Just last October, a week after raising interest rates for the eighth time in this cycle, Fed chairman Powell said that rates were still “a long way from neutral”. See https://cnb.cx/2V5yC9k . It was both an expression of confidence in the economy and in the Fed’s plan to continue methodically tightening policy. Growth was strong and the board projected five more rate hikes through 2020.
But life comes at you fast. Predictions that the robust US economy would spark a broader global recovery in 2019 haven’t worked out as planned. Almost the opposite. Persistent weakness abroad has now washed up on American shores, forcing an about-face at the Fed.
It’s becoming somewhat alarming that many regions of the world still struggle to sustain growth despite years of extreme stimulus. Authorities in Japan and Europe have grossly distorted their markets with negative interest rates and yet have very little to show for it. Even the massive credit impulse launched by the Chinese in the past few months appears to have landed with a thud as purchasing manager’s (PMI) numbers for April in both manufacturing and services sectors missed across the board. See https://cnb.cx/2UQUAb0 .
The deflationary impact from technology and the challenges it poses to conventional monetary policy prescriptions is unprecedented, and expanding. Traditional remedies simply aren’t as effective as they once were and many central bankers are unsure how to respond. Policymakers urge patience as cover for a growing sense of anxiety.
This leaves the heavy lift of stabilizing global growth and inflation expectations to the Fed, forcing them to compensate for the impotence of their foreign counterparts. They also can’t allow the dollar to explode higher. See “The Dollar and Deflation .” You probably won’t hear much about it at this week’s FOMC meeting but the Fed will begin lowering rates later this year, and by more than what anyone currently expects. The front-end futures market has one cut priced in for 2019 and one for 2020. There’s more to come and still good value in this play.
Friday’s better than expected number for first quarter GDP may be dominating the headlines but it’s the report on Personal Consumption Expenditures that is driving the market reaction. Prices paid by consumers for goods and services, excluding volatile food and energy components, fell sharply in the first three months of the year, extending a decline that began at this time last year (see chart below.) The big drop in US bond yields on the week despite otherwise good news for new home sales, durable goods orders and growth, in general, is a sign that global deflationary forces are gaining an upper hand.
It wasn’t supposed to be this way. In theory, robust growth, rising wages, and full employment create greater aggregate demand that leads to higher prices and higher inflation. Ever since the Fed began raising rates in 2015, tighter monetary policy has been predicated on this basic economic assumption.
The disconnect isn’t limited to the US. Some foreign central banks are beginning to panic as inflation fails to respond to years of stimulative policy. This past week Japan and Sweden joined a growing list of countries putting off any chance of rate hikes in 2019. See here: https://reut.rs/2GI0gjI and https://reut.rs/2IUj6pv . The problem is that like Europe and Switzerland, they too have already imposed negative interest rates and are running out of options to kickstart growth.
Credit to the Fed for pursuing a course of policy normalization over the past few years. They planned ahead. Part of the rationale for raising rates was to make room for rate cuts in the event of a slowdown. While this gives the US a distinct economic advantage on the world stage it doesn’t necessarily mean it will produce a happy ending.
As I mentioned in (See “Good news, bad news“) the downside in this scenario of divergent global growth is that it will drive the dollar higher against the world’s other currencies. In fact, it has already begun. While the equity markets are still celebrating a good Q1 earnings season, the risk going forward now shifts to the negative impact a stronger dollar will have on the bottom line as it makes American exports less competitive. It also starts to turn the screws on entities that leveraged cheap dollars at low rates during a decade of Fed largess. In my opinion, the aggregate short exposure to the USD is grossly underestimated.
The most efficient way to express the view of intensifying deflationary pressure is to own both the dollar and treasuries. The 2-year sector is especially attractive as a play on possible rate cuts and as the flattening trend in the yield curve of the last couple of years begins to reverse (see chart below).
You would be forgiven for thinking that the title of this piece referred to the new record high in the S&P. The index is up more than 25% since the December lows and investors still can’t get enough, driven by better than expected Q1 corporate earnings mixed with a healthy dose of FOMO…fear of missing out. So far they’re not wrong.
Rather, it’s the US dollar that feels like it’s about to go on a run higher. Perhaps significantly so. The dollar index (DXY) stands at its best level in almost two years. The US economy may have hit a wall late last year but it appears to have since blasted right through. Tuesday’s report of new home sales is more evidence of good news that continues to pile up (chart below.) The US is again proving itself to be a bastion of strength in a world full of uncertainty, and that is being reflected in demand for its currency.
