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JohnDFX

DFX Market Analyst
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  1. JohnDFX
    From the Data, Growth is Top Concern Again 
    If we were to gauge how much market movement is arising from scheduled event risk relative to those unexpected winds from the headlines, I would put greater emphasis on the latter. That can make for difficult trading conditions considering updates like the coronavirus spread do not abide a clear time and distinct categorical outcomes. In this kind of environment, it is more difficult to establish clear and productive trends as there is not a clear thread to be draw enough interest to hit critical mass. Instead, we are left with the risk that otherwise important updates could come at any time – bullish or bearish – which leaves a clear footprint of caution among those participants in the market. Jolts of volatility with unexpected breaks and limited follow through to quench traders’ thirst is instead the norm. It is very possible to adapt one’s own approach towards the markets with this backdrop in mind – even if the result is greater caution, shorter duration and fewer trades. 
    As far as the data is concerned, there are a number of themes and regions to watch over the week before us. However, I will once again keep my principal focus on growth. That is in part because the ebb and flow of coronavirus headlines are leaving a tangible concern around the cumulative impact on growth – much like trade wars in previous months. Yet, from the economic calendar itself there is plenty to give direct insight on the health of key economies. In the first half of the week, we have Japanese 4Q GDP along with a growth forecast update from the Eurogroup and Bundesbank. The more comprehensive reading though is the February composite, manufacturing and service sector PMI releases from Australia, Japan, Germany, the Eurozone and the US, chronologically. That is a comprehensive and global overview of growth. Will it be market moving? Look to see how receptive the market is prepared to be for this more ‘mundane’ theme. 

    ‘Markets Fall on Coronavirus’ and ‘Markets Rise on Coronavirus’ 
    When it comes to fundamentals, there can be a steep learning curve to make the analysis technique functional in the average person’s arsenal. It isn’t surprising that there is only so much time to dedicate to this venture for many (even when it is their money at stake) or when they encounter too many instances of the analysis lining up without the commensurate reaction from the market. This often leads to statements like ‘these markets don’t make sense’ or an appetite to fall back on the more accessible technical side of the markets. However, I find one of the most important factors in interpreting fundamentals is to find what the most important and influential themes are to the greatest portion of the market and calculating a distinct interest into the equation when one shows itself through the noise of an overwhelming range of various factors pulling at our attention.
     
    As far as the systemic fundamental influences go, it seems that the intense but muddled impact of the coronavirus (COVID-19) still flashes its control over the markets. The warnings of tangible economic toll on the economy from this contagion are added to each week. This past week, the Federal Reserve and European Central Bank reiterated the risk through the official testimony of their respective heads while a number of their members issued individual remarks to much the same effect. Supranational groups are also warning caution. Standard & Poor’s offered the most prominent caution when it cut its 2020 GDP forecast for China by 0.7 percentage points to 5.0 percent while global growth could see its pace trimmed by 0.3 percentage points – China does account for nearly a third of global expansion. The importance of this risk is clear, but the influence is starting to be taken for granted to the point that seemingly every rise and fall is either the direct influence or allowance of this novel risk. In fact, if you check the worldwide search interest in Google Trends the past months containing the worlds ‘stock’, ‘market’, ‘falls’ and ‘coronavirus’ the results are almost exactly the same as ‘stock’, ‘market’, ‘rises’ and ‘coronavirus’ (see the attached picture). This is a short-cut many take in assigning a universal influence on a popular theme, which will inevitably breakdown and draw out the ire of investors attempting to follow the logic. Remember to always evaluate what the dominant fundamental theme is and acknowledge that this influence changes hands while also passing through periods where it dilutes across many different matters.
    Intervention in the FX Market Is Not That Uncommon Nor Is It Effective 
    This is a topic I have touched upon previously in the context of the US Dollar and its supposed purity in the eyes of those that observe liquidity as a virtue. There is little doubt as to the currency’s superior depth as the BIS numbers are very clear on the status. However, that position doesn’t mean that outside forces will not attempt to nudge the market in a perceived favorable direction. Most notable in the hierarchy of critics as to the level of the benchmark currency is the US President Donald Trump who has repeatedly accused global peers (China, Japan, the Eurozone) of depressing their own currencies for competitive advantage while simultaneously lambasting Fed Chairman Jerome Powell for the period of monetary policy normalization that he claims has robbed the Dow of ten thousand points and driving up the Greenback. Given the complicated fallout that would follow attempted manipulation of this particular global financial lynchpin, I will continue to monitor it without my typical deep-seated doubt – as this White House is proving reliably unpredictable and the unexpected carries such a serious impact. 
    In the meantime, there are more proactive efforts to alter the course of different currencies out in the wild. This past week, Brazil’s central bank let it be known that they had acted (via 20,000 swap contracts) to prop up the Real. The USD/BRL had advanced to record highs five consecutive sessions, leading the group to take action in an effort to break a slide that threatened to gather further speculative momentum. In the context of the average daily turnover of this very actively traded currency (it is one of the BRICS), the scale of the intervention could not be overwhelming the market through sheer volume. Instead, the idea is to shift market sentiment to align to the effort. Japan attempted the same back in 2011 to 2013 to very disappointing result. While Japan’s Ministry of Finance and Bank of Japan are still attempting to passively guide the Yen lower, there desperation has waned and so have their threats. In contrast, Switzerland has maintained the threats against the Franc as EUR/CHF – the focus rate for Swiss officials – has extended a decline to the lowest levels since third quarter 2015. As the markets continue to rebuff efforts of manipulation, believes of monetary policy ineffectiveness grow, pushing countries further into competitive devaluation and restrictive trade-based policies.

  2. JohnDFX
    An Economic Update on the Calendar and In the Public Eye
    Concern over the course of the global economy was revived this past week with a few troubled indicators raising awareness, but the real interest was what arose in the market-based measures. With the recovery in capital market measures, the meaningful divergence in performance from growth-sensitive assets like copper and crude oil (with a 13-day consecutive drop and 13-month low respectively). In fact, the 60-day correlation – a three-month relationship – between WTI crude oil and my preferred baseline of speculation, the S&P 500, flipped negative for the first time since September 2018. Perhaps the most loaded of the growth indicators that is once again raising concern was the 10-year to 3-month US Treasury yield curve whose inversion (a higher yield on the shorter duration than the longer) recently became mainstream recession signal watching. It was this segment of the curve which dove into negative territory this past August that the market seized upon as search interest in ‘recession’ exploded globally. The yield comparison flipped briefly once again this past week to further draw starker contrast to the performance of more financially-oriented market benchmarks.
    These market measures will be a prime feature in my analysis in the coming week and beyond. However, fundamental and data based charge is still the most potent motivation to elevate growth concerns into a dominant current for the financial system. In the week ahead, there are a few overt, big-picture 4Q GDP updates on tap. The UK’s previous quarter may have ushered in the ultimate course for a clean Brexit, but the cumulative pressure of fear around the Brexit impact was a vital feature of the backdrop. As the government attempts to strike trade deals with Europe and other countries in a very short time frame, the starting point set by the economic setback will feature prominently in Sterling traders’ view. Perhaps the most important government growth update on my list is the German 4Q figure. Not only is Germany the Eurozone’s largest member economy, it is particularly exposed to trade and manufacturing which have been negatively effected by global trade wars and the recession in factory activity. If this reading prints poorly, it could add a new troubling dimension to the world’s underlying health check. 
    Outside of the official quarterly government updates, there is a host of monthly data that can give a more timely read on the health of the broader economy. The Japanese Eco Watchers economic sentiment survey Monday, US small business confidence figure (a group responsible for approximately 70 percent of payrolls) on Tuesday, Eurozone industrial production Wednesday, Chinese vehicle sales on Thursday and US retail sales on Friday offer a constellation of data to navigate. If there is decisive enthusiasm or fear around the health of the global economy, these measures will act as fuel to the fire.
    Monetary Policy Updates that Test the Limits of Confidence 
    The Fed, ECB and BOJ rate decisions are behind us. Those are the three largest central banks of the developed world whose collective influence is commensurate with the scale of their respective balance sheets (massive). Yet, the influence of monetary policy is not simply on pause until March when the next updates are due from these groups (the 18th, 12th and 19th respectively). There is plenty in the headlines to keep us off kilter and fluctuations in market performance – particularly a bearish swoon – tends to draw the focus on this crucial building block of the past decade. 
    High profile central bank updates in the week ahead will still come via the two largest central banks. Fed Chairman Jerome Powell is due to testify before the House and Senate on monetary policy and growth in back-to-back testimony on Tuesday and Wednesday. Last month’s FOMC update left us with the wait-and-see intention that we had expected, but the markets went back into Fed-speak interpretation mode looking for the pain points for when the central bank would shift back into an active dovish or hawkish policy mode. Overview of local economic figures was fairly steadfast but the mention of external risks was repeated. That will likely be reiterated on the Hill after a mention of the coronavirus as a unpredictable risk late last week. Similarly, ECB President Lagarde is due to present her central bank’s annual report at the European Parliament. It would not be surprising to see references to growth concerns, trade pressures and unorthodox concerns (like the coronavirus mentioned last week) alongside her official remarks. 
    If you are looking for more direct – though less globally influential – updates on central bank activity, the Riksbank, Reserve Bank of New Zealand and Central Bank of Mexico are all on tap for official updates to their mix through the week. Given the Swedish group has its benchmark rate parked at zero and is closely linked to the actions of the ECB (which did not shift in the last update) no change is expected Wednesday morning. The same forecast for no change to the 1.00 percent baseline is set among economists plotting the RBNZ’s course. Yet, given this currency’s role as a ‘carry unit’ which depends more on the yield to be drawn rather the size of the New Zealand economy, the short-term and long-term influence of this bearing can prove a greater sensitivity to the nuance. The only bank in this trio expected to change rates is the Mexican policy authority. Both swaps and economists are forecasting a 25 basis point rate hike from 7.00 to 7.25%. For those that have followed the lack of follow through on a multi-year triangle breakout from USDMXN, perhaps this can urge the move along short of a clear risk-based move or overwhelming Dollar collapse.
    A Focus on China’s Scheduled and Unscheduled Updates 
    In a financial world where complacency is a dominant feature of the landscape, it can particularly easy to simply write off the influence of China’s economic and financial updates. There is frequent – and in my opinion, well-deserved – debate over the accuracy of data that comes out of the country which could raise serious concern, but instead it  has generated a very noticeable apathy. That said, the pressures continue to mount in headlines developments, the official growth readings continue to notch three decade lows and there are unmistakable financial steps being taken to push risk to the open market (such as a rising allowance for default on nonperforming loans). Given that China now represents over 15 percent of global GDP, the opacity of its data should raise greater concern among global growth watchers.
    With the risks laid bare, there are two fronts for Chinese updates that I will be watching: scheduled and unscheduled updates. For the former group, the inflation figures on Monday don’t register a high threat level – though it can speak to problems further down the line. Much more prominent a concern are the January Chinese vehicle sales. For an industry (auto manufacturing) that is a global recession, this is one of the largest the largest markets in the world – not to mention, it can be a great discretionary spending and financial health reflection. The foreign direct investment (FDI) figure is another measure worth close review. How much the world is investing in the country speaks to not only confidence in its health but the level of optimism among global investors that have praised the exceptional clip of expansion. 
    Off the docket, the potential risks are much more profound. The headlines around the coronavirus have been particularly troubling for China – the originating country of the virus – with the numbers of infected and deaths rising. To stem the contagion, the government has gone to considerable lengths to shut down traffic through the major traffic centers which includes businesses which has a clear impact on economic growth. This has in turn lifted the demand for already-pressured liquidity levels across the Chinese financial system – a measure that is noticeably less stoic than what we see in economic measures. Furthermore, this abstract risk has pushed China to request flexibility from the US in the terms of the Phase One trade deal which adds additional burden to their economy. Yet, they know they can only ask for so much from a country that has very little tolerance for supporting other countries. China announced last week that it was cutting tariffs on $75 billion worth of US imports in half on February 14 which will appeal to the White House. Yet, whether that buys them leeway to redirect precious resources to stabilizing the local economy or not remains to be seen. 
  3. JohnDFX
    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. 
  4. JohnDFX
    Risk Trends Trembles, Is it the ‘Crazy’ Fed’s Fault
    Market’s suffered a painful correction this past week. From peak-to-trough, the benchmark I like to refer to as a measure of hold-out enthusiasm, the S&P 500, dropped nearly 8 percent. That is still a ways from the technical ‘bear market’ designation which is a 20 percent correction from peak highs, but that scale of loss from a seemingly indefatigable climber rattles confidence. To be clear, the slump in sentiment was not isolated to the US equity market. That was just among the more remarkable victims of the speculative swoon owing to its typical outperformance. Looking across the other capital markets with a risk bearing, there were meaningful losses registered from foreign shares, carry trade, emerging market assets and more.
    The intensity of these other assets however was notably less severe than what was registered from the lies of the S&P 500. Some would take this as an indication of source from and thereby restriction to US-based trouble. I, however, think this is just a retreat that is commensurate to how much premium there is to unwind. The US indices have continued there climb these past months while other related risk-profile assets have spun their tires either leveling out or falling into retreat. So, while the implosion by the Nasdaq 100 (dropping over 10 percent from peek) and its direct peers was violent, other sentiment forerunners like the EEM Emerging Market ETF registered smaller percentage declines to fresh multi-month or multi-year lows. The risk aversion was deeply rooted and carried wide influence. The question is whether the inexorable momentum behind a sentiment collapse is already underway. Much of that depends on motivation.
    We still have event risk that has set off few alarms recently as well as themes like trade wars which cued few explosions beyond their already-troubling contributions. US President Donald Trump took a jab at the Federal Reserve who labeled the group ‘crazy’ for tightening the reins on policy and seemingly laid the blame at their feet. I don’t think they are really to blame for this move, but they certainly contribute to the environment that has necessitated it. Years of expansive monetary policy that stretched far beyond the need insinuated by the economic and financial recovery encouraged/forced speculative build up to unsustainable levels. When the inevitable withdrawal has to begin, the monetary policy authorities of the world are held hostage by a predicament that sentiment has been founded on these groups’ shoulders. Through the end of this past week’s plunge, there was a remarkable bounce through Friday – with the largest opening gap for the Dow since 2000 – which will tempt the Pavlovian response from dip buyers. However, the reversion to complacency will not hold forever. The gap between major market corrections is diminishing as recognition of the major fundamental risks grows. Remain flexible and have plans for bound or utter unwind. 
    Light at the End of a Trade War Tunnel?
    We have seen some of the more prominent fronts on the on-going trade war find some measure of resolution lately. The holdout in negotiations between Canada and US was resolved and the three members are heading to a resolution that will bring about the USMCA (US Mexico and Canada Agreement). Whether the new program is more fruitful than the old one for the US or any other member is up for debate, but the fact that the threat of serious financial fallout from uncertainty in no resolution is not. Could his give some clue as to how the US plans to conduct negotiations to their conclusion with other countries in its line of sight? It certainly could stand as a template for the likes of Japan and the European Union (EU). These two major economies have not fallen into outright economic conflict with the United States. The willingness to appease in order to avoid the repercussions of lost business, investor and consumer sentiment in the face of verbal threats may show through.
    However, that is not likely the case with China. The US has found comfort in going after a country many have decried for unfair trade practices in the past and they have already applied aggressive tariffs. That said, the US Treasury is due to release its assessment on China, including whether to label the country a currency manipulator or not. According to sources, they did not find the country met the designation, but that is up to Treasury Secretary Steve Mnuchin who will have the President’s words in his ear. The US is unlikely to back out of its engagement without some further concessions, while China has pushed back such that its cost to meet this high bar requirement may pose more significant damage to its effort of maintaining a balance of landing steady growth and holding financial stability.
    Even if the situation was to be fully resolved as of tomorrow, it may have already pushed sentiment beyond a crucial threshold where recognition of more serious, systemic problems put us on an inevitable course. To add to this complexity, not all of the diplomatic scuffles are purely kept to decorous tariffs. The sanctions the US is returning to Iran are unlikely to be walked back, and that is creating greater tension with key trade partners (like the EU) which have economic and financial ramifications. Such economic/financial wars can escalate and get out of control faster than those who pursue them intend. 
    A European Threat Rising and Another Cooling
    Europe’s fundamental health will take on particular importance over the coming week. Having ground on for over a year-and-a-half – and earning near-constant coverage in the meantime – the Brexit negotiations will hit another crescendo. The EU summit on Wednesday and Thursday is another one of the key last-minute turnoff points for the two sides to find common ground on the divorce before hitting a point of no return. We still have over five months before the official separation is due to take place, but there are still many political steps that need to be taken in order for a solution to be agreed upon and put into action before the cut-off date. This past week, there was yet another clearing in the ominous cloud cover when the EU’s chief Brexit negotiator, Michel Barnier, offered uncharacteristically optimistic remarks regarding the status of discussions between the two sides.
