Mark Dow On Oil’s Tie To Bond Rout, The Fed’s ‘Message’ & Gold’s Uselessness

May 18, 2015

Mark Dow is the founder of Dow Global Advisors, based in Laguna Beach, California. He is also the author of the Behavioral Macro blog. He has 20 years of experience as a policymaker, investor and trader, focused on global macro and emerging markets. Dow has been a senior portfolio manager at Pharo Management LLC, a portfolio manager at MFS Investment Management and a senior sovereign analyst at Putnam Investments. He began his career in Washington, as an economist at the International Monetary Fund and at the U.S. Department of the Treasury. What do you make of the recent global bond yield spikes? Are rates headed up regardless of the Fed right now?
Mark Dow: It’s really much simpler than people think, and it has to do with oil. We know that commodities have been in a bear market. But oil mysteriously held up. And in June of last year, we saw it finally break out of its frames to the top side, and got up to like $110/barrel, and there was no follow-through. Oil is the most highly “financialized” commodity we have. When it broke out, a lot of hedge funds and other guys jumped on thinking it was going higher.

At the time, we were thinking that the Fed needed to move interest rates up sooner rather than later. Then oil started to fall. And as it fell, the hedge funds dumped their positions, causing it to fall precipitously because there was no one there to buy. As the decline accelerated, some of the commercial guys needed to hedge. There were a lot of structurally long oil positions still in the market and they started to come out.

Saudi Arabia intervened opportunistically and said, “Hey, it’s going down. Let’s let this thing play out. It’s to our advantage.” So oil just kept going down. We infer way too much about the fundamentals when oil prices fell over the past six months. If you remember, back in January, the talk was of global deflation. Do the central banks have the tools to stave off global deflation? People really thought this was reflective of global demand and global deflation.

Finally, oil fell off, ran out of firepower. Everyone who needed to sell, sold. And we started to rally. And what happened? Inflation expectations started to come back. Along with it came bonds, with a lag. The back end of the yield curve got steeper. There are some Fed reasons for that, too.

But primarily, oil prices rising changed the outlook on everything. And we went from pricing in a global depression, deflation, to pricing in something more normal. And that’s why bonds have been selling off. Should fixed-income investors be watching oil prices more closely?
Dow: Rarely do you get a move of that magnitude. And it takes that kind of sustained move to really get people to talk about global deflation. I doubt we’re going to get moves that dramatic in oil from here on out. Typically, when you get a big shake-out of risk positioning—which is really what it was—other things fit.

Shale production started in 2010 and people didn’t really notice it until oil started dropping in June. Is it a factor? Of course it’s a factor. But it was our typical belated overreaction. We ignored it for a couple of years and then all of a sudden, we overreacted to it. So I don’t think it’s going to be a big driver.

When you have a super big move, the psychology is that subsequent moves tend to be smaller, because you're caught less off guard. They're never as awe-inspiring as the first move. And to that extent, oil is less likely to be big a driver of the bond market going forward. As a former IMF economist, you’re a big Fed watcher. What’s your read there?
Dow: The Fed is trying to do two things right now, and they’ve largely achieved the first. They’ve been trying to get the market to stop focusing on forward guidance and start focusing on the data, hence their mantra “data dependency.”

Up until a few months ago, we were all focusing on how long the Fed was going to commit to keeping rates low. And finally, they said, “We’re getting closer to the point where we’re going to do something. So we need to switch the attention of the market onto data.” That’s largely been done.

Secondly, the Fed has been trying to tell us they want to go earlier, and more slowly once they start, than the market is currently thinking. They're doing that because the market hadn’t priced that in. That’s why the curve has gotten so steep. The Fed wants more uncertainty in the bond market, in the sense that they know, if we get comfortable, we just put more risk on.

So the Fed says, “We want you to be focused on the data. And we’re going to go when we go. We’re not going to tell you when we’re going to go. We’re not going to tell you the rate at which we’re going to increase rates. We’re just going to do it. And you're going to have to live with it and try and analyze the data alongside of us.”

