How a bull market becomes a bubble

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1 FX, Commodities & Rates Strategy March 16, 2015 How a bull market becomes a bubble

2 Summary: How a bull market becomes a bubble The March 18 th FOMC meeting begins the countdown to probably the most awkward tightening cycle of the past 30 years. The unemployment rate is declining at an unprecedented pace, but real GDP growth is weaker, inflation lower and the dollar much stronger than in months before the first hikes of the 1987, 1994, 1999 and 2004 cycles (slide 2). The dollar has been undeterred by a possible feedback loop in which this Fed cycle ends prematurely due to monetary conditions delivered through the currency. The lead-up to a June 2015 Fed hike is delivering faster appreciation than the 1994 and 1999 tightening cycles. The currency has only seen such combinations of a high real exchange rate and extraordinary momentum twice in the past 45 years in the mid 1980s and late 1990s. Some call those eras bull markets. Others call them bubbles (slide 3). Indentifying bubbles (Nikkei, dot-com stocks, US housing, Bitcoin) ex post has always been easier than forecasting them ex ante, much less trading both the upswing and the downturn profitably. Still, almost all mean-reversion cycles share these characteristics: extreme valuations, extraordinary momentum, leveraged positioning and an investment thesis that this time is different. All also tend to reverse due to a macroeconomic or policy shock (slides 4-5). Those who think of the USD s late 1990s bull market as a bubble remember that the currency was tethered to the stock market then. If create another USD bubble, it will more likely be driven by global bond markets. Negative interest rates are this cycle s game changer, according to the current narrative (slides 6-7). Of the usual hallmarks for a bubble, the most problematic one for the dollar now is valuation. Via some models, the dollar needs a 3.5% Fed funds rate to justify its current level (slides 8-10). Direct USD positions (probably leveraged) are easy to measure and known to be extreme. Indirect USD exposure through asset allocation is somewhat easy to track but impossible to quantify investors overweights of US assets (slides 11-13). Decision time: Do fundamentals improve to validate current valuations, or do they worsen and trigger reversal? If fundamentals deteriorate, how and when? (slide14). If this is a bubble, it needs a catalyst for reversal. The three most likely ones all seem like 2016 events: (1) Fed pauses after only -200bp of hikes because monetary conditions have already tightened through the currency; (2) ECB/BoJ begin taper talk as inflation approaches target; or (3) EM economies broadly turn higher (slide15). Strategy: staying long USD and volatility selectively, focusing on the laggards (slide16). 1

3 An awkward time to tighten US cyclical conditions at the start of the last four Fed tightening cycle versus today US cyclical conditions Apr-87 Feb-94 Jun-99 Jun-04 current headline CPI 1.8% 2.3% 1.9% 1.9% -0.1% core PCE 3.0% 2.3% 1.2% 1.9% 1.3% Inflation ex pectations 1 4.0% 3.5% 2.8% 2.8% 2.8% Unemploy ment rate 6.3% 6.6% 4.3% 5.5% 5.5% Change in UR in prev ious tw o y ears -1.0% -0.8% -0.7% -0.3% -2.7% Av g hourly earnings 2.0% 2.4% 3.6% 2.0% 2.0% real GDP grow th 2 2.7% 2.7% 4.9% 4.1% 2.4% USD REER v s long-term av erage 1.0% -1.0% 10.0% 1.0% 12.0% The March 18 th FOMC meeting begins the countdown to probably the most awkward tightening cycle of the past 30 years Indeed the unemployment rate is declining at an unprecedented pace, but real GDP growth is weaker, inflation lower and the dollar much stronger than in months before the first hikes in 1987, 1994, 1999 and

4 USD index is now outpacing previous bull markets USD index around previous four Fed tightening cycles USD index in two years before and after first hike JPM USD index business days around first hike current (June 2015) JPM USD real effective exchange rate level and change year-on-year USD REER (lhs) change yoy (rhs) The lead-up to a June 2015 Fed hike is delivering faster appreciation than the 1994 and 1999 tightening cycles. The dollar has only seen such combinations of a high real exchange rate and extraordinary momentum twice in the past 45 years in the mid 1980s and late 1990s. Some call those eras bull markets. Others call them bubbles. 30% 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% 3

5 What distinguishes a bull market from a bubble? Nikkei and Bitcoin Indexed to in 1980 for Nikkei and 2011 for Bitcoin Bitcoin Nikkei Anyone can identify a bubble ex post: it is the market that appreciated rapidly then reversed as dramatically Nikkei in 1980s, tech stocks in 1990s, US housing and yen-funded carry in 2000s and Bitcoin recently But all mean-reversion cycles tend to share these characteristics: Extreme valuations Extraordinary momentum Leveraged positioning An investment thesis that this time is different, this move is structural or the old norms don t apply All tend to reverse due to a macroeconomic or policy shock 4

