China’s Slowdown Could Mean Big Trouble For Base Metals

Industrial commodities stand on a deflationary cliff edge

Photo by Екатерина Александрова from Pexels

Written September 19, 2019

China’s quasi-capitalist system, where the communist party still retains a degree of control over the economy, leaves the true state of affairs subject to a certain amount of suspicion.  Is the economic data accurate or is it just what they want us to see?

Which is why many investors rely heavily on proxies for Chinese activity to more accurately determine the state of play in their economy.  Base metals widely used in construction and manufacturing, such as copper, steel and iron ore have well-deserved reputations as gauges of economic trends.  They are also all freely traded on financial exchanges, where price discovery and transparency allow them to be used as a check against official statistics put out by the state.

With the exception of oil and gas, China is the world’s largest consumer of most commodities.  According to data compiled by The Visual Capitalist’s Jeff Desjardins, China imports half or more of the world’s production of nickel, copper, and steel (as well as cement and coal), so any changes in behavior in China will have a meaningful impact on prices of those commodities. See https://bit.ly/2KPz9nZ.

Chinese growth has been steadily declining for the past year and a half.  The latest GDP reading for the second quarter of 2019 at 6.2% was the weakest result in twenty-seven years.  For experienced China watchers, 6% has long been considered something of a line in the sand as a minimum level of growth required to keep a sufficient number of people employed and to avoid any dissent against the government from taking root.  Two events this past week suggest that point may soon be at hand.

Underscoring the urgency of the situation, Chinese premier Li Keqiang admitted that it is becoming “very difficult” for China to maintain that crucial 6% growth rate. See https://reut.rs/2lTmjvV.  He must have been tipped off because just 24 hours later it was revealed that in August China’s industrial output fell to a rate of only 4.4%, its weakest showing in 17 years.  And that was before the latest round of trade tariffs were imposed. See https://bit.ly/2lVzL2g.

Not surprisingly, this slowing in growth is weighing on prices in the base metals sector as well as across the commodities complex in general.  One look at a chart of either copper or the broader CRB index shows that like the Chinese economy, commodities are approaching cliff edges of their own (see below).

Legendary trader Raoul Pal calls the current price pattern of the CRB index the most dangerous chart in the world, worrying that a break lower would be a sign of complete deflationary breakdown. China might be the center of this storm but it will have global implications for consumers and policymakers alike. A dire prediction for sure. As forward-looking indicators of this possibility, investors ignore the action in the base metal sector at their peril.

Copper
CRB Core Commodities Index

Middle East Turmoil Not What It Used To Be In Oil Markets

American crude supply offers a plentiful alternative

Photo by Zbynek Burival on Unsplash

Written on September 18, 2019

The attack on Saudi oil facilities over this past weekend knocked out more than half the kingdom’s current daily production of 9.8 million barrels, amounting to about 5% of global supply.  To be sure, a major disruption that shattered investor complacency and exposed the vulnerability of an important global energy source.  On Monday, the price of crude oil for nearby delivery shot up by almost 20%, the largest one-day move on record.  A consensus quickly formed around the possibility of future similar attacks, necessitating increased risk premium and ushering in an era of permanently higher crude prices.

The incident also raised broader concerns.  Investors are naturally wary of oil price shocks and for good reason.  According to Steven Kopits of Princeton Energy Advisors, many of the recessions since 1945 have been triggered by Middle East wars and oil politics.  The 1956-57 Suez Crisis, the 1973 Yom Kippur War and resulting oil embargo, the 1979-83 Iran-Iraq war, the first Gulf War in 1991 and the 2011 Arab Spring all produced negative economic fallout in the US and other advanced economies. See https://bit.ly/2kSJJ4j.

But what looked to be a potentially game-changing event in the markets on Monday morning was already fading in the rear-view mirror by Tuesday afternoon.  Prices in the futures market had largely retreated to near levels seen before the attack after Saudi assurances that production capabilities would be fully restored in the next few weeks, sooner than initially expected. See https://fxn.ws/2knw84S .  However, that is only part of the story. 

Global crude supplies remain plentiful, especially as expanding shale production in the U.S. provides a reliable alternative to Middle Eastern oil.  Already the world’s leading producer, domestic American supply is expected to increase by another 1 million barrels per day over the next year to 13.3 million barrels, an almost 50% jump from this time in 2016. Bloomberg reports that more than ten export terminal projects along the Gulf of Mexico coast are in the works to handle the expected surge, notably from the oil-rich Permian Basin. See https://bloom.bg/2kDMyX7.  Ironically, according to Donald Luskin at Trend Macrolytics, OPEC was already looking to cut production among its member countries to offset the increase in American crude and prevent an outright glut in the marketplace. See https://on.wsj.com/2kTfL0f.  He notes that the last thing the Saudis need in the lead-up to the Aramco IPO is a collapse in prices or a war with Iran.