    He noted the progress made recently and suggested a deal could be struck as soon as this coming Wednesday – when he has more consistently warned that they were heading down a path of the UK crashing out of the relationship. Yet, despite his enthusiasm, there are still key sticking points (like the Irish border); and reports over the weekend indicate progress stalled before important breakthroughs were made. It has been suggested they will not hold technical discussions again until Wednesday – which would insinuate this will have to be a top-level call. Tuesday, Prime Minister Theresa May is reportedly going to gather her Cabinet in order to cement a common front in the discussions over the days following. If there is a breakthrough by Thursday, expect the Sterling to have a considerable rally ahead of it. Should they again fail to find common ground, the mood will darken significantly as the clock winds dangerously short. Unfortunately for EU leaders, the two-day meeting will not be a one-topic event.
    Besides Brexit, global trade strains and diplomatic troubles (between the US and Iran); the heads of state will have to address Italy. The third largest economy in the Euro-area, Italy has made clear its intent to bolster spending beyond the EU’s acceptable targets. The only scenario for which they will fall in line is based on an improbable forecast (a 1.6 percent or better GDP clip next year). This tests the tolerance of the collective versus the conviction of a member who has seen anti-EU sentiment grow out of economic struggle. Remarks by Italian leadership that the ECB could be a backstop if things grow too problematic for Italy in the market, only draw clear attention to the situation by global investors. The ECB’s reported rejoinder that such help would only come after a bailout only raises the specter of a return of the Eurozone debt crisis of six years ago. While official EU remarks surrounding this situation will be key, there are numerous other events that should be watched carefully to stay abreast of this situation. The Italian Prime Minister is due to speak the day before the EU meeting’s first day, the Finance Minister is set to speak, the Deputy Premier is on the docket for multiple appearances, but it is perhaps his visit to Moscow Wednesday that will draw some of the greatest scrutiny. Keep tabs on Europe.
  5. JohnDFX
    Will Holiday Conditions Save Us from Fundamentals and Speculation? 
    Normally, there is not a strong appetite for holiday trading conditions because it can materially slow markets – and most traders seek out volatility, even if it is as much a risk as a basis for potential. However, this year, there will be a strong appetite for the typical conditions associated with the time of year. In 2018, we have seen an extraordinary bout of volatility with dramatic bear waves in benchmark risk assets like the US indices through February and October while the progress of the previous years of this decade long bull run has grown increasingly uncertain. We have yet to see a commitment to a bear trend by the S&P 500 and its ilk, but it is a far greater probability in these conditions – systemic shifts more readily occur after periods of consolidation rather than sudden ‘V’ tops or bottoms. It is against this backdrop that the promise of November and December seasonal performance expectations can raise hopes. The ‘holiday’ markets and ‘Santa Clause Rally’ are popular reference to the same general market conditions. 
    Through the closing 8 weeks of the year, holidays break up the momentum that can build behind systemic trends, losses are booked for accounting purposes and open period for funds encourage portfolio changes. There is a reason that such seasonality expectations exist, there is statistical relevance behind the views. Yet, as the saying goes: ‘this time may be different’. Historically, the S&P 500 has accumulated an oversized portion of its annual gains through the final two months and the VIX volatility index has in turned dropped through the same period denoting a reduction in the variability of returns (in other words, risk). That said, conditions and context matter. If the markets are unstable and there is outsized exposure, sparks can turn into flames that raze a financial system. There are plenty of catalysts to track as potential catalysts of crisis, from trade wars to political instability to monetary policy normalization. Yet, it is the general state of the financial system that truly represents the threat. 
    The excessive leverage taken on by investors (notional and thematic), businesses (buy back shares with proceeds of bond issuance), consumers (revolving credit and housing) and governments (growing debt burdens) makes the growth we have enjoyed these past years look borrowed and far more threatening than reassuring. That excess is already showing through in certain corners of the financial system. The steady dive in emerging markets, high yield fixed income and global shares relative to the unrealistic buoyancy of US stocks signal some sign of recognition. Nevertheless, it is clear that such appreciation hasn’t translated into capitulation. Deleveraging is essential and it will occur via intent or force with timing dependent on the method.  
    Pushing Brexit to the Breaking Point 
    An emergency November summit between European Union and United Kingdom leaders to secure a deal on Brexit will only occur should the latter party make significant progress on its position involving critical points of impasse at the previous meeting. And, recent reports don’t offer much to be enthusiastic about. Multiple times over the past month, we have seen enthusiasm trumpeted on breakthroughs among UK government and between the UK and EU; but each time, that confidence was quickly snuffed out. It seems virtually impossible to satisfy all relevant parties in this stalemate. The Prime Minister’s cabinet has a concentration of hardliners that demands no alternative to an absolute Brexit is acceptable. In contrast, Parliament is more flexible in its interest to maintain some connection to the shared markets and is willing to bend on some points of contention – though the number of its rank open to a second referendum creates some inherent difficulty. 
    And, then there is the EU itself. The collective wants to maintain strong economic ties with the large economy, but it is not willing to make exceptions to its requirements for access for fear of other countries demanding the same benefits as they file their own Article 50 withdrawal intentions. This past week, the UK’s transportation minister resigned from the cabinet owing to his belief that the deal they can reach with the EU would not be the Brexit that the country had voted for, and a second referendum on the new terms would be necessary. Ultimately, this will not materially change the general complication of the process; but it does speak to the frayed nerves and quickly winding down clock. PM May has stated repeatedly that ‘Brexit means Brexit’ and that they fully intend to push forward when the two-year time frame for Brexit negotiations expires at the end of March. Adding the countdown to this situation only raises the risk that difficult negotiations will ultimately prove a push over a financial and economic cliff. If there is ultimately a breakthrough immediately at hand, there still are significant difficulties brought on by the short time left to work up technical requirements and to push through approval for all the member countries. 
    That said, should the situation continue to shamble forward, the risks grow exponentially as businesses and investors move operations to avoid the unknowns that they march towards – already the 3Q GDP figures reported a further reduction in business spending. The flight in capital will in turn slow growth and undermine confidence figures which slowly graduate into more systemic economic factors. A financial crisis may not come to pass until later, however, as liquidity can hold up to hesitation – though not capital flight. It is growing clear that there is no ‘best case scenario’ with this situation whereby there will not be additional political, economic and/or financial stress for some participant in the divorce. Investors should be concerned with the subsequent issues, but they may not have the luxury given the threats so prominent in the immediate risks. 
    Is an Italian-EU Debt Crisis Inevitable?
    Financial and political fractures in the European Union will continue to erode confidence for an entire trading session. In the week ahead, Italy’s standoff with the European Community over its plans to defy austerity measures the previous government had agreed to will hit another important deadline. After the EC rejected Italy’s budget proposal a few weeks ago for setting spending targets and GDP estimates too high, the country was told to go back to the drawing board to significantly reduce the projected 2.4 percent spending to GDP ratio it had planned. In the lead up that second effort due on Tuesday, Prime Minister Conte and Deputy PM Salvini made clear they had no intention of making significant changes to appease Brussels. If that is true, there is almost no chance that this situation will not devolve into some measure of an existential crisis for the Union. 
    The middle ground is extraordinarily far for both parties with Italy operating on a voter mandate to rebuke austerity and Europe seeing little chance of avoiding an avalanche of anger amongst members should it make another exception to its budgetary rules to a country that has such an extraordinary debt in a general period of global economic strength and while so many of its peers are holding true to significant austerity. If the standoff between this country and collective does not turn off its current course, it could cause irreparable damage to the Euro’s standing in the currency market. The world’s second most liquid currency depends on the stability of its unions. If a member of this smaller subset were to leave – especially the third largest – it would carve out a significant portion of GDP and financial liquidity not to mention raise the risks of other countries following suit from ‘virtually zero’ to ‘probable’.  
    Holding ‘European’ exposure against those risks would be a non-starter, especially if the situation were to unfold alongside global risk concerns (more likely). Specific interest in individual countries can continue to hold up, but identifying what portion of a country’s market will be unaffected by the financial ripples would be difficult and a bridge too far if risk aversion is undermines patience and nuance. Should this threat balloon, the lessons of the European sovereign debt crisis between 2009 and 2012 will be revisited. Yet, this time, populism is far more pervasive, the region is still recovering from the previous austerity and the central bank has no capacity to ramp up ramp up support beyond LTROs which will find its effectiveness as diminished as the QE program that replaced it. 
     


  6. JohnDFX
    Jackson Hole Symposium Has Too Much to Cover 
    There are two particularly important, multi-day summits scheduled for this coming week. Given the individual market-moving capacity of US President Donald Trump, the G7 Summit from August 24th through the 26th will be particularly important to watch. He has announced remarkable change in policy at or around such large events before – particularly when provoked by flabbergasted global counterparts. There are five general topics on the agenda which are all important but the market-centric among us – and who wouldn’t considering them more dialed in given the state of the economic outlook – will be most interested in the third of the listings which is the conversation on globalization. It is worth noting that as of January 1st, 2020, the United States will take over the presidency of the group. Yet, as far as the impact this can reasonably have on the markets for the week in front of us, there is very limited potential given that the event begins on a Saturday. If anything, anticipation for surprise policy tweets will discourage positioning for fear of another painful weekend gap. 
    The other major gathering on tap from Friday through Sunday is the Kansas City Federal Reserve-hosted Jackson Hole Symposium. This is a gathering of major policy authorities (government and central bank), business leaders and investors whereby they discuss the most important matters for the financial system and economy of the day.  Given the current fragile nature of both dynamics at present, there is enormous pressure on this event and its participants to urge a sense of calm. They will find this exceedingly difficult to achieve. The official topic of the event is the ‘Challenges for Monetary Policy’ which is certainly a concern, but not one designed to immediately provide relief. The politicizing of monetary policy threatening short-term focus and policies that result in currency war- like conditions will likely come up explicitly if not in the undertone. If the Fed and others use this event to warn that the effectiveness of there tools are diminishing as they are already stretched to the max and face diminishing returns in economic and financial influence, that will only solidify reality for so many that have grown to believe that there are only three things certain in life: death, taxes and asset inflation. They will attempt to hedge their language, but market participants are extremely vigilant of cracks in our troubling backdrop. Furthermore, the world will be looking for as much reassurance of a safety net against an increasingly probable economic downturn as can be mustered. This will likely prove a very disappointing event for many. 
    The Inverted Yield Curve vs Sovereign Debt Sliding Into Negative Yield 
    The story of the inverted yield curve continues to gain traction across the market – from bond to FX trader, new investor to old hand. In part, this is testament to the self-reinforcing influence of the financial media and financial social platforms. That is why there is a cottage industry in analyzing the collective views garnered from browsers and tweets, whether for genuine view or contrarian signal. Yet, how much should we really read into such a signal. There is very strong statistical evidence to suggest that certain yield comparisons in certain countries heralds economic and/or market troubles. The 10-year to 3-month Treasury yield curve is an economist favorite and has been inverted for a number of months now while the trader-favorite 10-year to 2-year spread only slipped below the zero mark this past week. Just to be clear, this is essentially a situation where the market demands more return from (virtually) triple-A rated government at the front of the world’s largest economy to lend to them over 3 months and 2 years versus 10 years. Something is systemically wrong if this is the case. Usually, this portends recession as we’ve seen for most similar instances in history. There is caveat in the reality that the sample size is small and conditions do change between the generations that pass between many of these instances. The Fed and other central banks being so active in purchasing their local government’s debt is a very big systemic change. However, there is also very serious data to suggest that we are looking at a stalled economy despite all the unique circumstances and distortions we are dealing with at present. 
    Another consideration with the signals these curves offer is the time gap between the market-based cue and the official flip on the economic switch. Yet, just because there is an average 12 month lag time between the two, does not mean we can comfortably assume that we can continue to press our luck until mid-2020. The official signal of a recession by the NBER and others is two consecutive quarters of economic contraction. What’s more, the speculative nature of the financial markets rarely has investors hold out on their judgement of risk until that lumbering signal has flashed red. I find that the curve is not so personally concerning as the overall level of global yields themselves. The US 30-year Treasury yield plunged to a record low this past week. Globally, an unprecedented amount of government and high-rated debt is facing negative yield. That may seem fine on the face of it from a consumer’s perspective – who wouldn’t want to be paid to borrow money – but it is a reflection of serious problems in the system. Negative yields are an indication that there is no appetite for lending despite the affordability, it creates sever problem for profitability of financial institutions and it means there is very little policy room for authorities to ease conditions to jump start growth whether stalled or collapsing. As you see the headlines continue to flash negative yield around the world, remember that this is a serious problem for the environment in which you are investing. 
    Trump Eased Trade War Pressure but Neither Markets Nor China Placated 
    There was a noticeable waver in the Trump administration’s trade war pressure this past week, which many political pundit zeroed in on from both ends of the spectrum. Perhaps spurred by the market’s sudden bout of indigestion following the reciprocal escalations between the US (announcing the remaining $300 billion in Chinese imports would face a 10 percent tariff) and China (allowing the 7.0000 level on the USDCNH exchange rate give way), the White House backtracked to offer some modest relief in the pressure. It was announced that some small portion of goods would be left off the list all together owing to their importance to health and security while a wider range of consumer goods (clothing and consumer electronics) would avoid the new tax until December 15 to avoid hitting the American holiday shopping season. The half-life of the market’s enthusiasm was even more brief than their shortened bout of fear following the initial one-two punch to global trade. China’s was similarly dubious in its response. The White House lamented that China did not move to ease its own policies aimed in retaliation, but that should not exactly surprise given that the US had enacted a disproportionate escalation and China’s own measures cannot be linearly throttled – to push the exchange rate back below 7.0000 would only reinforce the belief that the PBOC is fully manipulating its 
    Moving forward, we will have to rely on unscheduled headlines to update our standings in US-Chinese trade relations. Perhaps the Jackson Hole Symposium or G7 summit will offer up some key insights, but there is little reason to believe these administrations are plotting it out thoroughly to offer investors genuine relief. Furthermore, it is crucial that we don’t lose sight of the other trade conflicts building up around the world. Japan and South Korea as well as the Eurozone and UK skirmishes are serious problems to the fabric of global growth. Yet, my top concern remains on the risk that the two largest regional economies in the world could see threats evolve into actions. The US and EU have warned each other with complaints and suggestion of policy preparation, but there hasn’t been serious movement yet. That may have changed however when France decided to push forward with a 3 percent digital tax on the largest tech companies in the world – which happen to largely be US-based. Some of these biggest players (Google, Amazon, Facebook) are due to testify to Congress early next week and they will no doubt cry foul. Yet, if they push the volatile government too far; their efforts to reduce their tax bill could trigger a much larger drain on global growth and trade…which will cause a much larger hit to their income. 
     
  7. JohnDFX
    Weeks Left of Liquidity, A Laundry List of Unresolved Fundamental Threats
    We have officially closed out November Friday and we are now heading into the final month of the trading year. Historically, December is one of the most reserved months of the calendar year with strong positive returns for benchmark risk assets like the S&P 500 along with a sharp drop in volume and significant drop in traditional volatility measures (like the VIX index). There is a natural, structural reason for this moderation. The abundance of market holidays, tax strategies and open windows for various funds all contribute to this norm. That said, there is another element that plays as significant a role in the seasonal pattern as any practical influence – if not more – and that is habit. Mere anticipation of quiet during this period does as much to ensure a self-fulfilling prophecy as the practical developments of the period. Yet, assumptions of quiet when the market as a whole – and most traders individually – have so much exposure to surprise financial squalls would be particularly poor risk management.  
    Looking ahead, it is first important to assess the practical time lines of full liquidity. The next two weeks (the first half of December) are only sheltered from unforeseen storms by expectations alone. It would be prudent to at least be engaged and dynamic in the markets through this period. The third week of the month will see position squaring take its toll on speculative positioning and liquidity. This is a useful time as we can establish where investors believe the most aggressive risk exposure is held (‘risk on’ or ‘risk off’) as they unwind anything with a shorter-duration holding period. Through the final full week of the year, the markets will be severely drained by market closures and limited time and market depth to meet the tax and portfolio redistribution windows. To general a strong market move – trend or even a severe drive – would take an exceptionally disruptive event for the financial system. I am concerned over the complacency in the market, but not so apprehensive as to believe we will tip the beginning of a lasting financial crisis through the final week of the year – and yes, it would be a bearish run if anything as there is virtually no chance of a sudden wave of greed that will bring investors back to such a fragmented and thin market. 
    That said, there is still plenty of potential/risk that conditions could deteriorate exponentially through the first half of the month owing to the convergence of structural and seasonal circumstances. In general, a near-decade of uninterrupted speculative advance has started to lose traction as market participants have recognized their dependence on extreme but limited monetary policy, the growth of securitized leverage and sheer self-enforcing momentum. In 2018, we have seen conviction built on that unreliable mix start to falter with severe bouts of momentum in February and October with sizable aftershocks in March and November. This speaks to the underlying conditions in the market that could fuel a sweeping fire if properly ignited by any of a number of systemic threats that we are tracking across the global markets. Trade wars, Fed policy, convergence of global monetary policy, lowered growth forecasts, breaks in trade relationship (Brexit, Italy, US,etc) and other issues are systemic threats that have gained some measure of purchase these past months. If there were a sudden panic spurred by recession fears for example, then the drain on liquidity naturally associated with this time of year could in turn amplify fear into a full-blown panic with systemic deleveraging into 2019. 
