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.

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

Aussie-Yen: Currency Canary Keels Over

June 14, 2019

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.

Fed Rate Action Could Boost India Modi Euphoria

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

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.”  

Bonds and Commodities are the Unwanted Guests at the Equity Party

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.

Two diverging outcomes: the S&P and 10yr Yields