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JohnDFX

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  1. Anticipation and Scenarios Into the Sunday US Deadline for China Tariff Escalation The active week of trade ahead will be pocked by a few very high profile events which will tap into key themes. Monetary policy and Brexit updates – both with explicit growth implications – are top listings while liquidity is readily available. Yet, one of the most potent potential events ahead has a deadline that occurs over the weekend. The United States warned some months ago that it would increase the tariff list on Chinese imports if the two countries had not reached a meaningful compromise. Though the two countries seemed to agree to the concept of a Phase One deal back in mid-October before a planned escalation in the tax rate on existing tariffs, the details on this accord have thus far been notoriously absent. White House officials and President Trump himself have stated explicitly these past two weeks that they intend to follow through with the escalation if a bargain was not struck. Of course, what qualifies as acceptable to reach a stage one accord and ward off the onerous escalation is open to interpretation, so the future is ambiguously in the Administration’s hands. We have been here so many times before (see the image) that the markets have grown numb to the risks that exist should the outcome be poor. That is a particularly dangerous brand of complacency. With this uncertainty and hopefully a little more introspective appreciation of the risk it represents in mind, it is worth considering the scenarios. Through the active trading week, it is unlikely that US or Chinese authorities pull the plug early and make clear another wave of painful tariffs is in the cards. Rhetoric to reiterate what is at risk is very likely as both sides intend to pressure the other in their long-standing ‘game of chicken’ but that is par for course. That suggests that if there is any truly definitive development in this tense trade negotiation, it would more likely turn out to be a breakthrough that disarms the threat. That could very well offer a relief rally to risk assets, but there aren’t many that are deeply discounted at this point and it would struggle to recharge the year-end liquidity fade. More productive would be a rally for the Australian Dollar. The currency has suffered a crushing depreciation over the these past years as the same connection between the Australian and Chinese economy that helped the former avoid recession during the Great Financial Crisis is now steering it into the rocks. With AUDUSD also suffering from the lowest activity reading (25-day ATR) since 2002, conditions seem ripe for a spark. Alternatively, if we head into next weekend without a favorable resolution in hand, traders should consider thoroughly their risk tolerance with holding exposure as exchanges close through Friday. It is certainly possible that there is a last minute agreement in the hours before the stated US Trade Representative’s Office deadline, but that is a lot of assumption to put on the shoulders of politicians who have not committed to any significant de-escalation efforts since this trade war started. What’s more, the bullish case scenario is relative tepid as discussed above. Alternatively, the inability to strike an agreement, would increase the stress on global growth materially. Considering the US indices as a milestone for risk are just off record highs, there is worrying premium at risk should blind enthusiasm be crack. This revelation of pain could be made when Asian markets are online and thereby some liquidity to respond, but shallow market conditions amplify rather than absorb volatility shocks. Consider your risk tolerance. The Genuine Concern Underlying Both the Fed and ECB Rate Decisions There are a host of major central banks due to update their policy over the coming week. For the majority of them, no change is expected. That doesn’t come as much of a surprise given the general state of monetary policy across the globe as well as the condition in capital markets as of late. There has been a not-so-subtle escalation in global accommodation through 2019 that has included rate cuts (for some into or further into negative territory) and material purchases of assets. Growth measures of late may have also solidified the lackluster outlook, but the balance of risk assets removes some of the urgency to push support further into uncharted territory. There is a cost associated to everything, and the balance of global monetary policy is showing increasingly greater cost relative to the quickly fading benefit with each subsequent iteration. That is what traders should be truly monitoring when it comes to monetary policy events like these this week and into 2020; because should confidence founded on this support falter, the optimism that it has filled in for these past years will cause a likely-severe rebalancing of priorities. Now, we have seen serious questions over the effectiveness in monetary raised these past few months, but the concerns have been beat back after some short pangs of concern. That said, so long as the global economy continues to flounder despite the efforts; the risk of recognition of an inevitably-bankrupt strategy and pillar of current stability will rise when the largest actors maintain or escalate their efforts. Thus approaches the Fed and ECB policy meetings. The US central banks is first and on the hawkish end of the scale. They have come off of a series of three consecutive rate cuts which leaves their benchmark at 1.75 percent but it is expected that they will hold this month with no commitment with further easing into the future. We will get a better sense of their policy course moving forward with the planned Summary of Economic Projections (SEP), but they have not been particularly aggressive with their forecasts. The stability this may insinuate is undermined by the short-term funding pressure that has pushed the Fed to flood the repo market with liquidity. This has led to a sharp increase in the central bank’s balance sheet which they are quick to remark is not a return to traditional stimulus efforts. I would agree that it is not the ‘traditional’ QE effort, but its purpose is even more troubling: to fend off serious financial stability threats rather than to simply accelerate growth. Watch references to this in Chairman Powell’s press conference along with any insight into the discussions on general strategy that the board has been engaged. At the other end of the perceived policy spectrum, the dovish ECB is in just as profound straits as its US counterpart. With a negative deposit rate and actively engaged in quantitative easing (the traditional type), we already know that there is a serious measure of concern for this authority when it comes to growth and financial health. It is between his effort and the immediate concern of its effectiveness that we find the most tangible threat to a crack in the façade of cure-all monetary policy. There has been a well-publicized uprising in the rank of the ECB with a host of members openly questioning the effectiveness of their extreme accommodation and the dilemma it leaves them in should an actual economic downturn – or worse, financial seizure – necessitate an effective response. Will the market adopt and action these concerns? Take the Global Traders’ Perspective of the UK Election Passions inflame when it comes to politics – particularly if you are a citizen of the country heading to the polls. That said, when navigating the markets, it is very important to divorce one’s personal, social and even moral views of parties and candidates to consider the genuine implications to the financial system. That is easier said than done, but the mantra should be repeated. For the upcoming UK general election Thursday, there is a clearly impassioned populace. With Brexit still hanging over the future leader and party like the Sword of Damocles and economic activity sputtering, it is easy to see the financial line blur in the myriad of concerns. Is this a matter of economic recovery, the future of trade between the UK and its largest economic partner or just a binary assessment of whether the divorce will finally proceed to a conclusion? While there are many important implications from this event, I believe the market for the Pound – and certain capital asset benchmarks – will respond first and foremost to the favor for party and proximity to a majority. The closer the UK is to a unified position towards negotiations, the more likely a path will be decided for Brexit with deadlines being kept rather than pushed back. As an aside, an outcome that sees a reversal on the Article 50 could eventually charge the Sterling much higher, but it is a very low probability and would not be interpreted as such a possibility immediately after the General Election outcome necessary as a first step. This past week, we have seen remarkably volatility behind the Cable, EURGBP and other Pound crosses owing largely to the polls signaling a clearer support for the Conservative party (again not a party preference but rather the clarity it suggests) The volatility signals just how much activity could follow this event. DailyFX will be covering the election through the day and evening with live updates, outcome articles and forecasts for Brexit next steps.
  2. What Matters More to Risk: Healthy Growth or More Stimulus? This seems like it would be a simple question to answer from a textbook perspective; but if you’ve been active in your investment these past years, reality has clearly deviated from the theoretical. We have seen economic activity the world over progressively struggle for traction. This is not a question of interpretation or the reliability of the signals being triggered. There have been far too many realized indications of strain (global GDP, PMI activity reports and investment figures among many others) while warnings over the future course have come from wide-ranging and reliable sources (such as the IMF, WTO and numerous central banks). Yet, despite this obvious strain, capital markets have held their bid. Not all benchmarks – equities or otherwise – have performed as well as the key US indices, but their strength has generously surpassed more rudimentary measures of value nonetheless. While we can attribute this to some measure of complacency – pursuing return while remaining numb to growing risk – there is something that fosters that speculative abandon. In the moment, it can be difficult to recognize the unusual foundations of sentiment; but past years have clearly shown an assurance in monetary policy. While the early waves of unorthodox monetary policy, such as quantitative easing, were necessary to stabilize confidence in capital availability and financial stability, the subsequent rounds beyond 2013/2014 seemed to be more devoted to accelerating growth to some unclear goal of hitting a pace that could somehow be more self-sustaining to ‘buy out’ the major policy groups. Though economic activity has slowed, improvements in employment pacing have diminished and inflation targets have never been met consistently; the central banks pushed on. It may not seem this way yet, but such dependency is placing enormous pressure on the world’s monetary policy and setting it up for inevitable trouble. The debate that these groups have reached the end of their effective range is a common one, so it stands to reason that it is eventually applied to capital market inflation as readily as standard price growth. Any fits of desperation – even coordinated ones at this point – will highlight the strain. And, if fear is indeed triggered by questions over the efficacy of this backstop, there is no greater power to swoop in to save us. Top Fundamental Theme Updates for the Week Ahead These past months, I have been keep tabs on three principal fundamental themes that have drawn more consistent responsibility for global sentiment than anything else. Rather than arranging these considerations for their ultimate potential impact, I’d rank them thusly for their recent outsized influence: trade wars; recession fears and monetary policy. Each of matters has key event risk that can rise to the scale of universally market moving so long as there is an attentive and liquid environment and the events themselves issue some fundamentally-meaningful surprise. For trade wars, the US-China trade war concern will eschew monthly trade war figures for impromptu headlines referring to the two parties’ moods. The underappreciated risk remains other fronts of this external economic throttling. The Trump Administration still hasn’t given official word on the section 232 auto tariffs and is reportedly still mulling a section 301 investigation, but neither is certainly to offer update this week. One point of known contention next week is the US Trade Representative office’s findings on France’s controversial decision to apply digital tax on large tech companies – many that are domiciled in the US. Another, more nebulous risk is the NATO summit through the final 48 hours of the week. There will be many high-level topics, many of which revolve around economic competition and/or conflict fostered by the US. Health of the global economy – more specifically, fear of recession – is the next most omnipresent matter. As mentioned above, it is far more important than the market is accounting for which is why its influence should not be underestimated. There are more explicit growth measures on the horizon such as official 3Q GDP updates (Australian, Brazil, South Africa), timely PMIs (China, Italy and ‘Final’ readings for so many others) and sector-targeted readings for key economy economies (such as Germany’s industrial production update). The indicator I will be watching the most closely, however, will be the US service sector activity report from the ISM. The US economy – the world’s largest – has been running at a premium to most of its major counterparts; and the services sector is the largest source of GDP for the country. This is as much a risk of destabilizing as it is source of potential assurance. As for monetary policy, most would put the onus on the US employment report through the end of the week. I believe it will due more to distract with unfulfilled anticipation than it will provide actual market influence. The Fed is presently held hostage by the market’s demands more than anything as mundane as a dual mandate. There is greater potential at genuinely moving the needle on the surprise scale from either the Reserve Bank of Australia or Bank of Canada rate decisions. Yet, even if they do offer up surprises relative to forecast; they will struggle to catch the full attention of the global cadre. Given the dependency on monetary policy and line of doubt running through the system, I would watch ECB President Lagarde’s testimony to Parliament, looking for any unexpected changes to one of the most extreme efforts at accommodation across the world. What Type of Trading Should We Expect in December? One of the most overlooked questions by nearly ever trader is: ‘what kind of market am I facing?’ This isn’t a one-off existential analysis but rather an evaluation that should be raised at regular interval – if not before every trade. Though fundamentals and technicals matter for filtering out opportunities where they may arise, they are secondary to understanding the general shape of the environment. Asking whether there is enough liquidity in the system is important for establishing whether we could fuel consistent trends or foster enough volatility to afford significant moves. This and certain other factors are also important to determining whether we are more likely to encounter range, trend or breakout setups over our investing horizon, because why would you pursue trends when most assets in the market are offering ranges. For general current patterns, we have seen limited liquidity over these past few months – the period from which we usually see a revival from summer doldrums. We haven’t exactly faced any significant strains to test the availability of a market owing to the quiet climb in risk assets, but that may also starve any attempt at more systemic drives of enthusiasm – or what seems enthusiasm. In the event that we take a more troubling turn for the global financial system, the lack of market depth will lead to more erratic market conditions and could hasten the elevator ride down. Volatility is also exceptionally low – a serious function of liquidity. It is far too quiet, but history has shown that the final month of the year normally enjoys a positive drift for capital markets. That will represent a strong draw for keeping the status quo, but don’t overlook the possibility that ‘this time can be different’. Given the liquidity situation and the uneven conviction in global risk appetite, I see trends as particularly difficult to fuel. As such, I would need the greatest level of conviction to pursue any serious trends – which is over a week at this stage. Breakouts are more appealing, but the tenaciously deflated VIX (and most other assets’ volatility measures) means that a serious catalyst is of upmost importance to get the ball rolling. A further complication is that there are few truly inspiring ranges to count. If you look for too large a congestion pattern to resolve over a longer period of time, the time frame for follow through is likely to run up against liquidity issues. Those two types accounted for, ranges will likely be the most plentiful. That said, you still need volatility and technical milestones of merit to make such technical patterns worthy of pursuit.