6 How a bull market can become a bubble Six phases from a fundamentally-driven bull market to a potential financial market bubble Price Shock Macro or policy surprise erodes underlying fundamentals Turn Fundamentals go from bad to good Upgrade Fundamentals go from good to great Momentum Fundamentals haven t improved yet prices still rise Denial Valuation metrics signal expensiveness but this time it s different/structural By some measures, USD index is between these two phases Mean reversion Prices correct quickly towards long-term fair value Time 5

7 A refresher on the late 1990s twin bubbles in stocks and the dollar JPM USD real effective exchange rate level and S&P500 P/E forward P/E since 1987 and trailing P/E before) Those who consider the late 1990s USD rally and subsequent reversal a bubble recall this context JPM USD REER Index dot-com bubble 115 S&P mo forward P/E as measured by P/E ratios S&P mo trailing P/E Record valuations on US stocks as measured by P/E ratios Record volumes for cross-border M&A, particularly in tech and media Record foreign buying of US equities A narrative that the old valuation rules did apply because the internet was a game changer 6

8 If there is a next USD bubble, it would be linked to a different asset class probably global government bonds Less than zero: Yield on JPM Global Bond Index ex US by maturity bucket % JPM GBI ex-us, 1-3yr sector, yield, % JPM GBI ex-us, 3-5yr sector, yield, % JPM GBI ex-us, 5-10 yr sector, yield, % We learn sometimes and somewhat from our mistakes. If there is another USD bubble, it would likely be linked to a different asset class probably global government bonds Many investors think government bonds have a valuation problem but that yields are kept artificially low via central bank purchases (QE) and regulatory requirements. The valuation problem is most acute in Europe due to negative yields. The current narrative is that incalculable amounts of fixed income flows will target the US because at least the Fed is not taxing cash and bond holdings. Thus, negative interest rates are this cycle s game-changer There s one problem with this story: it ignores the feedback loop from a strong dollar to Fed policy 7

9 What s wrong with this story? Nothing except the Fed scenario required to validate valuations. USD this strong seems to require a 3%-3.5% funds rate USD needs the Fed to hike to 3.5% to justify current valuations Actual versus predicted USD from regressing on trade-weighted 5-yr spreads and equity volatility JPM USD nominal trade-wtd index Model USD diverged similarly from rates in the late 1990s Actual versus predicted USD from previous regression JPM USD nominal trade-wtd index Model The dollar has become unhinged from rate expectations, just as it did in the late 1990s. Rates markets expect Fed funds to peak around 2.25% in To justify current USD valuations, some models suggest that bond yields need to move at least bp in the US s favour. A move of this magnitude might require the Fed to tighten at least bp more than in the forwards, so to 3%-3.5%. 8

10 Valuations (part 2): USD real effective exchange rate JPM USD real effective exchange rate with 2-sigma deviations from long-term average The dollar s real effective exchange rate index is one of the more stationary (meanreverting) series in global markets It now sits about 12% above it s long- run average (approaching a 2-sigma deviation) The current level is about 5% below the 2002 peak but 15% below the 1985 peak 9

11 Valuations (part 3): breadth of USD expensiveness/foreign currency cheapness JPM real effective exchange rate indices % deviation from long-term average 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% INR CAD JPY COP SEK KRW ZAR TRY EUR RUB HUF MXN GBP PLN MYR SGD IDR CLP CZK ILS USD AUD NOK CNY CHF NZD BRL USD real effective exchange rate is quite elevated in that it sits about 12% above its long-run average (1.5 sigmas). But the distribution of valuation is skewed Cheap currencies: INR, JPY, SEK, KRW, EUR Still expensive: commodity currencies like AUD, NOK, NZD and BRL. Also CNY, which has a large index weight. 10

12 Momentum in the dollar and fund manager returns USD momentum versus returns for trendfollowing funds 30 JPM USD REER index, change yoy, % 25 HFR Systematic Diversified funds, returns yoy, % USD momentum versus returns for currency managers 25 JPM USD REER index, change yoy, % 20 HFR Currency funds, returns yoy, % , HFR USD momentum, as measured by year-on-year returns, has only been stronger once in the past 45 years (after Lehman) Unsurprisingly, trend-following funds (represented by HFR Systematic Diversified composite) are posting above-average returns. Surprisingly, dedicated currency funds (represented by HFR Currency composite) are not. 11

