ALPHA SOURCES

DECEMBER 4, 2017
 ALPHA SOURCES
SEARCHING FOR A NEW NARRATIVE
E veryone is now talking about the
flattening yield curve in the U.S.,
and it appears that a consensus is
emerging for a Fed-induced recession
or severe slowdownin 2019. The
rationale here is simple. If the Fed hikes
three times a year and 5y-to-10y yields
wont get traction, the curve will invert
at some point in the latter part of 2018.
This, in turn, has historically been one
of the best pre-cursors for shift in the
U.S. economic cycle.
It warms my heart to see that
attention has turned to the 2s5s. Forget
about the 2s10s and 2s30, the 2s5s is
all we need. If markets truly believe
that the Fed is about to steer the U.S.
CREATIVE COMMONS LICENSE, 2017
CLAUSVISTESEN.COM, CLAUSVISTESEN@GMAIL.COM
economy into a slowdown, 5-year yields
wont go anywhere as the fed funds
rate edge higher. If, on the other hand,
markets think the economy will keep
trucking despite higher ratesperhaps
because the Fed gets behind the curve
on tax cutsthey will move to sell
5-year notes, in size.
Alternatively, markets could take
the position that the Fed is unlikely to
push too far on the short end in light
of still-record low policy rates in Europe
and Japan. If thats your tipple, you are
buying 2y notes, and selling the 5y. I
have to assume that this months
Fed meeting will give markets
some guidance on these questions.
 ALPHA SOURCES

In light of markets increased focus at the same time as it signals its

on the yield curve, some Fed governors
have said something to the effect that
the FOMC should not deliberately invert
the curve. This is great, but it doesnt
make sense in the context of a normal
policy cycle. Monetary policy 1-0-1 says
that Fed controls the front end via its
policy rate, but not necessarily the long
end. Indeed, with negative yields and
external surpluses in Europe and Japan,
the Feds control over long-term interest
rates is even weaker. If the Feds
objective is not to invert the curve,
it puts constraints on its movement
next year. I dont buy the idea that
the Fed should fear a flat curve. But as
with so many other narratives in the
bond market, the Fed has the chance to
confirm or deny it this month.
The Federales also will have to
present their assumption for a tax
reform and what it means for monetary
policy. In theory, a late-cycle shot of
fiscal stimulus should result in a more
assertive Fed. I am sure you can see
where I am going with this. The Fed
cant worry about a flat yield curve
vigilance towards a fiscal stimulus-
induced late cycle jump in inflation.
Bond investors will be looking for
direction on these questions this month,
and they are coming into the Fed
meeting positioned for a further rise in
short-term rates. The first chart below
shows speculative positioning on the
front end. It suggests that punters are
all in on the bet that the Fed will keep
going. The second chart completes the
picture by showing that the market
is positioned for a flat curve. The
conclusion is pretty clear to me. Risks
are tilted towards a dovish hike by
the Fed in December, and a short-
squeeze on the front end.
ALL IS (STILL) CALM IN THE ECONOMY
If youre using a macro-dashboard
to make your investment decisions, a
change in narrative is a long shot. The
first chart on the next page shows that
industrial output growth in the G4 is
accelerating. We dont have the full
batch of October data yet, but barring a
disaster in the EZ, growth accelerated to

fig. 01 / Will 2y shorts hold on in December? fig. 02 / That flattening feeling

COT positioning, Z-score U.S. two-year notes, no. of contracts U.S. 10-year yield less two-year yield, %, (Left)
4 * In standard deviations above/below median COT positioning*, U.S. 10-year less two-year, no. of contracts, (Right)
based on data going back to 1999 3.5 -6
3
3.0 -4
2

1 2.5
-2
0 2.0
0
-1
1.5
-2 2
1.0
-3
0.5 4
-4 Do you fell lucky? * Non-commercial, inverted. Latest
observation is week ending November 21st.
-5 0.0 6
04 05 06 07 08 09 10 11 12 14 15 16 17 18 09 10 11 12 13 14 15 16 17

