Selling Time

Equity & Commodity
25th March 2015
Fulcanelli Report
Paul Mylchreest
Email: paul.mylchreest@admisi.com
Tel: +44 20 7716 8257
Selling Time
Can you arbitrage time? Central banks made the whole world buy
time. There are signs that were beginning to sell it
Central banks artificially lengthened time horizons in financial markets and the real economy by
distorting time preference. There is evidence that time horizons are now shortening, e.g. weak
capital investment, flattening yield curves, dollar strength & physical gold demand. Perhaps the
tsunami of global speculative capitala result of extreme financialism - is getting nervous and
seeking safer havens. Historically, volatility in currency markets has led to destabilising flows in
speculative capital which have subsequently impacted other financial assets. One way to sell
time is, paradoxically, buying long-term Treasuries and, therefore, bond-like equities, such as
financially strong Consumer Staples and Utilities companies. For equities in general, we found
two indicators which gave well-timed sell signals at the last two peaks in the S&P 500 in 2000
and 2007. Both of them Treasury yield curve (7s10s) and adjusted MACD - are getting close
to giving the first sell signals in nearly eight years.
1
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Equity & Commodity Strategy - Fulcanelli Report

Paul Mylchreest
Tel: +44 20 7716 8257
Contents
Executive Summary
Time, Debt and Central Banks
Shortening Time Horizons
14
- Japan
14
- Real economy
16
- Financial markets
20
Global Speculative Capital
29
- Financialism and the scale of global speculative capital
29
- Volatility and the turning point in mid-2014
34
- Key risks: divergent central bank policy and dollar liquidity
41
- Exters Pyramid and capital flows
51
2
subsidiary of Archer Daniels Midland Company. Risk Warning: Investments in Equities, CFDs, Futures, Options, Derivatives and Foreign Exchange can fluctuate in value, investors should therefore be aware that they may not realise the initial amount invested, and indeed may incur

Paul Mylchreest
Tel: +44 20 7716 8257
Executive Summary
Can you buy and sell time? We think that you can from the perspective of time horizons. In our view,
financial markets are operating on the wrong time horizon one that is too long (thanks to central
banks ZIRP/NIRP and credit creation) - although there are signs that this is beginning to change.
We are in a global debt bubble and debt has a time function given its ability to bring forward consumption from the future into the present. Debt essentially buys time and the world has bought a
(hell of a) lot of time. The present is inexorably catching up with what was the future.
Time preference reflects the relative valuation placed on goods at an earlier date versus a later date.
While current goods (including cash) should always have a higher valuation than future goods, time
preference declines as an economy becomes wealthier, i.e. the proportion of income devoted to current consumption falls versus that devoted to saving/capital accumulation.
Since the crisis, central banks have sought to address under-consumption (how many people do
you know who voluntarily under-consume?) by distorting time preferences in the real economy and
financial markets via zero interest rates and excessive credit creation. Negative interest rates are another step in this direction. At the heart of their policy, however, is a fundamental contradiction.
On one hand, their policies seek to increase current consumption, at the expense of long-term
saving & capital accumulation, in an over-leveraged world. This increases time preference and
would normally equate with higher interest rates, shortening time horizons and diminution in
wealth.
However, by forcing down interest rates, the substitution of savings (real wealth) by cheap credit
and by supporting financial markets, they have created an impression that time preference is
lower than it really is. This lengthens time horizons, implies that current/rising consumption levels are more easily sustainable and induces incorrect spending decisions.
While artificially increasing time preference fundamentally weakens an economy, there is no immediate concern unless there is evidence that businesses, consumers and investors are recognising that
time preference is too high and are responding accordingly.
We detect signs that time horizons are shortening in both the real economy and financial markets.
In real economy terms, this already looks well advanced in Japan, which is the cutting edge of the current monetary experiment (spending, investment and saving are all weak). However, we are much
more concerned about the weaker-than-expected levels of capital investment. This has been apparent
for months on an almost global basis.
The global production chain for manufacturing and services can (also) be thought of in terms of a term
structure or time series. It begins with higher orders of production, e.g. natural resources and capital
goods which are furthest from the final consumer, and ends with producers of goods sold directly to
consumers. Investment in upstream production has a positive effect which cascades down through the
economy as a whole (implicit in Says Law of Markets). If the ability of central banks to lengthen
time horizons in the real economy is fading, you would expect to see cutbacks to new investment and
asset write downs in upstream sectors. This is what weve been witnessing in Oil & Gas and Mining.
In the financial markets, there is evidence of shortening time horizons in the flattening of yield curves
and a shift of capital into the most marketable assets such as:
3

Paul Mylchreest
The Dollar
Highest quality sovereign bonds; and
Physical gold.
Tel: +44 20 7716 8257
While the result of central bank policies is to initially suppress volatility in the business cycle and financial markets, the end result is to exacerbate volatility. This is also starting to happen. Currency volatility began to rise from historically low levels in July 2014 and rapidly moved into other markets, such as
bonds and crude oil. It has also been picking up (much more slowly so far) in equities.
Signs of trouble have previously materialised in currency markets before having significant impacts on
other assets. In extreme cases, this has led to crises such as 1873, 1929 (which is much misunderstood)
and 1987. We are concerned that currency volatility could trigger destabilising capital flows if the divergence between the tightening bias of the Federal Reserve and extreme monetary easing by the ECB
and BoJ is maintained.
What also makes todays situation more precarious is the unprecedented degree to which the global
economy has been financialised. This comes in a number of guises, such as the unprecedented volume of global speculative capital. While central banks have added more than US$ 10 trillion of new
credit since the crisis, the stock of globally traded financial assets has increased from US$7 trillion in
1980 to something approaching US$200 trillion.
Surges/reversals in speculative capital are never taken into account by static economic models. Under
the right conditions, speculative capital flows can overwhelm almost anything in their path. If one
were asked to create the conditions which could encourage flows in global speculative capital, one
might include many which are already present, e.g. a global debt bubble, slowing global growth, instability in a key currency bloc, heightened geo-political tension, currency mismatch on US$9 trillion of
offshore debt and diverging policies amongst major central banks.
As time horizons shorten, we see growing evidence that speculative capital is moving towards safer
havens in general. We would pinpoint the start of this trend to late-June/early-July 2014 which
marked the beginning of the upward move in the dollar, the acceleration in Fails to Deliver in the repo market, rollover in the global manufacturing PMI, the trough in high yield spreads and the acceleration of the fall in the oil price.
Whats happening broadly fits the framework of Exters Pyramid where capital progressively flows
down from the top layers of the pyramid, containing the riskiest assets, into the bottom layers which
contain the least risky assets, e.g. Treasuries, AAA corporate bonds, defensive equities, cash, etc. Occupying the lowest level of the pyramid is gold.
For the time being, dollar strength will probably remain central to this process: due to.
Central bank policy divergence;
Tightening dollar liquidity;
Slowing global growth; and
Global Dollar Short at unprecedented levels.
We looked back to May 2013s Taper tantrum to see which markets were adversely affected by
tightening dollar liquidity the most. These included the Shanghai Composite, Brazilian Real and
Ibovespa, Turkish Lira and Borsa Istanbul, Rand, Ringitt, the EMB ETF and European banks.
4

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Going forward, we expect to see the unfolding of the final leg in the bull market bubble in developed world sovereign bondsmuch as it pains us to say it.
We also expect further flattening in the Treasury yield curve, with long-term US Treasuries outperforming short-term maturities which paradoxically implies selling time as we explain below. Our
view is that if the Fed does increase rates in June or September this year, we will still see further declines in long-term Treasury yields.
Capital is flowing into physical gold and the latest monthly data shows that gold demand from the four
major identifiable sources (China ex-PBOC, Indian imports, central banks and ETFs) amounted to 150%
of the output of every gold mine in the world. The fact that the gold price remains depressed rather
than surging shows that price discovery is still being dominated by paper gold instruments and the leveraged long/short trade (long the Nikkei index/short paper gold).
What about equities? While long bonds might have a maturity of 10-30 years, equities theoretically
have infinite time horizons. Typically, equity investors make detailed estimates for cash flows for 7-10
years, beyond which cash flows to infinity are capitalised. Sticking with our time theme, when so much
consumption has already been brought forward due to debt, valuing more distant cash flows on PEs
above historic averages seems generous. But how do you even come close to an objective valuation in
an increasingly (thanks to central banks) ZIRP or even NIRP world?
Valuation difficulties aside, there are two main indicators, and a third confirmatory indicator, which we
are tracking to signal a top in the S&P 500. The first two gave well-timed sell signals at the last two
peaks in the S&P 500 in 2000 and 2007. The three indicators are.
A crossover in the adjusted MACD;
The flattening of at least part of the Treasury yield curve all the way to zero; and
By way of confirmation - the ISM manufacturing survey crossing the 50.0 line to the downside.
These indicators incorporate signals from credit markets, technical analysis and the real economy.
We are getting close to, but have not yet reached, another bearish crossover in the adjusted MACD.
Source: Bloomberg
5

Paul Mylchreest
Tel: +44 20 7716 8257
In terms of the Treasury yield curve, Fed intervention has obviously led to substantial distortion, making us reluctant to rely on either the very short or very long end. Focusing more towards the middle,
the 7s10s spread is now only 20 basis points from flattening ( while the 5s10s is at 51 basis points).
7s10s Yield Curve (basis points)
90.0
80.0
70.0
60.0
50.0
40.0
30.0
20.0
2015
2014
2013
2012
2011
2010
10.0
Source: ADMISI, Bloomberg
The ISM crossed the 50.0 line to the downside shortly after the last two peaks in August 2000 and
December 2007. The latest monthly reading was 52.9 and the trend has been downward since October
2015.
Naturally, our stance on equities is defensive and we would highlight bond-like equities, particularly those which have good correlations between outperformance and falling long-term yields and
flattening yield curves. This includes sectors such as Consumer Staples and Utilities.
On the other side of the coin, cyclical sectors such as Capital Goods, Steel and Chemicals have good
correlations between underperformance and falling long-term yields and flattening yield curves.
Finally, we want to mention Martin Armstrongs Economic Confidence Model (ECM) as more people
seem to be taking an interest. In the past, the ECM has been surprisingly successful in tracking the market which is seeing the greatest concentration of global speculative capital (hot money), e.g. Nikkei in
1989, US sub-prime in 2007, not to mention the 1929 Crash. While he is bullish on the dollar, Armstrong commented earlier this year that in this cycle, the model is capturing the shift of capital into the
bond market, primarily. However, our analysis shows that the dollar index has also been tracking the
ECM closely since the major low in the model in June 2011 (2011.45). Many people dont seem to realise that the ECM is fractal, so it operates on multiple, but related, time horizons. According to our calculations, there was a recent intermediate low on 4 March 2015. The dollars performance since then has
been impressive. The next major high in the ECM is on 1 October 2015 (2015.75) and we will be watching to see if this also marks the high in the dollar (and/or sovereign bonds).
6

