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Equities and bond yields have been at the forefront of all the discussions about valuations and market turns. Investors appear to have accepted that falling interest rates – especially the short-term like US 2 year yields – tend to move in tandem with stocks. See the following chart.

2 years US government yields (black) vs S&P 500 (blue) 1997 till 2018

2 year vs spx 1997-2018

Source: Bloomberg

The relationship have been rather tight over the last 20 years. Interestingly 1997 was the year of LTCM and the time when Federal Reserve did see the necessity to “save” the world form potential systematic disaster which could have developed from the highly leveraged hedge fund. The world has been saved and the relationship between Fed, yields and the stock market established.

This was the time when investors who has been seasoned in the prior 20 years of stock market might have overlooked the changes in the investment weather. (Not only the dot.com) The years till 1997 did see very little of a correlation between 2 year yields and the stock market. See the following chart.

2 years US government yields (black) vs S&P 500 (blue) 1977 till 1997

2y vs SPX 1977-1997

Source: Bloomberg

In those 20 years the relationship was rather positive for falling 2 year yields and rising stock market although also this relationship did not occur all the time. Especially 1977 till 1981 and 1986 till 1990 would challenge this point of view.

The length of the two periods of 20 years might be a pure coincidence. However, it is important to entertain the idea that our views of relationships between yields and stock market might be just the backward looking short-terminism. The future will show.

 

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Oil price revival

Positive assessment of the oil price for nearly the last 2 years is now looking a bit stretched. The long-term prices target may be much higher than the current price. In the meantime, however, long oil appears to be the consensus investment as OPEC complies with production cuts and the US-production, although growing, does not appear to be threatening the stable increasing prices.

Oil chart enters a congestion zone which has been established back in 2015. The action within this congestion zone will be very important for the continued future price development. Any break out of this congestion zone could deliver important clues as to the future price direction.

WTI weekly price Chart

CL1 2018-01-03

Source: Bloomberg

Now enters the futures markets. The current long positions in the WTI oil futures are at all-time highs and continue to rise. This obviously adds to the speculative character.

As investments in oil increase and the market maintains strong momentum the volatility is falling a reach lowest levels since 2014.

WTI price chart, volatility and long futures positions

CL1 vola 2018-01-03

Source: Bloomberg

Additionally, the current forward curve shape is providing additional food for though. Just 6 months ago the forward curve showed the normal shape as it was in contango. The current shape is backwardation as the prices for immediate deliveries are higher than future settlement prices. This make a long position in oil futures profitable as the investor can buy futures at lower prices than the current deliveries and through holding the position it continues to appreciate.

WTI oil futures curves

CL1 curve 2018-01-03

Source: Bloomberg

An oil futures curve in backwardation can be an indication of currently tight supply in the markets which would correspond to geopolitical tensions, production cuts or constrains and weather related issues. Furthermore recent continued long-term hedging activities of the various producers could have depressed future prices in the intermediate term.

Volatility and futures positioning create some risk around the positive environment for oil. This negative technical background is mitigated by continued geopolitical developments in Iran as well as the extremely cold weather in USA. If those conditions subside and/or the futures markets reverses there could be some setback to the current price momentum which would neatly coincide with the congestion zone.

 

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Surprises for 2018

Looking back on own predictions can be very revealing and exciting. I did not make any predictions in 2017 but 2016. Quite surprisingly it took 2 years for many of those to come true. Thus it often will take longer than one expect.

Here the link to the blog entry from January 2016 http://blog.ad-vanced.de/index.php/2016/01/8-market-surprises-for-2016/

All the market predations were actually defined as surprises. According to a long standing believe the market does everything to surprice an unexpected investor. Now with the end of the year 2017 approaching fast I embarked on the tedious quest to look for more market surprises for 2018. Or shall I rather do it for 2019 as it seems to take 2 years for the surprises to materialise.

