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JohnDFX

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  1. There is Way Too Much for the G20 to Cover Typically, the G-20 summits that brings together leaders for some of the world’s largest developed economies cover matters that are important but not especially urgent. For the meeting in Osaka, Japan this coming Thursday and Friday (June 28-29), the members will officially and unofficially have to cover topics of exceeding importance. That would seem unusual considering we are still in the longest bull market on record and the closest state to general peace that we’ve seen in some time. On the official agenda are: global economy; trade and investment; innovation; environment and energy; employment; women’s empowerment; development; and health. As you can imagine, there will be certain themes that are more loaded than others and likely to generate more friction in group discussion as well as sideline talks than others. Since negotiations last broke down and the US raised its tariff rate on $200 billion in Chinese imports – to which China moved to match the tax on $60 billion in US goods. Trade wars will be the most frustrating topic to discuss for most of the members. In particular, the US and China have used this gathering as a timeline for the next stage of an ongoing trade war between the two economic giants. Since negotiations last broke down and the US raised its tariff rate on $200 billion in Chinese imports – to which China moved to match the tax on $60 billion in US goods – the rhetoric between the two has ranged between mild encouragement to outright threats. If President Trump’s timeline holds, the stakes are high for a breakthrough between the two. After the last move to raise the stakes, the White House said it would expand its onerous levy against its trade partner to encompass all of its goods coming into the US (another $300 billion or more) in ‘three or four weeks’. That time frame has come and gone which prompted negotiators to move out the deadline to a natural conversation between Trump and Xi at the summit. If these two fail to come to an understanding in order to de-escalate their economic conflict, it will represent the biggest notional curb on growth thus far. It would also almost certainly usher in the next stage of unorthodox measures as the options for retaliation have expended standard arsenal. China cannot meet the US like-for-like with straightforward taxes and will therefore need to consider actions on rare earth materials, blacklisting US entities, US asset exposure levels, exchange rate manipulation and other as-yet unmentioned options. The circumstances between these two giants is enormous but it is even more desperate for the other countries around the world who are caught in the middle as collateral damage. Further, depending on how President Trump views the benefits-risk balance of the affair with China – and conversely Mexico and Canada – there is the persistent risk that the Trump administration could expand its trade vigilantism against host Japan, the Eurozone and many of the other G-20 members. One thing is clear from previous gatherings of state leaders, President Trump does not respond well to multiple countries ganging up on him whether through aggression or frustrated pleas for reason. While trade will likely take up a disproportionate amount of the mental focus, there are further matters of flagging economic growth and geopolitical tensions to discuss. Trade is compounding a general cooling of economic activity and there is an unmistakable awareness as to the limitations of over-extended monetary policy. Further, protectionism is casting plans to offer more through burdened central banks and even plans for fiscal policy as provocative means to compete to the detriment of global peers. As for global relationships, there are many points of fray, but the only area where a military war seems a genuine risk at the moment is between the US and Iran. The downing of a US drone by Iran followed by reports that a retaliation was green lit then forestalled has raised the threat level enormously. Perhaps after these ‘manufactured’ issues are thoroughly covered, we will see a serious discussion on ingrained concerns like the environment and gender equality. The Market Prefers Its Own Interpretation of the Fed’s Options Sentiment in the global markets is a force of nature. It can readily overpower subtlety which is what happened this past week following the FOMC rate decision. At its ‘quarterly’ gathering, the world’s largest central bank held its policy mix unchanged with a benchmark rate at a range of 2.25 to 2.50 percent while its balance sheet efforts held trajectory. While the market had afforded an approximate 25 percent probability of a cut, there was little actual surprise and repositioning to be registered by the market. When it came to forecasts, however, there seemed to be outright disbelief; and the markets were willing to run with their own interpretations of what the future held. Looking to the group’s own Summary of Economic Projections (SEP), there was an official forecasts for no change to the current rate spread through the remainder of this year, one 25-basis point cut projected in 2020 and a subsequent rebound to our present altitude in 2021. That strayed dramatically from the market’s own debate over two or three cuts this year and further easing at a similar pace into 2020. Given the nature of speculation, we will be left with a state of hyper vigilance around data and rhetoric from Fed officials that reinforces the market’s skepticism or contradicts it. After the Fed’s attempt to throttle expectations, the markets only solidified its forecast with Fed Fund futures and overnight swaps showing the probability of three quarter-percent cuts this year rising to near certainty. Now, to be fair, the breakdown of the SEP’s rate forecasts shows an optimistic outlook for growth while the ‘blue dots’ indicated beyond the median vote that 8 members expected cuts and 7 of those assumed two 25bp moves. It would not be difficult to tip that balance should the economy start to flag more seriously. While capital markets are holding relatively steady through this disparity (and the Dollar has finally started to show the risk of lower returns and the economic state that would necessitate the response some deference), the divergent paths these forecasts represent are extreme and necessitate a convergence. That merging of views will come with significant market response whether it is speculative enthusiasm closing the gap to the central bank’s forecasts or vice versa. Given the nature of speculation, we will be left with a state of hypervigilance around data and rhetoric from Fed officials that reinforces the market’s skepticism or contradicts it. There are many prepared speeches among various members scheduled this week. That is likely on purpose as members make an effort to reinforce forward guidance. The members more on the extremes of the policy curve will be important to watch but the centrists and Chairman Powell’s scheduled speech are arguably the most important. On the data side, the Fed’s favorite inflation indicator, the PCE deflator, is due. Keep tabs on forecasts for Fed intent, because the record high from the S&P 500 that encouraged other risk assets higher, has drawn much of its lift from favorable US monetary policy. My Greatest Concerns: Recognizing Monetary Policy’s Bark is Bigger than Its Bite and Trade Wars Turn Into Currency Wars While my greatest fears for the future are ultimately a global recession, financial crisis or the beginning of a global war (much less all three); there are certain intermediary events that are more probable and could more readily usher in those systemically disruptive states. And, as it happens, they relate to both the aforementioned concerns. As chaotic as trade wars seem to be through their development and potential risk to the norm, they are at least conducted in measured and definable steps. The Trump administration has signaled its intent and indicated the criteria for which would trigger further escalation or a walk back of existing burdens. The other countries engaging the US or other global players have done the same. It is true that the decisions to intensify or cool the fight have been flippant at times, but it seems to always followed a clear lines of tactics and escalation. This is not the same pace that is employed when the fight shifts to exchange rates. The world’s largest central banks had to cut their rates to near zero and inject the system with extraordinary amounts of stimulus in order to make [an unprecedented climb in capital markets] happen Currency wars are inherently messy. They can confer significant economic benefit to those employing the tactics and detriment to all others. There is significant disagreement as to what constitutes a country pursuing this unfair line of policy which leads to fights out of sheer misunderstanding. And, ultimately, there is tendency for a retaliatory policy to escalate rapidly. We haven’t seen many genuine claims of currency manipulation over the past few decades, but the Japanese authorities were forced to quickly backtrack on a ‘misstatement’ and the Chinese Yuan has a permanent question mark next to it. That said, with trade wars underway and the US President not shy of labeling China’s and Europe’s currencies unfairly devalued, it seems risks now are far higher than they’ve been in generations. It is difficult to pull up from a currency war, and evidence shows these are not the leaders that are likely to let cool heads prevail. The other escalation that plagues my fears is: what happens should the markets develop an unshakable sense of skepticism around central banks’ ability to maintain control? The past 10 years has enjoyed an unprecedented climb in capital markets and underwhelming average pace of expansion. The world’s largest central banks had to cut their rates to near zero and inject the system with extraordinary amounts of stimulus in order to make that happen. While we have long ago restored record highs for the likes of the Dow and seen GDP stabilize in expansionary territory, most of the banks kept going. The reasoning was that either the extreme support was needed to keep the peace or it was worth it to leverage just a little more growth. Regardless of the justification, it meant that there was very little effort to re-stockpile policy ammunition for any future troubles. Now, as pressure seems to be building up once again, the markets are clearly looking to the Fed, ECB, BOJ and others to head off crises. If we were to reasonably evaluate what happens in the scenario where we face another slump, there should be little confidence that monetary policy could truly hold back the tide. That said, limitations for future troubles will start to trace back to an assessment of the current structure’s ability to keep the stability we currently enjoy. If central bank credibility were to truly falter, the fallout would be severe -all the more for the fact that it would commence from record high prices (with arguably a record gap to value).
  2. It’s Okay, This One is On the Fed There has been a notable shift in the market’s mood in just the past week. A sense of dull complacency that traders who were active during the first wave of the large scale, central bank stimulus infusions would recognize has bolstered key assets. After the benchmark S&P 500 and Dow topped at the beginning of May, a steady slide in the indices encouraged the same sinking feeling in conviction that was dependent on complacency. Evidence that we are the late stages of the economic cycle, the business cycle and the market cycle is piling up. Normally, as the pace of expansion flags, we find the market’s tolerance for lowered speculative potential is partially offset by higher rates of return as the demand for funds drives yields higher. However, the record-breaking bull trend that we have enjoyed over the past decade defied that particular convention as its initiation and extension was supported through extreme accommodation from central banks – first lowering interest rates to record levels and then adoption quantitative easing measures. While this would help stabilize financial markets and help stimulus growth, it would also necessarily lower rates of return to be expected from the investing. After a while, it grew more and more apparent that the latter waves of support produced less and less traction towards economic objectives (bolstering economic output and inflation) but they nevertheless ensured a lower baseline for expected returns. With a presumption of indefinite support by monetary authorities and a highly competitive financial market, it should come as little surprise that moral hazard would thrive. It is that base assumption that exceptional risks taken in recent years to drive assets of questionable value to record high prices (like the S&P 500) would be discharged by the Fed and its international peers. The anticipation is impossible to miss in the markets with Fed Funds futures pricing in an 85 percent probability of a 25 basis point cut by July and a healthy chance of multiple cuts before year’s end. Considering President Trump has called out the central bank multiple times over the past months and economic warning signs like the inversion of the 10-year/3-month yield curve have garnered greater attention, the assumption of more assistance comes as little surprise. Language from the Fed Chairman Jerome Powell, other board members and even official communiques have also made clear a willingness to step in should growth stall. My concern is not whether the Fed and others will step in should we lose traction, but rather what happens as we realize their limited capacity to extinguish further financial fires. The Fed arguably has the greatest capacity of the major central banks as it has tightened rates around 200 basis point since its first hike in December 2015. Yet, that isn’t a particularly sizable arsenal when we consider how little economic amplitude we leveraged from the massive stimulus programs and given how much more premium in capital markets they are expecting to keep propped up – the S&P 500 rose another 39 percent beyond 2015’s peak. If actions by the Fed fail to steady the market, it would do far more damage to sentiment Don’t Forget the Trade Wars Are a Thing With the recent rebound in speculative market benchmarks, there is an innate tendency to seek out favorable fundamental winds in order to justify the prevailing bias. Anticipation of further support from the Federal Reserve is one such rationalization for speculative lift, but another potential source of confidence heading into the new trading week is the Friday evening news of a trade war breakthrough. Following the week’s end market close, President Trump announced in a tweet that a deal had been reached with Mexico for the country to take action on stemming migration through the country destined for the United States in order to avoid a 5 percent blanket tariff on all Mexican exports destined for the US. This warning was made less than two weeks ago and it was roundly criticized by members of Congress, US business leaders and (reportedly) even White House senior staff. That means the market likely maintained a hefty skepticism that the threat would ever be put into action. As such, we now await the new week’s open to see if there is a flush of relief rally to play out or if the markets will struggle despite the faux breakthrough. Meanwhile, progress on one front of trade dispute for the US could be used as justification to escalate tensions on another in a bid to force capitulation. The last official action in the US-China standoff was a hike in the tariff rate by both countries on each other’s list of target goods ($200 billion and $60 billion worth respectively). Treasury Secretary Steven Mnuchin said over the weekend that the President would be “perfectly happy” to fulfill his vow to expand the list of taxed imports to all of China’s trade – over $500 billion in goods and services. If imposed at the prevailing 25% rate, that would translate into an incredible 250% jump in the notional bill of the trade war on just one side of the battle line. Perhaps even more troubling would be China’s inevitable retaliation. The country has already maxed out the like-for-like goods for which it can impose a tax. That would mean it would have to resort to further unorthodox means. With the US already moving to ban Huawei, it seems inevitable that the Asian giant would move to blacklist a number of important US technology companies. It is also very likely that it would throttle shipments of rare earth materials – for which it is the world’s largest producer – to hit the production of cellphones and other consumer technology. While that bill will add up over time, it is likely that China will pursue additional means of pressure in order to have a more pointed effect. A concerted selling of US corporate assets is the next logical line, but many are watching for Yuan depreciation or a strategic selling of Treasuries. Those are unlikely however as the financial repercussions would be too severe with necessary losses in their own capital exposure and a high probability that other countries rally to the United States’ cause. An Inconvenient Time to Worry About Eurozone Stability With the US Dollar losing viability owing to its pursuit of trade wars that undermine global stability, the Pound plagued by a directionless Brexit and the Japanese Yen lost in a deflationary quagmire, there is an acute need for a stable benchmark currency. Despite its many fundamental shortcomings, the Euro showed itself willing to offer an outlet for liquidity over the past few years as the recovery from the region’s sovereign debt crisis between 2009 and 2012 seemed to offer a sense of hard-fought stability that was prized above all else. When the European Central Bank (ECB) veered off its course to normalize policy following the December cap on its open-ended stimulus program – by implementing a new targeted-LTRO – the Euro’s appeal deflated significantly. With a renewed sense of dubiety, we have seen attention turn to other cracks in the Euro’s perceived durability. Perhaps the most tangible of the unique risks facing the shared currency is the pressure brought by its third largest member: Italy. The coalition government of staunch anti-EU parties has struggled to find a common cause outside of the general revolt against the European cause. After the Prime Minister threatened to resign over infighting by his government, the coalition parties seemed to settle their differences for now but that would not translate into any renewed support for the Union. In fact, the unifier between these extreme parties seems to be their agreed-upon discontent. Last week, one of the deputy Prime Ministers stated clearly that Italy would not change course from its plans to offer its citizens relief through tax cuts. In the meantime, the European Commission found the country warranted a preparatory document on disciplinary action over its financial position. According to deputy PM Salvini, this could amount to a 3 billion euro hit. The country and Union leadership can draw this fight out for some time before we reach the limits of financial stability as Greece showed us nearly a decade ago, but the market is unlikely to allow the pressure to build up for that long before it starts to price in a systemic threat. In the week ahead, the Eurozone and European Union finance minister meetings will no doubt discuss this situation, and any uniform positions will not pass unnoticed. Generally-speaking, the Euro would not retain the same global reserve that it represents today if one of its core members were to make a credible threat of withdrawal. That is still very unlikely, but there are first stage cracks that are being threatened that could build an unplanned head of momentum: It has been suggested that Italian authorities are considering the use of an ‘alternative currency’ to service its debt, a move that naturally ushers in reasonable speculation of a stability concerns underlying the Euro. As the second most liquid currency comes under pressure, it is natural to keep tabs on the only more ubiquitous benchmark – the Dollar – but I believe gold is the best measure to our particular set of financial uncertainties as the 2009-2011 period surge stands out for those seeking alternatives to the traditional currencies.
