In Graphs: eight inflection points to look out for in 2013
A steadily weakening gold price over the past few months began to slide after the release of Federal Reserve minutes at the beginning of January, signalling the first suggestion the Fed is getting cold feet on quantitative easing (QE).
Over the course of five days from 2 January, the price fell by more than $40 to $1,646, from a high of $1,788 in early October. Dollar devaluation and its inflationary potential has been one of the biggest driving impulses behind the extraordinary bull market, and its removal would take away a key support.
Gold exchange traded funds now reportedly hold more physical gold than any other single buyer other than the European Central Bank (ECB), the Fed and the Bundesbank. While they would add gold on pricing if retail investors began to flee, they are unlikely to do so at anything like current levels.
A key support level both up and down seems to be about $1,550; if it crosses this, expect it to keep going.
US Treasury prices weakened after the release of the Fed minutes on QE. The shift in the risk-free rate has not been reflected in high yield pricing, however.
The chart above shows the Merrill Lynch High Yield Index spread plus the yield on 10-year Treasuries. The spread between the two has been lower in the past, but only during periods when the Treasury yield appeared both more realistic and more sustainable.
The last time the spread was this narrow the 10-year US Treasury benchmark yielded 2.746% versus 1.9% on 4 January. Treasuries had already moved from a low of 1.4% last year, while commercial paper continued to tighten sharply. It is clearly not a relationship that can be sustained indefinitely.
This makes high yield pricing doubly vulnerable to any reversion in inflationary expectations, with both absolute and relative pricing offering little leeway: a potential double bubble.
While bond and gold pricing are two of the biggest potential game-changers this year, the third variable, equity, has begun moving largely independently.
The ratio of equity/bond returns has sharply broken out of its recent range. While sovereign pricing has wavered, the degree of movement in the index is almost entirely due to the recent equity rally.
‘The [equity/bond] ratio is now in a clear uptrend and is poised to test its early-2011 highs,’ said Phillip Colmar, partner at global investment analyst the Macro Research Board. ‘A breach of those highs would represent a breakout of the trading range that has prevailed since 2010 and could provide technical support for further gains.’
Short of a major breakdown in economic prospects, with the US or China or both re-entering recession, it is hard to see fixed income having any mileage from current low, stable levels.
While the reference numbers above are not hugely up-to-date, they illustrate how much sentiment has the potential to drive returns over the next year, dependent on how the wind blows.
Institutional investors continue to sit out the equity market in huge numbers – a clear reason for sustained market weakness but also an illustration of how much potential powder remains dry.
The chart above shows Professor Robert Shiller’s Equity Confidence Index, a measure of institutional investors’ confidence in the value of equity. As of November 2012, they were less confident than at any point since September 2010 and within a few basis points of July 2007, as the S&P hit its all-time high.
Recent equity highs have been reached on record-low market volumes. A change in sentiment and a more broad-based rally would offer a much more sustainable starting point for a further leg-up.
Interest rates are arguably the single most decisive factor behind the trend reversals that could fundamentally shift the course of gold and bonds this year. However, interest rate expectations are both volatile and distorted.
It is too soon to claim there is any strong evidence that a substantial change in expectations is under way, despite three and six-month forward rates (above) moving up from their late-2012 lows. But Fed minutes revealing shakiness over the duration of QE3 could yet be a game-changer in an environment where low interest rates had broadly been expected to remain static to infinity. ‘A sidelined Fed is very positive for the US dollar relative to European currencies, and negative for gold and government bonds,’ said Stewart Richardson, chief investment officer at RMG Wealth.
GAM rates manager Adrian Owens pointed out last year that QE distortions offered a range of arbitrages. ‘Volatility has been crushed at the short end but that will at some point appear at the long end,’ he said.
Wealth Manager has extensively covered the shift in the US economy due to US fracking, but the revolution seems to be happening even faster than many industry evangelists expected.
The chart above shows the US Energy Information Agency (IEA) forecasts for West Texas Intermediate oil pricing from 2012 and 2013.
A year ago, the IEA was forecasting an average 2012 price of $101 and a 2013 price of $106. The actual price was $94.12 and this year’s was revised down by a massive $16.
That is obviously partly due to demand, but unexpected supply is the main driver. As recently as late 2012, the IEA expected 2014 US oil imports to fall to a 20-year low; this has now been revised to 25.
Aside from being bearish for the extended recent high in oil prices, it is a huge change for the world economy. The unforeseen consequences are a multi-year story, but will begin to be felt in 2013.
The ECB’s commitment in September to spend unlimited amounts of cash to shore up member states’ sovereigns has put the euro crisis on the backburner, but crucially has so far gone untested. The history of sweeping financial assurances suggests that if you tell the world you have a bazooka, at some point you will be pushed to actually use it.
The first trigger for a run on confidence could be as soon as next month, when a series of wildcard candidates in the Italian election could shake bond market confidence in the government’s ability. More broadly, Greece will enact its next round of austerity measures this year, with youth unemployment above 56% and the economy due to shrink by 22% over the five years to 2014.
Spain also continues to struggle. Credit default swap (CDS) prices across southern Europe have tumbled but are likely to rise again before ECB boss Mario Draghi pulls the trigger.
In the last week, S&P 500 Volatility as measured by the Vix Index has fallen back to a level not seen since 2007.
While significant, more interesting is how low it remained throughout the extended debt ceiling negotiation: the market did not seem to price in the very real consequences of failure, but rather a resignation that the political class will make a lot of noise but eventually do the right thing.
Was this a wise acceptance of the new normal, or complacency? With large numbers of Republican representatives deeply unhappy about the fiscal cliff deal and a further increase in the debt ceiling required within the next six weeks, we may soon have an opportunity to find out.
If the current low level can be sustained over that period then it would suggest that the last five years of elevated volatility have been tamed by the calm waters of near-unlimited liquidity.