Coal miners used to carry caged canaries down into the mines on the theory that any presence of dangerous gases would kill the birds before the humans and serve as a warning for workers to exit the tunnels.
Over the years the term has evolved as a metaphor for early signs of trouble in the financial markets.
The Australian dollar (AUD)/Japanese yen(JPY) FX pair is probably the best-known benchmark of risk sentiment, with a well-deserved reputation as a leading directional indicator for markets in general.
On one side is the Aussie dollar, a liquid high-beta currency that is reflective of prevailing global macroeconomic trends, and on the other is the yen, best known as a reliable safe harbor destination in uncertain times. If that pair is rising (AUD outperforming the yen,) it most likely means economies are expanding, markets are happy and the outlook for asset prices favorable. If it’s falling (JPY outperforming,) the opposite. Simply, AUD/JPY is the ultimate canary in the Wall St. coal mine.
International trade and supply chain disruptions have taken a big bite out of global growth. Despite the slowing economy, expectations of even more central bank stimulus have kept financial asset prices elevated. But that fundamental divergence can’t go on forever. The Fed has some room to cut rates but in most other countries yields are already at historic lows while world-wide debt stands at record highs. Investors appear to be slowly coming to the conclusion that more of the same policies aren’t the answer. Either growth needs to accelerate or there has to be a reset lower in the financial markets. The breakdown underway in AUD/JPY is a sign that the canary is keeling over and that the latter outcome may be unfolding.
The AUD/JPY FX cross and the emerging market ETF (EEM) are both headed lower.
The re-election of Prime minister Modi and potential rate cuts from the Fed have been well received so far but the general softening in global growth remains a threat, especially to the emerging markets.
June 12th, 2019
I have joined the team at ConnectedtoIndia.com as a special contributor, providing market commentary with an Indian angle.
The euphoria in Indian stock markets after the recent reelection of Prime Minister Narendra Modi’s National Democratic Alliance could find further support next week if the US Federal Reserve decides to do an abrupt turn in its interest rate policy, from raising interest rates last December to possibly reversing that decision at its upcoming meeting.
Bombay Stock Exchange Photo courtesy: Wikipedia
A US interest rate cut would help provide assurances to India and the rest of the world that dollar liquidity in offshore financing markets will remain plentiful. This has already brought relief to market risk sentiment, at least for now. Despite some signs of profit-taking today, equity prices in general across all sectors are up sharply in the past week since the Fed hinted at the move.
Weak global economic growth made worse by intensifying international trade tensions is squeezing the finances of many export-dependent countries, drawing comparisons to the turmoil last year that began in the emerging markets and later spread to developed economies.
Currencies of China, Turkey, South Africa, and Brazil, where the first signs of trouble appeared in 2018, have recently come under pressure again. This has attracted the attention of central bankers, notably Federal Reserve chairman Jerome Powell, who are eager to head off a repeat performance in 2019.
Many countries, as well as corporate entities, took advantage of cheap dollar loans at low rates during the Fed’s easy money regime in the wake of the financial crisis of 2008. The resulting increase in leverage left these same borrowers negatively exposed as the Fed began to unwind those policies in earnest beginning in 2017.
Higher interest rates, declining liquidity, and a rising US dollar make that debt more difficult to service or roll over, precipitating a loss of investor confidence, potentially triggering a feedback loop of asset liquidation and in the extreme, lasting economic impairment.
The lesson of 2018 is of how fragile the global financial system remains despite the trillions of dollars deployed under central bank quantitative easing programs. Half of the USD5 trillion investment grade bond universe is now rated BBB, just one notch above junk status. A sustained economic downturn or an adverse credit event has the potential to unleash an avalanche of corporate downgrades and forced selling that would affect all markets.
Reserve Bank of India governor Urjit Patel was one of the first to raise the alarm over the unintended consequences of policy tightening by the Federal Reserve.