  3. Trump Using Mexico as a Trade War Warning to China? In a surprise move, the United States is now fighting a full trade war on two fronts as of this past week. With the path to a US-China compromise still lacking any clear hand holds, US President Donald Trump announced a wholly unexpected economic move against neighbor Mexico this past Thursday evening. According to his tweet, the United States would charge a 5 percent import tax on ALL Mexican goods coming into the country as of June 10th. He further made clear that this was move not in retaliation for trade issues – in fact conditions had seemed to improve significantly on that front with the US dropping the steel and aluminum taxes on both of its direct neighbors in a bid to push through the USMCA agreement. Instead, Trump said that this move was in response to his administration’s frustrations with illegal immigration from Mexico into the US. This political move drew serious consternation from a number of officials and institutions. Aside from the obvious Mexican bewilderment and condemnation; it was reported that Trump’s senior advisers (Mnuchin and Lighthizer) had argued against the move, Congressional members on trade and finance questioned the motivations and the economic impact and business groups in the US moved to bring legal action in a bid to prevent the inevitable hike in their supply chain costs (GM for example produces an estimated 30 percent of the cars it sells in the US in Mexico and could absorb a $6.3 billion hit). Trump said that this move was in response to his frustrations with illegal immigration from Mexico into the US We are starting to see some of the disparate systemic themes that have individually pulled at the markets – trade wars, political risk, growth concerns – begin to converge. There is little doubt that the growing chants of impeachment from some portions of the Democrat party are pushing the President to a more aggressive stance with domestic and foreign policies. Looking to secure a ‘win’, he is attempting an alternative route to curb illegal immigration to circumvent the roadblock in Congress. This solution, however, carries serious threat to growth and diplomatic relations; and the possibility of an alternative source of support via an a delicate infrastructure spending program negotiation which would rely heavily on Democrats seems a non-starter. As this new fissure grows, it is important not to forget the extraordinary and expanding risk from the US-China row. It has been a few weeks since the US hiked the tariff rate on $200 billion in Chinese imports from 10 to 25 percent and China’s matching retaliation on $60 billion in US imports (which went into effect June 1). The mood has only further soured since this salvo. The banning of Huawei – China’s largest telecommunications company with a global presence – has lead to considerations of a response through Apple, using rare earth materials and reports of a recent draft on US companies that could be partially or completely blacklisted. Theoretically, the US is counting down to an expansion of the goods it is taxing to encompass all of China’s imports, but that timeline doesn’t look solid. The US and Chinese Presidents are due to meet at the end of the month, but a lot can happen between now and then. What’s truly worrying is that both sides are increasingly favoring escalation in a bid to break their counterpart’s will – a game of economic chicken. Ignoring the Fallibility of the Dollar’s Reserve Status There is general acceptance that the Dollar is the world’s most liquid currency backed by the largest economy and market. That is easily confirmed through data, but with these statistics comes a level of undeserved assumption. Because the country is a superpower and the use of its currency around the world accounts for nearly two-thirds of all global transactions, it is assumed by many on faith that these standings are permanent. I would venture a guess that the British felt the same way 100 years ago, the Spanish 300 years ago or the Romans two thousand years ago. Looking far enough into the future, the US Dollar will not be the principal means of transaction, whether that leads to a direct and singular counterpart (Yuan?), an aggregate (the long-fabled effective SDR) or the era of the blockchain. Regardless of the next epoch of money, there was an inevitable move towards evolution as the rise of global trade and spread of wealth around the world raised issues with transacting through third parties. A plan to pullback on economic ties to the United States translates into a diminished use of the US Dollar which in turn reduces the need to hold the country’s currency and risk-free debt as a financial balance. The bottleneck risks from a common currency were further exposed in the last two financial crises. The excess leverage produced by the Dot-com bust was particular acute in the United States which witnessed a convergence of economic strength, favorable policy and supportive regulation to land on an investment phenomena. When the excess peaked and started to cave in on itself, the fallout was transmitted to the rest of the world. The following financial crisis in 2008 was even more obvious in its amplification of a US-originated problem (subprime housing) tipping the global dominoes until an unprecedented response from the world’s policymakers was the only feasible means of restoring stability. Many governments and institutions in the aftermath of this worldwide crisis stated some level of need to mitigate future contagion risks by reducing their unchecked exposure where possible – including the dependency on the US Dollar. Yet, the haste to make this shift was throttled initially by extreme monetary policy creating fragility in domestic financial paths while the economic expansion also encouraged feet dragging. That landscape has shifted however in recent years with a slowdown in global growth that looks natural in the waning light of the cycle while barren monetary policy stores looks increasingly incapable of holding back any storm tides. It is in this troubling convergence that populism has taken hold. Policies that favor domestic growth at the expense of shared expansion lowers the aggregate potential for the global economy but it sells well to the electorate. The Trump White House has certainly seized on that fervor with the President pushing for trade policies that look to correct perceived imbalances. If the US kept its fight isolated to China, there would be little outcry from other developed and developing economies that have felt the Asian giant’s policies unfair. That said, the US has embarked on a global fight with the metals tariffs from last year, the emergence of the Mexican tax, lingering threats made against Europe and the lurking consideration of a global auto import tariff. When the world’s largest consumer raises barriers, it can be difficult to retaliate in a meaningful economic way. However, when there are many countries that share the burden and willing to cooperate in order to ease the pain – and deliver some punishment – there is greater capacity to retaliate as a group. A plan to pullback on economic ties to the United States translates into a diminished use of the US Dollar which in turn reduces the need to hold the country’s currency and risk-free debt as a financial balance. That accelerates the seismic tide changes in currency dominance and economic position. Add to that the pressure through forced sanctions (such as the demands to trade partners to stop doing business with Iran) and the need for an alternative route increases further. Even at this pace, it will be a very long time before the Dollar is fully supplanted, but the measurable influence will show through far more quickly. A Jostle of Growth Data, Monetary Policy and Brexit Ahead My number one rule for the successful employment of fundamental analysis is to determine which theme or themes will carry the greatest potential influence. It seems intuitive, but many traders will end up assuming far greater weight to every known event – especially those that are prescheduled – than is reasonable. And, when you assume greater influence for every eddy in the market’s stream, you inevitably drown out those factors that are truly market moving. In gauging the fundamental landscape ahead, there are both themes and specific events that hold the potential of significant volatility or trend development if they render the proper outcome. Aside from the dominant force of trade wars, monetary policy will be a substantial influence over the coming days. The most pointed events in this vein will be the RBA and ECB rate decisions. According to overnight swaps there is an approximate 95 percent probability of a rate cut. That degree of discount means an actual cut is likely already priced in, so the Aussie’s response will depend on either the language in the aftermath of the cut or a surprise hold. As for the ECB, they have already made their dovish move a few months back with a hold on any intent for rate hikes and the deployment of the LTROs to compensate for the end of QE. This is a mess of exit from extreme easing and it leaves serious questions about the health of the global economy and financial system. In addition to these two policy calls, we have a host of central bankers speaking including the chiefs of the Fed (Powell), BOJ (Kuroda) and BOE (Carney). With the growing interest in market measures like the US yield spread, this stands to be an important theme ahead. Another collective theme that will find significant prompting ahead will be the general concerns for the state of economic growth. We have received most of the 1Q GDP figures at this point, but Australia is due its own figure. Instead, we will look for more timely metrics that act as good proxy to the big picture. There are a range of monthly PMI stats for May due – though the US and European figures are ‘final’ measures. The US ISM metrics are given considerable credit as are Japan’s quarter capital spending report, the US quarter net household wealth and NFPs data. It is not the concentration for any single economy that matters here but rather the breadth of the statistics that can form a clearer picture of global growth. With the growing interest in market measures like the US yield spread, this stands to be an important theme ahead. In terms of region-specific event risks that are worthy of our close watch, I will dedicate significant mental energy to following the progression of the Brexit situation for the Pound and the EC-Italy fight for the Euro. on the former, the British and European conversations on terms for divorce are actually still on ice. That is due to the long reprieve afforded the Article 50 extension but also the state of politics in the UK. Prime Minister Theresa May is due to step down on Friday and the leadership battle is clearly underway. The PM’s shortcomings and the EU Parliamentary election results are likely to encourage support for a candidate that is more friendly to using the no-deal outcome to make progress on the separation. That of course means greater uncertainty and preemptive capital flight as the markets await the fog to lift. In Europe, the cohesion among EU members will come under scrutiny with a number of events scheduled around the state of play in Italy. PM Conte was shown strong supporting in the EU Parliamentary elections, and he is looking to pull together the various countries’ nationalist seats. Given their stated policies, a loosening of cohesion to the foundations of what holds the Euro together will be a consequence. Alternatively, the European Community is not simply waiting for the disruption. The group is due to take up its review of Italy’s breaking financial rules, which Deputy PM Salvini recently warned could land Italy a 3 billion euro penalty recently.