    Now Everything Fed-Related Carries More Consequence 
    There has been a notable shift in Fed policy intent, and the markets will be engrossed with interrupting exactly what this course correction will mean for the capital markets. Though there has been subtle evidence of a waning conviction in pace for some weeks, FOMC Chair Jerome Powell made it explicit (well, as explicit as their careful control of forward guidance would allow) in his prepared speech on the bond markets in which he remarked that the group was perhaps closer to its neutral rate than previously expected. Now, some would say that is merely practical observation that after three rate hikes in 2018, they have closed in on their projected ‘neutral rate’ range of 2.50 to 3.50 percent. We could still keep pace and extend the most hawkish forecasts and hit the top end of that scale. That is true, but we have to remember what the central bank’s primary monetary policy tool has been over the past half-decade. 
    It hasn’t been changes to the benchmark rate or adjustments to the balance sheet but rather forward guidance. They have gone to exceptional lengths to signal their policy intent without making promises for the course so that they could back away from extreme easing without triggering a speculative panic based on exposure leveraged by years of excess backed by the vaunted ‘central bank put’. If so much effort is being put into this tool, then changes should be taken seriously rather than downplayed for convenience of a comfortable trading assumption. If there was intent behind the subtle change in rhetoric, it is an effort to acclimate the markets in advance of an event whereby the forecast will be delivered in black-and-white without the ability to establish nuance before the market’s respond with speculative shock (an event like the December 19 rate decision whereby the Summary of Economic Projections will make explicit the rate forecasts). 
    If indeed this is the objective to temper the market before the frank forecast is offered, then each speaking engagement and key data update between now and then will carry greater consequence. In the week ahead, we have Powell testifying before the Joint Economic Committee, which is a perfect opportunity to slightly extend the effort to make its intentions known. Recognition of this undertaking is the first step. Establishing what it means for the Dollar with rate premium and risk trends that have found confidence in the central bank’s reassurances will be critical. 
    G20 Aftermath Produces an Official Communique and US-China Trade War Pause 
    Pop the corks. The G20 has agreed to an official communique while the US and Chinese Presidents made a breakthrough on the escalation of their escalating trade war. Yet, before we over-indulge in risk exposure build up, we should perhaps look further ahead to the hangover that confidence in which this development is likely to lead us. Typically, an official press briefing that all the leaders agree to (dubbed the ‘communique’) is routine. However, with the rise of populism in the global rank and subsequent deterioration of relationships, simply signing off a commitment to shared goals of growth and stability has become an exceptional milestone. The leading consensus heading into this gathering in Argentina was that no official briefing would be released as the United States would not approve anything that would set its America-first agenda into a negative light. Further, China would not sign off on a statement that cast its own policies as unfair trade. 
    Perhaps recognizing the deteriorating sentiment amongst businesses, investors and consumers globally; the other parties would not demand these inclusions as protest for making so little traction with their constant protests. The indirect references to US and Chinese policies were left out. That is not genuine progress but simply self-preservation. As for the more remarkable ‘breakthrough’ in US and Chinese relations, the countries’ leaders found enough common ground to compromise a pause in the rapid escalation of their trade war. For discussing key economic issues between the two countries, the US agreed to delay the increase in its tariff rate on $200 billion in Chinese imports from 10 to 25 percent due previously to take effect on January 1st. The threat made by President in the weeks preceding this gathering of adding another $267 billion in Chinese goods to the tax list didn’t seem to warrant specific reference – perhaps as a backdoor strategy or because it would assumed to be included. 
    This is a pause in the escalation of activities rather than a genuine path back to a state of normalcy where collective growth is the foundation for the global economy. This is the bare minimum for registering an ‘improvement’ in relations, and it will be this thin veneer of progress that will truly test the market’s appetite to source anything of ancillary value to build up speculative exposure. I doubt this will inspire a true effort to significantly build up exposure in these unsteady times. In years past, such a development may have spurred the next leg of a yield chase; but recognition of the risk/reward imbalance is far too prominent nowadays. The question is how long this pause in an explicit outlet of fear lasts? Long enough to carry us through the end of the year? We’ll find out soon enough. 
  8. JohnDFX
    Markets Heading into October and the Fourth Quarter
    With this past Friday, we closed out week, month and quarter. The shortest measure was a period of consolidation for most assets – from the top performing US equity indices to the EURUSD’s make over break technical move to trade back into range. More impressive for its deviation from character (statistical norm) was the performance for the month of September. Historically, this period is one of significant upheaval for the capital markets (see the attached images). Using the S&P 500 as the imperfect standard bearer, September is historically the only month that has averaged a loss in the calendar year as volume picks up and volatility measures rise. That clearly was the case for 2018 and it also wasn’t true of 2017. Using the same study to evaluate October, it would suggest that significant gains are ahead for October. However, if one month’s average can deviate from the norm, so can any other’s – there is a reason it is called the law of averages.
    Statistically, the range of the samples for the monthly performance for the benchmark is wide in signal. For measures of activity – via volume for the same index and volatility from the VIX – there is far less ‘spread’ in the readings. Volume rises through the month of October as the post-Summer lull and pre-holiday trade period draws in active market participants looking to weigh in on market direction. Volatility similarly peaks in October historically, which makes an interesting combination of circumstances. Traditionally, volatility rises as risk aversion kicks in while a rise in volume behind market moves frequently signals commitment to trend. Of course, how the market commits depends on what is motivating capital distribution (positioning).
    It is possible to see assets with a ‘risk’ bearing bid as there is a host of assets that currently stand at a significant discount to the S&P 500’s record high. An ‘idolizing’ speculative play would depend on complacency and the avoidance of possible disruptions from the fundamental current. To propose a windfall improvement in economic and investment circumstances in the multi-speed environment with protectionism continuously rising is an approach akin to passing through the eye of a needle. Spinning our wheels around current levels is certainly a high probability given the market’s penchant for the status quo, but it is difficult to miss the laundry list of troubles we have yet to reconcile. With trade wars escalating and political risks growing (US election cycle, UK government fracturing over Brexit approach, EU facing another budgetary rebel), we should keep track of scheduled and ‘mundane’ influences like GDP readings as if they are asteroids that we discover are on a collision course with the planet. 
    A Two Speed Trade War the Break in the Clouds?
    The updates on trade wars for the new week offer a modicum of hope that we can stave off an utter collapse into a global economic conflict. Yet, with so much riding on a steady bearing of economic activity, avoidance of financial troubles amid monetary policy normalization and even the whims of a single powerful individual (the US President); it would be careless to put so much faith into apathy. Between the United States and China there is as yet no sign of improvement – nor even a let up from further escalation of force. Following the United States implementation of a further range of tariffs on an additional $200 billion in Chinese goods and China’s $60 billion rejoinder, the situation has been in negotiation limbo.
    An effort to revive talks seems to have hit the skids and the only sliver of solace is that President Trump didn’t move immediately to execute his threat for a further $267 billion duty on its largest economic counterpart should it retaliate against the latest effort – which of course, it did. Perhaps the smaller response has bought them relief, but the ideological belief for both of these countries as to their righteous efforts likely leads this particular course to a ‘total’ engagement. We will soon run out of room to add more items to the tax list. New policy outlets will need to be explored, and they will either be ignored by the markets and populations which will only encourage desperation for those looking to exact pain in order to force capitulation or it will exact the intended pain. Either way, it ends in the same economic trouble. Of course, as far as this pain is isolated to these two countries, the better off the world will be.
    This past week, Japanese Prime Minister Abe managed to elicit the same vow from President Trump that EU President Juncker earned: no new import taxes so long as discussions continue. Of course, the US already slapped tariffs on both region’s steel and aluminum imports, but they may let that go so as not to provoke further lash out. Yet, progress will likely lack until there is some tangible blood sacrifice to appease the Trump administration’s demands for more favorable trade conditions. Meanwhile, the effort to steer the NAFTA deal to a successful conclusion is the most encouraging corner of this global pressure. Yet again, language this weekend has tempted hope that a deal is close at hand, but investors are acutely aware that the suggestion of a proximate deal were raised and dashed multiple times over the past week. If an agreement does go through, other US counterparts will evaluate what was agreed to as a template for charting their own course to a resolution. 
    What is Driving the Dollar = What Can Drive the World
    What is driving the US Dollar? I like to keep particularly close tabs on markets or benchmarks that are at the center of so many overlapping fundamental considerations. Over the past months and years, I have paid particularly close attention to the S&P 500, gold, USDJPY and others for their ability not to cue trade opportunities of their own but rather to act as signal for the system at large. At present, the Greenback reflects that ‘deep cut’ market perspective that can offer seismic shift for the financial system at large. Starting from the most recent of the rapidly growing fundamental concerns, political uncertainty is moving out of the tabloid-like headlines into the tangible expectations of an impending mid-term election. We are six weeks out from the polls opening, and the country and world are even more on edge than usual for the event. Partisan appetites and beliefs should be kept out of our evaluation or market effect, rather it is the sense of uncertainty that breeds concern for the financial system. A turn in either of the houses can make an already difficult-to-operate government virtually grind to a halt.
    Meanwhile, the ongoing trade war may be multi-faceted and hosting many different participants, but there is an easily recognizable common denominator amid all of it: the US. Not content to lead the world to general growth, the country has pressured its trade partners to sacrifice some of their own advantages to accelerate its own pace. There is little doubt that its size could be used to leverage capitulation from a few counterparts, but engaging a host of the world’s largest players runs the risk of a collaborative retaliation or simple an effort to reduce exposure to avoid themselves being held hostage so readily again in the future. That would be a significant and permanent downgrade to the United States’ financial position and its currency. Of course, it is possible that all of these countries yield – but what is the probability of that? And, lest we forget, there are also traditional fundamental themes that are as-yet resolved of the US.
    The Fed continues to push forward with a policy effort clearly set to normalization with steady hikes and reduction in balance sheet. After the last Fed hike, the central bank made it known that it expects to hike again in December and three more times in 2019. That can be encouraging from a carry perspective, but it doesn’t bode well for markets that depend on low lending rates such as corporate debt and real estate. Higher yields to be found in the US relative to other countries is appealing only so long as the markets are set to unhindered risk appetite. Yet, with dollar-denominated loans for areas like the emerging markets seeing rates soar to tip nonperforming loans, this divergence from the world norm can be the spark for its own immolation.  



  9. JohnDFX
    Positioning Extremes Grow More Extreme 
    There are a few undisputable and universal forces when it comes to the financial markets. One of those all-powerful winds is the concept of risk trends which is referred to by many names such as ‘risk on, risk off’ or referenced unknowingly when we blindly attribute market wide movement to animal spirits through technical cues, smart versus dumb money, panic to greed. Another of these truisms is the allocation of capital. While total wealth does grow and contract, it is apportioned to some market whether that is emerging market equities to US Treasuries to home mattresses. In a global market, there is also distribution to different regions according to what country or collective economy presents the best opportunities. And, from this parsing of investment preference; we can learn a lot about the market; but one of the most elemental solutions is the global market’s general bearing for sentiment (the risk trends referenced before). There are no easy, definitive measures for allocations across such a wide universe of markets, but there are various measures for specific areas and key ports for which to apply measure such that we come to a good understanding of the markets’ health. 
    One of the most basic measures of preference on a regional basis is exchange rates. We have seen the USDCNH surge the past few months showing capital leave China and enter the US. That is likely a bi-product of trade wars and can signal deeper problems for China if they risk signaling to the world that there is capital flight that can disrupt their efforts to promote stability between economy and market. Given that there is certain control that Chinese authorities have over their systems, we could get more complicated in the evaluations by comparing the USDCNH to the USDHKD, look to derivatives or wait for the lagging economic data like the TICs from the US. Another good equivalence is the performance of ETFs. These derivatives are quickly becoming favorite products for global investors due to their supposed risk reduction through diversification (we heard the same thing with AAA rated subprime housing MBS 11 years ago) and the wide range of coverage they offer. There are measures of capital flowing into and out of specific, liquid ETFs (ie SPY, TLT, FXI) as well as general groups (all equity versus all bond). 
    Another measure of positioning is the use of leverage. We may not know what people are doing with their cash in many instances, but the use of borrowed funds is often better tracked as the ‘investors’ (or lenders) want to know their exposure. As it happens, in the US, there is record use of leverage by investors, consumers, corporations and the government. Further measures of positioning are the sample readings like that on the DailyFX Sentiment page which shows retail traders (who have a very short time frame and primarily fight existing trends) and the CFTC’s COT report of speculative futures. From the latter, this past week has shown a dramatic swing in Dollar interest from the biggest short in 5 years to the heaviest long in nearly 2 (all in a few months), Treasury net short has hit a dramatic record low, and gold flipping to net short for the first time since 2002 among other surprises. There is a lot to learn once you know what to look for and how to put it into context. 
     
    A Lesson from the 2013 Taper Tantrum Applied to a Global Scale 
    Back on June 19, 2013, then-Fed Governor Ben Bernanke announced that the US central bank would begin to ‘taper’ its theoretically open-ended bond buying stimulus program (known as QE3). By the time he stated their intention, the market had already suspected this was going to take place owing to the language of the group and the performance of data coming out of the economy. However, the announcement had a significant impact nonetheless. What resulted was termed the ‘taper tantrum’. In response to this news, US Treasury yields shot higher as the markets largest sovereign debt buyer at the time announced their intention to reduce purchases moving forward. And that had a material economic effect as the cost of US Dollar-based loans – particularly for foreign buyers who had exchange rate risks – started to shoot higher. 
    It therefore comes as little surprise that emerging market corporations that borrowed funds in Dollars shuddered at the news, and the EEM Emerging Market ETF showed the discontent. However, after some months of fear, conditions stabilized and borrowers and investors acclimated to the notion of higher costs. Even if they were exiting the active rate-depression game, they would still be low for a long period of time. What’s more other central banks like the ECB, BoJ and others were still at or near record lows with some pursuing equally massive stimulus programs. As such, complacency returned for some years after. Yet, where are we today? 
    We still have that telltale complacency – as mentioned above – but the foundation of confidence has continued to erode as global central banks have reached the end of the road. Either they are willfully plotting their own exit from their extraordinary accommodative states (like the ECB, BoE, BoC) or they are floundering as the market realizes they have essentially reached the extent of their influence (BoJ, SNB, RBNZ). Financial markets from equities to real estate have performed remarkably well in the interim, but economic activity and inflation plateaued long ago. That has produced an elevated risk exposure without the economics to fund the exposure. So, with exceptional risk, moderate economic potential, external pressures increasing (trade wars) and central banks either easing back or losing tractions; it is worth evaluating that 2013 ‘taper tantrum’ and consider what the possible implications would be if we raised the stakes from one country to the world. 
     
    Jackson Hole Symposium and US-China Trade Top Event Risk
    The coming week carries one of the most deflated expectations for seasonal activity for the financial markets. The Labor Day holiday for the US (September 3 this year) traditional signals a change in ‘Summer Lull’ activity to a more active and liquid Fall trading. These activity levels are as much self-fulfilling prophecy as actual liquidity phenomena, but it occurs nevertheless. However, a footnote here before we analyze further. There are some dramatic examples in our recent past where volatility as exploded in August despite the conventions. The 2015 market-wide tumble triggered by Chinese exposure fears began in August and the same month in 2011 led to global losses for shares and other risk assets as the Eurozone debt crisis unfolded. We should never rely on market parables when we are employing our capital – especially when so many global risks are so plain, such as a possible Chinese crisis arising from the US-China trade war or Italy threatening Euro-area stability to register as echoes of history. 
    This said, the standard global economic docket is particularly thin over the next five days of active trade. It would be fitting to assume the markets are just going to drift down a lazy river if we did not appreciate the broader context. While the biggest risks to our immediate future are likely unknown fundamental waves, there are two themes that are scheduled and we can follow as they unfold. The first is the US-China trade war. The US Trade Representative’s office is expected to hold a public but off-camera hearing on Chinese tariffs throughout the week. It is worth reminding that the Treasury has left public feedback open until early September until they decide on whether or not to proceed with the $200 billion in new tariffs President Trump threated some weeks ago. More promising, US and Chinese officials are due to restart trade talks on Thursday and Friday. It was reported that this meeting will start to build a map that can take the countries back to more favorable terms such that the countries’ two Presidents can agree at the highest level when they meet in November. 
    The other high-level event to watch over the coming week is the Jackson Hole Symposium. The annual meeting of central bankers, business leaders and key financial lawmakers hosted by the Fed can cover crucial developments in global markets and the economy. The official theme of this conference is ‘Changing Market Structure and Implications for Monetary Policy’, but expect the conversation to touch many of the key themes mentioned above: global retreat from extreme easing, the failing effectiveness of stimulus, global pressures via trade wars and the extremely inflated levels of global capital markets.
  10. JohnDFX
    Add Political Risks to Our Long List of Market Concerns
    It isn’t like we are lacking for fundamental motivation for the global financial markets. If anything, there is a surplus of critical themes that could – if properly induced – could single-handedly turn the universal tide. Nevertheless, it seems we will have to add another principal concern to our list alongside trade wars and the transition away from emergency monetary policy: political risk. This is not an unfamiliar market concern. Concern over governments’ and their influence on economy and financial health are fairly regular occurrence throughout the world and history. However, the tension seems to be rising quickly as of late. While there are still clear concerns over stability in the UK (constant discord between PM May, her Cabinet and Parliament), the Euro-area (Italy’s aggressive stance of budget and immigration) and Australian (having replaced its Prime Minister last week); the issues in the United States register more readily as a situation for global spillover. 