But a launch in the dollar sets up a potential conflict with the current euphoria in the asset markets. A stronger dollar tends to suppress commodity prices, creating deflationary headwinds while most central bankers are still struggling unsuccessfully to generate higher prices.
It’s also likely to cause some serious problems for countries with large amounts of dollar debt, especially among emerging economies. Memories are still fresh from 2018 when similarly uneven global economic conditions spurred the dollar, squeezing the finances of countries like Brazil, India, Turkey, South Africa, Russia and even China, sending their markets falling like dominoes and eventually impacting developed regions.
The u-turn in Fed policy in December brought relief by temporarily capping the dollar and helping many markets to recover. The key word here is “temporarily”. As the dollar finds fresh legs it will serve as an unpleasant reminder that the underlying problem of massive negative exposure to the buck abroad hasn’t gone away. This piece in the Wall St Journal today certainly raised some eyebrows: “China’s banks are running out of dollars.”
Smelling trouble, the emerging markets are beginning to weaken. We have a good idea of what happens next. If the dollar is on the move, which appears to be the case, it’s time to give your seat on the equity bandwagon away to someone else.
Despite a blistering start to 2019, there’s a growing popular narrative that the equity markets are just getting warmed up and stocks are on the verge of a “melt-up” in prices. Even Larry Fink, CEO of the world’s largest asset management firm BlackRock says so. (https://reut.rs/2Pq3ISJ) Who are we to argue?
Respectfully, I’d be very careful before jumping on that bandwagon. Market price action always reveals a change in trend well before it becomes otherwise obvious and it makes its way into the financial press. Some signs are subtle and others are not, but they’re always there if you look for them. A couple of tell-tale red flags have popped up in the past few days that are worth paying attention to. Mr. Fink might be correct in the long run but right here I think his view represents a bad bet.
Stocks are up big so far this year in most regions of the world due to more plentiful liquidity and easier financial conditions courtesy of the major central banks, especially the Fed and the People’s Bank of China. Those policies appear to be producing green shoots. Good numbers last week for US retail sales, trade and jobless claims alongside indications that China is stabilizing is certainly encouraging.
But don’t confuse the economy with the market. As I say in (Good news, bad news ), the downside of better economic performance means potentially tighter monetary policy from the Fed than is currently priced in. It also likely means a stronger US dollar. Both outcomes pose risks to equity and commodity sectors that have become addicted to easy liquidity. (Beware the dollar)
Last Thursday the S&P traced out one of the more distinctive and predictive chart patterns; a key reversal. China’s benchmark Shenzen CSI 300 did the same just yesterday (after mainland property sector stocks got hammered on talk that authorities may pull back on credit due to the improving economy. (https://reut.rs/2viCGDP) Of course these patterns aren’t infallible signs of a turn but when both of the world’s bull market leaders throw up the same cautionary flag, only a fool would ignore them.
The good news is that the US economy appears to be in much better shape than was forecast barely a month ago. Stronger than expected numbers this week on trade, inventories and retail sales have sharply lifted estimates for first quarter GDP which is due to be reported next Friday (Apr 26). The widely-watched tracking model published by the Atlanta Fed now estimates a pace of 2.8%, up from a reading of near zero as recently as March 12. http://bit.ly/2GlNPc3
The bad news is that this renewed economic momentum has potentially set the US dollar in motion for another leg higher after drifting sideways for the last several months. And as we learned in 2018, a stronger dollar does no favors for global asset prices and the ongoing effort by the central banks to reflate the markets. See “Beware the dollar”
Even though the broad dollar index (DXY) has yet to break through resistance, several key dollar FX pairs appear to be showing the way. The first chart below of the dollar against the Swiss franc is especially bullish.
The second chart overlays the dollar with the benchmark emerging market equity ETF (EEM). I watch EEM closely as a leading indicator of global risk sentiment. If there’s a change in investor appetites, it’s going to show up there first. The historically tight correlation between the two has weakened this year but to ignore the impact that a higher dollar could have on equities is simply betting against history.
Stock markets have generally had a great run over the last 14 weeks but they are losing momentum. Yesterday the S&P traced out a bearish technical reversal as noted here: “The sound of one hand clapping” If the dollar is breaking out, the case for reducing risk becomes even stronger.
