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JohnDFX

DFX Market Analyst
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  1. JohnDFX
    Market Conditions in Data Overload 
    Markets often struggle for traction when there is a lack of a clear motivator such as meaningful event risk or an evolving systemically important theme. On the other hand, there are times when a surfeit of important events, indicators and headlines overwhelm the clear speculative picture, leaving us with an abundance of volatility without the benefit of a reliable course. We have dallied with this latter scenario these past weeks, but the constant redirection of our attention will be in special form in the week ahead. There is a near constant run of high-importance events scheduled for release moving through the next five days of active trade. What’s more, many of these various measures will tap into the top level themes that have stood as the undercurrent for economic and financial conditions for months, if not years. 
    For trade wars, much of the critical development rests in the hands of a few officials who are weighing policy decisions that could significantly alter the course of the global economy. Washington and Beijing continue to negotiate after verbally agreeing to a ‘phase one’ deal back on October 11th  but the details and sign off are still  vague. The EU meanwhile is weighing whether to retaliate against the United States for the Trump Administration using the WTO ruling of a $7.5 billion ‘allowance’ for tariffs to recoup losses owing to unfair Airbus subsidies with a 25 percent tax on imported European agricultural goods. Meanwhile, data like the US trade balance and Chinese industrial profits figures on Monday will build upon trade-dependent earnings from the likes of AMD, United Steel and Alibaba. 
    More tracked out for the timing of its updates is the wave of monetary policy updates we are due over a particular 48 hours period. There are a number of supportive updates such as the October US NFPs due Friday, but five central bank decisions between Wednesday and Thursday will make for a far more incisive view of our financial system. In chronological order, we are due the Bank of Canada; Federal Reserve; Brazilian Central Bank; Bank of Japan and Hong Kong Central Bank. Stacking these events so closely together will cater to the relative comparison of the currencies and their assets, but it may also stir further collective discussion of the distortion and costs associated to the extreme easing. 
    The fundamental theme that will pack the most obvious punch in my view is the run of official (government-derived) GDP updates on tap. The United States is the world’s largest economy, so its Wednesday release will draw particular scrutiny. The Eurozone, French and Italian figures will be similarly important - particularly given the chatter about recession risks and the added pressure of external pressures like Brexit and the US tariffs. Two additional updates that are worthy of reflection for the big picture is the health reports for Mexico and Hong Kong. These are two large economies that stand on the cusp of the developed/emerging market designation with particular exposure to trade wars. This data can potential thaw fears of recession that have hardened over the past year behind data and increasingly complicated diplomatic situations, but the potential definitely skews the opposite direction. If this run of data reinforces the reality of economic struggle, it will serve as another cut to a speculative reach that seems divorced from fundamentals that are traditionally assumed to reflect value. In general, all of the thematic risk represents a greater role of risk rather than relief. 
    Redressing the Limitations and Costs of Extreme Monetary Policy as Fed Arrives
    With the world’s largest central bank and its most dovish both on tap for this week, it is important to consider what is driving these groups to loosen navigate into uncharted dovish waters rather than just go along for the ride by trading relative yield advantages in FX or capitalizing on a familiar speculative equation that suggests more external support buys more lift from favorite capital market benchmarks. There is little denying the years of connection between the amount of accommodation (low interest rates, negative interest rates and quantitative easing programs) and the enthusiasm from the investing masses. This is a relationship forged originally in ‘monetary policy in capital markets’ textbooks, but the connections have grown more than skewed in the latter years of this extended cycle of easing. First and foremost, the overriding intent of monetary policy to foster economic health have been proven to be lacking. It could be argued that the dovish shift after the 2008 Great Financial Crisis / Great Recession stemmed the bleeding. Yet, the exceptional support has only grown over the years and we find ourselves on the cusp of another economic stall. This is a feature of the landscape for most of the major groups, but it is perhaps a lesson that should have been learned earlier through the Bank of Japan’s own experiences. The central bank has failed to return inflation to its target for any period of consistency for decades – not just years. So, though it is not considered one of the most prescient groups for a global overview, there is much to learn here. 