  4. Are We Turning the Corner on Global Trade Wars? There were a few very prominent, positive developments on the trade war front this past week, but is it enough to systemically change the course of the global economic standoff back towards the cooperative growth of the past? Throughout the past week, there was a building din of unconfirmed reports that US President Donald Trump would delay the decision on whether or not to apply tariffs on auto and auto part imports at the May 18th initial deadline to the Section 232 report the administration ordered to investigate the competitive field. As the headlines channeled unnamed officials trying to assuage investor fear, the market slowly stabilized and started a tepid climb. Full confidence was withheld however as participants were still shell-shocked from the sudden reversal on US-Chinese relations the week before. Rather than wait for a weekend reveal to potentially leverage news cycle response and a Monday market swell, the President confirmed Friday morning through his press secretary that he would delay the decision ‘up to 180 days’ as negotiations continued. Technically, this is only a delay, but previous stretches of peace have been occasion for speculative interests to rally in the past. Interestingly, the market responded to the official news with a weighty skepticism, squandering a recovery developing through the second half of the week. There was another chip to play to potentially rouse the bulls to life. The stalled progress on the North American economic pact – replacing the long-standing NAFTA accord with Trump’s centerpiece USMCA – could find a jump should the White House drop the steel and aluminum tariff quotas on Canadian and Mexican partners. That would lower Congress’s reservations towards the deal and perhaps secure a clear ‘win’ in the course of a global trade war. The administration issued another confirmation Friday that it had done just that - removed the metals tariffs on those key trade partners – and Trump issued remarks shortly thereafter calling on the Legislature to pass the stalled deal. Yet again, the news was met with an apathetic response. Averting a dramatic escalation of ongoing trade wars (autos) and making strategic moves to realize previously stated plans (USMCA metals) carries limited sway when compared with the full stride of the US-China trade war. A week after the US ramped up tariffs on $200 billion in China’s goods from 10 to 25 percent and China retaliated on $60 billion in imported US goods (also up to 25 percent), we have seen strong language from both sides and reports that efforts to restart talks have thus far failed. This standoff is not a practice in academic curiosity but an earnest throttling of economic activity. We have seen the consequences of the higher costs and restrictions bleed through in the wide run of Chinese indicators while the US sentiment surveys and inflation reports show a more subtle, but still nefarious, influence. There are still approximately three weeks for the two sides to make headway according to the President’s warnings before the US expands it imports tax list to include all of China’s goods (they estimate another $325 billion). Speculative appetites may be such that they simply won’t run simply because they have a little longer leash. However, my concern is that we are already seeing the fruits of full expectation that this trade war will be resolved. If all of these artificial encumbrances are removed and the market still fails to gain altitude, the recognition of a decade-long cycle end may be difficult to miss. Is the Second Quarter Going to Cap Recovery Hopes Since the United States issued its better-than-expected first quarter GDP update, there has been a notable shift in the outlook for global economic activity. Before that milestone, there were mounting concerns that the cumulative effects of trade wars, central banks easing off the accelerator on monetary policy and feet dragging on fiscal policy were converging with natural late-cycle economic struggles. What the official quarterly growth update from the world’s largest economy was less of a definitive turn in conditions and more of a boost to sheer sentiment. Mere collective bias can dramatically change the way market’s move in terms of direction and tempo by amplifying the ‘favorable’ developments and tempering the fallout from the ‘adverse’. This prejudice of systemic speculative appetite will be put to the test moving forward on a number of key issues. The resurgence of the US-China trade war turns the focus onto the snowballing pain absorbed as long as the fight continues and any sign of intent for central bank support moving forward can be offset by a practical appreciation as to what the stretched monetary policy authorities can even hope to deploy. There real traction on sentiment however will always take more readily from unambiguous data. While sentiment surveys are still vitally important to translating the abstract issues into intent for investors, consumers and businesses; there is more mileage in price action from clear growth data points. On this point, we will be processing a number of updates through the forthcoming week that will cut right to the heart of the growth question. The most comprehensive ‘backwards’ update will come in the form of the advanced PMIs (Purchasing Manager Indexes) for May. We are due updates on manufacturing, service sector and composite activity readings from Japan, the Eurozone and the United States among other countries. As we’ve discussed before, the correlation between these proprietary – and timely – economic measures and the official – and slow – quarterly GDP figures is remarkably high. A strong showing in this run of data could beat back growing concern, but it will struggle to topple an entrenched bias. On the other hand, a poor showing could shake loose the hold outs in the financial system like the S&P 500 and other US equity indices to compound fears. There is plenty of complementary growth data that can subtly change course but much of it is dated (like the Japanese 1Q GDP update) or too narrow in focus (such as the US durable goods). If you are looking for a better line to project growth, keep an eye on the OECD’s updated growth forecast. As far as supranational group economic projections go, this group tends to hit close to the mark. The EU Parliamentary Election’s Influence Over Euro’s and Pound’s Future Perhaps one of the most influential events on the docket for the coming week is the European Parliamentary elections starting Thursday the 23rd and running through Sunday. As far as systemic but abstract fundamental themes go, there is enormous economic and financial influence from the pursuit of nationalistic interests. Frustrated by slower measures of growth these past years, global citizens and politicians have taken to escalating the portion of blame to be assigned to strategic economic and diplomatic relationships with other countries and regions. Never mind that the leverage from global growth over the past decades would have been far less expansive if it had been just the collective efforts of domestic agendas. In Europe, the threat of populist interests could turn into a existential risk. The European Union and Euro-zone (the narrower monetary collective) are held together by the belief that economic might – and no small measure of militaristic security – is dependent on their cooperation. That said, there has been an unmistakable rise in nationalist fervor across Europe with previously unrepresented parties gaining significant presence in governments. Perhaps the most prominent example of this political shift comes from Italy which is ruled by a coalition government that ran on a platform that was not shy about its anti-EU views. Alone, Italy represents a threat to stability for the EU and the shared Euro. Deeper rifts may develop as representation in the EU Parliament is sorted if we see a universal foothold in anti-Union sentiment. The stronger the showing from anti-EU/Euro representation is, the more fragile the future for a collective Euro. If there were an overwhelming threat to the economic alliance to draw from the results, it would not be a stretch to expect EURUSD to fall to parity through 2019. Another perspective to watch in the vote is the UK’s position. They have opted to participate in the election even though they intend to withdrawal from the EU as a requirement to earn an extension on their Brexit proceedings. The rhetoric from the British government has born little-to-no fruit with the allowance of additional time, and now the citizenry is likely to punish the principal political players for their inability to move forward and compound economic loss along the way. According to recent opinion polls, the Labour party was still in the lead for intended votes but it gave up a significant portion of its base to the new Brexit party. In the meantime, the Conservatives that are currently leading government are expected to drop back to fifth in the standings losing the bulk of their support to the aforementioned new entrant. This vote will also be used as strategy to force a vote on the Withdrawal Agreement and the timeline for the Prime Minister, Theresa May, stepping down. The Sterling does not need more reason to succumb to pressure.
  5. Trade Wars Between the US and China – Perhaps the US and the World The world seemed to be on a very different path a week ago. Through the close on Friday, May 3rd, the rhetoric serving as forward guidance for the US-China trade war was clearly being directed to suggest the end to the economic conflict was at hand. That took a dramatic turn two days later when US President Trump contradicted the leaks of an impending compromise and deal by stating clearly that the United States would raise the tariff rate on $200 billion in Chinese imports that were being levied 10 percent to an even more punitive 25 percent. True to his word, the President ratcheted up the trade war between the world’s two largest individual economies. While this may not have the same level of shock impact as the first venture into the current trade wars, it is notionally the largest escalation and a peak in this period of ‘growth at the expense of others’ policy. With the upgrade in the tariff rate, the White House issued a further direct warning making it clear that the US is willing to push forward and tolerate its own economic and financial blowback to redirect the course of a trade partner that has long defied the conventions of free markets by pursuing emerging market tactics. According to the Trump administration, China has ‘three to four weeks’ to compromise on the United States’ key demands or the trade burden will expand to another $325 billion in Chinese imports (though 2017’s total imports was only $505 billion). Given last week’s unexpected escalation, there is increasingly less skepticism that Trump will avoid further dramatic moves that hold economic consequence for the US as well. Given the US has pushed forward with an exceptional escalation in the trade wars as of early Friday morning, the market’s reaction through the session that followed comes as quite the surprise. After an initial tumble across the board through morning hours, the week’s final session closed to gains for the S&P 500, the VEU rest-of-world equity ETF, the EEM emerging market ETF, junk bonds and a broad swath of carry trade. We have seen the markets write off other ambiguous issues over the past weeks and months, but the implications behind this situation are unmistakable: there will be negative economic and capital flow repercussions from this situation. Suggestions that the impact will be minimal or that this about face was priced in are nonsensical. Optimism sourced in the fact that the two sides are still talking or that a tough stance by the US will rebalance a global bias that is detrimental to most does not fit with the market’s short-term focus. It would be disingenuous not to mark this market disconnect to some degree of complacency. At what point does the market start to register the pain in the way that we would reasonable expect? Chinese markets (Shanghai Composite, Yuan) will start to process the pressure when government intervention is overridden by the markets. The emerging market and non-US developed market economies are already trading at a substantial discount to the US assets which receive a disproportionate amount of attention. When – not if – the Dow and S&P 500 cave, we are at even greater risk of catalyzing an accelerated and universal ‘de-leveraging’. In the meantime, it will be important to watch the spread of financial troubles beyond the US-China quarrel. The USMCA is still facing an insurmountable wall so long as the metals tariffs persist, there are two direct threats from the US to levy taxes against the EU that have yet to be activated, and the Trump administration has to make a decision on broad auto tariffs as the initial 90-day review process of the Commerce Department’s Section 232 assessment ends on Saturday, May 18th. The Expanding and Abstract Threat to Markets from Political Risks When the markets are looking for threats, there is usually an emphasis placed on those risks that are well-defined and carry an explicit date/time. The ‘convenience’ of counting down to a trouble with certain boundaries can help with preparation for its occurence. And, in such situations, the known unknown can also significantly reduce the sense of fear and in turn dramatically temper their impact. In contrast, those storms beyond the horizon that could inflict unknown damage offer poor preparation and conversely amplify the fallout that accompanies surprises. When we consider the dominant fundamentals winds trading influence over the global markets, there ware fairly well-defined criteria to recession fears (global growth), clear timelines for trade wars and key policy decisions that carry greater weight over the influence of monetary policy as a temporary prop and artificial amplifier of speculative excess. The concern that has constantly lurked on the border of our apprehension is the simmering threats from various points of political risks. Political discourse in general has deteriorated over the past few years with economic and defense-based relationships like the TPP, NATO and Iran Nuclear accords all facing existential pressure. Yet, the pressure isn’t simply reserved for ‘external’ trade partners. Nationalism has taken root across the world with an inevitable result of dissonance and resistance to progress where the benefits cannot be guaranteed to be evenly distributed. This is not the first time in history that such a tide has risen, and it will not be the last. When will it have run its course and give way to alliance and progress – as messy as that inevitably will be? That remains to be seen. In the meantime, we will continue to see the strife that arises from all players pursuing self-interests. The most overt example of this ongoing conflict is between the UK and European Union. The past weeks’ headlines offered little to be enthusiastic over when it comes to compromise for a favorable resolution to both sides. There is nevertheless a time limit in place – whether that be the late October extension deadline or participation in the EU Parliamentary elections from May 23rd to the 26th. Speaking of the forthcoming elections in Europe, there is an unmistakable presence of typically anti-EU nationalist participation and a host of top roles that are up for grabs (head of the European Parliament, European Commission, European Council and European Central Bank). While there are some disruptive voices in the campaigning, no one is as antagonistic as the Italian leadership which is committed to pushing forward with pursuing fiscal support for the economy despite its deficit forecasts ballooning to levels north of the Union’s allowances. In the Middle East, the United States is pushing hard to isolate Iran which is driving energy prices higher and threatening stability in the region – prompting the US to send war ships to the area to prevent rumored threats – while the developed nations fight over the relationship. Asia has multiple points of tension but China’s efforts to promote a sense of cooperation through its Belt and Road initiative are increasingly falling on skeptical views for those monitoring the progress of the US-China trade war. The internal conflict is worst in the United Sates itself. Hopes of massive fiscal stimulus in the form of a $2 trillion infrastructure spending program (necessary to pick up the reins from flagging monetary policy) are potentially held hostage by the growing warnings of constitutional crisis and pressure to pursue impeachment for the President’s perceived transgressions. Any one of these issues could take a severe turn for the worst with enormous consequences for financial stability. For more tracked out Political risks, keep tabs on the known elections around the world – beyond the EU and after Africa’s results have come in, we also have India and Australian campaigning underway. Volatility Measures are an Imperfect Tool We Too Often Find False Confidence Considerable weight is afforded to volatility measures as a definitive measure of sentiment. However, there are many caveats to these typical benchmarks that undermine both their presumed timeliness as well as their ability to even verify sentiment. This past week, there was a notable swell in volatility readings across asset class and region – though unusually not in the aftermath of a confirmed escalation of the US-China trade war as mentioned above. FX derived volatility measures hit the highest in six weeks as did measures for yields and oil, while the S&P 500-based VIX volatility index hit an intraday high last seen back in the opening days of January and the emerging market measure exploded to its highest levels since February 2018 when the market first made its transition from an environment of total complacency. There is little doubt that the fundamental gears were turning through the past week, but the concerns starting the engine turning were clearly not deep enough to undermine the markets such that a true market retreat would set obvious, deep roots. It is worth a refresher on the source of these activity measures. The popular indexes are almost universally ‘implied’ figures which are backed out of related options – the VIX is for example measured from S&P 500 options. Given all of the aspects of the traditional pricing model are known with the contract, that means only the ‘implied volatility’ as a measure of uncertainty and thereby the cost of protection are unknown. Also the underlying index may be traded in both directions, but the vast majority of capital behind the benchmark asset are dedicated to a buy-and-hold mentality. That makes options predominantly hedges, and therein lies the negative correlation between the performance of the index and the direction of the volatility measure. Tracing these indicators back to its fundamental originations, we can better understand their short-comings and perhaps derive some underappreciated signals to use towards our evaluation of the markets and our trading decisions. One of the most overlooked issues is that indicators like the VIX are not indicative of activity itself but rather strong bearish movements in the underlying. That may not seem a problem, but experienced traders will recognize that there is often an erratic nature to markets with violent moves higher or chop back and forth before that intensity is channeled towards a frenetic deleveraging. Another critical shortcoming for such indicators is the fact that they are hedges for which traders frequently disregard at the most inopportune times. Back in the second half of 2017, the US equity markets were defying concern over the upheaval in politics, the growing concerns over global growth forecasts and a march towards a trade war with an incredibly stolid march higher. The run of days without a one percent or greater decline from the S&P 500 hit a stretch not seen in decades. A push to record highs through a period of improbable quiet was destined to ‘revert to norms’ with a slide that would almost certainly offer violence to balance to roaring quiet. It is at such times that there is the most to lose and therefore hedges would be most important to hold. Instead, the VIX printed a record number of days below 10. Of course, we saw how that period ended, with a February collapse across all risk-leaning assets. As misleading as these indicators can become, we can use the lack of counterbalance the indicator should offer as a sign of how disconnected and exposed the participants of the system have become. When ‘realized’ (or actual) activity starts to rise and anticipation remains stoic, there could be systemic risk building that results in not only violent correction but follow through to the unwind. There is also something to be said about the picture of volatility across the financial system. Most will base their assessment of the market-at-large on a single measure like the VIX, but that is as flawed as using the S&P 500 as litmus for the entire capital market. There can be bursts of activity for certain asset classes with some leading depending on catalysts that can turn systemic (like monetary policy failure driving the FX and Treasury yield volatility measures to life), but there are few better confirmations than ‘fear’ spreading throughout the most liquid asset classes. This is much the way I feel about the direction and tempo of the different key assets like US and global equities, emerging markets, junk bonds, government yields, carry trade and more.