We walked in this morning to ebullient headlines out of China, proclaiming that better than expected economic data from the mainland was evidence that their massive stimulus effort is finally working. First quarter 2019 GDP expanded at a 6.4% rate, unchanged from the fourth quarter of 2018 and scraping along the bottom at the weakest pace since 1990 (see chart below). If you’re wondering why that’s good news, it had been expected to fall further. Yay! I guess. This is what my friend and legendary investor, the late Mark Turner, would describe as the sound of one hand clapping.
China has been in the news a lot lately as authorities try to boost their slowing economy. The growing influence that China will have on the outcome for all regions and all markets can’t be overstated.
Despite the hype, the financial markets today were also largely unimpressed with the numbers. A lot of high expectations have already been discounted over the last 3 1/2 months, from stabilization of the Chinese economy to a positive result from the US-Chinese trade talks. Today’s muted response served as a gut check. I have been saying to watch the Australian and Canadian dollars, and gold for confirmation of an upswing in global growth trends. None moved today and all remain vulnerable.
Subsequently, equity and commodity markets are at risk that frothy expectations have run far ahead of reality . The S&P today traced out a bearish reversal pattern (see below). The risk/reward profile of the broad market has shifted decidedly to the downside.
Questions that successful traders constantly ask themselves are “given what I know, are markets behaving as I expected?” and “Is my thesis solid, or does something not fit?” They are always looking for tell-tale signs that either confirm their bias or, more importantly, serve as warnings. The near-vertical run in the major equity indices over the past 14 weeks has left a lot of investors pleasantly surprised. Almost everyone hopes for more. But the smart ones will become even more vigilant for what could potentially go wrong.
Leading the charge in equities this year is China. With most of the major central banks either sidelined or impotent, the Chinese are doing all of the heavy lifting in the effort to reflate global markets in 2019. And they haven’t disappointed. Bank lending in China surged to an all time high in January, leading a 40% year-on-year increase in social financing over the course of first quarter. This is the policy equivalent of throwing the proverbial kitchen sink at the economy. No wonder their stock market is up 30% on the year. It’s also helped create a rising tide that has benefited global asset prices in general. By this measure alone equity markets are responding logically, and favorably, to massive monetary and fiscal stimulus. But will it last or is it just a sugar high?
Yesterday the Organization of Economic Cooperation and Development (OECD) warned of the long-term consequences of current policy in China by piling up too much debt and stealing growth from the future. https://reut.rs/2V4L1JN Normally these agency reports don’t get much play but it does serve to highlight the predicament that the central banks have found themselves in. A decade (and trillions of dollars in stimulus) down the road from the last recession many regions still don’t have sustainable recoveries.
To this point, a potentially significant red flag was raised by news this week that Australia is considering rate cuts to offset a weakening economy and slowing inflation. https://bloom.bg/2VPLaxE Canada may not be far behind. http://bit.ly/2v7O4SL This is significant as both regions have well-earned reputations as leading indicators for the global macro-economic condition. Because each depends heavily on international trade and commodities prices, if reflation (and the Chinese recovery) is for real it will show up in their respective currencies. So far, it’s not.
Gold offers a similar warning to asset bulls. If reflation was robust it would be rising. Instead, the chart looks ugly (see below).
Divergences between reliable benchmarks like the Aussie dollar, the Canadian dollar and gold, and the prevailing positive news flow in equities is the market’s way of telling you to pay attention. Trend changes show up in the form of subtle price discrepancies well before it becomes obvious to the folks on CNBC. Good traders take note knowing that these discrepancies may just be meaningless blips on the radar, or they may mean everything.
There’s an old cliché on Wall Street popular with traders of a certain vintage that says “as go the banks, so goes the market.” Its a reminder of the importance that the financial sector plays in confirming trends in corporate earnings and hence the condition of the broader equity market.
Without getting into the influence from Fed policy over the past decade, performance in bank stocks often tells us a lot about the underlying fundamentals in the economy. If the banks are profitable, chances are other sectors are as well.
The financials were a major driver of the nine year-long bull market run from the post-recession lows in 2009. Between March 2009 and the January 2018 peak, the K&B bank index (BKX) rose by 559%, hugely outperforming the S&P which advanced by (only)331%.
But since then, and as the economy slows, the banks have given up their leadership role. In a few months, the current economic expansion will overtake the 1991-2001 cycle as the longest on record. Impressive, but also old. These things have finite lives and the banks, as well as the bond market, are sensing the end.
