The Single Most Important Chart For Markets Right Now

Asia Confidential's picture

Last year, developed market equities were the big winners and if you didn't have a large dollop of them in your portfolio, you invariably under-performed. Bonds had some of their worst losses in almost two decades while gold had its poorest year since 1981. And shock, horror - the vast majority of analysts and commentators are forecasting more gains for equities and more losses for bonds and gold (the end of their respective bull markets, apparently). Investor flows have been reflecting this advice. So far this year though, things haven't gone according to plan with bonds and gold bouncing back and stocks under-performing.

Moving beyond price action, one of the most critical issues going forward will be the ongoing battle between inflation and deflation. For five years, central banks have been fighting deflationary forces in order to spur their economies into action again. Deflation is seen as preceding recession or even depression, while inflation has the nice benefit of reducing bloated government debts (inflation leading to depreciating currencies and therefore lower local currency debts). So far, the central banks efforts have met minimal success with a weak economic recovery and disinflation (declining inflation).

There are some signs though that this may be changing. U.S. inflation expectations are ticking up, giving us the first signs that inflation could be around the corner. If this trend continues, it may prove the defining theme for markets in 2014. It would be bullish for stocks, particularly in under-performing markets such as Asia. It would also be negative for bonds and commodities, the latter at least initially. So perhaps analysts could be right after all: that the performance of the various asset classes this year mirrors that of 2013.

Or perhaps not. Count me a continued skeptic of the view that inflation is on the way, at least for now. But it would be wrong to ignore incoming data which is contrary to my view. This newsletter then is an attempt to show some of the key trends which I have my eye on for what's head for economies and markets.

Rising inflation expectations

The world's central bankers have fought desperately to prop up economies for the past five years, after the worst downturn (at least, in much of the developed world) since the 1930s. Undoubtedly, their massive doses of stimulus combined with interest rates near zero prevented an even greater downturn. Whether they also prevented a faster recovery will be debated for years to come.

Anyhow, the deflationary forces which preceded the downturn and continue to haunt economies is perceived as enemy number one by these bankers. They'll do anything to prevent these forces gathering steam.

And they've struggled, to this day. Let's focus on the U.S., the world's most important economy and market. Here, the monetary base (commercial bank reserves plus total currency in circulation) has exploded more than 4x since the financial crisis, reflecting massive central bank stimulus.

US_monetary_base_since_1918 (1)

The Fed has bought bonds off commercial banks in the hope that these banks would lend the said money to the public. Unfortunately, bank loan growth has been tepid, and trending down of late. That's indicative of weak demand for debt from consumers.


That's resulted in money velocity dropping to more than 60 year lows. This means money isn't changing hands and circulating in the economy. A strengthening economy has rising velocity, or the same quantity of money being used for several transactions.


The U.S. inflation rate itself has reflected the above. Inflation peaked near 4% in 2011 before declining to 1% in November last year, and a minor pick-up to 1.2% in December.


The important thing to note is that these charts are all lagging indicators: they tell us what's happened rather than what's going to happen.

That brings us to what we consider the most important chart in the world right now: inflation expectations.

US inflation expectations

Inflation expectations are measured by the difference between U.S. Treasury yields and Treasury Inflation Protected Securities (TIPS). TIPS are indexed to CPI and as the latter increases, so does the value of TIPS. In other words, you own TIPS as a hedge against inflation.

As you can see from the chart, the spread between the two is rising. What this indicates is that investors are expecting inflation ahead. The chart is crucial because it's normally a forward looking indicator ie. these expectations filtering through to official inflation statistics. In other words, it's suggesting that investors see the pace of economic recovery in the U.S. picking up and that filtering through to inflation.

Winners, if the trend holds

The rise in U.S. inflation expectations is consistent with recent market action. Markets are forward-looking and the considerable out-performance of stocks versus bonds in 2013 has been telling us that a U.S. recovery may be gaining hold and inflation is coming.

It's important to note that inflation expectations and stock market multiples (price-to-earnings multiples) are closely correlated.