  1. Most daring would follow the idea that somehow Bitcoin would be shown as the world’s biggest Ponzi scheme run by…….…now you can pick Russia or North Korea or China. The real surprise would come if it was not a state that run this Ponzi scheme but rather a group of rogue gamers who enjoyed the greatest game of their life.
  2. Federal reserve is expected to increase interest rates by 3 to 5 times over the course of 2018. A real surprise would be 0 or 7! Now both implications are rather disturbing to think of. The markets would really experience a turmoil and the correction which is so widely predicted for 2018 would finally hit.
  3. Oil rising is a more or less done deal. So the magnitude might be a surprise. Here like with the Federal Reserve the real surprise would come from the price deviating substantially from exceptions. Oil at 100 USD or 30USD would be real hit. –  The very high oil prices would lead to some adjustments in growth and pricing levels. Possibly driving inflation to around 2% – 2.5% in developed countries. This would support some stronger response from Fed supporting case in point 2. –  Global excessive production of oil and a stronger focus on e-mobility could drive oil price toward to 30 USD. This in turn would upset numerous scenarios. Fed would not raise rates, inflation could fall dramatically, worries about Middle East and fraking would reappear, high yield anxiety especially in US-oil companies would resurface, market wobbles.
  4. Equity bull market does not finish 2018. Against all odds the equity market will not make a pause and continue at the nice pace for a low double digit performance. All calls on valuation would go unheard as equity market would see new excesses in valuation.
  5. Euro collapses toward 1:1 to the US-Dollar. This used to be the most common prediction for 2017 and now we are closer to 1.20 then 1.00. The surprise would come with the reversal of fortune for the Euro as most of the market participants are now calling for lower USD and higher Euro.
  6. Gold revival will not materialise and the price falls by 30%. In 2016 we were close to 1000 USD per ounce. So this surprise is not as substantial, nonetheless a decent surprise. Obviously, this could come as cryptocurrencies are winning the battle for the hearts of the investors and equity markets could continue the rally
  7. Europe continues to crumble with Catalan pressing for independence, Poland and Hungary drifting further away from the EU, Five Star Movement winning Italian elections and Germany is forced into Minority Government which does not last the next 12 months.
  8. A combination of the issues in Europe could force ECB to prolong the current lose monetary policy beyond 2018 pushing rates continuously below zero in Europa and embarking on new QE round. Sounds dramatic. Yes, however this definitely would be a surprise for the markets.

There could be also numerous black swans which would be great surprise for the markets. However, black swans are not easily predictable and due to the nature are rather pure luck to identify beforehand. Thus I refrain from any crystal ball predations here. If you have any other great surprises for 2018 I am more than happy to hear from you or discuss your views on my humble list of surprises.

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The time has come that central bankers stopped talking about inflation and allow the monetary policy to deviate strongly from the inflation. The best example is Bank of England. Since 2010 it has continuously disregarded the inflation pressures and kept the base rate low. Despite plenty of historical precedence from the 80s till 2008 that base rate typically stayed above the RPI rate.

It appears that nobody cares about this development. Neither the politics which are now deeply entrenched in Brexit nor central banker which are supposedly protecting the consumer from inflation. The magic 2% has been reached surpassed and….Bank of England does pretty nothing about it.

BoE Base Rate vs RPI Inflation Index

Base rate and RPI 2017-10-23

Source: Bloomberg, Bank of England

Central bankers must have a new goal now which is not inflation. There could be the intrinsic government financing goal which nobody would want to happen due to historical cases in Germany or Japan which show the shortcomings of any government financing through the central bank.

However, with long-term rates in UK below 2% and below the inflation rate it all has the writing on the wall. The government can continue borrowing money at long-term depressed rates. Additionally BoE continues buying government debt.

Rising government debt even at low and depressed financing costs can become unbearable over time if the government does not use the low rate environment to lower the debt burden. Unfortunately, very few do.

If the central bank is doing nothing about the inflation so the currency does. This is the second reason after Brexit why the British Pound loses its value. The pressure needs a vent. Bank of England supports the government so the currency needs to move in order to balance the new situation. If BoE decides to rise the base rate one day in the future it will be great for currency but very difficult for the debt.

The question remains if the other central banker will follow BoE example. Forget the inflation and focus on affordable government debt financing.