Paul Mylchreest
Tel: +44 20 7716 8257
Time, Debt and Central Banks

We are in a global debt bubble and debt brings forward consumption into the present from a more
distant point in the future since it removes the need to save the loan value out of disposable income. Consequently, the accumulation of debt has a time function.
Debt essentially buys time, so borrowers are literally long time and short the currency/credit
which they must return to the lender at a later date. While lenders lend money, they are also
lending or selling time to the borrowers.
While it has a geared effect on economic growth, buying more and more time becomes problematic. As time progresses, what is the present begins to catch up with what was the future.
In the US, total credit market debt outstanding is US$58.0 trillion, or $62.4 trillion if you include the
Feds balance sheet. At 331.7% of GDP, it is significantly higher than the 275% reached at the peak of
the Great Depression.
Total Debt, Total Debt + Fed Balance Sheet v. Nominal GDP (US$ bn)
65,000
60,000
55,000
50,000
45,000
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
Q1 1960
Q1 1961
Q1 1962
Q1 1963
Q1 1964
Q1 1965
Q1 1966
Q1 1967
Q1 1968
Q1 1969
Q1 1970
Q1 1971
Q1 1972
Q1 1973
Q1 1974
Q1 1975
Q1 1976
Q1 1977
Q1 1978
Q1 1979
Q1 1980
Q1 1981
Q1 1982
Q1 1983
Q1 1984
Q1 1985
Q1 1986
Q1 1987
Q1 1988
Q1 1989
Q1 1990
Q1 1991
Q1 1992
Q1 1993
Q1 1994
Q1 1995
Q1 1996
Q1 1997
Q1 1998
Q1 1999
Q1 2000
Q1 2001
Q1 2002
Q1 2003
Q1 2004
Q1 2005
Q1 2006
Q1 2007
Q1 2008
Q1 2009
Q1 2010
Q1 2011
Q1 2012
Q1 2013
Q1 2014
Total Credit Market Debt (US$bn)
Total Credit Market Debt + Fed B/S (US$bn)
Nominal GDP (US$bn)
Source: Federal Reserve, ADM ISI
What deleveraging?
7

Paul Mylchreest
Tel: +44 20 7716 8257
Its noticeable how central bankers almost never mention that TOO MUCH DEBT is the key factor
holding back growth in what is a credit-driven global economy. This is the sleight of hand to deflect
guilt. In fact, their strategy has been to address the fallacy (think about it) of under-consumption by an
all-out attempt to make it cheaper to borrow so that the world accumulates even more debt.
And the US is only a part of the story.
The total amount of debt accumulated on a global basis is approximately US$200 trillion according to a
recent report from the management consulting firm, McKinsey.
Source: McKinsey
The world is long (a hell of) a lot of time.

Looked at in another way, central banks have artificially lengthened time horizons in the real economy
and financial markets by distorting time preference. They have created an illusion at the heart of which
is a fundamental contradiction.
Time preference is the relative valuation placed on goods (including money) at an earlier date versus a
later date. It almost goes without saying that, in general, people would rather fulfil their desires today
than tomorrow. Who wouldnt? People value present goods more highly than future goods. This concept is obviously used in DCF calculations to value financial assets/projects, i.e. cash flows at an earlier
date have a higher valuation than cash flows at a more distant date.
In an economy, the way that time preference alters the balance between consumption today versus
saving/investment for the future - and how debt accumulation interacts with this process has major
implications for growth. As an economy becomes wealthier, time preference declines.
Time preference plays a key role in the formation of interest rates along with diminishing marginal utility (e.g. if you were on a desert island with nothing but 2 bananas, it probably makes sense to eat the
other one tomorrow).
8

Paul Mylchreest
Tel: +44 20 7716 8257
Implicit in time preference is that interest rates should be positive. Borrowers have to compensate
lenders for the use of cash now if they dont want to (or cant) save it out of disposable income. Lenders
require positive interest rates to defer consumption over and above some level of precautionary cash
reserve.
Negative interest rates violate the normal concept of time preference, implying the premium of present
goods to future goods is reversed. A person who saves SFr100 and gets SFr 99 back in a years time
must judge that the value of SFr 99 for consumption in a years time is more than SFr100 now.
Switzerland was the first country to see its 10-year yield slip into negative territory.
Source: Bloomberg, ADM ISI
9

Paul Mylchreest
Tel: +44 20 7716 8257
More than 15% of all developed market sovereign bonds are now trading on a negative yield. Swiss
yields are currently negative out to nine years, German yields out to six, Danish out to five and Swedish
out to four.
This strikes us as an extraordinary market signal. How could things have become so distorted and why
is the consensus view so complacent? It seems that as long as stock markets are buoyant and sovereign
bond yields of major nations remain very low, the majority will bask in the status quo.
Many suggestions are being put forward to explain negative yields so far out on the curve.
Rising deflation risk;
SNBs negative policy rate (reduced from 0.00% to -0.75% since December 2014);
A shift towards safe assets as some investors question the future stability of the current financial architecture;
Limited guarantees on bank deposits and risks to the banking system;
A view that Swiss government bond prices will continue rising, so there will be an opportunity to
sell them at a higher price to someone else;
Supply shortages of specific assets relative to the massive liquidity injections from central banks;
The financial system has been so distorted by central banks that its almost impossible to value
anything even with a degree of objectivity any more; and
Asset prices are increasingly driven by flows of capital as markets try to front-run changes in central bank policy.
All might be contributing, to a greater or lesser extent, but most are reflecting economic weakness and/
or risk aversion on one hand and extreme policies of central banks on the other.
In contrast to the Fed, BoJ, BoE and (now) the ECB, the Swiss National Bank has never bought its own
sovereign bonds. Nor should we forget that there are still alternative sovereign bonds with respectable
credit ratings and much higher (its all relative) yields, e.g. US Treasuries. Yet the yield differential has
not been arbitraged away, or at least not yet. And if it was, which way would it go?
Whats happening made us think about time preference and the way in which it is being distorted.
An increase in time preference implies that a higher ratio of income is devoted to consumption versus
saving/investment for the future.
It should be obvious that this is precisely the aim of central bank policies to correct what they view as
under-consumption. At its heart is a cynical inducement for businesses and consumers to make what
are, in some cases, incorrect or risky spending decisions. Increasing consumption when savings ratios
are low and debt is high suggests that central banks are trying to create the illusion that time preference is lower/falling when its actually higher/rising.
If we look at the US, for example, while debt is at an all-time high, the savings ratio is at a very low level
by historical standards.
10

Paul Mylchreest
Tel: +44 20 7716 8257
US Personal Savings as % of Disposable Income (since 1959)

18.0
16.0
14.0
12.0
10.0
8.0
6.0
4.0
2.0
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
0.0
The problem becomes clear when you think more deeply about rising time preference in an economy.
An increase in time preference means a corresponding reduction in saving. Saving/investment, in case
we forget these days, is the basis of wealth creation, i.e. the creation and productive application of surplus. An economy with a time preference of 100% would spend all of its income on consumption and
would never have any surplus for capital investment in order to increase its standard of living. Indeed,
in no way is it an exaggeration to say that it was only by lowering time preference that civilisation was
possible.
In normal circumstances, the more that time preference is raised, the more people live a hand-tomouth (or paycheck to paycheck) existence. Current levels of consumption become harder to sustain,
there is less confidence in the future and time horizons shorten. In this environment, capital investment, which is the basis for wealth creation, suffers. All things being equal, high time preference would
normally equate with higher interest rates as borrowers compete for scarce funds and need to offer
high rates to induce people into saving.
Time preference tends to be higher for the very old, the very young, people living in less developed societies and for individuals and entities which are heavily indebted (which increasingly includes governments). In extreme cases, it can be associated with a rise in central planning, big government, the
subversion of property rights and rule of law and when a system starts decaying towards socialism.
Venezuela is an example of this. In such circumstances, governments kill productive investment,
there is hoarding/shortages and capital flight emerges.
What about the opposite situation?
When time preference is low or declining, a smaller ratio of income is devoted to consumption versus
savings and investment. This implies a comfortable level of financial surplus. Current levels of consumption should be sustainable and time horizons lengthen due to greater confidence in the future.
Abundant savings implies lower interest rates for borrowers. Businesses and entrepreneurs react to the
higher savings/confidence with new capital investment, particularly in higher orders of production
11
11

Paul Mylchreest
Tel: +44 20 7716 8257
which are more distant from the final consumer. This includes natural resources, like oil & gas and metals and mining, and capital goods projects.
In a big picture sense, time preference tends to decline when a society experiences a broadly-based rise
in wealth/capital accumulation. It is often associated with other factors such as technological progress,
free-market capitalism, small government, the respect for property rights and the rule of law.
This was Douglas French writing in High Rises and High Time Preferences.
The lower the time preference rate, the earlier the onset of the process of capital formation, and the
faster the roundabout structure of production will be lengthened. Civilization is set in motion by individual saving, investment, and the accumulation of durable consumer goods and capital goods.
It should be clear how central banks are attempting to distort time preference and how their policies
contain a fundamental contradiction in terms of time horizons and wealth creation. In essence, they are
creating an illusion.
While aggressively seeking to increase time preference, with all its negative implications, on the one
hand, they are trying to give the impression that time preference is lower than it really is by making current levels of consumption seem more sustainable by forcing down interest rates and replacing savings
with cheap credit. This artificially extends time horizons and increases confidence. But, lest we forget, a
rising time preference is indicative of a weakening economy, not a strengthening one, and one which is
more vulnerable than it looks.
It doesnt take a genius to realise that the end result of trying to artificially lower time preference is to
exacerbate the volatility of the business cycle and financial markets.
We know the result.
S&P 500 (since 1996)
2200
2000
1800
1600
1400
1200
1000
800
600
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
400
Each bubble is bigger than the last because the recovery from the previous bubble requires even lower
interest rates and more credit creationwhich induces some businesses and consumers to make a new
round of risky spending decisionsand eventuallyinvestment decisions.
12

Paul Mylchreest
Tel: +44 20 7716 8257
There comes a point when the illusion should start to fade. The average person will start to realise that,
in spite of historically low interest rates and all around central bank largesse, their time preference is
not that low. In fact, its been rising and increasing it further would be irresponsible. Time horizons will
shorten and risk increases.
The focal point of the last bubble was US house prices and associated securitised loans. House prices,
which (according to Bernanke) were never supposed to fall, but were already falling more than a year
and a half before Lehman collapsed.
US House Prices (S&P/Case-Shiller 20 City Home Price Index, % yoy)
20
15
10
-5
-10
-15
-20
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
-25
This got us thinking about what signs we should we look for to tell if the central banks time preference
illusion is running out of road.
13
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Shortening Time Horizons

Shortening time horizons Japan
We need to start with Japan, which is the cutting edge of central bank monetary experiments.
Its a heavily indebted nation;
Using extreme policies in terms of low interest rates and credit injections; and
Suffering from an ageing demographic.
The embryonic signs that Abenomics is failing suggest that it might not be possible to control time
preference indefinitely.
The BoJs policy rate has been almost zero for most of the last 15 years and its balance sheet is currently expanding at an (almost unbelievable) annualised rate equivalent to 17% of nominal GDP. In spite of
this, retail sales growth is non-existent.
Japan: Retail trade (yoy %)
12.0
10.0
8.0
6.0
4.0
2.0
0.0
-2.0
-4.0
-6.0
-8.0
Jan-15
Nov-14
Jul-14
Sep-14
May-14
Jan-14
Mar-14
Nov-13
Jul-13
Sep-13
May-13
Jan-13
Mar-13
Nov-12
Jul-12
Sep-12
May-12
Jan-12
Mar-12
Nov-11
Jul-11
Sep-11
May-11
Jan-11
Mar-11
Nov-10
Jul-10
Sep-10
May-10
Jan-10
Mar-10
Nov-09
Jul-09
Sep-09
May-09
Jan-09
Mar-09
-10.0
Even though the once high saving Japanese population has moved into dissaving mode.
14

Paul Mylchreest
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Cant spend and cant save.

