Supply and demand (and not inflation expectations) boosting yields

Outlook:

Yesterday we complained about both Bloomberg and the FT mentioning a shift toward more fiscal stimulus and away from the diminishing returns from ultra-accommodation. Japan has done some fiscal stimulus, to be sure, and the UK is gearing up for some in the No-vember budget, but fiscal stimulus is not on the table in the eurozone or the US, no matter what the pres-idential candidates say. In the eurozone, despite Draghi's begging, fiscal spenders run into Treaty limits. In the US, whoever wins the presidency will have to get past a Congress that has just spent eight years denying every spending initiative.

Today we have another press item to complain about. The WSJ writes that Inflation Fear Fuels Bond Rout. What's the evidence? "In the year to September, consumer inflation was 1.5% in the U.S. and 0.4% in the eurozone, the fastest annual price increases since 2014. Last month, Chinese factory prices rose for the first time in 41/2 years."

Really? Separately, Japan reported both headline and core CPI down 0.5% y/y in Sept, the same as Aug. Ultra-core CPI fell to zero from 0.2%. Germany is getting 0.7% in Sept and France and Spain, 0.5%. While hardly the galloping inflation of the 1970's, a tiny first time in 4½ years.”change in inflation can have a big effect on returns. "Overall, the difference between inflation of 1% and 2% seems trivial, but it has a dramatically different effect on invested capital over the long term. It would take nearly 70 years for inflation of 1% to cut the original value of an investment in half. But inflation of 4% would reduce its value in half in just 17 years.

"That could hurt the bond market. A mere 1 percentage point rise in yields would reduce the value of Bank of America Merrill Lynch's Global Broad Market Index, which measures prices of bonds around the world, by around 6.9%, wiping away $3.36 trillion in market value. "The market has become quite one sided in terms of how inflation is priced," said Sharon Bell, European equity strategist at Goldman Sachs Group Inc."

The real reason reporters seek an explanation for the global bond sell-off is that it adversely affects equi-ty prices, ending the week on an unhappy note. Never mind earnings or P/E ratios above the historical average or the slowdown in capital spending over the past five or more years.

It's bad reasoning to see a rise in yields and instantly impute the rise to rising inflation expectations when inflation and inflation expectations are not, in fact, rising (again, except in the UK). Disappointment in diminishing returns from ultra-accommodation doesn't necessarily lead to a shift to-ward fiscal stimulus when in fact, only two countries (Japan and the UK) are talking about fiscal stimulus at a government level that carries credibility.

If it's not inflation expectations boosting yields, what is it? Plain old-fashioned supply and demand. Reuters reports a poll showing European investors raised their bond exposure to a one-year high in Oc-tober. A majority expect the ECB to extend QE at end-March. Holdings rose by more than 5% to 57%, the highest proportion of bonds in the average portfolio since Oct 2015. Asked whether the QE pro-gram would end in March, leading to tapering, 85% said no.

And in the UK, Reuters reports "British funds cut their bond holdings in October to the lowest level since June on fears of a broad sell-off in fixed income markets as central banks run out of easing op-tions... UK investors slashed their overall bond allocations by over 3 percentage points to 27.2 percent and raised their cash holdings to 9.6 percent, the highest since July, worried that the long-running bond bull market was coming to an end." It's the beginning of the end of the bull bond market.

Meanwhile, in the US the Reuters survey shows "fund managers made no major changes to their model global portfolio this month... equity allocations were cut by around one percentage point to 51.3 per-cent from 52.2 percent, with exposure to bonds also trimmed slightly."

Does this look like the behavior of managers expecting robust growth and inflation? No. Instead we have a Bloomberg story about managers, including the sainted El-Erian, increasing cash holdings to 30% and more to avoid getting involved in this whole yield curve puzzle.

We like a Bloomberg story saying the economy is not too hot and not too cold, according to Credit Suisse economist Sweeney, who says "the U.S. inflation rate is unremarkable, unemployment is pretty standard and levels of global production are in keeping with their long-term trends. What is unusual is how much this data conflicts with the prevailing narrative, as hand-wringing over the economy's fragili-ty persists among investors, voters and politicians."