  3. Trump Threatens to Move Forward With Dec 15 Tariff Escalation, Considers Section 301 There have been a few critical developments these past few weeks that could have significant deescalated the daunting momentum of global trade wars. However, with each small improvement, we are met with an asterisk that could quickly undermine the good will as well as an alternative stab to weaken the outlook for global trade. For the US-China engagement, the White House backed off of the planned tariff escalation scheduled for October 15th after the countries agreed in principal on a Phase One trade deal. Now over a month since that relief, the two countries have not made any material progress. Sure, there have been bouts of optimistic rhetoric, but the enthusiasm has fluctuated back to cynicism just as frequently. Whether ‘confidence’ or warnings, market participants have grown increasingly ambivalent to the situation. What can carry greater certainty as we move forward is the threat of an escalation in the scope of US tariffs on Chinese imports scheduled for December 15th. It was presumed that if the countries were working towards a first step to ultimate resolution, this jump would be avoided. However, multiple administration officials suggested the pressure would not be removed for fear of the President losing support from his base in an election lead up and to discourage China from pursuing a strategy that is founded on a different US government this time next year. Another seeming miss on the path towards further economic disaster was the passage of the October 14th deadline for the administration’s decision on whether or not to pursue auto tariffs. That date was itself the deferment after an extended review. While the White House has not said definitively that it was laying the Commerce Department’s investigation to rest, many believe that the matter is behind us owing to legal questions if not strategic ones. The European Trade Commissioner stated her belief that the risk has passed. That said, I would not forgot that this uncertainty is still somewhere in the wings. In the meantime, Europe still finds some of its agricultural exports to the US under a hefty 25% tariff rate, deciding whether and how to retaliate – and knowing there is a WTO ruling to come sometime near the beginning of 2020. Adding another layer of trouble, there was suggestion from some close to the US government’s strategy that the a Section 301 investigation may take the place of the 232 in order to keep the pressure on the EU (and potentially other major trade partners) to capitulate under trade pressure. This evaluation looks into broader trade practices rather than specific sectors under a national security assessment. Recession Risks Slowly Recharge Back in August, fear of an oncoming recession had hit troubling levels. With a host of warnings by supranational authorities (IMF), central banks and even governments; search interest in ‘recession’ through Google hitting a decade high; and a surprising mainstream interest in the otherwise wonkish interpretations of the Treasury yield curves; it was clear that there was serious concern about the further reach of the already mature global economy. Yet, with a few disarming updates and a shift in favor towards more speculative measures, the threat seemed to deflate through the subsequent two months. Now, to be clear, the economic trouble never really vanished. The US and Europe are still in extremely tepid course of expansion, there are certain key countries (Germany and Japan) that are oscillating quarters in contraction and China is running its slowest tempo in three decades. Instead, investors, governments and consumers simply just grew larger blind spots. This past week, it was even more difficult to ignore the signs of trouble ahead. The OECD lowered its outlook for global growth yet again to its worst standing in 10 years. The 2019 forecast stood at 2.9 percent with the 2020 projection nudged down another tick to the same pace. That is itself troubling and indicative of skepticism that a recovery is ‘around the corner’. To ensure that the world does not simply hold course on its current mix of beliefs and dependencies, the group extended its outlook to 2021 with a disconcerting 3.0 percent pace. That more distant prediction, it was mentioned, was only possible if significant risks like trade wars and China’s economic struggle leveled out. Warnings like these have come frequently and just as readily overlooked (OECD, IMF, World Bank, etc); but data is a little more black and white. Just this past Friday, the November PMIs crossed the wires with a clear warning in their mix. The Australian, Japanese, German and UK overview readings were all in contractionary territory (below 50). The Eurozone figure slowed to just barely positive territory (50.3) and only the US improved in a measurable way (to 51.9). Some may consider that US reading an opportunity to pursue a further run in the country’s assets to relative return. However, it should be said that a single country – even the world’s largest – would not hold back to the crushing tide of a global economic retrenchment. That is particularly true when we consider the excess built into the system through investment, borrowing and public debt. Trading Against Risk Versus Holding a Position Through Quiet Complacency is a danger in the financial markets just as much as it is in life. However, there is far more threat when we throw caution to the wind and actively pursue a line that attempts to extract ever-smaller rates of return as the risk profile we must adopt to chase it grows larger and larger. The evidence of complacency is abundant. Record high Dow and S&P 500 are perhaps the most obvious and the most aggressively rationalized. Consider the performance of this favorite capital market benchmark should represent some combination of ideal economic trajectory and/or the greatest potential for forward returns. There is nothing of the sort on our horizon, but many are perfectly happy to live on confidence central banks and previously-unmatched stability in the speculative future – the preferred opiates of the masses. Other risk-sensitive markets are not pushing such extraordinary levels, but the steadiness is still a feature. Meanwhile funding pressure is starting to show up even in the US short-term – arguably one of the most liquid areas of the global markets – but the rise in the Fed balance sheet is again putting most at ease. Yet, when we consider these conditions without the benefit of a blind faith in the unique profile of our present market mix, there are plenty of obvious threats that we face: including the trade wars, economic struggle and stretch valuations mentioned before. There is good reason to be concerned about the fundamental landmines that we continuously weave, but my principal concern is not with what straw breaks the camel’s back nor how indicative of the big picture it may be. Rather, the real risk is the collective exposure that the masses have taken. Adding to leverage despite the underlying risks with smaller returns to cushion any unfavorable winds, raises the serious threat of a panicked exodus from the financial markets. When leverage is applied, the losses accumulate much more quickly. I maintain that the best single asset analogy to the present conditions is the speculative interest behind the VIX futures contract. The net position has pushed a record short these past four consecutive weeks…despite the measure of activity already standing at an extreme low of approximately 12 throughout that period. This is a profound lack of reasonable return against an enormous amount of risk and in extraordinary volume.
  4. We Have Unresolved Trade War Issues Guided by Rumor or Complete Blackout We closed out this past week to a broad swell in risk appetite. This enthusiasm wasn’t consistent for the global markets throughout the week, however, with most of the asset benchmarks that I follow for scope were struggling until the Friday pop. The exception to the rule was once again the seemingly impervious US equity indices. Whether you were evaluating sentiment for the Dow and S&P 500 through the week or the global bump on Friday alone, the popular justification seems to have been the same: improvement on the trade war front. Given its importance to the course of the global economy, the contentious trade relationship between the US and China was naturally a point of regular speculation over the past week. The announcement of a ‘Phase One’ deal by the two economic powerhouses was announced back on Friday, October 11th. Since then, there has been far more speculation and rumor than there has been tangible policy change. Perhaps the only concrete development since that hailed breakthrough was the deferment of the planned October 15th tariffs escalation by the United States. This past week, the balance of headlines was neither consistent in trumpeting improvement nor did it offer foothold for genuine progress. Concern that China was cooling on agricultural goods purchases and balking at enforcement mechanisms while demanding rollback on existing tariffs contrasted the cheerleader-like language from some US officials (Trump, Ross and Kudlow). It is hard to tell which of these headlines gives us the most accurate picture of this important economic relationships, but there is more consistency in the market’s interpretation of it all. Skepticism has set in some time ago and it only deepens with each week that passes without black and white terms for the Phase One deal for Presidents Xi and Trump to sign off on. As an aside, reports that a deal could be approved on the deputy level should raise concern. It suggests that it is not something the leaders would want their names affixed to; which should be a ‘win’ that they would want credit for, but would instead be viewed as either a more mediocre step or capitulation by both sides that could receive blowback by both constituencies. Keep a wary eye on the headlines for updates on this discussion as we pass implicit deadlines and the contentious explicit dates, like the December 15th increase of the United States’ tariff list of Chinese goods. Perhaps even greater a threat of volatility – or opportunity for removing risk – is found in trade spats the US is fostering with the ‘rest of world’. This past Thursday was the supposed deadline for the Trump Administration to decide on the Commerce Department’s Section 232 evaluation for auto imports. This was the deadline after a previous six month extension. Through the weekend, there was still no word on whether import taxes on foreign autos and auto parts would be implemented, avoided or a decision postponed once again. Should it be delayed or completely avoided at this point, it would likely offer little boost to sentiment, but a sudden implementation would certainly trigger a significant slump in the global markets. Another dispute to keep on the radar is that between the US and EU. We have received very little insight on how negotiations are going between these two developed world leaders, but we know the US-applied tariffs on imported European agricultural goods is sowing ill-will among leaders. Dow: Recharged Rally, New Plateau or Blow-Off Top Though there is always room for debate, the performance of the US indices qualifies as one of the most remarkable of the global financial markets this past week. While ‘rest of world’ shares markets, emerging markets, junk bonds, carry and other sentiment-sensitive asset classes were sliding for most of the week, the Dow, S&P 500 and Nasdaq were holding steady or even advancing. This is not an unusual disparity of late. While the performance metrics change depending on your starting point, as a general benchmark for year-to-date 2019, a rolling 12-month comparison or plotting from the beginning of the recovery after the Great Financial Crisis concluded (roughly March 1, 2009), we find the ‘US market’ pacing the financial system. Determining the source of this outperformance can give critical insight into whether the bullishness will continue for local assets and whether it can establish more reliable traction across the world and asset classes moving forward. There are some traditional fundamental measures that can referenced as sources of relative strength. The broadest measure of economic growth for the United States is certainly not roaring by historical standards, but it has held rather steady at its moderately expansionary tempo through the past years. That has in turn afforded the Federal Reserve an economic backdrop that allowed for rate hikes up through 2018 and offers some support for their stated intention to level out the benchmark rate range around 1.50 percent for the foreseeable future. A rate of return from the US offering a substantial premium versus most liquid counterparts while also having room to operate should future risks demand response is also beneficial. However, I believe much of this backing to this climb to record highs is based in sheer speculative appetite. Investors are willing to commit to their complacency, but they prefer to seek exposure where the progress is most consistent as that is where the greatest theoretical return would be made – while some may also justify their decision from a supposition of safety out of that climb. Sentiment is fickle. Sometimes it can bulldoze through troubling updates while others it falters at any supposed crack. I would not, however, consider it reliable when you must dramatically increase exposure in order to extract further value out of the deal. If we consider the US indices’ particular outperformance paired with the lack of tangible fundamental catalyst through Friday, that impressive bullish breakout to end this past week does not look nearly as inspiring. Sure, the Dow gapped higher to clear out one of the most congested periods in the past few years (measured as a nine-day historical range as a percentage of spot), but follow through at progressive record highs requires steadily greater conviction. Unless something more tangible – like the wave off of auto tariffs – occurs, a recharged rally is really low on my probability list. A plateau would likely depend on some ‘catch up’ in other areas of the risk spectrum while pull of risk rebalance will be a constant force. An Steady End-of-Year Coast for S&P 500 and Risk Markets Ala 2017? If the genuine fundamental backdrop isn’t improving to support a stretch higher in capital markets, the next best thing seems to be complacency fueled by a perceived reduction in risk. We measure risk in the volatility of the underlying markets, and it is in that assessment that we find another questionable perspective whereby we seem to be pricing in perfection. The VIX volatility index has slid back to a remarkably deflated level around 12, which is the approximate low back to October 2018. Even more impressive though is the realized (versus implied) measures of activity. The past month (20-day) realized measure of volatility for the underlying S&P 500 is the lowest since the extreme quiet registered in the second half of 2017 – a period of such quiet itself, that we hadn’t seen anything comparable to it in half a century. We have further seen other exceptional readings such as the longest stretch with out a back-to-back loss for the same benchmark in decades and an exceptional record of days with lower than 1 percent registered moves from close to close. It is in other words very quiet. With this quiet and the blatant complacency the markets have fallen back upon, it is easy to understand the efforts to ‘justify’ the next steps for a contentious climb. Reference made to the extreme quiet – and still-impressive progress – forged through the latter half of 2017 makes an appealing case study for bulls that may lack a more traditional foundation of conviction. There is another, more common point upon which investors may rationalize their interest in pushing their penchant for steady capital gains that can compensate for lost, reliable income through financial investments: seasonality. November and December are two of the most favorable months in terms of gains for the S&P 500 of the calendar year going back three decades for reference. Volatility also tends to retreat over this period which would add to that same incredible compression through the end of 2017. Yet, be mindful of the reassurances you are willing to accept to keep on extreme risk. Just as many market participants will remember February 2018’s explosion as those that recall the third and fourth quarter of 2017. What’s more, there is even greater appreciation as to the exposure that has built behind this controversial speculative perch. A record net short positioning in VIX futures has made it into headline news. So has the general leverage in risk assets across the system – even record debt levels for consumers, governments, businesses and central banks. Suspension of reasonable risk rules paired with great awareness translates into a market that is more likely to be flighty and prone to avalanche. By all means, take advantage of prevailing trends; but don’t blindly continuously build your risk profile for steadily deteriorating return potential.
