MAX WIETHE: Hello, everyone. Welcome to the Real Vision Daily Briefing. My name is Max Wiethe. I am joined today by Ed Harrison, but before I sit down with Ed, let us kick it over to Nick Correa for today's stories.
NICHOLAS CORREA: Thanks, Max. Today, I am going to provide a rundown for newly released December data for the Consumer Price Index. For this past December, the data shows the CPI experienced a 0.4% gain seasonally adjusted. This is on par with economist projections of a 0.4% increase in the CPI, and this follows a 0.2% gain in November. The Bureau of Labor Statistics attributes this gain to an increase in the gasoline index, which experienced an 8.4% gain and contributed to more than a 60% increase in the overall CPI.
Overall demand for all grades of gasoline still is lower with prices per gallon, now about 10% below than they were a year ago as virus related restrictions are being implemented and consumers are staying at home and therefore reducing their driving. The cost of food has also increased 0.4% as both groceries and eating out have gone up by 0.4%. This follows 0.1% decrease in November. All items less food and energy rose about 0.1% in December.
For 2020 overall, CPI Rose 1.4% which is less than the 2.3% increase in 2019 and is the smallest December to December increase since 2015. The average rise in inflation for the past 10 years has been 1.7%. If you want more on the inflation, Steven Van Metre and Michael Ashton today did a deep dive on the subject, and on the interplay between inflation, interest rates and the dollar. To flesh this out and more, let us go back to Max and Ed.
MAX WIETHE: Thank you, Nick. Well, Ed, back again on Wednesday. Glad to be here.
ED HARRISON: Yes, it is good to talk to you and we have some interesting stuff to talk about. We had a good back and forth literally right before we came on now about the reflation trade.
MAX WIETHE: Yes, I am excited to hear the nuance that you are adding to it. It is certainly not something that is a new topic. Everybody is talking about the reflation trade, and when everybody is talking about it, that leads to bad takes. You are going to help our viewers dissect a little bit about what they should be paying attention to, because they are going to be hearing about this at least for now.
ED HARRISON: Yes, I have two main themes, I think. Theme number one is what the toggle is in the reflation trade and theme number two are what are the discrete outcomes that we should be thinking about? The first on the toggle. When we talk about the reflation trade, we are talking about reflation. That is things going up as a result of economic stimulus, the economic goodness that comes from the vaccine as well as anything else that might be like pent up demand out there. The result is we see commodities going up, we see equities going up, we see yields going up.
We also interestingly enough, see the dollar going down because of that reflation trade because there is an incipient inflationary expectation there. All those things are put together in terms of this one nexus, the reflation trade, and usually most people call the toggle the US dollar. When the dollar is down-- and it was down to really low levels, and it kept on going further and further-- hey, great, it means more reflation trade, everything else goes up. Now, the dollar has reversed. I would say actually, the reason the dollar is reversed is actually because it is not the toggle, the toggle is the bonds, 10-year bonds in the United States.
Over the past week and a half, we have seen a massive rally in 10-year bonds. We went from basically flatline for this month, or even three months since November, to a massive upward spike in the order of 26 basis points at its worse when we got to almost 119 on the 10-year. This is something I talked to Peter Boockvar about yesterday, and to me, that unwound everything else partially and actually, mostly because this is a rise in real rates as opposed to a rise in inflation and that really put a dent on all the reflation trades that people were talking about. It put a dent on gold, it put a dent on Bitcoin, it put a dent on the dollar, the dollar moving higher.
MAX WIETHE: Yes, I think the relationship between real yields and gold is pretty well established. Obviously, if you have yields rising and inflation expectations are keeping up with it, real yields are going to creep up and that is going to put pressure on gold, but some of the other assets, it might not be as clear to viewers how what is happening with the bond market is playing out of those other assets. How directly is it? Is it playing out, say in equity markets?
ED HARRISON: This whole "it is the DCF, stupid" thing that I started because of Holger Zschaepitz, it has some merit. What I would say is actually, the framework that I am looking at in terms of where it has merit is it goes like this. It is that when you look at long dated assets, like equities, basically what you are looking at is discounted cash flows. If the discount factor is greater, everything else equal, the near term present value of those assets is less. The question is, when does that matter? Because we have been, I would say in the midst of a speculative mania, a reflationary mania, where multiples are expanding, but at some point in time, the DCF matters and what we are seeing is we are approaching those levels right now.