  6. The Fed Finds Themselves in a Market, Economic and Credibility Quandary There is a lot of high-profile event risk – both data and events – on the docket this week. The distinction of importance for these potential catalysts is defined by their capacity to tap into more systemic fundamental themes. By that evaluation, there is a lot that can further shape our collective interests/concerns through trade wars, concerns over stalled global growth and the inadequacies of monetary policy as a financial firefighting tool. However, the most influential among the deluge will be the event/s that can reach as many of the major themes as possible. Naturally, there is connection between the aforementioned matters: earnings is an economic benchmark, trade wars stunt growth and recession threatens to expose central banks lack of tools. I would argue that the most loaded item on the menu is Wednesday’s FOMC (Federal Open Market Committee) meeting. This is not one of the quarterly meetings for which we expect the Summary of Economic Projections (SEP) and upon which every rate hike that has been pushed through in this cycle occurred. That won’t preclude a significance to this update however. The interest in this event is more a product of the broader market circumstances rather than an anticipation for any change in rates or unorthodox policy. There is essentially no anticipation for change at this meeting but there is approximately a 65 percent chance of a cut by year’s end according to Fed Funds futures. That is a dramatic reversal of course from where we were at 8 months ago. Before the market’s epic tumble through the fourth quarter (yes, market performance and policy intent are connected), the Fed’s members expected three rate hikes this year while the markets believed it would be more on the order of fourth hikes. There is essentially no anticipation for change at this meeting but there is approximately a 65 percent chance of a cut by year’s end according to Fed Funds futures. What prompted this dramatic about face? Inflation forecasts were generally in line with the central bank’s targets and the unemployment rate is still hovering around its multi-decade low. That would put the onus on forecasts and external factors. The assumptions of follow on pain from the government shutdown and year-end financial market volatility clearly shaped expectations. Therein lies the problem. The US markets have recovered dramatically through the past four months. Trade wars are still a burden with the threat that they will spread to envelop the US and European lines, but the US-China relationship seems to be improving materially. And, just this past week, the 1Q GDP release signaled that we wouldn’t see the world’s largest economy stall out in the immediate future with a 3.2 percent annualized reading – though the inflation figure that is derived from that comprehensive data notably dropped further below objective. Market’s cheered the general dovish shift by the world’s largest central banks, and none offered more relief than the Fed’s turn off of a steady course of rate hikes. So, what is the US central bank to do? Most likely they will default to patience with status quo settings through the foreseeable future. Meanwhile, the White House will continue to berate the Fed for not doing more and the market’s will cry out with any stall in the climb from indices. If there is a sharp drop in output potential for the US economy through the second quarter, response rate will be delayed owing to the strong 1Q figure, and that in turn may raise the interest in financial market performance to avoid late response. In this environment where everyone has different views on what the next stage will be for economic and market health, even the status quo from the Fed will draw out concern from some and speculative leverage from others. Earnings Season Fades as Trade Wars, Recession Fears and Monetary Policy Return Should Trump follow through on any of his three general threats against the EU ... the market is unprepared and the ultimate economic impact would be far more severe. Raising our focus from the top event to the steady drumbeats of more systemic fundamental issues, there is reason to anticipate the range of frequent systemic winds these past months to once again sweep across our markets. Before the ‘oldies’ to return to form, we will first see the recent top headline relinquish its influence. Earnings season in the US technically extends for a few more weeks, but the number of economically-important companies issuing their numbers to tout a greater influence over global growth forecasts or shape the other systemic matters in the financial system is dwindling. Most of the top listings are concentrated to the first two days of the week. Google and Apple will tap into the speculative leverage of the tech sector, Eli Lilly and Pfizer hits the worst performing major sector of late, General Motors will weigh in on trade wars, and General Electric will be another representative blue chip. Shifting the focus back to monetary policy, the Fed decision is the obvious focal point while the Bank of England decision is essentially a reflection of Brexit concerns. Beyond the official meetings, we should keep tabs on regular data and any sign that participants of the financial system are starting to question the capacities of central banks to foster growth and avert market crises. Speaking of economic activity, the sentiment around this fundamental health gauge has certainly jogged higher these past weeks. Both the US and Chinese 1Q GDP readings beat expectations – though the latter’s beat simply avoided a further multi-decade low. We have another official growth reading from a key economic center: the Eurozone figures. Yet, as we have seen from speculation preceding these official figures, fear can arise from less-comprehensive monthly data or even external measures like the US yield curve inversion. Trade wars will once again prove the least predictable overarching concern. Through the end of this past week, President Trump once again suggested he expected his Chinese counterpart in the US soon (insinuating a deal they could sign) while President Xi echoed a similar belief that the end of the negotiations is within sight. As for the market’s interest and ability to leverage this belief; headlines such as the second largest Chinese e-commerce companies being put on the US blacklist raise concerns, we have already seen the markets recover significant lost ground (‘erase the discount’), and new fronts threaten to open on the global trade war. Should Trump follow through on any of his three general threats against the EU (the $11 billion in tariffs in retaliation for Airbus subsidies, the loose threat to seek retribution for trade restrictions on Harley-Davidson earnings and the general threat to put levies on imported autos and auto parts), the market is unprepared and the ultimate economic impact would be far more severe. A Spat of Breakouts a Plenty of Reason to Question Conviction I’ve weighed in on this question before, but the occasion calls for a revisit: what constitutes a true breakout? We just happen to be facing potential technical breaks for the benchmark for global equities, the FX market and commodities. And, a side note before we delve in on the topic: ‘breakout’ is a non-directional term. Owing to the default long-only perspective of so many market participants (particularly those in equities), the association is immediately made for ‘favorable’ developments. If we are experiencing a bullish clearance from congestion, the proper term is a ‘breakup’ or ‘bullish break’ while the opposite conclusion would be a ‘breakdown’ or ‘bearish break’. With quibble out of the way, we have certainly witnessed some charged technical intent this past week. The most remarkable breaks would come from US indices which found the Nasdaq drive to record highs while the S&P 500 hit a technical high on the close, the DXY Dollar index surged through a near two-year range high which translated to EURUSD sliding below 1.1200, and crude oil tumbled through $65 and then below its 20-day moving average for the first time in 50 days (the longest bull run in years). For many, a technical cue is all that is needed to register a break, and the switch flips in their minds to expect a committed move to follow in the marker’s wake. That is supremely presumptuous. What if very few traders considered the same level relevant and therefore there was little intent to drive the market following the ‘break’ that an individual may have put emphasis on? I live by the axiom: it isn’t about the break, it’s the follow through. Yet, follow through is the result of intent. While sheer speculative appetite or an extremely popular technical level can occasionally heft its own influence over the market, the case is a rare one. Far more common in successful technical breaks evolving into robust modes of follow through is a scenario that involves a fundamental motivation that can help secure the tentative break but more importantly draws more speculative interest in or fuels the absolute need to abandon the market. Robust growth or a chase for yield are the best motivators for equities, but that seems far-fetched in our present environment. With the aforementioned three market leaders, we should consider their motivation rather than just the fact that they surpassed their technical boundaries. Crude oil’s slump through the end of this past month is the least convincing of the three. It’s tumble seems to have a very particular catalyst in President Trump’s suggestion that he reached out to OPEC members to encourage them to lower the market price for the commodity. Given the spotty record of his demands and the subsequent market movement over the past year, a bearish drive will depend far more on either a clear downturn in global growth and/or a systemic drop in risk trends. From US equities, the Nasdaq Composite readily cleared its previous record highs from September/October and extended the move beyond that level. That said, the S&P 500’s break was purely ‘technical’ with a new high based on a close over close basis. There were no intraday highs. Meanwhile, the Dow hasn’t even reached its previous high. Robust growth or a chase for yield are the best motivators for equities, but that seems far-fetched in our present environment. The Dollar arguably holds the most probable bullish scenario. The currency can find charge from more favorable relative growth or through a rate advantage leveraged through more dovish counterparts. Alternatively, a full-tilt global risk aversion can revive the Greenback’s absolute haven status. At present, neither end of those extremes seem probable, but they can certainly arise.
  7. Amid Extreme (Low) Volatility, Determine Your Approach and the Eventual Change Volatility continues to sink into extreme levels of doldrums – and this is a theme that all traders should take time to appreciate at regular intervals. Low volatility is a defining feature of a financial landscape. Whether fundamentals catalyze a cascade of value repricing or a technical cue is capable of triggering an avalanche of entry/stop orders is predicated on the conditions first laid out by the depth and activity level of the speculative medium. First and foremost, the type of markets we are dealing with should determine the trading approach we take. If we were to expect a high probability of key breakouts or simply expect such explosive moves to be relatively frequent in the broader market, we would expect volatility to be high and liquidity low – the thinner market depth helps amplify the ‘run’ from sudden jolts of activity. For trending markets, low volatility is a prevailing theme; but liquidity or market breadth are usually generous as participation in the move remains strong. In markets were both volume and volatility are low, observance of ranges (or imperfect congestion patterns) is more common. Recognizing the state of our markets alone is of incredible value for all traders. If my specialty is momentum trading in trends, I would want to remain sidelined when range trading prevailed or endeavor to create a robust range strategy and a barometer to tell me when we are transitioning to different speculative states. Yet, just as the phases of matter (solid, liquid, gas) are all related, so too are the phases of a speculative market. Range can transition to breakout with the application of volatility which then transforms into trend when liquidity follows the spurt of activity as the uncertainty in the volatility itself settles. In the conversion of these different forms, it often proves difficult to determine what kind of market we are dealing with – not even the market is certain – and thereby what type of trading approach we should take. Arguably one of the least forgiving transitions occurs from the quiet and steady ranges into the more explosive breakouts. The shallow liquidity can precipitate enormous moves beyond just the first bloom of volatility. This is often the ignition to sudden speculative collapse as with February 2018 or the eruption of a full-blown financial crisis as with the Dot-com bust. We are once again facing this particular fluid state. Some are comfortable in the range that they are seeing from the likes of the EURUSD which has carved out one of its longest, controlled ranges (as a percentage of spot) since the Euro began trading. Or even more dangerous, there is a default assumption of trend like that from the S&P 500 or Dow which are in the midst of recovering from the last explosion and are not yet returned to the decade-long bull trend so many have profited from through a passive strategy approach. From the trend assumption, there is an assumption of slow capital gains and modest dividend income against a backdrop of risk that is unrealistically low. So, how do investors/traders approach such an ambiguous situation? Use the strategy most common with range trading. Shorter term trades, more reasonable targets, awareness of important levels and more engaged observation of market conditions will make for active trading but also faster reaction time should conditions truly start to change. Trade Wars and US GDP: Top Theme and Top Event As we move into a new trading week with the recognition that market conditions are extremely restrained, it is natural to assume continuation of the same. Yet, as we discussed above, that is an assumption that leverages far greater risk than potential. When we consider the exact conditions for transition, there are various circumstances that can bring about a transition of indecision to trend or low volatility to explosive. That said, the evolution of quiet to volatile is very rarely based in sheer technical originations. It is possible that the rank and file grow so complacent and liquidity so shallow that an unexpected technical development triggers an outsize market drop that then cascades into wholesale deleveraging as everyone returns from the sidelines with a single motivation: to exit quickly. Far more common in the annals of transitional market history is a fundamental spark that draws mass participation and trading intent all at once. And, for those already familiar with the inverse correlation between the S&P 500 and VIX, the more capable driver is the one that is bearish and/or stokes fear. With that flight path established, we should take into account what the most promising/threatening theme and event risk are through the period ahead. On the theme side (meaning a general fundamental influence that is steadily a concern with flare ups around scheduled or impromptu developments), trade wars are presently the most ominous circumstance. It is true that we have a key growth-based risk (US GDP) and dependency on depleted monetary policy has leveraged an impossible future, but recognition of global recession or a hopeless backstop aren’t inevitable do to their existence alone. In some contrast, trade wars are starting to draw greater and greater scrutiny as burden to the global economy and circulation of capital around the world. What’s more, there are a number of threats being juggled presently and any one could drop. The US just recently threatened to apply $11 billion in tariffs against the EU in retaliation for subsidies the latter has given to plane manufacturer Airbus – and of course, the EU has said it is ready to retaliate as soon as the threat is acted upon. With the United States’ direct neighbors, there are hurdles being erected to the USMCA negotiated as a revamp of the previous NAFTA; but the real risk resides with the President’s threat to shut the Mexico border and/or apply tariffs to imports of Mexican auto parts if the country doesn’t do more to stem the flow of illegal immigrants into the United States. Then there is the universal risk of President Trump weighing a universal import tax on all autos and auto parts, a measure that will predicate a global trade war (or at least US versus the Rest of World) that assures a stalled economy. If we are looking for a capable threat with a clear date and time, the US 1Q GDP release will act as top event risk. The world’s largest economy is a bellwether for the globe with so many troubling figures coming cross the wires these past months and open risks like the monetary policy losing its ability to stabilize and the impact of trade wars leeching through. Market it on your calendar. US Earnings Will Have More to Say Than Just the State of US Corporate Profitability For systemic themes, the most frequent three in the rotation these past months has been: monetary policy; concern of economic recession and trade wars. However, these are not the only complicated matters that can spur fear (or greed in positive turn). One typically-seasonal consideration that will return to the forefront in the week/s ahead is US corporate earnings. We have actually had updates from a few major corporations over the past two weeks, with a greater concentration on the top banks. Thus far, we are left with an impression that registers as continuation of the questionable enthusiasm the markets has sustained for quarter after quarter stretching out through some years. If we are to maintain that questionably content view of profitability and growth through the weeks and months ahead, this week’s run will play a particularly important part in setting the course. At the top of the list, we have the likes of: Amazon; Microsoft; Anthem; Caterpillar; Exxon Mobil and Procter & Gamble among many others. These are some of the largest companies in a variety of different industries and they will naturally account for a strong overview of the entire systems health. However, there is another aspect to this bout of earnings season that we should consider: the thematic influences that will be touched upon in the underlying economy and financial system. If you were looking at the ‘bleeding edge’ of speculative appetite, there is good evidence to suggest that the tech sector continues to hold the torch that investors in most other areas of the economy and markets continue to follow. If you want to look at a quantifiable measure of this preference, consider the general performance of the tech-heavy Nasdaq Composite to the blue-chip Dow – or even the ratio of the two. A leader can be a boon or a burden though depending on the direction it takes. If tech were to pitch lower into a speculative dive, it would likely undermine confidence across the system. With that in mind, consider the largest players in Amazon and Microsoft or a more forward guidance-leveraged FANG member like Facebook as greater risk than reward. Another theme that we will touch upon is general economic growth. The largest companies in the indices or a look into the core of economic activity through the likes of Procter & Gamble, Anthem or Exxon will give some direct lead in to the GDP figures due. Then there are trade wars. We have seen these concerns flag as the threats are days or weeks old – and in the case of the US-China, negotiations are progressing – but the financial impact cannot be overlooked. The likes of Caterpillar who has registered negative impact in the past, Boeing who is at the center of the EU threats via Airbus and even Harley Davidson who was a target for President Trump last year can tell us the state of play.