We can't recognize "normal" when we see it. Sweeney points out "inflation [is] now exactly at a 20-year average, U.S. employment of 5 percent just a whisker above the median Federal Reserve vot-ing member's long-run estimate, and global industrial production estimated at 3.1 percent precisely in line with the trend of the last 40 years." Market prices do not reflect this normalcy. Adjusted for infla-tion, bond yields are at the lowest since 1919.

"While financial-market asset prices have been out of keeping with the unextraordinary state of the economy, so too have productivity and income distribution, which are far more dire than the headline stats imply. ‘The next U.S. president looks set to inherit normal cyclical conditions, weak productivity and GDP trends, low interest rates, and a dissatisfied public. We hope that chosen policies will not throw the macroeconomic baby (i.e., decent cyclical dynamics and low nominal volatility) out with the structural bathwater (i.e., low productivity and dissatisfaction by many households over what they see as slowly rising living standards)."

Sweeney's policy ideas aside, this leaves us with the same yield puzzle. Yields are too low for funda-mental conditions but rose too far this week for reasons nobody can explain with any coherence.

We can hope for some resolution from this morning's GDP. The Atlanta Fed GDP Now forecast has 2.0% but others see higher numbers—the WSJ has 2.5% and the Bloomberg survey gets a median read-ing of 2.6%. Yowza! The last estimate from the Fed is 1.8%. Today's release could wreak havoc. A number not much under 1.8% might not stay the Fed's hand, but something dramatically lower could do it, say 1.0%. And a number well over the Fed's 1.8%, like Bloomberg's 2.6%, would presumably set off another round of rising inflation expectations.

Then we would understand the rise in yields. We really don't like inconsistencies and inexplicable price moves based on thin air. Fabulous growth might justify the idea that yields have farther to rise, perhaps back to well over 2%--where they were at year-end 2015.

Higher growth does not necessarily imply higher inflation, but try telling that to the market. The Cleve-land Fed's inflation metric shows 10-year expected inflation is 1.69%. "In other words, the public cur-rently expects the inflation rate to be less than 2 percent on average over the next decade." But the pub-lic is not the market. In a nutshell, we have various regional Feds, including New York, seeing inflation low and "well-anchored" (Dudley), but what they are measuring is not what markets are imagining. At least for the moment. The problem is that when analysts and traders wake up to the no-inflation story, yields can crash. And the dollar along with it.

Political Tidbit: The childish and repulsive Trump still has a small chance of winning the elec-tion, according to Nate Silver at 538 (http://fivethirtyeight.com/features/election-update-the-polls-disagree-and-thats-ok/?ex_cid=2016-forecast). Silver analyzes poll problems in deep detail, including the latest rise in Trump's chances (to 17% from 13%). Clinton still leads by a mile, but it's no time to be complacent. The NYT does it by electoral college vote and gets 211 for Clinton vs. 97 for Trump—it takes 270 to win. This is a lot less promising than some of the polls showing a Clinton lead by double digits.

The latest Clinton problem is recognition that the Arkansas couple had to chase big money to get power and chase even bigger money to rotate through ever-more powerful positions. We all know politics is money-driven but we don't like to see it in action--it's ugly. Besides, the Clintons could have hidden it better, like all the other pols. Neither one can be said to be a good manager. Good management would have avoided the whole email thing and the messy Foundation issues, as well. And Hillary's syrupy for-children-and-families mantra is tiresome. We want to hear about rebuilding the US' now third-world infrastructure and the deficit.

At a guess, if Clinton were running against a conventional candidate, even Romney, she would lose. But Trump is clearly unqualified. He is unprepared and ill-informed. He can't control himself when provoked. Over half of what he says is not true. As a narcissist, he is probably not a racist—non-whites just don't count, so how can he be prejudiced? The problem is that to Trump, women don't count, ei-ther, and women constitute over half of the voting electorate. As Senator Warren says, mean women are going to match their mean feet to the polling booth. We have eleven days to go.