    Though an inability to reach their principal economic objectives is a significant problem in itself, it may not be the straw that ultimately breaks the camel’s back. That is more likely to be the consequences to come out of the financial market influences from these extraordinary measures. Though it may not be their intent, the central banks’ easing has inflated capital markets substantially. The pressure is not even, but we have seen risky assets hit record highs at various points with different levels of excessive price to value. Few places is the extravagance more evident than with the US equity indices. At record highs, we should consider that the equity market is pricing in perfection for growth, earnings and returns. It is not very controversial to say that is not the case now. Far from it. Stimulus and low rates has not improved circumstances that remarkably rather the lack of significant return and a tepid economic environment has left investors starved for opportunities that can provide substantial growth at a reasonable risk. And so, they accept greater and greater risk to make ‘ends meat’. Propping capital markets higher may seem a net benefit in the absence of genuine growth, but there are serious risks associated to this state. Expectations for more support will grow exponentially with time. Capital distribution outside of the healthy business cycle will encourage funds to underperforming or zombie businesses that will further weaken economies. And, the growing disparity will inevitably lead to a point at which recognition of risks will force an acceleration of deleveraging which will manifest as a financial crisis that more readily turns into an economic crisis.
    This troubled state is growing increasingly apparent to investors and business owners, but now the concern seems to be permeating the central banks themselves. Outgoing ECB President Draghi admitted concern late in his tenure, though not as loudly and directly as some of the more hawkish members of his board who will remain with Lagarde at the helm. Some of the Fed officials have stated concern along these lines as well, but the group is not yet as overextended as most of its counterparts. In previous years, the US group’s tightening was viewed as a sign of optimism around the potential of self-generated growth. That perspective may hold as the circumstances change. If the Fed seems forced to loosen the reigns to match the ECB or BOJ, it may not be interpreted as a uniform source of speculative liquidity but rather admission that all economic traction has been lost. It is not wise to cheer negative rates and QE.
    A Brexit Solution Seemed So Close 
    Less than two weeks ago, a breakthrough between the UK and EU teams in their negotiations for a quickly approaching Brexit cutoff date seemed to have changed the dynamic of an impending crisis. With Prime Minister Boris Johnson repeatedly stating the Article 50 extension date of October 31st would be held to ‘one way or the other’, there has been an understandable intensity by all those involved to find a compromise to avoid an economically-painful ‘no deal’ outcome. As such, the concessions found between the UK government and European representatives to form a Withdrawal Agreement Bill seemed the most important hurdle to overcome and sentiment understandably swelled after the developments. Yet, that optimism has significantly deflated this past week. First, it was the previous weekend’s extraordinary Saturday Parliamentary session which delayed the Government’s implementation of the deal which started the decline in ambitious optimism. Tuesday’s ‘second reading’ further delivered PM Johnson a blow when he was outright rejected on pushing forward to meet the short time frame. What was more remarkable to me than the familiar trouble to find an agreement exit from such disconnected parties was the Sterling’s ability to hold onto the gains of the previous weeks – prompting GBPUSD to an incredible 6.5 percent rally in in just a few weeks. 
    Trading not far from multi-decade lows, it may not seem that difficult for the Cable to hold some of its recent buoyancy even if progress seems to have dangerously stalled. Yet, the real fair value question is to be found in the array of possible outcomes and their market influence. A divorce with no terms is still a serious probability and its economic and financial impact is not likely priced in even after the slide of the past three years. An extension is nevertheless a greater probability than a cliff on Thursday evening. That said, we are inviting more complication and additional cutoff dates while maintaining the same mix of impasses. Prime Minister Johnson, frustrated by the lack of progress, called for a snap election for December 12th this past week. That request will be considered in Parliament Monday. Presently, polls suggest conservatives could gain support but it is not clear if he will be granted his wish. Further a complication is the EU’s allowance for an extension. The PM sent a request for an extension to January 31st according to the Benn Act back on October 19th , and to this point no reply has been given. France is reportedly skeptical of giving the disgruntled country so much additional time without clarity on what they will actually do with it. Uncertainty is having tangible economic impact, and the discount is increasingly permanent even if the next steps are still fluid. So, this week, we will have to find out what Parliament will agree to concerning the election on Monday and the EU will have to grant an extension before the deadline on Thursday night. Mind your UK/Sterling exposure. 
