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Reflationary Momentum Has Not Subsided

Feb 02, 2021

Executive Summary

  • Cyclical equities continue to outperform large-cap "defensive" equities.
  • The Treasury curve is bear steepening as long-term yields rise and short-term yields remain flat-to-down.
  • Leading indicators of cyclical inflation pressure continue to point higher, which will pressure long-term bonds and support cyclical equities.
  • Corporate credit spreads highlight the exuberance and lack of caution in risk-assets.
  • While cyclical growth and inflation indicators remain higher, risk assets will have support from the economic cycle.

Reflationary Momentum Has Not Subsided

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In the July edition of the [Weekend Dashboard] report, we started to highlight the emerging inflationary pressure that was developing across the cyclical leading indicators. 

At that time, the portfolio was overweight long-term Treasury bonds but started to discuss hedging the transitory rise in growth and inflation indicators by adding cyclical commodity exposure.  

It is most probable given the long-term forces that the current rise in growth and inflation expectations proves short-lived and entirely correlated to an expected pent-up demand rebound from the forced shutdowns. Still, adding commodity exposure to the portfolio to hedge the gains in bonds and prepare for a potential continuation of this trend remains a prudent choice.

The tonality of the above comment from July rings true today as the cyclical rise in growth and inflation indicators remains firmly concentrated in the manufacturing sector thanks to a forced shift in consumption and subsequent depletion of all "goods" inventory, a theme discussed at length in recent months. 

Through the summer and into the fall, the cyclical leading indicators continued to rise, and the portfolio respected the trends, lowering the exposure to the long-term bonds and increasing the exposure to commodity prices. 

As the leading indicators continue higher, the model portfolio will continue to make similar shifts on the margin while sticking with the balanced framework. 

The long-term trends will still prevail as the past decade has seen four cyclical upturns come and go. At present, there is no reason to believe this upturn will be any different. When studying a chart, a 4-6 quarter window seems brief. While this upturn is expected to fade in time, there is no other way to time the pivot other than to follow the leading indicators of the growth and inflation cycle, which suggests there is no immediate risk of a shift back to disinflation. 

It took the market time to react to the shifting economic conditions, with the ratio of small-cap stocks to large-cap stocks failing to catch momentum until the start of December. 

Russell 2000 / S&P 500 Performance Ratio:

Source: YCharts

While the cyclical upturn is still underway, typically favoring cyclical equities, this week bucked the trend as the energy sector, regional banks, material stocks, and transports posted losses while technology and growth stocks led the market to a 1.2% gain. 

 Asset Class Performance Table (Stocks & Bonds):
Source: YCharts, EPB Macro Research

Long-term Treasury bonds clung to a fractional gain on the week after correcting a full 10% over the past six months. 

Gold has similarly struggled over the past several months as the cyclical upturn in growth is preventing a continuous decline in real interest rates, the most important fundamental driver for the price of gold. 

Asset Class Performance Table (International Stocks & Currencies):

Source: YCharts, EPB Macro Research

Over the past one, three, and six months, international equities have outperformed the S&P 500 thanks to a rapidly declining US Dollar. 

 This week also bucked that multi-month trend as international equities declined on average and emerging market currencies fell close to 1.0%. 

While the leading indicators of growth and inflation point to the upside, the weekly counter-trend moves are mostly to be ignored. 

If market-based trends persist in this direction, and we couple that move with a deterioration in leading indicators, we can then start to build confidence in a high probability economic turning point. 

For now, these weekly market moves remain just that, a counter-trend move waiting for further confirmation. 

Treasury Rates

Treasury rates have increased significantly on the long-end of the Treasury curve, but not at all on the front-end for reasons outlined in the recent note titled, "Unintended Consequences." A follow up to this note is warranted in the next several weeks. 

Six Month Change In Treasury Rates:

Source: Federal Reserve, YCharts, EPB Macro Research

The spread between the 20-year Treasury rate and the 5-year Treasury rate is one of the more informative "yield curve charts." 

