Anchors Away

Being a retired old guy has its advantages. Time is the biggest one. Time to do things. Things that would otherwise not fit into a busy schedule.

Recently, with visiting friends, I toured the 'Keewatin', a 1909 decommissioned CP passenger ship, now a floating museum in nearby Port McNicoll. This once proud vessel plied the Great Lakes for 60 years, taking passengers in grand style to Thunder Bay for their journey to the West. The ship was built in Glasgow Scotland, sailed to Montreal and cut in half in order to fit through the then shorter Welland canal. You can still see the riveted iron plates that re-joined the two sections.

This ship, with its museum-quality exhibits, is well worth the visit. It takes one back to a bygone era of elegance and stylish travel. Our tour guide was knowledgeable, if not a bit too scripted. She told us of an incident during one voyage that sparked my interest.

Apparently, one of the ship's chains suddenly gave way during a storm and an anchor was lost to the depths of Lake Huron. There was a replacement made locally and the ship now sports one Scottish anchor and one new Canadian partner.

Financial anchors, those of the behavioral economics kind, can also give way too, it seems.

Anchoring of inflation expectations is much on the mind of central bankers as they struggle to push the 'economy rock' up the 'growth hill'. Generating a collective consensus on the forward rate of inflation -known as 'anchoring'- is a primary goal of the Fed. They see it as a way of stabilizing the system, avoiding dangerous, uncontrolled bouts of inflation or deflation.

But I believe they are starting to lose control of current inflation expectations, thereby risking a dangerous deflationary feedback loop.

The explicit policy of 2% inflation, codified in 2012 by Bernanke's Fed, is an increasingly chimerical goal. It is now impossible to achieve and increasingly irrelevant in the modern globalized economy.

There is nothing magic about 2% as a level. It seems to have been a number picked out of thin air. Economic systems, with their natural entropy, don't naturally inflate without constant stimulus. Systems tend to run down, and global central banks are running low on ammo to fight this trend. And now, the markets know it.

Like a ship in a storm, inflation expectations have been attacked from above and below. Global export growth is in free-fall, owing to the supply-chain chilling tariff war. Weakening commodity prices are a direct result of this zero sum game of trade chicken. Technology and demographics have undermined the traditional linkage between consumer spending and inflation. One can add income inequality to this mix as we are seeing a loss of affordability in housing.

'Easy money' monetary policy has mostly pushed up the price of assets instead of goods and services. As a result, bond markets have started 'pricing in' a downward step function in inflation expectation levels.

A useful tool for gauging market expectations on inflation is the interest rate futures market. The Fed publishes this data on the gap between current and 'forward' interest rates. The chart below shows just how the five year, five year forward curve is breaking lower, heading for a test of the 2016 lows around 1.5%.

5 Year Fwd Inflation Expectations 2015-2019

Just how persistent and embedded inflation expectations can become is seen in the longer term version of this series, shown below.

5 Year Fwd Inflation Expectations 2003-2019

For many years the curve was above 2.5%, surprisingly even after the 2008 financial crisis (shaded area). Only in the "what ever it takes" era of the ECB that followed from the 2015-16 mini-recession, did investors start to question the ability of central banks to generate an inflation rate above 2%.

The 2.5% anchor dropped away in 2015.

My reading of the recent move lower is the 2% anchor is now failing. With the U.S. thirty year treasury at 1.97% this morning, the final nail in the coffin of the 2% inflation expectation regime is being hammered down.

US 30 Yr Yield- 2005-2019

The bond market has gotten to the point of no return. It has been pushing the FED ever since the December '18 market break. Hence the inverted curve. The Fed is openly talking about the curve, but they are acting cautiously, waiting for confirming data. Either the market is right or the Fed. Right now they are agreeing to disagree.

An 'anchored' Fed is a dangerous Fed. They are staying patient, needing to see 'bad' data on which to act to normalize the curve. Former Fed Chair Janet Yellen, has chimed in on the inverted curve saying effectively 'this time is different'. I get that it's different. But not in a good way.

Global forces are overwhelming the domestic-centric Fed. That's what's behind their resistance to normalizing the curve. They should realize there is already plenty of bad data, just not in any of the domestic Fed regions. Look at Chinese growth and German exports for your bad data. As the central banker to the world, this should be of more concern to an antiquated, parochial Federal Reserve.

Soon, the U.S. will start to see confidence-sapping declines in domestic manufacturing as a direct result of the global slowdown and the tariff tantrum. There are already job-layoff notices being issued in the auto sector. Housing has been resilient, but affordability, not income, is slowing that sector too. Do you want to wait for more of that narrative to unfold? I don't. Risk assets will remain vulnerable for now. The Fed will inevitably acquiesce to the market view.

In a Bloomberg essay this morning, former Fed Vice-Chair William Dudley, as much as said the current Fed should tank the economy in order to counter Trump's badgering. Dudley's right in a political sense, but the fall-out from that approach would not be pretty. Chairman Powell is now being caught in a squeeze play, not wanting to be seen sucking up to Trump. Unfortunately Trump's right, although for the wrong reason. Powell should be more Dow dependent and less data dependent in my view.

To make matters worse for him, the bond market has sided with Pres Cheeto.

My advice to the FED: anchors away!

Risk Model: 2/5-Risk Off

I note with interest that the Copper/Gold ratio break of the triggering 50 dma in early May coincided with the high in the TSX. What is interesting is that the XIU has not corroborated the new lows set by the Cu/Au ratio recently.

The recent sentiment extremes should have been enough to send stocks lower than their June lows if they match the commodity market signal. I can only conclude that the TINA bid is still at play here.

The fact that bank yields are 400 basis points above 5 year Canadas means bank bears are trying to push a beach ball under water. Cue the asset mix rotation towards equities by the longer term players.

We'll need a real earnings recession in order to set new lows. The jury is still out on that one.

Copper/Gold - top panel

XIU - bottom panel