The Composite PMI, covering both manufacturing and services, is rolling over again.
Japan: Composite Output PMI (since Feb 2012)
58.0
56.0
54.0
52.0
50.0
48.0
46.0
Jan-15
Feb-15
Dec-14
Oct-14
Nov-14
Sep-14
Jul-14
Aug-14
Jun-14
Apr-14
May-14
Mar-14
Jan-14
Feb-14
Dec-13
Oct-13
Nov-13
Sep-13
Jul-13
Aug-13
Jun-13
Apr-13
May-13
Mar-13
Jan-13
Feb-13
Dec-12
Oct-12
Nov-12
Sep-12
Jul-12
Aug-12
Jun-12
Apr-12
May-12
Feb-12
Mar-12
44.0
No matter what the BoJ does in terms of interest rates or credit creation, time preference in Japan
seems reluctant to go any higher. It could take suicidal currency debasement to create enough inflation
to change this mindset and we cant even rule this out with Abe/Kuroda at the helm.
15
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Tel: +44 20 7716 8257
Its hard to say, but there is a chance that the Japanese economy has moved into a state of semipermanent decline.
Shortening time horizons real economy

Besides Japan, another focus for us is the trend in capital investment on a global basis. We highlighted
the importance of capital investment to wealth creation in our discussion of time preference earlier.
The global production chain for manufacturing and services can (also) be thought of in terms of a time
series. It starts with the higher orders of production, e.g. natural resources and capital goods, which
are the most distant from the final consumer, and ends with businesses producing goods in their final
form for consumers. Profitable investment made in upstream production translates into wages and
flows of goods and services which cascade down through the entire chain.
We have more sympathy with Jean Baptiste Says Law of Markets than Keynes thinking with regard
to under-consumption. The basic idea of the Law of Markets is that when an individual produces a marketable good or service and gets paid for it, he/she is then able to demand other goods and services
(including money which is an intermediate good used in exchange).
In essence, the argument is that it is the production of goods and services that drives consumption, not
the other way around. Once a unit of a good or service has been consumed, its value has been eliminated. In order to continue to demand, you need to continue to supply. Its not that supply creates its own
demand, as Keynes mistakenly interpreted, but that supply is a precondition for demand.
Says Law has nothing to do with an equilibrium between aggregate supply and aggregate demand,
but rather it describes the process by which supplies in general are turned into demands in general. It
is always the level of production which determines the ability to demand.
It reminds us of the fallacy that deposits create loans in the banking system when the reality is that
loans create deposits - nothing more than double entry bookkeeping in a pure credit system.
Savings are the source of capital accumulation and provide the basis for entrepreneurs to finance productive resources. The consequence, however, is that wealth and economic progress is created by production increasing the quantity of goods and services available - not consumption. According to Say.
"it is the aim of good government to stimulate production, of bad government to encourage consumption."
For companies in the upstream part of the production chain, capital investment projects tend to be
very costly, high-risk and long-term in nature. Distinguishing between a genuine reduction in time preference and an artificial one crafted by the central bank is, therefore, criticaland mistakes can be
made.
Recent capital investment trends in Japan illustrate this perfectly.
Japanese machinery orders rebounded strongly after Abes election victory in December 2012. However, the marked weakness weve seen in recent months seems to imply that confidence in making longterm capital investment has deteriorated.
16

Paul Mylchreest
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Japan: Machinery Orders (yoy %)

50
40
30
20
10
-10
-20
-30
-40
2015
2014
2013
2012
2011
2010
2009
-50
If central banks induce businesses to make incorrect capital investment decisions, the end result will be
that production is out of line with consumer preferences. This will distort the ratio between capital
goods and consumer goods. In such circumstances, some of the increased capacity for capital goods will
turn out to be malinvestment.
Capital will decrease, both in terms of physical wastage and loss of value, and decisions on new investment will be cancelled.
This is exactly whats been happening in the Mining and Oil sectors and these industries represent the
highest orders of production, i.e. at the top of the production chain. First came mining and here is a
chart of Rio Tintos capex since 2010 and its forecasts through 2017.
Rio Tinto - Capex 2008-17 (US$bn)
20.0
18.0
16.0
14.0
12.0
10.0
8.0
6.0
4.0
2.0
0.0
2008
2009
2010
2011
2012
2013
2014
2015e
2016e
2017e
17
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Paul Mylchreest
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Oil and gas are following suithere is the same chart for BP with its 2015 forecast.
BP - Capex 2008-15 (US$bn)
30.0
25.0
20.0
15.0
10.0
5.0
0.0
2008
2009
2010
2011
2012
2013
2014
2015e
The capital investment cycle is weak on a global basis. Here is data from the US and Germany, in addition to Japan which we showed above.
Capital Goods Order Books: US, Japan & Germany (yoy %)
40.0
30.0
20.0
10.0
0.0
-10.0
-20.0
-30.0
-40.0
US Capital Goods Orders (ex-def/air)
Japan Machinery Orders
2015
2014
2013
2012
2011
2010
2009
-50.0
Germany Manufacturing Orders
18

Paul Mylchreest
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Switching to China, the investment boom is cooling rapidly. Growth in floor space of buildings under
construction is at its lowest rates since the National Bureau of Statistics started reporting the data in
late 2005.
China - Floor Space of Buildings Under Construction (yoy %)
40
35
30
25
20
15
10
2015
2014
2013
2012
2011
2010
2009
2008
2007
2005
2006
It seems that time preference is rising and time horizons shortening at the front end of the worlds production chain.
In the US, profit margins are at record levels
Source: Ed Yardeni
but the corporate sector is not investing in corresponding fashion.

19
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Paul Mylchreest
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Instead it prefers the short-term fix of financial engineering.
Source: MarketWatch
When all of the data has been collected, 2014 will have been close to a record for share buybacks in the
S&P 500.
Besides reflecting shorter time horizons, this is yet another aspect of the increasing financialism
which has taken the global economy hostage (see below).
Shortening time horizons financial markets

If we are correct about shortening in time horizons in the real economy, can we observe a similar trend
in any key financial markets?
We think so. Lets consider US Treasuries and the slope of the yield curve given the way it can relate to
time horizons.
We know from reams of empirical studies that flattening yield curves typically precede economic weakness and inversions often signal a coming recession. This quote is taken from The Yield Curve as a
Leading Indicator from the New York Feds website.
The difference between long-term and short-term interest rates (the slope of the yield curve or
the term spread) has borne a consistent negative relationship with subsequent real economic activity in the United StatesThe measures of real activity for which predictive power has been found include GNP and GDP growth, growth in consumption, investment and industrial production, and economic recessions as dated by the National Bureau of Economic Research (NBER).
Since the long-term yield is effectively the weighted average of future short-term yields, the market also believes that interest rates further along the curve, i.e. further into the future, will need to decline to
reflect lower growth.
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Paul Mylchreest
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Paradoxically, therefore, buying the long end of the curve (versus the short end) reflects a shortening of
time horizonseffectively a way to sell time.
The yield curve flattened completely in advance of the last two peaks in the S&P 500 (March 2000 and
October 2007 red lines in chart below) and the onset of the subsequent recessions (March 2001 and
December 2007 black lines). You see the same thing regardless of which part of the curve you look at
anywhere between 2 years and 30 years, e.g. 2s10s, 5s10s, 5s30s, etc. Here is the 2s30s curve.
2s30s Yield Curve (basis points)
400.0
300.0
200.0
100.0
0.0
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
-100.0
Here is the same 2s30s curve versus the ISM Manufacturing Index.
21
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Paul Mylchreest
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In a ZIRP, and increasingly NIRP, world, our bond colleagues argue that this is largely due to an ongoing reach for yield which his pulling down yields at the long end. We think that it is that and more besides, i.e. shortening time horizons and flight to safety.
We also think the yield curve might be helpful again in predicting a peak in the equity market (below).
Besides the flattening in the yield curve, a shortening of time horizons and flight to safety might also be
reflected in capital flowing into the most marketable financial assets. InvestorWords.com defines
marketability as:
A measure of the ability of a security to be bought and sold. If there is an active marketplace for a
security, it has good marketability.
Which reminds us of this quote from Oddball in the movie Kellys Heroes.
These engines are the fastest in any tanks in the European theatre of operations, forwards or backwards. You see, man, we like to feel we can get out of trouble quicker than we got into it.
Three of the most marketable financial assets on the planet in our opinion are:
US dollar;
Treasuries (although QE has interfered with this); and
Physical gold.
As we are all well aware, the dollar has been strong - the breakout from the pre-Plaza Accord wedge,
which dates back more than 30 years, is extremely significant.
US Dollar Index (since 1984)
170
160
150
140
130
120
110
100
90
80
2014
2015
2012
2013
2010
2011
2008
2009
2006
2007
2004
2005
2002
2003
2000
2001
1998
1999
1996
1997
1994
1995
1992
1993
1990
1991
1988
1989
1986
1987
1984
1985
70
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Paul Mylchreest
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Its slightly worrying for us as gold advocates that the worlds benchmark debt security the 10-Year
US Treasury - still looks good value (relatively speaking) in a global debt bubble.
10-year Yields - US v. Germany v. Switzerland (%)
5.00
4.00
3.00
2.00
1.00
0.00
10-Year US Treasury Yield (%)
10-year Bund Yield (%)
2015
2014
2013
2012
2011
2010
2008
2009
-1.00
10-Year Swiss Yield (%)
In the gold market, its still the case that black is white, white is black and up is down.
The chart shows that gold has been doing very badly in dollars.
Gold US$/oz. (since 2013)
1800
1700
1600
1500
1400
1300
1200
Feb-15
Mar-15
Jan-15
Dec-14
Oct-14
Nov-14
Sep-14
Aug-14
Jul-14
Jun-14
May-14
Apr-14
Feb-14
Mar-14
Jan-14
Dec-13
Oct-13
Nov-13
Sep-13
Jul-13
Aug-13
Jun-13
May-13
Apr-13
Feb-13
Mar-13
Jan-13
1100
23
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However, its doing far better in non-dollar currencies like the Euro, although people rarely think this
way.
Gold in Euros (since 2013)
1300
1250
1200
1150
1100
1050
1000
950
900
Jul-14
Aug-14
Sep-14
Oct-14
Nov-14
Dec-14
Jan-15
Feb-15
Mar-15
Aug-14
Sep-14
Oct-14
Nov-14
Dec-14
Jan-15
Feb-15
Mar-15
Jun-14
Jul-14
Jun-14
Apr-14
May-14
Mar-14
Jan-14
Feb-14
Dec-13
Nov-13
Oct-13
Sep-13
Aug-13
Jul-13
Jun-13
Apr-13
May-13
Feb-13
Mar-13
Jan-13
850
The price had doubled in Roubles at one point.

