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Trade war measures, Dollar alternatives, risk trends and yields - DFX Key Themes



It Can Be Difficult to Measure Complex Issues Like Trade Wars

When dealing with a complex fundamental theme – without a binary outcome, numerous inputs and important to different investors for different reasons – it can be difficult to both analyze and trade the subject. Those are certainly criteria that would fit the ongoing trade war. It is proving exceptionally difficult to keep a clear bead on the progress of the economic conflict and the market has started to veer back into its comfortable habit of allowing complacency to take over. Drifting without accounting for clear and present danger is a recipe for eventual financial market seizures, and we would do well not to simply through caution to the wind as so many others have. That said, it does not do to simply position against the current presuming recognition will eventually dawn. To reconcile important but complicated themes with an appropriate trading approach, it is first crucial to keep accurate and as-quantitative-as-possible analysis on the matter as possible. In measuring trading wars, that can be a task. The trade figures like we have seen from the United States last week and are due from China next week are accurate but constrained and lagging updates. 

Simply referring to exchange rates or even capital markets alone does not give an accurate account either. From USDCNH (Dollar to Chinese Renminbi), we find the exchange rate has held to range for weeks after an initial surge. For those keeping track, this is a false sense of stability derived from the People’s Bank of China (PBoC) actively working to stabilize the rate. They are similarly acting to keep the Shanghai Composite and other equities propped up. Just as we learn from the Chinese index the government’s intent, we learn from the likes of the S&P 500 the extent of speculator’s complacency. But where do we see better measure as to the impact that the specific US-China trade war is having? I like AUDUSD. First and foremost, the cross liquid and un-manipulated. Further, Australia is heavily dependent on China for its own economic health thanks to its trade relationship (further solidified during the Great Financial Crisis). Other fronts of the US-led trade war can be even more difficult as they are not fully engaged. While the NAFTA replacement (USMCA) seems to on the path to being codified, the breakthrough has thus far had limited impact the Dollar, Peso and Loonie. Of the three, the Loonie was best suited to channel a response as it was the most at-risk in the final phase of negotiation with fewer competing fundamental themes. 

Meanwhile, the standoff the US has taken against the EU and Japan are in limbo. However, the temperament of the Trump administration and efforts to subvert the US’s efforts to reshape the global landscape (like the EU’s efforts to circumvent the United States’ sanctions on Iran) can readily revive these issues. Since President Trump made repeated threats to import European and Japanese autos before agreeing to the armistice, the health of the global vehicle production industry can be a good measure. I like the CARZ fund. In economic terms, it is also important to follow closely with sentiment figures. There are economic, consumer, business and investor surveys for various countries. Consumers tend not feel the impact of such economic efforts until later on when the costs trickle down and businesses outside of exports often initially see the upside before the full effect is registered. Investors and economists however, tend to evaluate on a wide basis with a significantly further projection. This may be a difficult issue to assess, but it is certainly important enough to make the effort. 

Dollar: Always Evaluate Alternative Scenarios

Personally, I consider the best trades are those that I cannot come up with a viable reason as to why a market move will not happen. Such an approach puts us in a different frame of mind where we are inherently more critical of market conditions that could readily trip up trades. More often, the preferred method of trade evaluation is to filter all possible options and come to a decent – often people stop far short of the ‘best’ – option that can be pursued with the proper risk and money management. Find, and execute. However, when dive into the markets with such an intent, it often encourages us to tolerate shortcomings that are likely to trouble our positions as we simple want exposure to the market and unknowingly fall back on hope that the practical issues may not come to pass. It is generally not good to approach most things in life from a perspective of skepticism, but it most certainly prudent to evaluate our markets in this critical way when our money is on the line. 