  8. A Return to Extreme Volatility and Realization It Won’t Stay This Quiet for Long Any way you cut it, the markets are experiencing extreme levels of inactivity. And, for those that are satisfied with the superficial and textbook interpretations of the mainstream measures, this seems like a cue to leverage exposure and commit to the decade-long bull trend which blossomed under the controlled conditions. Previously, traders would have been readily satisfied by the readings and thrown in with the assumptions. However, there is an unmistakable air of skepticism surrounding activity measures with indicators of exposure and uneven performance for ‘risk’ assets drawing focus back to the extreme bouts of volatility this past year. While market participants have shown a penchant for overlooking troubling fundamental backdrop and conveniently forgetting previous lurches in the financial system, the proximity and severity between the February-March and October-December storms were too prominent to simply slip quietly into afterthought. With that said, the question then must be raised as to what could trigger another wave of concern. While the best motivations for trend development in my opinion are systemic fundamental themes that can draw the largest swaths of market participants; during these periods of speculative interlude complacency can raise disputes over the urgency of otherwise serious themes. When we get into these self-sustaining periods of complacency, one of the best sparks to break clear of speculative opportunism borne of quiet is to see a uncomplicated slump across the capital markets. In other words, price-determined risk aversion. While the strongest indication that the markets are succumbing to their own fears is an intense deleveraging across all or most assets with a heavy dependency on speculative appetite, there can be fairly reliable precursors before we get to that undisputed scale. At present, one of my favorite leading indicators is the S&P 500. Representing the most ubiquitous asset class in the capital markets and in the largest economy, it is well placed at the center of focus. Further, its outperformance in this role has once again afforded it a position of carrying a heavy mantle of keeping the fires stoked in other assets and regions due to its approximate return to record highs over the past quarter. Most other preferred assets for the trading rank are significantly behind in their recovery efforts – rest of world equities measured by the VEU index is only now passing the midpoint of its 2018 losses. This attention isn’t just a benefit to the markets though. If the US indices were to falter in an overt and troubling way, it can spell disaster for other areas of the financial system that were considered far less resilient. A stall for the S&P 500 and Dow before overtaking a record high could certainly achieve this throttling for global sentiment, but a more complete obliteration of future efforts to recharge confidence would likely come from a scenario whereby the benchmarks overtake their respective highs, struggle briefly to mark new progress and then collapse. Currently, we find measures of volatility like the VIX back at lows last seen in October which is appropriate comparison. Yet, in other asset classes we find more incredible readings like FX implied volatility at levels that are only comparable to a few points in history (like the Summer of 2014). In historical terms, the Dollar’s range (an equally-weighted index) over the past 200-days is the smallest on records back to when the Euro started trading two decades ago. This misplaced association of confidence and lack of preparation sets up the market to be extremely exposed to a mere slump escalating into something more catastrophic. Trade with caution and diligence. China GDP Next Week’s Top Event – Could the World Survive Its Stall? In a holiday-shortened week with speculative focus blurred, the top event risk is unmistakable. The Chinese 1Q GDP reading will come along with a run of monthly readings for March that are influential in their own right. While the employment, retail sales, industrial production and other monthly data are worth taking stock of to establish direction for specific nodes of the broader economy – important for projecting where problems or resurgent growth could arise in the future – it is all superseded by the comprehensive growth report in the short term. The world’s second largest economy is expected to slow even further from a 6.4 percent annual pace to a fresh multi-decade low 6.3 percent. That will still sit comfortably within the growth target lowered from 6.5 percent to a range of 6.0 to 6.5 percent the last National Peoples’ Congress. Nevertheless, the international market’s more critical eye towards growth and unorthodox threats will disproportionately raise the risk for impact form a negative outcome. The implications for China and its markets are relative straightforward when it comes to the forecast for the soft landing that officials are trying to engineer against the backdrop of struggling global growth and amid a trade war. Though rhetoric around negotiations with the United States has improved, a year’s worth of economic pain has built up. The March trade balance offered a timely mixed picture this past week with a significant surplus for the month resulting from a distinct drop in imports (a poor reflection of domestic economic health). For the global economy, this particular economic update holds significant weight over assumptions for the future. As the world’s second largest economy and the stalwart through the Great Financial Crisis, a slide that seems to be picking up momentum outside the central authorities’ control will leverage serious concern about what the smaller economies with significant less control are facing. For countries that supply China with the many raw materials that it consumes for its unmatched manufacturing machine (Australia, New Zealand, etc), the restriction in export demand and likely drop in foreign investment flows will expose an unbalanced economy. For the rest of the world, the buffer China has maintained will mean the country’s demand for trade partners’ goods will not pose the greatest risk, but rather its carefully-controlled financial connections will represent the true destabilizing influence. Potential delay in impending efforts like the Belt and Road initiative and the tentative vow to ramp up purchase of US goods are tepid relative to the cascading exposure we would see if the country was forced to repatriate in order to shore up its own system which is heavily built upon leveraged and low-quality lending initiatives. The question I would pose is whether the world could survive a stall in Chinese growth – which would occur well above 0.0 percent GDP – given how troubled the globe’s future currently looks? I doubt it. Should China tip into a market-defined economic stagnation or contraction, it would infer one of the key players in the world’s stage has lost control over its reliable ability to plan and direct activity. The environment that would force that loss of control would be a serious threat to the rest of the world as the shock would eventually hit other shores like a financial tsunami. Brexit Delayed Six Months and Pound Range Trading Reinforced A sense of relief washed over the Pound this past week – though not that kind that can readily supply buoyancy to the battered currency. In an increasingly familiar story line in Europe, we have found the Brexit situation has resorted to the comfortable solution of punting an unsavory decision to a time significantly into the future. This is the same path we have seen taken when it comes to Europe’s monetary policy (ECB), political standoffs and external diplomatic issues. This is not to say everyone is simply defaulting to this delay. This results from serious impasse between parties that believe strongly in their solutions as well as the folly in crossing their red lines. At the direction of Parliament, UK Prime Minister Theresa May requested an extension from the European Union, with an initial suggestion of a hold out until June 30th. After a long summit, the EU-27 agreed to a six month delay that would move the cutoff date to October 31st. In the interim period, the UK is expected to participate in the EU Parliamentary elections which will take place starting May 23rd and for which some in May’s party and her own government are piqued. The question on most peoples’ minds are whether the additional time will offer the opportunity to overcome the impasse or whether it will just draw out the misery. According to the IMF, uncertainty will only accumulate greater economic deterioration over time – and given the state of data over the past year in particular, that is not difficult to understand. In terms of how that translates into the competitive position of the Sterling and UK-based assets, many would see this as a window for a speculative influx on discounted markets. In previous years when complacency was de rigueur, that is almost certainly what would have transpired. An appetite for even marginally underpriced assets would have triggered an avalanche of speculative influx which would have quickly sent GBPUSD above 1.3500 and the FTSE 100 rushing towards 7,900. However, as discussed above, there is a deeper sense of skepticism built into the system. As such, the sudden drop in implied volatility measured by currency options or the CME’s index is as likely to short circuit momentum as it is to prompt it. Whether you agree or not as to the potential in the Sterling moving forward, think it through to establish a bias and set criteria for when that view shifts. Having thought the situation through beforehand will better set your expectations for an event like the GBPUSD’s inevitable break from a wedge this past month with boundaries currently stationed at 1.3125 and 1.3050. If you think a more robust recovery is possible then you may see more intent on a bullish break – and be confounded by a move lower.
  9. The US Yield Curve Flipped Back to Normal, Is the Recession Off? A lot of attention was paid this past week by the financial media to the inversion of the yield curve. To understand the signal, it is important to define the circumstances. The yield curve is a comparison of the yield – in this case, on US Treasuries – of different durations. Normally, the longer the duration, the higher the yield should be owing to the longer tie-up of exposure. When a curve inverts, we have an atypical circumstance where there are lower yields (and thereby it is construed lower risk) to hold US government debt of a longer maturity than that of a shorter variety. That is unusual but not at all unheard of. When looking at two proximate maturities – such as 2-year and 3-year debt – brief, technical inversions can occur owing to issues like liquidity. Yet, what we saw last week tapped into the extremes: the 10-year / 3-month yield curve inversion. These are the most extreme of the top liquidity issues and thereby a favorite measure of economists to gauge economic potential. In fact, this specific spread is one of the economists’ favorite recession measures. So you can understand the wave of concern, and media interest, when the 3-month yield overtook its much longer termed counterpart. However, I was (am) skeptical that this signal is as useful as it has been in the past. Thanks to the Fed’s adoption of quantitative easing so many years ago, we have seen a serious distortion in monetary policy that comes to the forefront with their effort to normalize – starting with rate hike before addressing the unorthodox policy outlook. Given my skepticism of the signal’s efficacy with the inversion, I am equally as indifferent to the fact that the curve flipped back to positive this past Friday. There are some interesting considerations from this yield comparison, but they shouldn’t be taken at face value as they have in the past. So, where to from here with this traditional economic measure? I am of the opinion that the yield curve has been distorted and its ability to reflect economic pacing has been seriously undermined. However, the interest should not be in the tool that measures sentiment but rather sentiment itself. While I am dubious of what the 10-year / 3-month yield curve represents, its inversion just so happened to coincide with other more convincing indications that the economy is at risk of capsizing. Measures of economic activity virtually the world over have signaled a throttling while readings considered forecast (such as sentiment readings) continue their own slide. Add to that a speculative market that recognizes the unquestioned safety net of the past through central bank commitment will no longer support the kind of speculative excess we are dealing with, and we find traders are more cognizant of their personal exposure. Where few risk benchmarks are as excessive as the favored US indices, there is still a remarkable amount of speculative appetite / complacency built into most sentiment-dependent measures. As the realities of the economy and practical rate of return deepen, the systemic appetite for ‘risk’ exposure will continue to struggle. In short, recognize that the market is increasingly attentive to troubles on the horizon rather than the ‘troubled’ or ‘return to normal’ signals that we register from some of these traditional measures. The Start of a New Quarter and Greater Scrutiny Over Sentiment Depending on how you evaluate this past week, you could be left with a dramatically different opinion of market intent moving forward than some of your market peers. With this past Friday’s close, we have not only capped the trading week; but it was also the end of the month (March) and the first quarter. If we look at performance via the largest of those time frames, the recent past was extraordinary. Both the S&P 500 and crude oil posted their biggest quarterly rallies in a decade – 13 and 31 percent gains respectively – which is fantastic for diehard bulls that had grown nervous in 2018. That said, this performance was far from uniform across all assets with a sentiment bearing. Global indices regained much less of their lost ground compared to their US counterparts, while both more overt risk assets and growth-dependent benchmarks were seriously struggling. What’s more, the impressive rally follows a period of even more intense loss for these assets. The fourth quarter of 2018 suffered the kind of loss that we can only compare to the Great Financial Crisis. Mounting a recovery from such a severe retreat naturally insinuates a certain degree of pacing. Yet, it does not automatically imply intent. If we put these past two quarters into further context of the previous year, regular bouts of volatility and focus on fundamental maladies speaks to a lost momentum to self-sustaining speculative inflow. A rebound, in other words, is easier to accomplish. Fostering new sense of enthusiasm and a fresh wave of investment is a different beast entirely. That is not what we have registered recently. As we move into the second quarter of 2019, we continue to face a number of systemic fundamental threats: trade wars, fears of monetary policy limitations, fading growth forecasts, and more. If indeed the temporary discount from emergent, manufactured threats (like trade wars) has already been tapped; fostering further gains will prove very difficult as the global economy struggles and central banks are forced back into the role of protector. A contrast in market performance will be even more critical to keep tabs on. The performance of US equities relative to their global counterparts is one point of clear division that makes clear confidence is not global. Emerging market assets underperformance speaks not only to the lack of return the markets expect from this high-risk assets, but also the concern that global central banks are unable to close the gap. In particular this quarter, my interests will be the relative health of those assets that are more explicitly speculative in patronage compared to those with deeper ties to the genuine health of an economy. Commodities are just such an asset type that finds itself in the latter category. If GDP is throttled, demand for these goods flags which is an inherent weight on prices. Perhaps the most interesting market to keep tabs on for the overall health of the financial system is government bond yields. Historically, yields on these products are positively correlated to risk benchmarks like equities as capital moves away from their haven appeal thereby raising the return necessary to draw interest. Yet, we have to add to this the economic implications that are starting to garner greater interest as well as the central banks’ distorting influence through stimulus – a dubious structural support. If government yields continue to tumble as stocks rise, it is much more likely that equities are the market that capitulations to close the divergence. Brexit, Now What? Like a chess board cleared of all but a few pieces that are constantly moved to avoid a conclusion, the outcome for Brexit has been officially delayed (again) and the remaining possible outcomes is dwindling to fewer – and in most cases, more extreme – options. This past Friday, March 29th, was the original Article 50 conclusion date. Before this milestone was hit, Parliament attempted to wrest control over the directionless ship with a series of indicative votes that put to tally solutions that MPs believed could overcome the lack of support for Prime Minister May’s repeatedly rejected plan. All eight of the proposals failed to hit the critical market necessary to signal clear support. Empowered by this outcome and perhaps imagining strategic advantage in growing concern of a ‘no deal’ outcome, May put her scheme to vote once again on Friday. The third time was not the charm as 344 rejected her effort against 286 that supported it. After the outcome, the European Commission’s Donald Tusk called for a council meeting for April 10th while the EU stated, for both dramatic and practical effect, that a ‘no deal’ outcome is now a likely result. As a reassurance to local citizens and businesses, European officials said that they were prepared for such an outcome. Underlining this pledge is a not-so-subtle ding against the United Kingdom, insinuating that they, in turn, are not prepared for course they don’t seem to be able to navigate away from. The next critical date on paper for the divorce proceedings is Friday April 12th. That is the time frame that was given for the UK to find a deal or ask for an extension. It was previously offered by EU officials that if May’s withdrawal agreement – agreed between both sides late last year – then they could offer time out to May 22nd, just before the EU elections to work out the details. On the docket over the coming week, we have specifically penciled in another House of Commons run of indicative votes with MPs making the same assumption that May did that support will be mustered behind recognition that time is frighteningly short and the solutions extraordinarily few. These votes are non-binding and the mood of the crowd doesn’t seem to have shifted materially. Instead, what progress we do find on Brexit this week is likely to originate from unexpected headlines. A change in support from the DUP, surprise concessions from the EU, allowance for a ‘people’s vote’; while these may seem low probability, they are as fair to consider as an ‘accidental’ no deal would be. Don’t be surprised to see either some unexpected shift in the landscape or the plug to be pulled altogether. Anticipation and fear will keep liquidity in the Pound tempered and thereby volatility high. That makes for very difficult to trading, so don’t let the flash of sudden movement lure you in like a fish to hook. That said, it is worth noting that one of my top trades for 2019 was – and remains – a long Pound view when we clear on the outcome of the divorce. If it is a deal, the earnest recovery will begin soon after confirmation is delivered. If it is a no-deal, the rebound will take longer as the market acts to work out its exposure.
