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Economic stagnation; ECB and other central banks; range trading - DailyFX Key Themes

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JohnDFX

Growth Takes Center Stage with Peoples’ Congress and OECD Forecasts 

Most investors and traders attempt to project into the future in order to take advantage of large market moves before they are priced in and the trend potential is spent. That is perhaps the most basic precept of speculation, yet it also brings with it a range of collective cognitive biases. One such mass psychological distortion is a prioritization of the means over the ends. When looking back to the 2008 financial crisis, there is often specific reference to the US subprime housing market implosion while 2000 is referred to as the Dot-com bubble owing to the remarkable outperformance followed by decline of technology shares. Both situations were charged by excessive leverage and resulted in both financial and economic pain, but they are best remembered by their ‘touch off’ event. Why is that? As pattern recognition machines, humans want to avoid a repeat of a painful event from the past, but we don’t always bore down to the root of the problem – especially when the situation is complicated or inconvenient (such as chasing mature and fundamentally dubious trends). At present, we have a range of high-profile fundamental themes that could ease experience another flare up that coincides with the eventual turn of the markets (trade wars, monetary policy flub, fiscal policy flub, political crisis, diplomatic relationships breaking down, etc). 

Yet, in a neutral market environment, all of these issues could be absorbed readily with little more than a brief injection of volatility. To see the market reverse course systemically, the fuel is more important than the ignition. As with most other periods of extravagant speculative reach – which have subsequently turned to collapse – we are dealing with an overabundance of leverage across the global economy. It doesn’t matter if we reference location (US, Europe, Asia) or participant segment (consumer, investor, businesses, governments), there is an exposure issue. As extensive as the risk may be, it doesn’t necessarily reach an obvious or quantitative level of critical mass whereby it collapses upon itself. As the saying goes: ‘the markets can remain irrational longer than you can stay solvent’. That said, recognition across the market that the ‘fundamentals’ are extremely divergent from the prevailing levels in the market will eventually trigger a cascading of hold out sentiment capsizing under the recognition. Arguably the most incontrovertible evidence that value does not align to speculative ambition are broad measures of economic health like GDP. We have absorbed most of the 4Q GDP readings from the US, Europe and Asia over the past month, and the general consensus is one earning clear caution. Of course, the period may prove a lull or a true turning point, but only time will bear that out. 

Yet, the impatient, speculative nature of the market may dictate determination before the data has a chance to verify months after it occurs. More timely data and surveys are therefore consumed veraciously as market participants perform their qualitative or quantitative assessments. References to historical, market-based patterns (such as the yield curve) grow in popularity. All this said, there is still greater weight attributed to ‘official’ figures. In the week ahead, we have a few important updates that will represent ‘official’ benchmarks. For the trade war-racked Chinese economy, the effort to throttle a debt-fueled explosive expansion threatens to trigger an unwanted rapid economic slump. How genuine a risk is this from a country where data is just as regularly second guessed? Their own growth target provided in the official Peoples’ Congress is one of the most insightful measures we find from the world’s second largest economy. In the meantime, the developed world will see a more comprehensive update to its growth forecast from the OECD who will release its updated projections mid-week. The more sensitive the reaction to these data points, the more worried about basic growth the market is. 

Monetary Policy and a Possible Repeat of History for the ECB

The world’s largest central banks have taken a noticeably dovish shift over the past year. Many were unnerved by the disruption in global markets through the first half of 2018, but the second extreme bout of volatility in the fourth quarter and subsequent downturn in the economy in that same period has pulled most holdouts into the same camp. In recovery that unfolded after the Great Financial Crisis, monetary policy authorities played a critical role in fostering the revival of investor sentiment and economic stability. Yet, their efforts over the past five, where the more extreme expressions of monetary policy hit their stride, resulted in far less productive economic return (inflation and growth). Not official objective, but nevertheless a sought-after result, additional waves of stimulus have also seen progressively less appreciation for local capital markets (targeting a ‘trickle down wealth effect’) and even a disconnect from forcing a trade-supporting depreciation in currencies. While in previous years this was not a mainstream topic of conversation as the impact was nuanced and there were supporting factors concealing the erosion of efficacy, it is now a glaring disconnect that the market is instantly wary of should reliance of economic health shift back onto the banks’ shoulders. 

This may be a trial that we are not able to avoid as the global economy sputters and the world’s governments’ show little interest or capacity to collaborate on a scalable solution. Thus far, most of the movement towards a more accommodative monetary policy position – from the already ‘crisis’-level setting for most – has been verbal. However, action may soon be on the way. Swaps are pricing in modest probabilities of rate cuts from the Fed and RBNZ with the RBA sporting a high probability while the Bank of Japan continues to inject stimulus with reckless abandon. The most overt signal to the global financial system that central banks have lost control would come from the European Central Bank should it decide to act. The group has just capped its progressive easing effort as of December and it finds itself already at the extreme with negative rates along with a massive balance sheet. Unlike the Fed, the ECB hasn’t given itself enough time to reestablish a buffer to employ further support should push come to shove. That said, the group has started to signal growing caution and seems to be testing the market’s reaction with thinly veiled suggestions of another policy adjustment. 

Despite this, going back to the QE program is not an option while further rate cuts deeper into negative territory would only prove the current settings are ineffective. Another tool has come back into the conversation from the Eurozone debt crisis days: LTROs. While not the same stigma as quantitative easing, it is nevertheless a tool looking to do the same thing – coax along stubborn economic recovery. The last time this central bank connected policy to economic trouble (at the time, it said the interest was deflation sustained by a too-strong currency), the side effect was an incredible 3,500 pip slide in EURUSD. If even a portion of that depreciation were realized today, the competitive trade environment would almost certainly trigger a currency war. And, in this environment, that would almost assuredly result in a stalled global economy and financial crisis. 

There is More to Trading Than Spotting Explosive Breakouts and Trends 

This is something I have written on before, but it is so important that it bears repetition. There is more to trading than spotting fantastic breakouts or riding enormous trends. These are the kind of market developments that can result into large profits if properly navigated, and the former tends to render those large returns more quickly. Large returns in a short timeframe is what every market participant is looking for, but these events are statistically infrequent and require considerable discipline to exploit. So, those seeking these conditions are projecting improbable regularity and they more-often-than-not do not have the experience to properly pilot. That is not a successful strategy. 

In contrast, range or congestion-based markets are historically the most common environment. Further, the shortened time frame of market moves, the greater compliance to technicals and a more forgiving connection to fundamentals (events and themes) makes for a backdrop that is far more aligned to the average traders’ tendencies. So, why do so few traders look to take advantage of these conditions? There are a multitude of reasons but among the most common are an unrealistic appetite for extreme returns in a very short time frame as well as a misconception of what successful investors are (everyone wants to be the hedge fund manager that makes an incredible account doubling return on one trade). 

This digs not into the conditions of the market or even strategy in particular but rather it speaks to trader psychology. If we can change our objective to more timely trades with reasonable objectives that lead to respectable returns over time, we will naturally align ourselves to more readily take advantage of the market. Now, this is not to say that we are always navigating a range-based market – only that such settings are the most common. The most prepared market participant is the one that has a different strategy or adaptations of a single strategy that are more appropriately attuned to range, breakout and trend environments. Of course we also need the tools to assess which setting is currently on display. 

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