    We have seen headlines related to various investigations into certain Trump administration officials dating back to before the election, and last year’s more reserved headlines seemed to earn far more distinct response from price action – such as the drop back on August 17, 2017 when fears arose that cabinet members could part ways with the President following the lead of business leaders on his economic council. Over the past weeks, concerns have turned more directly onto the President himself with a jury finding his former campaign manager guilty on 8 charges, his personal lawyer pleading guilty to charges including campaign violations and the Trump Organization’s CFO being granted immunity for testifying in the Cohen trial. These may be for matters that do not implicate the President directly, but markets do not tend to act aloof to high impact potential risks. 
    Perhaps feeling the pressure, in an interview President Trump warned that if impeachment proceedings were started against him, he believed the market would crash and “everybody would be very poor”. That would not likely happen. For a financial market, who is President does not matter. Potential for returns and the course of the economy is primary. Markets didn’t immediately fall apart with the start of the Clinton or Nixon impeachments. However, when there are other concerns that the markets previously discount for favor of higher returns amid complacency, adding another source of uncertainty is a build-up of cumulative ‘risk’. Just as subprime housing tipped the scales in 2018, tech shares in 2000 and an emerging Asian markets in 1997; history shows the rolling over of markets owing to complex and deep fundamental issues often start with a single, smaller catalyst. 
    A Theme of Sentiment and a Market Prone to It 
    In the seasonal-dampened market conditions for the week ahead, we have a list of important, discrete event risk; but there is little that we could point to as systemically important and capable of single-handedly shifting direction or altering momentum for the entire market. That has more to do with a sense of complacency, appetite to hold to seasonal lulls and distraction from ‘themes’ that are not readily resolved with a single update (trade wars, political risks, Brexit, etc). However, the data should be registered nonetheless. It is the fundamental equivalent of keeping your eye on altitude in a hot air balloon as the risk of it popping grows. While the key listings ahead will touch on important topics – the US PCE for Fed tempo, an emergency Brexit meeting for the House of Lords – there is a particular theme that will offer greater weight due to its prevalence across the globe: sentiment. 
    There are a number of countries that will offer updates on confidence from consumers, businesses, on economies, etc all while the world deals with greater threats to passivity. The Eurozone and Italy will release current sentiment readings for various aspects of the group and individual country’s economies. With concern over the unity of the Economic and Monetary Unions growing, these will be critical reads for local and global investors. Clearly dealing with concern over an escalating probability of a ‘no deal’ Brexit, the UK’s business and consumer confidence reports Thursday evening will be crucial. Perhaps the most important reading on outlook will come from the US consumer via the Conference Board’s update Tuesday. 
    Not only are there the standard uncertainties for employment and financial security; but we have seen political stability and a U-turn on North Korea starting to position as external risks. Expectations are important as fear translates into reduced plans to buy goods, invest in factors, lend to entrepreneurs and other means to seed economy and markets – just as speculation of future events leads to speculators’ lifting or throttling a market before events truly come to pass. 
    T’was the Week Before a Seasonal Liquidity Shift
    The week ahead is the final week of August. That is clear, but what is less obvious for the uninitiated trader, this also happens to reference a crucial period for transition for the financial markets. The ‘summer lull’ is a familiar axiom for speculators and it is sustained as much by self-fulfilling prophecy as it is by any tangible changes to the markets themselves. Historically, August represents the ‘quietest’ calendar month of the year – qualified by the S&P 500’s volume going back to 1980. Yet, this is a probability, not a certainty. There are always exceptions in open markets where the winds of economic and financial crisis don’t necessarily abide the same assumptions. For instance, global risk assets were sliding sharply in August in both 2015 and 2011. And, we have more than enough unresolved fundamental uncertainty in the wings of our markets to spur a speculative avalanche for expensive markets. 
    However, the period encompassing the UK Bank Holiday and US Labor Day Holiday represents a period that historically carries a statistically high probability of quiet. That said, just as remarkable As August and this week is for restraint, the month of September is renowned for its volatility (VIX peaking in September and October) and a sense of risk aversion (historically the only month for the S&P 500 that averages a loss). We may find market participants are less restrained when making decisions with their portfolio amid economic uncertainty in a few weeks’ time, but that doesn’t mean we should simply check out in the meantime. 
    If markets are to offer up a surprise level of activity in the week ahead, what would it likely follow: a sudden sense of unexpected enthusiasm or fear amid an unseen crisis? Fear typically arises from the blue and prompts action more readily than greed. This is not a high probability occurrence, but it would lead to a remarkable amount of financial pain (probability vs potential). Hedges are still very cheap as evidenced by implied volatility. It is also the case that there is no risk when we are out of the markets, only the self-flagellation some suffer when they feel they are ‘missing out’. But if markets are genuinely quiet as assumed, there should be little to miss out on by closing now and reopening when liquidity tops off again... 
  11. JohnDFX
    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. JohnDFX
    In the Aftermath of the Fed
    The baton has been dropped. The Federal Reserve was by far the most aggressive major central bank through this past financial epoch (the last decade) to embrace ‘normalization’ of its monetary policy following its extraordinary infusion of support through rate cuts and quantitative easing (QE). Over the past three years, the central bank has raised its benchmark rate range 225 basis points and slowly began to reverse the tide of its enormous balance sheet. As of the conclusion of this past week’s two-day FOMC policy meeting, we have seen the dual efforts to level out extreme accommodation all but abandoned. A more dovish shifted was heavily expected given the statement in January’s meeting, the rhetoric of individual members as well as the state of the global markets and economic forecasts. Yet, what was realized proved more aggressive than the consensus had accounted for. No change to the benchmark rates was fully assumed, but the median forecast among the members accounted for a faster drop than the market likely thought practical. From the 50 bps of tightening projected in the last update in December, the median dropped to no further increases in 2019 and only one hike over the subsequent two years.
    The Dollar responded abruptly Wednesday evening with a sharp tumble, but there was notably a lack of follow through where it counted – the DXY Dollar Index wouldn’t go the next step to slip below its 200-day moving average and break a ten-month rising trend channel (a hold that confounded those trading an presumed EURUSD breakout). Why did the Greenback hold – for now – when the move was clearly a dovish shift? Likely because the market is already affording for an even more dovish forecast as Fed Fund futures have set the probability of a 25bps cut from the Fed before the end of the year as high as 45 percent. What’s more, if you intend to trade the Dollar; it is important to recognize that even with a more dovish path ahead, the Dollar and US assets will maintain a hearty advantage over its major counterparts. That would particularly be the case should other groups extend their dovish views to more actively explore deeper trenches of monetary policy.
    Looking beyond the Dollar’s take, however, there are far more important considerations for the global financial system and sentiment. The Fed was the pioneer of sorts for massive stimulus programs designed to recharge growth and revive battered markets. It was also the first to start pulling back the extreme safety net when its effectiveness was facing deserved scrutiny by even the most ardent disciple of the complacency-backed risk-on run. In other words, its course change carries significantly more weight than any of its peers. The question ‘why is the Fed easing back and so quickly’ is being posed consistently whereas in the past market participants would have just indulged in the speculative benefits. The overwhelming amount of headline fodder – from trade wars to frequency of volatility in the capital markets – makes for a ready list of considerations. Yet, the group’s own economic forecasts brought the reality home far more forcefully.
    Though we have seen numerous economic participants downgrade the growth outlook (economists, investors through markets, the IMF, etc), to see the median GDP forecast in the SEP (Summary of Economic Projections) lowered from 2.3 percent to 2.1 percent for 2019 made the circumstances explicit. We’ve considered multiple times over previous months what happens if the market’s start to question the capability of the world’s largest central banks to keep the peace and fight off any re-emergences of financial instability. Now it seems this concern is being contemplated by the market-at-large. That doesn’t bode well for our future.
    A Sudden Fixed Income Interest When ‘Recession’ Warnings Take Hold
    Except for fixed income traders and economists, the yield curve is rarely mentioned in polite trader conversation or in the mainstream financial media. Its implications are too wonky for most as it can be difficult to draw impact to the average traders’ portfolio and given the considerable time lag between its movements and capital market response. Yet, when it comes to its most popular signal – that of a possible recession signal – the structure of duration risk suddenly becomes as commonplace a talking point as NFPs.
    On Friday, the headlines were plastered with the news that the US Treasury yield curve had inverted along with a quick take interpretation that such an occasion has accompanied recessions in the past. There have actually been a few parts of the US government debt curve that have inverted at various points over the past months, but this occasion was trumpeted much more loudly as it happened in the comparison to the 10-year and 3-month spread (what has been identified as a recession warning even by some of  the Fed branches themselves). First, what is a ‘curve’? It is the comparison of how much investors demand in return (yield) to lend to the government (for Treasuries specifically) for a certain amount of time. Normally, the longer you tie up your money to any investment, the greater the risk that something unfavorable could happen and thereby you expect a greater rate of return. When the markets demand more for a short-term investment than a longer-term one in the same asset, there is something amiss. When the markets demand more return from a three-month loan to the US government than a 10-year loan, it seems something is very wrong. Historically, the inversion of these two maturities has predated a number of us the recessions in the United States – most recently the slumps in 2008, 2001 and 1990. 
    First is the lead period the curve reversal has to economic contraction. The signal can precede a downturn in growth by months and even years. Preparation is good, but moving too early can ‘leave money on the table’ for the cautious or accumulate some serious losses for those trying to trade some imminent panic. Further, there are certain distortions that we have altered the course in normal capital market tributaries that could be doing the same for Treasuries and therefore this reading. More recently, the revived threat of the US government shutdown through December and the unresolved debt ceiling debate put pressure on the asset class. At the same time, though, few believe the US would do little more than allow for a short-term financial shock in order to make a political point. Far more complicating for the market and the signal is the activity of the US and global central banks. The Federal Reserve has purchased trillions in medium-dated government debt as part of its QE program. They only started to slowly to reduce holdings and push longer dated yields back up a few years after they began raising short term rates in earnest. Their recent policy reversal only adds to the complication.
    Now, all of this does not mean that I believe the US and global economies will avoid stalling out or even contracting in the near future. Between the dependence on capital markets and stimulus, the heavy toll of trade wars and nationalistic policies, and the pain for key players in the global web; there is a high probability that we will see an economic retrenchment in the next few years. That said, that wouldn’t make this particular signal a trigger (causation) or even correlated through the main forces that would bring on a recession. Nevertheless, yelling ‘fire’ in an a panicky crowd on foggy day can still yield volatile results.  
    Brexit, Just Winging It
    Another week and another upheaval in Brexit expectations. Through much of the past year’s anxiety over the withdrawal of the United Kingdom form the European Union, there was at least some comfort to be found in the finality of the Brexit date (March 29th, 2019). While it could end in favorable circumstances for financial markets (a deal that allows considerable access for the UK) or acute uncertainty (a no-deal), at least it would be over. Well, that assurance is as clouded as the expected outcome from the negotiations themselves. Shortly after I wrote the Brexit update last week whereby there was a clear timeline for another meaningful vote on the Prime Minister’s proposals – after Parliament voted for an extension of negotiations – the Speaker to the House of Commons thwarted the effort when he said the scheme would not be reconsidered unless it was materially different. It is likely that see another significant change in this drama any times (and even multiple times) this week.
    At Prime Minister May’s request, the European Commission agreed to an extension of the discussions beyond the original Article 50 end date for this coming Friday. Yet, where the PM intreated a postponement out to the end of June, the EU agreed only to May 22nd – the day before European Parliamentary elections. Beyond that date, the UK would theoretically remain under the regulations and laws of the EU but would have no say in their direction which wouldn’t appeal to either side. So, now we are faced with another ‘fluid’ two months of critical deadlines. 
    This week, it has been suggested the government will try to put up once again for a meaningful vote – though it is still not clear whether the proposal will be meaningfully different (the EU has offered no further concessions) or there has been a successful challenge against the Commons speaker. When this could be put up to vote is unclear, but it has been suggested between Monday and Wednesday. If the proposal is approved, the timeline to May 22nd will remain and we will start to see a genuine path form. If it is not, then the following week Parliament will have to indicate that “they have a way forward”. If they do not, an extension or no deal will likely be considered for April 12th – out to the previously mentioned May 22nd date. If we pass April 12th without a clear plan, the probabilities of a ‘no deal’ or ‘no Brexit’ will rise significantly. Those two scenarios are extreme and on the opposite end of the spectrum. From a Pound trader or global investor considering UK exposure, you can imagine what a situation where the probability of diametrically-opposed, market-moving outcomes are considered balanced would do to the markets. It will curb market liquidity and leverage uncertainty. That would translate into divestment, difficulty establishing trends and serious volatility. If that isn’t your cup of tea, it is best to seek opportunities elsewhere for the next few months until this is sorted. 
  13. JohnDFX
    Amid Extreme (Low) Volatility, Determine Your Approach and the Eventual Change 
    Volatility continues to sink into extreme levels of doldrums – and this is a theme that all traders should take time to appreciate at regular intervals. Low volatility is a defining feature of a financial landscape. Whether fundamentals catalyze a cascade of value repricing or a technical cue is capable of triggering an avalanche of entry/stop orders is predicated on the conditions first laid out by the depth and activity level of the speculative medium. First and foremost, the type of markets we are dealing with should determine the trading approach we take. If we were to expect a high probability of key breakouts or simply expect such explosive moves to be relatively frequent in the broader market, we would expect volatility to be high and liquidity low – the thinner market depth helps amplify the ‘run’ from sudden jolts of activity. For trending markets, low volatility is a prevailing theme; but liquidity or market breadth are usually generous as participation in the move remains strong. In markets were both volume and volatility are low, observance of ranges (or imperfect congestion patterns) is more common. Recognizing the state of our markets alone is of incredible value for all traders. If my specialty is momentum trading in trends, I would want to remain sidelined when range trading prevailed or endeavor to create a robust range strategy and a barometer to tell me when we are transitioning to different speculative states. Yet, just as the phases of matter (solid, liquid, gas) are all related, so too are the phases of a speculative market. Range can transition to breakout with the application of volatility which then transforms into trend when liquidity follows the spurt of activity as the uncertainty in the volatility itself settles. 
    In the conversion of these different forms, it often proves difficult to determine what kind of market we are dealing with – not even the market is certain – and thereby what type of trading approach we should take. Arguably one of the least forgiving transitions occurs from the quiet and steady ranges into the more explosive breakouts. The shallow liquidity can precipitate enormous moves beyond just the first bloom of volatility. This is often the ignition to sudden speculative collapse as with February 2018 or the eruption of a full-blown financial crisis as with the Dot-com bust. We are once again facing this particular fluid state. Some are comfortable in the range that they are seeing from the likes of the EURUSD which has carved out one of its longest, controlled ranges (as a percentage of spot) since the Euro began trading. Or even more dangerous, there is a default assumption of trend like that from the S&P 500 or Dow which are in the midst of recovering from the last explosion and are not yet returned to the decade-long bull trend so many have profited from through a passive strategy approach. From the trend assumption, there is an assumption of slow capital gains and modest dividend income against a backdrop of risk that is unrealistically low. So, how do investors/traders approach such an ambiguous situation? Use the strategy most common with range trading. Shorter term trades, more reasonable targets, awareness of important levels and more engaged observation of market conditions will make for active trading but also faster reaction time should conditions truly start to change. 
    Trade Wars and US GDP: Top Theme and Top Event 
    As we move into a new trading week with the recognition that market conditions are extremely restrained, it is natural to assume continuation of the same. Yet, as we discussed above, that is an assumption that leverages far greater risk than potential. When we consider the exact conditions for transition, there are various circumstances that can bring about a transition of indecision to trend or low volatility to explosive. That said, the evolution of quiet to volatile is very rarely based in sheer technical originations. It is possible that the rank and file grow so complacent and liquidity so shallow that an unexpected technical development triggers an outsize market drop that then cascades into wholesale deleveraging as everyone returns from the sidelines with a single motivation: to exit quickly. Far more common in the annals of transitional market history is a fundamental spark that draws mass participation and trading intent all at once. And, for those already familiar with the inverse correlation between the S&P 500 and VIX, the more capable driver is the one that is bearish and/or stokes fear. With that flight path established, we should take into account what the most promising/threatening theme and event risk are through the period ahead. 
    On the theme side (meaning a general fundamental influence that is steadily a concern with flare ups around scheduled or impromptu developments), trade wars are presently the most ominous  circumstance. It is true that we have a key growth-based risk (US GDP) and dependency on depleted monetary policy has leveraged an impossible future, but recognition of global recession or a hopeless backstop aren’t inevitable do to their existence alone. In some contrast, trade wars are starting to draw greater and greater scrutiny as burden to the global economy and circulation of capital around the world. What’s more, there are a number of threats being juggled presently and any one could drop. The US just recently threatened to apply $11 billion in tariffs against the EU in retaliation for subsidies the latter has given to plane manufacturer Airbus – and of course, the EU has said it is ready to retaliate as soon as the threat is acted upon. With the United States’ direct neighbors, there are hurdles being erected to the USMCA negotiated as a revamp of the previous NAFTA; but the real risk resides with the President’s threat to shut the Mexico border and/or apply tariffs to imports of Mexican auto parts if the country doesn’t do more to stem the flow of illegal immigrants into the United States. Then there is the universal risk of President Trump weighing a universal import tax on all autos and auto parts, a measure that will predicate a global trade war (or at least US versus the Rest of World) that assures a stalled economy. If we are looking for a capable threat with a clear date and time, the US 1Q GDP release will act as top event risk. The world’s largest economy is a bellwether for the globe with so many troubling figures coming cross the wires these past months and open risks like the monetary policy losing its ability to stabilize and the impact of trade wars leeching through. Market it on your calendar. 
