US: "Lower for longer" is the correct diagnosis

Outlook

The FX mar ket is doing its usual per ver se thing—rates are lower in Europe and economies are stagnant, while the US is headed for higher rates and the economy is robust, so buy euros, sell dollars. This just points out that traders have the attention span of a gnat. On the losing side are the macro global hedge funds and other investors who use the big-picture factors that orthodox economics tells us to use. Yellen said “ignore the dots” and “lower for longer,” and FX traders know exactly what to do with that guidance.

This is why it’s fruitless to attribute dollar moves to anything else happening in the financial world, at least so far. To say that the dollar fell on oil prices rising—or gold prices rising—is almost certainly not true. It’s not a coincidence, either— all are reflecting current fears and worries, just not in tandem. If oil is up because of geopolitical fears, the 10-year yield should be falling as capital flight flows to the safe haven. But it’s not—it’s up. If gold is up because of those same fears, the dollar should be down—that’s the conventional wisdom. But over the past 18 hours, gold went one way, up, while the dollar went two ways, down but then up. When gold and the dollar are both up at the same time, what’s the excuse?

The Market News fixed income analysts wonders whether gold went up yesterday because some traders see the Fed as overly complacent about inflation. The WSJ concurs, writing that “it was gold that benefited most from the US central bank’s apparent commitment to maintaining an accommodative policy stance. The metal was up $39, or 3.1 per cent, at a two-month high of $1,319 an ounce – its biggest one-day gain in percentage terms in eight months.”

Gold is up about 5% since the beginning of June and Brent crude is up about 5.5% over the same period. There’s more connection here between these two and there is any connection with the dollar. In fact, the dollar isn’t in the equation at all yet. And we are not sure the Fed is in the equation, either. Maybe gold is up because oil is up, period.

Separately, the classic horse-trading between stocks and bonds is coming down against bonds. Investors have pulled money out of bond funds for the first time in 15 weeks, according to EPFR data distributed by Bank of America Merrill Lynch and reported in the FT. “Bond funds experienced $2.3bn of outflows this week. High yield bond funds saw $700m of outflows, in the first net redemption for 19 weeks.

“Equity funds saw $12.6bn of inflows last week, according to the EPFR data, which is seen as a barometer of retail in-vestor activity. Investors tend to favour stocks over bonds at times when the market is betting on continued low interest rates. The largest fixed income outflows this week were from US Treasuries…” If investors are committed to fixed in-come paper, they are more interested in high-risk stuff like Greek bonds and even Spain/Portugal/Italy, as we have seen in recent weeks. Late yesterday the FT reported Ecuador (defaulted in 2008) issued 10-years at 7.9%. Cyprus sold 5-years at 4.85%. “Debt issued by emerging market governments has been on a tear this year, outperforming most fixed income asset classes. Total returns on emerging market debt climbed to 7.84 per cent as of Monday, according to JP Morgan Chase, and the sector remains the darling of many asset managers.”

And yet the Fed sees little evidence that the desperate quest for yield should be of any real concern. The Fed is more concerned with coaxing the US recovery into full bloom than it is about whether Uncle Fred’s pension fund is buying emerging market bonds, but surely they can see the seeds of a disaster being sown in the inability or unwillingness to price risk in a sane and reasonable way. When US investors get over-invested in low-quality paper and liquidity vanishes in a puff of smoke, will the Fed by buying Cyprus paper? Hardly. Booms and bubbles always cause mispricing and it’s silly to pretend otherwise. This is not to say the Fed should intervene in US equity or other markets, but it is to say that failure to acknowledge irrational exuberance is a failure. We don’t know yet how big a failure. Gold and oil are telling us there is turmoil afoot. Traders in both commodities are famously flighty and equally famously enmeshed in foolish ideo-logies. But we ignore them at our peril. At the least, rising oil prices can impact the US recovery and US inflation, not to mention the trade balance. We all think domestic production (and maybe alternative energy) will save us this time, but that is an unproven thesis.

If oil prices continue rising, the average Joe will not be buying new shoes, let alone a new house or a new car. If gold continues rising, he will be fearful and hunker down. What happens to the housing-led recovery? It likely fizzles. Partic-ularly discouraging is the latest data from the Mortgage Bankers Association yesterday, saying new and existing home sales will fall 4.1% this year to 5.28 million, the first retreat in 4 years. Mortgage lending volume will drop 8.7% to $751 billion, the first retreat in three years. Bloomberg reports “The share of Americans who said they planned to buy a home in the next six months plunged to 4.9 percent last month from 7.4 percent at the end of 2013, the highest in records going back to 1964, according to the Conference Board.” Granted, house prices rose too far, too fast—up 11.5% in 2013. The National Association of Realtors sees 5.6% this year. But household income/wages are not keeping up with either infla-tion or house prices—up only about 1% in 2013.

Bottom line, this seems like a glass half-empty. To the extent that the US recovery supports the dollar—and over long data series, currency valuations are positively correlated with GDP growth—a retreat in the US recovery could be just awful. We can even imagine a scenario in which the Fed halts tapering or enlarges the NY Fed’s fancy long-term repo—favoring some growth, any growth, over inflation. This would vindicate the liquidity-obsessed NY Fed Pres Dudley. Therefore, “lower for longer” is the correct diagnosis. At the least, the Fed wants to keep the banks lending and mort-gage rates low (not incidentally, a big difference with the UK).

Unless we get war and a safe-haven flow to the dollar, the dollar is toast on this outlook. Any small gains on rising 10-year yields will be fleeting. We will likely see the 10-year back down again. See the chart. It’s hardly out of the woods. At yesterday’s close, the daily bar encompassed the 10-day, 20-day and 200-day moving averages and was just barely above the long-term support line. This looks congestive and can easily be a harbinger of another dip.