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.
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.
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.