US expectations key driver of equity multiples

Inflation only becomes bad for equity multiples in the U.S. once it reaches above 4%. More than 6% inflation leads to the more dramatic de-rating of stocks.

  inflation correlation with equities

Therefore, rising inflation without a concomitant rise in interest rates is very bullish for stock markets. Given developed market central banks are pledging to hold interest rates near zero for a considerable period of time, there may be a sweet spot for equities to outperform further.

If bond yields rise sharply, and interest rates with them, that would be negative for stock markets. The first rate hike in the previous six rate cycles in the U.S. has resulted in corrections of 2-9% to the S&P 500.

If the sweet spot of rising inflation expectations and low interest rates continues though, what can we expect from markets? Well, we've mentioned that this environment would be bullish for equities. But more specifically, you're likely to see Asian equities explode higher, substantially outperforming stocks in developed markets. Asia has been a considerable laggard and any global recovery scenario would be very positive for the export-dependent economies in the region (think South Korea, Singapore, Malaysia and China).

Bonds would obviously suffer under this scenario, heralding the end of a huge bull market. Many bond markets haven't seen such low yields in hundreds of years and therefore the rise in these yields could prove a painful event.

Lastly, commodities are likely to under-perform, at least initially. That's because rising U.S. yields would result in a higher U.S. dollar, which is normally inversely correlated to commodity prices. However, if inflation really does take off, commodities could increase considerably from current depressed levels.

Why I'm not buying it yet

The question then becomes: do you buy into this scenario? Asia Confidential doesn't and here's why:

1) Central bankers and sell-side strategists want us to believe that a normal business cycle is about to ensue after the most extraordinary global stimulus measures, probably in history but certainly since the Great Depression. Normality after grotesquely abnormal central bank policies, in other words. The central bankers themselves have all but admitted that they don't have a clue about the end-results of their post-crisis policies. I'm betting on more unintended consequences over a return to normality in 2014.

2)  In the debate over inflation versus deflation, I'm still in the latter camp, at least for the next few years. Weak demand and global excess capacity are likely to weigh on inflation. Japan yen depreciation and a China downturn won't help either.

3) But I could be wrong and if recovery does take hold, serious inflation is likely to follow. All those bank reserves will make their way into economies and money velocity will spike accordingly. Put simply, I'm betting on the unintended consequences of either a deflationary shock (my preference) or conversely serious inflation. Mild inflation from here seems like a central bank (wet) dream.

4) If I'm right about deflation, then over-sold bonds could make a significant comeback and prove the doomsayers (99% of pundits right now) wrong again. But given the risks from current policies, making grand bets on such things is a mugs game and it's best to diversify your assets (beyond just stocks and bonds) as much as possible at this juncture.

AC Speed Read

Inflation expectations in the U.S.are rising, indicating inflation may be around the corner.

- If that trend continues, stocks are likely to continue to out-perform, but Asia should start to play catch-up to developed market equities.

Asia Confidential isn't buying into the coming inflation and global recovery thesis. Deflation remains the primary risk in our view.

- If that view is right, bonds could stage a big comeback, defying the doomsayers (99% of pundits) once again.

This post was originally published at Asia Confidential:

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starman's picture

Love the first chart resembles the "ski" slopes of Kilimanjaro ! wait can you down ski on the Kilimanjaro?

jeffgroove102's picture

Gotta love the cynicism of our remarks, I believe this is what public discourse is coming to.

jeffgroove102's picture

Just a part of the disproportionate world we live in. Less important people like me have to work for a living, while others just get to type whatever they want into their bank account.

Nothing new here, move along.

Boxed Merlot's picture

There is nothing remotely usable here...


I would disagree a bit, the following, "The Fed has bought bonds off commercial banks in the hope that these banks would lend the said money to the public. Unfortunately, bank loan growth has been tepid, and trending down of late. That's indicative of weak demand for debt from consumers.

That's resulted in money velocity dropping to more than 60 year lows. This means money isn't changing hands and circulating in the economy. A strengthening economy has rising velocity, or the same quantity of money being used for several transactions..."  is an important observation.