    US Earnings Will Have More to Say Than Just the State of US Corporate Profitability 
    For systemic themes, the most frequent three in the rotation these past months has been: monetary policy; concern of economic recession and trade wars. However, these are not the only complicated matters that can spur fear (or greed in positive turn). One typically-seasonal consideration that will return to the forefront in the week/s ahead is US corporate earnings. We have actually had updates from a few major corporations over the past two weeks, with a greater concentration on the top banks. Thus far, we are left with an impression that registers as continuation of the questionable enthusiasm the markets has sustained for quarter after quarter stretching out through some years. If we are to maintain that questionably content view of profitability and growth through the weeks and months ahead, this week’s run will play a particularly important part in setting the course.  At the top of the list, we have the likes of: Amazon; Microsoft; Anthem; Caterpillar; Exxon Mobil and Procter & Gamble among many others. These are some of the largest companies in a variety of different industries and they will naturally account for a strong overview of the entire systems health. 
    However, there is another aspect to this bout of earnings season that we should consider: the thematic influences that will be touched upon in the underlying economy and financial system. If you were looking at the ‘bleeding edge’ of speculative appetite, there is good evidence to suggest that the tech sector continues to hold the torch that investors in most other areas of the economy and markets continue to follow. If you want to look at a quantifiable measure of this preference, consider the general performance of the tech-heavy Nasdaq Composite to the blue-chip Dow – or even the ratio of the two. A leader can be a boon or a burden though depending on the direction it takes. If tech were to pitch lower into a speculative dive, it would likely undermine confidence across the system. With that in mind, consider the largest players in Amazon and Microsoft or a more forward guidance-leveraged FANG member like Facebook as greater risk than reward. Another theme that we will touch upon is general economic growth. The largest companies in the indices or a look into the core of economic activity through the likes of Procter & Gamble, Anthem or Exxon will give some direct lead in to the GDP figures due. Then there are trade wars. We have seen these concerns flag as the threats are days or weeks old – and in the case of the US-China, negotiations are progressing – but the financial impact cannot be overlooked. The likes of Caterpillar who has registered negative impact in the past, Boeing who is at the center of the EU threats via Airbus and even Harley Davidson who was a target for President Trump last year can tell us the state of play.
  14. JohnDFX
    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.  
     
  15. JohnDFX
    Trade Wars Update: It No Longer Matters? 
    Seemingly a routine occurrence for the global financial markets, we saw the state of global trade deteriorate yet again through the past week. As expected, the United States went forward with tariffs on an additional $200 billion in Chinese goods. The terms are for a 10 percent rate on a range of imports that will increase to 25 percent by the end of the year. The standard, immediate response from China was quickly implemented, but only on $60 billion in US goods. It is not clear the strategy from China as they vowed a ****-for-tat response to what they have deemed unprovoked trade wars, but the country does not have much more room to tax imports from its major counterpart – and certainly not $200 billion worth of goods. This alone moves us into a new phase of a standoff of escalating cost for the US, China and the world. 
    Will China ease off the pressure? Are they simply plotting an alternative course? Could this be an attempt to prevent President Trump from pursuing his threat to trigger the $267 billion in further duties in the event of a reprisal to the $200 billion? It isn’t clear. With the situation clearly under greater tension, the news over the weekend that plans for further talks had broken down ensures greater financial threat from this already-enormous burden. What is even more remarkable than the state of trade from these two economic leaders is the apparent state of obliviousness from the speculative markets. While certain assets show greater disregard to the threat than others (the S&P 500 is at a record high while the EEM Emerging Market ETF is only modestly off its multi-year low), they have all displayed a measure of neglect these past weeks as the tab has grown exponentially. 
    To suggest that this situation simply doesn’t matter would be recklessly negligent. It isn’t impossible that speculators accustomed to complacency and FOMO, but it would nevertheless increase the scope of risk to stability through the future. Ignoring the dangerous wobble in a tire as you steadily accelerate down the freeway is not a reasonable state even if we can sustain it for the time being. If we continue to build up exposure until a severe economic or financial crisis arises, it will only amplify the eventual collapse. 
    What is Eating the Dollar and How Long Does it Dine?
    The Dollar marked an important technical tumble this past week. Already under pressure over the past months, the DXY’s drop below 94.35 and EURUSD charge above 1.1700 represents the break of ‘necklines’ on head-and-shoulders patterns (the latter inverted). This is pressure not isolated to the trade-weighted aggregate or its heavily represented most liquid pairing. We can see the currency’s unique struggle intensifying distinctly across the spectrum over these past few weeks. But with this evidence of broad struggle, we should attempt to identify its source if we intend to establish the intent of follow through – whether persistent or near its conclusion. Reverting to an old textbook relationship, some are connecting the currency’s traditional safe haven role to the recent rebound in risk assets – including record highs for certain benchmark US indices. 
    That would be a tidy explanation, but is suspicious for its timing considering this haven function hasn’t played a significant role for months. Further reason to question this relationship is the explicit status for the Greenback as the highest yielding major currency. That advantage will likely increase this week as the Fed is expected to hike rates another 25 basis points to a range of 2.00-2.25 percent. It could be the case that the currency’s premium could be deflating under expectation that the central bank is planning to downgrade its pace of tightening at this meeting through the Summary of Economic Projections (SEP) and Chairman Powell’s press conference. Yet, we don’t see that anticipation in assets that more directly relate to such forecasts - overnight swaps and Fed Funds futures. 
    Political risk will prove an increasingly prominent risk through media headlines in particular over the coming weeks, but there is little direct threat to economy or financial markets just yet. This slow reversal of a six-month old bull trend may also have developed in response to the longer-term concerns. Over enough time, the accumulated cost of engaging in a multi-front trade war while increasing the budget deficit during a healthy economic phase will erode the appeal of the United States’ currency’s principal status. It is possible that this long-term pressure is starting to set in; but if that is the motivation, it can readily be sidetracked by more intense short-term concerns (like next week’s FOMC decision). 
    Political Risk Increasing as US Election Cycle Heats Ups 
    Political risk is an abstract fundamental influence on the financial system. Certainly each trade has their political beliefs on policies ranging from economy to social causes; but more often than not, these views only cloud our assessment of the markets. It is generally-accepted market wisdom to remove emotions from our trading; and there are few things in life that more readily trigger emotion than politics. Practically-speaking, however, there is little in the way of policy that can readily translate into significant market movement in the short-term. That said, one of the few outlets with a direct link to financial health and stability is the state of international relations. And, on that front, the danger has grown visibly and exponentially. Perhaps one of the most obvious instances of this pressure on net global growth and capital rotations through trade comes from the United States. 
    The Trump Administration has driven forward with hefty tariffs and economic sanctions on some of the largest economies in the world. Whether we personally view the policies as good or bad / right or wrong, the economic impact is straightforward. As time marches on, attention on politics will intensify with the mid-term elections approaching. While much of the high drama related to the balance of the Legislative branch, threats of Presidential impeachment and the Supreme Court pick has little to do with the kind of direct market implications that we should keep in the forefront; it can nevertheless bolster the appreciation of economic and financial connection by virtue of its mere presence in the headlines. What’s more, this is not a uniquely US concern. There is political pressure rising across the world. 
    Reports of a possible election call in the United Kingdom have followed the failure of progress in the Brexit negotiations at the EU leaders summit in Salzburg. Mainland Europe is not immune to systemic risk via political pressures. Italy is still a massive concern to stability between its enormous debt and populist government. Poland and Hungary pose a threat to core EU beliefs – and have drawn criticism for such – owing to their nationalist governments’ policies. In Asia, financial pressure is starting to show subtle cracks in social contentedness while US sanctions have spilled over from Russia restrictions. Japanese Prime Minister Abe managed to keep his position this past week, but the economic and international diplomatic position or the country has not improved materially. The question investors should ask themselves is whether these relationships improve for compromise or rapidly intensify should economic or financial crisis start to emerge. 
  16. JohnDFX
    Risk Trends – Monitor Liquidity Closely 
    Sentiment is turning increasingly septic across the financial markets. This past week certainly wasn’t the first week that signs of trouble were starting to show. However, a clear capitulation by one of the favorite benchmarks of hold-out bulls – US indices – has undermined one of the few reliable backstops left. The S&P 500 and Dow have been in retreat through much of October after hitting their respective record highs. Up until this past week, the slip still fit the mold of a measured retreat for which the ‘buyers of the dip’ have flourished. Yet, the past five-day stretch added a troubling gut punch to the opportunists’ gut. The major American indices, paced by the S&P 500, crashed through their respective multi-year bull market trendlines. While Wednesday’s 3.0 percent tumble was particularly acute, it was Friday’s more restrained drop that was perhaps more remarkable technically and a record setter. The gap lower on the open was the biggest in almost exactly 10 years (2 days off during the height of the Great Financial Crisis) and the largest on record. Furthermore, it the move that would treat a former critical level of support as new resistance. With this symbolic risk leader removing its support, we may find one of the most critical contributors to keeping the peace allowing progress as we slide into deeper retreat. 
    As we keep track of this small sliver of the financial system, comparison to deeper and more productive retreat for global equities (VEU), emerging markets (EEM), junk bonds (HYG) and so many other important assets will act as a sort of speculative gravity. One of my favorite measures of genuine sentiment is to gauge correlation for these various risk assets as they commit to a clear and consistent trend. Yet, where that may indicate that sentiment is in control with a viable direction, the measures of intensity are different. Two crucial elements of a market that is tipping from controlled descent into relentless deleveraging are market positioning and liquidity. For market positioning, exposure can be assessed through open interest via derivatives like futures and ETFs. The net speculative futures position monitored by the CFTC (COT) is a significant medium-term evaluation – in contrast to the short-term readings from the DailyFX-IG sentiment data. That said, there are longer duration measures that we can utilize for trends. Total open interest in futures (for speculation and hedging signals), capital moving into and out of ETFs and leverage readings for different economic participants (investor, consumer, corporate and government) can all register the state of the financial system. As these readings start to reverse course and funds begin to prioritize safety over return, we begin to solidify a self-sustaining course. However, tipping the market into a true panic with all its important implications, we must monitor the liquidity behind the market. 
    An abundance of selling overwhelming bullish interests is one thing. Attempting to unload exposure but finding no market forcing a rapid drop in price to satisfy the offload is something completely different. There are many ways to measure the strain on the system, but not all are made the same. I find many of the government (Cleveland Fed) and bank (BofAML, Goldman) measures are lagging. Spreads between market and sovereign (TED spread) or risk premium (high yield fixed income over blue chip) is more timely. Given how exposed investors are up the risk curve, the natural rolling out of the tide from higher risk and thinner markets can trigger a cascading problem in the opposite direction towards the core of the market. It is worth noting that late this past week, Japan’s central bank, Finance Ministry and financial authority (FSA) held an unscheduled meeting to discuss the tumble in equity markets (15 percent down in October). We should keep a close eye on whether more such concerns are confirmed on other points across the globe. 
    Themes Versus Event Risk for Euro and Pound 
    There are already significant fundamental winds blowing for the European currencies, but the storm will start to foster confusing cross winds in in the coming week. In particular, traders will have to untangle the influence between scheduled event risk and more systemic themes. We have seen this many times before in different asset types and different regions. How many times have we seen a high profile event draw the market’s attention in its approach only to find its ultimately impact waylaid by an unresolved and overriding theme? For this week, least severely conflicted currencies (hardly an inspiring designation) is the Euro. On the docket, we have a range of economic releases including inflation to region-wide sentient surveys. As important as those figures are, there is far more fundamental charge from the likes of the Euro-area 3Q GDP figures and Italy’s specific data. Italy will report its own GDP update, its monthly budget and other various indicators. We care about this specific country for its systemic, thematic influence. The standoff between the European Union and one of its most indebted members has hit a critical stage. 
    Italy has made clear it has no intention of backing off of commitments to increase public spending to help spur growth through pensions, support for the poor and more. Yet the Union and other member countries’ leaders have demanded change to meet the previous government’s commitments and not run afoul of the Union’s restrictions. We were here before with Greece approximately 9 years ago. If this moves forward, the situation could prove far more severe as Italy is a core member rather than a small, fringe component to the healthy system. From the Pound, the fundamental conflict will be far more substantial. The ongoing drumbeat for the Sterling is the unresolved Brexit. This has been the general state of the market backdrop for over a year and a half. However, we are fast approaching a critical deadline which looms like a cliff. They have to start decelerating now to ensure they do not pitch over the ledge. Where it seemed last weekend a breakthrough was reached when it was suggested Prime Minister May was ready to compromise on the boarder, we saw late in the subsequent week that talks within her government had stalled over strong infighting yet again. We have few definitive dates to monitor for progress through the immediate future, so we have to rely on erratic headlines instead. 
    In the meantime, the Bank of England (BOE) rate decision on Thursday carries more weight than normal. While speculation of another hike by the MPC (Monetary Policy Committee) before the end of the year has dropped off sharply, focus on policy standings has ramped up considerably thanks to the Bank of Canada’s rate hike. What’s more, this is one of the nuanced meetings for the BOE as we are also expected the Quarterly Inflation Report and Governor Carney’s press conference – which is collectively referred to as Super Thursday. Expect volatility but question trend. 
    The Unique Signal on Risk from the Dollar, USDJPY and Aussie Dollar
    As we attempt to untangle the commitment in risk trends – a worthwhile pursuit given how much potential lays underneath this evaluation – there are a few measures in the FX market that deserve closer attention for their unique readings. First in that is the US Dollar. The most liquid currency in the world, this asset is often considered a binary safe haven. It is true that the currency represents a good harbor to stormy financial markets, but there are shades of grey to sentiment and to this indicator’s signaling. In the event that we see a full-tilt deleveraging of risky exposure, there is no question that the Greenback will climb. This has less to do with the depth of the currency’s own market, and relies far more on the international appetite for US Treasuries and money markets when the walls are falling down around us. When capital is fleeing to such safety, it first must cross the exchange rate barrier. However, short of the extreme measures capital shift, the Dollar’s status comes with significant caveats. This is a currency that has also drawn significant interest as a carry currency over the past few years owing to the Fed’s unmatched path of policy normalization. That hasn’t always afforded the USD lift, but it has factored in nonetheless. 
    If we are in risk aversion that sees the Dollar drop, it is less likely to be the type that is systemic and associated to ‘panic’; while a USD surge would indicate something very different. This ambiguous picture of the Dollar can be extended to a specific currency pair as well: USDJPY. Both the Dollar and Japanese Yen respond to market sentiment as safe havens. The Yen is more appropriately ‘safe haven adjacent’ however as it is a funding currency that facilitates carry trade appetite. As confidence gives way to fear, a deleveraging of carry nevertheless sees the Yen appreciate and signals a change in course. Yet, what if the intensity picks up? The Dollar’s carry status would facilitate a drop in the exchange rate, but an extreme tempo would likely designate a more appropriate harbor from extreme fear. If it is difficult to evaluate confidence from the USD alone or via the correlation between assets, use the USDJPY as a barometer. We have done a lot of ‘preparing for the worst’. What if sentiment stabilizes and there is a rebound in risk appetite? First, it is important for me to qualify that I would not consider a bounce in risk appetite to signal a lasting trend. There are still deep, unresolved inequities between risk assets prices and their values. 
    I would look instead for short-term opportunities. One such opportunity may come with the Australian Dollar and/or New Zealand Dollar. Both are carry currencies that have lost all appeal for their carry. They further have exposure to China which is troubling and host their own domestic issues (such as housing tension). Yet, if risk trends stabilize, there is deeper discount here than more confused outlets such as the Dollar or the Yen crosses. Further, these currencies have not dropped in recent weeks’ sentiment slump, which denotes a bias that can reduce risk and leverage potential under favorable conditions. There is still key event risk to monitor ahead such as Australia’s 3Q GDP and CPI, but we shouldn’t underestimate the opportunity should the course be set. 
  17. JohnDFX
    Don’t Forget Trade Wars Aren’t Isolated to US-China
    Trade wars remain my greatest concern for the health of the global markets and economy. There have been threats in the past where a localized fundamental virus has turned contagious to the rest of the world by unforeseen circumstances – such as the Great Financial Crisis whereby a US subprime housing derivative implosion infected the wider financial markets by destabilized a foundation built on excess leverage throughout the system. When it comes to trade wars though, there is no need to connect the dots. The systemic implications are apparent. The world’s two largest economies (and markets) are engaged in an escalating ****-for-tat economic conflict. There is little chance that the fallout from such a profound distress would be contained to these two contestants. The United States is the world’s largest consumer of finished goods and China is the principal buyer of the commodities. Whether appetite is trimmed owing to trade policy or stunted economic growth, its smaller trade partners would feel the pain.
