

Extract from Quarterly Asset Allocation No. 37, 20^th Mar 2019:

“(continue to) Position for ‘Global Reflation’ in Strategic Portfolios” – see HERE

Extract from Quarterly Asset Allocation No. 37, 19^th Mar 2019:

“Global Valuation Chartbook: Valuations Now Compelling (in certain markets)” – see HERE

Weekly Market Positioning Update, 18^th Mar 2019:

"Shifting message from the bond & rates market"