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Spooky Action At A Temporal Distance

The parallels of the current equity market rally to the August 2010-February 2011 rally following Chairman Bernanke's hints about QE2 (a parallel I mentioned first about a month ago here) continue to mount. I can't call today's rally (a mere 0.1% on the close) a 'cheerful' rally except in the context of what might have been. Over the weekend, the G20 met in Mexico City, partly to discuss whether to increase the global commitment to a European solution (via funding for the IMF, which would then pitch in more than it has pledged to do so), and in very clear terms said no. That anything "in clear terms" would come out of a G20 communiqué is in fact unusual, but there seemed little doubt that further aid will not be forthcoming unless the Eurozone members themselves increase their commitment further.

Stocks were mildly irritated about this surprise in the overnight session, but only mildly, and that negativity was erased when the German parliament approved the Greek rescue package this morning. There was no doubt that it would do so, and yet there was a relief trade anyway.

Again, this reminds one of the mood in Q3 2010, when there were plenty of reasons for stocks to stay down (if not to fall further) and yet the market climbed; not only that, but it climbed inexorably. (It should be noted that core inflation bottomed in the month immediately preceding the month that QE2 was formally announced, although the precise timing is surely spurious.)

Another parallel is worth exploring here. The August 2010-February 2011 rally was actually in two parts. The first part ran from late August, when Chairman Bernanke delivered the Jackson Hole speech in which he all but promised QE2, until the week of the November FOMC meeting and the announcement of QE2. It covered 70 days and around 175 S&P points. Through the end of November 2010, while QE2 actually began, equities nevertheless declined about 50 S&P points; beginning in December and continuing through February 2011, the next leg tacked on another 175 S&P points over 79 days.

So far, this equity rally has covered 69 days and 167 S&P points. The similarity so far in pace and scope has been striking, with the main difference being the extremely weak volume on the advance. Now, there is no FOMC meeting tomorrow, and so the parallel is surely going to break down. Moreover, there seems not much chance that the Fed will announce a QE3 at the March 13th meeting. If there is a parallel, are we going to rally until the Fed actually announces QE3, or are 70 days and 175 points the measure to compare?

I suspect that the market has extended itself enough that, QEx or not, it is due for some turbulence. And, frankly, a 50-point setback wouldn't exactly crush the bull swing any more than the 50-point correction in November 2010 did. Leveling off and correcting into the end of the quarter, or at least into late March when we will find out for sure if Greece navigated one more payment bulge, seems reasonable to me especially with the cyclically-adjusted P/E up above 22 and the S&P dividend yield down below 2% (now 1.99%) again.

The parallel in bonds is somewhat more interesting. Bonds had rallied into the 2010 Jackson Hole speech, with 10-year yields falling from 4% in April to around 2.5% when the speech took place. So the rally in fixed-income had already taken place, and little else happened in nominal yields over next couple of months (see chart, source Bloomberg). But inflation breakevens rose sharply and real yields (not shown) fell, so that while nominal yields were not moving in the aggregate, inflation swaps actually rose about 50bps and real yields fell about 50bps between August 27th and the Fed meeting in November. I first wrote about this divergence here and here.

Generic 10-Year

While nominal yields were not registering anything in particular between Bernanke's loud hints about QE2 and the formal announcement thereof, there was considerable action below the surface. With that back story, consider the history of yields and breakevens since last summer, illustrated in the chart below.

The divergence is more subtle, to be sure, but at least since the beginning of the year breakevens have been moving steadily higher while real yields steadily fell. The tale of the tape: 10-year inflation swaps since year-end, +37bps (was as much as +44); 10-year real yields -32bps (was as much as -35bps).[1]

Coincidence? I don't think so. This rally has all the hallmarks of being money-induced, whether it's the perceived promise of QE3 or the actual LTRO from the ECB and other monetary actions from other benevolent central banks. (Oh, how interesting. LTRO2 is the day after tomorrow, about 71 days after the beginning of the first leg.) Had this been an actual rally on strong economic fundamentals, we should have seen real yields rise.

There have been a couple of other developments worth noting in inflation-land recently. One is that the short end of the curve has risen appreciably, so that the 1-year inflation swap rate is above the 2-year swap rate - something which hasn't happened since March and April of last year when oil prices were also on the rise (and 10-year nominal yields were about 150bps higher than they are now). Actually, the whole shape of the swap curve is different than it has been for a while (see Chart, source Enduring Investments).

Inflation Swaps Curve

Although you can't see it from the chart, 5y inflation 5 years forward (aka 5x10 inflation) is above 2.90% and is threatening 3%. That hasn't happened since last August (when 10-year nominal yields were 50bps higher than they are now).

Oh, and what happened to 10-year nominal yields after the first leg of the QE2 trade, and their long period of quiescence? Between November 4, 2010 and December 15, 2010, they rose by 100bps.

Incidentally, in 22 of the last 31 years, 10-year yields have risen in the 30 days following February 27th. While 10-year note yields have fallen some 1200bps over those 31 years, they have risen, on average, about 20bps between now and early May (see Chart, source Enduring Investments).

10-Year Yield Deviation

It is, in short, an inopportune time to be long fixed-income. And, frankly, I'm not too sanguine about stocks, as I have said. Our model continues to allocate quite heavily to commodities in this environment, as do I in my personal accounts. Among ETFs, I am long USCI, GSG; long INFL and RINF as long-inflation expectations plays, and long TBF to be short nominal bonds. I also own SPY puts and FXY puts (which is unrelated to what I discuss above) in small amounts.


[1] Note that I'm correcting the 10-year real yield for the substantial roll to the new TIPS issue, as otherwise it looks like real yields have fallen less than they actually have.


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