The Fed wants to get a hike or two on the books, just to show us that this is in progress. They’re going to change your cost of leverage. But the economy is not as strong as they’d like it to be. So they’re going to proceed really, really slowly from there on out. That’s a super important message from the Fed. Are emerging markets vulnerable again to the same “taper tantrum” we saw in 2013 when the Fed began talking about winding down QE3?
Dow: Emerging market equities, as well as commodities, started to underperform in 2011. Fixed-income emerging markets didn’t start to underperform until 2013 with the taper tantrum. And that’s because people got very complacent in the view that the Fed was going to be lower forever. They layered on a lot of the type of risks that people do when they think interest rates are going to be low. They buy emerging market equities, and they buy emerging market currencies, and they buy emerging market fixed income.

Equities were already in a downside, so they didn’t benefit so much. But people stayed with their fixed-income positions. And those finally got shaken out. We have more shaking out to come. It’s probably not going to be as dramatic, but they're going to bleed.

My view on emerging markets has been negative for quite some time. We’re looking at a period where rates are going to start to rise in the U.S. The dollar is biased to get stronger to the extent that rates rise. And emerging markets no longer have a growth differential to brag about.

One of the things that you need to see to get into emerging markets is a growth differential to compensate you for all the risks that are associated with those markets. The other head winds facing emerging markets are higher U.S. interest rates and a strong U.S. dollar.

I expect to see more bleeding from emerging market fixed income and equities. But I think they're ahead of the process in terms of the de-risking, so it’s strategically too early to allocate to emerging markets on a long-term basis. You're fairly critical of gold, no matter what the markets are. Tell me, is there a place for gold in a portfolio?
Dow: No, there isn't. It’s a vestige, an anachronism of a monetary system gone by. We’re not going back to a gold standard. It really doesn’t have any value. People don’t have gold teeth anymore. The nature of commodities is that we find technological substitutes for them. We use PVC instead of copper. Commodities are the antithesis of technology, and gold is a great example of this.

It’s also a tax on monetary ignorance. A lot of people bought it thinking that we were going to get inflation when the Fed started QEs back in 2008. That was the first round of the unwind of the gold bubble from late 2011 until mid-2013. Gold fell from $1,900 down to $1,200, more or less where we are today. We’ve gone sideways since.

The second phase of the unwind of the gold bubble comes when the U.S. starts raising rates. We know historically, commodities don’t do well when the Fed raises rates because storage cost, and the opportunity costs of holding it, goes up. It also suggests that the economy is doing better, so people find better alternative uses for their assets.

Gold is just a precious metal. It’s an embarrassing investment thesis, really, because it screams of ignorance, of just not understanding how modern monetary systems work. U.S. stocks markets continue to remain at all-time highs. Is there more to run in this market?
Dow: The investment landscape looks better. The big change this year, for me, is Europe, not because I think they're going to grow materially better. But they're going to appear to be growing better because our expectations got so low last December about what Europe could do. So, we’re going to feel a little bit better. But they're demographically challenged and have other issues too. They're going to have a hard time growing.

However, I do think Greece will leave. I don’t know when. And when they do, the runway will have been sufficiently formed, so it won't be the crisis that a lot of people fear, and that a few hope for. That will also give us a template for other countries that might want to leave the single currency if it gets to that. The fact that the single currency can reconfigure its membership without bringing about a financial cataclysm is a really good thing. My guess is that you probably want to wait until Greece is getting ready to leave if you wanted to buy into Europe.

Our stock markets are going to grind higher. Typically, risk markets don’t top until the economy gets frothy. People can say what they want about markets being frothy. That’s all conjecture. What's unambiguous is the economy is not frothy. We’ll sell off and we’ll go up, but we’re going to chug higher. So I am an individual investor, even an advisor, and I’ve been riding the stock market, if not from 2009, for the last few years. And I keep hearing, “Reduce your U.S. exposure.” Is there any reason to change?
Dow: The U.S. is, by far, the furthest ahead in the cyclical recovery. The other guys aren't going to fall off the map. They have to work their way through a lot of problems. So, if we’re the one that’s most advanced in the recovery, and we’re nowhere near optimistic in terms of investment and hiring and things like that, it’s really hard to bet that the stock market is going to go down significantly. Could it go down without us having a recession? Anything is possible. But it’s never happened that way before. Thanks for your time.

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