Part of it is not necessarily level but also step into [?] level. Perhaps it is not just that we are moving to 120, 125, 130 potentially on the 10-year, it is really that the 10-year yield went up so abruptly, that it really put a shock into the system and cause people to readjust their expectations about discount factors and it wound back the whole reflationary trade.
MAX WIETHE: Well before there was the reflation trade, there was the rotation trade, and that was the rotation from the high flying growth names into the dogs that were lagging. These were value stocks and stocks that should generally would benefit in an environment where yields are rising, where the yield curve is steepening, and where growth is no longer scarce. Are you saying here that, yes, that is true that those stocks tend to do better in those periods, but they are already at valuations that are lofty, because of the low rates and because of the DCF, and so that, although maybe in other periods of time, where we see this steepening, maybe we are heading into a period of higher growth, it does not matter because they are already so frothy, and that the DCF is actually outweighing this cyclical rotation that would happen in these types of periods?
ED HARRISON: Value is just taking a pause by and large. I would not necessarily say that value certainly is frothy. The froth is on the other side, with the Teslas of the world. Even with the Fang stocks of the world. I would look at a chart that you and I were looking at literally right before we came on, the commodities chart that The Economist posted on commodity prices from January of 2000 to today as being representative of the action, the price action that you are seeing in equities.
If you look at what is going on there, you basically see that there has been a reflation of commodities across the board with iron ore, in particular, going up the most. Interestingly, the commodities all did relatively well in that first period from January through April, when we had the shutdown. Oil is the one that collapsed. Even though oil has gone up at the same amount, it has lagged the others in terms of its going up. You could look at equities as, okay, we rotated into these plays, now we are looking for other players to take advantage of. The same thing is probably true in commodities that people got into copper early, copper has run up, but maybe there is still some juice left in oil and oil related stocks.
MAX WIETHE: Yes, and that is why you are seeing some of the flows dynamics playing out with XLE ETF. I saw two sources actually talking about this. Chris [?] was saying that there is some real flows moving into XLE and should this continue, it would put some real legs behind the rotation trade. Then as well, there was an article from Zero Hedge talking about a similar dynamic and the potential for a gamma squeeze. There is a little bit of positioning behind that narrative.
I want to switch, though, to those discrete outcomes that you hinted at before. What do you think of the discrete outcomes? What is the current situation in terms of where we are headed, most likely, or at least the trajectory we are on?
ED HARRISON: Yes. This is where you and I, we had the best back and forth about what does this mean? The three outcomes that I am thinking about are one, outcome number one, which is the trajectory that we were on before we pulled back and that is a steepening yield curve before we reach the post-vaccine stage. By and large, everyone is thinking that we are going through a dark winter, that we are going through a fallow period, we just lost 100 and some 1000 jobs. That could potentially continue into the new year, but people are looking through that into mid-year into the fall, and that is when good things are going to happen, but we are getting the steepening now well before that happens, and that is not necessarily a good scenario.
That is scenario number one. Scenario number two is where we continue to flatline. We backed off the 119 level, the last I saw, we were at like 106. Two days of good options, you back up five basis points, you back up another six basis points, and now suddenly, you are back in action to where you were before, maybe we flatlined for a very long period of time. 119 was just a phantom move, and we get to nirvana, post-vaccine nirvana, and then the yield curve steepens. That is a really bullish move, because that is where the reflation should be. That tells you the move is up, because now, we are getting this pent up demand, people are coming back, they are buying stuff.
The third scenario is that actually, what has happened, the move to 119 was premature, the reflation trade actually was somewhat premature, and the yield curve re-flattens, and we get a flattening of the yield curve, because this dark period, the light before the end of the tunnel, the tunnel gets longer, and it has much more of a negative impact. That third scenario is representative of when I talked to Jack, I was telling him, I was looking at three different bond proxies. One was HYG versus the ETF for investment grade bonds. This is a proxy for that.
If we see a bad scenario where you see the yield curve flattening, then you would expect to see more defaults, and therefore you would expect to see spreads go up. Then there are two other things. One is I am looking for TIPS versus Treasurys. That is where you get to see what the real yields are looking like. Then finally, it is just the overall rate of the 10-year, what is happening with the overall rate, what is happening with inflation, and then what is happening with credit?