BofA Merrill Lynch UK Inflation Linked Gilt Index vs Bloomberg Barclays Series-E UK Gov all Maturities >1 Bond Index

UK ILB 2017-10-23

Source: Bloomberg

The only protection appear to be inflation linked bonds. They have outperformed nominal bonds over the last years and as the inflation in the UK settles on a higher level and could be even rising with weaker currency this outperformance is scheduled to continue.

 

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Oil rising

The time of electric cars is dawning and the whole International Automobile Fair in Frankfurt was all about electric cars as well as autonomous driving. The demise of the fuel driven car has been discussed and the government are pushing for ever stricter environment standards.

China, United Kingdom are already discussing the end of the combustion and the beginning of the e-automobile era.

At the same time there is different narration. Saudi Arabia is planning the biggest IPO with Aramco coming. Clearly allow oil price would not be a great news for such a high profile IPO.

The oil production in the US is strong reaching nearly highs registered in 2015 and highest level in more than 40 years.

Despite production cuts by the OPEC the global oil production as reported by the Energy Intelligence Group reached the same levels as 2016 and is expected to continue growing in the coming years.

Oil price weekly (WTI future continuous)

CL1 2017-09-27

Source: Bloomberg

The oil price is suddenly and mostly unexpected by the most investors higher. There is very little indication that the consumption increases. The imbalances of the last years appear to be working out slowly particularly as strategic holdings by the governments normalise.

The price development looks very much like the price chart of the emerging markets. It might be difficult to call for USD 80 on oil on fundamental ground or any data that is currently available. Charts like to follow patters and if history is any guide and emerging markets oil may appreciate stronger than most anticipate.

There is little indication why the price of oil is increasing and breaking higher. However, listening to the market is important to see the early signs of change. Oil is currently indicating that it might move higher. The market anticipates fundamental improvement.

 

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Black swan

It has become very fashionable to speak about black swans in the recent years since the now so famous book showed how powerful black swan events can be. Since it has proved very difficult to predict it is not impossible to flag or indicate any real future black swans. Especially the one least expected. Just the probability of event is by definition minuscule.

I tried to refrain from this futile exercise but nonetheless it is very tempting to try and at least flag some events which have the ability to develop into the initial spark which could bring the next big market correction.

Here three ideas which are rather obvious but somehow have been neglected.

German election. The clarity is stated by numerous recent polls that the winner will be CDU/CSU and the second biggest party will be the SPD. However, there is a very little debate about which coalition is the most likely and what market impact it may have. What if CDU/CSU will not find common ground with SPD for a grand coalition? What about SPD, die Linke (the left party) and die Grünen (the green party) will be able to gain 50% of total votes? What about if no coalition will be achievable and a minority government in Germany will need to go through daily grind of politics?

The markets are very complacent about the outcomes.

A week after the German election there is the planed Catalonian Vote of Independence. Spain intends to use all the legal avenues to stop the vote. The avenues are clearly numerous but it may kick-off a continued struggle in Europe about the stability of EU and the future of the EU structure. Poland and Hungary are already a burden which may gain additional support from an independence struggle of Catalonia in Spain.

Markets do not see it as a real issue.

Weather has been hitting the newswires in the recent weeks and month with ever larger issues and financially bigger damages. The recent events are clearly Hurricane Harvey and Irma currently followed by Maria. At the same time the magnitude of earthquakes intensified as well as the occurrence with the latest hitting Mexico City.

Past earthquake may offer some illustration of the events. On September 21, 1999, when a 7.6-magnitude earthquake struck Taiwan, killing almost 2,500 people and causing billions in damage, the stock prices of major U.S. tech companies, including Apple, Dell and Hewlett-Packard, plunged. The industry had become so concentrated that American companies half a world away were paralyzed by the lack of crucial parts.

An earthquake in Asia or California could see this scenario repeated. The markets are not discounting this highly unpredictable event which nonetheless is likely.

Delving into the geopolitical events around Russia and North Korea would add to the list of black swans. The markets have their own way dealing with predictability and fear. Possible the most interesting event was the last launch of a North Korean rocket and the markets did not blink. Markets react only to surprises but the launch was not a real surprise.

Markets are calm waiting for the next surprise.

