When you get such an enormous reversal, especially over a year- end, it takes a lot of mental and emotional fortitude/recklessness to do it. A fund manager has to go to his investor base and not only explain that he got the deflation idea wrong but that he is now positioned fully in the inflationary opposite to what he had only a few months ago. Eyebrows might be raised! At least on this occasion, the unexpected Brexit/Trump fiscal boost might have been a tolerable excuse. Certainly if the fund management community were to waver again, on the new reflationary positioning, it would be totally unacceptable. So they simply cannot do it. They are really wedded to this position, right or wrong. The turnaround has been so quick that to reverse it again would simply be nonsensical. Let me be clear, I am NOT saying being short bonds and long commodities is wrong, it is simply overcrowded and due to the speed of the reversal it will take longer for anyone to admit defeat, if needs be. That is a dangerous set up, if or when it occurs.
real returns. For anyone with savings in Germany, that would mean your savings, by doing nothing, would fall in value by roughly 40%, over ten years. Call me old-fashioned but consumer spending and GDP don’t benefit heavily in those circumstances, unless wages accelerate considerably to compensate.
However, the peripheral European bond markets have been falling swiftly. Italian 10 year bonds, over our two month period, have seen yields rise from 2.00 % to 2.3% . The danger with peripheral Europe is that it can be swept into a death spiral fairly quickly, especially as their banks have been forced to hold, and mark to market, an enormous amount of their own countries debt.
Five year chart of speculative positioning in US 10-year Note Source: Bloomberg Finance L.P.
It is a concern that inflation, being a state of mind as much as a mathematical calculation, is taking hold. We all knew that inflation in the first quarter of 2017 was going to be elevated due to the crude oil base effects but it is a surprise how much more inflation has emanated from weak currencies and by how much other commodities have joined the game. The world’s central banks will readily try to ignore real interest rates. They have pillaged retirees for a number of years with low actual interest rates and they will attempt an even dirtier sleight of hand by keeping real interest rates heavily negative.
The Japanese have interestingly been heavy sellers of foreign bonds recently as their own interest rates, albeit only pitifully positive in actual terms have actually become acceptable in real terms compared to the developed world equivalent!
However, when real interest rates are ignored for too long, or by too much, those aberrant countries eventually have their currency sold off. This creates the spiral of lower currency, higher inflation, lower real returns, lower currency etc . The markets will get you eventually. Real interest rates are real money investments. German 10 year bonds sit at 0.44%. There is idle but entertaining discussion that if the ECB reach their pan-European 2% inflation target, German inflation would have to be close to 4% : That implies 3.46% negative
The spectres of a reduction in ECB QE and of ‘reverse QE’ by the Fed, through the process of balance sheet reduction, which is potentially the biggest theme this year, do not favour bonds. Those vital flows are more Q2 effects. With economic surprise indices sitting at very elevated levels , the scope for disappointment is high. Any time over the last 30 years when we have had a recipe of a 100% YOY increase in the crude oil price, a marzipan layer of a 100 % increase in YOY long end Treasury yields, and the topping cream of a strong dollar, the US economic cake has been so overbaked , a significant slowdown, and normally a recession, has ensued. It does seem ironic that everyone now seems positioned the other way. The most concerning aspect of US herd like investing is that they very rarely see the lateral consequences of the actions that they are positioned for. With globalisation being unwound, for every ‘ying’ that Trump for instance might impose, there will be a yang elsewhere. While everyone positions for yings, and then creates over-crowded trades, yangs are what then appear to make the trade go wrong.
As an example, if the US Administration were to allow the repatriation of all the corporate offshore dollars, primarily ‘eurodollars, it could cause a massive liquidity shortage of offshore dollars outside of the United States. With no fungibility existing between these two, onshore and offshore dollars, highly indebted countries –like China- could witness such dollar liquidity shortage, that it would imperil their banking system, as lenders of enormous quantities of dollar debt. It is important not to fight momentum and
to allow positioning to develop to its most overzealous level but, while waiting, look for some yangs.
Andy Ash E:
andy.ash@
admisi.com T: +44(0) 20 7716 8520
9 | ADMISI - The Ghost In The Machine | January/February 2017
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