The 85B monthly frn pump has only increased the number of frn equivilent for the same percent of ownership of listed public companies.  So the 40B / 45B US domestic / EU "gifting" props Ben and his cohorts have been providing will only be a danger to inflationists if the velocity of exchanging the stuff were to return to pre 2008 levels.  This predicament is similar to electricity measurements, i.e. voltage / amperage / wattage relationships where Watts equal Volts X Amps.  I don't see a flash / burnout scenario as long as the fed retires their accumulating bonds to a zero valuation as velocity, (amperage), iincreases sometime in the future.  Whether there will be the discipline to do so by the heirs of the system at that point in the future is yet to be seen.  Solomon's kid disregarded the advice of the seasoned folks when his time came to rule and most of his charges bolted.  I suspect the same thing will happen again, imho.

Laughing Stock's picture



Futhermore, "The Fed has bought bonds off commercial banks in the hope that these banks would lend the said money to the public."

Is nonsense....for the first, middle and last time....BANKS DO NOT LEND RESERVES

They don't need the Fed to give them "money" -- that "money" is created as part of the loan making process

Banks create credit and offsetting cash during the loan making process 

Bank -- makes loan (asset), debits cash (liability)

Businessman -- takes in cash (asset), assume loan (liability)


Longing for the old America's picture

This whole article is total garbage.


You say 'on the one hand' and then 'on the other hand; time after time while continuously stating 'you could be wrong'.

Your 'most important' chart contradicts your thesis.


There is nothing remotely usable here. 

OC Sure's picture

Can you use this?

Buy the 30yr ZB now and on any pullback this week that approaches 129; stop out on a daily close below 128.26.


1) On thursday, January 9, the zb gapped down 5 ticks from 129.05 to 129. This gap was quickly filled and held as support in a bowl of beauty that broke out into what appears now to be an ascending triangle into the spike high on friday's news event at 130.24. Buyers on friday never gave up.

2) The call/put ratio into mid December was below .80 for 5 weeks in a row. This is extreme pessimism; not from what the jawwaggers are chattering about but from what real market participants are doing. The opposite extreme of a ratio over 1.25 screamed sell in April and again in July.

3) Since mid-December, every negative news event for long rates was a swing traders delight if you were a buyer of the knee jerk down. This is typical: the trend begins to change as negative news no longer pushes the market down and when positive news is released now it pushes the market up. That is where we are as of friday.

4) The monthly Slow Stochastics have not been this oversold since 2006 and that was when the price was 25 points lower! The recent lows in the ZB are at the fallback line from the highs of year end 2008 through the fall of 2010. This too is the apex of of the 3 year triangle.

5) Everywhere, everyone just knows that rates HAVE to go up. Everyone knows this. The reason attributed to the selloff since April was the threat of taper (the "news"). Now, the taper has begun so why would the selling continue?

6) If the ZB closes higher this week, then the weekly morning star is confirmed. Maybe look for a daily breakaway gap too.

7) I would look for the sentiment of what market participants are doing along with the jawwaggers telling everyone why rates just MUST go down for signs that it is time to sell again. My best guess (opinion) is that we test the 140 area and around that time kiss off the down trend from the 2012 highs through the 2013 highs.

I hope you can use this and as for the debate of Inflation or deflation? Every market leaves footprints that when followed can lead to diamonds in the sand. Forget Opinions, Focus On Fact. FOFOF.

(As I click Save, that ascending triangle just broke out. Yaayyyy!)


Crusader Rabbit's picture

OC Sure-


Great call - Good Analysis.

It sure did POP.

I will save and follow your comments.

madbraz's picture

I like your inputs.


The article makes no mention of the 5 year forward inflation expectation (implied inflation from year 6 to 10 based on breakevens on 10yr and 5yr) - one of the favorite inflation gauges used by the FED.


The 5x5 forward implied inflation is at the top of the channel it has been since the great crash, at 2.8%.  Doubtful it goes higher.


The 2-10 spread is near it's recent all time high of around 2.90% - this too looks like it's topping and the year on year rate of change seems to confirm this (heading lower).


Also worth noting, the ratio of SPX to the long bond is forming a low at a level where it reversed in 2007.


Finally, bloomberg recently has put out snippets from some bond players suggesting treasuries are a buy - some of the big boys planted those snippets there as bloomberg never has anything good to say about treasuries.


Time to turn the corner.