  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
    The Economic Costs Versus the Sentiment Costs of the Coronavirus 
    Interest in – or really, fear of – the spread of the Wuhan China-based coronavirus ballooned this past week. We could take an anecdotal peruse of the headlines, but I prefer something a little more quantitative. The global, financial-related search for ‘virus’ this past week hit its highest level in over 15 years according to Google. Their data only goes back to 2004, but there is a good chance that the SARS epidemic the year before gave it a run for the proverbial money. This level of attention will naturally draw out the speculation. In an environment defined by better balance, the investors could be a little more sanguine about the impact such an event would have on their portfolio as it can indeed be difficult to evaluate the direct economic toll such a situation will exact. Unfortunately, the status of the global financial situation is anything but poised. 
    Benchmarks for speculative exposure (like US indices) are pushing record highs while traditional measures of growth and return are struggling. As we discussed last week, these more ambiguous risks can extort a heavier tax on a market. The imagination of the masses and the threat of a worst-case-scenario trepidation. Looking back to 2008 and 2000, the systemic risk was not necessarily US low-credit quality housing loans nor the exorbitant highs of tech stock shares – though they were certainly high visibility sparks. Consistency across these periods is the over-reach of enthusiasm, supporting a build up of exposure. 
    I consider this a thematic extreme in leverage whereby we take on greater and greater exposure while the risks associated with the situation are progressively downplayed. Until, of course, the tipping point is reached. What do we look for from here if we are indeed transitioning? Aside from progressive retreat in capital markets and focus on the coronavirus headlines, look for evidence of liquidation and pressure in financing. 
    The Implications of a Sentiment Plague on Growth, Trade and Monetary Policy 
    As we look for the mutation of the global health threat into a full-tilt financial hazard, my focus is back on those principal themes I’ve been tracking for the past few years. Recession fears, trade wars and questions over the effectiveness of monetary policy have popped up with consequences for volatility at various times over the recent past; but they have generally fallen short of truly sending the global capital markets reeling. The decade-long bull trend persists. Yet, as genuine concern starts to take among otherwise optimistic investors, the cracks will become more visible. 
    My chief apprehension rests with the state of global economic health. If you recall, back in August, there was a swift and sweeping faint in confidence around very public concern over the bearing of the global economy. Headlines and search interest in ‘recession’ spiked to the highest levels since the financial crisis at the time. The situation was such that the 10-year to 3-month Treasury yield curve inversion – an event and measure of wonks – suddenly because a main talking point among the average retail trader. Of course, the situation at the time was prompted by data that showed the now familiar ‘technical recession’ in manufacturing and worsening of the trade wars, but it was the outcome rather than the catalyst that upended the market. It is therefore worth noting that the same yield curve returned to inversion this past week. Growth-linked commodities crude and copper have also tumbled. This will likely intensify the focus in the week ahead on data that will range from Chinese PMIs to Hong Kong GDP to US service sector activity (ISM) to global auto industry activity (also in technical recession). 
    Basic growth is not the only concern that will be exacerbated by a possible turn in sentiment and the virus that has urged the about face. We have already seen China take drastic actions to spread the spread of the contagion, but it still did not like the call by US authorities from announcing a health emergency and warning that travel between the countries could be more significantly restricted. As China and other countries feel the economic pinch, added pressure from steps like this will raise tensions. And, should a country like the US feel the blowback, its tendency has not been towards opening trade conditions but rather the opposite. Meanwhile, should conditions prove more difficult for investors, the assumptions of outside support to ease the pain will grow. There has been no more relied-upon source of respite for the markets over the past decades than the world’s largest central banks. It would be natural for the cries of help to be redirected towards them. And that would be the risk as these groups are already sporting extremely low – sometimes negative – rates and large stimulus programs. Their capacity to offer more help is severely limited and nothing would highlight that more than a fresh crisis.  