Gold in Rubles (since 2013)
95,000
90,000
85,000
80,000
75,000
70,000
65,000
60,000
55,000
50,000
45,000
40,000
Apr-14
May-14
Feb-14
Mar-14
Jan-14
Dec-13
Nov-13
Oct-13
Sep-13
Aug-13
Jul-13
Jun-13
May-13
Apr-13
Mar-13
Feb-13
Jan-13
35,000
24

Paul Mylchreest
Tel: +44 20 7716 8257
So gold has started to strengthen in major and minor non-dollar currencies.

As weve said numerous times over the years, the gold market is bifurcated between a truly vast
amount of trading of paper gold instruments, which only purport to be physical gold, and a tiny
amount of actual physical gold. The Reserve Bank of India estimated the paper/physical ratio at 92:1
and price discovery remains ludicrously skewed towards the former.
Historically, when the gold price has been rising and bullion banks have refrained from adding more
paper shorts (i.e. Commercials increasing their net short position on COMEX), the gold price has
gone parabolic. Here are three examples in 2005-06, 2007-08 and 2010-11.
Gold Price v. COMEX Net Commercials Futures Positions (2001-11)
2000
-320000
-300000
-280000
1800
-260000
-240000
1600
-220000
-200000
1400
-180000
-160000
1200
-140000
-120000
1000
-100000
-80000
800
-60000
-40000
-20000
600
0
20000
400
40000
60000
Gold Price (US$/oz)
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
200
Gold Net Commercial Futures Positions (Inverted)
Lets go back to the gold/dollar relationship.

In the London market, there was something called GOFO the Gold Forward Offered Rate which the
LBMA stopped reporting a few weeks ago (funny that). GOFO is the cost, in terms of the interest rate,
of borrowing dollars using gold as collateral. GOFO moving close to zero implies that the market has a
greater need to borrow physical gold, i.e. to swap it for dollars.
GOFO should never be negative in an efficiently functioning gold market with adequate physical supply.
However, GOFO went negative several times after June 2013 and very negative in November/
December 2014.
25
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Paul Mylchreest
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Negative GOFO implied that the market was so short of physical gold that it would PAY you to borrow its DOLLARS (yes dollarsin which the gold price has been weak) if you lent it your gold for a month. So you got paid to
borrow dollars which could then be put on deposit, earning you TWO interest rates.
A scramble to obtain physical gold is indicative of a short time horizon in the gold market.
Its the same story in the gold futures market, which has been in and out of backwardation in recent months.
The gold basis is the difference between the spot price of gold and its price in the near-month futures contract. The gold market should always be in contango and should never move into backwardation (negative basis),
i.e. where the offer price of the near-month future is lower than the bid price of spot gold. Given the off-thescale ratio of stock to flows in gold, backwardation implies a risk-free profit from selling spot (physical) gold and
buying the future at a lower price with the intention to take delivery.
Its a risk-free profit unless the market is growing concerned about the availability of physical gold upon expiry of
the futures contract. By definition, gold bought in the futures market is a future good, whereas physical gold
bought on a spot basis is a present good.
Time horizons againand talking of physical gold demand.
Withdrawals of bullion on the Shanghai Gold Exchange (SGE) are a good proxy for Chinese gold demand. Under
Chinese law, all gold either mined domestically or imported has to be sold through the SGE. The SGE regulations
(Article 23) specify that bars which have been withdrawn cannot be re-deposited. If they are re-deposited, withdrawn SGE bars have to be recast and assayed into new bars which count as scrap supply. In addition, please
note that the Chinese central bank does not purchase gold on the SGE, so its purchases (which are only disclosed
every 6 years) are additional.
In each of the last five months (September 2014 January 2015) SGE withdrawals have been in excess of 200
tonnes. In the last two months, they have equated to more than 100% of the output of all of the worlds gold
mines.
26

Paul Mylchreest
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Shanghai Gold Exchange: Monthly Withdrawals (tonnes)

275
250
World gold mine output monthly - 233 tonnes

225
200
175
150
125
100
75
50
25
Jan-15
Nov-14
Jul-14
Sep-14
May-14
Jan-14
Mar-14
Nov-13
Jul-13
Sep-13
May-13
Jan-13
Mar-13
Nov-12
Jul-12
Sep-12
May-12
Jan-12
Mar-12
Nov-11
Jul-11
Sep-11
May-11
Jan-11
Mar-11
Nov-10
Jul-10
Sep-10
May-10
Jan-10
Mar-10
So, we have one customer increasing its demand to more than 100% of world production, coupled with
free market indications (GOFO, futures backwardation) of tightness, yet we see a decline in price. Just
to hammer home the point, the next chart aggregates the four major identifiable sources of global gold
demand and plots them on a monthly basis. These are:
Gold withdrawals on the Shanghai Gold Exchange (data from the SGE);
Gross gold imports into India;
Net change in gold holdings of all-known ETFs (Bloomberg); and
Net change in central bank gold holdings (WGC, quarterly data weighted on a monthly basis according to the WGCs incomplete data for the latter).
Gold Demand - Major Swing Factors (tonnes/month)
400
India Gold Import Duty 2%
8% 10%
6%
4%
350
World gold mine output monthly - 233t

300
250
200
150
100
50
Jan-15
Nov-14
Sep-14
Jul-14
May-14
Mar-14
Jan-14
Nov-13
Sep-13
Jul-13
May-13
Mar-13
Jan-13
Nov-12
Sep-12
Jul-12
May-12
Mar-12
Jan-12
Nov-11
Sep-11
Jul-11
May-11
Mar-11
Jan-11
Nov-10
Sep-10
Jul-10
May-10
Jan-10
Mar-10
27
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Paul Mylchreest
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In aggregate, the four major identifiable sources of demand (SGE, Indian imports, ETFs, central banks)
have exceeded 100% of world gold mining output for last 6 months. The latest figure, for January 2015,
of 349.7 tonnes was equivalent to 150.0% of world gold mine output.
This is probably the biggest unreported run on the banks, or rather a run on bank vaults in
history. You wouldnt know it, though, from the gold price. Very clever.
As weve said before, the current lockdown in the price reflects a large, leveraged long/short trade
which is long the Nikkei Index and short paper gold instruments. From our analysis, this trade has been
in operation since the Feds QE3 announcement in September 2012.
Given the strength of physical gold demand during the last couple of months unprecedented in the
last four and a half years - its not surprising that gold showed signs of breaking free. That was until
heavy shorting of paper gold futures (yet again) pushed the price back down.
Nikkei (Inverted) v. Gold since Sep 2012
8000
1750
10000
1650
1550
12000
1450
14000
1350
16000
1250
1150
18000
Nikkei 225 (Inverted)
Mar-15
Jan-15
Feb-15
Dec-14
Oct-14
Nov-14
Sep-14
Jul-14
Aug-14
Jun-14
Apr-14
May-14
Mar-14
Jan-14
Feb-14
Dec-13
Oct-13
Nov-13
Sep-13
Jul-13
Aug-13
Jun-13
Apr-13
May-13
Mar-13
Jan-13
Feb-13
Dec-12
Oct-12
Nov-12
Sep-12
1050
Gold spot (US$/oz.)
Hopefully its obvious that the screen price of gold in dollars is not remotely reflective of supply and
demand fundamentals. Strong demand, in conjunction with physical golds marketability and ultimate
safe haven status, is further evidence of shortening time horizons.
Another way of putting it would be hoarding.
Another financial market indicator is the Credit Suisse Fear Barometer, which is at a post-crisis high.
In technical terms, the Credit Suisse Fear Barometer reflects the cost of the zero cost collar, how much
it costs to buy a 10% OTM (out of the money) 3-month put versus a 3-month out of the money call.
Right now, investors really want to buy puts. Curiously it has not been a contra-indicator in the past.
28

Paul Mylchreest
Tel: +44 20 7716 8257
Credit Suisse Fear Index (since 2009)

45.00
40.00
35.00
30.00
25.00
20.00
15.00
2015
2014
2013
2012
2011
2010
2009
10.00
Global Speculative Capital

Financialism and the scale of global speculative capital
The situation today is made more precarious by the unprecedented degree to which the global economy has been financialised. There is no agreed definition of financialism, but the general principle is
the vastly increased role of finance during the last 30-40 years at the expense of the real economy.
This was Lawrence E. Mitchell writing about the US economy in his book The Embedded Firm. Unfortunately we have more sympathy with his view than wed like.
It has created a new economic system that appears to be capitalist but no longer performs the functions of capitalism. Capitalism is a system in which wealth is created and sustained by the production
of goods and services determined through market supply and demand. A variety of related structures
support capitalism, including the institutions of finance, which provide the funds necessary for the
production and trade of goods and services. While capitalism still characterizes a portion of the
American economy, it has become subordinated to a new economic orderThis new economic system is Financialism.
While we are focused on excessive credit creation and the almost unimaginable volume of global speculative capital, financialism comes in many guises.
The power of financial markets and speculative capital within;
Reliance on central banks to rescue TBTF financial institutions and support financial markets at
critical moments;
Unhealthy influence of major investment and commercial banks;
Volume of outstanding financial instruments and securitisation of just about everything in sight;
29
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Paul Mylchreest
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Financially-driven transactions, e.g. share buybacks;
High frequency and algorithmic trading methods;
Financial performance targeting;
Personnel involved in financial services (including compliance); and
Innovation in financial instruments, especially in derivatives (claims on claims on claims which

become ever more removed from what most people would view as reality).
This was Jeffrey Snider of Alhambra Investment Partners writing in January 2015 about financialism and
the role of the Eurodollar markets in creating the tsunami of global speculative capital.
There was no global savings glut as the increase in available finance for speculation was created
and nurtured by that very federal funds rate. Bubbles are not the end result of decades of positive
and productive expansion, but rather the intrusion of finance over and far above any rational means
to service actual economic activity the system is upside down as finance rules all now
The conjuring of dollars was based on one accounting regulation, namely that US banks operating
in NYC (or foreign bank subsidiaries) could use eurodollar liabilities as their own (with or without a
holding company structure), and as such that eurodollars were real. That was aided in no small part
by Alan Greenspan himself who lobbied and received board approval to end any capital charge on
eurodollar liabilities in 1990. The global dollar complex thus connected everywhere the dollar as
reserve currency penetrated which was far and wide. This hot money bastardization of the global
economy was thus predicated on not decades of decent economic stewardship but rather heightened appetites for bank balance sheet growth in eurodollar markets.
In September 2014, the BIS published a paper Why does financial sector growth crowd out real economic growth? It concluded that the expansion of the financial sector is only positive up to a point,
after which it becomes a drag on growth and productivity. The chart below shows the relationship between the financial sectors share of employment growth on the horizontal axis and growth in GDP-per
-worker growth on the vertical axis as deviations from their country means.
30

