Markets ≠ The Economy: Confusing Them Can Cost You Money
Breaking Down Breakeven Rates Part 1
Breakeven rates are all the rage these days. The chart below has been posted (and printed) all over the place showing the huge rally in breakeven rates since the lows of March 2020. People are looking at this rally and using it as evidence that the US economy (and by extension the world’s) is on the verge of “boom times!”
Their thinking runs along the lines of: breakeven rates represent market expectations for future inflation, hence higher breakevens = higher inflation. Higher inflation means that the Fed’s (together with, at this point, almost every other major central bank on the planet) QE is working! Add into this talks of a massive fiscal stimulus package from the Biden administration and all of a sudden what had been talk of reflation becomes turbocharged into “boom times”.
Are things really as simple as looking at the yields of some fixed income products and saying that everything is peachy? Of course not, because the global financial system and economy are anything but simple.
Proponents of the “boom times” narrative are conflating two distinct scenarios, inflation and growth, into a single, hyper bullish outcome. But not all inflation is of the kind that indicates robust economic growth. Which begs the question, what kind of inflation is currently being “priced into” breakeven rates?
Let us first begin by understanding what breakeven rates are, how they are calculated, and what they represent. Breakeven rates are the difference between nominal Treasury yields and yields on Treasury Inflation Protected Securities (TIPS), for example:
5 year Breakeven Rate = 5 year Treasury Yield – 5 year TIPS Yield
It is useful to think of this equation as representing the calculation of real interest rates in the economy, real in this case simply meaning adjusted for inflation:
Real Interest Rates = Nominal Interest Rates – Inflation
With a little readjustment, we get:
Inflation = Nominal Interest Rates – Real Interest Rates
When arranged in this way, it is quite easy to see that the breakeven rate is “supposed” to represent the level of inflation; US Treasury yields, nominal interest rates; and US TIPS, real interest rates. Because the breakeven rate is derived from market prices of US Treasuries and US TIPS, it is often thought of as representing market expectations of future inflation.
All in all, the breakeven rate and what it represents is quite easy to understand on an intuitive level, except that all too often people take this intuitive understanding and extrapolate linearly from there, the “boom times” narrative being a good example.
To be continued…
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Markets ≠ The Economy: Oil
Crude oil is another commodity that market participants like to look at in order to gauge the overall health of the global economy. The logic here is the same as with copper, since oil is what the modern industrialized economy runs on, a higher price per barrel must mean strong global growth… right?
Alas, as mentioned before, and will most probably have to be mentioned over and over again, it never is so simple.
Again, like copper in Covid 2020, do not forget what producers are (or aren’t) doing. For oil this is doubly important because of the outsized influence Saudi Arabia (OPEC), Russia, and American shale producers have on the market.
The confluence of every negative factor possible caused chaos in the ranks of American shale producers, leading to many filing for bankruptcy protection. The aggregate debt of these producers was approximately $50 billion, close to 2016’s record of ~$57 billion, and 2016 was a horrible year, where WTI bottomed out at ~$30 a barrel after selling off from highs of ~$100+ a barrel in 2014.
Needless to say, supply in the American shale patch was very badly affected, with oil and gas extraction dropping sharply, while drilling of new wells fell below 2016’s low. Note that both index values have not recovered to their pre-pandemic levels.
Obviously, everyone else was suffering as well, and Saudi Arabia with its OPEC allies came together with Russia to jointly cut their production in order to force prices higher.
As with copper, these supply cuts and bankruptcies coincided with global reopenings and the massive rebound in demand that comes with industries bringing back production capacity, with exactly the same result – an upward surge in prices.
It cannot be overemphasized how important it is to gain an understanding of both supply and demand before coming to some kind of conclusion about what commodity prices represent. Jumping to the conclusion that higher commodity prices, especially energy, are due to a robustly growing economy is a very linear and reductive way of thinking about a very complex global system.
Avoid reductive thinking as much as you can.
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Is Dr Copper Making A Fool Out Of Us?
A favorite trick of global macro commentators, and some traders, is to look at short term price action in a particular market and from there extrapolate broader economic conditions, which they then use to make other forecasts.