With that said, I want to come back to the US Dollar. Over the past few weeks, I have weighed in on the Greenback owing to the turnover from the third into the final quarter of the year. My baseline forecast is a bearish one owing to: the lack of enthusiasm despite the Fed’s extreme disparity in pace, the role the currency now plays as a carry, the fact that the United States is the instigator of many different fronts of the ongoing trade war and the slow but destructive interest by the world’s wealth centers to diversify its exposure to the USD. Evaluating all of those themes, there is little potential in mind that these themes will ultimately turn out in favor of the currency. At best, they will be temporarily overlooked. However, there are ideal situations that can be considered that may ultimately afford favor to the Dollar, so it is worth enumerating them here for your consideration. First and most effective for supporting the Dollar would be a full-blown financial crisis. The currency has taken on a considerable carry status over the years and that can see it drop in the initial phases of risk aversion as weakly-held longs looking for carry in these low returns environs are shaken out. Yet, if the situation turns gangrenous, liquidity will be all that matters; and no other global asset is as revered for its haven status as US Treasuries and its most liquid money markets. Yet, in such circumstances, the opportunities will be endless – though most will likely be bearish, but panic tends to generate the faster moving markets. 

There has been suggestion that the US economy will continue to run at full speed aided by fiscal policies like tax cuts and benefits of trade wars. However, the US has not somehow found itself outside of the laws of market physics that maintain cycles nor is it so self-sufficient that a global pain will not wash up at its own shore. Further, if economic conditions stagnate and deteriorate, the Fed will have to slow its hikes preventing the speculative value from a growing monetary policy gap in the USD’s favor. A more recent, technical consideration has been proposed via the reduction in liquidity for US Dollars via policy and trade. This has shown some modest pressure, but if the Dollar were to continue to rise, President Trump has made clear his criticism of a higher currency as their debt load rises and trade war bites. If it is in his power to somehow arrest the currency’s climb – and he has avenues for it – he will prevent it. 

Correlation in Risk Assets – But for Government Bond Yields

Some people like to draw their assessment of investor sentiment from indicators like the VIX volatility index or more simply from the performance of a ubiquitous asset like the S&P 500. Others will evaluate volume and open interest for participation, data like GDP, or pure sentiment surveys. I like to refer to correlation. In extreme conditions, what happens to markets in different countries or in different asset classes? They tend to move in concert. In a deep bear market or full financial panic, the market adage that ‘correlations go to one’ reflects on the fire sale mentality that cuts through any concept of which ‘mildly’ risky investment is worth holding when everything seems to be crashing down around us. In a boundless bull run where qualifying the risk that is assumed with high returns goes out the window. At the poles, we find the commonalities between these otherwise very different markets and their investors: the fundamental evaluation of risk and reward. That said, when we are not in an environment where animal spirits are running rampant or everyone is rushing for the exits, it can be difficult to see these undercurrent at work as individual catalysts promote a bid or unwind from the various assets. 

Yet, just because we are not in a panic or mania doesn’t mean that sentiment is nonexistent. Risk appetite can rise or fall with conviction in the middle of trends and with limited intent. Then, there are the periods where we are just gaining traction on a systemic move before it is obvious to everyone. This is why I like to reference the correlation between assets that are otherwise very different to each other: equities, junk bonds, carry trade, emerging markets – and for opposing relationship the likes of gold and government bond yields. Recently, we have seen the relationships between many of these markets tighten up. The US indices were unique for a while in that they have spent months forging higher until they returned to record highs while their global peers floundered and emerging market assets outright tumbled. That may be starting to firm up again as of this past week however. Another, persistent detractor from the global sentiment relationship are government bond yields. 

US Treasury yields have climbed alongside US equities, perhaps owing to the Fed’s influence; but even with equities retreat this past week, the government rates kept rising. That is unusual. If Fed forecasts are at play, hikes are a dubious course to set our time by, but consistent balance sheet reductions are more reasonable. The fact that other countries’ sovereign yields (Germany, UK, Japan, etc) were rising in tandem suggests there is something more systemic afoot. Is this evidence that global investors are now confident the central banks of the world will back out of their extreme accommodation either because they are confident or (more troubling to consider) they have run out of resources? If that is the case, beware the future for risk trends. The past decade of general bullish drift has been facilitated by the distortion of central banks affording speculative rampancy. If faith in monetary policy collapses, there is penance to pay. 


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