  5. The Cost of Drawing Out Trade Wars, Even If They Lift As with most global military wars of the past, economic engagements exact a toll on the participating countries – and their peers – long after the ceasefire is struck. That is what we need to remember as officials on both sides of the table in the US-China negotiations offer rhetoric that attempts to keep local confidence buoyant. In reality, both governments are trying to walk the fine line whereby local consumers, businesses and investors do not abandon the economy while still resonating a toughness such that their counterparts feel compelled to offer greater concession to make the ultimate compromise. While both sides have done a fairly decent job of not triggering acute crises in their respective financial systems, there is little doubt that the economic pain is accumulating. On the US side, the slowdown in growth is unmistakable but it is isn’t nearly as severe as some of its counterparts – though the fact that so many large economies are on the cusp of contraction should be very concerning to the single largest as a representative of the global course. Nevertheless, there has been a far more significant drop in US trade health, sentiment measures have slid across the system and the President seems to be concerned enough to call out the Fed regularly for not pursuing negative interest rates – not the most encouraging economic signal. In China, the impact is far more palpable, which is far more concerning than it would be for any other country. There is a well established perception that the Chinese government has greater control over the economy – or at the very least the perception around it. Growth at the lowest levels in decades, manufacturing that is contracting and industrial production that has clearly been throttled is very concerning. It would be extremely naïve to believe that a trade deal between these two economies would result in a renaissance of growth for either, much less both. Diplomacy can change on a dime, but economic performance alters course over the span of months, if not quarters. The curb on spending and investing intent both through local and foreign interests would take time revive to a productive clip even if market participants were that enthusiastic at the theoretic tipping point (which they won’t be). What’s more, there are many other issues plaguing the global economy and financial system beyond this particularly costly tiff; and a solution here does not compensate for those many other lines of restriction. All of this said, ‘hope’ can fill in for the practical and keep speculative assets buoyant. It is when recognition starts to set in among the masses – and whether it happens before a deal is struck or it dawns that there is not enough lift at the signing – that we will see the greatest market impact set in. The European Economy We are due a heavy run of high-level economic updates over the coming week. While I will certainly keep close tabs on the third quarter GDP readings from Japan and Russia – the third and eleventh largest economies respectively – my principal interest will be in the overview we will be given for Europe. There are many Eurozone, European Union and European area economies on the docket scheduled to report last quarter’s performance. Collectively, Europe is either the largest or second largest economy depending on what body you are referencing. That said, there are serious concerns over the health of this juggernaut of influence as warnings from official bodies, both governmental and supranational, have indicated that there is a worrying probability that the region’s expansion stalls. If that were to occur, it is very unlikely that the world will be able to avoid the inherent contagion. There are quite a few economies on deck whose own growth will matter significantly to the collective including: Norway, Netherlands, Finland and a host of the Eastern bloc. However, my focus will be fixed on two major economies in particular: the United Kingdom and Germany. For the former, there is a lot for which needs to be accounted. The UK is the sixth largest economy in the world (according to the IMF), and it now doubt feels the receding tide that has occurred across the world. That said, the more unique issue of Brexit is exacting its own toll on the country. While the threat of a no-deal divorce from the EU has not been realized owing to two extensions of the Article 50 date, anticipation of the pain that could eventually come to pass is throttling intent nonetheless. The consensus forecast among economists is for the country to have grown 0.4 percent over the third quarter. Such a reading is necessary after the -0.2 percent drop in 2Q. If we continue to head down this course of soft economy, striking a fruitful deal as a best outcome may still leave us on a lackluster path. Anything less could spell a serious problem. Germany’s health is to some extent the counterpoint to the UK’s performance in the Brexit situation. Yet, as a signal for Europe and the world overall, its health can exert far greater influence for setting our global path. Forecasts for the fourth largest economy in the world anticipate a -0.1 percent contraction. That would secure a technical recession which is defined by the NBER as two consecutive quarters of retrenchment (the previous quarter registered a -0.1 percent reading as well). While there are caveats to such a reading – it would be a mild reduction, it is in seasonally adjusted terms, the government has anticipated it to some extent – there is serious sentimental baggage that comes with the signature of a ‘recession’. Don’t think of these troubling signs as isolated, when they are so widespread. The Markets are Favoring No Further Fed Rate Cuts Through 2020 There is rare agreement it seems between the capital markets and the Federal Reserve at the moment. Most can readily recollect that world’s largest central bank cut its benchmark interest rate range (by 25 basis points) three consecutive meetings in a row. They may not remember however that the group had believed before each move that no cut was in the cards. Such situations do little to bolster confidence in the institution, which is serious when forward guidance is the principal tool for the developed world’s monetary policy mix. That said, the market was quite certain that easing was necessary owing to a modest flagging of inflation, just a hint of wavering in labor conditions pushing decades’ highs an of course a little stir in volatility in capital markets. After that run of three cuts, though, the market is now pricing in a 96 percent chance that the Fed will hold next month in its final 2019 meeting and a 55 percent probability that they will hold at the current level through December 2020. The FOMC’s own Summary of Economic Projections (SEP) had a hike by end of 2020, but I won’t quibble that optimism. They are generally on the same wave length. Aside from the atypical convergence of policy authority and market participant views, the outlook is particularly remarkable because it reflect expectations of economic health through the foreseeable future. Clearly the Fed does not expect the US economy to stall, much less contract, otherwise they would offer more cushion through preemptive policy. For the market’s part, their outlook accounts for the GDP component but it also reflects the general complacency around capital markets. There is no shame among speculators such that they expect Fed support whenever ‘risk’ benchmarks like the major US indices start to retreat. There is a not-so-subtle connection between American investors’ assessment of economic health and the performance of the capital markets as they push further record highs. That is in turn an unsustainable connection. Eventually, markets have to ease and its girth is simply far too great for the Fed (or all of the major banks collectively) to offset committed deleveraging. Their weight is based in their ability to encourage enthusiasm among economic participants (consumers, businesses, investors) not shifting all liability onto their own balance sheet. Therefore, if the market takes another tumble, the natural response will be an assumption that the Fed will put out the fire. When it eventually becomes clear that the central bank is reaching the full extent of its capabilities to keep everything afloat, we will enter into a new, troubling phase whereby recognition of artificial extremes in speculative markets could start a fire sale that overwhelms the complacency and external buffers that have kept the peace for so long.
  6. Critical Fundamental Themes to Keep Watch For Next Week: Volatility Slipping Back into Habit of Complacency as Liquidity Fills [Indices, VIX] US-China Trade War – Beyond the Point of De-Escalation? [AUDUSD, USDCNH, Indices] A Climb in Risk Appetite as More Fundamentals Fall Away [S&P 500, Dow] Recession Warnings In the Market Converging with Those in Data [Indices, Yields, Gold] Monetary Policy Ability to Stabilize Growth, Markets [EURUS, ECB, Fed, BOJ, Gold] Politics Increasingly Core to Market Outlook [S&P 500, Yields, Gold] Natural Growth Versus Monetary and Fiscal Stimulus-Led Growth [Indices, Dollar, Gold] UK PM Johnson – Parliament Fight Over No-Deal Cliff on Oct 31st [GBPUSD, EURGBP, FTSE100] US $7.5 Bln in WTO-Approved Tariffs Threatens US-EU Trade War + General Auto Tariffs Back to November [EURUSD, USDJPY, USDMXN, USDCAD] The Threat of Currency Wars [EURUSD, USDJPY, USDCNH, Risk Assets] Gov’t Bond Yields and Commodities as a Growth-Leaning Risk Asset [Dollar, Euro, Yields, Oil] Specific Safe Havens: Dollar, Treasuries, Gold, Yen [Dollar, EURUSD, GBPUSD, USDJPY, Gold] Excessive Leverage / Debt in Public and Private Channels [S&P 500, Yields, Gold] US-China Trade Progress: The Boy Who Cried ‘Progress’ My favorite flawed, risk benchmark in the United States S&P 500 index jumped to a record high through the end of this past week. A technicians overview would suggest that intensity of a gap higher, a daily candle that opened on the low and closed on the high as well as the clearance of a long-term rising wedge top added considerable luster to an already momentous achievement. It wasn’t a stretch to assign this thrust – shared by most risk-leaning assets – to either a general state of speculative complacency or perceived improvement in US-Chinese trade relationships (I believe it is a combination of both). After a few swings in rhetoric this past week, investors were bequeathed a rare perspective of enthusiasm in negotiations into the weekend. The headline that charged bulls reported on Chinese sources remarking that the two sides had reached a “consensus in principle” on the ’Phase One’ deal. It is important that this perspective would come from China rather than the US. Beijing has been the most dubious of its counterpart’s intent and commitment since the Washington changed direction dramatically following the G-20 meeting where both sides seemed to have struck an accord. The reported breakthrough in this first stage deal would requires China to purchase US agricultural goods, open financial services markets to US companies and maintain stability behind the Yuan (ironically, what would be technical manipulation). On the other hand China requires the US to ensure it is dropping the planned tariff escalation – to encompass essentially all of the country’s goods – on December 15th. If we see this effort move forward, it would indeed offer a significant measure of relief. How would we judge a step in the right direction without President’s Trump and Xi signing on a finished plan? An official date and time for a summit would represent a tangible milestone for intent. Yet, as important as it is to ease back on the accelerator of growth-killing trade restrictions, we should not treat this as a wellspring of untapped growth. This is avoiding greater pain. To fully de-escalate, we would theoretically need to see the passage of the ‘Phase Two’ which would have far more difficult requirements to agree upon. Agreement would need to be found on intellectual property rights, enforcement, state run enterprises and the full reversal of the onerous tariffs applied to this point. That is a high hill to climb for two countries that are attempting to use their size and position to avoid capitulation. Against this backdrop, we need to consider just how much lift such a first step deserves for something like US equities where it is technically already pricing in perfection. A More Extreme Signal of Risk Appetite Than SPX Record: Record Short VIX Interest I am a considerable skeptic when it comes to the record highs the major US equity indices reflect. From a landscape perspective, the S&P 500, Dow and Nasdaq are significantly higher that global equity counterparts and pushing far greater excess relative to alternative asset types with a risk connection. While you could point to relative yield, an assumption of growth or perhaps an element of safety in US assets; it is more than a stretch to afford this degree of premium relative to counterparts. Furthermore, speculative measures are broadly running far afield of traditional measures of value. We would expect peak growth, peak earnings and/or peak yield to push record highs on capital measures. We are far, far from those milestones. Yet, here we find ourselves. That is the biproduct of speculative conviction/complacency, growing leverage, extremely generous monetary policy and no small assumption that fiscal support will offer a backstop should the other two nodes fail. Should these joists of risk appetite be truly tested, it is very unlikely to hold up. Yet, as we track the fundamental weather between economic health updates, trade wars and monetary policy effectiveness; we are also finding optimists latching on to familiar runs such as seasonal norms. We have entered the month of November whereby the S&P 500 historically averages a strong advance as volume drops. The November/December climb is one of the most fruitful of the year and is often associated to holiday activity and other year-end efforts. Yet, another seasonal norm that raises serious questions is the expected drop in volatility through this month. We are already at extremely deflated levels as investors grow incredibly sanguine on the increasingly discussed risks. To assume we will just ride out with prices of perfection and a horizon with nary a wave of trouble is simply impractical. To give a sense of just how extreme the expectations are in volatility terms, we can look at the speculative positioning on VIX futures. The securitized product of what was meant as a hedge has attracted aggressive trading these past years. At present, the speculative interests in the future market are holding a record net-short position on the volatility measure. That is despite being substantially deflated. That smacks not just of complacency but of outright hubris. Top Event Risk - for Volatility Rather Than Systemic Trend - Through the Week When you are looking for the biggest fundamental impact, it is best to find the systemic undercurrents that can strike a nerve for the entire market and thereby develop true trends. However, those measures are not always clearly directed and properly motivated, as is the case seemingly for the week ahead unless something comes out of the blue. That doesn’t mean however, that we cannot expect event-driven volatility for different currencies and regions’ assets. Here are the events that I think can carry the greatest impact and why through each day this week. On Monday, there are some interesting events like the UK House of Commons voting on its new speaker, but it is new ECB President Christine Lagarde’s first official speech in her new role that is most interesting to me. There is a clear rift at the central bank which either threatens to curb the aggressive support it has issued these past years or threatens to call into question the effectiveness of their efforts – that latter scenario may happen regardless. On Tuesday, I will be watching two key events: the RBA rate decision and US service sector activity report from the ISM. The Australian Dollar is a carry currency and it depends heavily on its comparatively higher rate of return to draw foreign capital – especially now when the health of China is called into question. If this group offers a mere escalation of the dovish rhetoric – and not even a cut, the Aussie Dollar has some pent up premium that can be cut back. Ultimately, the US services report is one of the most important indicators overall because it represents the vast majority of output in the world’s largest economy. The manufacturing sector in the US has contracted for four months and services has been keeping overall growth afloat; but it has been showing signs of wear. On Wednesday, we are due Germany factory activity which is a good proxy for this key economy’s malaise as well as plenty of Fed speak. My top event though is the earnings report from Baidu, the Chinese search company. This is an important business update for the economy (as with the likes of Alibaba and Tencent) which can offer a more reliable gauge of the country’s health than even official and private figures that relate directly. The Eurogroup meeting on Thursday will produce the economic outlook from the European Union which can tell us how one of the largest economies collectives in the world is doing from their own perspective – far more important than a BOE decision and economic forecast which is constantly snowed in by the Brexit uncertainty. On Friday, Chinese trade will be a figure to watch, but I won’t hold my breath for volatility. Instead, the US consumer confidence figure from the University of Michigan can leverage bigger moves in US speculative markets given how aggressively they are priced.
