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 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 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.
Economists are having a tough time figuring out why the market is pricing in potential rate cuts in the US while the economic data is so good. It’s a good question. GDP growth is above trend and the country is considered to be at full employment. Assuming all markets are equally forward-looking, it’s hard to reconcile the growing gloom in the rate complex against generally positive news flow on the economy and with equities posting record highs.
As of now, the front-end rate futures markets are discounting one rate cut for this year and one more in 2020. This implies a sense of trouble appearing on the horizon that could require a policy response. The Fed says that rate cuts are not in play but they’re not trying too hard to dissuade investors from arriving at that conclusion.
Part of the concern can be attributed simply to the age of the current economic expansion. These things don’t last forever. Absent a total collapse, by July this expansion will become the oldest on record at 121 months. That would be more than twice the average of 59 months for the prior 13 cycles.
Another explanation is the lack of inflationary pressure now playing a larger role in overall policy calculus. Something has gone wrong when trillions in stimulus don’t buy a sustainable inflation rate.
But a more interesting theory for the move in rates involves the growing probability of a much stronger US dollar, an outcome that could ultimately force the Fed to hold back its rise with looser monetary policy. Deep liquidity and a robust US economy make the dollar the most attractive currency on the world stage, but it is a double-edged sword.
It remains my opinion that a higher dollar poses an unknown and very underappreciated risk for the global macroeconomic condition, and not just as a general deflationary headwind. The leveraged exposure to the dollar created by years of borrowing against easy Fed policy by both sovereign and corporate entities is massive. And like other extremes caused by excessively profligate central bank policies, it’s truly unprecedented. We really don’t know what these actions have wrought and what the impact will be when the unintended consequences are eventually revealed. 2018 gave us a small taste of what happens when the dollar goes up: emerging markets and other vulnerable dollar-sensitive credits fall first, and then like dominoes end up knocking over the developed markets. It could happen again.
For now, the conundrum continues. As we have been witnessing since December (and for the past decade), the equity sector thrives on even the slightest prospect for easier Fed policy. The reasons why never seem to matter. Until they do. If I’m right about the dollar, signs of economic weakness and lower rates should not be taken as a benign development but rather as a warning.
Friday’s better than expected number for first quarter GDP may be dominating the headlines but it’s the report on Personal Consumption Expenditures that is driving the market reaction. Prices paid by consumers for goods and services, excluding volatile food and energy components, fell sharply in the first three months of the year, extending a decline that began at this time last year (see chart below.) The big drop in US bond yields on the week despite otherwise good news for new home sales, durable goods orders and growth, in general, is a sign that global deflationary forces are gaining an upper hand.
It wasn’t supposed to be this way. In theory, robust growth, rising wages, and full employment create greater aggregate demand that leads to higher prices and higher inflation. Ever since the Fed began raising rates in 2015, tighter monetary policy has been predicated on this basic economic assumption.
The disconnect isn’t limited to the US. Some foreign central banks are beginning to panic as inflation fails to respond to years of stimulative policy. This past week Japan and Sweden joined a growing list of countries putting off any chance of rate hikes in 2019. See here: https://reut.rs/2GI0gjI and https://reut.rs/2IUj6pv . The problem is that like Europe and Switzerland, they too have already imposed negative interest rates and are running out of options to kickstart growth.
Credit to the Fed for pursuing a course of policy normalization over the past few years. They planned ahead. Part of the rationale for raising rates was to make room for rate cuts in the event of a slowdown. While this gives the US a distinct economic advantage on the world stage it doesn’t necessarily mean it will produce a happy ending.
As I mentioned in (See “Good news, bad news“) the downside in this scenario of divergent global growth is that it will drive the dollar higher against the world’s other currencies. In fact, it has already begun. While the equity markets are still celebrating a good Q1 earnings season, the risk going forward now shifts to the negative impact a stronger dollar will have on the bottom line as it makes American exports less competitive. It also starts to turn the screws on entities that leveraged cheap dollars at low rates during a decade of Fed largess. In my opinion, the aggregate short exposure to the USD is grossly underestimated.
The most efficient way to express the view of intensifying deflationary pressure is to own both the dollar and treasuries. The 2-year sector is especially attractive as a play on possible rate cuts and as the flattening trend in the yield curve of the last couple of years begins to reverse (see chart below).
In 2019 the major central banks have been focused on reflating markets by either pausing or reversing plans for policy normalization (higher rates) that hit many markets hard in 2018. Despite ongoing fears of slowing global growth, equities and commodities have so far responded positively to the prospect of easier rates and more plentiful liquidity.
But the one thing that could ruin the party is the strength of the dollar. In my opinion the rising USD was an underappreciated factor that squeezed many regions hard last year, especially emerging economies with current account deficits. Many of these entities had borrowed heavily cheap dollars at low rates under the Fed’s QE program after the 2008 recession, leaving their fiscal position vulnerable as the dollar rose. Not only does it make debt repayment and refinancing more expensive, it also tends to pressure commodity prices that these countries often rely on for exports, creating an unenviable situation where the things they are short (dollar debt) go up and the things they are long (raw materials) go down. And as 2018 proved, because global markets are more interconnected than ever, it wasn’t long before problems in the emerging markets became a problem for the developed markets.
Normally, you would expect that the dovish shift at the Fed this year would undermine the dollar. I certainly did. As it became more apparent that the highs were in for interest rates in early Q4 last year, I assumed the same for the dollar. It was a perfectly logical conclusion given that major currencies often track the path of underlying interest rates. Wrong. Except for a few shallow dips, the dollar has been remarkably resilient. It even shrugged off the appointments of inflation doves Steve Moore and Herman Caine. In the currency world it remains the best of a bad lot and the safety and liquidity it offers in uncertain times can’t be matched. Being short hasn’t cost much money so far but the longer it remains here at the top of its range, the probability grows that the next move is higher.
The chart of the dollar index (DXY) is potentially very bullish, and a break above 97.75 would signal the beginning of a (perhaps significant) leg up. This would unleash a deflationary impulse, and much like in 2018 leave stocks and commodities vulnerable. The world needs a weaker dollar to keep the 2019 bull reflation trade going. But it may not get it.
Here in Washington, DC, packing the courts is a charge frequently used by both parties to accuse political opponents of trying to influence judicial outcomes by getting their guys of similar ideology seated on the bench. This comes to mind with news that President Trump intends to elevate Herman Caine to join recently-appointed Steve Moore to the Fed https://on.wsj.com/2CX3vBv. By putting forward two notable inflation doves (and political allies,) it’s clear that the President is trying to tip the balance of power on the board to favor a more market-friendly composition. Wasting no time, Moore called on the Fed to begin cutting rates immediately https://cnb.cx/2uvSWRm.
Late last year as global growth slowed and equity markets stumbled badly the president made no secret of his feelings toward the Fed, blaming them for having no ‘feel’ for market conditions as they continued to methodically raise rates https://reut.rs/2ONDd9M . The data since then suggests Trump was right. As the stimulative impact of last year’s tax cuts fades and signs of weakness in the economy intensify, Trump is leaving nothing to chance. For a president that often references the Dow as a benchmark for economic policy success, he intends for the Fed to be his electoral insurance policy.