13 Positioning (direct): outright long USD exposure is undeniably extreme Net speculative positions in currencies and gold In $ bn Leveraged positioning is an essential element on any market remembered as a bubble current all-time high all-time low For several months, outright currency positions reported on US long and other exchanges has indicated currency record USD length in aggregate and (conversely) near-record shorts in all currencies but JPY and CHF short currency EUR JPY GBP CHF CAD AUD NZD MXN RUB BRL CLP Gold USD, CME, BM&F, Central Bank of Chile 12

14 Positioning (indirect): Asset reallocation is obvious is the flows, but quantifying the extent of US overweights is difficult due to heterogeneous investors Euro area: massive bond outflows, but we do not know where they are heading Balance of payments flows, 12-mo sum, billion equities bonds (short + long term) , ECB OMT May ECB meeting Emerging markets: outflows paused after the taper tantrum, so could resume Cumulative flows into emerging market equity and local bond markets ETFs and mutual funds, $ bn EM equities, $bn (lhs) EM local ccy debt, $bn (lhs , EPFR Global and Bloomberg Even if direct (leveraged )exposure to the dollar appears to be record high, global asset reallocation to the US could still drive the dollar higher. Europe is experiencing record bond outflows. Japan s bond outflow is average but it s equity outflow is record-level (GPIF-related). The EM rotation to DM paused when the taper tantrum ended but could resume. But it is almost impossible to quantify whether investors are overweight/underweight US assets. 13

15 A recap of the issues so far Valuations Real effective exchange rate levels: above average (about 1.5 sigmas) but 5% below 2002 peak and 15% below 1985 peak Real effective exchange rate breadth: USD is becoming expensive, but mainly due to cheapness of currencies like JPY, EUR and a few EMs. Most commodity currencies and CNY remain expensive. Rates-based models: extreme misalignment. Fed would probably need to tighten to 3%-3.5% to validate current USD index levels Momentum Price change over the past year: extreme. Only exceeded once in the past 45-year (after Lehman) Positioning Direction positioning: extreme. IMMs show record USD length in aggregate and against all currencies but JPY and CHF. Indirect positioning (through asset allocation): difficult to gauge. Cross-border outflows from Euro area bond investors and Japanese equity investors is unprecedented, but their desired asset allocation is tough to predict. So is the preferred allocation to emerging markets. Narrative This time it s different: Negative rates are the game-changer. But how much can the Fed deliver in this context? Decision time: what, how and when? Do fundamentals improve to validate the valuations, or do they worsen and trigger reversal If fundamentals deteriorate, how and when? 14

16 Catalysts: short Fed tightening cycle, ECB/BoJ tapering or EM growth upturn US monetary conditions index vs Fed funds rate MCI based on deviations of real funds rate and real USD index from long-term average EM growth slowdown has contributed to the dollar s broad rise EM - G10 real GDP growth versus USD index 8 25% 10% US MCI (lhs) EM - DM real GDP growth, q/q saar, lhs 6 9% Fed funds rate (rhs) USD trade-weighted index (inverted), rhs 4 20% 8% 2 7% 0 15% 6% 5% -2 10% 4% -4 3% -6 5% 2% -8 1% -10 0% 0% If this is a bubble, it needs a catalyst for reversal. All look like 2016 risk scenarios Fed pauses after only -200bp of hikes because monetary conditions have already risen from record loose in 2011 to the long-term average due to USD strength. Possible in early to mid ECB/BoJ begin taper talk as inflation approaches target. Possible in mid EM economies broadly turn higher. Possible in

17 Trading the bubble risk: side with policy momentum, focus on laggards Theme Fed will move -- eventually Trades Long USD vs JPY, GBP, SGD, TWD and ILS in cash Oil oversupply long EUR/NOK China s mini regime shift Limits to central bank balance sheet expansion Political risk Selective vol hedges long USD/TWD in cash short EUR/DKK in cash short EUR/CZK in options (6-mo 1x2 put spread, strikes ) short GBP/USD in cash Vol curve steepeners in EUR/USD (6M vs 1Y), GBP/USD (2M vs 6M), USD/JPY (3M vs 2Y), USD/CNH (2M vs 1Y) and USD/CLP (3M vs 1Y) Top Technical trades long USD vs EUR, JPY, CAD, NZD and SEK short EUR vs CHF, JPY, MXN and IDR

2015 FUZZY DAY CONFERENCE Facts that are Not Facts. The US dollar Safe Haven Myth and the United States Hedge Fund.

2015 FUZZY DAY CONFERENCE Facts that are Not Facts The US dollar Safe Haven Myth and the United States Hedge Fund Alessio de Longis 1 The Role of Currency in Institutional Portfolios, edited by Momtchil