CREATIVE COMMONS LICENSE, 2017

CLAUSVISTESEN.COM, CLAUSVISTESEN@GMAIL.COM
 ALPHA SOURCES

a three-year high of just over 4% year- sterling has hit consumers real incomes
over-year at the start of Q4. Moreover, via imported inflation. It is too soon
my diffusion index of the OECD LEI to talk about a recession, but the
suggests that the good news will U.K. economy runs a large twin
persist. In other words; hard data deficit, whichas far as I can see
for Q4 should be decent. will only correct via a slowdown
Across the OECDs data, leading in domestic demand. This correction
indicators in Latin America are showing was coming eventually, and it is not a
the most robust momentum, but coincident that Brexit is looking like a
headline indices in the U.S., Germany catalyst. Low interest rates and ample
and Italy also are pushing higher. By savings on the continent have allowed
contrast, indices in Russia, the U.K., the U.K. to borrow at will. It stands to
Poland and Spain are relatively weak. reason that if the island is hell bent
Another interesting macro story told on cutting its ties to the Continent, it
by headline leading indicators is that the means that the ability to rely on its
U.K. doesnt appear to be participating savings to smooth consumption via the
in the synchronised global recovery. external balance will be curtailed.
The Conference Boards leading For the rest of Europe, a slowdown
indicator for the U.K. now is falling in the U.K. will do their economies
year-over-year. This is in contrast to no favours. Robust domestic demand
firm growth in the Eurozone index and across the Channel provided an
accelerating momentum in the U.S. essential lift to the major euro area
The setback in the U.K. is no surprise economies when they needed it the
in light of the Brexit vote. Uncertainty most after the sovereign debt crisis.
over the future relationship with the With rapidly ageing population, un-
continent appears to have dented fettered access to a spendthrift U.K.
the investment cycle, especially in consumer is a good deal. Brexit, it
construction. In addition, the plunge in seems, isnt doing anyone any favours.

fig. 03 / Dont look, but everything seems fine fig. 04 / The U.K. is the odd man out

Alpha Sources, global LEI diffusion, advanced one month (Left) U.S. leading indicator, y/y%
OECD industrial production, y/y% (Right) Eurozone leading indicator, y/y%
1.5 15 U.K. leading indicator, y/y%
15
1.0 10
10
0.5 5
0.0 5
0
-0.5 0
-5
-1.0 -5
-10
-1.5
-10
-15
-2.0
-20 -15
-2.5
* GDP weighted index of the U.S., the EZ,
U.S.: NBER. Latest observation is October 2017.
-3.0 Japan and the U.K. Latest value is available -25 -20
Eurozone: DZ Bank. Latest observation is October 2017.
data for October, and otherwise September. U.K.: Conference Board. Latest observation is September 2017.
-3.5 -30 -25
08 09 10 11 12 13 14 15 16 18 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18

CREATIVE COMMONS LICENSE, 2017

CLAUSVISTESEN.COM, CLAUSVISTESEN@GMAIL.COM
 ALPHA SOURCES

EQUITIES POISED, BUT FOR WHAT?
In years when the market is up,
a lot, performance in December
usually is a declicate balance between
punters taking profit after a good run,
and chasers scrambling to minimise
underperformance. Fridays price
action suggests that the market is
settling on the former narrative. The
tightening noose on Trumps inner circle
concerning the Russia Affair appears
to have been the main driver of the sell-
off. That said, at this point, any story
will do, if punters decide to take profit.
A number of my market-based
indicators suggest also hint at risk in the
near term. The first chart below shows
that the put/call ratioas of November
30thhas plunged. It indicates that
punters perhaps are a bit too optimistic
going into the final month of the year.
This ratio usually mean-reverts quickly,
however, and doesnt always precede
changes in the short-term trend.
Earlier this yearin Septemberit
also crashed without any discernible
impact on the market. But it did
precede the sell-off at the beginning of
August. Investors should consider this a
necessary, but not sufficient, condition
for a sell-off in equities.
The second and final chart shows
my relative value model for the S&P
500. It suggests that good ol Spoos is
expensive compared to the other major
asset classes. The summer of 2016 was
the last time the divergence was this
stark. On that occasion, Spoos sold
off 4% from August to November.
Such predictions, however, have been
put to shame recently. Rotation between
sectors have been the key story, and I
see no reason why that will change.
On that note, I was relieved to see
the portfolio stepping into the light
last month. Short squeezes in Urban
Outfitters and Syntel were the primary
drivers, and I am banking on both to go
higher. Urban Outfitters is benefitting
from mean-reversion in the retail sector,
and Syntel is strong based on the
rebound in free cash flow. The success
of those two represents a change in the
narrative in equity markets, and here is
to hoping that further shifts will come
my way next year.

fig. 05 / Too much kool aid? fig. 06 / The S&P 500 looks too hot

Normalised Put/Call Ratio (Left)* * Z-score based on daily S&P 500, price index in $
S&P 500 (Right) data going back to 2006. S&P 500, price index in $, modelled*
3.5 2800
3.0 * Backed out level of S&P 500 from two y/y return
2500 regressions using TY1, HYG, gold, DXY and CRB.
2.5 2600
2.0
1.5
2400 2000
1.0
0.5
2200
0.0 1500
-0.5
2000
-1.0
-1.5 1000
-2.0 1800
-2.5
-3.0 1600 500
14 14 15 15 16 16 17 17 08 09 10 11 12 13 15 16 17

CREATIVE COMMONS LICENSE, 2017

CLAUSVISTESEN.COM, CLAUSVISTESEN@GMAIL.COM