  10. In the Aftermath of the Fed The baton has been dropped. The Federal Reserve was by far the most aggressive major central bank through this past financial epoch (the last decade) to embrace ‘normalization’ of its monetary policy following its extraordinary infusion of support through rate cuts and quantitative easing (QE). Over the past three years, the central bank has raised its benchmark rate range 225 basis points and slowly began to reverse the tide of its enormous balance sheet. As of the conclusion of this past week’s two-day FOMC policy meeting, we have seen the dual efforts to level out extreme accommodation all but abandoned. A more dovish shifted was heavily expected given the statement in January’s meeting, the rhetoric of individual members as well as the state of the global markets and economic forecasts. Yet, what was realized proved more aggressive than the consensus had accounted for. No change to the benchmark rates was fully assumed, but the median forecast among the members accounted for a faster drop than the market likely thought practical. From the 50 bps of tightening projected in the last update in December, the median dropped to no further increases in 2019 and only one hike over the subsequent two years. Over the past three years, the central bank has raised its benchmark rate range 225 basis points and slowly began to reverse the tide of its enormous balance sheet. The Dollar responded abruptly Wednesday evening with a sharp tumble, but there was notably a lack of follow through where it counted – the DXY Dollar Index wouldn’t go the next step to slip below its 200-day moving average and break a ten-month rising trend channel (a hold that confounded those trading an presumed EURUSD breakout). Why did the Greenback hold – for now – when the move was clearly a dovish shift? Likely because the market is already affording for an even more dovish forecast as Fed Fund futures have set the probability of a 25bps cut from the Fed before the end of the year as high as 45 percent. What’s more, if you intend to trade the Dollar; it is important to recognize that even with a more dovish path ahead, the Dollar and US assets will maintain a hearty advantage over its major counterparts. That would particularly be the case should other groups extend their dovish views to more actively explore deeper trenches of monetary policy. Looking beyond the Dollar’s take, however, there are far more important considerations for the global financial system and sentiment. The Fed was the pioneer of sorts for massive stimulus programs designed to recharge growth and revive battered markets. It was also the first to start pulling back the extreme safety net when its effectiveness was facing deserved scrutiny by even the most ardent disciple of the complacency-backed risk-on run. In other words, its course change carries significantly more weight than any of its peers. The question ‘why is the Fed easing back and so quickly’ is being posed consistently whereas in the past market participants would have just indulged in the speculative benefits. The overwhelming amount of headline fodder – from trade wars to frequency of volatility in the capital markets – makes for a ready list of considerations. Yet, the group’s own economic forecasts brought the reality home far more forcefully. Though we have seen numerous economic participants downgrade the growth outlook (economists, investors through markets, the IMF, etc), to see the median GDP forecast in the SEP (Summary of Economic Projections) lowered from 2.3 percent to 2.1 percent for 2019 made the circumstances explicit. We’ve considered multiple times over previous months what happens if the market’s start to question the capability of the world’s largest central banks to keep the peace and fight off any re-emergences of financial instability. Now it seems this concern is being contemplated by the market-at-large. That doesn’t bode well for our future. A Sudden Fixed Income Interest When ‘Recession’ Warnings Take Hold Except for fixed income traders and economists, the yield curve is rarely mentioned in polite trader conversation or in the mainstream financial media. Its implications are too wonky for most as it can be difficult to draw impact to the average traders’ portfolio and given the considerable time lag between its movements and capital market response. Yet, when it comes to its most popular signal – that of a possible recession signal – the structure of duration risk suddenly becomes as commonplace a talking point as NFPs. On Friday, the headlines were plastered with the news that the US Treasury yield curve had inverted along with a quick take interpretation that such an occasion has accompanied recessions in the past. There have actually been a few parts of the US government debt curve that have inverted at various points over the past months, but this occasion was trumpeted much more loudly as it happened in the comparison to the 10-year and 3-month spread (what has been identified as a recession warning even by some of the Fed branches themselves). First, what is a ‘curve’? It is the comparison of how much investors demand in return (yield) to lend to the government (for Treasuries specifically) for a certain amount of time. Normally, the longer you tie up your money to any investment, the greater the risk that something unfavorable could happen and thereby you expect a greater rate of return. When the markets demand more for a short-term investment than a longer-term one in the same asset, there is something amiss. When the markets demand more return from a three-month loan to the US government than a 10-year loan, it seems something is very wrong. Historically, the inversion of these two maturities has predated a number of us the recessions in the United States – most recently the slumps in 2008, 2001 and 1990. When the markets demand more return from a three-month loan to the US government than a 10-year loan, it seems something is very wrong. First is the lead period the curve reversal has to economic contraction. The signal can precede a downturn in growth by months and even years. Preparation is good, but moving too early can ‘leave money on the table’ for the cautious or accumulate some serious losses for those trying to trade some imminent panic. Further, there are certain distortions that we have altered the course in normal capital market tributaries that could be doing the same for Treasuries and therefore this reading. More recently, the revived threat of the US government shutdown through December and the unresolved debt ceiling debate put pressure on the asset class. At the same time, though, few believe the US would do little more than allow for a short-term financial shock in order to make a political point. Far more complicating for the market and the signal is the activity of the US and global central banks. The Federal Reserve has purchased trillions in medium-dated government debt as part of its QE program. They only started to slowly to reduce holdings and push longer dated yields back up a few years after they began raising short term rates in earnest. Their recent policy reversal only adds to the complication. Now, all of this does not mean that I believe the US and global economies will avoid stalling out or even contracting in the near future. Between the dependence on capital markets and stimulus, the heavy toll of trade wars and nationalistic policies, and the pain for key players in the global web; there is a high probability that we will see an economic retrenchment in the next few years. That said, that wouldn’t make this particular signal a trigger (causation) or even correlated through the main forces that would bring on a recession. Nevertheless, yelling ‘fire’ in an a panicky crowd on foggy day can still yield volatile results. Brexit, Just Winging It Another week and another upheaval in Brexit expectations. Through much of the past year’s anxiety over the withdrawal of the United Kingdom form the European Union, there was at least some comfort to be found in the finality of the Brexit date (March 29th, 2019). While it could end in favorable circumstances for financial markets (a deal that allows considerable access for the UK) or acute uncertainty (a no-deal), at least it would be over. Well, that assurance is as clouded as the expected outcome from the negotiations themselves. Shortly after I wrote the Brexit update last week whereby there was a clear timeline for another meaningful vote on the Prime Minister’s proposals – after Parliament voted for an extension of negotiations – the Speaker to the House of Commons thwarted the effort when he said the scheme would not be reconsidered unless it was materially different. It is likely that see another significant change in this drama any times (and even multiple times) this week. At Prime Minister May’s request, the European Commission agreed to an extension of the discussions beyond the original Article 50 end date for this coming Friday. Yet, where the PM intreated a postponement out to the end of June, the EU agreed only to May 22nd – the day before European Parliamentary elections. Beyond that date, the UK would theoretically remain under the regulations and laws of the EU but would have no say in their direction which wouldn’t appeal to either side. So, now we are faced with another ‘fluid’ two months of critical deadlines. This week, it has been suggested the government will try to put up once again for a meaningful vote – though it is still not clear whether the proposal will be meaningfully different (the EU has offered no further concessions) or there has been a successful challenge against the Commons speaker. When this could be put up to vote is unclear, but it has been suggested between Monday and Wednesday. If the proposal is approved, the timeline to May 22nd will remain and we will start to see a genuine path form. If it is not, then the following week Parliament will have to indicate that “they have a way forward”. If they do not, an extension or no deal will likely be considered for April 12th – out to the previously mentioned May 22nd date. If we pass April 12th without a clear plan, the probabilities of a ‘no deal’ or ‘no Brexit’ will rise significantly. Those two scenarios are extreme and on the opposite end of the spectrum. From a Pound trader or global investor considering UK exposure, you can imagine what a situation where the probability of diametrically-opposed, market-moving outcomes are considered balanced would do to the markets. It will curb market liquidity and leverage uncertainty. That would translate into divestment, difficulty establishing trends and serious volatility. If that isn’t your cup of tea, it is best to seek opportunities elsewhere for the next few months until this is sorted.