Just over one year ago, in a June 3, 2018 Financial Times op-ed Patel warned of the negative impact created by a dollar shortage across the emerging market sectors and urged the Fed to back off on plans to shrink its balance sheet.
He described the combination of balance sheet reduction and increased US treasury bond issuance (to finance tax cuts) as a “double whammy” threat that had essentially caused dollar funding in the sovereign debt markets to evaporate, sparking foreign capital outflows and leading to instability in currencies like the rupee.
The Fed listened. As a result, they will cease drawing down their balance sheet this September. And if prices in the futures market are any indication, the US could cut rates four times between now and the end of next year.
But is it too late and will it be enough? Terms of trade are being reshuffled on a global basis, and the effect on growth from disruptions to supply chains is still in the early stages and most likely underestimated. The risks ahead for India’s, and more broadly emerging nation’s, financial markets is that the extraordinary nature of these challenges falls beyond the control of not just the RBI but of all central banks, leaving India with one foot on shaky ground.
[The rupee and the Indian equity market are essentially the same trade right now as investors remain nervous over the entire emerging market sector. The prospect for easier policy from the US Federal Reserve has taken some pressure off of the rupee and its currency peer group for now.]
“The views expressed by the author in this article are personal and do not reflect those of Connected to India.”
Bond yields and commodity prices see a much different outcome than stocks.
June 10, 2019
Have you noticed that issues the Fed cares about are conditional and dependent on whether the stock market is going up or down? When the market is rising things like trade wars and weak price trends, while worthy of mention, are still considered “transitory” events. More annoying than scary. On the other hand, when the market is falling these same factors are considered full-blown threats to the economy.
Market action in the month of May and the Fed’s response is a good example of the latter. Even though the S&P had dropped nearly 8% from all-time highs, it was still up 9% on the year when Fed chairman Powell hit the panic button on June 4 saying the Fed was ready to act “as appropriate” to counter growing protectionist threats to the economy. See https://cnb.cx/2WaWNi5. Wink, wink. That’s all the markets needed to hear to launch six straight days of vertical ascent. Forget about why the Fed might be considering rate cuts: collapsing inflation expectations, potentially impaired corporate earnings or deteriorating credit, the fact that they are is all that matters. The playbook for equities remains the same as it has for the past decade: the bad news is (still) good news. As renown economist John Maynard Keynes once said, “the market can stay irrational longer than you can stay solvent”. So true.
But several reliable macroeconomic benchmarks don’t seem to be playing along. While stocks rip higher, bond yields and prices for copper and oil have barely budged off their lows. It appears that the economic outlook projected by the fixed income and commodity sectors is quite a bit less optimistic than what is expected in the equity space. The conflicting message between these two worlds might be temporary and meaningless or it could be something worth paying attention to.
At some point, the marginal utility of repeated deployments of the Fed put will begin to decline. I have no idea if that time is near but subtle market divergences like these will be the first sign that the game may be over. Therefore I will be paying attention.
The Strike Price on the Fed Put is A Lot Lower Than You Think
June 4, 2019
For anyone doubting the severity of the economic impact triggered by an escalating trade war, take a look at the ongoing collapse in the commodities and short term interest rate sectors. The CRB Index is on its way to getting flushed and Fed Funds futures are pricing in the possibility of four full rate cuts over the next 18 months. Any hope that investors had that tariffs and supply chain disruptions were just temporary inconveniences is now out the window.
The fundamental narrative is beginning to catch up to what the rate complex has been screaming for months. A report Monday showed US manufacturing activity slowed to the weakest pace in two years. See https://reut.rs/317v4m3 . In addition, the JP Morgan Global Manufacturing Purchasing Manager’s Index (PMI) posted its worst result since 2012, indicating an outright contraction in worldwide factory production. See https://bit.ly/2WiNqBS. But these are lagging indicators. It will get worse.
