Submitted by Paul Mylchreest of admisi.com
Exter’s Pyramid “in play” (and is Martin Armstrong right?)
In a global debt bubble, it concerns us when the benchmark debt security still looks good value, albeit on a relative basis.
Source: Bloomberg, ADMISI
In spite of this, the consensus is (once again) calling for higher US yields and FOMC “lift off.” The two-year Treasury yield has been pricing in the latter…
Source: Bloomberg, ADMISI
…but the question is what is the long end of the Treasury curve pricing in?
Slower growth and lower inflation, most likely. Risk of global contagion, possibly. That the FOMC makes a mistake (in raising rates)…maybe that too.
The Fed might be desperate to raise rates ahead of the next downturn (how embarrassing not to) but this analyst would be surprised to see more than 1 or 2 token 0.25% increases – and that’s if things are rosy.
As we know, the narrative from central banks can change at the slightest hint of trouble, e.g. Ballard’s QE4 comment during last October’s selloff. Watch the spin as the Fed portrays lower energy prices as “transitory” and no reason to alter its desire to tighten, while the ECB’s desire to ease only grows, even though neither is achieving its mandate on prices.
Do what thou wilt shall be the whole of the law?
The key point is that you can’t normalise rates in the “Winter” phase of a long wave (Kondratieff) cycle. There is just too much debt. It’s debt that drives these cycles and eventually brings them to an end.
This is the fourth cycle since the Industrial Revolution and the longest by far. The lack of a gold standard has allowed the central banks to extend it through unprecedented credit creation.
Here is our timing of these cycles:
1788—1843 56 years
1844—1896 53 years
1897—1933 37 years (1937 was a policy error when recovery established in our opinion)
1934—? 81 years (and counting)
The next cycle doesn’t begin until the excess debt from the previous cycle has been purged. Historically this has occurred via debt deflations of varying length and severity. In a world of unlimited credit creation, inflating the debt away remains an option and we question whether renewed onset of debt deflation will ultimately be dealt with via central bank-created inflation? Mr Abe and Mr Kuroda are conducting such an experiment.
In the meantime, we see a possibility that the Fed could raise the Fed Funds rate in several months’ time only for long-term Treasury yields to continue their decline, while the ECB could instigate sovereign bond QE and long term sovereign yields (ex-Germany certainly) could rise…which was the experience of the US (QE1, QE2 and QE 3 pre-taper).
Talking of flattening yield curves…
We’ve been looking at yield curves in the run up to the last two peaks in the S&P 500 in March 2000 and October 2007.
It basically doesn’t matter which part of the Treasury curve you choose in terms of 2s, 5s, 10s and 30s, but spreads declined to roughly zero, or negative, prior to the equity market peaks.
Here is the 2s10s...
Source: Bloomberg, ADMISI
The 2s30s...
Source: Bloomberg, ADMISI
The 5s10s.
Source: Bloomberg, ADMISI
And the 5s30s, although we could have added the 2s5s and 10s30s just for the hell of it.
Source: Bloomberg, ADMISI
Could the same thing happen again in a structurally (much) lower interest rate environment this time around?
Well 190 bp of flattening in the 2s30s might be pushing it, but 46bp in the 5s10s is certainly possible in the fairly near future with the way things are going. Funnily enough, if the 10-year Treasury yield was in line with the 10-year Bund, the 2s10s spread would be -8bp, i.e. close to zero.
While we expect the S&P to be lower at the end of 2015 than the beginning of 2015, our point is that more flattening might be in order prior to a major correction in equity markets like the S&P 500, Footsie, DAX,, etc. In general terms, it also suggests that it might be too early to lose faith in “bond proxies” such as Utilities and some Consumer Staples.
A significant further flattening in the curve is looking increasingly more likely...
Indeed, the major story for us right now is that the broad concept incorporated in “Exter’s Pyramid” is in operation. This something we mentioned in Autumn last year and it’s occurring across currency and credit markets and, to some extent, in equities.
To recap, John Exter (a former Fed official, ironically) thought of the post-Bretton Woods financial system as an inverted pyramid resting on its apex, emphasizing its inherent instability compared with a pyramid resting on its base. Within the pyramid are layers representing different asset classes, from the most risky at the top down to the least risky at the bottom.
He foresaw a situation where capital would progressively flow from the top layers of the pyramid towards the bottom layers.
“…creditors in the debt pyramid will move down the pyramid out of the most illiquid debtors at the top of the pyramid…Creditors will try to get out of those weak debtors & go down the debt pyramid, to the very bottom."
Below is his drawing of the inverted pyramid as he saw it in the late-1980s, when the riskiest assets were Savings & Loans (“thrifts”), Third World debt and (relevant to today) junk bonds, etc.
We think that Exter’s Pyramid went “live” in in late-June/early-July 2014 when the dollar index (DXY) began to strengthen…
Source: Bloomberg, ADMISI
…along with junk spreads.
Source: Bloomberg, ADMISI
The perfect illustration of Exter’s Pyramid is across the credit markets (as seen via ETFs) with capital flowing from HY through IG…
Source: Bloomberg, ADMISI
…and from IG into Treasuries.
Source: Bloomberg, ADMISI
There is some evidence that this is happening intra-equity market.
For example, here is the chart of the S&P 500 High Quality Index versus the Low Quality Index, where “Quality” is measured in terms of growth and stability of earnings and dividends.
Source: Bloomberg, ADMISI
The point about Exter’s Pyramid is that there is a large amount of capital in riskier financial assets in the upper layers of the pyramid which can flow downwards.
Consequently, the valuations of perceived “safe” assets could obviously overshoot if there is no let up.
Capital flows into dollar assets are a major part of this process right now.
We haven’t mentioned Martin Armstrong’s “Economic Confidence Model” (ECM) for quite some time but we’ve been thinking about it recently. The ECM, based on 8.6 year cycles, is often very successful at tracking turning points in the “hot money” flow of global capital.
Now is not the time for a detailed explanation, but for anybody not familiar with the ECM, Armstrong’s report “It’s Just Time” (google it) from several years back is one of the best we’ve ever read and provides excellent background.
The ECM’s peak on 2007.15 (i.e. late-February 2007) picked out the emergence of the sub-prime problems almost to the day. It did the same with the peak in the Nikkei Index in December 1989 and, we know this because we checked, the Great Crash of 1929 (which was 7 x 8.6 years back from the Nikkei’s peak). The 1987 crash was an intermediate peak in the cycle which ended in 1989.
What is fascinating is that the current ECM cycle peaks on 2015.75, i.e. at the end of September this year. The low point of this cycle was 2011.45, i.e. June 2011 which Armstrong refers to as:
“The 2011 bottom was the peak in oil and gold and the start of the breakout in stocks and the beginning of the Euro Crisis in full bloom.”
In contrast, we think that the 2011 low in the ECM marked the low in the dollar…here is the DXY again back to 2010.
Source: Bloomberg, ADMISI
Furthermore, the intermediate peak of 2013.60 (July 2013) and the intermediate low of 2014.68 (early-September 2014) also align quite closely with the dollar, as is obvious from the chart.
Armstrong is talking about this September 2015 being the peak in the “bond bubble”.
If our interpretation is correct, the dollar AND ng-term Treasuries could have further strong upward moves between now and late-Summer 2015.
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