Paul Mylchreest
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Source: BIS
From the BIS paper.

financial booms are not, in general, growth-enhancing, likely because the financial sector competes
with the rest of the economy for resources. Second, using sectoral data, we examine the distributional nature of this effect and find that credit booms harm what we normally think of as the engines for
growth those that are more R&D intensive.
We cant ignore the role of central banks in creating the monster of financialism.
Central banks are important facilitators of financialism via ZIRP policies, credit creation and subversion
of free markets. It has reflected an ongoing takeover by an interlocking supranational state apparatus,
although the vast majority have been slow to see it for what it is.
The ECB and BoJ are pouring more gasoline on to the $10 trillion liquidity infusion fire with their current programmes which are set to add an additional US$1.5 trillion during the next 12 months.
The ECBs recently announced QE was, in some ways, a perfect example of some of the least attractive
aspects of financialism. Few people (us included) think that c.Eur1.05 trillion of securities purchases by
September 2016 will be of significant benefit on Eurozone economic growth. Ironically, this also seemed
to be Mario Draghis view as he argued time and again that action from Eurozone governments and the
European Commission was needed on the growth front.
Draghis threats to instigate QE eventually caught up with him as financial markets had already discounted much of the benefit, e.g. via substantial declines in peripheral bond yields. After jawboning for
so long, there would have been a violent reaction in bonds and equities had Draghi failed to provide the
additional credit infusion that financial markets were not only demanding, but had heavily discounted.
31
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Paul Mylchreest
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Central Bank Balance Sheets - Fed + ECB + BoJ + BoE + PBoC + SNB (US$bn)
17,000
16,000
15,000
14,000
13,000
12,000
11,000
10,000
9,000
8,000
7,000
2015
2014
2013
2012
2011
2010
2009
2008
6,000
Besides succumbing to market expectations, was it really necessary for the ECB to launch QE? Probably
not.
Our simple, but (usually) effective, model of Eurozone GDP growth had been suggesting for months
that, even without QE, Eurozone growth was poised to see some recovery in early-2015.
Eurozone: M1 money supply (9 mths forward) v. GDP growth
14.0
4.0
3.0
12.0
2.0
10.0
1.0
8.0
0.0
6.0
-1.0
4.0
-2.0
2.0
-3.0
0.0
Jun-15
Oct-15
Feb-15
Jun-14
Oct-14
Feb-14
Jun-13
Oct-13
Feb-13
Jun-12
Oct-12
Feb-12
Jun-11
Oct-11
Feb-11
Jun-10
Oct-10
Feb-10
Jun-09
M1 money supply 9-mths forward (yoy %)
Oct-09
Jun-08
Oct-08
Feb-09
Feb-08
Jun-07
Oct-07
Feb-07
Jun-06
Oct-06
Feb-06
Jun-05
Oct-05
Feb-05
Jun-04
Oct-04
Feb-04
Jun-03
Oct-03
Jun-02
Oct-02
Feb-03
Oct-01
Feb-02
Jun-01
Oct-00
Feb-01
-4.0
GDP (yoy %)
What about deflation?

32

Paul Mylchreest
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Well mild deflation, which is what we have in Spain and Italy, for example, increases consumer purchasing power. Retail sales volumes have been trending higher in both countries.
Retail Sales Volumes: Spain and Italy (yoy %)
8.0
6.0
4.0
2.0
0.0
-2.0
-4.0
-6.0
-8.0
-10.0
Spain
2014
2013
2012
2011
2010
2009
-12.0
Italy
Draghi, like Abe/Kuroda, by swamping the system with new credit is determined to diminish purchasing
power in an already weak economic environment. Genius.
As central banks continue to add to the credit bubble and financialism reaches extremes which would
have been unimaginable a few years ago, we are at greater and greater risk from surges/or reversals in
flows of global speculative capital.
In the right conditions, it can overwhelm almost anything in its path. Economic and financial models and
statements from policy makers never take account of this risk. For some reason, it reminds us of that
quote from former heavyweight boxing champion, Mike Tyson.
Everybody has a plan until they get punched in the mouth.
In its static state, global speculative capital, or hot money, represents potential energy which can
quickly change into kinetic energy, like a snowball at the top of a mountain or a battering ram.
Mass times velocity.
The potential energy in terms of speculative capital which could flow is now almost beyond comprehension, although the inter-connectedness of global finance is hardly a new phenomenon (e.g. see the discussions of the Panic of 1873, 1929 and 1987 below).
When hot money shifts in size, e.g. out of emerging nations, out of the shale industry, or into the
Swiss franc, there can be substantial impacts on asset prices, access to funding and its cost, the P&Ls
and balance sheets of businesses and financial players (especially leveraged ones), capital investment
budgets and complicated feedback loops which include consumer confidence. For example, the cheap
credit which was advanced to the US shale industry had the appearance of capital until recently. Now
it has the appearance of negative capital in some cases.
33
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Paul Mylchreest
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Theres never been more speculative global capital, although precisely how much remains unclear.
Having said that, a recent IMF paper Asset Bubbles: Re-thinking Policy for the Age of Asset Management gives us some idea of the growth in the market value of quoted financial assets between 19802012.
As global capital markets continue to expand in scale and scope, there are further reasons to expect
asset price movements to attract the close attention of policy makers. The stock of globally traded
financial assets (i.e. excluding real estate) has expanded sharply over recent decades, from US$7 trillion (71 percent of world GDP) to US$163 trillion (226 per-cent of world GDP) between 1980 and
2012.
And that was in 2012. Like McKinseys estimate for global debt, it must be approaching US$200 trillion
now. And that doesnt include the several hundred trillion dollars notional of derivatives.
Making matters worse is the increasing pro-cyclicality of speculative capital as institutional ownership
and short-term performance requirements continue to grow.
It reminds us of the quote in the Wall Street movie from the Lou Mannheim character, who acts as the
voice of reason on several occasions.
Too much cheap money sloshing around the world.
Volatility and the turning point in mid-2014

We think that the shortening of time horizons is beginning to, for want of a better word, disturb global speculative capital. Speculative capital is getting nervous and starting to move towards safer havens
in general.
We would pinpoint the start of this trend as late-June/early-July 2014 - which coincided with the start of
the major upward move in the dollar.
34

Paul Mylchreest
Tel: +44 20 7716 8257
Risk remains contained as long as capital flows remain relatively orderly, but it doesnt go away. Ronni
Stoeferle, a portfolio manager at Incrementum AG in Liechenstein has noted that.
The superficial veiling of risks, therefore, also leads to superficial stability.
Raoul Pal of GMI has his own take on this.
Suppression of volatility leads to hyper-volatility.
Which precisely describes what happened to the Swiss franc (see below).
Our knowledge of financial history tells us to watch the currency markets - currency volatility is often a
good indicator of future instability. Signs of trouble can materialise in currency markets before having
significant impacts on other asset prices. Examples include 1873, 1929 (currency effect much misunderstood), 1982, 1987 and 1997 to name a few.
The Panic of 1873

This triggered a depression in Europe and North America which followed a worldwide boom in equity
markets focused on railway speculation. However, the problems began with a currency crisis when Germany shifted from a silver standard to a gold standard following the Franco-Prussian War.
This led to a drop in the price of silver which hit the US mining industry, which was a major supplier.
The Coinage Act of 1873 moved the US to a de facto gold standard which put further pressure on silver
prices. This reduced US money supply and raised interest rates.
The catalyst for the crisis was the crash of the Vienna Stock Exchange in May 1873. This bankrupted
several Austrian banks and led to bank failures in other European countries, including Britain. The flow
of British capital across the Atlantic, which was helping to finance the American railroad boom, was reversed. With the crisis in the silver market already tightening monetary policy, it was the collapse of Jay
Cooke & Co., which had over-extended itself in the bonds of the Northern Pacific Railway, which precipitated a stock market crash and knock-on US bank failures.
The 1929 Crash and Great Depression

