Where’s the Pain Trade?
Featuring Michael Purves
Published on: August 5th, 2019 • Duration: 17 minutesMichael Purves, CEO of Tallbacken Capital Advisors, is closely watching the divergence between stocks and bonds. In this interview with Alex Rosenberg, Purves makes sense of this discrepancy with an analysis of the differing factors influencing those respective markets. He also explains how an uptick in global economic data could catch many investors offsides. Filmed on August 2, 2019.
ALEX ROSENBERG: Welcome to Trade Ideas. I'm Alex Rosenberg, here with Michael Purves of Tallbacken Capital Advisors. And before we get into everything we're going to talk about today, what's a Tallbacken?
MICHAEL PURVES: Thank you for asking and thanks for having me back, Alex. So, Tallbacken is the name of my new firm. It's an obscure Swedish phrase referring to a gnome with large pine trees on it actually, it's a slightly obscure reference. But one I'm fond of. As you know, I've been- for last couple years, I've been at Wheaton company, broker dealer. The way the sell side is changing is that it's really bifurcated. There is either trade execution over here, if you will, which is increasingly favoring large scale, heavy technology, or there's this content.
And there's an unbundling of how content and trade execution is happening. And so for me, just looking prospectively, looking at some of the trends in Europe with method and so forth, it just made it was clear that just going to a pure content model that where the clients, institutional clients are just paying a monthly or quarterly fee for high quality advice.
ALEX ROSENBERG: Let's get some of that advice here. Last time you were on was in June, you talked about this divergence between what the bond market and what the equity market seemed to be looking at. You said it was almost like they were looking at two different sets of economic data with the bond market looking for much slower growth, maybe even recession, equity markets, a lot more sanguine. And a lot's happened this week. We've gotten the Fed same, and we got Powell talking about how his insurance cut, we got another tweet about tariffs from the President. And then today, Friday, we got a jobs number that pretty good overall, pretty substantial wage growth at least. So given all that, who has the upper hand, who's winning this fight between stocks and bonds?
MICHAEL PURVES: I think one of the most enduring things is this enduring gulf between the bond market. And when I say the bond market, I'm talking about the Treasury market, on the one hand, and then the equity market, and I'll put credit with that as well, high yield investment grade credit over here. And you asked me who's winning, well, in a sense, I guess they're both winning, because the S&P is up 20% year to date. And if you went long Treasuries, even doing great. But within that both are winning condition, the question is, is what is the story between those two? Because still, okay, Powell gave us 25 basis points.
And it would seem to be a little bit more of a nudge that, hey, we're not starting our cut cutting cycle, but we could easily do more than just this one cut. So, between those two areas, trying to thread a few different needles, which was quite candidly, for all the criticism that Powell gets, he has a very hard job, when on the one hand, there's an enormous gulf between where the rates markets, the bond market, the Treasury markets decided to go over the last several months on the one hand, and where his economic forecasts are, which are pretty much by the way, right in line with Wall Street consensus forecast as well. And most other institutional forecasts, whether it's IMF or World Bank, or so forth, there's variances, but they're usually marked by 10 or 20 basis points in terms of 2020 GDP and inflation.
And then, on the other hand, Powell also has to fight this battle, in a sense with the White House, because sure enough, right after Powell came on Wednesday, Trump was out there commenting that, hey, you know what, he's not playing the ball here. And, this morning, Larry Kudlow was in the media discussing how lucky that we've had highly restrictive monetary policy for the last few years. So, he doesn't have an easy job, he's fighting a war on two fronts, the White House and the markets. And with a huge gap between that. I think it's how this gap gets resolved is A, going to require a lot of finesse from Powell, finesse that a lot of people would say he hasn't actually mastered yet.
But frankly, you could have the most articulate and nuanced Fed chair ever, in this role, it's a hard job to navigate that, because on the one hand, let's say he doesn't give us a cut in September, because the economic data is strong and the bond market is still heavily bullish rates, meaning they're expecting yields to be lower for longer across the curve, well, that's almost like giving a rate hike in a sense to the markets in terms of it's jarring, and therefore, he drives up the VIX. And he's going to put a little bit more financial stress, and it's a little bit circular. Because then of course, financial stress is one reason for him to cut.