    Yet another organization that is warning over the risks these two are charging was the United Nations whose trade group said further planned escalations could severely impact GDP (it estimated ease Asian economies could drop by $160 billion), trigger currency wars and generally promote contagion. That said, the headlines this past week should raise serious concern among traders. Reports (and remarks) signal the White House does not expect a deal to be struck between the two countries by the end of the 90-day pause on the planned tariff hike. What’s more, sources say President Trump is not going to extend that date and intends to increase the tariff rate on the $200 billion in Chinese imports from 10 percent to 25 percent on March 2nd. That is a severe escalation and one that Chinese officials will not likely take in stride. As tensions rise, there is movement in Congress to curb the White House’s powers to pursue this economic war through its utilization of Section 232 of the Trade Expansion Act of 1962 – this at the same time Trump is attempting to leverage more control.
    As this effort progresses, it is important to remember that this is not playing out on a single front. Where it seemed that the United States’ pressure on Mexico and Canada via the NAFTA agreement was resolved by the creation of the USMCA, Congress is now signaling that it may reject the effort if material changes are not made. What’s more, we may see the pressure expand yet further. The loose threats by Trump to place tariffs on auto imports have been made multiple times over the past year. A deadline is finally in sight of this threat to potentially gain serious traction. Next Sunday, the Commerce Department is due to give its recommendations following its evaluation of auto imports. Given Secretary Ross’s disposition, it is likely to be a charged report. If the US were to implement tariffs on imported automobiles, the economic and diplomatic impact would be far more significant than what we have seen between the United States and China thus far. Global economic stagnation would follow soon in such a development’s wake. 
    Paying More Attention to Rates as Outlook Weakens
    Monetary policy as a financial theme never truly lost any of its influence over the global markets these past years. However, investors’ attention has waned on this critical pillar of speculative reach as appetite for yield has solidified complacency. Yet, conditions are beginning to change with economic activity slowing and volatility in the capital markets picking up. That in turn draws attention back to the backstop that so many have based their convictions – whether they realized it or not. To some, fear that markets are at risk of retrenchment bolsters expectations that the largest central banks are going to step in to temper volatility and lift risk assets by flooding the system with cheap funding once again. For those whose confidence remains, they still consider the likes of the Federal Reserve (Fed), European Central Bank (ECB) and Bank of Japan (BOJ) forces of nature. Closer examination of these groups’ current policies and the available tools still at their disposal, however, should raise serious concern.
    While the Great Financial Crisis is a decade behind us with growth having stabilized and markets surged in the period since, collective monetary policy has changed little. While the Fed may have raised its benchmark rate range over 200 basis points, none of its largest counterparts have moved significantly off of their own zero bound. Furthermore, there remains an enormous amount of stimulus awash in the system with central banks’ balance sheets bloated with government bonds, asset backed securities and even more traditional investor assets. If push comes to shove and markets started to avalanche lower despite the present mix of support still in place, what would these authorities be able to do muster in order to counterbalance? There is no meaningful capacity to lower global rates and QE has gotten to the point where its effectiveness draws as much cynicism as assurance.
    Adding more support against a persistently incredulous market would only solidify the realization that central banks are no longer the effective backstop for speculators they once were. And then where do we expect to turn for help? A coordinated effort from global governments when they cannot even maintain existing trade deals? As our markets remain volatile and economic forecasts soften, expect scrutiny over monetary policy and its effectiveness to increase. We have seen that already take place with the market’s response to the Fed’s dovish shift and even the RBA’s and BOE’s growing concerns this past week. Rate decisions, speeches and even data close to policy mandates will leverage greater focus – and likely market reaction – moving forward. 
    Dollar Can Compensate for Issues By Advancing on Euro, Pound Pain 
    The Dollar is in a complicated fundamental position. There are numerous domestic issues that represent a serious fundamental weight on the benchmark currency but global troubles will consistently work to counteract the loss of altitude. Of course, the likelihood of a perfect equalization is highly improbable. One development or the other will prove more severe than was expected or the market will decide a particular issue is of far greater consequence to the financial system. It is not clear which node will trigger a tidal wave of capital market flows, so we need to keep tabs on those themes that will exert greater influence on the benchmark as the dominant force will likely arise from these known quantities. On the economic front, the US economy has shown signs of economic slowdown and a sharp drop in sentiment readings from consumers to businesses to investors. This was only accelerated by the US partial government shutdown and the risk that it closes once again is worryingly too high. The stopgap funding runs out on Friday.
    The delayed economic readings with the status check before the shutdown impact was full felt are starting to trickle out and the GDP reading seems to be due next week. An ineffectual government looks to like it will increasingly be a core issue for the world’s largest economy moving forward with promising programs like infrastructure spending increasingly relegated to the dustbin of unrealized campaign promises. And of course, with the promise of economic wealth fading and sentiment withering, the Federal Reserve’s intention to further raise rates to establish a higher rate of return on US investments will naturally recede. Yet, all of these shortcomings will have powerful relative corrections. While the Fed may very well halt its monetary policy ambitious of the past three years, to stabilize at a 2.25-2.50 percent benchmark range while major peers like the ECB, BOJ and BOE shift to a dovish course from zero rates and expansive stimulus will maintain relative advantage to the Greenback.
    Should risk aversion build globally, the Dollar has more investment interest premium built up over the past years that could leach away, but a tip into severe risk aversion (which would be difficult to avoid in a committed downturn) would leverage the currency’s absolute haven appeal. What’s more, where the political infighting in the US is more localized, it is not a unique trouble to the United States. Further, it is persistently applying greater pressure on trade counterpart around the world through the trade war. Perhaps one of the truly untested and underpriced risks to the Greenback however is the intentions of the US President. Over the past year, Trump has voiced his consternation over the level of the currency as an impediment to his strategy for course correct trade and perceived inequities to trade partners. In the event of universal risk aversion which puts serious pressure on the global economy, we are unlikely to see an effective collaboration across the world’s largest countries as the game theory in their competitive efforts will more likely intensity under the weight. With demand or Treasuries resulting in a rise for the Dollar, it would not be out of the question to imagine the White House responds with unorthodox policy aimed at driving the currency lower. The real trouble would only begin if the world’s largest player touched off a currency war.
  18. JohnDFX
    Fed Sets the Tone for Global Monetary Policy Expectations
    Global monetary policy trends have shifted towards a more accommodative stance as forecasts for economic activity have stuttered and worries of ‘external risks’ have gained traction. This has sharpened the relative value of currencies as market dig into the grey areas trying to determine which groups are taking greater strides to loosen than their peers. However, it is crucial that all investors – no matter your preferred market nor time frame – keep sight of the collective impact the world’s central bank effort has on the health of the economy and stability of the financial system. While there has certainly been a boost to economic activity and all of its trappings through this past decade’s bull trend, there is undoubtedly a divergence between the extraordinary performance of capital benchmarks like the US equity indices and the more tepid clip of expansion we have registered lately. In fact, I would go so far as to say that the past four to five years of speculative abundance was chiefly the work of the largest monetary policy groups. The course change towards halting normalization efforts and entertaining further easing looks to tap some of the speculative magic of the past, but there is a definitive diminishing returns to successive waves of support. 
    From central banks like the Bank of Japan (BOJ) and European Central Bank (ECB), the limitations are more overt as the scale of easing grows exorbitant. The BOJ for example owns an extraordinary percentage of the country’s ETF market and in turn holds an astounding amount of its capital market. That smacks more of desperation than safety net, and other regions are at risk of shifting to that unflattering distinction. Just how precarious that balance is finds more distinctive measure not at the most dovish end of the curve, but rather the most hawkish. The Federal Open Market Committee’s (FOMC) two-day policy meeting will conclude on Wednesday with no anticipation of a rate hike to follow on the ambitious pace of 2018. In fact, looking at Fed Fund futures, the market is pricing in a slight probability of a 25 basis point cut to the 2.25-2.50 percent range. The group’s view of the future is where the market will set its focus. This is one of the ‘quarterly’ meetings for which we are due the Chairman’s  press conference and the Summary of Economic Projections (SEP). In the December update, the median forecast set expectations for 50 basis points of tightening this year (two standard rate hikes). Given the rhetoric used by most officials of late, that forecast is likely to drop at least one hike and could very well put even one move in 2019 under serious debate. If there is still a forecast for two, expect the Dollar to jump as the market has fully written off any moves (with nearly a 40 percent chance of a cut priced in by year’s end according to futures). 
    The monetary policy statement and Chairman Powell’s remarks will offer important insight into the plans for the balance sheet reduction effort. We have already seen indication that they are planning on throttling the effort soon which will cap longer dated rates in the market – which will also mean rates of return will flag. Is this backing away from a tighter policy setting more supportive of economic activity or more troubling as clear indication that the world is in need of external support – support that is exceptionally limited compared to the past? Meanwhile, we are also due the Bank of England (BOE) rate decision which will be a conduit for Brexit uncertainties for better or worse. The Swiss National Bank’s (SNB) policy is a more extreme example of desperate policy that has lost traction, so its only true insight into global perspective is to amplify fears that the guardians of stability have failed. It is further worth registering what the Brazilian and Russian central banks do with their own policies as the emerging market draws direct connection to US health and risk trends register far more readily here. 
    Trade Wars are Increasingly an Underappreciated Threat 
    There is a hierarchy of systemic themes that rotates in its influence over the global markets and its participants. ‘Basic’ appreciation of economic potential was the focus these past two or three weeks owing to targeted economic data and troubling forecasts (such as China’s lowered target for the coming year at its National People’s Congress). Attention on this particular intersection of market-wide health will not simply vanish – we have important measures to contribute to forecasts like the Fed’s GDP forecasts and March PMIs on Friday – but appreciation will likely soften as catalysts offer a more obvious update. Monetary policy will offer the most tangible impact on a fundamental basis, but there is another theme that has garnered less attention of late but which should not be forgotten: trade wars. The course for competitive economic policies via trade pacts has shown definitive improvement in the status quo from six or nine months ago. 
    The outright US-China trade war has seen the course of steady escalation frozen by the Trump administration as they continue to negotiate towards structure improvement as well as balance of consumption equity. Of course, the President’s threats that they could walk away if the deal is not favorable and President Xi’s calls for a clear time frame remind us that this is not a done deal. Another assumed reversal of fortune that is once again raising concern comes from the revamped relationship between the United States, Mexico and Canada. The replacement of the NAFTA accord with the USMCA deal was considerable relief for Mexico and Canada while simultaneously promoted as a success for the Trump Administration’s appetite for aggressive negotiations to hash out trade deals. That bargain is starting to come under significant pressure however as Congress threatens to scuttle what was agreed to amongst the three countries’ negotiation teams. Where we are already in the weeds on these two fronts of US trade, the threat of new economic conflicts garner even less appreciation. 
    That is extremely shortsighted given the financial repercussions of the past year to the other efforts and the volatile nature of dealing with the US. A month ago, the US Commerce Department delivered its findings on an auto tariff probe that it conducted at the behest of the White House. We don’t know the results of that report and the President still has two months to decide whether to pursue something. However, we have seen explicit threats by the White House against countries with perceived unfair trade advantages for their auto industries – as well as vows of large scale retaliation by those in the crosshairs. If the President considers dealings with the USCMA and China a success, it is more likely that they pursue the same line on autos, particularly should political popularity rankings flag and/or domestic economic activity measures continue to crawl. 
    A Third Meaningful Vote and an Update on Brexit Scenarios
    I don’t think anyone will miss Brexit when it is done. Nonetheless, we need to keep close tabs on its progress as it continues its uncontrolled tumble down the hill. This past week was loaded with votes – and subsequently volatility. Prime Minister Theresa May put up a rejiggered proposal for vote in Parliament this past Tuesday and the MPs dismissed it outright once again – though this iteration wasn’t a record-breaking defeat for the PM. That in turn led to the debates this past Wednesday which resulted in a decision to direct May to avoid a ‘no deal’ scenario at all costs, which definitively beats back the range of uncertainty inherent in this saga. Sterling traders took notice as we saw GBPUSD produce its largest single-day rally since April 2017. With a seeming cap on the economic repercussions this event may pose, the next question was whether May should be directed to request an extension from the EU on the Article 50 end date (set for March 29th). Approval of that particular leg is perhaps the least surprising of the week’s discussion points. Yet, with direction to seek deferment on the divorce date, serious questions followed asking whether more time would actually translate into a feasible deal. Given the state of discussions after two years, there is reason for skepticism. In turn, some hold outs have begun to signal a willingness to take a more moderate stance in order to find some compromise. 
    That has encouraged the Government to put up proposal from May – it doesn’t look like she expects to have further concession – for another meaningful vote (MV3). Set against this Wednesday vote, we have seen the slogan turn to a simple arithmetic of May’s deal or risk a protracted period of uncertainty or even no Brexit at all. There are suggestions that some in Conservative party are willing to throw in some support in exchange for the PM’s resignation, but that does not come close to guaranteeing a majority. If the proposal is rejected once again Wednesday, focus will turn to the mood of the UK-EU negotiations. If support does not significantly shift in favor of the Government and May sticks to her warning that rejection will necessitate a long extension, then we will start to run up against the EU’s restrictions. EU elections will create further tumult in negotiations with the UK at risk of holding under the Union’s influence without say over the course the collective is taking – a very unattractive proposal. 
    When assessing the Sterling and foreign investor appetite in the UK, the ultimate question is not the detail nor political advantage of one outcome versus the other. The basic question of taking risk or not is uncertainty. The longer the uncertainty is for the course of the UK’s economic and financial relationships moving forward, the greater the perceived risk for investors. That does not mean the Pound will just continue to drop throughout the imposed purgatory, but it will add volatility and cap the ambitions for substantial rally. 
    Critical Fundamental Themes to Keep Watch For Next Week:
    -    Recession Signals in Data, Markets and Forecasts [Indices, Yields, Gold]
    -    Monetary Policy Supporting Risk Trends or Falling Short [Fed, ECB, BOE, EURUSD, GBPUSD, Gold]
    -    Gov’t Bond Yields and Commodities as a Growth-Leaning Risk Asset [Dollar, Euro, Yields, Oil]
    -    Brexit Article 50 Extension [GBPUSD, EURGBP, FTSE100]
    -    US-China Trade War Deal Detail Headlines, Trump-Xi Meeting Time Frame [AUDUSD, USDCNH]
    -    Threat of US Implementing Auto Tariffs [EURUSD, USDJPY]
    -    Excessive Leverage / Debt in Public and Private Channels [S&P 500, Yields, Gold]
  19. JohnDFX
    So Much Risk, Status Quo is an Improvement
    In individual trading sessions or entire weeks where there is an overwhelming amount of important, scheduled event risk; we often find the market frozen with concern of imminent volatility. Even as a remarkable surprise prints on the docket early in the week, the impact it generates is often truncated by the concern that the subsequent release can generate just as much shock value but in the opposite direction. Many opportunities have been spoiled by such situations.
    Yet, what happens if we face the same situation on a grander scale? What if the threats are thematic, global and frequently lacking a specific time frame? We are facing just such a scenario now. The most troublesome subject is the unpredictable winds from the global trade wars. For influence, this is a systemic threat as the economic pain will inevitably come to a head. If we had an end date to work with, there would be a more decisive risk aversion, but it is the uncertainty of pacing that leaves the markets to drift with anxiety. Most critical updates in this ‘war’ have come out of the blue in the form of a tweet from US President Donald Trump.
    Add to this fully capable theme conflicting – though less capricious – matters, and there is just enough sense of opportunity in short-term efforts to keep bulls clinging to hope. Monetary policy, new and failing economic relationships, corporate earnings and more can fill in between shocks of new tariff threats. Though, if we came to a scenario of a universal dovish shift in central banks (or any other theme for that matter), would it be enough to offset the blight to global growth from trade wars? Not likely.
    Any Whiff of Fed Worry and a Dollar with Everything to Lose
    I weighed out my theory last week that Fed policy can only disappoint moving forward. That is not to say it can maintain a sense of status quo – it certainly can. However, the genuine opportunities for this central bank to ‘surprise in favor of the bulls’ is so improbable as to be impractical. It has already established a pace remarkably aggressive relative to counterparts. If conditions continue to support growth and optimism, it would lead other central banks onto a path to close the gap with the Fed. If economic and financial health floundered, the Fed would in turn have to ease its pace.
    This past week, the CPI data gave quantitative support for the status quo – though not any material Dollar lift. The Fed’s monetary policy update to Congress on the other hand laced its confidence on the economic outlook with modest concern over the fallout from trade wars while a separate report suggested the tax cuts would have less positive effect on the economy than previously anticipated. You can bet Fed Chairman Jerome Powell will have to address questions on both fronts when he testifies before the Senate Wednesday in the semi-annual Humphrey-Hawkins testimony. There are many Congressmen and –women from both parties who have called out the President’s aggressive position on trade as self-defeating.
    Powell will want to avoid triggering market fears (avoiding volatility is a third, unspoken mandate of the central bank), but the lawmakers will push the topic whether to illustrate the damage they fear or to earn political points. If he admits growth is at risk from the advance of trade wars, it would signal to the market that the pacing already baked in is less stable than what is presumed, and the passive premium behind the dollar may start to bleed off.
    China Data Run and Data Questions 
    China is in a very difficult position. It is attempting to transition itself from methods of growth that are impossible to maintain over the long term without inadvertently causing disastrous instability. To successfully make this ‘evolution’ to an economy primarily supported by domestic consumption, stable capital markets and a wealthier population (rather than leveraged financing and questionable export policies), the government requires a remarkable amount of stability.