SPX und VIX 2017-09

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It has been a while since Emerging Markets were the darling of the crowd. There were various names for the various regions, BRICS, Asian Tigers etc as the roaring economies inspired investments. Now most of this is gone. Financial crises broke the case for EM investing and since 2009 emerging markets investing was mired in continued challenges.

Emerging Markets have been generally associated with growth, inflation, investments and strongly expanding population. Additionally, opening of the economies added to the appeal. Not to forget fast growing consumer, new economic structures and price advantages which were supporting the exports to develop countries.

Since 2009 global growth was slow and continuous reason for debate and concern. Inflation turned into deflation as pricing power vanished with growth. Central banks were concentrating on supporting economic growth at any rate. At the same time inflation appeared to be a wishful thinking as it vanished not only in the developed countries but also started to fall dramatically in Emerging Markets in general. The 2% inflation target which appears to be somehow a magical number was the line in the sand for central bankers to fight for. So far illusive.

Emerging Markets shared the same fate as value investing or commodities.

Now the Emerging Markets appear to have found a new life line. Not that there is apparent change in the economic fundamentals. The strength in Emerging Markets equities appear to be seeping through as investors look for new avenues to invest.

Suddenly the commodities appear to be supporting the return of Emerging Markets and inflation expectation begin to rise in the developed markets.

Clearly there is no just one reason for the return of Emerging Markets. Some large markets like Brazil appear to be stabilising and the political and economic environment supports stocks. Energy prices are stable to slowly growing supporting numerous smaller and larger countries like Mexico. China grows as expected between 6% and 7% as the exact number is rather a concept. Finally the local consumer in the EMs did not vanish over the recent years. Countries like India did see continued growth in middle class and the average income. The same happens in all the Asian countries from South Korea to Indonesia.

MSCI Emerging Markets

EM 2017-09

Source: Bloomberg

The self-healing process appear to have been accomplished. The Emerging Markets rallied from the low of 2016 back to the same highs seen in 2012 and 2014. This is now a very pivotal level. Relative performance in comparison to MSCI World in Euro bottomed in late 2016 just after the US presidential election and outperformed the Developed Markets in 2017.

To make the bottoming process perfect Emerging Markets need to rally above the resistance levels created in the years 2010 -2015. This could herald the end game in the 10 years of financial crises. Back to normal.

 

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VIX indicator

Volatility as investment style and asset class begun a stellar career as and when investors discovered its positive hedging properties against an equity market dislocation during 2008/2009 equity market rout. The popularity grew over the years and new investment styles and strategies where developed.

One of the more successful strategies which attracts investor’s attention and assets, is centred on various ways to short volatility.

As volatility has a profound tendency to return to the mean any bout of higher volatility generally can be used to short the respective volatility index most prominently the VIX in order to profit from mean reversion. At the same time the shape of the forward curve adds to the appeal of the strategy. It is mostly in contango.

Shorting the VIX future was extremely profitable as the following chart shows.

VelocityShares Daily Inverse VIX Short-Term ETN

XIV 2017-08-23

Source: Bloomberg

As the strategy becomes ever more popular there is a growing number of strategies and funds which try to replicate the historical success and collect assets.

This popularity leads clearly to an ever rising short position in the VIX futures of various maturities. The strong short bias is clearly connected with the demise of the corresponding long strategy in the VIX and other volatility strategies. As long strategy in volatility loses so the short strategy wins. The original purpose of hedging against the market event becomes obsolete and the technical curve trading gains.

CFTC CBOE VIX Futures non-commercial net total/futures only

VIX and futures 2017-08-23

Source: Bloomberg

Extremely low volatility has been a continuous feature of the recent equity market advance. It has puzzled investors particularly as the various risk factors multiplied. Stable and gradual central bank policy is deemed to have contributed to the environment of low volatility. The widely cited absence of investment opportunities in the world of low nominal interest rates and the continued investment rush into equities might have supported this tendency.

However very few focus on the possibility that a direct investment in volatility, here VIX, may depress the volatility measure and partially decouple it from the equity market development. The more investors short the futures the more they depress the volatility. This may clearly impair the ability of volatility measures to continue its well documented ability to indicate and/or warn against any market related stress.