The usual explanation for the Crash of 1929 is that the Federal Reserve began raising rates in the early
part of 1928 and the policy tightening eventually pricked the stock market bubble in October 1929. The
reality is a little more complicated and involves currencies and flows in speculative global capital (and
gold), which is the reason for mentioning it in this report.
In apportioning blame, policy makers in France and the UK share significant responsibility along with
those in the US. For context, lets briefly rewind to World War I, The major combatants abandoned the
gold standard in order to finance their role in the conflict. This caused inflation and left high levels of
debt, especially in Britain, France and Germany. In the mid-1920s, nations began returning to the gold
standard to control inflation. Under this system, exchange rates were fixed and central banks were required to keep a gold cover ratio amounting to a minimum of 30-40% of currency in circulation and
bank deposits.
35
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Paul Mylchreest
Tel: +44 20 7716 8257
The problems began with the exchange rates adopted by certain key nations. Britain returned at its prewar rate which overvalued the pound and basically guaranteed deflation, a need for higher interest
rates (to support the pound) and a deficit on its balance of payments. The latter were financed by gold
outflows (exports). In stark contrast, France adopted an exchange rate which undervalued the franc.
This made its exports very competitive and led to balance of payments surpluses and gold inflows. The
system should have been self-correcting, i.e. gold inflows in France should have increased the money
supply leading to higher prices for French goods. The resulting impact on competitiveness would have
weakened the balance of payments, leading to gold outflows, thereby bringing the system back to equilibrium.
Unfortunately, the Bank of France (still traumatised by the severe inflation of 1924-26) and the Federal
Reserve (when gold inflows resumed in 1928) decided to sterilise the gold inflows rather than monetise
them. Although US gold holdings increased slightly during 1928-30, the scale of increase in Frances
gold reserves is almost mind boggling. Its share of world gold reserves increased from 7% in 1926 to
about 17% in 1929 and 32% in 1932. Cover ratios (ratio of gold to currency and bank deposits) in the US
and France rose to almost 50% in France and nearly 70% (from a higher base) in the US in 1929. This
had an increasingly deflationary effect on the world economy as other nations were forced to follow
rate increases and contract their money supply.
In early 1929, Keynes warned that central banks would compete for gold, forcing each other to tighten
policy out of self-protection, which would cause deflation. He got that one right. In the 1990s, Milton
Friedman commented that if he had been aware of the scale of French gold imports, he would have assigned a much greater contribution in his famous Monetary History of the United States to Frances
role in the Great Depression.
After Britain went back on the gold standard in 1925, the US, the Federal Reserve had been keeping interest rates low, in part to help Britain with its balance of payments/gold outflow problem. In the Summer of 1927, as the US economy was poised to emerge from a mild recession, the Fed cut the discount
rate from 4.0% to 3.5% and instituted open market operations in which it bought Treasuries. This left
the banks with high levels of surplus cash, much of which started to find its way into the call loan market. Here the borrowers were stock brokers and traders pledging stocks as collateral for loans for stock
speculation on margin. Not surprisingly, this helped to fuel the emerging boom in equity prices.
In the mid-1920s, the US had been making large loans to Germany to help with its war reparations and
recovery. However, outflows of capital and gold from the US to Europe reversed when the Fed raised
the discount rate in steps from 3.5% to 5.0% during January-July 1928. So in 1928-29, gold was flowing
into both the US and (especially) France, leaving less to go around elsewhere.
The Feds rate increases were aimed at curtailing excessive speculation on Wall Street, but they failed.
This is from the Federal Reserve Bulletin in early-1929.
During the last year or more, however, the functioning of the Federal Reserve system has encountered interference by reason of the excessive amount of the countrys credit absorbed in speculative
security loans. The credit situation since the opening of the new year indicates that some of the factors which occasioned untoward developments during the year 1928 are still at work.
While US banks cut back on their lending to the call loan market, their role was more than compensated for by non-banks/foreigners attracted by interest rates which peaked at more than 14%. Gold and
capital were flowing into the US from Britain, Germany and other nations.
36

Paul Mylchreest
Tel: +44 20 7716 8257
In February 1929, the Bank of England raised the bank rate to 5.5%. The Economist argued that:
the 5.5% rate comes as a definite signal to Americathat Europe is not prepared to stand idly by
and see the worlds stocks sucked into a maelstromIn any case, the establishment of European interest rates upon a new and higher level may well draw gold back from New York before long; and if
so the 5.5% rate will have done its work.
It didnt and after a temporary hiatus, the outflows resumed. The Fed raised its discount rate to 6.0%
on 9 August 1929 and the Dow Jones peaked about a month later on 3 September 1929but there was
no crash (yet). The coup de grace came shortly after from the Bank of England. On 26 September 1929,
it raised the bank rate to 6.5% and The Economist reported Chancellor of the Exchequer Snowdens
comments in its 4 October 1929 edition:
In New York, with Americas plethora of liquid capital and high rates, there has been a usual years
orgy of speculation, draining money away from EnglandThere has been a raid on the financial resources of this country which the increased bank rate is now intended to check. The object of the
increased rate is to draw money back to England.
Snowdens comments led to increased volatility in the Dow Jones in early October and the BoEs action
withdrew funding from the call loan market. With so much stock bought on margin, and the collateral
for loans being stocks whose prices were declining, many investors had no option but to sell when the
crash began later that month. In the wake of the crash, The Economist on 23 November 1929 was
praising the Bank of Englands contribution via its rate increasewith little idea of what the next four
years had in store.
That advancewas a by no means negligible factor in turning the opposite direction the tide of
funds which had been flowing so strongly toward New York, and in causing the edifice of the American speculation to totter.
1987 Crash
The background to the 1987 Crash was the repatriation of Japanese capital due to the falling dollar
(currencies again). With the signing of the Plaza Accord on 22 September 1985, the US, Japan, West
Germany, UK and France agreed to intervene in the currency markets to reduce the value of the dollar
in relation to the Yen and the Deutschemark. The situation reached a head when US Treasury Secretary, James Baker, threatened to devalue the dollar further during the weekend before the Black
Monday market crash if Germany didnt reverse its interest rate rise. The flow of speculative capital
into Japan, which was also encouraged by expansionary policies aimed at overcoming the impact on
Japans export-dependent economy from the strength of the Yen, helped to drive the final stages of
the Japanese asset bubble. The latter reached a climax with the peak in the Nikkei in late December
1989.
37
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Paul Mylchreest
Tel: +44 20 7716 8257
Currency volatility bottomed in late-June/early-July 2014.

Currency Volatility (CVIX)
24.00
22.00
20.00
18.00
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2.00
Immediately after the low in currency volatility, came the recent low in volatility in the US Treasury
market, as reflected in the MOVE index (Merrill Option Volatility Estimate implied volatility on 1month Treasury options).
Treasury Volatility (MOVE)
300.0
250.0
200.0
150.0
100.0
50.0
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
0.0
38

Paul Mylchreest
Tel: +44 20 7716 8257
Fails-to-deliver in the US repo market became more frequent signalling a tightening in dollar funding
markets (since QE3).
US Treasury Securities Fails to Deliver, US$m (since QE3)
200,000
180,000
160,000
140,000
120,000
100,000
80,000
60,000
40,000
20,000
Jan-15
Feb-15
Dec-14
Nov-14
Oct-14
Sep-14
Aug-14
Jul-14
Jun-14
Apr-14
May-14
Mar-14
Jan-14
Feb-14
Dec-13
Oct-13
Nov-13
Sep-13
Jul-13
Aug-13
Jun-13
Apr-13
May-13
Mar-13
Jan-13
Feb-13
Dec-12
Nov-12
Sep-12
Oct-12
Crude oil volatility also bottomed in the middle of last year.

Merrill Lynch 3-month WTI Volatility Index (since 2013)
55
50
45
40
35
30
25
20
15
10
Mar-15
Feb-15
Jan-15
Dec-14
Nov-14
Oct-14
Sep-14
Jul-14
Aug-14
Jun-14
May-14
Apr-14
Feb-14
Mar-14
Jan-14
Dec-13
Nov-13
Oct-13
Sep-13
Aug-13
Jul-13
Jun-13
May-13
Apr-13
Mar-13
Feb-13
Jan-13
39
39

Paul Mylchreest
Tel: +44 20 7716 8257
The crude price began its accelerated decline at the same time.
High yield rates bottomed.
Barclays US Corporate High Yield Average % (since 2013)
5.75
5.50
5.25
5.00
4.75
4.50
4.25
4.00
3.75
3.50
3.25
Jan-15
Feb-15
Mar-15
Jan-15
Feb-15
Dec-14
Dec-14
Nov-14
Oct-14
Nov-14
Sep-14
Aug-14
Jul-14
Jun-14
Apr-14
May-14
Mar-14
Jan-14
Feb-14
Dec-13
Oct-13
Nov-13
Sep-13
Aug-13
Jul-13
Jun-13
Apr-13
May-13
Mar-13
Jan-13
Feb-13
3.00
And the JPMorgan/Markit global Composite PMI peaked in mid-2014.

JPMorgan/Markit Global Manufacturing PMI (since 2013)
56.0
55.0
54.0
53.0
52.0
51.0
Oct-14
Sep-14
Aug-14
Jul-14
Jun-14
May-14
Apr-14
Feb-14
Mar-14
Jan-14
Dec-13
Nov-13
Oct-13
Sep-13
Aug-13
Jul-13
Jun-13
May-13
Apr-13
Feb-13
Mar-13
Jan-13
50.0
40

Paul Mylchreest
Tel: +44 20 7716 8257
Key risks - divergent central bank policy and dollar liquidity

Speculative capital could destabilise financial markets if confidence is lost in one part of the system, or
central banks inadvertently encourage it to flow.
If you were asked to conduct an experiment where you were tasked with creating the conditions which
could encourage destabilising flows in global speculative capital, what would you come up with?
Circumstances which you might include would be.
A global debt bubble;
Slowing global growth;
Instability of a key currency bloc;
High geo-political risk;
Currency mismatch on offshore dollar debt (now estimated at c.US$9 trillion); and
Sharply diverging policies between the worlds major central banks.
All of which we obviously have, to a greater or lesser degree.

From our perspective, the major risk we are facing today is the divergence between the tightening bias
of the Federal Reserve and extreme monetary easing by the ECB and BoJ. This is the most recent development and increases the risk of the others, potentially turning the situation critical.
The Swiss francs peg against the Euro was abandoned on 15 January 2015.
Swiss Francs per Euro (since 2009)
1.55
1.50
1.45
1.40
1.35
1.30
1.25
1.20
1.15
1.10
1.05
1.00
2015
2014
2013
2012
2011
2010
2009
0.95
The SNB specifically mentioned central bank policy divergence and dollar strength in its statement explaining why it was ending the Euro peg.
41
41

Paul Mylchreest
Tel: +44 20 7716 8257
Recently, divergences between the monetary policies of the major currency areas have increased
significantly a trend that is likely to become even more pronounced. The euro has depreciated considerably against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US
dollar.
The ECBs balance sheet is about to play catch-up with the Fed with the launch of QE.
The growth in newly created dollar liquidity by the Federal Reserve was declining throughout 2014.
Fed Balance Sheet - Total Assets (4wk rate of change, %) since QE3 announced
4.0%
3.0%
2.0%
1.0%
0.0%
-1.0%
Mar-14
Jan-14
Feb-14
Dec-14
Oct-14
Nov-14
Sep-14
Jul-14
Aug-14
Jun-14
Apr-14
May-14
Mar-14
Jan-14
Feb-14
Dec-13
Nov-13
Oct-13
Sep-13
Aug-13
Jul-13
Jun-13
Apr-13
May-13
Mar-13
Jan-13
Feb-13
Dec-12
Oct-12
Nov-12
Sep-12
-2.0%
42

Paul Mylchreest
Tel: +44 20 7716 8257
The growth in foreign exchange reserves began to slow sharply in mid-2014.