  7. Market Conditions in Data Overload Markets often struggle for traction when there is a lack of a clear motivator such as meaningful event risk or an evolving systemically important theme. On the other hand, there are times when a surfeit of important events, indicators and headlines overwhelm the clear speculative picture, leaving us with an abundance of volatility without the benefit of a reliable course. We have dallied with this latter scenario these past weeks, but the constant redirection of our attention will be in special form in the week ahead. There is a near constant run of high-importance events scheduled for release moving through the next five days of active trade. What’s more, many of these various measures will tap into the top level themes that have stood as the undercurrent for economic and financial conditions for months, if not years. For trade wars, much of the critical development rests in the hands of a few officials who are weighing policy decisions that could significantly alter the course of the global economy. Washington and Beijing continue to negotiate after verbally agreeing to a ‘phase one’ deal back on October 11th but the details and sign off are still vague. The EU meanwhile is weighing whether to retaliate against the United States for the Trump Administration using the WTO ruling of a $7.5 billion ‘allowance’ for tariffs to recoup losses owing to unfair Airbus subsidies with a 25 percent tax on imported European agricultural goods. Meanwhile, data like the US trade balance and Chinese industrial profits figures on Monday will build upon trade-dependent earnings from the likes of AMD, United Steel and Alibaba. More tracked out for the timing of its updates is the wave of monetary policy updates we are due over a particular 48 hours period. There are a number of supportive updates such as the October US NFPs due Friday, but five central bank decisions between Wednesday and Thursday will make for a far more incisive view of our financial system. In chronological order, we are due the Bank of Canada; Federal Reserve; Brazilian Central Bank; Bank of Japan and Hong Kong Central Bank. Stacking these events so closely together will cater to the relative comparison of the currencies and their assets, but it may also stir further collective discussion of the distortion and costs associated to the extreme easing. The fundamental theme that will pack the most obvious punch in my view is the run of official (government-derived) GDP updates on tap. The United States is the world’s largest economy, so its Wednesday release will draw particular scrutiny. The Eurozone, French and Italian figures will be similarly important - particularly given the chatter about recession risks and the added pressure of external pressures like Brexit and the US tariffs. Two additional updates that are worthy of reflection for the big picture is the health reports for Mexico and Hong Kong. These are two large economies that stand on the cusp of the developed/emerging market designation with particular exposure to trade wars. This data can potential thaw fears of recession that have hardened over the past year behind data and increasingly complicated diplomatic situations, but the potential definitely skews the opposite direction. If this run of data reinforces the reality of economic struggle, it will serve as another cut to a speculative reach that seems divorced from fundamentals that are traditionally assumed to reflect value. In general, all of the thematic risk represents a greater role of risk rather than relief. Redressing the Limitations and Costs of Extreme Monetary Policy as Fed Arrives With the world’s largest central bank and its most dovish both on tap for this week, it is important to consider what is driving these groups to loosen navigate into uncharted dovish waters rather than just go along for the ride by trading relative yield advantages in FX or capitalizing on a familiar speculative equation that suggests more external support buys more lift from favorite capital market benchmarks. There is little denying the years of connection between the amount of accommodation (low interest rates, negative interest rates and quantitative easing programs) and the enthusiasm from the investing masses. This is a relationship forged originally in ‘monetary policy in capital markets’ textbooks, but the connections have grown more than skewed in the latter years of this extended cycle of easing. First and foremost, the overriding intent of monetary policy to foster economic health have been proven to be lacking. It could be argued that the dovish shift after the 2008 Great Financial Crisis / Great Recession stemmed the bleeding. Yet, the exceptional support has only grown over the years and we find ourselves on the cusp of another economic stall. This is a feature of the landscape for most of the major groups, but it is perhaps a lesson that should have been learned earlier through the Bank of Japan’s own experiences. The central bank has failed to return inflation to its target for any period of consistency for decades – not just years. So, though it is not considered one of the most prescient groups for a global overview, there is much to learn here. Though an inability to reach their principal economic objectives is a significant problem in itself, it may not be the straw that ultimately breaks the camel’s back. That is more likely to be the consequences to come out of the financial market influences from these extraordinary measures. Though it may not be their intent, the central banks’ easing has inflated capital markets substantially. The pressure is not even, but we have seen risky assets hit record highs at various points with different levels of excessive price to value. Few places is the extravagance more evident than with the US equity indices. At record highs, we should consider that the equity market is pricing in perfection for growth, earnings and returns. It is not very controversial to say that is not the case now. Far from it. Stimulus and low rates has not improved circumstances that remarkably rather the lack of significant return and a tepid economic environment has left investors starved for opportunities that can provide substantial growth at a reasonable risk. And so, they accept greater and greater risk to make ‘ends meat’. Propping capital markets higher may seem a net benefit in the absence of genuine growth, but there are serious risks associated to this state. Expectations for more support will grow exponentially with time. Capital distribution outside of the healthy business cycle will encourage funds to underperforming or zombie businesses that will further weaken economies. And, the growing disparity will inevitably lead to a point at which recognition of risks will force an acceleration of deleveraging which will manifest as a financial crisis that more readily turns into an economic crisis. This troubled state is growing increasingly apparent to investors and business owners, but now the concern seems to be permeating the central banks themselves. Outgoing ECB President Draghi admitted concern late in his tenure, though not as loudly and directly as some of the more hawkish members of his board who will remain with Lagarde at the helm. Some of the Fed officials have stated concern along these lines as well, but the group is not yet as overextended as most of its counterparts. In previous years, the US group’s tightening was viewed as a sign of optimism around the potential of self-generated growth. That perspective may hold as the circumstances change. If the Fed seems forced to loosen the reigns to match the ECB or BOJ, it may not be interpreted as a uniform source of speculative liquidity but rather admission that all economic traction has been lost. It is not wise to cheer negative rates and QE. A Brexit Solution Seemed So Close Less than two weeks ago, a breakthrough between the UK and EU teams in their negotiations for a quickly approaching Brexit cutoff date seemed to have changed the dynamic of an impending crisis. With Prime Minister Boris Johnson repeatedly stating the Article 50 extension date of October 31st would be held to ‘one way or the other’, there has been an understandable intensity by all those involved to find a compromise to avoid an economically-painful ‘no deal’ outcome. As such, the concessions found between the UK government and European representatives to form a Withdrawal Agreement Bill seemed the most important hurdle to overcome and sentiment understandably swelled after the developments. Yet, that optimism has significantly deflated this past week. First, it was the previous weekend’s extraordinary Saturday Parliamentary session which delayed the Government’s implementation of the deal which started the decline in ambitious optimism. Tuesday’s ‘second reading’ further delivered PM Johnson a blow when he was outright rejected on pushing forward to meet the short time frame. What was more remarkable to me than the familiar trouble to find an agreement exit from such disconnected parties was the Sterling’s ability to hold onto the gains of the previous weeks – prompting GBPUSD to an incredible 6.5 percent rally in in just a few weeks. Trading not far from multi-decade lows, it may not seem that difficult for the Cable to hold some of its recent buoyancy even if progress seems to have dangerously stalled. Yet, the real fair value question is to be found in the array of possible outcomes and their market influence. A divorce with no terms is still a serious probability and its economic and financial impact is not likely priced in even after the slide of the past three years. An extension is nevertheless a greater probability than a cliff on Thursday evening. That said, we are inviting more complication and additional cutoff dates while maintaining the same mix of impasses. Prime Minister Johnson, frustrated by the lack of progress, called for a snap election for December 12th this past week. That request will be considered in Parliament Monday. Presently, polls suggest conservatives could gain support but it is not clear if he will be granted his wish. Further a complication is the EU’s allowance for an extension. The PM sent a request for an extension to January 31st according to the Benn Act back on October 19th , and to this point no reply has been given. France is reportedly skeptical of giving the disgruntled country so much additional time without clarity on what they will actually do with it. Uncertainty is having tangible economic impact, and the discount is increasingly permanent even if the next steps are still fluid. So, this week, we will have to find out what Parliament will agree to concerning the election on Monday and the EU will have to grant an extension before the deadline on Thursday night. Mind your UK/Sterling exposure.