 

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The verbal war between North Korea and USA moved into a new phase last week. The usual reaction to political and economic stress is to look for safe haven which could protect from any financial fallout. Traditionally Swiss Franc and Japanese Yen alongside the German government bonds offered this safety. Just wait a moment! Japanese Yen?

The Korean peninsula is only 300 Miles from Japan and US forces are located in Japan. Thus Japan could become a prime target for any military intervention from North Korea. This somehow makes it difficult to understand how Japanese Yen could suddenly be the safe haven currency like in the past.

Nonetheless markets follow usual patterns and the patters are like habits. They die hard. Despite changed geopolitical situation and the resulting tension just couple of mile away from Japan it is still seen as safe.

The new player in the safe haven game appears to be the crypto currencies. Especially Bitcoin. As the tension intensified so the price of bitcoin increased. After the July correction the Bitcoin in US-Dollars surged to new highs. Especially the last week it rallied strongly as allegedly Korean, Chinese and Japanese investors turned to digital currencies for safety. This appears to be logical. The currency can be transferred globally on the flick of the finger and it is replicated/stored on countless machines globally. It makes the currency utterly independent form a single country, regional tension or global turmoil.

Bitcoin in USD

Bitcoin 2017-08-14

Source: Bloomberg

The independent set-up as well as the global reach make the crypto currencies an ideal instrument to store value in difficult time. Obviously such developments and trends would enshrine the crypto currencies as long-term reliable store of value. If the really can live up to this expectations may be seen if and when a real crises hits. However in the meantime there is rising conviction and acceptance. All that is needed to create and maintain a fundamental value for such virtual currencies.

 

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It has been a great libertarian idea that Bitcoin could be established as independent currency which could be used globally outside of the central banks’ systems and governmental control. It had all the flows from the start which clearly made Bitcoin unacceptable for global transactions.

Bitcoin had unintended consequence. It begun a new quest by banks, independent fintech companies, governments and above all central banks. The idea is simple. The technology behind Bitcon, blockchain, can be used for a government and central bank controlled crypto currency.

http://www.telegraph.co.uk/business/2016/03/13/central-banks-beat-bitcoin-at-own-game-with-rival-supercurrency/

This idea and the dawn of crypto currencies do have the ability to reshape the world not even envisioned by George Orwell or the creators of sci-fi films. The crypto currencies based on blockchain technology could permit the governments and central bankers to exert a full control over all financial transaction and money movements.

This idea is further promoted by the current discussion if physical money, notes and coins, have to be phased out. Electronic payments and finally crypto currencies would take their place. The formal discussion targets criminals and makes people believe that once physical money is gone, crime can be controlled and combated more efficiently. At the current moment the criminals are even able to trick central banks to transfer money to illegitimate accounts.

http://www.businessinsider.de/new-york-fed-bangladesh-central-bank-cyber-attack-2016-3

Anyone who bothers to look at the current credit card fraud, electronic money transfer fraud and direct successful cyber-attacks on banks will realise that crime is part of the cyber age and that criminals have discovered more than one way to thrive in the cyber world. This means that removing physical money would not really impact the criminals.

Control can be exerted with crypto currency. Investors and ordinary tax payers will become fully transparent allowing insight into the behavioural side. Every payment can be verified and followed. The total control over the tax payers freedom will be possible.

The ultimate idea is to create a system which can survive without boom-and-bust cycles. The utopian phantasy depicts financial world with no crises and full macro and micro control of the financial systems.

Banking system as we know it today will stop to exist. Commercial banks will not be necessary to process payments. Accounts could be held directly with the central banks. Investments could be facilitated directly from central bank account via digital connection between two parties without the need for one or numerous intermediaries.

http://positivemoney.org/publications-old/digital-cash-why-central-banks-should-start-issuing-electronic-money-new-report/

Let us follow this utopian idea till the logical end. Brokers could become obsolete as the electronic platforms based on blockchain could verify the owner of the assets and the purchaser. The transaction would be secure and virtually free of charge. Banks and credit card operations could be largely phased out. The software based on central bank account keeping could easily transact the volumes of payments.

Our financial system would change for ever. Financial sector will do anything to survive and thrive in this environment. Thus not all the efficiencies of the blockchain technology and the crypto currency will come to fruition.

 

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