    Consult the Technicals and Correlations for Sentiment 
    We once again find ourselves in a situation where the market’s confidence is under significant strain but it is unclear whether this could be the tension that finally ushers in a lasting bear market. There are plenty of fundamental observers and traders that are willing to point to issues underlying economy and financial system to say this is it. However, value is always in the eye of the beholder. Should the historically tepid return still appeal and headline-worthy risks find a crowd willing to downplay, the run can persist. One of the difficulties to the balance in our system is that sentiment is not founded on the belief of a single person or entity but rather the collective view of a broad market of participants with different risks profiles and incentives. We are at the mercy of often-irrational speculative appetite. 
    How do I deal with this irrationality? I like to incorporate technicals into the mix. Trying to apply tangible milestones of progress to key global market benchmarks can help reduce the discretionary we naturally apply to our probability assessments around a reality where the future cannot be intuited. There is as much flexibility in technicals as fundamentals particularly when we consider risk profiles. For example, if you were more risk tolerant, you may be willing to be more convinced of a sentiment reversal with a more proximate support. I am more conservative in this regard. That said, there are certain elements that I believe can be more generally applied when assessing global sentiment. At the top of my list is the collective performance of ‘risk-leaning’ (higher return via capital gains or yield) assets. The stronger the correlation and the further the progress towards a technical bear markets (20 percent correction from highs), the more stout the signal in my book.
  4. JohnDFX
    Coronavirus Adds Another Wild Card for Sentiment to Absorb 
    When it comes to the standard themes I have been following closely these past few months – growth fears, trade wars and monetary policy effectiveness – there have been frequent updates and it hasn’t been particularly challenging to take their temperature at any particularly time. While the threat of a recession or trade war that threatens to encompass much of the world will not exactly inspire confidence among investors, the knowledge that there are regular updates along the way offers at least some relief. And, as we have seen through this economic and financial cycle, any relief is interpreted by a class of complacent speculators to push their advantage. Yet, the formula changes when the risks are more vague in terms of timing, duration and intensity. That was initially the situation with the US-Iran escalation earlier this month when the former executed an airstrike on the Quds Force general’s convoy and the latter retaliated with an missile attack on US bases in Iraq. However, when both sides  offered their unique brand of conciliatory boasting, the market returned to its risk-seeking self. 
    Looking out over the coming months, the approach of the US Presidential election will represent just such an abstract risk. For now, the focus is on something more erratic by its very nature: the spread of the coronavirus. Since the highly communicable virus first made the international headlines a little over a week ago, cases have spread well beyond the Chinese city of Wuhan where they were first reported and have seen people fall ill in surrounding Asian countries, Australia, France and the United States among other nations. It is difficult to determine exactly what impact this medical and social threat can have on markets and/or the economy, but highly-tuned sentiment can certainly amplify the reaction. Consider the cases of SARS in 2003 and swine flu in 2009 which had a material impact on market-based headlines – though whether that was owing to an already ‘raw’ confidence is up for debate. As more cases are reported of this pandemic are reported, it is worth watching whether the market responds to the additional uncertainty by de-risking any further. 
    The Pull of the EURUSD 
    The FX market is very large in terms of sheer liquidity. It is easy to group the entire asset class into a certain category of depth that adds an innate stoicism and inactivity that seems natural. While the ‘majors’ in the currency market are typically far less volatile than indices, commodities and a range of other popular asset classes on average; they are not themselves quiet. History has shown substantial volatility from even the deepest of the exchange rates, EURUSD – just look at the tumble the pair suffered from May 2014. That said, there is little doubt that currencies have suffered from the same lethargy that has overtaken most other financial markets. While the S&P 500-based VIX has consolidated back down around 12, the FX market equivalent has notched an even more extreme. The popular currency volatility measures from JPMorgan and Deutsche Bank have dropped back to record and near-record lows respectively. My own measure of an equally-weighted implied volatility of EURUSD, GBPUSD, USDJPY and AUDUSD has done the same. Naturally, when these conditions hit, defenses are progressively dropped. Traders don’t expect significant moves so default to either positioning for the carry (for which there is very little nowadays) or trade the range. 