Copper is a perfect example of this.
Dubbed “Dr. Copper” (the PhD kind) by market folk, copper prices are seen as a leading indicator of the global economy’s health because of how widely it is used across industrial economies; power generation, construction, electronics, and telecommunications, to name a few.
The logic runs that higher prices for copper = higher demand from across industrial economies, therefore massive economic growth. BUY BUY BUY!
While copper’s cyclical price moves are correlated with global growth over the long term, such linear, reductive thinking does not really work well when it comes to short term market movements.
Copper is no exception, and its price is much more than a function of demand driven by global economic growth.
For example, what about supply?
Demand cannot be considered in isolation, it must be seen relative to supply. In the case of copper, supply in 2020 was affected pretty adversely by the spread of Covid simply due to two countries accounting for 40% of global production.
Chile and Peru, the first and second producers respectively, both had a very difficult time dealing with both the first and second waves of Covid in 2020, with lockdowns and concerns about the health of miners curtailing production.
As such, it isn’t surprising that forecasts for 2020 production stand at around -1.5% according to the International Copper Study Group.
Which brings us to the economic situation post April 2020.
As lockdowns rolled across the globe in the first quarter of last year, global economies shut down, leading to that now forgotten sharp and vicious move lower across global financial markets.
With immediate threats to employee health, frantic government actions to control the spread of Covid, and an extremely uncertain outlook for the future, miner’s cut their production.
Then Western governments decided to open their countries and economies again as spring turned to summer, and demand came rushing back.
However, demand didn’t rush back due to a rosy and robust global economy, but instead from the reopening of economies and the restart of previously mothballed industrial activity.
This left the copper market with producers seriously struggling, while demand rebounded like a coiled spring being released.
As an example of how dire the supply situation was at the peak of last year’s supply shock, Peru’s production dropped 38% over April and May 2020.
There simply was no way producers could keep up with rebounding demand from the world’s reopening.
In other words, one hell of a short squeeze.
Markets and economies are extremely complex – do not conflate the short term price moves of an asset with the general state of the broader economy!
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Why It Isn’t Important If Markets Are Right Or Wrong
Are market prices right or wrong?
Market watchers and participants can be forgiven for asking this question as over the past year, the West has lurched from Covid Wave 1 to Covid Wave 2, lockdown to reopening and then new lockdowns followed by renewed lockdowns.
They have gone from V-shaped optimism to whatever letter can be used to describe the economic trajectory of: massive drop, rebound for a while, plateau for a shorter while, and drop again.
Yet financial markets all over the world continue to trade with unshakeable optimism. The clearest indicator that such optimism isn’t what market participants deem to be within the “acceptable” range is the re-emergence of the word ‘Bubble’ in the media.
So, are markets pricing assets correctly?
Well, it depends.
If one views markets as having to be a somewhat accurate reflection of the economy, then yes, markets are absolutely bonkers and are priced wrongly.
However, if one steps out of mainstream narratives that tie economic performance to market performance, and views markets as driven by the emotions of market participants instead, then markets aren’t right or wrong.
Its participants are simply exuberant.
How does this matter?
When viewing markets from this perspective, whether a market is right or wrong is an irrelevant question. Simply because for a market to be correct/incorrect, it has to be correct/incorrect relative to something else, which in the mainstream view, is the economy.
If one steps out of the “prices are either right or wrong” dichotomy and sees the market for what at its core it really is – a bunch of people making bids and offers, one can see that humans, and hence their emotions, are right in the middle of it.
Navigating price moves in the market now becomes a matter of gauging human reactions to headlines/data points.
This is in contrast to the mainstream way of interpreting headlines/data points, then coming to a conclusion on how markets should react to them.
This way of thinking about markets can be especially helpful when everything is being furiously bid up across major asset markets, as being in tune with how bullish the markets are can help to keep an individual trader running with the trend.
Furthermore, keeping track of how emotions gradually change from Fear of Missing Out to just plain Fear, and hence from bullish to bearish, can help in making the decision to exit longs, and depending on the individual, maybe even enter into new short positions.
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