Behavioral Macro

Mark Dow's microblog, analyzing global macroeconomic and market issues, often through the prism of our cognitive shortcomings

Of Trends, Yields, and Metals

Markets are hard. One of the main reasons they’re hard is because it’s in our nature to overthink. We’re tempted to believe deep thought is our value added, how we justify our fees. It’s also how we impress clients.

But market reality is usually far simpler. Investors chase returns. We fall for stories. We’re masters of belated overreaction. And we have a hard time sticking to a game plan in the face of the huge emotional swings that come with managing other peoples’ money. For these reasons (inter alia), trends tend to be more powerful and go much further than would seem reasonable.

It took me years to curb my impulse to fight trends. The temptation to engage in counter trend trades can be overwhelming, especially if performance is lagging and/or a trend is new or not well established. But it’s rarely worth it. It’s especially not worth fighting something that looks like it might be a new trend.

I don’t know for sure if the rise in short-end Treasury yields or the breakdown in metals constitutes a new trend. All I know is the odds are massively against you if you try and go against it.

Below is a graph of the 2 year Treasury yield. Note that unlike the long end where all the Fed buying has been taking place, the front end has been creeping higher since the Taper Tantrum of May 2013.

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The 5 year Treasury yield shows a more interesting pattern: it looks like it just broke higher after a long period of consolidation. Yes, if in the short term we get more risk aversion this yield would likely tread water or pull back. But this chart tells us that the odds favor higher yields. And soon. I’m not one who fears a pernicious rise in inflation as the cycle strengthens, and I also think many market participants have mentally anchored on equilibrium levels for both policy rates and Treasury yields that are too high. But, all this notwithstanding, this is still a train I wouldn’t dare stand in front of.

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The 5 year Treasury real yield tells an even more powerful story. It shot up in the Taper Tantrum and when sideways until a few weeks ago. It tells us yields are going up, and not because of inflation fears.

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Then we have the metals. When we see a sustained fall in metal prices, most people think “weak global growth”. We systematically read too much about economic fundamentals into commodity price moves. Again, we overthink. The market has made this mistake time and time again. Instead, my first thought is financial liquidation/deleveraging, because financial operators have come to dominate commercial hedgers over the past 15 years.

Specifically these days, I think about Chinese financial liquidation. We know there was a boom in China. We know there was a boom in commodities. And we know Chinese entities were stockpiling commodities and in many cases pledging them as collateral. They are now unwinding. They are not alone, but they’re the most salient example.

My fundamental view is that commodities got overhyped and over loved over the 2004-2011 period and we’re going through a long period of mean reversion. Initially, the hype was based on emerging market economies plugging into the grid and consultants convincing slower money that it was its own asset class and a great diversifier. The second phase of the ramp came from misunderstanding QE.

Now, however, we’re in the down cycle. We saw the first leg of the great commodity unwind and the second one may be upon us. The first shakeout was mostly tourist dollars getting shaken out of the gold tree. Many of the investors who bought gold as protection against QE-induced inflation were forced out over 2011-2013, as it became clear they got it wrong. The second phase, will come as higher real rates drive the wooden stake the rest of the way through, shaking out the long term money, the asset allocators and the true believers. And based on the charts above, if this is not happening now, it is likely to happen very soon.

The charts below, to my mind, confirm what the charts above were suggesting. I know short term positioning is more supportive of metals, and sentiment is more bearish than bullish, but look at the charts below. If an experienced market participant were to flip these charts upside down and imagine they were stocks, I’d be hard pressed to think they wouldn’t want to do some two-fisted buying. Whatever the short term may bring, you do NOT want to step in front of the break down train.

Here’s copper:

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Gold doesn’t look any better:

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And silver looks to be the worst of the bunch, have arguably already broken down:

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Again, there’s a chance that this is a big head fake and not a new trend. But managing money is about pressing your bets when the odds are in your favor—either the odds of being right or the odds of an asymmetric payoff, or, in a dream sequence, both. And right now—whatever the ultimate outcome—being long bonds and long metals doesn’t meet that criterion. Simple money management only gives you two choices here: be short, or get the hell out of the way.

Got Your Market Update Right Here — In Two Paragraphs

Hedge funds are chopped and flat. Real money managers are more worried about getting caught out in a downdraft than missing an upside breakout. Risk positioning is light. The decline is bond yields is more about bad positioning and a shortage of AAA assets than it is about the bond market “knowing something”.

But the vulnerabilities are also there: markets have had a big run, economic fundamentals are still tepid and falling on the short side of expectations. Implied volatilities are low. Market internals are bad. Bottom line: It will take a growth breakout into escape velocity or something like it to get a resumption of the rally, or, more serious disappointment to get the washout that so many are already expecting. Unsatisfactory though this is, the right move is to be patient. The bull market is not over, but it’s not a smart time to press your bets. The longer we twist in this limbo, the more attractive the upside will become. Time heals. Keep your strategic positions and hedge out market beta as best you can. Sometimes you have to keep your bat on your shoulder—something guys collecting two percent management fees have a hard time doing.

Happy Mother’s Day.