  11. Fed Sets the Tone for Global Monetary Policy Expectations Global monetary policy trends have shifted towards a more accommodative stance as forecasts for economic activity have stuttered and worries of ‘external risks’ have gained traction. This has sharpened the relative value of currencies as market dig into the grey areas trying to determine which groups are taking greater strides to loosen than their peers. However, it is crucial that all investors – no matter your preferred market nor time frame – keep sight of the collective impact the world’s central bank effort has on the health of the economy and stability of the financial system. While there has certainly been a boost to economic activity and all of its trappings through this past decade’s bull trend, there is undoubtedly a divergence between the extraordinary performance of capital benchmarks like the US equity indices and the more tepid clip of expansion we have registered lately. In fact, I would go so far as to say that the past four to five years of speculative abundance was chiefly the work of the largest monetary policy groups. The course change towards halting normalization efforts and entertaining further easing looks to tap some of the speculative magic of the past, but there is a definitive diminishing returns to successive waves of support. From central banks like the Bank of Japan (BOJ) and European Central Bank (ECB), the limitations are more overt as the scale of easing grows exorbitant. The BOJ for example owns an extraordinary percentage of the country’s ETF market and in turn holds an astounding amount of its capital market. That smacks more of desperation than safety net, and other regions are at risk of shifting to that unflattering distinction. Just how precarious that balance is finds more distinctive measure not at the most dovish end of the curve, but rather the most hawkish. The Federal Open Market Committee’s (FOMC) two-day policy meeting will conclude on Wednesday with no anticipation of a rate hike to follow on the ambitious pace of 2018. In fact, looking at Fed Fund futures, the market is pricing in a slight probability of a 25 basis point cut to the 2.25-2.50 percent range. The group’s view of the future is where the market will set its focus. This is one of the ‘quarterly’ meetings for which we are due the Chairman’s press conference and the Summary of Economic Projections (SEP). In the December update, the median forecast set expectations for 50 basis points of tightening this year (two standard rate hikes). Given the rhetoric used by most officials of late, that forecast is likely to drop at least one hike and could very well put even one move in 2019 under serious debate. If there is still a forecast for two, expect the Dollar to jump as the market has fully written off any moves (with nearly a 40 percent chance of a cut priced in by year’s end according to futures). The monetary policy statement and Chairman Powell’s remarks will offer important insight into the plans for the balance sheet reduction effort. We have already seen indication that they are planning on throttling the effort soon which will cap longer dated rates in the market – which will also mean rates of return will flag. Is this backing away from a tighter policy setting more supportive of economic activity or more troubling as clear indication that the world is in need of external support – support that is exceptionally limited compared to the past? Meanwhile, we are also due the Bank of England (BOE) rate decision which will be a conduit for Brexit uncertainties for better or worse. The Swiss National Bank’s (SNB) policy is a more extreme example of desperate policy that has lost traction, so its only true insight into global perspective is to amplify fears that the guardians of stability have failed. It is further worth registering what the Brazilian and Russian central banks do with their own policies as the emerging market draws direct connection to US health and risk trends register far more readily here. Trade Wars are Increasingly an Underappreciated Threat There is a hierarchy of systemic themes that rotates in its influence over the global markets and its participants. ‘Basic’ appreciation of economic potential was the focus these past two or three weeks owing to targeted economic data and troubling forecasts (such as China’s lowered target for the coming year at its National People’s Congress). Attention on this particular intersection of market-wide health will not simply vanish – we have important measures to contribute to forecasts like the Fed’s GDP forecasts and March PMIs on Friday – but appreciation will likely soften as catalysts offer a more obvious update. Monetary policy will offer the most tangible impact on a fundamental basis, but there is another theme that has garnered less attention of late but which should not be forgotten: trade wars. The course for competitive economic policies via trade pacts has shown definitive improvement in the status quo from six or nine months ago. The outright US-China trade war has seen the course of steady escalation frozen by the Trump administration as they continue to negotiate towards structure improvement as well as balance of consumption equity. Of course, the President’s threats that they could walk away if the deal is not favorable and President Xi’s calls for a clear time frame remind us that this is not a done deal. Another assumed reversal of fortune that is once again raising concern comes from the revamped relationship between the United States, Mexico and Canada. The replacement of the NAFTA accord with the USMCA deal was considerable relief for Mexico and Canada while simultaneously promoted as a success for the Trump Administration’s appetite for aggressive negotiations to hash out trade deals. That bargain is starting to come under significant pressure however as Congress threatens to scuttle what was agreed to amongst the three countries’ negotiation teams. Where we are already in the weeds on these two fronts of US trade, the threat of new economic conflicts garner even less appreciation. That is extremely shortsighted given the financial repercussions of the past year to the other efforts and the volatile nature of dealing with the US. A month ago, the US Commerce Department delivered its findings on an auto tariff probe that it conducted at the behest of the White House. We don’t know the results of that report and the President still has two months to decide whether to pursue something. However, we have seen explicit threats by the White House against countries with perceived unfair trade advantages for their auto industries – as well as vows of large scale retaliation by those in the crosshairs. If the President considers dealings with the USCMA and China a success, it is more likely that they pursue the same line on autos, particularly should political popularity rankings flag and/or domestic economic activity measures continue to crawl. A Third Meaningful Vote and an Update on Brexit Scenarios I don’t think anyone will miss Brexit when it is done. Nonetheless, we need to keep close tabs on its progress as it continues its uncontrolled tumble down the hill. This past week was loaded with votes – and subsequently volatility. Prime Minister Theresa May put up a rejiggered proposal for vote in Parliament this past Tuesday and the MPs dismissed it outright once again – though this iteration wasn’t a record-breaking defeat for the PM. That in turn led to the debates this past Wednesday which resulted in a decision to direct May to avoid a ‘no deal’ scenario at all costs, which definitively beats back the range of uncertainty inherent in this saga. Sterling traders took notice as we saw GBPUSD produce its largest single-day rally since April 2017. With a seeming cap on the economic repercussions this event may pose, the next question was whether May should be directed to request an extension from the EU on the Article 50 end date (set for March 29th). Approval of that particular leg is perhaps the least surprising of the week’s discussion points. Yet, with direction to seek deferment on the divorce date, serious questions followed asking whether more time would actually translate into a feasible deal. Given the state of discussions after two years, there is reason for skepticism. In turn, some hold outs have begun to signal a willingness to take a more moderate stance in order to find some compromise. That has encouraged the Government to put up proposal from May – it doesn’t look like she expects to have further concession – for another meaningful vote (MV3). Set against this Wednesday vote, we have seen the slogan turn to a simple arithmetic of May’s deal or risk a protracted period of uncertainty or even no Brexit at all. There are suggestions that some in Conservative party are willing to throw in some support in exchange for the PM’s resignation, but that does not come close to guaranteeing a majority. If the proposal is rejected once again Wednesday, focus will turn to the mood of the UK-EU negotiations. If support does not significantly shift in favor of the Government and May sticks to her warning that rejection will necessitate a long extension, then we will start to run up against the EU’s restrictions. EU elections will create further tumult in negotiations with the UK at risk of holding under the Union’s influence without say over the course the collective is taking – a very unattractive proposal. When assessing the Sterling and foreign investor appetite in the UK, the ultimate question is not the detail nor political advantage of one outcome versus the other. The basic question of taking risk or not is uncertainty. The longer the uncertainty is for the course of the UK’s economic and financial relationships moving forward, the greater the perceived risk for investors. That does not mean the Pound will just continue to drop throughout the imposed purgatory, but it will add volatility and cap the ambitions for substantial rally. Critical Fundamental Themes to Keep Watch For Next Week: - Recession Signals in Data, Markets and Forecasts [Indices, Yields, Gold] - Monetary Policy Supporting Risk Trends or Falling Short [Fed, ECB, BOE, EURUSD, GBPUSD, Gold] - Gov’t Bond Yields and Commodities as a Growth-Leaning Risk Asset [Dollar, Euro, Yields, Oil] - Brexit Article 50 Extension [GBPUSD, EURGBP, FTSE100] - US-China Trade War Deal Detail Headlines, Trump-Xi Meeting Time Frame [AUDUSD, USDCNH] - Threat of US Implementing Auto Tariffs [EURUSD, USDJPY] - Excessive Leverage / Debt in Public and Private Channels [S&P 500, Yields, Gold]
  12. 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.
  13. Pricing in Trade Wars Versus Pricing in Recession Risks Investors are starting to see a path form for the United States and China to find a way out of their economically and financially-damaging trade war. After months of little more than a few words of optimism from only one side of the table – which was frequently reversed only days later – we are starting to see conviction from high level officials on both the American and Chinese sides. This past week was the most encouraging period for this year-long economic conflict, even offering a few tangible policies to break through some of the skepticism that had calcified these past months. Following an announcement of five MOUs (memorandums of understanding) to form the backbone of a deal, negotiators made a concerted effort to dazzle the markets Friday suggesting that significant progress had been made and that a summit between Presidents Xi and Trump was being arranged, perhaps for the end of March. And, while some of the US team qualified that some structural policies and intellectual property protection were unresolved, reports that an agreement was already made to prevent current manipulation and that China was prepared to buy $1.2 trillion in US goods indicated serious collateral to push the deal through. So, now what? Will committed breakthroughs and tangible deadlines prompt successive legs of a sustained rally? We have already seen a significant recovery through the opening two months of the year offset much of the painful slump through the fourth quarter of 2018. This wasn’t a recovery forged ‘in spite of’ the unresolved situation between the two superpowers. There was invariably a healthy measure of speculation that a breakthrough would be found in the foreseeable future. It is unlikely that the full weight of this fundamental threat has been fully shed by opportunistic interests (just look at the Australian Dollar or emerging markets), but we would not likely see a full economic recovery even if the issue were fully reversed. For trade wars, there remains the uncertainty that the US could engage other major economies. In particular, there is reasonable concern that the Trump administration could apply hefty tariffs against imported autos and auto parts. That would put a severe strain on relationships with the EU and Japan (some of the largest developed world economies), and the former has taken pains to spell out its preparations for retaliation should the US move forward with the Commerce Department’s recommendations. How much concern for future possible engagements is already weighing the market, it is impossible to tell; but the sheer economic implications suggests it is not being taken seriously as yet. Pricing in the rise and fall of trade wars can be complicated and volatile given the variable scale of the impact and the flippancy of headlines involved, but some of the direct economic impact related to this threat are not so capable of being fully accounted for in prevailing market prices. In other words, we can fully discount a full blown trade war in the short-term with a sharp decline in assets, or completely alleviate the pressure with speculative appetites reverting to complacent norms. In contrast, the implications of these efforts tipping the economy over the edge into recession cannot be adjusted for in spot. There is no ‘sell the rumor’ on true economic contraction that can see a ‘buy the news’ as the pain unfolds. The markets simply continue their tumble as capital is divested from financial, fixed and human assets. This is where market participants should tread more carefully about their calculations for the near future. The trade wars may have seen their peak, but economic data suggests the momentum if dragging us closer to the cliff. Central Bankers to Testify to Their Governments and the Markets Monetary policy around the world is in a difficult transitional phase. After years of unprecedented easing and venture into unorthodox stimulus programs, it seemed that we had finally found the central banks’ nadir. Though the Federal Reserve was the only major bank to actually take meaningful steps towards ‘normalizing’ its balance sheet and rates, many other outfits had taken small moves or had signaled their paths had leveled. Considering this shift was taking place years after the global economy had righted itself from the Great Recession and markets charged back towards record highs, the sentiment the transition engendered was a mixed one. While in part a sign of confidence that conditions had improved, it had also left the markets with the clear impression that the effectiveness of their policy tools had all but collapsed. If these officials had years for the economy and markets to return to cyclical norms while their own policy settings slowly reset to afford a future crisis-fighting platform, this lack of capacity would fade into the backdrop and perhaps not even resurface in the next economic slump. Yet, conditions are already getting rough and there is virtually no buffer rebuilt. Now some authorities are starting to recognize the trouble in the environment and the impotent position for which they find themselves. There are a few strategies being pursued to inspire confidence. The least surprising tonal change is the commitment to turn back to a dovish setting and provide further easing should conditions warrant it. While not unexpected, it raises serious concern as it highlights the lack of capacity they were hoping to paper over. The other unofficial approach to dealing with 2018’s volatility and the unmistakable slide in growth forecasts is willful ignorance. As all paths of the future are a set of probabilities and they have little ability to affect systemic change by their hands, why not just profess optimism and try to inspire consumption, investment and expansion through their own enthusiasm. Neither of these are the kind of options that could genuinely fend off genuine trouble, but it is where the policy authorities currently find themselves. The Fed’s minutes this past week has built on the speculation that new hikes would come this year (priced into the markets) with clear suggestion that the balance sheet wind down would stop – still around $4 trillion. This will make Fed Chairman Jerome Powell’s testimony in Congress this week that much more important. The conversation goes where the Senators and Representatives steer it; but expect assessment of his economic forecasts and evaluation of external risks. We may also find our way to some incisive questions as to the lack of means left to the world’s largest central bank. There will similarly be a Parliamentary testimony delivered by key members of the Bank of England (BOE) – as well as an open presser on a separate day. Here, the attention will be more directly fixed on a specific fundamental risk to the local economy: Brexit. There are other speeches scheduled by members of other central banks along with important data that often goes into authorities’ separate mandates. Yet, almost regardless of how the data populates or how the central bank members come off (optimistic, fearful, dovish, etc), the markets will be more critical with the overt troubles on the horizon. Another ‘Meaningful Vote’ as Brexit Realities Come Into Play As of Wednesday, there will only be 30 days until the scheduled March 29th Brexit date whereby the United Kingdom and European Union are due to spilt ways. Given how much back and forth there has been on this process, it is easy to forget that lawmakers were looking for a deal sometime this past September or October from which they could begin preparations for the actual Brexit date. Now, they are simply scrambling to secure a legally-binding agreement rather than end with the ambiguity of a ‘no-deal’. There is little doubt that some parties are using the pressure of the clock to draw more submission from their counterparts for a better overall deal. Traditional game theory applies, however, with the parties needing to have a degree of cohesion within their own rank and a general acknowledgement of the risks that their side faces. There isn’t strong evidence that these factors are present in this particular match. With a few painful defeats for the Prime Minister this past month and the EU making little movement to meet the requirements laid out by Parliament’s amendments to their leader, we are coming upon another important day in the Commons. On February 27th (Wednesday), MPs are set to debate whether they should take over greater control over the divorce proceedings from May. Previous votes looking to do exactly this were rejected, but time is growing very short. Furthermore, there have been a number of Conservative and Labour members who have publicly left their party owing largely to the lack of meaningful progress in the negotiations. Another crimp to the process are reports late this past Friday that senior members of May’s government have called on the Prime Minister’s resignation by the month of May. That could be construed as troubling, but it could also signal acquiesce to a deal in exchange for a change in leadership. Over the weekend, May promised a vote on her latest Brexit deal by March 12th, looking to buy a little more time at home and likely to avert a more serious defeat that could make negotiating with European counterparts armed with grand threats all but impossible. How much good will does Theresa May have to buy more time to negotiate when so little time remains? We will find out on Wednesday. In the meantime, concern by investors, businesses and consumers – already showing hints of panic – will increasingly translate into action. Investors will move their capital out of the Pound and Euro, businesses will push forward with their ‘no-deal’ contingency plans and the more alarmed Brits will look to safe guard their accounts from financial jolts. Anticipation and fear can carry very real world and lasting impact.