  8. UK Parliament Votes to Delay Brexit Deal, Now What? Heading into the weekend, overnight implied volatility behind the Cable and other Pound crosses had charged to their highest level in over two years. That reflected well the fundamental weight represented by the first Saturday sitting in the Commons in 37 years. Parliament convened to debate the government’s withdrawal agreement bill which Prime Minister Boris Johnson managed to hash out with European negotiators during the EU leaders summit. The compromise came at the last possible moment as the law passed by MPs before their proroguing required Johnson had a deal in hand by October 18th or he would be required to send a letter to European officials requesting an extension for negotiations to avoid a no deal outcome. It was telling that the progress towards avoiding a hard Brexit scenario to this point had seen GBPUSD charge its biggest 7-day rally in decades yet anticipated volatility had soared in tandem. That speaks to the level of speculation going on and the very convoluted situation with which we are dealing. Ultimately, Saturday’s vote would confound the momentum that had built towards a tangible deal and in turn trip up the speculative charge that had gained such remarkable purchase these past few weeks. The MPs voted 322 to 306 on the so-called Letwin amendment which would withhold approval of the deal until legislation was in place. That would in turn trigger the ‘Benn Act’ which required to the PM to send a letter requesting an extension from the October 31st deadline out to January 31st. The government did this begrudgingly along with a second letter in which Jonson made clear he believed a delay would be a mistake. The impact that this has on the market is inevitability convoluted as the array of scenarios for the ongoing negotiations is itself complicated with options. Though the deal was not pushed through, the effort to delay is principally based on an effort to push back a no-deal outcome in a bid to permanently prevent it from ever coming to pass. Nevertheless, the intensity of the recent charge is compounding speculative appetite that will likely be frustrated by this turn of events. A swift retreat that could then turn to contemplative balance. It is possible that the EU could reject the request to push back the decision date which would send a shock of panic through both the Sterling and capital markets, but that is a low probability. Granting the UK an extension that only lasts a few weeks rather than three months would leave very little time to accomplish anything other than an approval of the offered withdrawal agreement or risk reviving the no-deal scenario. Some European leaders want to know what will be the point of offering an extension – coming to agreement on the given deal, general election or perhaps referendum. The pressure will remain in all of these scenarios, but the intensity will be greater depending on the immediacy of the scenario. Meanwhile, the government officials (the Foreign Minister) have stated their belief that they have the necessary numbers to push the current deal through Parliament. It has been suggested they will call for a ‘meaningful vote’ and possible seek to work through the details of the current deal in order to find the majority that Johnson needs to move forward. To Pound traders and foreign investors, this will look like general uncertainty which is naturally reflected as volatility. Committing to a particular course for a market steeped in such instability will be exceptionally risky. That kind of scenario will draw more speculators than steadfast investors, only compounding the situation. Beware trading GBPUSD this week. A Serious Escalation of the Global Trade War…Underappreciated Despite efforts by the European Union’s trade delegation to negotiate a compromise, the United States Trade Representative’s (USTR) moved forward with slapping hefty tariffs on certain EU imports. The White House will not be easily swayed with this push as it considers the effort to be sanctioned – at least partially – by the global community. The World Trade Organization (WTO) found that the US could pursue corrective measures against the EU to the tune of $7.5 billion for what it considers harm done through unfair subsidizations for the Europe’s principal airplane manufacturer, Airbus – never mind the group found the US guilty of similar practices in favor of Boeing, it just has yet to rule on the amounts that can be pursued. While the lack of ground the US is willing to negotiation is a general problem that the whole world is experiencing, the particular trouble for the EU is in the products that are being taxed. In addition to the expected 10 percent tariff on imported airplanes, the US has also imposed a 25 percent hit to certain agricultural products and there was also reports they were pursuing industrial goods as well (though that isn’t yet clear in the details). These unrelated industries to the initial dispute register as economic aggression that urges retaliation. Remarkably, despite what this situation would insinuate, the coverage around its unfolding has been particularly light. In part that is likely owing to more immediate concerns such as Brexit, the US-China stand off and regular warnings of economic lethargy. Just as crucial to the limited impact is the lack of retaliation from European officials. That is unlikely to last. In a best case scenario – short of an unexpected compromise – would be Europe waiting until the WTO rules on the notional amount it can pursue against the US for the Boeing finding. That could keep this additional threat to the already fading growth forecast at a simmer rather than rolling boil. Yet, there is considerable debate among European officials on how to act. Germany’s Finance Minister has urged his counterparts to hold off on retaliations to allow for negotiations to work and likely to avoid a high probability path of steady escalations that seems routine with the US. On the other hand, the EU’s Trade Minister warned before the official tariff start date that they would have “no alternative” but to take countermeasures if Washington wouldn’t deal. If Europe moves to counter the US, risk trends and economy watchers will pick up on it readily. We may find some grey area should retaliation be held to what is considered like-for-like for industries unrelated to airplane manufacturing. If that is the case, the US may not be quick to cry foul and escalate, particularly when they are distracted by so many other issues nowadays. Alternatively, if they are spoiling for a fight and looking for a reason to spread their self-labeled righteous efforts to rebalance trade practices around the world, the Trump Administration could make another sharp response in a shock-and-awe approach. Ultimately, we will not be able to avoid that recession that seems to be lurking at the fringes if the two largest economies in the world decide to gouge the trade between them. EURUSD Launches a Rally, But From Where? There is a lot going on in the FX and global capital markets, so it is understandable that some significant movement in some of the less-trafficked corners of our charts goes overlooked. Yet, that doesn’t suit the EURUSD. The world’s most liquid exchange rate (and arguably asset) has accelerate a bullish reversal that began with the month. Technicians would recognize the move for being the strongest two-week advance in approximately 13 months. From there, the technical boundaries that we’ve overcome – like the 3-month descending trend channel – carry some weight of their own. But what makes this effort particularly remarkable in my estimation is the starting point. Through the end of September, the pair was trading at its lowest level in two-and-a-half years. Adding to the interest in the move is the context of a market that has proven remarkably stagnant. Sure, we were plumbing new lows, but the decline was coming in starts and fits with a very gradual descent which reflected well on the broad restraint this benchmark has exhibited for the past 17 months. Are we finally seeing volatility restored to a pair that has successfully avoided large swings for that long? To interpret the probability of a transitional period, we need to understand what has steered the market through its restrained routine thus far. Why has EURUSD been so controlled? While some believe this is an anchor born of two reserve currencies, I suspect that we are witnessing the confluence of multiple competing forces. Safe haven capacity, relative growth and now trade war implications are just a few of the more exceptional forces jostling these currencies. It is very likely that these matters take up a bigger role in their relative performance into the future. Yet, at present, the bullish reversal from EURUSD has a few interesting properties to perhaps highlight what is the most interesting matter at present. This past week, the Euro didn’t show a broad rally across its major counterparts and EURCHF in particularly made no effort to reinforce. Alternatively, the Dollar made a fairly broad retreat. Realization of trade war blow back, recognition of the struggling economic data or political uncertainty may all be contributing to the slide; but I think a more familiar catalyst is responsible: monetary policy. Through the end of the past week, the probability of a third consecutive rate cut from the Federal Reserve rose to 89 percent according to Fed Funds futures. That is a significant escalation from a week ago and up from little more than 20 percent a month ago. If this is indeed the root of this ground swell, thing should get more and more interesting as we approach the Fed’s October 30th meeting.
  9. Is This a US-China Trade War Turn We Can Rely In? The market was struck with a broad sense of enthusiasm through the second half of this past week. There were a number of developments – or expectations for forthcoming events – that contributed to this buoyancy. The theme stirring the most optimism was anticipation that the United States and China were finally making progress in their 15-month trade war. Just before the New York close on Friday, officials announced that indeed they had found some middle ground for compromise. The question global investors should be asking is whether this is tangible and significant enough progress between the world’s two largest economies to foster enough confidence in the economic and financial outlook to beat back unrelated systemic concerns that continue to march forward – such as the fears of an impending recession. It certainly draws some measure of concern that the build up to the announcement was answered by a pullback when the news actually hit the wires (‘buy the rumor, sell the news’), though that may be a function of the twilight hour for liquidity. To properly evaluate the heft of the ‘compromise’, we need to first understand what was agreed upon. An agreement by China to purchase $40-50 billion in US farm products was the most tangible improvement – though it will partially be working to offset trade restrictions suffered the past year. The most important agreement is the deferment of the 5 percent point increase in the tariff rate on $250 billion in imported Chinese goods to 30 percent due to take effect October 15, though it was not clear if this was completely off the table. After that, the measures are more ambiguous. The US vowed it would review its entities black list (though Huawei was not part of that consideration) as well as reconsider the decision to label China a currency manipulator. There was also language to suggest discussions would continue over one of the Trump administration’s principal issues, cracking down on intellectual property theft and subsidies for state run enterprises, but there was nothing approaching detail on enforcement. There is certainly material to point to in this agreement, but it falls far short of the milestone whereby the leaders couldn’t just reverse course with little warning as they have done a number of times before, including after the June G20 agreement. The potential of a mere delay in the tariff rate hike isn’t nearly as concerning as the fact that the planned increase in the United States’ tariff list on December 15 was left in place – likely as pressure to speed along a deal. Further, China’s interest to loosen control over its economic and financial influence for IP enforcement, subsidies and American access to the Chinese economy will be very thin as the government faces the slowest pace of growth in three decades. There is significant interest on both sides of this standoff to find a compromise – President Trump wants to avoid a recession before the campaign season heats up and China wants to avoid too severe economic pressure that can further contribute to social unrest – but the struggle to secure superpower status can be powerful and the pain absorbed thus far can prove difficult to reverse. Market performance Monday will be very telling as to where sentiment stands on whether there is enough confidence in these two parties and whether their cooperation is even enough. Hope for a Brexit Breakthrough Mounts Amid General Good Mood Market Another ongoing political standoff that both carries broad economic / financial risk and found a seeming break in the cloud cover this past week was the Brexit negotiations. It was difficult to miss the market’s enthusiasm with a Sterling rally that translated into the biggest two-day GBPUSD rally in over a decade. The Pound has shown time and again that while it may feel some of the crosswinds buffeting the global markets, the status of the UK’s separation from the European Union is chief to its bearing and all other matters have their volume turned to zero when there are developments. So, how encouraging was the news this past week? Looking to the headlines, there were updates to reflect upon. UK Prime Minister Boris Johnson and his Irish counterpart Leo Varadkar stirred hope when they both offered enthusiasm after their meeting, saying there was a “pathway” forward as they discussed the contentious border. That was followed by a meeting between the EU’s main negotiator Michel Barnier and UK Brexit minister Stephen after which it was stated they 'look forward to these intensified discussions in the coming days'. Though nothing material has yet been agreed to, this seems like a meaningful break owing to the language alone. Neither side has voiced confidence in their discussions for some time, so this does represent a significant change. With this modest progress, what are the scenarios moving forward? A full compromise on the Irish border would likely set up a true breakthrough for the extended Brexit with an actual deal in hand. If that progress if found, the British currency will continue to climb. While the health and bearing of the UK’s economy and markets will not be able to avoid other known and unforeseen crags, there is a substantial discount to afforded to the possibility of a no-deal outcome. On the other hand, if Johnson refuses to settle on his aggressive position with the country’s withdrawal, there remain certain insurance measures that can forestall imminent crisis. Parliament voted before its court-ordered, shortened suspension period that the PM would have to request an extension from the EU should no deal be struck by October 19. While he has been adamant on the timetable of the exit, it is unlikely he challenges a law, and the EU for its part likely has no interest in triggering a recession in any regional economy by refusing. Keep abreast of headlines that will inform us on the state of talks as well as the planned EU leaders summit on Thursday and Friday. The IMF Updates Growth and Financial Stability Forecasts While some cracks in the iron walls of global trade disputes seem to be providing a foundation for speculative enthusiasm heading moving forward, there are still serious fundamental encumbrances to a genuine bullish view of the future. Perhaps the most critical of the risks on the horizon is the threat that the global economy cannot avert its impending stall out. While trade wars have exerted material pressure on growth (the IMF director estimated the US-China fracas was going to cost the world $700 billion in GDP) and even more detriment through investor, consumer, business confidence; there are other – more natural – matters throttling growth. With the US enjoying its longest expansion and bull market on record, a moderation is overdue. I do not fully buy into the belief that periods of growth do not die of old age as there is limited resources that can be utilized to support such a period. That is especially true of the period we have experienced this past decade which has experienced bouts of extreme pace helped along by external and temporary influences such as monetary policy. Fed and other central banks have set their expansionary policy as a key strut to the health of the global economy. What is worrying is that this measure finds as much influence through self-reinforcing speculative belief as it does through genuine distribution of productive capital. That is why it is so troubling that recent waves of stimulus have not been met with the same conviction from market participants and disagreements among the policy setters threatens to further invite scrutiny. In this fragile backdrop, we are expecting an important update on the economic health of the globe this week. In truth, there are important milestones on a weekly basis at this point – from monthly PMIs to sentiment surveys to warnings from supranational groups like the OECD. Yet, what we have on tap is both comprehensive and targeted to perhaps the most contentious situation in the global market. In the latter case, we are due the 3Q GDP reading from China. Though hope for an improved trade relationship with the US is warming markets, the absorbed effect of months of tariffs will show through in this lagging indicator. A poor showing is very likely (whether a new 30-year low or near the previously set figure) or otherwise the markets will treat it with deep skepticism. The only favorable aspect of this update from a trading perspective is that it occurs on Friday, so more anticipation in price action than actual discounting. As for the comprehensive view, we are awaiting the IMF’s updated forecast on world’ growth through its semi-annual WEO (World Economic Outlook). The week long meetings are anchored around this particular update and the new Managing Director, Kristalina Georgieva, has already signaled that the update would downgrade the perspective to the worst course since the Great Financial Crisis. Have her warnings already led the market to fully price in the pain? I will also be watching the groups GFSR (Global Financial Stability Report) very closely. Stability of the markets is one of the more critical accelerants to crises when things start to fall apart and the discussions around the effectiveness of monetary policy are starting to push these questions to the forefront.
