Waze to Go!

Using the wildly popular app for navigation, Waze, drivers can navigate around traffic jams quite easily. The advantage Waze has over simple navigation is in the user community's ability to interact and provide 'real time' data on ever-changing road conditions. The driver doesn't need to have a pre-set route. She just listens to the turning instructions and responds accordingly. Users constantly provide the data and the least-time algorithms do the rest.

Could the Chairman of the Fed be using an economic equivalent of Waze in his deliberations on policy?

It would seem so, from reading Jerome Powell's speech at the recent Jackson Hole conference. His reference to "shifting stars", a reference to the asterisk notation often used in econometric models, implied increased flexibility in the use of data in formulating policy.

R* is often cited as the holy grail of Fed policy settings. It is the inflationary-adjusted short term rate that is consistent with the full use of economic resources and steady inflation near the Fed's target level. The chart below shows the estimate of R* over time. It is hardly stationary! Fixed ideas on Fed policy levels are now as outdated in the current world of realtime data as paper maps.

Source: Federal Reserve Bank of San Francisco

The 'Taylor Rule' for non-inflationary growth and the 'Phillips Curve' for unemployment, are the Perly's maps of economic guidance. (anybody over 50 remembers Perly's - the rest of you ... Google it).

With his pronouncements at Jackson Hole, Powell basically has thrown these models out like so many crumpled up road maps.

Monetary policy circa 2018? There's an App for that.

Implications for markets are less clear, but mostly the interpretations are supportive of a dovish shift. Short rates can now be expected to move in a less proscriptive manner. Just because unemployment is below 4% or inflation is above 2% doesn't mean rates need to rise. Get ready for a pause in rate hikes.

This provides ammo for the Bulls on asset prices. The market rally in the U.S. since Jackson Hole has reflected the dovish implications of the new Powell doctrine of 'shifting stars'. It is a precursor to the real shift that will come when inflation rises above the policy range of 2%.

I believe the Fed is so afraid of a curve inversion that they are setting up a dovish defence in advance.

Because of geopolitical threats, demographic forces and the lack of global fiscal policy alignment, there is a glut of savings that is flooding into the U.S. depressing long yields. Global risk aversion is powerful global force for depressed long term real rates.

As well, credit spreads in the U.S. are aberrantly depressed, despite rising balance sheet leverage. The yield starved pensions are having their risk appetite force-fed by excess savings phenomenon in Treasuries. After the 2008 collapse they embarked on the "Great De-risking of 2009-16", purging public traded equities for a new policy mix that emphasized risk-adjusted returns. Credit products in all markets soared and spreads compressed. And the pensions still have to keep buying junk bonds to make their assumed returns.

For foreign investors, what does it matter that inflation erodes the value of bonds when the currency gains offset the paper loss. Eurozone and Asian savings are still being recycled into the U.S. market, supporting prices. Until Draghi starts to normalize Eurozone policy, the inflows to treasuries will continue unabated. Its unlikely he will move aggressively, given the weakness in Eurozone growth and the growing populist backlash against German austerity.

And U.S. yields continue to founder, despite record issuance, a growing primary budget deficit and a rising CPI. The last environment like this was the late seventies. Then, rates were kept artificially low despite rising inflation because the Fed was afraid of domestic economic stagnation. By the end of the decade, inflation was out of control, ushering in Paul Volker and his punishingly tight money.

Back in the 20th century, in a more "closed" economy, the Fed only concerned itself with domestic matters. They don't have that luxury in the globalized world of today. They cannot control the long end anymore than Trump can silence Stormy Daniels.

The 2s - 10 spread is now 20 bps and falling.

The "Squeeze Play" is on.

After his "shifting stars" comments, I'm now thinking that Powell will blink.

Buy some gold. Seasonally strong returns are imminent.

The Most Hated Bull

David Rosenberg of Gluskin Sheff has recently disputed my long held belief that this is the most hated bull market in history. Some of his arguments are specious. The proportion of wealth argument is self fulfilling in a rising stock market. The flows into ETFs argument ignores the low risk profile preference of those flows (it includes income and bond funds). But most importantly, he cited the recent AAII survey of 36% bulls and 29% bears as support for this argument. This cherry-picked weekly reading ignores the fact that bullish readings in August plunged to near cycle lows and the smoothed weekly longer-term moving average has been declining since 2005.

Adam Bomers (pension advisor to the stars) and I have extensively back-tested AAII and found the ratio of Bulls to Bears is the best indicator. The last two cycles are shown below. The lower slope on the second of the two bull markets shows a decidedly more tepid uptake of risk appetite than was experienced previously.

Figures lie and ...

Ratio of AAII Bulls to Bears

Risk Model: 4/5 - Risk On

As I had expected last week, the improved risk appetite evident last week following Powell's dovish message, combined with strong corporate results, especially in retail, have boosted the AAII Bull/Bear ratio above the 30wk moving average, kicking the model into a sweet-spot level of 4 out of 5.

Economic slowing in global markets, combined with a strong U.S. dollar have depressed commodities, especially copper.

Its ratio to gold is stuck in risk-off mode.

Should U.S. continue to rally on the Trump trade deals (Canada will capitulate and sign) the over-bought market will top out soon. China will be used as a political football for the elections and the more critical trade deal with them is unlikely. The Eurozone must endure the populist backlash in Italy and France, so I doubt they will join the economic stimulous party anytime soon.

Copper is telling us that something is still rotten in more than just Denmark. I just can't get behind a market that continues to make new highs on fewer groups and weak banks. Without seeing a lasting economic rotation to cyclicals, I'm just not a player.