Another limiting factor to any potential oil shock is the diminishing impact of the price of crude on the economy.  In a Barron’s interview, Barry Banister, head of institutional equity strategy at Stifel Nicolaus figures that the $2 trillion spent annually worldwide on oil at current prices amounts to only about 2.6% of the $85 trillion global economy, far less than the 6.5% of the early 1980s.  He calculates that even if crude were to average $100/barrel (from $63 currently) that figure would rise to only around 4%, still well below historical standards https://bit.ly/2knG7qS.

The lesson of the past several days, as calm has quickly returned to both energy and equity markets, is that Middle Eastern oil matters but not nearly as much as it used to in the past.

WTI Crude for September 2020 delivery. What crisis?

Enjoy the Party but Dance Near the Door

Reason to be skeptical of the latest central bank reflation trade

Photo by Filios Sazeides on Unsplash

The title of this piece refers to an old cautionary Wall Street cliche that describes a trader’s dilemma where the price action says one thing but his gut warns him that something is not quite right, and to not get too complacent. This is an apt description of the current state of play over the past few days. Markets are reacting optimistically to a potential trade deal with China and the prospect of supportive policy intervention by the major central banks, most of which involves creating more debt. Besides possible rate cuts by the Fed, BOJ, and ECB, China unleashed another huge credit impulse, see https://bit.ly/2kAGnTz, South Korea has enacted a massive fiscal spending program, see https://on.ft.com/2ZBihGx and the Germans are exploring ways to circumvent current limits on debt issuance, see https://reut.rs/2kDcsKl. That’s a lot of stimuli. No wonder the markets like it.

However, this collective panic among the policy crowd in the face of slowing economic growth doesn’t offer any new ideas other than to throw more money at a situation that previous waves of cash have failed to fix. Most investors now realize that after a decade of extreme monetary policies, excessive debt is becoming the problem, not the answer. It’s the reason why large parts of the world are trapped in a deflationary malaise. Not only will piling on more debt not work, but it will also make the eventual reckoning even more painful.

Since early this year we have focused on several trends: slowing global growth, falling rates, and a stronger dollar. A continuation of these generally-bearish themes, along with the pressure that it exerts on the vulnerable corporate credit and emerging market sectors, is still our base scenario.

Nevertheless stocks, yields, credit, and commodities have all caught a bid in recent days. The dollar is offered. With good reason, investors still strongly believe that the central banks can affect outcomes and that a safety net is firmly in place under the markets. One of our favorite risk sentiment canaries, the Canadian dollar, impressively held support at USDCAD 1.3400 (see chart below.) This is a sign that a broader recovery in the marketplace in the near-term is not only possible but likely.

Longer-term, the prospect of a global economy that is weakened by over-indebtedness and unable to maintain sustainable growth without the repeated intervention of central banks is a frightening prospect, and remains our primary concern. The big danger in our future will come at that point when investors lose faith in central bankers’ ability to keep the markets propped up. We’re not there yet but that re-set in valuations will be the trade of a lifetime…and not in a good way. Will it be next month, or next year, or five years from now? Nobody knows. So in the meantime enjoy this latest bull party but remember to dance near the door.

USD/CAD. The Canadian dollar (CAD) is a reliable indicator of global risk sentiment. Stronger CAD is bullish for asset prices.
US dollar index (DXY). Fails to break out higher, also bullish for asset prices, especially emerging markets.
Benchmark US 10yr Yield. Bottom in for now as broad risk sentiment recovers.

Fed Rate Cut: Too Little, Too Late

Strong dollar poses risks for reluctant policymakers

Photo by Colin Watts on Unsplash

August 4th, 2019

The Fed cut rates by 25 basis points (one-quarter of a point) last week, as expected, amid signs of slowing global growth. Chairman Jerome Powell tried to reassure investors that the economy was still on solid ground and that the move was merely a “mid-cycle adjustment”, not the beginning of a prolonged easing cycle. Don’t bet on it. Persistent strength in the US dollar is both a sign and a reason why a recession is closer than they think.   

As we’ve noted repeatedly here before, the US dollar is the Achilles heel of the international financial system. Through their easy-money policies in the wake of the 2008 recession, the Fed encouraged a massive buildup in leverage by both sovereign and corporate entities. Unfortunately, to service that debt borrowers are negatively exposed to any decrease in the supply or increase in the price of those dollars.

