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A bear market; Fed rate cuts; flash crashes - DFX Key Themes

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JohnDFX

Happy New Year everyone!

Coming to Terms with a Bear Market

We have experienced a remarkable level of volatility recently, which is particularly incredible from the past few weeks considering markets were distorted by holiday trading conditions. When volatility meets thin liquidity, the results can prove explosive. That said, the intensifying fluctuation in the global financial system is not just a phenomenon that could be attributed to shallow markets as we have seen both the price-based results and the explicit sensitivity to fundamental triggers increase through the months preceding the official holiday season. Through the past three months, we have seen a number of specific instruments that have stood as baseline for general asset classes tip into official ‘bear market’ territory – which is defined by a 20 percent correction from a recent peak. Appreciation for the changing tide really didn’t start to peak the sense of panic however until equities started to hit the critical, technical milestones. 

When key US indices started to trip 20 percent – first the Russell 2000 in mid-December and then the S&P 500 Christmas Eve – the few that may have been oblivious were put on alert and diehard bulls started to feel a true sense of dread creep up their spines. Sentiment has notably shifted from unshakable confidence that the markets will bottom and return to their decade-long bull trend to a sense of desperation that buoyancy will hold out long enough to erase some of the losses late-comers had incurred since October or keep the window open long enough to simply exit. The bounce this past week with the S&P 500 moving back above 2,520 does play to the sense of hope. It is possible that we have found a low for the time being having only just technically hit the bear market milestone for a single day, but that seems improbable. Even with the retreat in this market – not to mention the rest of the world’s speculatively-inflated assets – we are still far from previous cycle peaks. Prominent fundamental themes from slowing growth to failing monetary policy effectiveness to deteriorating international relationships are not going to simply reverse course anytime soon. 

Further, rising volatility is looking more and more a permanent feature of our landscape. Market’s struggle to calmly inflate already-expensive assets amid tense periods of possible instability. It is possible that we have seen the low, but it would not be wise to assume that is the case. Instead, the better approach for market participants would be acclimatize to a world where we are in a bear market or on the cusp of one. Just as bull markets have periods of correction before they reassert themselves, the bear markets can have interludes of recovery. That does not mean we should commit to the about face just because it is desired. Though some people prefer longer duration, systemic positioning; I still favor taking trades with shorter duration and closer targets until it is clear that momentum has returned to the bears. 

Fed Fund Futures are Now Pricing in Rate Cuts 

Through 2018, the Fed’s steady tightening (also fairly described as normalization) efforts accelerated. The fact that the US central bank was tightening at a regular clip while the rest of the developed world’s policy authorities were still contemplating when to make their first move, or at best attempting to take bites when conditions were ideal, became almost mundane. If we were to evaluate the benefit to the Dollar from the contrast in the textbook fashion, we would assume that the Greenback should continue to climb against its major counterparts for as long as it enjoys a yield premium – especially as the spread continues to grow. Yet, we know in speculative markets that investors will move to price in the advantage as soon as it seems feasible – and they did. While they couldn’t full price in the benefit to the USD of a Fed hike regime against such a cold backdrop, it could price in a considerable advantage. 

After that high water market was set, it would be increasingly difficult to confer greater benefit – perhaps if other central banks were forced to revert to ever more extreme easing techniques while the Fed kept course – but it would be far easier to disappoint. This is what is referred to more generally as discounting the outlook. It also goes a long way to explain 2017 where the Dollar dropped steadily versus the Euro despite the fact that the Fed hiked three times and the ECB had yet to nail down a time for its first move higher. Fast forward to today. We have seen markets slump and economic forecasts drop significantly. As would be expected, the forward guidance from the central bank has cooled materially. The shift is clearly apparent to the broader market as Fed Fund futures and overnight swaps have completely reversed course on the hawkish outlook for 2019 – that at one point was fueling debate on whether they would hike three or four times through the year – with no further tightening expected. 

In fact, the next move priced into the markets is a cut with the greatest weight afforded to 2020, though 2019 was clearly being assessed as a possibility given contracts through December. NFPs and the rebound in US indices through this Friday have cooled the dovish build up, but the shift has been dramatic. It will be difficult to lift speculative enthusiasm so high again especially after key Fed officials have suggested the need for forward guidance has waned significantly.
 
What Flash Crashes Say About Market Conditions Rather than the Afflicted Asset 

One of the more remarkable episodes from this past week’s extremely unorthodox opening play at a new trading year was the flash crash that struck certain currencies (and even a few capital assets). Much of the focus was on the Japanese Yen, but it was not the only currency to exhibit extreme price fluctuation. The Australian Dollar exhibited even more extreme fluctuation in historical and percentage terms (its intraday reversal was the largest I found on record) while the ripples readily expanded out to the British Pound which didn’t even seem to connect to the purported spark to the move. 

Afterhours to Wednesday’s New York session saw headlines light up on news that Apple (one of the principal firms in equity investors’ portfolios) was lowering its revenue guidance owing to the US-China trade war. Paired with the downgrade in Chinese activity readings earlier in the day and the ongoing US government shutdown, and it was no surprise that fear would hit. With the Tokyo markets offline for a holiday, the thin-liquidity-high-volatility conditions were once again triggered with a subsequent tsunami. This time however, the market response would not play out over days and weeks with a pervasive trend but instead struck all at once with extreme intraday volatility. The catalyst did matter as any lit match would, connections to risk trends are important and certainly automated trading influences (stops, limits, algorithms) no doubt contributed. However, boiling what happened down to these elements is a misleading – but common – psychology effort to regain a sense of comfort. 

If this unforeseen disaster can be attributed to these elements, then we can feel more comfortable that it is unlikely to happen again and we can keep an eye out for the same environmental triggers. This is not an unusual development in the global markets, even for the most liquid. The Japanese Yen  saw rapid rallies followed by abrupt reversals (Yen cross tumbles followed by rebound) multiple times between 2009 and 2011 brought on by risk aversion, then monetary policy distortion and the intervention efforts of authorities (BOJ and the Ministry of Finance). The point is that conditions facilitated multiple such ‘fat tail’ events through that period, and they could continue to do so for us moving forward. It is the confluence of deteriorating investor sentiment, recognition of excessive exposure, fear that authorities cannot fend off any future financial crises and the abundance of threats to the collective complacency that currently colors our markets. While we may not see another 3.5 percent-plus swing from the Yen specifically in the near future, expect to see more developments that were considered unthinkable over the past 10 years. 

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