Canadian dollar vulnerable to drop in energy prices
July, 21, 2019
Energy is by far Canada’s largest export and production accounts for close to 10% of the country’s annual GDP. Subsequently, the Canadian dollar, colloquially known as the Loonie after the bird featured on the back of the dollar coin, is heavily influenced by the state of play in that sector and rarely strays too far from the prevailing trend in commodities prices, especially oil.
So far in 2019, the CAD has ridden a rising tide in stocks and commodities as the major central banks, led by the Fed, try to reflate the markets and breathe life into an aging economic cycle.
The promise of plentiful liquidity has been generally successful in driving financial markets higher, but we have doubts that this strategy will produce a meaningful boost to actual growth. One reason for that skepticism is derived from the distinct underperformance of the commodities complex this year (see chart below.) As a macroeconomic benchmark, commodities appear to be far less optimistic on the future than the message coming from the stock market. Like any divergence between normally-correlated markets, it could mean nothing or it could be an important message. Time will tell.
Oil, in particular, has had a very bad week when perhaps it shouldn’t have, given the tension with Iran in the Strait of Hormuz where 20% of the world’s petroleum supply passes. See https://bit.ly/2Y5BJyI. Prices in the futures market are down more than 9% and the energy sector as a whole looks vulnerable to further pressure. It’s tempting to sell commodity-sensitive currencies on the bet that they will follow suit.
Shorting the Canadian dollar represents an attractive risk/reward proposition. Not only is it still within 0.5% of its highs on the year (vs USD) but unlike most of its peer group of commodity currencies the speculative community is long and leaning the other way.
Calling turns in any market is tricky. We like owning USD/CAD here as long as it holds 1.3000, a risk of less than 1%. We think it’s a good trade but if we are wrong it won’t cost a lot to find out.
The Fed’s unspoken hope is that lower rates will keep the credit market from crumbling.
July 15, 2019
Something doesn’t add up. Last week the Fed chairman Jerome Powell went before Congress to say that while the economy remains on “solid footing” it might need some assistance in the form of lower interest rates. It was barely six months ago when he was using similar language to advocate for higher rates. It makes no sense to pitch for easier monetary policy amid a hot labor market and record highs stock prices, but that’s exactly what Powell did.
The Fed chairman referred to economic headwinds blowing toward the US from abroad due to weakening global growth and disruptions in international trade. These pressures are real but hardly justifies the abrupt U-turn in Fed policy this year. It has to be something more than that.
Although Powell didn’t address it directly, the simplest explanation is growing concern over the state of the credit markets. As we wrote in “BBBe careful” one of the unintended consequences of easy money policies has been the explosion in debt, especially among weaker credits (lower-rated companies.) Despite a decade of massive monetary stimulus, the aggregate corporate credit profile has fallen well short of growth trends in the economy. In fact, half of the $5 trillion investment-grade bond universe is now rated just BBB, one notch above junk status.
It’s an understatement to say that this is an accident waiting to happen. It is quite literally a cliff edge, where even a handful of ratings downgrades could quickly create a feedback loop of forced liquidation by funds that are prohibited from owning junk, spreading outward and turning a simple economic slowdown to into a financial crisis.
The only option the Fed has is to play for time, massaging investor sentiment with the prospect of lower rates, maintaining ample liquidity and hoping (!) that growth will recover enough to feed through to corporate balance sheets. But considering that the current expansionary cycle is now already the oldest on record the odds are against it. Second-quarter corporate reporting season begins this week and will give us a look at whether the Fed-inspired exuberance in equities is matched by actual earnings.
Don’t underestimate the downside potential for interest rates. The Fed knows the credit market is the monster in the closet and is preemptively setting the stage for rate cuts despite the lack of any significant stress on the system. They are teed up to ease quickly and aggressively at the first outward sign of trouble. Whether the Fed has enough ammunition to alter the outcome under that scenario remains to be seen but given that the starting point on this next rate-cutting cycle begins with a policy rate at just 2.4%, we have our doubts. There is not much room between here and zero.
In April, we recommended owning short (2-3 year) treasuries. See “The dollar and deflation“. It’s still the best trade on the board and has much more to go.
Global USD funding shortfall pressures becoming more acute
July 8, 2019
Even before Friday’s better than expected jobs data, dollar bears had reason to be nervous. Despite the massive decline in interest rate expectations, doubts over the Fed’s independence, the implementation of a functional alternative global payments system (circumventing the USD) and rising twin deficits the dollar remains surprisingly well bid and within 2% of the highs of the year. Even President Trump’s threat to engage the US in the same currency manipulation that he accuses other countries had virtually no adverse impact on the price of the dollar. Occasionally, what doesn’t happen in the markets is as telling as what does happen. This is one of those times and a sure sign that the setup for the dollar is now skewed asymmetrically to the upside.
We’ve written previously about the growing dollar shortage as a result of a smaller Fed balance sheet and declining international trade volumes, making it more difficult (and expensive) for leveraged corporate and sovereign entities to access adequate funding. The potential impact on financial markets worldwide continues to be largely both misunderstood and underappreciated. A strong dollar, driven by increasing scarcity, risks creating its own negative feedback loop, tightening financial conditions and slamming the brakes on a global economy that is already decelerating. It’s the ultimate pain trade, and the odds of it playing out that way are rising.
Look no further than the news out of Europe last week for evidence that the liquidity problem is becoming more acute. Negative interest rates have already impaired lending and crippled the banking system, but the new head of the European Central Bank somehow thinks that policy has been a success. See https://on.wsj.com/2KWOg12. What? With inflation expectations literally collapsing, under LaGarde’s leadership, the ECB will likely cut rates even further, driving the banks into the ground as access to funding becomes ever more problematic. Deutsche Bank is the first to be forced into a massive restructuring but it won’t be the last. See https://reut.rs/2YEjI7N. As the old expression says, there’s never just one cockroach.
The resilience of the USD on the FX markets is a sign that investors are in the process of discovering that the central banks may not be able to easily solve the problems resulting from the dollar funding shortfall. The upside trade is clearly the path of least resistance. Last month’s pullback in the dollar index (DXY) held at 96.00, roughly the same level it finished 2018. This becomes major support and a point for long positions to now lean against.
We’ve been bullish on the dollar and bonds for months. (See The Dollar and Deflation, April 29) Bonds have worked out, and have much more to go. While the FX component of that trade has been dead money so far, it feels like the dollar is getting ready to spring back to life.