The 5-year Treasury rate is the first part of the curve that starts to lose all influence from the Federal Reserve, and the 20-year rate is the longest maturity bond that is not influenced by the mortgage market and hedging flows. In the long-term, the 30-year Treasury rate moves with the rate of expected inflation. 

The 5s20s spread is a highly informative spread between long rates and the belly of the curve without influence from the Federal Reserve. 

The Treasury spread graphed below has been steepening since 2019, but the type of steepening has shifted from a "bull steepening" to a "bear steepening."

20-Year Treasury Rate Minus 5-Year Treasury Rate:

Source: FRED

A bull steepening is when short-term rates are falling faster than long-term rates, mainly due to interest rate cuts or expected interest rate cuts from the Federal Reserve. All interest rates are falling, but short-term rates are falling faster. 

A bear steepening is when long-term interest rates are rising faster than short-term interest rates on higher growth and higher inflation expectations. 

A bull steepening is a recessionary signal while a bear steepening is consistent with a cyclical upturn in leading economic indicators of growth and inflation. 

The bear steepening should persist while the indicators of growth and inflation are pointing higher. Eventually, higher long-term rates start to slow the housing market and cyclical industrial sector, leading to the opposite effect in which long-term rates start to head back lower. For now, the housing market and the industrial sector continue to have strong upward momentum.

Inflationary Trends

Looking out over the next couple of months, higher inflationary expectations are still likely to be the dominant force. 

Lesser-traded commodity prices, outlined in the four-panel chart below, continue to show rising rates of price growth, even relative to the price of gold, which tends to offer more of a growth signal than an inflationary signal.

Commodity Price Growth:

Source: CRB

One of the best survey reports is the very timely ISM Manufacturing index with several sub-components, including prices paid at the factory gate. 

Converting the standard diffusion index into a growth rate (black line) shows the uptrend emerging during the summer of 2020.

The six-month delta in the growth rate offers a loose signal as to when the trend is changing. 

Prices Paid: Growth Rate (%):

Source: ISM

The leading indicator approach never takes one metric as a stand-alone signal. Watching a basket of 6-10 indicators all make subsequent pivots, and having those pivots start to appear in market-based data is when the highest conviction can be had in an economic inflection point. 

Market-based inflation expectations, defined by the 5-year, 5-year forward breakeven rate, continues to rise, exceeding 2.0%. 

5-Year 5-Year Forward Breakeven Inflation Rate (%):

Source: YCharts

As a reminder, market-based "breakeven" inflation expectations are not solely driven by inflation but also the liquidity premium associated with TIPs compared to nominal Treasury bonds. 

The DKW Model offers one variation of clean inflation expectations over the next ten years.

Expected Inflation From DKW Model:

Source: Federal Reserve

Directionally, the expected rate of inflation is moving higher, which is consistent with market-based inflation expectations and the host of reliable inflationary indicators. The magnitude of the rise is certainly smaller, but the main concern at EPB Macro Research is making the directional changes when appropriate, and currently, all signals suggest it is still too early to pivot back to a heavy disinflationary stance. 

The real interest rate is expected to rise during this upturn in economic growth. 

Generally, higher real interest rates are very damaging to asset prices, but as discussed in a prior research report, asset prices can support higher real interest rates only if the rise in real rates is accompanied by higher real economic growth. 

Today that remains true, and while the rise in real rates has been very minor, stocks continue to rise. 

10-Year Real Interest Rate:

Source: Federal Reserve

Gold prices, on the other hand, have struggled since the summer when real interest rates bottomed and will find it hard to break out to new highs unless the trend in real interest rates continues lower. 

Over the long-term, secular forces are working in favor of lower real interest rates, but the cyclical upturn in growth and inflation have caused the downturn in rates to stall. 

Monetary & Credit Aggregates

Reserves at depository institutions continue to increase as the Fed remains highly engaged in Quantitative Easing "QE". 

Higher reserve balances will continue exerting downward pressure on short-term interest rates as banks look to trade away reserves for other high-quality liquid assets when the rate on those assets exceeds the interest rate paid on reserves. 