  10. The Trade War Spreads to More Critical, Global Growth Organs We have been unofficially engaged in a global trade war since March 2018. That is when the United States moved forward with a tariff on imported metals (steel and aluminum) from any destination outside of the country. Since this opening salvo, there have been small actions against countries outside the singular focus of China, but the incredible escalation between Washington and Beijing has drawn most of the global attention. With tariff rates running as high as 30% on over $350 billion in goods between the two economies, it is no surprise that we evaluate the growth-crushing competitive efforts on the basis of these two superpowers alone. As it currently stands, we are still awaiting another wave of products receiving a hefty tariff rate upgrade in approximately two months’ time while talks are set to resume on Thursday between the two parties. That said, reports over the weekend indicated China was not impressed with the Trump administration’s most recent efforts to find middle ground. It is important to keep tabs on the situation between the US and China, but at this point the markets seem to place greater emphasis on the data that reflects the tangible repercussions of their fight. If you want to watch the next stage of painful escalation in this systemic threat, it seems clear that the tension between the US and the European Community is the emergent battlefield. There are already a few active trade levies between these two largest developed world economies, but most of the systemic threats have been reserved to an escalation in mere threats….until now. This past week, the WTO (World Trade Organization) ruled that the United States could raise $7.5 billion in tariffs against the EU for unfair subsidies supporting the region’s principal airplane manufacturer, airbus. The US Trade Representative’s office wasted no time in moving forward with the punitive action. That itself is not a surprise nor even a serious controversy. What was provocative were the details of the United States’ plans. The country announced a 10% tariff on imported airplanes, but it would slap a far more punitive 25% tax on European agricultural and industrial goods. That is a move that registers more directly as a trade war action, moving well beyond the cover of WTO ‘sanction’ (the group urged negotiations) and encouraging reprisal. To their credit, the EU held back from retaliatory actions this past week, hoping that an understanding could be met. That said, they EC will not wait forever. It was reported that they were ready to react immediately before the ruling, and they have been quick to respond verbally to all of the US threats over the past months. If we go down this route of a trade war even half the scale of what the US and China have committed to, expect forecasts for global recession to change from an outlier of the pessimists to the baseline view of the investing masses. A Near-Daily Update on Recession Fears Until late August, the word ‘recession’ was only uttered by conspiracy theorists or serial pessimists. That reticence was despite a growing wave of economic data, sentient surveys and supranational organizations warning that a stall could be in he not-so-distant future. That isolation has dissipated quickly over just the past few months. The inversion of the US 10-year to 3-month yield curve was the first distinct cue that the market and then media picked up on. With a moniker like ‘economists’ favorite recession signal’, the headlines wrote themselves. Once attention was called to the frailty of the longest running expansion on record (at least in the US), the other holes started to become more overt. In the US, the NY Fed’s own recession indicator listed the probability of contraction for the world’s largest economy over the next 12 months above 30 percent – a signal that has indicated momentum into the genuine article in all but one instance going back decades. Meanwhile, the warnings from global groups have been taken more seriously: such as the OECD, WTO and IMF over these past two weeks – warning of significantly slower growth though not necessarily full contraction. Data has similarly indicated trouble from US and Chinese manufacturing contraction (‘recession’) to some full GDP readings around the world actually printing a negative monthly or even quarterly report – an official recession is two consecutive quarters of contraction according to the NBER. Ultimately, the market determines what is important or market moving. We have seen numerous data points and warnings shrugged off by the markets over the past years because the speculative bias was such that market participants were happy to allow complacency to dictate a capital market drift higher. That does not seem our undercurrent at present however. Since the February 2018 plunge, we have seen a serious struggle among speculative interests to lift the markets back to their previously-set all-time highs, much less beyond them. The US indices were the most bubbly among the traditional risk assets and even they have not progressed far beyond the early 2018 swing high. Most other recognizable benchmarks are significant lower than their respective peaks from that year. In other words, the markets are paying closer attention to warning signs and are more willing to leverage their occurrence into meaningful market movement. With that setting in mind, there are a number of indicators this week that can stir our imaginations for the worst including: China service sector PMI; China foreign reserves; Eurozone investment sentient; Japan household spending; Germany industrial production; US small business sentiment; US consumer confidence; UK July GDP and Germany factory orders among many others. Keep tabs on the economic calendar as well as the headlines (Google search of ‘recession’ is quite informative). Gold – When Fundamentals and Technicals Conflict Gold is perhaps one of the indicative signals from the market as to the state of the global financial system and economy that you can find from any single source. The precious metal is a well-known safe haven, but its climb this past year has deviated significantly from the performance of fellow measures like the Dollar and sovereign debt not to mention risk assets like US indices. Its position as an alternative to traditional fiat is far more important. With central banks once again turning to expansive policy regimes while economic forecasts barely budge, there is a natural depreciation of all assets that represent this quandary: which includes currencies and government debt. There are few reliable alternatives to these traditional stores of wealth – especially when they are all dropping in tandem (Dollar, Euro, Pound, Yen). One of the very few, historical benchmarks that can meet the test is gold which is global and has played its role as a means for exchange many times through history. Given this unique role, consider the outlook for the economy and markets. Even if you don’t believe a recession is at the door, the threshold for significant expansion is very high at this point. Further, there is not much room for easy speculative gain but enormous room for retrenchment. Where would you seek safety and stability if push came to shove? We – the market at large – were faced with that existential question to some degree this past week. On a technical basis, the precious metal took a remarkable bearish jog, a move that textbooks would place a high probability on fueling an overwhelming bearish trend. This past Monday’s drop cleared two months of range resistance that happened to also stand as the ‘neckline’ on a large head-and-shoulders pattern over the same period. There are few more preferred reversal measures among pattern watchers. If unencumbered by fundamental complications, speculative fear could have readily taken over and guided a more significant move for the bears. Instead, the reversal stalled immediately upon launch. This is the conflict that can arise when two favorite analytical techniques conflict. There is considerable debate over which measure is more indicative and reliable. In reality, they both have their merits and place. The backdrop and depth of catalyst can tip the scales of influence from one method to the other. Yet, if you are a trader willing to considerable a broader picture of the market in order to identify more reliable signals, it is better to find opportunities where the techniques coincide rather than conflict. Yet, in this world of contradiction, it is worth watching gold on a regular basis whether you intend to trade it or simply use it for signaling purposes.
  11. Politics and Markets There are numerous, open political fissures around the world – including the approaching Brexit deadline; the ongoing flux of Euro-area stability and Chinese social pressure arising from economic concerns. Each of these represents significant headline fodder both within their respective country as well as in the international press. Yet, as many newspaper column inches or top headlines in online news aggregators these issues may represent, they don’t naturally adapt to clear economic or market impact. Evaluations are made over the prevailing trends and assumptions applied as to how these issues will work their way into tangible impediments to either growth or returns. That said, the uncertainty of all three of the aforementioned issues has unmistakably dimmed investors’ and consumers’ growth expectations. To ignore these matters when they are key motivators for a majority of market participants would allow a gaping hole in your analysis. Then again, it is easy to allow the drama of the headlines to overshadow the practical impact it may exert, allowing the natural passions of politics to take your well thought out strategy completely off the rails. The difficulty in striking this fine balance is even more folly prone when it comes to the state of US politics. There has been an extreme divergence in party politics over the past decade and President Donald Trump has only fostered the divide. This creates a situation in which those in strong support of the White House allow their values outside the market paint a further exaggerated picture of an already complacent and exposed position, seen in the recent consumer sentiment surveys in which those reporting unsolicited enthusiasm for economic health via the President’s policies hit a record high. On the other end of spectrum, there are those that believe a recession is imminent through trade wars, political gridlock, dramatic debt expansion or income disparity. Naturally, the rise of the impeachment inquiry by the House of Representatives for interactions with the Ukraine exaggerates the reach into actual market impact. So how do we make a practical assessment as to what impact such political events can legitimately have so as to avoid emotions-based missteps and/or exploit the ‘wisdom of the crowds’. There are two measures of response that I typically expect in such developments: short-term and long-term impact. For the former, we can evaluate how much interest is concentrated on issue by using tools like Google Trends search or hashtag density for social interest to inform how likely a headline around the topic will leverage a market response. However, I prefer the empirical approach of assessing how much impact a related development will have on the market to set expectations for future updates. For long-term implications for growth and investor positioning, sentiment surveys such as the University of Michigan’s, Conference Board’s or Gallup’s for consumers or New York Fed’s for large investors can help course correct. Yet if you take the time each week or determine which developments are consistently taking control of the market most of the time through the bulk of the movement – what I consider rule number one for fundamental analysis – you’ll find yourself not as readily prone to finding the passions of politics drawing you away from the objective work of applying a successful strategy. Trade Wars Deadlines When discussing the course of trade wars, most people would move to evaluate the state of play between the United States and China, and for good reason. These are the two largest independent economies in the world and their relationship has steadily deteriorated to the very costly detriment of the global economy since the first economic ‘shots’ were fired back in March 2018. However, to judge the course of the global economy and investment environment on the talking points between these two superpowers alone would be to miss the truly virulent threat in stalled global trade. There are some caveats to the particular US-China standoff that keeps it from readily inciting panic. Many developed countries consider China a long-term bad actor when it comes to fair trade and have so for many years. Therefore, they are willing to tolerate some degree of pressure. Also, there is an unrealistic assumption of the Chinese government’s control over the health of its economy and financial system born of the command style approach they have used for decades. Then there is dulled reaction time globally that follows a decade of bullish market performance which earns an unreasonable sense of immortality as it keeps buoyant despite supposed fundamental setbacks. This confidence evaporates though if and when the altercations shift to encompass other developed world economies. The United States’ renegotiation of the NAFTA agreement seemed to have lifted its pressure on the markets as high-level agreement was made on the replacement USMCA. Yet, are have yet to see Congress approve the deal with Democrats asking for more and the year-end deadline is approaching. With many threats, we face tangible fractures between the two largest developed economies in the world this week as the WTO is due to deliberate the United States ability to apply tariffs for the claim that Europe had illegally subsidized Airbus for an uncompetitive advantage. This is a point of contention, but the risk lingering a seven weeks out is far more likely to provoke extreme retaliations on a global basis. President Trump received a report from the Commerce Department on the threat to national security inflicted by foreign auto imports. The White House had until May 18th to make a decision originally, but he deferred 180 days. That puts the deadline at November 14th. To suggest he wouldn’t go through with a tax on this competition would be to ignore the precedence already set. Also, the political pressure can also lead to more brash decisions. What Should We Expect If a Recession Hits? According to the New York Fed’s recession probability indicator – based on the increasingly popular Treasury yield curve – the world’s largest economy is facing a 38 percent probability of tipping into contraction over the next 12 months. Speculative interest/fear of this occurrence is significantly higher. Many have pointed out that previous instances of this same indicator rising to this level in the past have signaled eventual recessions in all but one instance. Further, there is also the increasingly popular belief that the chances of recession increase significantly as it is discussed and surveys reflect greater anticipation – a self-fulfilling prophecy so to speak. Google search ranking of ‘recession’ surged in the United States this past month to highs not seen since the actual Great Recession a decade ago. Further, other major countries have struggled with their own expansion – such as China running at a decades’ low pace, Japan notching negative quarters, Eurozone members contracting and more. With economic storms such as trade wars, Brexit and deteriorating monetary policy effectiveness weighing, it would seem prudent to at least prepare a contingency risk plan. If a recession were to befall the global economy, how would it play out and what would the response to try and correct its course look like? As for the occurrence of a slump in global growth, there will be leaders and laggards to turn into the red. Some with artificial curbs to imported pain or unique sources of growth can hold back the tide for a little longer than others. Considerable attention will be paid to one of the sparks that would ultimately feed the consuming fire, but the recognition of the more prolific fuel – excess leverage throughout the system – won’t be appreciated until it is too late. Consumers, investors and politicians will demand action from the world’s largest central banks. They will attempt to lift the economy, but will come up wanting as they have little in the way of standard policy tools or even effective unorthodox means left to them after a decade of capital market padding. If the market recognizes their limits, it will only deepen the panic. Then the governments of the world will be expected to step in. Programs like the TARP and TALF in the US preceding QE will be unleashed, but these will not be any more effective this central bank stimulus. Coordinated response will be the greatest possible option, but the state of global politics has shown these authorities more interested in competing for limited resources (growth) than collaborating to create more for everyone. That will similarly deepen any crisis. Eventually, unprecedented actions would be taken, but after how much economic pain and investor loss? It is hard to tell.