    The healthy risk appetite and moderate growth registered for the global economy over the past five years was the perfect environment upon which to pursue this effort. That is especially true because the Chinese data that already draws a fair amount of skepticism from the rest of the world would look like an unlikely idyllic steering for the economy – a pace that could be dubiously attributed to the general environment. Now, however, that gentle landing has been disrupted by the aggression from the United States. The drive to escalate trade wars threatens not just the important trade between to two countries, it risks pushing disbelief over China’s statistics to the breaking point. Though they would not likely show serious pressure in any area of the economy or financial system that they control, markets have grown adept at reading between the official lines when it comes to China.
    Spurring fears of a ‘hard landing’ for the world’s second largest economy could spur capital flight as foreign investors look to repatriate and nationals attempt to slip through controls to diversify their exposure. It should be said that if there is a crisis in China, it will spread to the rest of the world; but some may be happy if China were permanently put off the path to securing its position as the antipodean super power to the US. It is this big picture landscape that we must keep in mind as the important data of the coming week – China 2Q GDP, fixed investment, surveyed jobless rate, retail sales and foreign direct investment – crosses the wires with unsurprisingly little impact on the controlled USDCNH exchange rate.
    Any questions, just ask.
    John Kicklighter
  20. JohnDFX
    Trade War Relief, But How Much?
    Finally, some trade war respite. Or at least, what looks like relief. Following week after week of steadily escalating threats and a few decisive actions (and retaliations) along the way, there was finally a joint statement of agreement between key global leaders. Following their meeting in Washington DC, US President Donald Trump and European Union President Jean Claude-Juncker issued a statement of success this past Wednesday. Any pause in this quickly ballooning threat to the global economic and financial order is welcome, but that doesn’t mean we should accept the event at face value.
    Did this summit result in a legitimate course correction for the growing destructive force was the press conference a political event designed to allow both leaders to claim a victory for their constituents? To evaluate that, we need to consider the terms. There was a commitment made by the EU to purchase more US-produced soybeans and natural gas. That seems encouraging at first blush, but pressing individual members to increase consumption is not reasonable. Vows to continue working towards solutions to the metals tariffs and avoiding tax on autos along with the suggestion that  they would work together towards ‘zero tariffs’ is likely more enthusiasm than a plan of action. Not everything was a means to score political point. The agreement not to introduce new tariffs so long as they were negotiating is material as it curbs fear of an impending 20 percent tariff on European autos by the US and the $300 billion retaliation threatened by the EU. This glad-handing may be lacking for tangible action, but it can help curb fears of imminent escalation.
    That said, general capital market benchmarks – such as US equity indices – seemed little perturbed by actual progress in the economic fight these past few months. Let’s hope that aloofness and the fresh optimism holds moving forward, because this theme has not likely hit its crest. The largest threats have been made by the US against China. The Trump administration is likely putting tension on other fronts besides China as a means to amplify the leverage on this economic powerhouse. When the US eases back against developed world counterparts like EU, perhaps they expect those countries to ingratiate themselves to the US and head off critique for their handling of relationships with China. Don’t expect trade wars to truly be on the decline – much less resolved – with last week’s developments.
    Fed, BoE and BoJ Rate Decisions for Individual and Collective Influence
    The ECB rate decision this past week didn’t earn the Euro much in the way of productive volatility. Compare that to the speculation it drove – much to the central bank’s chagrin – throughout 2017. For many traders, that makes it an event to disregard. However, market participants would be wise to keep tabs on these fundamental themes for both their longer term influence on the target currency over the coming weeks and months; but it is arguably even more important to account for such events collective sway over more systemic matters like the inextricable link between global monetary policy and risk trends. It would be wise to consider these larger concerns through the week ahead as we wade into a run of central bank decisions.
    On tap, we have five large central bank rate decision, but only three of them are ‘majors’. The greatest weight will be hefted by the Federal Reserve. In monetary policy terms, everything about this meeting will be well fleshed out by speculators. Through exceptionally transparent forward guidance, we know the group expects to hike four times this year and that they have operated ‘on the quarters’. This meeting is out of sync for that trend. The real interest is the language used to either maintain path to a September rate hike or to start pulling back from it. Furthermore, there will be some degree of interest to see if the Fed replies to the President’s critique of policy and the currency – though that may be more appropriate for individual members’ reflections. Meanwhile, the Bank of England’s (BoE) Super Thursday meeting is expected to deliver a hike (77% chance according to swaps) and the Quarterly Inflation report. This is the most action-oriented event, but it will compete with Brexit for Sterling momentum and scaling up to global risk trends is not something this group’s policies have been capable of in this cycle.
    Finally, the Bank of Japan will no doubt keep its rates in place and the size of its stimulus program untouched. However, last week, reports surfaced that the group was discussing changing its stimulus approach to make it more ‘sustainable’. It is unclear exactly what that would entail, but given they are already at an extreme, it was read as a ‘hawkish’ shift. While these events can generate movement in their own currencies and local capital markets, do not underestimate the malleability of global risk trends under monetary policy. Years of excessive (extended well beyond the needs to stabilize growth and past the point of proving it would not readily translate into desired inflation) monetary policy has inflated market levels. It won’t be the wholesale withdrawal of stimulus across the board that will prompt sentiment rebalance but rather the anticipation normally associated to risk trends. 
    FANG Has Set Up Apple as a More Important Capital Market Driver
    Earnings season has been mixed in the US thus far, but more important than the report of corporate numbers each trading session is the shift in bias surrounding these updates. There is considerable amount of ‘fudge’ room in reporting quarterly figures due to the dubious accounting allowances in GAAP (I obviously am not a fan). Yet, the details in questionable figures can be played up or played down depending on what the audience is willing to tolerate – or is actively seeking. With benchmark US indices struggling to regain the remarkably progress of 2017, sentiment has notably shifted towards earnings.
    No longer are the impressive elements of comprehensive reports amplified and the disappointing downplayed. The shortcomings are starting to be interpreted more readily in the general shortcomings that are more apparent in other areas of the economy. It is against this backdrop that we have had a troubled quarter from the concentrated speculative leader in the FANG. For those not familiar, it is an acronym of Facebook, Amazon, Netflix and Google – some of the largest and fasting growing market cap stocks in the world. The fact that they are also tech, which is the sector that has outperformed in US markets; and US equities which have outpaced most other liquid ‘risk’ benchmarks speaks to the concentration. As important as this group is, there support is starting to turn to borderline burden. Where Google and Amazon’s figures were positive (though they came with very clear caveats in fines and income), the Netflix and Facebook reporting were outright pained. The former dropped while the latter collapsed from record high to official bear market in a day.
    Given what the FANG represents, the market has paid closer attention to the state of earnings and perhaps the bias that has been applied here so consistently. How to settle a 50/50 split in the FANG updates and the plateau established in the group’s price indexing? Add an ‘A’. Due Tuesday after the bell, Apple’s earnings will tap into key US tech firms and it has its own innate amplitude as the world’s largest market cap stock. It will be important whether it beats or misses, but even more crucial is how the market treats a better or worse outcome than expected. This event can carry far more weight than just the immediate reaction for AAPL shares. 
     
  21. JohnDFX
    Pricing in Trade Wars Versus Pricing in Recession Risks
    Investors are starting to see a path form for the United States and China to find a way out of their economically and financially-damaging trade war. After months of little more than a few words of optimism from only one side of the table – which was frequently reversed only days later – we are starting to see conviction from high level officials on both the American and Chinese sides. This past week was the most encouraging period for this year-long economic conflict, even offering a few tangible policies to break through some of the skepticism that had calcified these past months. Following an announcement of five MOUs (memorandums of understanding) to form the backbone of a deal, negotiators made a concerted effort to dazzle the markets Friday suggesting that significant progress had been made and that a summit between Presidents Xi and Trump was being arranged, perhaps for the end of March. And, while some of the US team qualified that some structural policies and intellectual property protection were unresolved, reports that an agreement was already made to prevent current manipulation and that China was prepared to buy $1.2 trillion in US goods indicated serious collateral to push the deal through. 
    So, now what? Will committed breakthroughs and tangible deadlines prompt successive legs of a sustained rally? We have already seen a significant recovery through the opening two months of the year offset much of the painful slump through the fourth quarter of 2018. This wasn’t a recovery forged ‘in spite of’ the unresolved situation between the two superpowers. There was invariably a healthy measure of speculation that a breakthrough would be found in the foreseeable future. It is unlikely that the full weight of this fundamental threat has been fully shed by opportunistic interests (just look at the Australian Dollar or emerging markets), but we would not likely see a full economic recovery even if the issue were fully reversed. For trade wars, there remains the uncertainty that the US could engage other major economies. In particular, there is reasonable concern that the Trump administration could apply hefty tariffs against imported autos and auto parts. That would put a severe strain on relationships with the EU and Japan (some of the largest developed world economies), and the former has taken pains to spell out its preparations for retaliation should the US move forward with the Commerce Department’s recommendations. How much concern for future possible engagements is already weighing the market, it is impossible to tell; but the sheer economic implications suggests it is not being taken seriously as yet. 
    Pricing in the rise and fall of trade wars can be complicated and volatile given the variable scale of the impact and the flippancy of headlines involved, but some of the direct economic impact related to this threat are not so capable of being fully accounted for in prevailing market prices. In other words, we can fully discount a full blown trade war in the short-term with a sharp decline in assets, or completely alleviate the pressure with speculative appetites reverting to complacent norms. In contrast, the implications of these efforts tipping the economy over the edge into recession cannot be adjusted for in spot. There is no ‘sell the rumor’ on true economic contraction that can see a ‘buy the news’ as the pain unfolds. The markets simply continue their tumble as capital is divested from financial, fixed and human assets. This is where market participants should tread more carefully about their calculations for the near future. The trade wars may have seen their peak, but economic data suggests the momentum if dragging us closer to the cliff. 
    Central Bankers to Testify to Their Governments and the Markets 
    Monetary policy around the world is in a difficult transitional phase. After years of unprecedented easing and venture into unorthodox stimulus programs, it seemed that we had finally found the central banks’ nadir. Though the Federal Reserve was the only major bank to actually take meaningful steps towards ‘normalizing’ its balance sheet and rates, many other outfits had taken small moves or had signaled their paths had leveled. Considering this shift was taking place years after the global economy had righted itself from the Great Recession and markets charged back towards record highs, the sentiment the transition engendered was a mixed one. While in part a sign of confidence that conditions had improved, it had also left the markets with the clear impression that the effectiveness of their policy tools had all but collapsed. If these officials had years for the economy and markets to return to cyclical norms while their own policy settings slowly reset to afford a future crisis-fighting platform, this lack of capacity would fade into the backdrop and perhaps not even resurface in the next economic slump. 
    Yet, conditions are already getting rough and there is virtually no buffer rebuilt. Now some authorities are starting to recognize the trouble in the environment and the impotent position for which they find themselves. There are a few strategies being pursued to inspire confidence. The least surprising tonal change is the commitment to turn back to a dovish setting and provide further easing should conditions warrant it. While not unexpected, it raises serious concern as it highlights the lack of capacity they were hoping to paper over. The other unofficial approach to dealing with 2018’s volatility and the unmistakable slide in growth forecasts is willful ignorance. As all paths of the future are a set of probabilities and they have little ability to affect systemic change by their hands, why not just profess optimism and try to inspire consumption, investment and expansion through their own enthusiasm. Neither of these are the kind of options that could genuinely fend off genuine trouble, but it is where the policy authorities currently find themselves. The Fed’s minutes this past week has built on the speculation that new hikes would come this year (priced into the markets) with clear suggestion that the balance sheet wind down would stop – still around $4 trillion. 
    This will make Fed Chairman Jerome Powell’s testimony in Congress this week that much more important. The conversation goes where the Senators and Representatives steer it; but expect assessment of his economic forecasts and evaluation of external risks. We may also find our way to some incisive questions as to the lack of means left to the world’s largest central bank. There will similarly be a Parliamentary testimony delivered by key members of the Bank of England (BOE) – as well as an open presser on a separate day. Here, the attention will be more directly fixed on a specific fundamental risk to the local economy: Brexit. There are other speeches scheduled by members of other central banks along with important data that often goes into authorities’ separate mandates. Yet, almost regardless of how the data populates or how the central bank members come off (optimistic, fearful, dovish, etc), the markets will be more critical with the overt troubles on the horizon. 
    Another ‘Meaningful Vote’ as Brexit Realities Come Into Play 
    As of Wednesday, there will only be 30 days until the scheduled March 29th Brexit date whereby the United Kingdom and European Union are due to spilt ways. Given how much back and forth there has been on this process, it is easy to forget that lawmakers were looking for a deal sometime this past September or October from which they could begin preparations for the actual Brexit date. Now, they are simply scrambling to secure a legally-binding agreement rather than end with the ambiguity of a ‘no-deal’. There is little doubt that some parties are using the pressure of the clock to draw more submission from their counterparts for a better overall deal. Traditional game theory applies, however, with the parties needing to have a degree of cohesion within their own rank and a general acknowledgement of the risks that their side faces. There isn’t strong evidence that these factors are present in this particular match. 
    With a few painful defeats for the Prime Minister this past month and the EU making little movement to meet the requirements laid out by Parliament’s amendments to their leader, we are coming upon another important day in the Commons. On February 27th (Wednesday), MPs are set to debate whether they should take over greater control over the divorce proceedings from May. Previous votes looking to do exactly this were rejected, but time is growing very short. Furthermore, there have been a number of Conservative and Labour members who have publicly left their party owing largely to the lack of meaningful progress in the negotiations. Another crimp to the process are reports late this past Friday that senior members of May’s government have called on the Prime Minister’s resignation by the month of May.
     That could be construed as troubling, but it could also signal acquiesce to a deal in exchange for a change in leadership. Over the weekend, May promised a vote on her latest Brexit deal by March 12th, looking to buy a little more time at home and likely to avert a more serious defeat that could make negotiating with European counterparts armed with grand threats all but impossible. How much good will does Theresa May have to buy more time to negotiate when so little time remains? We will find out on Wednesday. In the meantime, concern by investors, businesses and consumers – already showing hints of panic – will increasingly translate into action. Investors will move their capital out of the Pound and Euro, businesses will push forward with their ‘no-deal’ contingency plans and the more alarmed Brits will look to safe guard their accounts from financial jolts. Anticipation and fear can carry very real world and lasting impact. 
  22. JohnDFX
    Reckless Acceleration of the Trade War
    With the global (including the US and China) economy already straining under the weight of the ongoing trade wars, the two largest individual economies too steps this past week to leverage the pressure even higher. As expected, China felt it necessary to respond to the upgraded efforts  announced by President Trump on a staggering $300 billion more in Chinese goods – the ‘rest’ of the country’s imports that weren’t already facing a tax. It seems the White House considered the phased application of the 10% duty between September 1 and December 15 was a show of good will, but Beijing did not. The response from Beijing of its own staggering of $75 billion in tariffs between those same dates as well as the return of a 25 percent tariff on US auto imports previously paused in April was somewhat surprising as the country is not in a particular strong position to match like-for-like taxes on the other country’s goods, a reality reflected in their allowance of the USDCNH to overtake 7.0000. This automated offset to direct charges from the United States responded as intended with a charge to a fresh record high through Friday’s close, and subsequent strong follow through into Monday’s Asia open to surpass 1.5 percent in a mere three days. It seems Washington’s strategy is following the shock-and-awe model as the President announced a further step mere hours after China’s response to the previous step. He upped the rate on all those tariffs already in place (25 to 30% on $250 billion) and those that are due to be imposed (10 to 15% on $300 billion). Yet, that ‘floating’ exchange rate will remain a point of frustration for the administration as it allows China more cushion to ‘wait out the President’. 
    It is very likely that Trump is intent on forcing China – who it is suggested intends to hold out until the election – to avoid rolling the US economy into a stall out that makes his reelection chances very difficult. While it perhaps seems a war devolving away from strategy, there are absolutely objectives on both sides, they just happen to be very rudimentary. While officials may very well have a cutoff point at which they intend to throw the breaks on the war, I believe we are already passed the point of no return. The leaders of these respective economies likely recognize this inevitability as well – Trump stated recently that a ‘short’ recession would be worth it if it changed China’s habits. At the point that these governments see a near-term recession as a foregone conclusion, they will revert to strategy aimed at safe guarding their long-term status in the global economy. While it may seem the US has the leg up on the trade war scale, China’s leadership has more breathing room against re-election pressure. This is a fight from which the participants cannot easily extricate themselves.  
    The Ominous Approach of a Stalled Global Economy 
    As the fighting in global trade escalates, the outlook for economic activity steadily erodes. There are certainly a number of data points and forecasts that project ominously for key local economies – and the aggregate global health by proxy – but it isn’t the number of flashing red lights that speaks to the inevitability of growth stalling out. It has a lot to do to the awareness of trouble an subsequent anticipation that is formed from these increasingly-perceptible readings. President Trump has repeated the claim frequently as of late that the news outlets are pushing fears of a recession in a bid to push self-fulfilling prophecy in a bid to oust his administration at the next election. While most news agencies work on an ad model that benefits from some measure of panic (‘if it bleeds, it leads’), engineering a regime change is far-fetched. That said, the purveyors of news inevitably play a role in the evolution of sentient among consumer, business leaders and investors. 