    That is the context with which we saw just a glimmer of activity from the EURUSD to end this past week. The ECB rate decision and then global January PMIs seemed to stir in investors enough attention to push the pair through its narrow three-month rising trend channel and what happened to be a 100-day moving average that was hovering around 1.1070. As far as technical developments go, few chart traders would likely consider this a systemic shift for the benchmark. Sure, it was running out of room with the much larger channel resistance capping upside progress below 1.1250, but the drop seemed a path of least resistance resolution with 1.0900/0875 still intact below to cap any serious concern of bearish momentum. Nevertheless, the boost to activity seemed to generate some serious attention in FX circles. This makes sense given the pair is the baseline for all of the FX market. According to the BIS, EURUSD accounts for 24% of all FX transactions while the Dollar is one side of 88% of all trades as of April and Euro 32%. Given that it has moved deeper into an established 2019 range, we should watch to see whether implied volatility settles. That said, there is some heavy event risk ahead to beat back the dark of inactivity. The Fed rate decision along with the US and Eurozone 4Q GDP readings are top events on this week’s docket. 
    S&P 500 Goes 72 Days Without a 1 Percent Daily Change 
    The world’s most heavily traded index (through derivatives and financial agents) has signaled extraordinary quiet through a number of remarkable statistics earned these past months and years. That is a understandable consequence of a market that continues to push to record highs. While the financial system has suffered very few shocks over the past decade and growth trends are generally steady, the environment doesn’t exude the economic potential nor the yield that normally encourages market participants to play down their risks and continually build their exposure to progressively lower rates of risk-adjusted returns. Eventually, the quiet will be so threadbare that speculators will see little choice other than to significantly reduce their exposure. Of course, the question is always “when”. 
    For most, the spark is expected to be a trigger from the headlines like the failure of the Lehman Brothers back in 2008 was for the financial crisis that followed. Such developments can certainly rock the financial system and send markets careening. On the other hand, I think there is something to say about the environment that builds up to the symbolic lighting of the future. The SPX pushing record highs and the VIX settling back towards the lower bounds of its extreme range are one thing, but experiencing a long stretch of extremely quiet days adds incredulity to the mix. The same index has passed 71 consecutive trading days without a 1 percent move either higher or lower (see SPX_1pct_71 attached) . That is two days shy of the period through Oct 8th, 2018 just before the tumble in the 4Q accelerated, and still well short of the 95 day run through Jan 25th, 2018 that preceded the near-bearish shift (20 percent correction from highs) in that period. Looking further back, we have to go all the way to 1995 and then 1972 to find anything comparable. Clearly enough, this is exceptional; and market activity is mean reverting. When we see a balancing from extreme quiet, it isn’t usually a slow pickup to more reasonable levels but rather a dramatic restoration that eventually settles.


  5. JohnDFX
    Will the White House Pick a Fight with Europe? 
    The long-awaited first step towards de-escalating the most taxing trade war in modern financial history – between the US and China – took place this past week. Representatives for both countries, US President Trump and Chinese Premier Liu He (notably not President Xi) participated in a very long signing ceremony. The contents of this first stage for finding a long-term and full compromise is important as is stands as the symbolic doorway with which these two superpowers can continue to work towards a true compromise that sees all the steep tariffs (largely put on by the US) rolled back and China take on the role of a norms abiding ‘developed economy’. That said, we are still critically lacking a path towards reversing the tariffs on $360 billion in goods already in place as well as acceptable monitoring for technology transfers and intellectual property protections. For now, we may find ourselves in a sort of purgatory for relationship between the two. 
    Looking out over the week ahead, however, trade will remain top of mind. For one thing, the World Economic Forum in Davos is likely to address the scourge of trade war just as it did last year. As confrontational as the members were the last go around, the tensions did not actually boil over into actions that the market would have to account for in price. That said, we do have a particular possible flashpoint staged by officials. The US and France set a deadline of January 21st (Tuesday) for negotiations over the controversial digital tax that the latter announced for large tech companies last year. The White House considers this a burden disproportionately applied to US companies and has threatened to retaliate against France if it is not lifted. A $2.4 billion tariff has been threatened if an agreement could not be struck. In turn, France and the EU’s trade chief have remarked that they are prepared to retaliate should the US act to retaliate.
