exter's pyramid, by paul mylchreest

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Equity & Commodity Strategy Fulcanelli Report

Paul Mylchreest Email: [email protected] Tel: +44 20 7716 8257

7th January 2015

1

Exter’s Pyramid “in play” (and is Mar n Armstrong right?)

In a global debt bubble, it concerns us when the benchmark debt security s ll looks good value, albeit on a rela ve basis.

Source: Bloomberg, ADMISI

In spite of this, the consensus is (once again) calling for higher US yields and FOMC “li off.” The two-year Treasury yield has been pricing in the la er…


ADM Investor Services Interna onal Limited is authorised and regulated by The Financial Conduct Authority. Member of The London Stock Exchange. Registered office: 4th Floor Millennium Bridge House, 2 Lambeth Hill, London EC4V 3TT. Registered in England No. 2547805 a subsidiary of Archer Daniels Midland Company. Risk Warning: Investments in Equi es, CFDs, Futures, Op ons, Deriva ves and Foreign Exchange can fluctuate in value, investors should therefore be aware that they may not realise the ini al amount invested, and indeed may incur addi onal liabili es. These Investments may entail above average financial risk of loss, and investors should therefore carefully consider whether their financial circumstances and investment experience permit them to invest and, if necessary, seek the advice of an independent Financial Advisor. Some services described are not available to certain customers due to regulatory constraints either in the United Kingdom or elsewhere. © 2014 ADM Investor Services Interna onal Limited 2014.

Equity & Commodity Strategy - Fulcanelli Report Paul Mylchreest Email: [email protected] Tel: +44 20 7716 8257

2

…but the ques on is what is the long end of the Treasury curve pricing in?

Slower growth and lower infla on, most likely. Risk of global contagion, possibly. That the FOMC makes a mistake (in raising rates)…maybe that too.

The Fed might be desperate to raise rates ahead of the next downturn (how embarrassing not to) but this analyst would be surprised to see more than 1 or 2 token 0.25% increases – and that’s if things are rosy.

As we know, the narra ve from central banks can change at the slightest hint of trouble, e.g. Ballard’s QE4 comment during last October’s selloff. Watch the spin as the Fed portrays lower energy prices as “transitory” and no reason to alter its desire to ghten, while the ECB’s desire to ease only grows, even though neither is achieving its mandate on prices.

Do what thou wilt shall be the whole of the law?

The key point is that you can’t normalise rates in the “Winter” phase of a long wave (Kondra eff) cycle. There is just too much debt. It’s debt that drives these cycles and eventually brings them to an end.

This is the fourth cycle since the Industrial Revolu on and the longest by far. The lack of a gold standard has allowed the central banks to extend it through unprecedented credit crea on.

Here is our ming of these cycles:

1788—1843 56 years

1844—1896 53 years

1897—1933 37 years (1937 was a policy error when recovery established in our opinion)

1934—? 81 years (and coun ng)

The next cycle doesn’t begin un l the excess debt from the previous cycle has been purged. Historically this has occurred via debt defla ons of varying length and severity. In a world of unlimited credit crea on, infla ng the debt away remains an op on and we ques on whether renewed onset of debt defla on will ul mately be dealt with via central bank-created infla on? Mr Abe and Mr Kuroda are conduc ng such an experiment.

In the mean me, we see a possibility that the Fed could raise the Fed Funds rate in several months’ me only for long-term Treasury yields to con nue their decline, while the ECB could ins gate

sovereign bond QE and long term sovereign yields (ex-Germany certainly) could rise…which was the experience of the US (QE1, QE2 and QE 3 pre-taper).

Talking of fla ening yield curves…

We’ve been looking at yield curves in the run up to the last two peaks in the S&P 500 in March 2000 and October 2007.

It basically doesn’t ma er which part of the Treasury curve you choose in terms of 2s, 5s, 10s and 30s, but spreads declined to roughly zero, or nega ve, prior to the equity market peaks.



3

Here is the 2s10s...


The 2s30s...




4

The 5s10s.


And the 5s30s, although we could have added the 2s5s and 10s30s just for the hell of it.




5

Could the same thing happen again in a structurally (much) lower interest rate environment this me around?