MAX WIETHE: You said scenario three is potentially a bad scenario, and scenario one is potentially a bad scenario. Scenario three sounds to me like return to growth is scarce, the yield curve is incredibly flat, and that benefits the high growth, Fang names that were the darlings before this rotation trade kicked off. Is that the outcome for assets that you think would occur in that scenario?
ED HARRISON: We are going back to that scenario, but the difference is we are going back to it after we have already seen cracks. Then we are in a new paradigm, so to speak, we do not know whether or not we are going to go back to the nirvana of Fang doing really well and all these other stocks doing well in that same way. It may well be that people then realize, oh, wait a minute, things are different now. We need to price accordingly. It is the scenario that is most similar to the earlier world that we were living in, in say, September, October time frame.
MAX WIETHE: Then as well, in scenario one, you said, that is also potentially a dangerous scenario, because the market is getting ahead of itself. Is that just creating a scenario really for the transition from one to three? That is the risk, is that we skipped two and go from one to three, and that is why you think one is really also potentially a dangerous scenario.
ED HARRISON: Yes. One leads to two. The real problem with one is both the level of rates but also potentially the rate of increase as well as the real rates, because what is happening now, or what did happen we got to 119 on the 10-year is that real rates were going up, rates were going up quickly, real rates were going up quickly and a reflationary trade as a result completely unwound because the toggle being rates went down into the dollar and the nexus of the dollar started to unwind everything else.
We had real rates going up. The dollar being smore attractive as a result of that, a selloff in gold, a selloff in Bitcoin as a result of that, a selloff in some commodities. All that started to unwind. If that were to happen in greater measure, then you could potentially get a serious credit event, and that would be very negative.
MAX WIETHE: Interestingly, though, not oil. Oil did not really participate in that selloff. That goes back to that chart that you showed, which has oil as the laggard of the reflation assets.
ED HARRISON: Yes. That is interesting. Also, if you look at oil, it is also interesting to look at where the kink in the line is on that chart. Oil went up, the rate of change started to roll over. Then there was a reacceleration around just before the November election. Right in that range, October, November, the rate of change started to steepen a little bit. People were believing in the oil store. It is not just necessarily supply and demand. They were believing in the reflation trade as manifest in that kink.
MAX WIETHE: Well, I think now is the time to give viewers something to pay attention to, to see which scenario really plays out. You talked about the level of yields, but you also talked about the rate of change of yields. What are the key levels and the speed that people need to be paying attention to determine which one of these three discrete outcomes we are really trending towards?
ED HARRISON: Yes. You are actually harkening back to a question that I asked Peter Boockvar yesterday, and we were talking about that. The question to him was, what level do you have to get to before this whole nirvana falls apart, and he was already saying we are really close. 120, 125, et cetera, I am starting to tend towards the view that it is not just the level per se, but rather that it is also the rate of change. If you get to 125, in a heartbeat from 100, that is a different story than if you get to 125 from 100 over a longer extended period of time.
Where we are now, when we retraced back to 106, I think that legitimately, if we were to go up quickly, 30, 35 basis points, that would be enough to trigger a selloff in that whole reflation nexus. The absolute level that I would look at is 150, that has been my bogey for some time, is 1.5 in the 10-year, irrespective of how you get there, that is a number that will be difficult for markets to digest over the longer term.
MAX WIETHE: All right. Well, Ed, I know we are working hard this week, you are going to be on RVDB every day. I am not going to take all your good ideas. I will leave you a few for Thursday and Friday, and we will end it there. Thank you for this. It gives us a lot to think about.
ED HARRISON: Very good. You had much less pushback here in our open forum than you had when we teased out the ideas a little bit right before we came on, but you did a great job in like peppering me. If there is anything else you want to pepper me with, any doubts that you might have, speak now or forever hold your peace.
MAX WIETHE: I still have some thinking to do. I still have some thinking to do, and yes, it is always nice to be able to push back in our private calls, but I put on the jacket, show the respect, you got to do that. You got to do.
ED HARRISON: All right.
MAX WIETHE: I will talk to you soon.
ED HARRISON: You bet.