    Let’s also not forget that there is another front to this battle already underway. The US has pushed forward with import tax on $7.5 billion in European good in response to the WTO’s ruling that the EU had unfairly subsidized Airbus and that the US could pursue recompense. Turning the screws further, the US has threatened to pursue further tariffs after a follow up evaluation by the World Trade Organization’s report that Airbus aid was still not fully curbed. European officials will have their day though as a ruling by the same organization is due on Boeing and the United States’ support soon – likely this month. Will the US ease off?
    Monetary Policy Will Gain Traction When Questions Over Reach are Asked 
    Monetary policy has been relegated to the backdrop as a systemic fundamental theme these past months, but its influence has not actually ebbed. The collective global yield (benchmarks set by the largest central banks) and additional stimulus infused into the system is still historically unprecedented. That reality seems to have simply become a natural part of our environment. Yet, a dependency on what was previously considered extraordinary monetary support – emergency stimulus – should not be viewed as a healthy foundation. For one thing, it leaves the world’s largest policymakers with very little in the way of ammunition to fight any future economic or financial fires that arise. Furthermore, the external support seems to have encouraged investors to bolster their exposure to ‘risk’ rather than seek value and help find balance in the system.
    In the schedule of large central bank meetings ahead, we will see this stretched situation for authorities and markets raised between the Bank of Japan (BOJ) and European Central Bank (ECB). The former will announce its policy mix Tuesday morning after the liquidity lull caused by the United States market holiday the previous day. This group is unlikely to change focus on the 10-year JGB yield target and its essentially-zero benchmark rate, but their reiteration of having room to do more if necessary and seemingly indefatigable optimism for a recovery in the future is drawing more and more skepticism from the market given the constant shortfall on objectives. They are perhaps the most over-extended of the major banks as a percentage of GDP. The ECB isn’t as exposed as its Japanese counterpart, but the changes this past year stand out more prominently. The return to QE and drop further into negative rates has more members of their board questioning what are the costs of this extreme policy. The group is due to announce the results to its review of framework which could either bring serious change to modern monetary policy or act as a foothold to skepticism over the old guard. 
    Another central bank worth watching this week will be the Bank of Canada (BOC), which is not expected to alter its rate and struggles to stand as a model for global policy – whether the average or extremes. Instead, this group’s dovish or hawkish lean could offer influence to the Canadian currency. And, given their general perspective of balance, moderate shifts could give charge to pairs like USDCAD. 
    Range, Breakout or Trend Conditions? 
    This is a topic that I have raised before, but it deserves to be revisited at regular intervals as it can significantly influence your ability to navigate the markets. I think most would agree that conditions change, and it should thereby stand to reason that we should adapt to the evolution in order to reasonably pursue profitability. In general, I believe there are three types of market environment that we progress through depending on liquidity conditions, volatility and prevailing fundamental themes. Range or congestion, breakout and trend are three distinct environments that cycle progressively almost regardless of the time frame we consult. Naturally, if you have tuned your analysis to one of the three and/or established a trading strategy that is optimized for one, a systemic shift in the market will leave you adrift. It is absolutely possible to appreciate your conditions and adapt; but those that think they can create a one-size-fits-all approach are deluding themselves.
    So what kind of market conditions are we dealing with? This is something I ask myself at least at the start of every week. There are some very interesting cases to be made by a few key assets out there. US indices for example have been climbing fairly steadily these past three months. On that alone, we can call a trend. However, the pace of the Dow’s advance is extraordinarily restrained; and there are not many markets that reflect the same intent. Recently, a bid for risk-based catch up from the likes of the FTSE 100, the EEM emerging market ETF and debatably some of the Yen crosses  look like they are just recently clearing prominent resistance levels. That may be true, but breakout is defined not by a laser-accurate level but the measure of follow through when it is cleared. There seems limited backing for follow through. That leaves congestion. There are plenty of false starts and large ranges to point out. Furthermore, remarkably low volatility levels doesn’t support the immediacy of breakout. FX Volatility measured by JPMorgan’s global measure has dropped to a record low this month. As a mean-reverting condition, activity will normalize; but it doesn’t have to do so immediately. 