In the past year, slower global growth, declining international trade volumes, tighter US monetary policy and a reduction in the Fed’s balance sheet have all contributed to a reduction of dollar liquidity in funding markets. This fundamental shortage of dollars has driven its price higher on FX exchanges. In 2018 a strong dollar roiled the markets (especially emerging markets) before the Fed was forced to pull the plug on its monetary policy normalization plans in the hopes of capping the currency’s rise. It worked, barely. After pausing for a couple of quarters the dollar is on the move again as the global shortage intensifies. See https://bloom.bg/2YnU5fh. The path of least resistance is clearly higher, perhaps significantly, and it’s going to take a lot more than one rate cut to turn it around.

Compounding the dollar squeeze is the current budget bill crafted by congress, which eliminates the debt ceiling for the next two years and allows US government spending to increase virtually unchecked. To meet these new financing needs it is expected that over the next several months the treasury will need to raise $250 billion in fresh cash, further draining the supply of dollars in the system. See https://on.wsj.com/2SXVJOE.

Despite the shift toward easier monetary policy, the broad dollar index (DXY) climbed to its best level in two years. The FX market’s message to the Fed is unmistakable: the cut in rates was too little, too late. The risk for policymakers from here is that a stronger dollar will create deflationary headwinds, possibly tipping weak economies into recession, and force the Fed to cut rates deeper than they’re willing to admit.

The US dollar, breaking out.

Loonie Set To Get Its Wings Clipped

Canadian dollar vulnerable to drop in energy prices

Photo by Michelle Spollen on Unsplash

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.

If you would like to discuss this or any other trading strategies please feel free to contact us at atradersperspective@gmail.com.

As a forward-looking indicator on the economy, commodities (blue) are decidedly less optimistic than stocks (orange).
The Canadian dollar (orange) and XOP, the oil and gas exploration ETF (blue). Both are vulnerable.

Powell Plays for Time

The Fed’s unspoken hope is that lower rates will keep the credit market from crumbling.

Photo by Adi Goldstein on Unsplash

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.

HYG, the high-yield bond ETF. Despite a lot of heavy lifting from the Fed the bounces are getting smaller.

Dollar Coming Back to Life

Global USD funding shortfall pressures becoming more acute

Photo by Jp Valery on Unsplash

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.

US Dollar Index (DXY). Longs can lean against 96.00.

Pushing on a String

Lower rates may not bail out the economy this time around

Photo by Tara Evans on Unsplash

June 29, 2019

Looking back on the best performance for the S&P in the month of June since 1938 reveals a familiar pattern: economy shows signs of slowing, earnings outlooks decline, equity market stumbles, Fed rushes in with the promise of easier policy, market rallies to new record (again)…problem solved. Completely predictable, and almost comical at this point. There aren’t many people left that think that the Fed’s real mandate of fostering maximum employment and price stability hasn’t taken a back seat to maintain the appearance that everything’s fine through higher stock prices.

How many times can they keep running the same play? Right now investors still seem willing to believe that the Fed can extend the business cycle forever, but it does beg the question of whether the economy and the markets are even viable without support from the central bank.

The big issue in front of us is whether another round of rate cuts can rescue the economy? It might. But the next big trade is going to be recognizing that tipping point if and when the markets and economy fail to respond.

Next month the current expansion will become the oldest on record. Investors need to start worrying about the marginal effectiveness of any potential rate cuts this late in the cycle, especially now that yields globally are already at rock bottom. Lower rates almost certainly aren’t the answer to a system choking on debt from the past decade of easy money, but apparently, that won’t keep policymakers from offering it up again. The minute the markets realize that the Fed and other central banks are shooting blanks the entire game changes.

Which is why housing data is worth paying attention to. Over the past week, a series of reports on pending, existing and new home sales showed a continuation of weaker year-over-year trends despite the stimulus normally associated with declining mortgage rates. It might be an early and important sign that aside from the raging bull market in equities, demand in the economy is slipping and becoming inelastic to the level of rates. See https://cnb.cx/2IHmcfT . So even if the Fed embarks on another round of rate cuts they may find themselves pushing on a string.

New Home Sales (blue) and 30 year mortgage rate (green and inverted). Chart courtesy Zerohedge.

‘Jaws’ Could Take a Bite Out of Markets

Stocks and bonds both can’t be right on the economy

Photo by Clint Patterson on Unsplash

June 24, 2019

Wall Street has coined a term for the opposing economic messages being sent by the bond and stock markets: Jaws. Look at a simple chart (below) with the S&P overlayed on the benchmark 10 year Treasury note and you’ll see what I mean.

It refers to the yawning gap that began to widen early this year as a function of sharply higher equity prices and collapsing bond yields. One side suggests a boom and the other signals recession. Describing it is the easy part, guessing how it turns out is not. Both can’t be right.

