Sunday, March 22, 2015
Size Matters & Their Estimates are Still Too Damn High
With the U.S. equity markets continuing to make and trade near their all-time highs, and as the U.S economy further distinguishes itself as the best street in an otherwise downtrodden neighborhood, it’s easy to get lost in the minutia of yet another Fed meeting deliberating a strong dollar and future rate hikes – and forget where we currently reside in the trough of the long-term yield cycle and the considerable history that brought us to this point. Looking back at the span of the broader cycle, you’ll find it was a period in history that encompasses 70+ years of remarkable growth – the last 30+ of which were traveled with increasingly benevolent credit conditions, in which the U.S. has enjoyed elevated equity market valuations on the back of a proportionately massive secular downdraft in yields.
Over the past four years since we first started sharing our thoughts on the market, we’ve commented on the relative symmetrical retracement in yields from their secular peak in 1981, extrapolating a mirrored projection that has rightfully guided our future expectations of lower for longer. Many times, complexity can be distilled with a simple solution or explanation. Einstein’s genius frequently displayed this kind of elegance. “It is the theory that describes what we observe”, he said – and his theories were as elegant as his understanding brilliant. Along those lines, although admittedly less brilliant (but certainly simple), we’ve observed great symmetry in the rise and return of the long-term yield cycle, with the basic theory that the return would be commensurate with the rise – as markets and economies wrangled with the complex and interconnected webs of their respective credit and growth cycles.
Interestingly, the relative symmetry represented in the current yield cycle is not unusual and quite characteristic when you look back at history. The previous cycle (from trough to trough) spanned 40 years to the month; a period in which yields rose for 20 years – followed by a 20 year decline. Unlike the current downtrend in yields that has trended to the trough with increasingly more symmetry with the mirrored rise in yields from 1941 to 1981, the previous cycle exhibited an asymmetric return below the 1901 lows, as economies pushed up against the limits and unbalances exposed and magnified during the great depression – and markets stumbled their way across the transitional divide to the next growth cycle.
When we approach future market expectations from a comparative perspective of low yields facilitated by extraordinary monetary policies following a financial/debt crisis, you arrive at a similar appraisal with the mirrored return profile – in that yields will be low for the foreseeable future. Even for long-term investors, patient may well prove to be an understatement when it comes to the length of the broader cycle’s trough. As shown above in Figures 3 and 4 – and especially evident below in Figure 6, the historic profile of the previous trough throws cold water on expectations that the Fed will be capable of raising the fed funds rate to ~ 3 percent by 2017 – or even 2027. Moreover, if our theory that the broader cycles “size matters” and influences the proportions of the return, it should be noted that the previous trough in yields followed a significantly smaller secular peak and cycle. All things considered, while they may look to raise rates marginally off ZIRP over the next year, expectations are still too damn high with respect to the magnitude of the potential move. Nevertheless, as mentioned in previous notes and implied by the mirrored return and historic analogs, we would still estimate that risk over the intermediate-term is for higher yields. The difference, however, is that we do not expect a sustained move higher – and would look for a trough range to continue to develop, with a mid-point ~ 2.25% for the 10-year.
Similar to the relative performance extreme registered in 10-year yields at the end of 2013 (which was also the closest move from a relative performance perspective with its secular peak in 1981), the USDX may be poised to complete a more symmetrical retracement of the potential blowoff move in the dollar that began last spring. If so, Treasury Secretary Lew’s “strong dollar/strong U.S” will be just a faded memory come Christmas and a potential foreboding premonition for what has been leading strength in U.S. markets over the past several years.