So, it's a very difficult condition there. And I think there's another dimension of this whole rates rally here, which is really important. I touched on it in June. But I think it's worth talking about again, which is that the global rates market has been one that's been even more extreme, of course. And look at the bund market where the 10-Year Bunds are minus 40 basis points, so they keep somehow making fresh lows. Now, we can debate the economic rationale buying a bund for 10 years with a negative 40-point yield on it. But nonetheless, that's where the markets are actually pricing that particular security.
So, one of the things that I think is a real conundrum for Powell is that he's talking about the rest of the world issues, rest of the world weakness, the Eurozone, China, and so forth, as being this principle rationale for the insurance cut we just got or for- and effectively for any dovish policy we get prospectively, but my question to Powell would be, but sure, but a lot of that stuff is already reflected in these foreign bond markets. So, with bunds are crazy low, that's reflecting real persistently weak economic condition in Germany and Europe and so forth. And those bund yields have been dragging down our Treasury yields with it right now, clearly, there's the Treasury market, the Eurodollars market, the Fed Funds markets are very focused on what Powell's policy is going to be with respect to the Fed Funds Rate.
Nonetheless, the correlation between the bunds and the 10-Year Treasury Yields has been spiking hugely as both yields came lower together. There's always some correlation, but the correlation got really, really strong here. So, to play out a scenario into later this summer or fall where it seemed so hard to imagine right now. But what if there's a big economic uptick in some of the Eurozone data? And what if those bund yields start climbing back to zero or up to positive 10, 20, 30 basis points where they were for a lot of the last several years, even though the Eurozone data never got that great. In 2017, it was picking up but it never really got back yet.
But still from minus 40, 60 basis points is a scenario you have to consider. And given how strong the correlation has been with rates coming down together, is that going to lift certainly at least the 10-Year back up, and also not only re-steepen our yield curves, but also throw yet another monkey wrench into how Powell is processing all this data and all this market data, the economic data and the market data.
ALEX ROSENBERG: So, if it seems like the bond market and the stock market are looking at different things, perhaps is because they are maybe earnings and the economy in the US is strong enough for equities to remain bid, while the bond market, that's a pool investors were thinking, do I want to buy US Treasuries? Or do I want to buy bunds at negative rates? So, I guess if you're thinking about the chance of improving economic data in Europe, leading those rates to go higher, obviously negative for the bond market in the US as well, I guess how correlated do you think that global economic data is? Especially, we're in a world with deep increasing trade tensions, increasing divergences between the political outcomes. Just look at Brexit and all the other things that are happening in Europe that are not necessarily related to what factors are producing in the US. I guess, how does that economic correlation play into that market correlation?
MICHAEL PURVES: Yeah, it's a great question. And thank you for asking it. But look, the stock answer about the US is that we're relatively insulated relative to certainly economies like China, the Eurozone, and so forth. It's just we're a lot more self-sufficient. And that's true. Having said that, if you talk about the US Equity Complex, that is not insular. That is, for discussions, just pretend the S&P is one giant company. It's a global multinational company where nearly 50% of its revenues come from overseas, therefore. So even if our economy is more like 25%, the S&P is more closer to 50%. When you talk about the US economy, and you talk about the stock market, you have to first start with appreciating that difference there.
The other thing that you were touching on is that this economic correlation across countries and look, clearly the US has been the outperformance story relative to the rest of the world, still is. Not saying on the face of it that those correlations are relatively weak. But there's also things that tend to lag. The correlations have been remarkably strong between the Eurozone, particularly a lot of the German manufacturing data and a lot of the Chinese economic data, those correlations tend to be really stickier and stickier.
ALEX ROSENBERG: So in the midst of this global situation where stocks and bonds are may be looking at different things, of course, all part of the global economy is, as we discussed, where is the greatest pain trade do you think? Is it in stocks? Is it in bonds? Is it in some other asset? And which way does that go? It's hard to figure out how people are- when so many people are looking at different things, it's not like everyone's on one side of the boat necessarily.