  12. What are Central Banks Attempting to Achieve at This Point? Over the past two weeks, we have seen major central banks loosen the reins on monetary policy or otherwise set the stage to move further into unorthodox policies. The most notable moves were made by the European Central Bank (ECB) and Federal Reserve. The latter cut its benchmark by 25 basis points to bring its range down to a high level of 2.00 percent – though it maintained its increasingly dubious position that it expects no further reductions this year. The former took more dramatic action. The 10 bp rate cut lowered its deposit rate to -0.50 percent, but it was the announcement that stimulus purchases (QE) would restart in November after an 11 month hiatus and introduction to tiered rates to help European banks struggling with profitability that represented a shifting frontier for policy. Just as extraordinary was the steady course held by the Bank of Japan (BOJ) who maintained its open-ended stimulus program tied to a 0% 10-year JGB yield target and the Swiss National Bank’s -0.75% benchmark. These four central banks alone could represent the landscape of global policy directing growth and inflation in the developed world, and that recognition itself should raise concern over the state of our economy and markets. An obvious question that should be raised in the face of this concerted easing is: what is the purpose? For all of the aforementioned groups, the target is either inflation and/or a growth metric like employment. It is reasonable to further assume there are certain unofficial objectives as well, such as general financial stability or even capital market appreciation as a means to fund a ‘trickle down wealth effect’ (something former Fed Chairman Bernanke was an ancillary objective of the US QE program). Yet, if we gauge the Fed against these various goals, we find core inflation above target, full U3 employment, volatility readings remarkably tame and capital markets at record highs. Why supply more fuel if you are already running at full speed unless you foresee a high probability of some crisis? Admitting this level of concern on the other hand could inadvertently trigger the conditions that realizes those fears. Many feel the hazy objectives shouldn’t matter so long as the potential results are faster growth and/or higher local markets. Yet, that is ignoring the reality of the costs associated to such efforts, and there is more recognition of this cost/benefit reality being voiced among the central banks’ ranks. Adding to the familiar criticism from the BIS, we have had officials from the Fed, ECB, BOJ, BOC, and many others voice concern over our inflated and distorted foundation. Just this past week, Rosengren added to the discussion after he dissented the rate cut saying such efforts lead to inflated asset prices and encourage excessive leverage among household and businesses. An underappreciated consideration in this mix is the more general case that the ineffectiveness of monetary policy as a tool grows increasingly obvious. What happens should a genuine recession of financial seizure – not just a soft patch of unmoored fear of such an occurrence – shows? These banks will be one of the few options to squelch the fire and they will have expended their influence when it wasn’t even necessary. Long-Term Versus Short-Term Objectives There is a well-known business school debate that CEOs are incentivized to pursue short-term profits at the expense of long-term business growth – and sometimes continuity. This often leads to the ‘CEO is a villain’ caricature that that prevails outside the world of finance, but these objectives are pressured by a very different market force: investors. Market participants have long sought as much ‘share-holder value’ as possible when considering where to allocate their capital to fulfill a desire to outperform the broader market .That is aggressive even in the best of times, and it is particularly difficult nowadays. Another side effect of the extreme monetary policy being employed across the globe is a remarkably low rate of return on investments tied to benchmark rates (essentially everything). Meanwhile, the S&P 500 upon which performance is benchmarked is setting an impossible pace. How is a company to provide that level of ‘value’ when underlying growth is tepid? They borrow against the future like most other systemic players, such as issuing debt to buy back shares. And so, the system grows ever more unstable. Another point of short-term focus arising on the horizon is found through government/fiscal objective. While there are certain countries that are shifting further towards long-term objectives – like China attempting to shift to service sector strength, consumer spending and open markets – the majority, particularly in the developed world, are heading in the opposite direction. That may be in part due to political cycles. Few places is this pressure more obvious than in the United States. The unfavorable polls for President Trump were easy to right off in previous years, but they are more difficult to overlook as the country starts to get into campaign gear. Just this past month, we have started to see a clear rise in concern over recession risks via investors and consumers in the United States. In a monthly economic Gallup poll, one of the reasons offered for the downturn in the outlook is the references to recession by economists – self-fulfilling prophecy. To stave off a leadership change in 2020, the Administration has very clearly fixed on the health of the economy as a critical target to boost reelection potential. Yet, they have also committed to the onerous trade war. How to offset a mature business cycle, a slower global economy and blowback from trade wars? Through the long-term, it is an improbable goal. For the short-term though, moves can be made to extend for a spell at the cost of greater instability and a deeper slump later on. This is why we are seeing demands for more central bank QE, fiscal policy that defies the typical party line and ruminations of devaluing the Dollar. Recession Signals Rising Again Fear over the health of the global economy continues to erode investor and consumer confidence. Sentiment surveys have stood as one of the most robust countermeasures against data that otherwise calls attention to struggling growth measures. Yet, even the most resilient of the economic participants are starting to show signs of wear. US consumers have maintained an almost unbreakable sense of enthusiasm until these past few months. That matches the sudden surge in search around ‘recession’ via Google – hitting the highest level since the Great Recession this past month. This shows a measure of awareness that will ‘weaponize’ poor data that gives weight to data that was previously overlooked. Testing this theory, last week, the OECD updated its growth forecasts and their perspective sent a chill into the market. With notable downgrades in 2019 and 2020 performance projections for the likes of the US, China, Europe and UK; they downgraded their global targets to 2.9 and 3.0 percent respectively. According to the previous IMF definition for global pacing, a reading under 3.0 percent could be construed a recession. The market didn’t tumble on the unfavorable update, but it certainly took the air out of speculative appetite in the aftermath of more central bank support. In the week ahead, we should keep very close eye on the various cues for economic performance. There are sentiment surveys that are scheduled such as the US, Eurozone, German and UK consumer readings; and there will also be those measures that are often overlooked but made more important given the general perspective in the backdrop. The market readings will further keep markets occupied and perhaps return to main street influence. The US Treasury 10-year/3-month spread has neared zero and the 10-year/2-year spread flipped positive recently. Sometimes, a temporary relief can sharpen the recognition pain when it returns. If these figures worsen again, an already on-alert market will read into the turn. As for traditional data, Monday’s session carries the most direct vehicle in the form of September PMIs from Japan, the Eurozone and US.
  13. And Now, the Fed The market has monetary policy on its mind heading into the new trading week thanks to the actions of the European Central Bank (ECB) this past Thursday. One of the world’s largest central banks, the group is making a bid – perhaps unintentional and perhaps not – to be the most accommodative group of its size. Already sporting a negative rate, a large balance sheet and a T-LTRO program; President Draghi steered his team back into an expansionary phase of dovishness despite his retiring in a few months. Testament to their forward guidance efforts, the market largely expected the 10 basis point cut to its discount rate (to -0.50 percent), the restart of quantitative easing or QE (20 billion Euros per month starting Nov 1) and the introduction of tiered lending aimed at helping banks struggling with profitability. In fact, the move was so thoroughly baked in that the Euro’s initial tumble reversed to gains and capital markets seemed little charged after the effort was made official. On the one hand, the ECB will be happy that it avoided triggering a volatility event which could create more difficult conditions to support moving forward. Alternatively, there is more than a little ‘wealth effect’ assumption to the transmission of current monetary policy. Underwhelming response from the markets could signal monetary policy is reaching the limits of its effectiveness. That is the unpredictable scene we are met with as we approach the Fed’s policy event. The Federal Reserve’s policy event is scheduled for Wednesday at 18:00 GMT. Even putting aside the existential crisis traders are facing with the concept that monetary policy may be losing its effectiveness, this was due to be an important meeting. September’s meeting represents one of the ‘quarterly’ events whereby we are due the Summary of Economic Projections. That includes the updated forecasts for interest rates that the markets watch so closely. Even more pressing with this particular meeting, is the question as to whether the Fed will follow up with its first rate cut in a decade this past July. After that meeting, Chairman Powell said the move was a ‘midcycle adjustment’, a phrase repeated in the official perspective of the group in the meeting minutes. That would insinuate that the next reduction – if there would be one – depends heavily on data. As it happens, recent jobs figures weren’t gangbusters but the trend is still the best in decades. Further, core inflation registered by the CPI was accelerating above target. These are not the developments that would signal easing is urgently necessary. Nonetheless, we are facing a serious difference of opinion on the subject with the market still pricing in a robust 80 percent probability of a rate cut - though down from certainty just a week ago. Does the Fed dare disappoint the market and trigger capital market fear that will in turn necessitate central bank support later regardless or will it cut despite its explicit remarks that it was unnecessary and tarnish its credibility? Many market participants – especially those that have benefit from the zombie-like complacency bid these past years – would advise protecting market gains to avert any speculative slump that can make more tangible the economic pain. Yet, the long-term risks of satisfying risk takers can be severe and irreparable damage to credibility and ultimately an inability to fight serious fires in the future. The global market is struggling under trade wars and the natural flagging of the economic cycle. There is certainly appetite for the world’s most hawkish, large central bank to make a more consistent distribution of support, but satisfying these appetites would only draw attention to the state of dependency growth and market performance attached to stimulus and negative rates – not to mention dissuades fiscal powers from taking on the responsibility themselves. If the Fed refuses to act and there is investor fallout globally, those central banks already all-in will find their own credibility razed to the ground. A lot rides on the Fed, and not just for the Dollar or Dow. Good Will and Rumors of Economic Pressure Points in Trade Wars There is an unmistakable enthusiasm around the state of the US-China trade war over these past two weeks. It started slowly enough with the suggestion that the two sides would return to the negotiation table in earnest early next month with leaders from each camp suggesting they were optimistic. As far as inspiration goes, that doesn’t even rank as a far-fetched cue for optimism. We have seen far too many slow starts of this exact type flame out and ultimately result in a worsening of relations between the two. Thankfully, there were more tangible efforts of good will to build momentum upon. China announced that it was waiving tariffs on 16 US imports that were previously taxed – the first such course reversal since the trade war began. Despite the relative minimal move, the US responded by announcing that it would delay the increase of tariffs on $250 billion in Chinese imports from 25 to 30 percent by two weeks, pushing it from October 1st to the 15th. Looking to surpassing that frequent trip point after the first round, China then followed up with the announcement that it would exempt US pork and soybeans from tax at the ports. This is indeed tangible progress, but recall that the higher level officials are not due to meet until early October. Further, there have been frequent false dawns whereby the absence of a compromise has not resulted in status quo but rather an escalation. Nonetheless, there is clear evidence that both sides are interested in boosting market sentiment – such good will reciprocation would never have occurred previously as each would have deemed it an overdue step by the liable party. For China’s part, it is concerned about the state of its local economy and financial system already under significant pressure. In the US, the Presidential elections are over a year away, but the campaign is already starting; and the rising fear of recession is posing a serious problem for Donald Trump. Fully reversing the trade war actions and striking a trade agreement would take serious time and capitulation from states and personalities not commonly known to ‘surrender’. It is still possible however. The real question we should ask though is: will the lifting of trade wars recharge growth or investment appetites? The absence of a ballooning crisis is not the same thing as seeding GDP or returns. Trade wars have taxed an already threadbare global economy while highlighting the dependency on external sources of support like central banks simply to keep the masquerade going. It is not a good point in time to look at markets through rose colored glasses. Repeated Accusations of Currency Manipulation Will Spur a Currency War There were a number of skeptics of the value added and intent from the ECB’s decision to escalate the support this past week – including some of the key bank members themselves. However, one person’s criticism that was fully expected as they took their rates deeper into negative territory and announced the restart of the QE program was US President Donald Trump. He has reflected on their efforts more often these past months as a platform to critique the Federal Reserve. Rather than decry their efforts as purely manipulative in a bid to earn growth at the expense of more virtuous trade partners, he has held their course up as a template for which the Fed is falling behind on. His berating of Chairman Powell has been relentless, but the haranguing hasn’t changed the central bank’s course – well, not as much as intended considering the President’s policy mix has weighed markets which the Fed is less capable over ignoring. At what point will a President frustrated by slowing growth and a central bank that is unwilling to supplement for the pain the trade war is causing – and ultimately incapable of holding back any serious collapse in economy – decide to take exchange rates as a tool into his own hands? The ECB’s moves will raise his ire, but the rebound in the currency will frustrated his claims that they are principally a move to devalue the currency. Such details haven’t held him back before however. With the Dollar holding near two-year highs with Euro, Yen and Yuan at the very lease employing serious policies that have at least a secondary result of FX depreciation; this will stand out as a genuine option in the event of emergency (a fading campaign in the face of economic struggle). Adding to the pressure, the Swiss National Bank (SNB) and Bank of Japan (BOJ) will likely hit upon the POTUS’s radar in the week ahead. Both are due to deliver policy updates. The SNB is not expected to cut rates further, but it is already hovering at a -0.75 percent rate and attempts to simply keep pace with the ECB so as not to allow EURCHF to drop. Meanwhile, the BOJ is similarly expected to hold course, but recently its officials have stated they were looking into the option of plumbing negative rates in a bid to finally earn the policy response they have failed to render thus far through a dovish mix anchored by an open-ended stimulus program.
