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May 14, 2015

Beware of A Massive Global Head Fake

Ralph Atkins and David Sheppard of the Financial Times report, Oil and bond yields signal shift from deflation worry:
Europe’s deflation scare is over — inflation is back. That is one interpretation, at least, of a tumultuous week in the region’s bond and other financial markets.

So far in 2015 the story of continental Europe has been about central bank action to avert a damaging deflationary slump, triggered by sharp falls in global oil prices. This week, however, two things changed, causing shockwaves across markets and highlighting the risk of investor complacency.

First, oil prices rose to their highest this year. Second, benchmark 10-year German Bund yields — which supposedly signal investors’ inflation and economic growth expectations — experienced a bout of exceptional volatility. Having fallen to just 0.05 per cent in mid-April, they shot as high as 0.78 per cent, before easing again.

Disentangling the extraordinary moves has baffled even seasoned market professionals; German Bunds should be dull and stable. Large-scale European Central Bank “quantitative easing” purchases have distorted the signalling role of bond yields and much of the sell-off was about profit-taking and investors exiting crowded positions. But evidence is growing of a decisive change in market expectations about future inflation.

“My feeling is that there has been a shift away from deflation worries — the ‘deflation trade’, which led to the collapse of long-term yields — towards some kind of reflation story,” says Frederik Ducrozet, economist at Crédit Agricole. “So it’s no surprise that at least the fast money has shifted out of Bunds.”

Trevor Greetham, senior manager at Royal London Asset Management, adds: “There is likely to be a global headline inflation shock in the second half of this year — although it will be one of the most predictable shocks ever.”

If perceptions have really shifted, bond markets may have reached a turning point, with European yields unlikely falling to fresh lows and possibly on a trend rise. With the US Federal Reserve expected to raise US interest rates later this year, that could ignite much more volatility across global bond markets — if not worse.

This week’s upsets ricocheted across Europe’s markets. The euro rose while share prices dropped — perhaps counterintuitively, because an escape from deflation should help corporate earnings.

“Equities hate deflation so if bond markets are moving away from [pricing in] deflation that should be constructive but the speed of the move has been a problem,” explains Nick Nelson, European equity strategist at UBS. Eurozone shares ended the week down 3 per cent from their April 15 peak.

The inflation outlook will hang crucially on whether evidence mounts of a pickup in economic growth — and what happens to oil prices. Since falling 60 per cent between June and January to a six-year low of $45 a barrel, crude oil has posted a strong recovery. On Wednesday North Sea Brent, which prices around two-thirds of global crude deals, hit a high for the year of $69.63 a barrel, its rally fuelled by stronger demand and a near record number of hedge fund bets that the US shale boom would slow.

A linear rise to $100 a barrel by the end of the year would theoretically push annual eurozone inflation from zero per cent in April to 1.8 per cent in December, according to calculations by UniCredit. With inflation back within the ECB’s target of an annual rate “below but close” to 2 per cent, the future of its QE programme would be thrown into doubt.

Such scenarios could, however, quickly prove wrong — if the stronger euro or higher oil prices hit growth, for instance. Moreover many investors are asking if oil’s rally is sustainable. By Friday Brent had already fallen back to nearer $65 a barrel as traders said the recovery had come too soon. US shale operators say the price rally may allow them to keep increasing output, adding more oil to an oversupplied market.
“You are hearing one US exploration and production company after another saying they are going to deploy more rigs in the second half of the year than the first,” says Edward Morse, head of commodity research at Citigroup. “You also can get as much as another 700,000 barrels per day incremental growth in 2016 from the backlog of drilled-but-uncompleted wells in ‘shale plays’.”

So far the change in market inflation expectations has not been dramatic. “It doesn’t feel like a strong end-of-cycle pick up in inflation,” says Mr Greetham. The swaps markets assume an average eurozone inflation rate over five years starting in five years of 1.8 per cent — up from less than 1.5 per cent in January, but still significantly lower than in recent years.

“Markets are still pricing in extremely low levels of inflation — and nobody is forecasting much of an acceleration,” says Laurence Mutkin, global head of rates strategy at BNP Paribas. “I don’t think you can expect annual rates to rise soon above 2.5 per cent on either side of the Atlantic, so you don’t have to see bond yields rising much further either.”

Nevertheless, the change in sentiment is noteworthy compared with past gloom. Gilles Moec, European economist at Bank of America Merrill Lynch, warns: “The market is waking up a bit late to the fact that global deflation is not going to happen.”
Global deflation is not going to happen? Really? That's news to me because I keep warning my readers to prepare for global deflation or risk getting slaughtered in the years ahead.

Let's go over a few things which I think are confusing people. First, the euro deflation crisisis far from over. The fall in the euro temporarily boosted import prices and inflation expectations in the eurozone but the underlying structural issues plaguing its economies have not been addressed.

Unless you have a significant pickup in eurozone employment and wages, you can forget about any reflation in that region. The ECB will keep pumping trillions into banks but unlike the Federal Reserve, it's limited in what it can buy in its bond purchases.

Then there is Greece. The latest payment plan is just a shell game. The Greek disconnect is alive and well and threatens not only the eurozone but the entire global financial system through contagion risks we're unaware of and by extension, the entire global economy.

But even if they find a solution to this ongoing Greek saga, there are other far more important worries out there. The China bubble is my biggest concern right now. According to a senior Morgan Stanley investment strategist, the worst of the Chinese economic slowdown is likely still ahead because of the nation's debt:
"China, to try and sustain its growth rate in the post-financial-crisis era, has engaged in the largest credit binge of any emerging market in history," said Ruchir Sharma, head of emerging markets and global macro at Morgan Stanley Investment Management,

Sharma, speaking Tuesday at the Global Private Equity Conference in Washington, D.C., predicted that the credit boom would cause problems.