St. Louis Fed president Jim Bullard is the first voting member of the FOMC to break ranks with his colleagues, saying yesterday that “signals from the Treasury yield curve seem to suggest that the current policy rate setting is inappropriately high.” See https://cnb.cx/2WCogO8 . Most of the board probably agrees with him but given their history of decision-making don’t know how they’re now going to explain rate cuts with a 3.6% unemployment rate.
Herein lies the problem for the equity and credit markets. This last leg down feels like investors are beginning to suspect that the willingness of the Fed to deploy a safety net under the stock market, as they have in the past, is now a much bigger ask. The economy is decelerating quickly but it’s hard to sell that story given the ongoing strength in employment. There will have to be more pain. In other words, the proverbial Fed put is still in play but this time around it might come with a much lower strike price.
Commodities in big troubleInterest rates collapsing
The US dollar yesterday closed at new highs for 2019, and at its best level in two years. It remains a safe haven destination in times of declining global growth and a weak investment climate made worse by seemingly unending trade disputes. The most recent move to impose tariffs on Mexican imports is proof that President Trump is not shy about using this tactic to advance policy. See https://reut.rs/2HLiYYc . Who would be surprised if Europe wasn’t the next target? If this is to be the new normal, traders are quickly coming to realize that many markets are not priced for it.
Two questions here are, can the dollar go higher and what is the impact? The answers are 1) yes and 2) not good.
FX, by nature, is all relative. Outside of the Swiss franc and the Japanese yen which also provide safe havens, there aren’t many currencies that you’d rather own than the dollar right now. Fundamentally, a 2% yield, deep liquidity, and a growing economy look pretty good compared to the mess in most other regions of the world. And export-dependent blocs like Asia-Pacific, Europe, and Latin America really have no choice but to weaken their own currencies to compensate for the hit to their economies from reduced trade.
Technically, the price action in the dollar is extremely bullish. In the short-term, the dollar index (DXY) continues to advance in a positive pattern of higher highs and higher lows. The long-term setup could see the DXY back at the 2002 highs, more than 20% higher from here.
The downside of dollar strength is that it’s likely to accompany, and even thrive on stress in the financial markets. The big dump in commodities benchmarks like copper and oil this week are signs that investors see this coming and are hunkering down. As we’ve written here before, the Achilles heel of the broader marketplace is the credit sector. See “Time to BBBe Careful .” A higher USD would squeeze leveraged dollar debtors, including many banking systems abroad, who are massively and negatively exposed. With half of the investment grade bond market rated BBB and hovering just one notch above junk status, a move up in the dollar could be the trigger that sets those dominoes falling and makes a credit meltdown our next black swan event.
It’s already been a big week for red flags in the bond market after the Fed’s most reliable recession indicator, an inversion in the US Treasury 3 month-10 year spread, led a rush to the safe havens of sovereign debt. See https://bit.ly/2BRqa4l . Yields are down everywhere, even hitting record lows in both Australia and New Zealand as negative effects of slowing growth and the US-China trade war intensifies and broadens. Globally almost $13 trillion of bonds now trade at a negative yield, meaning you have to pay the issuer for the privilege of owning them. Nuts, but a sign that investors are becoming more concerned with the return of capital rather than the return on capital. See https://bit.ly/2Wd91M1 .
The panic is starting to spread to the equity and credit sectors as two of the markets’ worst fears come into view. As we have noted repeatedly here, the possibility of 1) a higher dollar and/or 2) corporate credit downgrades remain the greatest threats for 2019 because of the destructive potential that both outcomes hold for a global financial system leveraged up on dollar debt. See “Rates Headed South for the Summer” and “Time to BBBe Careful“. These are the pain trades that central banks will find hard to mitigate and action in the bond markets is telling investors that they should indeed be worried.
.The benchmark 10yr Treasury yield and the S&P. Stocks ‘catching down’ to the message from the bond market.