  14. The Global Importance of the ECB Rate Decision Top event risk - both for concentrated volatility potential for its local currency and global influence via systemic means – over the coming week is hands down the ECB (European Central Bank) rate decision. Under normal circumstances, the monetary policy decision by the world’s second largest central bank is occasion for significant response from local currency and capital markets. For the Euro, the event is made far more potent at this particular meeting owing to the market’s aggressive speculation for a further infusion of support to their – and the economy’s – cause. Looking to overnight swaps, market participants are certain of a further lowering to the benchmark rate that is already set at -0.40 percent. Further, the group is expected to restore quantitative easing (QE) having only ended the previous effort back in December and failing to wean appetite for extreme accommodation with another TLTRO (targeted long-term refinancing operation). This would represent a virtual ‘all-in’ upgrade to an already-extreme support effort and is likely aimed at surpassing the market’s expectations. Yet, it would be difficult to live up to such lofty forecasts – much less best them. The Euro has already pushed to a more-than two-year low against the US Dollar so is already pricing in a substantial dovish view. Yet, beyond besting or falling short of the market’s expectations for the Euro’s purposes, we start to get into potentially systemic matters. If the central bank does depress the accelerator fully, outgoing President Mario Draghi will leave incoming Christine Lagarde with few reasonable options left to navigate any further tumultuous waters that occur early in her term. Just this past week, she was attempting to sooth German officials skeptical of unorthodox policies such as negative rates saying she would investigate the costs more thoroughly alongside the presumed benefits. She remains a firm advocate of easy policy however. That said, regardless of her commitment to carrying on Draghi’s regime, the question of the market’s willingness to respond to the effort is far more important to the health and stability of markets moving forward. We are already seeing the ‘effectiveness’ of central banks’ efforts wane in more recent iterations, a dangerous scenario if we ever genuinely need their (the ECB and its peers) support to stave off a crisis. If the ECB earns its near-term relief, all will not be immediately fine. If the markets respond favorably, economists adjust for the ‘stimulus effect’ and the Euro drops; it will instantly catch the attention of US President Donald Trump. He already uses the European authority’s policy as evidence of what he considers manipulation to afford an artificial advantage in his regular badgering of the Federal Reserve. Chairman Powell and crew have weathered the accusations thus far, but the President is being pushed by the pressure of an economy weighed by trade wars. If the Fed doesn’t indicate its willingness to follow the ECB down, he is likely to take measures into his own hands to – perhaps inadvertently – start a currency war. Brexit: All We Need Is More Time for a Pound Rebound The British Pound mounted an impressive rally this past week – and with no technical time to spare. GBPUSD through Tuesday dove to levels not seen since the post-Brexit flash crash back in October 2016. In fact, sliding any further would have put this benchmark currency cross back to its lowest levels in over three decades – more than just a simple drift in contrasting value and much more a statement on the troubled view of the British currency. Yet, just as the markets were nervously eying the exchange rate for perspective on the British currency, a short-term relief rally kicked in Wednesday. Part of this pair’s performance has to be assigned to the Greenback which started to slip across the board. Nonetheless, the Pound was rallying universally and it had a very clear fundamental cue with which to anchor its performance. Prime Minister Boris Johnson has been maneuvering these past weeks to ensure a ‘no deal’ option on Brexit be kept firmly in the mix in a bid to keep pressure on the EU to force concessions – if at all possible. Yet, his move to suspend Parliament for weeks before the official Brexit deadline on October 31st spurred new problems when his support from a razor thin majority in Parliament faltered. Now, the two institutions – government and parliament – are jostling for position in chess-like moves and countermoves. There is still significant risk that the country leaves the Union without an agreement to offer some economic and financial access – especially with weekend reports that France has no interest in offer an extension to negotiations even if the UK requests as they believe there is little sign they will work towards a genuine compromise. That said, merely tempering the threat of high probability ‘no deal’ outcome can afford significant lift for the Sterling. While it is possible the currency can always drop lower given its own situation and the context of its global counterparts, it is generally pricing in the ‘worst case scenario’ of the known circumstances at present. While buying time would not reset its long-term course, it can bleed some of the aggressive, short-term (short side) speculation and inspire more of the optimists to be opportunists. What Matters More to Fed: Consumer Inflation, Sentiment or the ECB While this week will be topped by the ECB’s monetary policy decisions, the looming event scheduled for Wednesday the 18th will pull at global investors’ fears and anticipation. There is even more riding on the US central bank’s policy choices. Beyond the practical consideration that it is directing the world’s largest economy and financial system, Jerome Powell and crew are directing the pace of retreat from the most progressive effort to ‘normalize’ extreme policy among the major central banks. This reflects how far the world’s monetary policy authorities are willing to go in a bid to prop growth, which will contribute to risk trends; but it will also set the baseline for effectiveness/ineffectiveness of their collective efforts. With 200 basis points available to ease and a reduced balance sheet that can carry the sentiment-based impact of a rebound, there is reason to watch even the fine tune adjustments in expectations. With that attention, there will be considerable weight afforded to the interim event risk that could possibly alter the ultimate decision a week forward. Through this week, the most traditional measure to keep tabs on will be the market’s favorite inflation indicator, the consumer price index or CPI. If there is an allowance for the group to resort to policy that under normal circumstances would be labeled ‘extreme’, they would have to find it in the price measures of their dual mandate as employment trends are on a decade-long expansion. As it stands, the Chairman and minutes have projected inflation pressures to reach target levels through the medium-term – which would suggest they do not intend to meet the market’s (and Trump’s) demands for aggressive easing. Another tangible event that isn’t part of the Fed’s official policy criteria but is of significance to the group’s forecasts and market’s divergent expectations is the University of Michigan’s consumer confidence survey. When the central bank says it is evaluating trends in employment and price growth through ‘the medium-term’, they are projecting out over the next two years on average. Of course, a lot goes into the change in these measures over that period, but few things are as informative of the outlook as sentiment surveys that state intention to alter course. Given the consumer is the backbone of the US economy and this particular survey has so many beneficial components – including measures like expectations for market performance – there is considerable influence in this indicator. Intention to reduce consumption, lower inflation expectations and fear of a financial retrenchment could sway the Fed to act ‘preemptively’. Now, even more untraditional but what may ultimately be the most important driver of US monetary policy moving forward is the actions of the ECB. Officially, the US central bank (and most of its largest counterparts) do not take into consideration external factors when making their own policies. In practice, the disparity in course of these major banks can lead to issues such as capital diversion. If the European authority cuts rates deeper into negative territory and restarts QE, further charge in the Dollar and market demand for US support to balance out the global spectrum could raise pricing risk to levels that trigger volatility and speculative fallout if the Fed doesn’t act.
  15. Is Trump Responding to the Dow – and Would He Prioritize Index Over Dollar? This past week generated another heavy round of criticism from the US President. In both ad hoc press conferences and tweets, Donald Trump scrutinized a number of economic and financial hurdles that he believes is threatening the health of the US economy. The most familiar critique continued to target the Federal Reserve and specifically its Chairman, Jerome Powell. Trump took to the wires to levy blame against the monetary policy authority essentially every day. His specific accusations were of a familiar flavor, but they boil down to an essential accusation that the independent setter of interest rates was keeping the Fed Funds baseline higher than it should be which is choking off growth. His specific targeting, however, shows some internal conflict over his interests and the paradox for which his own demands would not be met even by a fully compliant central bank. The most frequent issue the President has taken with Fed policy has been the level of the US Dollar – which notably closed this past week at a more-than two-year high, or EURUSD two-year low. An accusation that other authorities are manipulating their own currency (the ECB with the Euro and PBOC with the Yuan) isn’t his chief concern, but rather that the Fed isn’t responding in kind. From his remarks, it seems he is less concerned over the economic pain a stronger currency may bring, but rather that the transmission of the trade war efforts employed by the Administration are watered down by the exchange rate adjustment. Therein lies one conundrum as an effective policy push by Washington would lead to a weaker global counterpart and thereby weaker currency. Therefore, some extra-ordinary effort needs to be employed to keep the currency steady or to force it to depreciate alongside the transmission of the pressure – hence the badgering Powell. Conversely, when the stock market begins to sag, the focus from the White House shifts to the level of the Dow or S&P 500, though the stated interest remains the same in a reflection of strong growth. It should be said, the economy is not necessarily the market. As the market slips and recession signals multiply, there is an effort to identify the source. Relatively little attention is paid to the age of the maturity of the economic and financial cycle alongside the disparity of expansion and unrealistic investor expectations as there is a collective obsession for singular catalysts (a function of crowd psychology). There has been a growing din of criticism around the negative impact of the trade war tariffs in economist assessments, business sentiment surveys, earnings reports and more. The President has stated clearly though that he will not let up on the pressure mounted against China. With the blame building, Trump has instead started to redirect towards American businesses. This past week, he blamed auto manufacturer GM for not moving the operations it has in China back to the US. That same day, he also stated that companies that warned earnings could be negatively impacted by the trade wars were “weak” or “badly managed”. This does not exactly warm investor enthusiasm over the health of the markets. So, will the President continue to push for a lower Dollar and shame US businesses into amplifying the effort to transmit the tariffs or let up on the economic conflict to keep the markets buoyant? You can’t have both and eventually bouncing between the two objectives will seem conditions fracture. The Bank of Canada and Reserve Bank of Australia Kick off a Season of Critical Monetary Policy Decisions September is a month for which nearly every one of the major central banks are due to weigh on their local monetary policy; and this year, we happen to find this ‘external’ influence on economy and market performance at a particularly critical junction. Markets are buoyant – some like the US indices are much higher than others, but they are broadly trading well beyond value – and the underlying strength of the global economy has clearly eroded. This has put increased pressure on the world’s monetary policy authorities to compensate for where the markets lack in traditional form. Unfortunately, rates are already extremely low and there is already an enormous amount of stimulus (over $20 trillion from just 6 central banks alone) sloshing around the system. What more could these groups reasonably do? What would we as market participants assume policy efforts that have already earned limited economic performance and has more recently struggled to offer capital market lift can do through further iterations of the same? I am skeptical that there is the same delusion that has translated into convenient complacency that we’ve seen in previous years standing in wait to provide further lift through the foreseeable future. The limited capacity of the Fed, ECB and others is no longer an academic conversation but rather Main Street fare. We are due some critical rate decisions later in the month – the ECB on the 12th expected to introduce an open-ended QE, the Fed on the 18th is targeted with a demand for another cut, then a combo of BOJ, BOE and SNB is on the 19th – but we have a few decisions we should watch this week as well. The Bank of Canada (BOC) is currently the most hawkish major central bank, not for its current level but rather its reticence to commit to a dovish course. If this group capitulates, it can be a big Canadian Dollar charge, but it could also nudge views of global monetary policy. As for the Reserve Bank of Australia (RBA), the group is already into easing mode and generally contemplating unorthodox policy. This is significant on a global basis because the Australian Dollar’s position amongst the majors is in large part a function of its yield – it is a carry trade. As that trait falters, the systemic view of returns and value are further distorted. Seasonality Takes an Extreme Swing in September Through the S&P 500 and VIX With Friday’s close, we have brought to an end the week, month and season all at once. This period traditionally marks a serious transition of market conditions that usually moves from quiet listlessness and beneficial complacency into a period of significant activity and substantially higher risk of capital market losses. Historically, the month of August is the most reserved period of the calendar year according to the performance of the S&P 500 over the last four decades (see the attached image). While the index averages out a moderate level of gains for the month, what is truly remarkable is the volume behind the market. When adjusted by active trading days, August registers less trading than February or December (which have fewer total days). When we look to the reasoning behind such restraint, there is a certain level of self-fulfilling prophecy to the receding tide. Investors expect that quiet will dictate the decisions of other investors so they themselves accordingly with smaller adjustments to position that leave the systemic and long-term balance to another time. What is interesting is that the month of August is actually quite active when referencing the VIX volatility index. That mix of restraint in progress but rising volatility was actually in clear display this past month as the S&P 500 spent much of the period bouncing rapidly back and forth in a restrictive span. That sets the stage for September. With the US Labor Day holiday, we transition from the full ‘Summer lull’ to the active Fall trading season. Volume picks up, but volatility hits new highs through the month – peaking between September and October. Notably, this activity starts to register more progress in price action. Referencing back to the seasonal measures, the S&P 500 has averaged only one month of losses back to 1980 and that is during the month of September. This likely has as much to do with the markets living up to its fears as any repeatable development timed specifically during this part of the year, but it occurs with statistical relevance nonetheless. What’s more, the market has plenty to worry over at this juncture between the fears of recession, the persistence of trade wars, wavering confidence in the leveraged dependency on central banks and more. Often times, investors are simply waiting for a collective reason to de-risk from exposure they already consider excessive, and this gives a familiar anchor into the mass psyche.
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