  14. Don’t Forget Trade Wars Aren’t Isolated to US-China Trade wars remain my greatest concern for the health of the global markets and economy. There have been threats in the past where a localized fundamental virus has turned contagious to the rest of the world by unforeseen circumstances – such as the Great Financial Crisis whereby a US subprime housing derivative implosion infected the wider financial markets by destabilized a foundation built on excess leverage throughout the system. When it comes to trade wars though, there is no need to connect the dots. The systemic implications are apparent. The world’s two largest economies (and markets) are engaged in an escalating ****-for-tat economic conflict. There is little chance that the fallout from such a profound distress would be contained to these two contestants. The United States is the world’s largest consumer of finished goods and China is the principal buyer of the commodities. Whether appetite is trimmed owing to trade policy or stunted economic growth, its smaller trade partners would feel the pain. Yet another organization that is warning over the risks these two are charging was the United Nations whose trade group said further planned escalations could severely impact GDP (it estimated ease Asian economies could drop by $160 billion), trigger currency wars and generally promote contagion. That said, the headlines this past week should raise serious concern among traders. Reports (and remarks) signal the White House does not expect a deal to be struck between the two countries by the end of the 90-day pause on the planned tariff hike. What’s more, sources say President Trump is not going to extend that date and intends to increase the tariff rate on the $200 billion in Chinese imports from 10 percent to 25 percent on March 2nd. That is a severe escalation and one that Chinese officials will not likely take in stride. As tensions rise, there is movement in Congress to curb the White House’s powers to pursue this economic war through its utilization of Section 232 of the Trade Expansion Act of 1962 – this at the same time Trump is attempting to leverage more control. As this effort progresses, it is important to remember that this is not playing out on a single front. Where it seemed that the United States’ pressure on Mexico and Canada via the NAFTA agreement was resolved by the creation of the USMCA, Congress is now signaling that it may reject the effort if material changes are not made. What’s more, we may see the pressure expand yet further. The loose threats by Trump to place tariffs on auto imports have been made multiple times over the past year. A deadline is finally in sight of this threat to potentially gain serious traction. Next Sunday, the Commerce Department is due to give its recommendations following its evaluation of auto imports. Given Secretary Ross’s disposition, it is likely to be a charged report. If the US were to implement tariffs on imported automobiles, the economic and diplomatic impact would be far more significant than what we have seen between the United States and China thus far. Global economic stagnation would follow soon in such a development’s wake. Paying More Attention to Rates as Outlook Weakens Monetary policy as a financial theme never truly lost any of its influence over the global markets these past years. However, investors’ attention has waned on this critical pillar of speculative reach as appetite for yield has solidified complacency. Yet, conditions are beginning to change with economic activity slowing and volatility in the capital markets picking up. That in turn draws attention back to the backstop that so many have based their convictions – whether they realized it or not. To some, fear that markets are at risk of retrenchment bolsters expectations that the largest central banks are going to step in to temper volatility and lift risk assets by flooding the system with cheap funding once again. For those whose confidence remains, they still consider the likes of the Federal Reserve (Fed), European Central Bank (ECB) and Bank of Japan (BOJ) forces of nature. Closer examination of these groups’ current policies and the available tools still at their disposal, however, should raise serious concern. While the Great Financial Crisis is a decade behind us with growth having stabilized and markets surged in the period since, collective monetary policy has changed little. While the Fed may have raised its benchmark rate range over 200 basis points, none of its largest counterparts have moved significantly off of their own zero bound. Furthermore, there remains an enormous amount of stimulus awash in the system with central banks’ balance sheets bloated with government bonds, asset backed securities and even more traditional investor assets. If push comes to shove and markets started to avalanche lower despite the present mix of support still in place, what would these authorities be able to do muster in order to counterbalance? There is no meaningful capacity to lower global rates and QE has gotten to the point where its effectiveness draws as much cynicism as assurance. Adding more support against a persistently incredulous market would only solidify the realization that central banks are no longer the effective backstop for speculators they once were. And then where do we expect to turn for help? A coordinated effort from global governments when they cannot even maintain existing trade deals? As our markets remain volatile and economic forecasts soften, expect scrutiny over monetary policy and its effectiveness to increase. We have seen that already take place with the market’s response to the Fed’s dovish shift and even the RBA’s and BOE’s growing concerns this past week. Rate decisions, speeches and even data close to policy mandates will leverage greater focus – and likely market reaction – moving forward. Dollar Can Compensate for Issues By Advancing on Euro, Pound Pain The Dollar is in a complicated fundamental position. There are numerous domestic issues that represent a serious fundamental weight on the benchmark currency but global troubles will consistently work to counteract the loss of altitude. Of course, the likelihood of a perfect equalization is highly improbable. One development or the other will prove more severe than was expected or the market will decide a particular issue is of far greater consequence to the financial system. It is not clear which node will trigger a tidal wave of capital market flows, so we need to keep tabs on those themes that will exert greater influence on the benchmark as the dominant force will likely arise from these known quantities. On the economic front, the US economy has shown signs of economic slowdown and a sharp drop in sentiment readings from consumers to businesses to investors. This was only accelerated by the US partial government shutdown and the risk that it closes once again is worryingly too high. The stopgap funding runs out on Friday. The delayed economic readings with the status check before the shutdown impact was full felt are starting to trickle out and the GDP reading seems to be due next week. An ineffectual government looks to like it will increasingly be a core issue for the world’s largest economy moving forward with promising programs like infrastructure spending increasingly relegated to the dustbin of unrealized campaign promises. And of course, with the promise of economic wealth fading and sentiment withering, the Federal Reserve’s intention to further raise rates to establish a higher rate of return on US investments will naturally recede. Yet, all of these shortcomings will have powerful relative corrections. While the Fed may very well halt its monetary policy ambitious of the past three years, to stabilize at a 2.25-2.50 percent benchmark range while major peers like the ECB, BOJ and BOE shift to a dovish course from zero rates and expansive stimulus will maintain relative advantage to the Greenback. Should risk aversion build globally, the Dollar has more investment interest premium built up over the past years that could leach away, but a tip into severe risk aversion (which would be difficult to avoid in a committed downturn) would leverage the currency’s absolute haven appeal. What’s more, where the political infighting in the US is more localized, it is not a unique trouble to the United States. Further, it is persistently applying greater pressure on trade counterpart around the world through the trade war. Perhaps one of the truly untested and underpriced risks to the Greenback however is the intentions of the US President. Over the past year, Trump has voiced his consternation over the level of the currency as an impediment to his strategy for course correct trade and perceived inequities to trade partners. In the event of universal risk aversion which puts serious pressure on the global economy, we are unlikely to see an effective collaboration across the world’s largest countries as the game theory in their competitive efforts will more likely intensity under the weight. With demand or Treasuries resulting in a rise for the Dollar, it would not be out of the question to imagine the White House responds with unorthodox policy aimed at driving the currency lower. The real trouble would only begin if the world’s largest player touched off a currency war.
  15. With the Fed’s Language, Global Central Banks Signal Softening Policy Global monetary policy has shifted more noticeably to the dovish extreme of the scale over the past months, but investors were overlooking this questionable support because the markets were under serious duress. Yet, after the three-month tumble leveled out into a meaningful recovery into January, market participants began to look for fundamental reasoning to justify their growing confidence for their exposure. With the Fed’s unmistakably dovish transition between the December and January policy meetings, conviction in central bank support started to return to levels that mirrored the zombie-like reach for yield that defined the low-volatility, steady climb assets between 2011 and 2015. The terms of ‘plunge protection team’ and ‘QE infinity’ as applied to the world’s largest central banks are frequently voiced as skepticism by those that think extreme accommodation is ineffective and far more costly than central banks and the average investor appreciates. However, those phrases are just as significant to the bulls who have grown to depend on group’s like the Fed to keep an artificial calm over the financial system. There is good reason to believe the US central bank has taken a meaningful turn in its policy regime. The December Summary of Economic Projections (SEP) lowered the 2019 forecast for rate hikes, but last week’s rhetoric made clear that the water mark for even a single hike this year is likely beyond the reasonable threshold. The US central bank is only signaling a curb to future plans of rate hikes following 225 basis points of tightening, but that is arguably one of the biggest alterations of course that we’ve actually seen. There is little mistaking that the course is such that the comfort in slowly normalizing extreme policy easing has all but vanished amid slower growth, breaks in global trade and threats to financial stability. That will incur more concern amongst those in the markets than speculative opportunism. Benchmark risk assets are not trading at a value-based discount and our proximity to the extremes of traditional as well as unorthodox policy will curb hopes for the recharge for milestones like the S&P 500 to make it back to record highs – much less surpass them. Of far greater concern in monetary policy in my book is the consensus recognition among investors that central banks have no recourse to fend off a genuine crisis should the need arise. And, if we follow this path, the need will come. Only the US central bank has any leeway to purposefully lower rates, and that is only 2 percentage points to return to zero where the economy would once again find itself stuck in a financial hole. Returning to active stimulus expansion will only lead down the same path that the Bank of Japan has already found itself lost upon. The BOJ is stuck tying bond purchases to its 10-year Japanese Government Bond yield with no sign of reliably faster growth or sustained pressure for inflation to return to its target. The lack of traction for Japan’s central bank already draws enough unwanted attention to the state of monetary policy. If similar acknowledgement of a permanently disabled tool spreads to global monetary policy, we will find no other probable means to stabilize a market crash or economic slump by officials’ means alone. With Sentiment on the Upswing, Expectation Rise for Trade Wars We have seen a few of the more pressing fundamental threats to the global order abate over the past few weeks. It comes as little surprise in turn that sentiment in the market has improved in tandem. A slow normalization of monetary policy was seen as a slow strangulation of stubbornly nascent growth. With the Fed, ECB and others signaling their submission to the rise of external risks and stalling economic measures; the leash on speculative excess has been let out a little. Another point of perceived improvement comes from the end of the US partial government shutdown the week before last. After a record-breaking, 35-day closure that cost the economy an estimated $11 billion – a hefty portion that will prove permanent – this large component of economic activity is once again contributing to expansion. Of course, there are a number of caveats associated to this situation that should leave traders uneasy such as: the threat that the shutdown could be reinstituted by the middle of this month; that the tangible impact on the economy may have pushed a tepid expansion into a stalled or contracting economy; as well as fostering a collapse in sentiment around a government incapable of finding critical progress when it may be most necessary (such as in the emergency of a crisis). More generally, these improvements are notable the lifting of a fundamental burden imprudently applied to the system rather than a genuine upgrade to the outlook. How much growth and opportunity can we expect from the correction of errors? Well, at the moment; the answer to that question is: at least a little bit more. With these and a few lesser issues throttling back the burden, the markets will be monitoring for what other temporary boosters can earn a little further stretch. One of the most extensive threats to arise this past year with an explicit price tag attached to it has been the trade war. While there are multiple fronts to this effort to grow at the expense of trade, there is no skirmish more costly than the standoff between the United States and China. With tariffs on over $350 billion in products, we have seen sentiment and growth measures on both sides deteriorate. However, rhetoric surrounding the discussions between these two powerhouses has recently elicited more enthusiasm from officials and the market. This past week’s discussions between the Chinese Vice Premier and a delegation of key people from the US (Trade Representative, Treasury Secretary, Commerce Secretary) was said to have gone well and that the conversations would continue in China shortly. Never mind that there were no tangible policies suggested nor that President Trump said he would likely keep to a tariffs hike at the end of the 90-day pause as of March 1st. With speculative assets on the rise and market participants believing that officials are doing what is necessary to foster buoyancy in benchmarks like the S&P 500 (speculation the Fed capitulated in the market slump while Congress and the President surrendered in order to avoid the negative weight), it stands to reason that the White House would divert its trade course to afford further gains. In the end, though, these will still be temporary gains. How Important is this Week’s Bank of England Rate Decision? When it comes to the British Pound the principal fundamental concern remains the uncertainty that Brexit poses to the UK economy and financial system. This is more troubling for investors – foreign and domestic – than something more targeted and acute like a stalled GDP reading. There is no doubt that a halt to growth is a problem, but the issue would be a known quantity. From the details provided with the general update, we would know where policy and support would need to be targeted to course correct into the future and investors could still identify opportunities from those areas of the economy which are still progressing or are likely to do so from a temporary discount. When we are dealing with a complex and unwieldy situation like the UK’s divorce from the EU with a distinct countdown (to March 29th) and the sides obstinately at odds with each other, it can be extremely difficult to confidently assess the risks of your exposure. This same contrast will exist with the upcoming Bank of England (BOE) rate decision on Thursday. The central bank is very unlikely to change its key lending rate at this gathering and rates markets reflect that belief. However, this is one of the more nuanced gatherings with the inclusion of the Quarterly Inflation Report. The update includes pertinent information to assess the outlook for the economy and financial system – which Brits and investors are desperate for at the moment. Their growth assessment will no doubt reflect some of the troubled figures that we’ve seen via various timely sector updates. Further, acknowledgement of external risks and ongoing Brexit fallout (such as surveys showing businesses are actively looking to relocate or considering it) will be a central element to the update. Yet, will it be market moving? Governor Carney and his crew have warned of the risks to a ‘no deal’ split for some time now, and we have seen the market’s reaction to their concerns drop steadily over time. It is the case that the Pound’s recent climb these past weeks poses as certain degree of premium that could be cut down by otherwise routine concerns. However, if I were to see a headline suggesting a breakthrough or overt block in the dialogue between Prime Minister May and her EU counterparts, I would expect it exert far greater influence over the Pound than what the BOE could reasonable do.
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