World Foreign Exchange Reserves (yoy %)
35.0%
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
-5.0%
Which helped to tighten liquidity in the worlds funding currency the dollar index is inverted in the
following chart.
World Forex Reserves (yoy %) v. Dollar Index (Inverted)
35%
64.0
30%
69.0
25%
74.0
20%
79.0
15%
84.0
10%
89.0
5%
94.0
0%
99.0
World Forex Reserves (yoy %)
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
-5%
Dollar Index (Inverted)
43
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Paul Mylchreest
Tel: +44 20 7716 8257
It hits growth in emerging economies as policy is effectively tightening especially in those countries
linked to the dollar, likeerrChina.
World Forex Reserves v. EM Economic Surprise Index
40%
85
35%
65
30%
45
25%
25
20%
15%
10%
-15
5%
-35
0%
-55
-5%
-10%
World Forex Reserves (yoy %)
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
-75
Citi Economic Surprise Index - EM
Besides declining dollar liquidity and slowing global growth, we believe that further dollar appreciation
will be driven by the size of the Global Dollar Short (GDS) and the difficulty in rolling it/cutting it.
The BIS estimated in December 2014 that foreign non-bank borrowers have about US$9trn of US dollar
debt.
Source: BIS
44

Paul Mylchreest
Tel: +44 20 7716 8257
As Jeffrey Snider of Alhambra Partners has pointed out, prior to the 2008 crisis, foreign banks were
sourcing about US$400bn from domestic US money markets in order for their European head offices to
play in the Eurodollar markets (probably in London), e.g. European banks making loans/buying MBS
which helped to fuel the US housing bubble. This is shown by the yellow bar GDF (Global Dollar Funding) in the left chart below. By 2013, that had flipped with foreign banks sourcing about US$500bn
from Eurodollar markets and transferring them to the US see yellow bar in right chart.
Source: Office of Financial Research
For the most part, this probably involved foreign banks European head offices selling MBS back to the
Fed as part of the latters QE programmes. Notice the growth in the orange bar (cash reserve balances)
pre and post-Crisis which reflected the accumulated impact of the Feds QE programmes on foreign
banks in the US.
Foreign banks were the major counterparties to the Feds QE programmes as the corresponding chart
for US banks shows small size of orange bar in 2013.
Source: Office of Financial Research
45
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Paul Mylchreest
Tel: +44 20 7716 8257
What seems to have happened, and we can only surmise, is that European banks paid back a substantial chunk of their dollar short. As Snider elucidates.
the primary interpretation as it relates, importantly, to the global dollar short is that European
banks have retreated from the dollar market by about $900 billion across the last seven years or
so. But that is, again, only the portion of their retreat that we can see; I have little doubt there is
more, at least from the European side
If European banks have cut back their dollar short since the crisis and Euro area non-financials have
kept their dollar borrowings relatively flat as shown in the chart below
Source: BIS
those most at risk from tightening dollar liquidity and a stronger dollar are located in Emerging Markets.
But which ones?
We thought that one way of testing this might be to look back to the Taper tantrum on 22 May 2013
and see which EM currencies and asset markets were most impacted by the sudden expectation of
tighter dollar liquidity.
As far as we can tell China is at the top of the listwhich is hardly good for the global growth story.
While there was little disruption to the managed Chinese Yuan, the subsequent spike in Chinese money
market rates was unprecedented. The key Chinese 7-day repo rate hit the highest level since Bloomberg began reporting it in October 2003. Here is the 2013 chart.
46

Paul Mylchreest
Tel: +44 20 7716 8257
Shanghai Composite in 2013

2500
Taper Tantrum 22 May 2013
2450
2400
2350
2300
2250
2200
2150
2100
2050
2000
1950
Dec-13
Nov-13
Oct-13
Sep-13
Aug-13
Jul-13
Jun-13
May-13
Apr-13
Mar-13
Feb-13
Jan-13
1900
Look what happened to Chinese equities the Shanghai Composite fell 16% between late-May/lateJune-2013.
47
47

Paul Mylchreest
Tel: +44 20 7716 8257
The Shanghai Composite Financials sector fell 21% during the same period.
The Brazilian stock market fell 20%.
48

Paul Mylchreest
Tel: +44 20 7716 8257
The Borsa Istanbul 100 Index fell by approximately 27% by late-August 2013.
Borsa Istanbul 100 Index in 2013
95,000
90,000
85,000
80,000
75,000
70,000
65,000
Dec-13
Nov-13
Oct-13
Sep-13
Aug-13
Jul-13
Jun-13
May-13
Apr-13
Mar-13
Feb-13
Jan-13
60,000
The EEM ETF, which is the iShares/MSCI Emerging Markets large and mid-cap equity ETF fell more than
12%.
EEM - iShares/MSCI Emerging Markets Equity ETF in 2013
46.00
45.00
44.00
43.00
42.00
41.00
40.00
39.00
38.00
37.00
Dec-13
Nov-13
Oct-13
Sep-13
Aug-13
Jul-13
Jun-13
May-13
Apr-13
Mar-13
Feb-13
Jan-13
36.00
49
49

Paul Mylchreest
Tel: +44 20 7716 8257
The EMB ETF, which is an Emerging Markets bond ETF priced in dollars, suffered slightly more.
EMB ETF - iShares/JPM USD Emerging Markets Bond ETF in 2013
124

122
120
118
116
114
112
110
108
106
104
Dec-13
Nov-13
Oct-13
Sep-13
Aug-13
Jul-13
Jun-13
May-13
Apr-13
Mar-13
Feb-13
Jan-13
102
European banks might have reduced their exposure to a strong dollar, but they still got hit.
European Banks sector in 2013
145
140
135
130
125
120
115
110
105
100
Dec-13
Nov-13
Oct-13
Sep-13
Aug-13
Jul-13
Jun-13
May-13
Apr-13
Mar-13
Feb-13
Jan-13
95
Source: ADMISI, Bloomber
50

Paul Mylchreest
Tel: +44 20 7716 8257
Exters Pyramid and flows in global speculative capital

We are concerned because flows in global speculative capital are showing some early signs of having a
destabilising impact on currency markets. Divergent monetary policies are obviously fuelling this trend.
Euro Spot (since 2009)
1.55
1.50
1.45
1.40
1.35
1.30
1.25
1.20
1.15
1.10
1.05
2015
2014
2013
2012
2011
2010
2009
1.00
Capital is fleeing the riskiest countries which have the weak economic fundamentals and current account positions, e.g. Brazil, South Africa and Turkey. Below is the chart of the Brazilian Real versus the
dollar since the crisis (also note how it peaked in mid-2011 in relation to Martin Armstrongs model
discussed below).
Brazilian Real Spot (Inverted, since 2009)
1.50
1.70
1.90
2.10
2.30
2.50
2.70
2.90
3.10
3.30
2015
2014
2013
2012
2011
2010
2009
3.50
51
51

Paul Mylchreest
Tel: +44 20 7716 8257
Intriguingly, there are also signs that capital is fleeing China US$96.0bn in Q4 2014.
China - Capital & Finance Account (US$m)
350,000
300,000
250,000
200,000
150,000
100,000
50,000
-50,000
-100,000
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
-150,000
As we argued above, we think that global speculative capital is becoming nervous as a result of slowing
global growth and divergent policies of the major central banks. The ongoing buoyancy in equity markets (see below) is partially masking what we see as a shift of capital into safe havens, or perceived
safe havens.
In the latter category (perceived), we would include many developed world sovereign bonds since
the governments of many of these nations including the US are continuing to pursue a long and
winding road to insolvency.
Central to this process is tightening US dollar liquidity and a framework for whats happening is broadly
consistent with the concept known as Exters Pyramid. John Exter was a two-time Federal Reserve
official who viewed the post-Bretton Woods financial system as an inverted pyramid resting on its apex
reflecting its inherent instability.
Writing in the 1980s, Exter foresaw times when capital would flow from the most risky assets with the
highest credit risk to the least risky assets with the lowest credit risk. We obviously saw something similar in the wake of the TMT bust in 2000 and the crisis of 2008.
52

Paul Mylchreest
Tel: +44 20 7716 8257
Heres the chart as John Exter characterised it in the late-1980s although some of the middle and
higher layers in the pyramid seem quaintly out of date.
Source: John Exter
In the currency markets, the breaking of the Swiss franc/Euro peg in January this year fits this framework perfectly.
Its implicit in the upside down nature of the pyramid that there is a large amount of capital in the riskier financial assets in the upper layers of the pyramid which can flow downwards. Consequently, the
valuations of those assets which are considered safe could overshoot.
If we are correct, the recent recovery in the high yield market, for example, should be fairly short-lived
and we should see a move through the December 2015 high.
53
53

Paul Mylchreest
Tel: +44 20 7716 8257
The defensive shift across credit markets should see Investment Grade resuming its outperformance
against high yield
And long-term Treasuries versus Investment Grade.
Shortening time horizons should see renewed flattening in Treasury yield curves. Here is the 2s30s
which covers the entire curve apart from the very short end.
54

Paul Mylchreest
Tel: +44 20 7716 8257
We believe that even if the Fed raises rates this year, the long end of the yield will continue to decline.
As time horizons continue to shorten, we see the potential for a final blow-off phase in the bond
bubble of developed world sovereign bonds. While we are no more bullish on the prospects for US
government finances than we are on most other developed nations, the yield premium of long-term
US Treasuries versus some of its rivals, especially when some of the latter are aggressively pursuing QE,
remains attractive in relative terms. Below is the spread between the US 10-year Treasury yield and a
synthetic Eurozone 7-10 year sovereign yield.
55
55

Paul Mylchreest
Tel: +44 20 7716 8257
Despite the buoyancy in equities, there is some evidence that capital is already seeking safe havens
within the equity market. For example, the next chart shows the S&P 500 High Quality Index versus the
S&P 500 Low Quality Index, where Quality is defined in terms of growth and stability of earnings and
dividends. It is noticeable, given the earlier discussion, how the trend bottomed out in mid-2014.
What about equity markets in general? The S&P 500 is breaking down versus US Treasuries after a prolonged topping out. We have used the iShares 20+ Year Treasury Bond ETF as a proxy for the latter.
We expect this trend to continue.