MICHAEL PURVES: That is a great question like several minutes ago, you asked me like, so who's winning, bonds or equities? And I said, both. I would say, though, in terms of where the pain trade is, and I think that's a really good question or way to frame this discussion, where's the asymmetric risk to the downside? And I would say, candidly, and it's a tough call to make given how strong this bond market rally has been. But to my mind, I think there's still a very good case for rates in the United States to be going higher here.
We talked about some of those scenarios where what if the Eurozone data gets better? What if the China's stimulus starts taking hold, and that ricochets into the Eurozone data, and that lifts yields higher and that will be exported into our market over here and then you'll see a quick rise up higher here? And that very least there's a lot of sentiment pulled up on that whole Treasury notion, that 10-Year Yields go to 1% and all that. And some people were even saying, zero percent. I'm not quite convinced that's the case.
And then when you talk about where are people- how are people positioned? Well, look at the Eurodollars positioning, if you look at the net speculative positioning relative to the total open interest, they're at 7-year highs, basically post great financial high. So basically, in the money markets, everyone and their grandmother seems to be long Eurodollars right now. That to me, is a risk factor. That people are heavily on one side of the boat.
Equities, on the other hand, look, we've had year to date rally 20%, we came off those December lows, it was supposed to be this, oh, my God, we're going to be- that was part of that whole, like, we have trade, and Powell's going to hike us into a recession. We've had a really solid risk rally here. But I'm not convinced that it took everyone with it. I don't see a lot of sentiment gauges that were like, oh, my God, like it's not like every taxi driver is screaming about like get long Amazon. That condition, I don't see it. Either in the retail space or the institutional space right now. I think partly because of this bond market bid, there's a healthy skepticism about oh, my God, well, geez, do I really want to play here? Do I want to be buying the market 20% up year to date, when the bond market is seems to be telling me there's a recession in 2020?
So I don't think this- I think a lot of large scale allocators have been de-risked equities last year thinking it was top of the eighth inning of this economic cycle. And a lot of some of them have come back in like the Norwegian Sovereign Wealth Fund was public about buying that dip on late December, which obviously, was a brilliant trade. But I don't know how many of them are there. I think there's a lot of people that are still being very careful with risk right now, which means that there's room for the market to rally further or at least that if it does sell off, that maybe perhaps then, those guys will come back in and be dip buyers. So I think right now, my landscape is that if there's asymmetric risk to the downside, it's more in the bond market than there is in the equity market.
ALEX ROSENBERG: I think people are really going to appreciate this perspective, because we've had a lot of people come on Real Vision to be on what it sounded like is the consensus at a trade, John Burbank coming on talking about buying call options on Eurodollar futures, for instance, which is his way to play this potential recession, lower rates, even going down to negative rates, potentially outlook. So, first of all, really great to hear the other side. I think this is really useful, just from a high level, if you were to advise anything tactical to play off of this allocation and this idea that people are playing for these lower rates that if data turns around, especially in Europe, it could really turn the other way fast. How would you think about that tactical?
MICHAEL PURVES: Well, look, if you're using ETFs- so simply speaking, you can look at the TLT and shorting that or buying puts on the TLT would be an obvious way of rates going higher in the United States play. Within equities, I think if rates do go higher, utilities have been extraordinarily aggressively bid, just like Eurodollars have been aggressively bid. It's effectively the same trade, those have a lot of torque to the downside if rates do in fact break there. Getting long banks would probably play as well, if particularly the back end increases higher and that you see those yield curves ranging a little bit more dynamically to the upside.
ALEX ROSENBERG: Very good. Well, Michael, thank you for sharing this contrarian perspective. I think the way you look at the world make sense of the way assets are correlated and the way economies make sense together, it's just going to really useful for folks. So Michael, thank you so much for joining us.
MICHAEL PURVES: You bet.
ALEX ROSENBERG: So Michael fears bonds may be overbought, and specifically, he thinks the potential for an uptick in global economic data could drive Treasury yields higher and bond prices lower. He recommends playing the setup with put options on the TLT. That was Michael Purves of Tallbacken Capital Advisors and for Real Vision, I'm Alex Rosenberg.