    In reporting the subsequent inversion of the 2-10 Treasury yield curve this past Thursday or the troubled mix of data from the global August PMIs (timely proxy for GDP), they are raising awareness of the unfavorable environment in which there is tangible risk in making large purchases, ramping capital expenditures or adding to existing ‘risk’ positions. Falling into step with such troubling forecasts has more to do with human nature than any ploy and perhaps any sense of inevitability. Even though we are deep in an economic and investment growth cycle, it is always possible to stretch it out even further. Yet, pushing those in control of expenses to reach further increasingly marginal returns or gratification (from purchases) at the growing risk of losses to jobs, revenue or capital, requires greater and greater suspension of belief in traditional ‘value’. Unfortunately, the hope for tax cuts, infrastructure spending and monetary policy gearing does not offset the realities of an economy that has run out of traditional fuel and quickly burning through its reserves. 
    Jackson Hole Symposium: The Vows of Unlimited Economic Support Ring Hollow 
    With global investors showing obvious concern at the state of affairs around the world where governments are pursuing policy aimed at fostering growth at the expense of others and bursts of volatility continue to flash danger on many account statements (the S&P 500’s three worst single-day declines this year were all in August), it is natural for traders to seek out a savior. In textbook terms, a rise in risk would encourage a proportional response from market participants in reducing their exposure. Yet, that is clearly not the regime we have been operating in these past years – and frankly that has rarely ever been the case as speculation is an inevitability (and why I do not ascribe to the efficient market hypothesis). Often, the stalwarts of the financial system suggest their views of optimism or pessimism are based purely on the backdrop of economic growth, but their assessments are necessarily more complicated than just a single GDP projection pulled out of thin air. The scenarios of trade wars (both benefit and detriment), diverted capital flow owing to background policy change and monetary policy are more informative of our course moving forward than the linear projections of dated indicators like the quarterly growth figures from governments. So, when we are pressed to evaluate the heaviest influences for surprising risk and sustaining positive growth, there is no greater power than the world’s largest central banks. 
    For a decade, they have flooded the system with cheap funds with a stated goal of encouraging growth, but through a less-often admitted means of what amounts to ‘trickle down wealth’. There was actually a point during the Bernanke era that the Fed Chairman stated clearly that they were attempting to spur underlying economic growth by supporting financial venues. Well, over the past years, this mechanism to support expansion has clearly diminished in power. A Dollar, Euro or Yen of stimulus has translated into increasingly infinitesimal growth. Most investors recognized this diminished capacity but were willing to overlook the traditional conduit of performance so long as these same central banks could reduce their personal risk through their efforts. It is the unmistakable failing on that implicit effort that poses more significant threat to market’s moving forward. That is why there was so much attention being afforded to what the leaders of the financial and monetary authorities would say at the weekend Jackson Hole Symposium. It is also why it was virtually impossible to truly live up to the demands of market participants. Their assurances to do ramp up a weak response to another downturn with extremely limited capabilities certainly does not.
  23. JohnDFX
    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.
  24. JohnDFX
    Ending a Trade War is a Windfall for Growth? 
    US and Chinese trade officials met this past week to lay the groundwork for another attempt to push for a breakthrough in the superpowers’ ongoing trade war. These are lower level meetings aimed at finding concessions and terms for which Trump and Xi would eventually sign off on. With over $350 billion in goods from both countries saddled with import taxes, the economic toll the engagement is exacting is starting to show through in data. In the US, trade figures have shown a rise in the deficit and sharp drop in exports to China, costs have risen for a range of goods normally curbed by cheaper foreign production, and confidence metrics have reversed course. The NFIB small business sentiment survey for example has fallen back to the level it stood at during the Presidential election. China’s economic updates have also marked multi-year lows in GDP, industrial production and more. While they are generally all firmly in positive territory, there is likely a ‘premium’ China attributes to its data.
    A growing number of institutions and economists are warning that the world’s second largest economy may be on the path for a stall and/or the collapse of its excessive low-quality debt market. The Trump Administration seems to have gotten whiff of at least one of those analyses as they have made repeated remarks about the strained position of their counterpart’s health when justifying their steadfastness. Officials jawbone (or talk a market or asset to a higher or lower level) for a number of reasons. Some central banks have attempted to talk down their currencies (BOJ, RBA, RBNZ), the Fed turned it into a tool (forward guidance) and economic leaders are constant cheerleaders for their own economies and markets. Yet, it is highly unorthodox, to say the least, for leadership in one of the largest economies in the world to stoke fear in a global peer. And yet, that is what President Trump, Chief Economic Adviser Kudlow and Treasury Secretary Steve Mnuchin have done over these previous months.
    If neither of these countries were to blink, it would inevitably tip a financial or economic crisis for at least one of them. And, if one slips into the abyss, it will pull the other in with it. Perhaps this recognition is starting to sink in, or the ‘game of chicken’ is simply too dangerous now with the US equity markets sliding with the President starting to take some of the blame. It has been reported that Trump has told his team that he wants a deal to be struck to help stabilize the markets. It wouldn’t strain belief at all to imagine this was a serious demand from the President. There were some boilerplate remarks of optimism this past week which were largely overlooked, but the Chinese Vice Premier’s planned visit on January 30-31 may indicate they may be close to resolving their issues. It is worth evaluating a future where a resolution is struck. Yet, putting the scenario to the test, would pulling out of a destructive economic policy in turn translate into a windfall of growth and investment opportunities? No. It would remove a manufactured threat that has already inflicted permanent damage and would allow the focus to shift to a host of other unresolved issues. Preventing further damage is the best the two sides can hope for in this situation. 
    The Lasting Effects of a Record Breaking US Government Shutdown
    We have broken a record over the weekend. As of Saturday, the partial shutdown of the United States government surpassed 21 days to count for the longest closure on record (surpassing the 1995-1996 stretch during the Clinton era). This is not a record to be proud of as it will translate into weaker economic growth, a drop in sentiment and the complicated progression of lower sovereign credit quality. The general economic implications are perhaps the easiest to envision. Government supported industries (such as airlines) will see their costs and revenues suffer while the 800,000 federal employees that are furloughed will not be paid. It is estimated that every week, the US economy will lose between 0.05 and 0.1 percentage points of growth owing to the situation.
    Even three weeks of that is significant given the state of economic conditions when this factor is excluded. Perhaps a (small) silver lining was the strong bi-partisan vote by Congress to provide backpay for those same federal employees – though that doesn’t offset the ultimate pain. Sentiment is another victim of this situation. We have seen consumer, business and investor sentiment sink the past months for a few reasons, but this shutdown is no doubt a contributing factor. If the country can’t come to an agreement on a basic stop-gap funding, what is the probability that they will be able to fulfill the infrastructure investment plan touted ever few months for years? My greatest concern for this situation is the damage it does to the United States credit quality. All of the three majors have issued some sort of warning on pursuing this path, but the most recent official statement came from Fitch this past week. There are those that don’t believe a downgrade is possible for the US sovereign rating, to whom I say it already happened when Standard & Poor’s cut the country one step to AA+ back in 2011.
    There are far more that believe it wouldn’t matter if another cut was made – and they would use the 2011 example as their evidence. When S&P cut the US rating, there was a distinct and severe move in credit and risk assets. Eventually, the market’s did stabilize and push the concern to the background because exceptions were made for the event. Even though many covenants only allow for top credit rated assets as ‘risk-free’, most agreed to make accommodations so as not to completely upset a financial system that relies heavily on the haven status of T-notes. Add a second, third or more cuts, and it looks less and less like a one-off. It registers as an absolute need to diversify. It may be hard to appreciate how systemically important this is, but the tipping point could fundamentally change the financial system and US standing in the world.  
    Breakthrough or Not, A Brexit Vote that Can Charge the Pound 
    We are just over 75 days away from the official date that the United Kingdom is due to separate from the European Union. If all that was necessary was to come to terms with an agreement between the two parties on their relationship post-split, this would perhaps not be so frightening. Instead, there is considerable preparation that needs to be done before that date even comes around. Most would agree, that the time table for an accord and steady transition was some months ago. Now, with each passing week that infighting persists, the consideration and appreciation of painful scenarios increases. We have the opportunity to finally find agreement from the UK’s side this week. On Tuesday, Parliament is set to vote on the Prime Minister’s Brexit proposal. You may recall that a vote was called on a previous plan, but May called it off at the last minute when it became clear that it would be handily defeated.
    It is nowhere near as clear time around that the MPs will deal the PM another rejection, but that is the leading consensus. If the proposal is accepted and the UK can return to the table with the EU, it would certainly be construed as lifting a significant weight off the Sterling’s shoulders. There are still a host of unknowns including cross boarder investment, financing and banking liquidity; but at least there will be a viable path the markets can follow. If however, she is rejected, the markets will grow increasingly agitated, fearful that an accident will happen. Following recent votes, Parliament passed law that if the proposal was rejected, the government would have to produce a ‘Plan B’ within three sessions (Monday as Friday is closed) rather than the standard 15. They had also previously ruled that if the country were heading for a ‘no-deal’ Brexit, that Parliament would have more say over the ultimate path.
    As it stands, there seems less risk of a crash out; but the hurdle for an agreement between the government and parliament remains very high. Uncertainty is a bearish pressure on the Sterling. An agreement would remove a considerable amount of that fear and perhaps help stoke a recovery. Looking at the CME’s Pound Volatility Index, fear remains troublingly high relative to other currencies and even other assets. Outcome or no, be prepared for Pound volatility. 
  25. JohnDFX
    It Can Be Difficult to Measure Complex Issues Like Trade Wars
    When dealing with a complex fundamental theme – without a binary outcome, numerous inputs and important to different investors for different reasons – it can be difficult to both analyze and trade the subject. Those are certainly criteria that would fit the ongoing trade war. It is proving exceptionally difficult to keep a clear bead on the progress of the economic conflict and the market has started to veer back into its comfortable habit of allowing complacency to take over. Drifting without accounting for clear and present danger is a recipe for eventual financial market seizures, and we would do well not to simply through caution to the wind as so many others have. That said, it does not do to simply position against the current presuming recognition will eventually dawn. To reconcile important but complicated themes with an appropriate trading approach, it is first crucial to keep accurate and as-quantitative-as-possible analysis on the matter as possible. In measuring trading wars, that can be a task. The trade figures like we have seen from the United States last week and are due from China next week are accurate but constrained and lagging updates. 
    Simply referring to exchange rates or even capital markets alone does not give an accurate account either. From USDCNH (Dollar to Chinese Renminbi), we find the exchange rate has held to range for weeks after an initial surge. For those keeping track, this is a false sense of stability derived from the People’s Bank of China (PBoC) actively working to stabilize the rate. They are similarly acting to keep the Shanghai Composite and other equities propped up. Just as we learn from the Chinese index the government’s intent, we learn from the likes of the S&P 500 the extent of speculator’s complacency. But where do we see better measure as to the impact that the specific US-China trade war is having? I like AUDUSD. First and foremost, the cross liquid and un-manipulated. Further, Australia is heavily dependent on China for its own economic health thanks to its trade relationship (further solidified during the Great Financial Crisis). Other fronts of the US-led trade war can be even more difficult as they are not fully engaged. While the NAFTA replacement (USMCA) seems to on the path to being codified, the breakthrough has thus far had limited impact the Dollar, Peso and Loonie. Of the three, the Loonie was best suited to channel a response as it was the most at-risk in the final phase of negotiation with fewer competing fundamental themes. 
    Meanwhile, the standoff the US has taken against the EU and Japan are in limbo. However, the temperament of the Trump administration and efforts to subvert the US’s efforts to reshape the global landscape (like the EU’s efforts to circumvent the United States’ sanctions on Iran) can readily revive these issues. Since President Trump made repeated threats to import European and Japanese autos before agreeing to the armistice, the health of the global vehicle production industry can be a good measure. I like the CARZ fund. In economic terms, it is also important to follow closely with sentiment figures. There are economic, consumer, business and investor surveys for various countries. Consumers tend not feel the impact of such economic efforts until later on when the costs trickle down and businesses outside of exports often initially see the upside before the full effect is registered. Investors and economists however, tend to evaluate on a wide basis with a significantly further projection. This may be a difficult issue to assess, but it is certainly important enough to make the effort. 
    Dollar: Always Evaluate Alternative Scenarios
    Personally, I consider the best trades are those that I cannot come up with a viable reason as to why a market move will not happen. Such an approach puts us in a different frame of mind where we are inherently more critical of market conditions that could readily trip up trades. More often, the preferred method of trade evaluation is to filter all possible options and come to a decent – often people stop far short of the ‘best’ – option that can be pursued with the proper risk and money management. Find, and execute. However, when dive into the markets with such an intent, it often encourages us to tolerate shortcomings that are likely to trouble our positions as we simple want exposure to the market and unknowingly fall back on hope that the practical issues may not come to pass. It is generally not good to approach most things in life from a perspective of skepticism, but it most certainly prudent to evaluate our markets in this critical way when our money is on the line. 
    With that said, I want to come back to the US Dollar. Over the past few weeks, I have weighed in on the Greenback owing to the turnover from the third into the final quarter of the year. My baseline forecast is a bearish one owing to: the lack of enthusiasm despite the Fed’s extreme disparity in pace, the role the currency now plays as a carry, the fact that the United States is the instigator of many different fronts of the ongoing trade war and the slow but destructive interest by the world’s wealth centers to diversify its exposure to the USD. Evaluating all of those themes, there is little potential in mind that these themes will ultimately turn out in favor of the currency. At best, they will be temporarily overlooked. However, there are ideal situations that can be considered that may ultimately afford favor to the Dollar, so it is worth enumerating them here for your consideration. First and most effective for supporting the Dollar would be a full-blown financial crisis. The currency has taken on a considerable carry status over the years and that can see it drop in the initial phases of risk aversion as weakly-held longs looking for carry in these low returns environs are shaken out. Yet, if the situation turns gangrenous, liquidity will be all that matters; and no other global asset is as revered for its haven status as US Treasuries and its most liquid money markets. Yet, in such circumstances, the opportunities will be endless – though most will likely be bearish, but panic tends to generate the faster moving markets. 
    There has been suggestion that the US economy will continue to run at full speed aided by fiscal policies like tax cuts and benefits of trade wars. However, the US has not somehow found itself outside of the laws of market physics that maintain cycles nor is it so self-sufficient that a global pain will not wash up at its own shore. Further, if economic conditions stagnate and deteriorate, the Fed will have to slow its hikes preventing the speculative value from a growing monetary policy gap in the USD’s favor. A more recent, technical consideration has been proposed via the reduction in liquidity for US Dollars via policy and trade. This has shown some modest pressure, but if the Dollar were to continue to rise, President Trump has made clear his criticism of a higher currency as their debt load rises and trade war bites. If it is in his power to somehow arrest the currency’s climb – and he has avenues for it – he will prevent it. 
    Correlation in Risk Assets – But for Government Bond Yields
    Some people like to draw their assessment of investor sentiment from indicators like the VIX volatility index or more simply from the performance of a ubiquitous asset like the S&P 500. Others will evaluate volume and open interest for participation, data like GDP, or pure sentiment surveys. I like to refer to correlation. In extreme conditions, what happens to markets in different countries or in different asset classes? They tend to move in concert. In a deep bear market or full financial panic, the market adage that ‘correlations go to one’ reflects on the fire sale mentality that cuts through any concept of which ‘mildly’ risky investment is worth holding when everything seems to be crashing down around us. In a boundless bull run where qualifying the risk that is assumed with high returns goes out the window. At the poles, we find the commonalities between these otherwise very different markets and their investors: the fundamental evaluation of risk and reward. That said, when we are not in an environment where animal spirits are running rampant or everyone is rushing for the exits, it can be difficult to see these undercurrent at work as individual catalysts promote a bid or unwind from the various assets. 
    Yet, just because we are not in a panic or mania doesn’t mean that sentiment is nonexistent. Risk appetite can rise or fall with conviction in the middle of trends and with limited intent. Then, there are the periods where we are just gaining traction on a systemic move before it is obvious to everyone. This is why I like to reference the correlation between assets that are otherwise very different to each other: equities, junk bonds, carry trade, emerging markets – and for opposing relationship the likes of gold and government bond yields. Recently, we have seen the relationships between many of these markets tighten up. The US indices were unique for a while in that they have spent months forging higher until they returned to record highs while their global peers floundered and emerging market assets outright tumbled. That may be starting to firm up again as of this past week however. Another, persistent detractor from the global sentiment relationship are government bond yields. 
    US Treasury yields have climbed alongside US equities, perhaps owing to the Fed’s influence; but even with equities retreat this past week, the government rates kept rising. That is unusual. If Fed forecasts are at play, hikes are a dubious course to set our time by, but consistent balance sheet reductions are more reasonable. The fact that other countries’ sovereign yields (Germany, UK, Japan, etc) were rising in tandem suggests there is something more systemic afoot. Is this evidence that global investors are now confident the central banks of the world will back out of their extreme accommodation either because they are confident or (more troubling to consider) they have run out of resources? If that is the case, beware the future for risk trends. The past decade of general bullish drift has been facilitated by the distortion of central banks affording speculative rampancy. If faith in monetary policy collapses, there is penance to pay. 

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