Whenever a country increases its debt to gross domestic product sharply over five years, in the next five years there's a 70 percent chance of a financial crisis and 100 percent chance of a major economic slowdown, according to Morgan Stanley research.

The Chinese government this week cut interest rates for the third time in six months because of projected 7 percent GDP growth this year, the lowest level in more than two decades.

Sharma said the slow growth he forecast would be around 4 percent or 5 percent over the next five years, about half the rate of what it used to be. 

"If China follows this template, it really is payback time," he said.

Another speaker at the conference, former U.S. Gen. Wesley Clark, took a less grim view.

"I'm not as worried about the buildup of debt in China as other countries," the founder of Wesley Clark & Associates said.

He cited two reasons. The renminbi is not fully convertible to other currencies, and the Chinese economy still has elements of central control.

"Every year people at these business conferences say the demise of the Chinese economy is coming very rapidly," Clark added. "But it hasn't happened. And President Xi is not going to let it happen if he can avoid it."

Another China bull, Robert Petty, managing partner and co-founder of Clearwater Capital Partners, said China can forestall its debt problems.

"We believe the balance sheet of China absolutely has the capacity to do two things: term it out and kick the can down the road," Petty said.
It remains to be seen how Chinese authorities will forestall or mitigate  the inevitable slowdown but if it's a severe slowdown, watch out, we're going to have more deflationary pressures heading our way (any significant decline in the renminbi will mean much lower goods prices for the developed world since we pretty much import most of our goods from China).

The demographics of China and Japan are also scary. China is sliding into a pensions black hole and Japan isn't doing that much better. Some of the same structural issues plaguing the eurozone -- older demographics and low birth rate -- are plaguing China and Japan.

So if we China slows down considerably in the years ahead and Abenomics fails to deliver in Japan, where is global growth going to come from? Europe? Nope. BRICS? Apart from India, the BRICS are weak and getting weaker, not stronger. Russia is trying to hold on for its dear petro life and Brazil isn't going anywhere as China slows down.

Then there is America, the last bastion of hope! U.S. job growth rebounded last month and the unemployment rate dropped to a near seven-year low of 5.4 percent, but there's still plenty of slack in the economy with the number of Americans not in the labor force rising to a record 93.2 million (most of these long-term unemployed are women). Moreover,America's risky recovery poses serious challenges to the global economy, especially if the Fed makes a monumental mistake and starts raising rates too soon and too aggressively.

Perhaps this is why U.S. banks have tempered their bond purchases recently:
There's at least least one good reason why Treasury yields have been drifting higher all year: Banks haven't been buying.

In fact, total U.S. government debt holdings by the 18 largest banks in the country declined by $2.6 billion in the first quarter, according to SNL Financial data that Citigroup cited in a note Tuesday titled, "The Bid for Treasuries is Over."

The decline in purchases of Treasurys mirrored a general slowing in securities growth in the quarter, with holdings increasing by just $18 billion after rising $42 billion in the fourth quarter of 2014 and $61 billion in the third quarter.

Bond yields have been volatile through the year and on a general glide higher overall. The benchmark 10-year Treasury note began the year at 2.12 percent and traded around 2.24 percent Tuesday afternoon. The 10-year's price, which moves inversely to yield, has fallen 2.26 percent in 2015.

Fixed income bears believe U.S. economic gains and a less accommodative Federal Reserve will result in significantly higher interest rates this year. However, gross domestic product has shown only halting progress so far—and in fact could see a negative number when first-quarter revisions are through—while market expectations for a Fed rate hike are pegged firmly at the latter part of the year.

Of the biggest U.S. banks, most mildly added to their portfolios, but sharp drops from Bank of America, JPMorgan Chase and Morgan Stanley offset those gains. Wells Fargo was the biggest buyer in the quarter.
The bid for Treasuries is over? The end is near? Is the scary bond market about to get  a lot scarier?

I'm sorry but I'm not buying all this nonsense. We are one significant credit event away from another major meltdown which is why central banks around the world are still in easing mode, some much more aggressive than others. And there are plenty of nervous global investors hitting th bids on treasuries even if U.S. banks moderated their purchases.

All this liquidity being pumped in the global financial system is a desperate attempt to reflate risk assets and inflation expectations. As I've repeatedly stated, if there truly is a global recovery underway, pay attention to emerging markets (EEM), including China (FXI), Brazil (EWZ) and Russia (RSX) and sector ETFs like energy (XLE), oil services (OIH) and metals and mining (XME) which are early cyclicals. 

I remain highly skeptical and think many investors are confusing powerful countertrend rallies due to currency fluctuations and are underestimating the real potential of global deflation down the road, especially if the Fed moves on rates too early. 

But there's no doubt oil prices have recovered somewhat boosting many shares of energy companies. On Monday, there was another big countertrend rally in oil drillers and service stocks:

I can show you the same thing in other sectors leveraged to the global recovery, like shipping and mining stocks. You'll see powerful countertrend rallies and the bulls get all excited and will tell you the global recovery is only going to get stronger which is why bond yields are climbing all around the world. 

Be very careful here. There is a massive global head fake going on which will attract many suckers in only to disappoint them later on. I hope I'm wrong but if you're betting big on global reflation, hedge accordingly because I think it's going to be a long hot summer and scary Fall. 

Courtesy Leo Kolivakis, founder of Pension Pulse (EconMatters author archive here)

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