56

Paul Mylchreest
Tel: +44 20 7716 8257
Like currency, bonds and some commodity markets, volatility in equity markets bottomed out and began to rise in late June/early July last year although the rise has been modest so far.
While long bonds might have a maturity of between 10 and 30 years, equities theoretically have infinite time horizons. Typically, equity investors make detailed estimates for corporate cash flows for 710 years. Beyond that, cash flows to infinity are capitalised using long-term growth rate assumptions,
ROIC fades, etc.
Staying with our time theme and when so much consumption has already been brought forward due
to the global debt bubble, valuing more distant earnings on above average PEs seems generous. However, how do you even come close to an objective valuation in an increasingly, thanks to central banks,
ZIRP/NIRP world?
Valuation difficulties aside, we found two indicators which gave well-timed sell signals at the last two
peaks in the S&P 500 in 2000 and 2007. A third signal acted as confirmation. The three indicators are.
The flattening of at least part of the Treasury yield curve all the way to zero;
A crossover in the adjusted MACD; and
By way of confirmation - the ISM manufacturing survey crossing the 50.0 line to the downside.
Both the Treasury yield curve and adjusted MACD are close to giving their first sell signals for nearly
eight years as we show below. Its also worth noting that the three indicators incorporate signals from
credit markets, technical analysis and the real economy.
When we looked back at Treasury yield curves in the run up to the last two peaks in the S&P 500 in
March 2000 and October 2007, we noticed that it didnt matter which part of the curve we looked at,
e.g. 2s10s, 2s30s, 5s30s, 5s10s or 10s30s, etc, but spreads declined to roughly zero, or inverted (went
negative), PRIOR to the equity market peaks. But that was then.
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Paul Mylchreest
Tel: +44 20 7716 8257
In todays central banking fun house, yield curves have obviously become subject to substantial distortions. We are reluctant to use either the very short end or the very long end of the curve. Instead,
we are focusing on the 7s10s curve in terms of the equity market. This is thanks to Alejandro Reyes (of
the Rainmaker Investor Report) as we had not looked at the 7s10s before (we had been focusing on
the 5s10s). A caveat here as there were no 7-year Treasuries issued until March 2010 (after a hiatus
during the Clinton years) but, nonetheless, the spread is currently 19.3 basis points (bp). The spread on
the 5s10s curve, the next closest to inverting, is currently 52.3 bp.
The adjusted MACD indicator gave technical sell signals on the S&P 500 with crossovers JUST AFTER
the last two peaks in equities, i.e. in May 2000 and January 2008.
MACD stands for Moving Average Convergence/Divergence. It consists of three time series, i.e. the
MACD, the signal and the divergence between the two. The MACD consists of the difference between
a shorter period EMA (exponential moving average) and a longer period EMA. An EMA uses exponentially decreasing weights to older data points in a time series. The signal is the EMA of the MACD series
itself.
The MACD indicator is calculated on three time parameters for the three EMAs. The default values are
normally 12, 26 and 9 days. However, the best indication for predicting the last two peaks (thanks Cris
Sheridan) in the equity market has been 25, 26 and 9 days. This is shown in the chart below.
58

Paul Mylchreest
Tel: +44 20 7716 8257
Its clear that we are very close to, but have not quite reached, another bearish crossover in the MACD.
Source: Bloomberg
We view the ISM manufacturing survey as a confirmatory indicator for potential sell signals from the
yield curve and MACD. The ISM crossed the 50.0 line to the downside shortly AFTER the last two peaks
in August 2000 and December 2007. The latest monthly reading was 52.9 and the trend has been
downward since October 2014.
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59

Paul Mylchreest
Tel: +44 20 7716 8257
Our view is that the US economic outlook is considerably less robust than the consensus. Below are
two charts supporting that view. Firstly, the ratio of wholesale inventories/sales has climbed to levels
which were last seen during the 2008-09 crisis. It cant all be weather and port strikes.
In the US, if we take out spending on autos, since its currently in a bubble driven by cheap credit (do
they ever learn?), then retail sales growth is currently at levels seen in recessions and last years polar
vortex. We doubt that any rebound this year will be as strong as last.
60

Paul Mylchreest
Tel: +44 20 7716 8257
We dont believe in the US economy decoupling from the rest of the world if anything US growth has
converged with global growth since the crisis.
The subdued level of world trade confirms the softness in the global economy.
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Paul Mylchreest
Tel: +44 20 7716 8257
As does the renewed collapse in the Baltic Dry Index.
Within equity markets, our expectation for a further flattening in yield curves will have very different
implications for some industry sectors.
Given our defensive stance, we would highlight bond-like equities, i.e. those with good correlations
to falling long-term yields and flattening yield curves. This includes Consumer Staples and Utilities.
Beginning with Utilities, the S&P 500 Utilities sector has given up almost all of its relative gains since
the beginning of 2014 following the recent rebound in 10-year Treasury yields.
62

Paul Mylchreest
Tel: +44 20 7716 8257
The same with the UK Utilities sector.
National Grid has done slightly better.
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63

Paul Mylchreest
Tel: +44 20 7716 8257
As we said earlier, its possible to think of the production chain as a term structure, or time series, from
those businesses most distant from the consumer (like oil, mining and capital goods) to those which
are closest, including Consumer Staples. This includes many fast moving consumer goods (FMCG)
which Wikipedia defines as.
The term FMCGs refers to those retail goods that are generally replaced or fully used up over a
short period of days, weeks, or months, and within one year. Examples include non-durable goods
such as soft drinks, toiletries, etc, and grocery items...Global leaders in the FMCG segment include
Johnson & Johnson, Colgate-Palmolive, Anheuser-Busch InBev, Henkel, Kelloggs, S.C. Johnson, Beiersdorf, Mars Inc., Heinz, Nestle, Reckitt Benckiser, Unilever, Procter & Gamble, LOreal, Coca-Cola,
General Mills Inc., PepsiCo, Mondelez and Kraft Foods.
The S&P 500 Consumer Staples price relative has historically had a good correlation with the (inverted)
30-year Treasury yield.
Coca Cola has had some challenges recently, but the price relative has dramatically underperformed
the downward move in the 30-year US Treasury yield during the last 12 months. And it is rolling out a
major restructuring programme.
64

Paul Mylchreest
Tel: +44 20 7716 8257
In Europe, the Unilever price relative has been tracking the 10-year Gilt yield very closely.
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65

Paul Mylchreest
Tel: +44 20 7716 8257
Interestingly, Danones price relative has historically tracked the 10-year US Treasury yield but, like Coca Cola, has had its challenges and is significantly lagging the downward shift in yields.
Normally, it would have benefited from the decline in milk prices.
In the opposite corner to Consumer Staples and Utilities are the likes of Capital Goods, Steel and Chemicals. These are close to the top of the production chain, just below the natural resource companies.
66

Paul Mylchreest
Tel: +44 20 7716 8257
The Capital Goods sector, or heavy engineering as we think of it includes the likes of GE, Siemens,
Atlas Copco, ABB, Sandvik, Mitsubishi Heavy, etc.
This sector is at risk from slowing capital investment and further flattening in the yield curve. Below is
the S&P 500 Capital Goods sector versus the US 2s30s Treasury curve.
There is a similar relationship between the Euro Stoxx Industrial Goods and Services sector, and perhaps slightly surprisingly, the US 2s30s Treasury curve which has a better fit compared with a synthetic Eurozone 2s30s curve.
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Paul Mylchreest
Tel: +44 20 7716 8257
The relative performance of Japanese capital goods stocks is rolling over reversing much of the
outperformance which began with Abes election victory.
The relative performance of the worlds largest steel producer has tracked the 30-year US Treasury
yield.
68

Paul Mylchreest
Tel: +44 20 7716 8257
Staying with upstream production, the relative performance of the US Chemicals sector has tracked
the 2s30s curve fairly closely since the crisis.
Dow Chemcials correlation has been particularly close.
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Paul Mylchreest
Tel: +44 20 7716 8257
Finally, we want to mention Martin Armstrongs Economic Confidence Model (ECM) as more and
more people seem to be taking an interest in Armstrongs work. In the past, the ECM has been surprisingly successful in tracking the market which is seeing the greatest concentration of global speculative
capital (hot money). For example, it picked out the peak in the Nikkei in 1989 and the emergence of
the US sub-prime housing problems in 2007, both almost to the day. When we tracked it back, it also
picked out the 1929 Crash.
While he is bullish on the dollar, Armstrong commented earlier this year that in this cycle, the model is
capturing the shift of capital into the bond market, primarily. However, our analysis shows that the dollar index has been tracking the ECM fairly closely since the major low in the model in June 2011
(2011.45). This seems to have gone unnoticed, even by Armstrong himself as he commented.
The 2011 bottom 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.
Many people dont seem to realise that the ECM is fractal, so it operates on multiple, but related, time
horizons. According to our calculations, there was a recent intermediate low on 4 March 2015. The dollars performance since then has been impressive.
The next major high in the ECM is on 1 October 2015 (2015.75) and we will be watching to see if this
also marks the high in the dollar and/or sovereign bonds.
If so, it could also mark the low in the anti-dollar, i.e. gold, or commodity prices. Extreme dollar
strength, if it occurs, could trigger a backlash (led by the BRICS) to dismantle the dollars role as the
sole reserve currency and replace it with an SDR-like basket (potentially including gold). We are heading into interesting times.
70

Paul Mylchreest
Tel: +44 20 7716 8257
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Equity & Commodity

25th March 2015

Tel: +44 20 7716 8257

Equity & Commodity Strategy - Fulcanelli Report

Tel: +44 20 7716 8257

Time, Debt and Central Banks

Shortening Time Horizons

Global Speculative Capital

- Financialism and the scale of global speculative capital

- Volatility and the turning point in mid-2014

- Key risks: divergent central bank policy and dollar liquidity

- Exters Pyramid and capital flows

Equity & Commodity Strategy - Fulcanelli Report

Tel: +44 20 7716 8257

Equity & Commodity Strategy - Fulcanelli Report

Highest quality sovereign bonds; and

Tel: +44 20 7716 8257

Central bank policy divergence;

Tightening dollar liquidity;

Slowing global growth; and

Global Dollar Short at unprecedented levels.

Equity & Commodity Strategy - Fulcanelli Report

Tel: +44 20 7716 8257

A crossover in the adjusted MACD;

Equity & Commodity Strategy - Fulcanelli Report

Tel: +44 20 7716 8257

Source: ADMISI, Bloomberg

Equity & Commodity Strategy - Fulcanelli Report

Tel: +44 20 7716 8257

Time, Debt and Central Banks

Total Credit Market Debt (US$bn)

Total Credit Market Debt + Fed B/S (US$bn)

Nominal GDP (US$bn)

Source: Federal Reserve, ADM ISI

Equity & Commodity Strategy - Fulcanelli Report

Tel: +44 20 7716 8257

The world is long (a hell of) a lot of time.

Equity & Commodity Strategy - Fulcanelli Report

Tel: +44 20 7716 8257

Source: Bloomberg, ADM ISI

Equity & Commodity Strategy - Fulcanelli Report

Tel: +44 20 7716 8257

Rising deflation risk;

Limited guarantees on bank deposits and risks to the banking system;

Equity & Commodity Strategy - Fulcanelli Report

Tel: +44 20 7716 8257

US Personal Savings as % of Disposable Income (since 1959)

Source: Bloomberg, ADM ISI

Equity & Commodity Strategy - Fulcanelli Report

Tel: +44 20 7716 8257

Source: Bloomberg, ADM ISI

Equity & Commodity Strategy - Fulcanelli Report

Tel: +44 20 7716 8257

Source: Bloomberg, ADM ISI

Equity & Commodity Strategy - Fulcanelli Report

Tel: +44 20 7716 8257

Shortening Time Horizons

Its a heavily indebted nation;

Suffering from an ageing demographic.

Source: Bloomberg, ADM ISI

Equity & Commodity Strategy - Fulcanelli Report

Tel: +44 20 7716 8257

Source: Bloomberg, ADM ISI

Cant spend and cant save.