Shot Across the Bow

In any naval skirmish, someone has to shoot first. Often the first move is a warning shot, meant to scare off the opponent. It's a shot across the bow of the ship. Last week saw the bond market start the battle for investor hearts in earnest.

Even for casual readers of this space, this is not news. Given the enormous amount of stimulus thrown at the economy many expected this to happen, just not this fast. The median forecast for the U.S. ten-year bond yield from Wall Street was 1.4% - by the end of 2021! Right magnitude wrong timing. I have been calling for a rising rate environment since January, and now we have it.

Why does this matter? Aren't yields still near generational lows and below inflation expectations? Yes and yes. It just wasn't in peoples' heads that the price of money could change so quickly. Just how quickly is in the chart below, the 6-month rate of change of the 10y bond yield. It was a huge move in a very short space of time, dwarfing anything seen in the past 20 years.

10 Bond Yield; 6mo ROC

The markets reacted with a sharp, but short-lived, shudder. This seems reasonable given the fundamental improvement in the economy is the narrative behind the yield shock. Stocks still have a risk premium embedded in them, given that, based on forward earnings, the S&P 500 has an earnings yield of 3%. And those expectations are still rising. So what's the problem?

As usual, it's all about expectations. The bulls, fixated on the hoped-for recovery were caught napping. Investors are now faced with the daunting prospect of continuing to price securities at record high multiples while adjusting their interest rate expectations - a natural enemy of those lofty valuations. Something has to give. You can't have your cake...

With investor sentiment at elevated levels, the natural reaction is to call for a 'top' in the market. It won't be that easy. The high savings rate and relatively low levels of risk asset positioning should allow for an increase in the more cyclical areas of the market. The short duration trade now being rewarded in the bond market is a story increasingly being embraced by stock pickers. While duration is a wonky fixed income term, I use it here to describe the type of stocks that benefit from a cyclical rebound, like banks, materials and energy.

The problem I see is in the herding mentality in the current market. At one point last week, bond yields spiked 10 basis points, rising quickly above 1.60%. It doesn't sound like much but it had the feel of a flash crash. Were it not for some quick intervention (likely from a Fed call to the Street trading desks), the markets could have melted down.

Powerful forces are at work here. The holders of fixed income products in retail accounts have seen them lose 4 years of coupons in less than a week. "Down ten percent" isn't in the vocabulary of retired investors when discussing their previously 'safe' investments. Their advisors are running scared now, reluctant to push them into higher-risk equities, especially at all-time highs.

For now, the market has maintained its composure. The volatility spike last week was fleeting. As I pointed out last week, the "rotation trade" is in charge. Yesterday's action was a rally of everything - including the beaten-down growth stocks. Today, the one-day trade in over-priced growth segments is looking more like a dead cat bounce. They will continue to face the headwinds of rising bond yields as long as an economic rebound is driving expectations.

While the accepted narrative is one of a benign reaction to rising rates, it makes me wonder what could upset the apple cart. As we struggle through the next few weeks, and after a huge move in risk assets over the last six months, second thoughts will start to creep in. It may finally be dawning on people that the free pass issued by the Fed has a time limit on it. The better the news on the economic front, the worse I expect stocks to do. And hiding in the rotation trade won't be easy. The speculation that I worry about isn't in Gamestop - it's in copper.

My favourite indicator, the Copper/Gold ratio, as you know has been flashing a buy signal for weeks now. As investors in gold have been made to look foolish by Bitcoin fans, metals investors are loading up on futures positions in the red metal. And loaded up they are - just look at the positioning charts (below). Speculative levels in the Chinese market are similarly stretched and this past week saw a Chinese fund take an enormous 120,000-ton long position, dwarfing the near-term ability of commercials to supply the counter-party positions.

It's is a bit like Gamestop when you think about it. Speculators cornering a market.

So I can't go on blithely recommending risk assets when there is so much froth. Even my copper trade looks like it could come unwound. I don't like the tone coming out of the Chinese administration this morning - talking about 'bubbles' and blaming the Fed. I have said before that they don't like to lose control of markets and especially in economically important metals like copper.

As we transition to the long-awaited reopening of the economy, with all its reflationary potential, the balance of risks argues for a correction at some point. Last week was a shot across the bow by the bond market. Turbo-charged growth and inflation from a full recovery are highly possible, given the mistimed fiscal stimulus now being rushed through by Biden and his blank-cheque cheerleaders in Congress. Next time, the backup in bond yields won't be so friendly. It may start shooting to kill at some point this year.

Risk Model: 4/5 - Risk On

I'm not so sanguine as our happy risk model this week. I base that on the stretched levels of speculative positioning in both copper and gold - one positive and one negative. The chart of the relationship is instructive. The initial stage of a Fed-induced reflation often gets over its skis as financial players rush to judgement. A correction often follows.

I believe we are at risk of taking the Cu/Au ratio as a signal to go 'risk on' at our peril. The supply shortages created by last year's Covid19 mine closures won't support prices as they did last year. Just as I have been saying 'there is lots of $60 oil', I believe 'there is lots of $4 copper' in the short run. I see the upcoming OPEC+ meeting as a possible peak for $WTI prices this year. Watch for the Chinese authorities to clamp down on the metals mania shortly.

Copper/Gold Ratio

Gold fund flows are hugely negative as the strength from a U.S. dollar short unwind and the Bitcoin mania deflects attention (if not investment dollars). I don't think that we have seen the last of gold just yet. The inflation cycle has just started and all that bond money has to go somewhere.

Buy the dip.

Gold Fund Flows