Bonds & Currencies

[Paul MBMG]

Half Truths

Reuters Feb 21, 2005 “U.S. inflationary pressures remain muted despite a surge in January wholesale prices, Cleveland Federal Reserve President Sandra Pianalto said on Monday in remarks that dampened concerns the Fed would quicken its pace of rate hikes ... A surprise 0.8 percent January jump in the core U.S. Producer Price Index, which excludes food and energy, unsettled markets on Friday. But Pianalto showed no undue concern ... "Business people I talk to continue to say they continue to see some rising input costs. But they are not able to fully translate these rising input costs into their own prices," she told reporters when asked about the jump in PPI.”

For some time now we have highlighted the disconnect between the short term positive momentum of the market and the negative underlying fundamentals. In the last quarter of last year we believed that stocks would rally strongly despite themselves and would run out of steam sometime in the first quarter of this year. That call is looking pretty good now. Just before the Christmas holidays we forecasted a short term Dollar rally which took place and which might or might not have run out of steam already. We've also long believed that this year would start with a fear of inflation and that would turn into a realization of disinflation/deflation as the world turned recessionary towards the year end.

These tensions in the bond market are captured by one of our favourite commentators, Michael Belkin who like MBMG tries to look at the picture and see it for what it is, not make the stats fit in with a view of the markets that is cast in stone. Therefore when Belkin says that he sees a change in the direction of the markets, we tend to sit up and take notice. Belkin changed some positions significantly this week, mainly in bonds, commodities and sector and industry group rotation (but not stock index direction which has been negative since around the turn of the year). Belkin's recommended portfolio has been long the US 30yr bond future and has had a short commodity bias for awhile. His concept was that Federal Reserve negative real interest rates (fed funds = 2.5% CPI = 3.4%) have squeezed many market participants into reflation trades -- and rising interest rates (and liquidation) would squeeze the consensus out of those trades (short dollar, long commodities, overweight materials and industrials, etc.). Fading that reflation trade has worked (modestly) for months -- US bonds and the dollar rallied, while energy and precious metals prices declined.

However the outlook is changing. Belkin has gone from long to short on US bonds and many other global bond futures, saying that "a global bond top has been approaching in the model forecast for awhile -- it has probably now arrived. Rising energy prices and rising US short-term interest rates have undermined bond markets. There could be a short-term bond bounce -- we recommend selling into it and going short. Global bond prices should fall significantly over coming months."

His second change is in terms of US inflation. From a mild upward forecast for core CPI and PPI, he now sees more of a sharp spike in inflation (which we would see as the peak before a deflationary turn of events) adding that "those 25 basis point rate increases have left the Fed way behind the curve. Negative real interest rates tend to light a fire under inflation. The Fed is still pumping gas onto the blaze instead of water."

His third change is a recognition of the market's waking up to what we saw as an obvious fundamental some time ago - the increase in the cost and value of commodities, at this stage mainly metals and grains, with the outlook for energy neutral but improving (so watch out for higher oil prices again spooking the market towards the end of this quarter or some time in the next one). There are still some negative commodities but mainly in such areas as livestock (sell those pork bellies!).

Although the overall outlook for stocks is negative, Belkin is always on the lookout for any rally to capture and also looks for sectors that will outperform for relative value trades. His preferred outperform in the US is the S&P500 materials sector (and underlying industry groups) with energy stocks his preferred global outperformance prospect. Banks and financials have now become his global underperform prospects. Put those model forecasts together and his recommended trade is to sell banks and buy energy stocks in the US, Europe and Japan.

One fascinating aspect of all this is that Belkin's model based on momentum has now come very closely into line with our model based on fundamentals since the start of the year. In other words the market has only just spotted what we realized 2 months ago and now everyone is scrambling for a piece of that action.

As Belkin says "Our evolving scenario now calls for baked-in-the-cake inflationary pressures to spook bond markets and everything else tainted by negative real interest rates (stocks, tech, emerging markets, etc.). This week’s recommended portfolio changes are about how the global bubble ends, not about if there really is a bubble (duh ...) or if it can get much bigger (not likely). Getting back to the Fedhead quote at the top of this page about inflation not getting passed through to product prices -- it’s probably half true. The half true part suggests that industrial companies (CAT, CUM, etc.) are getting their margins squeezed. The half false part implies that the core CPI rate will rise more than expected. Lower margins and higher inflation? Not a great combination for equity markets."

[Braccobaldo]

...I don't agree with Belkin..

[Paul MBMG]

...I don't agree with Belkin..

maybe not, BRACCOBALDO, but he's got a very good track record. The facts, the interpretation and the forecasts do seem to make a lot of logical sense to me.