One of the unintended consequences of the Fed’s policy over the last ten years was the explosion in USD-based borrowing and the inevitable deterioration in credit quality whenever easy money is on offer. While this is not exactly new news, half of the $5 trillion investment grade bond market is now rated BBB, just one step up from junk. (See https://on.mktw.net/2MaGX7m .) Even if you don’t know anything about finance that statistic should be alarming, and easy to imagine what happens when these borrowers start to get squeezed. The implications are enormous. The obvious threat to the markets from here is one which a combination of slower growth and tighter financial conditions imposed by international trade tensions, weak investment, and declining dollar liquidity triggers rating downgrades, forcing the selling of newly-relegated junk credit as it becomes ineligible for inclusion in investment grade bond indices. Investors would inevitably turn to more liquid equity markets to hedge exposure, creating a negative feedback loop (or “doom loop”) of risk reduction and lower prices across asset classes.
The downgrading of General Electric debt last October brought the issue of corporate debt into sharper focus and was a factor in the broad market selloff late in the year. The plight of the formerly-iconic blue-chip name is providing a preview of what could happen on a wider scale and we’d be foolish not to take heed. (See https://on.mktw.net/2wuGIcZ and https://cnb.cx/2FWFlI9 .) Dallas Fed president Robert Kaplan underscored this concern recently by saying that he’s more worried about businesses than consumers being the “front end” of the next economic downturn. He’s right.
The lasting impact of trade disruptions and a stronger dollar is still an unknown for macroeconomic and credit trends but almost certainly underappreciated is the sheer volume of investment grade debt perched on the edge of descent into junk. Credit spreads have widened in the past month as global growth slows, weighing on stocks and forcing investors into the safe haven of treasuries. The high-yield bond sector will be calling the tune that the markets dance to for the foreseeable future and ETFs like HYG or JNK are good benchmarks to keep tabs on the state of play in the sector. BBBe careful out there.
Copper is often referred to as the metal with a Ph.D. Because of its broad range of industrial uses, Dr. Copper has a well-deserved reputation as a predictive indicator for global macroeconomic trends.
Today’s break of nearly 1.5% is noteworthy but not exactly surprising as the trade war with China expands (see Huawei), impacting supply chains and hurting demand through higher costs. A survey by the American Chamber of Commerce in China revealed that a third of U.S. companies operating in China have either delayed or canceled investment decisions, and 41% of respondents were considering relocating (or had already relocated) manufacturing operations. See https://bit.ly/2YAac54 . This is huge.
What is surprising, however, is the ability of the equity markets to shrug off a major disruption in global economic activity and the potentially negative impact on corporate earnings. Volatility remains low, reflecting a belief that the Fed can control the outcome of the business cycle. Maybe they can, but as we approach the tenth anniversary of the current expansion that bet becomes less attractive.
If 2018 taught us anything, the credit and equity sectors can depart from weakening macro trends for only so long. Though copper began breaking down in June of last year the S&P essentially ignored it until October, but the adjustment was quick and ugly (see chart below.) A similar divergent scenario appears to be unfolding, this time made worse by intensifying trade-related pressures and leaving stocks increasingly vulnerable. The Doctor’s prognosis for the markets is not good.
The U.S. rate market is putting “paid” to the latest narrative on inflation as it continues to discount even deeper rate cuts despite new projections that trade tariffs will push consumer prices higher and spark inflationary pressures. Like at any point in the last several years, inflation always seems to be looming around the next corner. Yet it’s not and the Fed can’t figure out why. While the Fed watches and waits, unsure of their next move, the futures market is busy pricing in the possibility of three rate cuts by the end of next year (see chart below.) For those paying attention to price action rather than talking points, the message couldn’t be clearer: the threat of an intensifying global economic slowdown is a much bigger problem than any inflationary uptick.
The short term rate complex is probably the least speculative of any financial market. It’s the quiet man of markets, often dull and boring and largely overshadowed by the latest IPO or equities in general. But its message should never be ignored. Forward rate expectations are breaking down hard, pricing an aggressive reversal in Fed policy. Something is happening macro-economically, and not in a good way. The risk is that trade uncertainties have disrupted supply chains and capital investment more than we thought. And rather than being a temporary phenomenon, tariff regimes could become the new normal, with longer-term impact.