The image of “jaws” also infers a danger to investors from a trap created by conflicting narratives that will inevitably snap shut, in this case as the macroeconomic state of play becomes clearer. But from which direction will the jaws close and who is most at risk? Will the economy take off or hit a wall? Will bond yields rise or will stocks succumb? We don’t know yet. Presently, both markets trade well and with the confidence that they represent the winning side.

Jaws is a reaction to 1) slower growth and 2) the Fed’s anticipated response. There’s no doubt that the global economy has been knocked off it’s footing by disruptions in international trade. In the US, it also suffers from old age. Next month the current expansion, that began in June 2009, will officially become the longest on record. Bond yields have fallen sharply as the possibility of a recession appears on the horizon, accelerated by these and other headwinds created by sub-par economic activity worldwide.

On the other hand, equity markets have enjoyed an impressive recovery since the Fed called off plans for tighter monetary policy back in January. The S&P spiked to fresh record highs last week after Fed chairman Powell went a step further and all but promised to begin cutting rates again. See https://bloom.bg/2WLgykO .

As I see it, the risk inherent in the jaws trade is that the prosperity projected by the equity markets is becoming more illusory, when in reality the economy and the markets are only viable when the Fed is backstopping them. All-time highs in stocks seem strangely disconnected from the expectation that more than half of the sectors in the S&P 500 are set to report negative growth in this current quarter.

In the last 50 years, only a quarter of all recessions were averted by easier monetary policy. Investors feeling confident that Chairman Powell has their backs may be overestimating the capabilities of the Fed to sustain a business cycle that is already past its sell-by-date.

JAWS. Competing outlooks from stocks and bonds.

Fed Set to Join Race to The Bottom on Rates

Increasingly negative yields in Europe and Japan weigh heavily on Fed policy

June 19, 2019

Photo by Braden Collum on Unsplash

Five years ago this month the European Central Bank made the desperate move of imposing negative interest rates in an attempt to spur growth and generate price inflation. It didn’t work. Economic activity on the continent now is barely noticeable, the banks are teetering and market-based inflation expectations are the weakest on record.

European bond yields are literally collapsing in a panic after European Central Bank president Mario Draghi revealed his latest prescription for growth: do more of the same. Because current policy obviously isn’t extreme enough the ECB thinks even deeper negative rates will certainly do the trick. Genius. Yesterday the benchmark 10yr German bund traded at -0.32 bps and similar yields in Poland, Sweden and France hit zero for the first time in history. Negative yielding bonds worldwide, mostly in Europe, now total about $12 trillion. What’s the goal here? How are banks ever supposed to profitably lend money with such a distorted yield structure? It has long been suspected, but today’s events confirmed that Draghi and the ECB are officially out of ideas. Europe is toast.

A similar experiment in Japan also failed miserably. The widely touted “shock and awe” scheme by the Bank of Japan in January 2016 also included a move to negative rates, which in theory was supposed to boost the economy by discouraging saving and encouraging spending. It didn’t turn out that way and the country remains trapped in a decades-long deflationary decline. A recent Reuters report claims that BOJ insiders knew immediately that the move to negative rates was a mistake. Despite the fact that they have nothing to show for it after three and a half years, the policy is still in place. See https://reut.rs/2Il0Sww .

This should be a lesson to all investors as the Fed stands poised to begin another rate cutting program of its own, possibly as soon as next month. While it’s becoming apparent that what ails the economy is moving beyond the reach of traditional policy remedies, central bankers like Mr. Draghi and Mr. Kuroda (of the Bank of Japan) are still fighting the last war. We assume that the Fed would never follow their lead and take US rates negative but who knows? The Japanese and the Europeans probably never thought they’d end up in their current predicaments either.

The last Fed easing cycle started in 2006 with an overnight rate of 5.25% before falling to 0% by 2008. This time around, if rates are eased again, the starting point will be less than half that, at only 2.4%. If the Fed feels compelled to ease policy every time the equity market gets in trouble, we’ll be at that zero threshold soon enough. In fact, some astute Fed observers think that chairman Powell’s recent reference to the downside limit on policy as being defined by the “effective lower bound” rather than a “zero lower bound” cracks the door for rates below zero. We’ll see.

Predictably, stocks are loving the possibility of lower rates but are we somehow supposed to feel good about all of this? It ignores the reason why an easier policy is back on the table in the first place. How long can we play the “bad news is good news” game before bad news actually becomes bad news?

As I wrote last week in Aussie-Yen: Currency Canary Keels Over, either growth needs to accelerate or there has to be a reset lower in the financial markets. The contrasting messages coming from the bond and equity sectors are as stretched as at any time in recent memory (see chart below.) One side will ultimately win out, but the waning influence of the central banks definitely poses a risk for growth.

Massive divergence: The S&P and the benchmark US 10yr Yield