Well 190 bp of fla ening in the 2s30s might be pushing it, but 46bp in the 5s10s is certainly possible in the fairly near future with the way things are going. Funnily enough, if the 10-year Treasury yield was in line with the 10-year Bund, the 2s10s spread would be -8bp, i.e. close to zero.

While we expect the S&P to be lower at the end of 2015 than the beginning of 2015, our point is that more fla ening might be in order prior to a major correc on in equity markets like the S&P 500, Footsie, DAX,, etc. In general terms, it also suggests that it might be too early to lose faith in “bond proxies” such as U li es and some Consumer Staples.

A significant further fla ening in the curve is looking increasingly more likely...

Indeed, the major story for us right now is that the broad concept incorporated in “Exter’s Pyramid” is in opera on. This something we men oned in Autumn last year and it’s occurring across currency and credit markets and, to some extent, in equi es.

To recap, John Exter (a former Fed official, ironically) thought of the post-Bre on Woods financial system as an inverted pyramid res ng on its apex, emphasizing its inherent instability compared with a pyramid res ng on its base. Within the pyramid are layers represen ng different asset classes, from the most risky at the top down to the least risky at the bo om.

He foresaw a situa on where capital would progressively flow from the top layers of the pyramid towards the bo om layers.

“…creditors in the debt pyramid will move down the pyramid out of the most illiquid debtors at the top of the pyramid…Creditors will try to get out of those weak debtors & go down the debt pyramid, to the very bo om. Below is his drawing of the inverted pyramid as he saw it in the late-1980s, when the riskiest assets were Savings & Loans (“thri s”), Third World debt and (relevant to today) junk bonds, etc.



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We think that Exter’s Pyramid went “live” in in late-June/early-July 2014 when the dollar index (DXY) began to strengthen…


…along with junk spreads.




7

The perfect illustra on of Exter’s Pyramid is across the credit markets (as seen via ETFs) with capital flowing from HY through IG…


…and from IG into Treasuries.




8

There is some evidence that this is happening intra-equity market.

For example, here is the chart of the S&P 500 High Quality Index versus the Low Quality Index, where “Quality” is measured in terms of growth and stability of earnings and dividends.


The point about Exter’s Pyramid is that there is a large amount of capital in riskier financial assets in the upper layers of the pyramid which can flow downwards.

Consequently, the valua ons of perceived “safe” assets could obviously overshoot if there is no let up.

Capital flows into dollar assets are a major part of this process right now.

We haven’t men oned Mar n Armstrong’s “Economic Confidence Model” (ECM) for quite some me but we’ve been thinking about it recently. The ECM, based on 8.6 year cycles, is o en very successful at tracking turning points in the “hot money” flow of global capital.

Now is not the me for a detailed explana on, but for anybody not familiar with the ECM, Armstrong’s report “It’s Just Time” (google it) from several years back is one of the best we’ve ever read and provides excellent background.

The ECM’s peak on 2007.15 (i.e. late-February 2007) picked out the emergence of the sub-prime problems almost to the day. It did the same with the peak in the Nikkei Index in December 1989 and, we know this because we checked, the Great Crash of 1929 (which was 7 x 8.6 years back from the Nikkei’s peak). The 1987 crash was an intermediate peak in the cycle which ended in 1989.

What is fascina ng is that the current ECM cycle peaks on 2015.75, i.e. at the end of September this year. The low point of this cycle was 2011.45, i.e. June 2011 which Armstrong refers to as:

“The 2011 bo om was the peak in oil and gold and the start of the breakout in stocks and the

beginning of the Euro Crisis in full bloom.”



9

In contrast, we think that the 2011 low in the ECM marked the low in the dollar…here is the DXY again back to 2010.


Furthermore, the intermediate peak of 2013.60 (July 2013) and the intermediate low of 2014.68 (early-September 2014) also align quite closely with the dollar, as is obvious from the chart.

Armstrong is talking about this September 2015 being the peak in the “bond bubble”.

If our interpreta on is correct, the dollar AND long-term Treasuries could have further strong upward moves between now and late-Summer 2015.



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exter's pyramid, by paul mylchreest

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