The chart below shows how a selloff in the financials last September, driven by similar economic concerns, preceded a general decline by a number of weeks. Since then the Fed has stepped in, putting off plans for further rate hikes in the hope of extending the expansion. https://cnb.cx/2v2g2zw It might work, but poor price action has returned to the banks, suggesting that all the Fed accomplished was delaying the inevitable. We’ll learn more tomorrow (Friday, April 12) as JPM and WFC kick off Q1 earnings season. Antennae up.
The major central banks may not be panicking, but they are most certainly beginning to sweat as the global economy continues to drag despite years of extreme policy support. Yesterday the IMF lowered its 2019 global growth forecast (again,) to 3.3%, predicting a slowdown in 70% of the world’s regions and reflecting downward revisions in Europe, Latin America, US, UK, Canada and Australia. https://bit.ly/2D12ys8
After 2018 there has been a coordinated effort to reflate markets: China opened the credit taps in January, the Bank of Japan has the pedal to the metal ( https://reut.rs/2YYQwZv ,) and the Fed is being forced to consider rate cuts, even though they’re reluctant to admit it. https://bit.ly/2UqVKi9 Today, the ECB balked at further stimulus amid signs of decelerating growth, not because they didn’t want to, but out of fear of showing their ever-weakening hand and making negative interest rate policy seem even more absurd than it already is. https://cnb.cx/2Ia5fvv.
Markets and macroeconomic fundamentals are at a crossroad. Investors want to believe that the central banks will be successful, but current policy prescriptions are exhausted, and at risk of being overwhelmed by greater structural disinflationary forces. Despite trillions spent globally since the 2008 recession, the recovery has been weaker and less-inclusive than projected. As former Pimco chief Mohamed el-Erian points out, the possibility of a deflationary “Japanification” of western economies is no longer being laughed off. https://bit.ly/2U5zzJo
The four-month old rally in stocks and commodities has been impressive but other widely watched risk benchmarks aren’t buying it. If underlying economic conditions were really improving, rates would be rising and the yield curve would be steepening. Money would be flowing into the equity sector, not out. https://bloom.bg/2X1d3mU And FX canaries-in-the-coalmine like the Canadian and Australian dollars would be rallying, neither of which is happening.
Competing market narratives can’t co-exist forever. Eventually one side will be proven right and the other wrong. As I wrote earlier in Beware the Dollar, the potential for a stronger US dollar poses a threat to the current reflation effort. Uncertainty over international trade and growth has served as a prop for the USD and where it goes from here will help answer the current conundrum. A break higher would be a sure sign that the global condition is worsening and a move to new highs in the dollar index (DXY – see below,) above 97.75 in the days ahead would raise that conviction.
In 2019 the major central banks have been focused on reflating markets by either pausing or reversing plans for policy normalization (higher rates) that hit many markets hard in 2018. Despite ongoing fears of slowing global growth, equities and commodities have so far responded positively to the prospect of easier rates and more plentiful liquidity.
But the one thing that could ruin the party is the strength of the dollar. In my opinion the rising USD was an underappreciated factor that squeezed many regions hard last year, especially emerging economies with current account deficits. Many of these entities had borrowed heavily cheap dollars at low rates under the Fed’s QE program after the 2008 recession, leaving their fiscal position vulnerable as the dollar rose. Not only does it make debt repayment and refinancing more expensive, it also tends to pressure commodity prices that these countries often rely on for exports, creating an unenviable situation where the things they are short (dollar debt) go up and the things they are long (raw materials) go down. And as 2018 proved, because global markets are more interconnected than ever, it wasn’t long before problems in the emerging markets became a problem for the developed markets.
Normally, you would expect that the dovish shift at the Fed this year would undermine the dollar. I certainly did. As it became more apparent that the highs were in for interest rates in early Q4 last year, I assumed the same for the dollar. It was a perfectly logical conclusion given that major currencies often track the path of underlying interest rates. Wrong. Except for a few shallow dips, the dollar has been remarkably resilient. It even shrugged off the appointments of inflation doves Steve Moore and Herman Caine. In the currency world it remains the best of a bad lot and the safety and liquidity it offers in uncertain times can’t be matched. Being short hasn’t cost much money so far but the longer it remains here at the top of its range, the probability grows that the next move is higher.
The chart of the dollar index (DXY) is potentially very bullish, and a break above 97.75 would signal the beginning of a (perhaps significant) leg up. This would unleash a deflationary impulse, and much like in 2018 leave stocks and commodities vulnerable. The world needs a weaker dollar to keep the 2019 bull reflation trade going. But it may not get it.