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Another last minute trade war fear, fundamental trading, the dark side of central banking - DFX key themes

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JohnDFX

Is There an Effort to Keep Markets Uneasy in Trade Wars?

How many times does something unusual have to occur before it is considered a planned? I have noted a number of times over the past month that some unexpected policy development was announced hours before the markets closed for the weekend. There is an unspoken commitment by central bankers and global leaders to prevent volatility in their respective financial markets. Volatility is the general definition of risk, and there is a clear connection between financial market and economy. In other words, no one wants to trigger speculative rout that could turn into tangible economic pain. And yet, that typical preservation of self-interest doesn’t seem to worry some of those in power looking to stir norms.

One of the more common culprits of this push against norms is US President Donald Trump and those in his administration. Announcements of new tariffs on Fridays are now commonplace. And this past week would not deviate from that new norm. Two people in the administration with knowledge of the plans said the President intended to push forward with the proposed $200 billion increase in tariffs on Chinese goods despite the effort to revive talks this past week. This is not exactly surprising given the United States negotiation approach of late. They seem to prefer discussing terms after exerting pressure on their counterparts in an effort to leverage a more favorable outcome. It is also the case in this instance that the remarks are not official – as in they do not come from the President himself. Typically, Trump prefers to announce such things himself to signal he retains final say over such matters.

Leaks are another increasingly common feature of the US political landscape which unexpectedly adds more uncertainty to an otherwise surprise-oriented policy approach – but at least one where we know to focus for answers. Whether intentional or not, the major announcements in policy from the US and other major economies into the twilight hours of the week creates a resting state of increased uncertainty for financial markets. We do not need any more reason to question our already excessive exposure to risky assets between the dependency on excessive monetary stimulus which is starting to correct, exploding levels of debt, increased speculative leverage and obvious efforts by superpowers to promote local growth through policies that curb others’. A frequency of last minute and troubling headlines just before the markets close is yet another reason traders could naturally want to curb their exposure. 

Evaluating Fundamental Themes for Both Their Probability and Pace of Progress

Trading fundamentals can be overwhelming for many. While there are many different motivations for market participants the world over to place or remove exposure, there are typically key reasons that draw many – if not the majority – to alter their views in tandem. If there were a first rule for trading using fundamentals, I would say it is to first establish what is most important to the market-at-large. Another functional application of this broad analysis technique (perhaps rule number 2) is to establish the nature of the theme or event itself. Is it complex or straightforward? Is there a distinct time frame for it to render its verdict or is the outcome something that can be debated through time?

Depending on the circumstances surrounding these fundamental matters, we can determine what kind of contribution they can make towards our trading – or how effectively they can otherwise complicate the opportunities that may otherwise seem complete. We can use examples to illustrate. The Federal Reserve’s next rate decision is scheduled for September 26th. There is clear anticipation for yet another 25 basis point rate hike by the policy authority with swaps pricing in nearly 100 percent probability. That is clear time and outcomes (hike or not). Such simplicity can make for straightforward Dollar or risk trends – though it will also drain the market-moving potential of an outcome that meets deeply discounted scenario. There is still complication in the forecast for another hike around December, pace in 2019, concern over external factors and more; but those clearly are not the primary interest.

A significant step up in terms of fundamental complication are the ongoing NAFTA negotiations between the US and Canada. While there have been a few dates of confidence thrown out by officials, there is no definitive end date. There is also substantial discrepancy in the outcome for these talks such that a compromise or dissolution of trade relations can render significant market moves. This is an even that is far more difficult to predict for timing and outcome, but it renders far more market movement. And, then there are those events that can continue without resolution for considerable time and the full impact cannot be readily be predicted until long after it is implemented. That is the situation with an event like the US-China trade wars. There are no milestones for furthering the tensions or reducing them and it can prove a systemic threat that directly leads to a global recession and/or financial crisis. Yet, without clear guidelines, the practicality of trading around it is exceedingly difficult. 

And Now, the Central Banks with Failing Credibility

This past week, the European Central Bank (ECB) and Bank of England (BoE) delivered their respective monetary policy decisions. These are important policy groups whose decisions carry far beyond their respective economies. The ECB marks one of the most aggressive dovish central banks amongst the majors and carries significant responsibility for sustaining the belief that market enthusiasm is borne out of the extraordinary support these groups are offering to the system. Perhaps recognizing the position they hold and uneven health of its member economies, it is struggling to decide its course. The BoE is one of the most hawkish major players with a course of inflation that is above target and could be used to evaluate the central banks’ commitment to the ‘rule of law’ for targeting price growth as a determinant for monetary policy. Of course, they are dealing with the uncertainty of Brexit which is a situation not uncommon across the world’s largest economies. So this group is acting as an unexpected template for how to deal with external pressures. These are important groups whose moves will be monitored and likely mirrored by other central banks.

The upcoming two rate decisions this week will not be evaluated for the guidance they can offer others. Rather, they will instead be used as lesson on what to avoid. The Swiss National Bank (SNB) and Bank of Japan (BoJ) have failed to apply policy that renders the deserved effect for promoting growth and price stability – not to mention unstated goals of financial health. They are in fact both groups that have lost significant credibility in the markets, which makes their job all the more unmanageable. The SNB will no doubt keep its rates firmly in negative territory, yet the desired depreciation of the Swiss Franc is unlikely to follow years of unchanged policy. Given the dependency on exports of goods and services – and particularly to the EU – they are primarily concerned with the unfavorable level of the EURCHF exchange rate. This will not change materially until the ECB itself follows a course that allows for more appreciation of the Euro.

While the BoJ has not done anything so dramatic as the SNB’s implementation and sudden removal of a floor on its key exchange rate, the central bank has clearly embarked on a policy course that has consistently fallen short of its mark. Interest rates in Japan have been kept near zero for decades, and the rise of QE programs was eagerly adopted by the group in an effort to stoke price growth. Despite a steady escalation of this downpour of funds, price pressures have not solidified and the markets have increasingly discounted their ability to even move the Japanese Yen for secondary favor. What we should worry about from these two is what the market response is when such groups are forced to capitulate or the recognition of how exposed the system is should another crisis arise where such groups have no hope of averting collapse. 

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