Total Reserves:

Source: FRED

The Treasury General Account "TGA" (the checking account of the Treasury Department) remains extremely elevated, at roughly $1.6 trillion.

This account will have to be spent, and when the TGA falls, reserves at banks increase as the TGA and reserve balances are both liabilities of the Fed. 

Treasury General Account:

Source: FRED

As a result, the banks, already saturated with more than $3 trillion in reserves, will see reserve balances balloon near $5 trillion. 

Banks will lower the rate on deposits to slow the growth in their balance sheet, and this may have the effect of pushing deposit rates and other money market rates into negative territory. The Federal Reserve may be forced to respond if they want to remain consistent with their language and avoid negative interest rates. 

You can read more on this topic in our original note by clicking here

Total bank lending is still in a downtrend, falling in nominal dollars (top panel) and declining in growth rate terms (bottom panel).

Total Bank Lending: Disinflationary Trend

Source: FRED

The reserve growth is only inflationary if the banks increase loans, which must come with demand on the side of borrowers. High levels of household and business debt will prevent a large surge in demand from private borrowers looking to invest in income-generating, productive economic projects. This will keep a lid on the long-term rate of inflation emerging from the banking channel.

The current upturn in inflation, however, is unrelated to the monetary shifts and is concentrated on a global backlog of manufactured goods as a result of the pandemic shifting consumer behavior and damaging (still) supply chains. 

As discussed in more detail in the last [Quarterly Webcast] presentation, a falling money multiplier highlights the lack of money growth coming from new credit. 

Money Multiplier:

Source: FRED

In other words, the new money growth is coming mainly from QE, likely to be recycled back into financial markets and not into the real economy. Thus, a decline in bank lending, the money multiplier, and the velocity of money are three long-term variables suggesting that the economy's long-term trends remain unchanged.

Corporate Credit

Aided by aggressive QE, corporate credit spreads have compressed to the tightest levels seen over the past ten years. This highlights or propels the exuberance in the equity market. 

Investment-Grade Quality Spread:

Source: FRED

The high yield quality spread continues to compress as investors are willing to reach for lower-quality debt. The spread between CCC OAS and BB OAS has fallen from 1250bps to 464bps. The spread has compressed almost 80bps YTD.

High-Yield Quality Spread:

Source: FRED

As the economy remains in a cyclical upturn, and the Fed remains engaged in QE, corporate credit spreads are likely to continue tightening. 

Upon a pivot in the economic cycle, stocks and corporate credit will be trading at some of the highest valuations in modern history. A problem that investors are willing to look through during an acceleration in economic activity. 

US Dollar Trends

The cyclical upturn in the global manufacturing sector historically comes with weaker US Dollar performance as investors shift capital to higher return areas of the globe when risks are perceived to be diminished.

Trade Weighted Dollar Index:

Source: FRED

Each week, we should watch the trade-weighted dollar indexes for signs that the US dollar is gaining upside momentum. Any sign of a stronger US Dollar in conjunction with a decline in the growth rate of the book to bill ratio, industrial commodities, and weekly hours worked in the manufacturing sector are strong indicators that the global industrial upturn is losing momentum.

Consistent with the research outlook on growth, the US Dollar remains in a long-term bullish trend but a short-term bearish trend. 

Summary & Outlook

Reflationary momentum continues with the Russell 2000 steadily outperforming the S&P 500.

Cyclical momentum continues in the industrial economy, supporting a rise in goods inflation, partially offsetting a decline in services inflation.

During this upturn, which is still underway, we should expect the macro ratios below to rise. Stocks generally outperform bonds and gold during accelerations in the global industrial economy.

Macro Ratios:

Source: YCharts, CRB

The risk-on market momentum is clear in the corporate credit market, with lower quality debt rallying relative to higher-quality issues.

The market will remain risk-on, dollar bearish, and pro-inflation until the market's cyclical momentum starts to fade as the global industrial upturn runs its course.

For now, reflationary momentum has not yet subsided. 

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