As I noted in “The Dollar and Deflation” and “Fed Resists Market Push for Rate Cuts” a sharp move up in the dollar is a strong and rising possibility as trade and political tensions consume major export-dependent regions abroad like China, Australia, UK, and Europe. The first line of defense for these countries is to offset the drop in activity by letting their currencies fall. All eyes are on the Chinese yuan in particular. A “source” on Friday claimed that China won’t let the currency weaken below 7.00 to the dollar. (See https://reut.rs/2YxkPp9 .) Believe that if you want to but central banks have a history of saying they won’t devalue their currencies, right up until the point that they do. I saw careers ruined in 1994 when Banxico (the Mexican central bank) devalued the peso just hours after insisting to the Street that they wouldn’t.
The rate market is sensing a dollar groundswell. Another leg up in the USD would be deflationary as well as destructive to dollar borrowers abroad. It’s hard to overstate the strength of this message. The dollar-inspired equity selloff of late 2018 might have been the warm-up act for what’s to come in 2019. The Fed and investors alike ignore this scenario at their peril because if this is how it plays out, inflation will be the least of their problems. Be long the dollar and bonds, preferably 2-3-year treasuries.
Forward rate expectations are collapsing. Dec 2020 Fed Funds (blue) trade at 1.80% vs spot May 2019 Fed Funds (pink) at 2.39%
Amid the back-and-forth of retaliatory trade tariffs between the U.S. and China are some important tells in price action that indicate the situation has moved beyond bluster and snark into a more protracted standoff with negative implications for global growth. Any inclination to think that this too will soon blow over, like previous disputes in the negotiating process, should be checked against the breakdown in commodity prices and treasury bond yields as well as macroeconomic risk benchmarks like the Australian dollar and the Chinese yuan. We warned about this possibility one month ago in What’s wrong with this picture. Both currencies are now perched on a cliff edge (see chart below.) As a proxy for the general global condition, the Aussie dollar’s plight is particularly concerning.
China and the U.S. appear squaring off for a harder fight. Trump clearly sees toughness on trade to be a winning issue for his 2020 election campaign. With an increasingly dovish Fed as his insurance policy against harm to the economy or equity markets, previous assumptions that the president had been bluffing a weak hand or was too eager to cut a deal with the Chinese are proving wrong.
Trump’s aggressive posture is backing Chinese leadership into a corner. One reason blamed for the collapse in talks late last week was China’s demand that the text of any agreement is “balanced,” reflecting respect for its sovereign “dignity.” (https://reut.rs/2JgYqZF ) Those are loaded terms that mean different things to different people. But the need for saving face in many cultures can’t be overstated and the insertion of feelings into the equation now makes any potential deal significantly more difficult to achieve. Investors are right to worry that this sharp-elbows approach on trade by the U.S. will also draw similar reactions when it comes time to negotiate with the Japanese or the Europeans.
Markets are on the edge of a paradigm shift. The FX, commodity, and bond sectors have been telling us for some time that the threat to global growth from disruptions in supply chains and to fixed investments due to changing terms on trade are more pervasive and may be longer lasting than many forecasts currently assume. Volatility is waking up as doubts emerge over central bankers’ ability to counter these headwinds with traditional monetary policy. It’s a massive red flag and a sign that risk may be underpriced. Despite that, the temptation to buy weakness in this ten-year-old equity bull market is both instinctive and strong. But if FX (especially AUD and/or CNH) starts to break lower from here, this time will almost certainly be different.
Australian dollar/Japanese yen cross (AUD/JPY). A reliable FX risk proxy, on the cliff edge.US dollar vs offshore Chinese yuan (USD/CNH). A break above 7.00 would be a major deflationary and risk-negative event.
A Trader's Perspective 