  6. JohnDFX
    Two Important Trade War Votes and A Lurking Threat
    We have had a few weeks of relative respite from the 2019’s constant headline generator: trade wars. That hiatus is past, however, as we are expecting key updates on global trade relations over the next few weeks. In an unusual twist though, the developments may be positive ones. Dead ahead on Wednesday January 15th we are expecting two opportunities to improve the collective growth trajectory. The most prominent of these is the planned signing of the Phase 1 trade deal between the United States and China in Washington DC. Though this deal was proposed back in October in an effort to ease the crush on business sentiment, we are only now coming to signatures. It is still unclear exactly what is entailed with this agreement besides the deferred tariff escalations due this past December, and it is likely the details are left ambiguous even though the two sides will declare it a black-and-white improvement. If we go back global indices or the USDCNH, the market is taking an optimistic view which will make it difficult to ‘impress’ while broadening the potential scenarios that ‘disappoint’. Easing more of the painful tariffs and seeing progress towards increased purchases as well as intellectual property rights policing is a matter for Phase 2 which President Trump waffles between commitment to steam ahead on and wait until after the election. 
    Another update that was on the docket for Wednesday – but for which doubt has been revived – was the Senate vote on the USMCA accord, which is the proposed replacement to the NAFTA agreement. This is one of the final hurdles to restoring tangible trade program in North America, one of the largest trading blocs in the world. Despite what it represents, the market is remarkably sanguine on this topic from global sentiment to Dow to USDCAD or USDMXN. Speculative interests started discounting the risk in this regional spat some time ago when the White House started to show a different path towards negotiation than it was taking with China – not a ‘favorable’ approach but ‘not as bad’ as the US-China trade war. Similar to the situation with the aforementioned countries’ discussions, assumptions are set with heavy skew to discount an improvement and wide open for deterioration. 
    As established as these trade negotiations have been with significant market attention along the way, the trouble brewing between the United States  and Europe remains underappreciated. Perhaps due to the distraction of open economic warfare or the side effects of complacency, there has been little active discounting taken as the two largest developed economies have moved from threats to actions. After 2018’s metals tariffs by the US, the WTO ruling on Airbus subsidies by the EU spurred the White House to charge forward with more than $7 bln in tariffs on European imports. France decided late last year to apply a digital tax on large tech companies’ revenues in its country which raised the ire of the US, urging threats of reprisal all while the country remarked that it was considering further tariffs for an updated ruling by the WTO saying Europe had not yet fully halted unfair support for Airbus. France the US have reportedly set a commitment to find a compromise by the Davos Economic Forum next week. Further, the WTO is due to make its ruling on US support of Boeing sometime in the coming weeks. 
    Will Growth Retake the Crown of Most Market Moving Theme…for the Week? 
    Geopolitical risk was an unexpected top concern to open 2020 on thanks to the situation between the US and Iran which boiled over on escalating tensions between economic sanctions and an attack on a US embassy. Though the two countries have openly attacked counterpart’s key people and installations and their rhetoric is openly hostile, it seems that the situation is back to an uneasy suspension. Despite the market’s blasé attitude towards the situation, it is worth keeping a close eye on the situation. Further escalation towards outright war between the two can have substantial economic and financial implications – not to mention draw attention to the exposure to risk the markets have built over time. 
    As we move forward with little appreciation for the threat in the backdrop, there is a theme that may find more reliable traction in the week ahead. Since the surge in fear of an impending global recession peaked in August/September, we have seen concern over the health of the economy all but vanish. That is not to say the situation has improved measurably. All that has happened is the developed world economies’ service sectors have generally avoided contraction and the US-China trade war averted steeper tariffs. Sentiment seems to be content with this situation, but it is difficult to gauge when interest will start to go down hill quickly – it certainly isn’t just a matter of an obscure Treasury yield curve event to decide. Data, while not always reliable for the seismic influence necessary to charge the markets, is at least a threat with a time stamp. There are a run of growth-related indicators on tap this week, but few of them has a ready claim to global influence. 
    A monthly UK GDP, Japanese eco sentiment survey and US retail sales are just a few indicators that will carry local weight but seriously struggle to reach global proportion. The Chinese 4Q GDP on the other hand is a big picture update from the second largest individual economy in the world as well as a key trade war milestone. That said, this report has a tendency to see very little change nor does it surprise meaningfully relative to economist forecasts. Nevertheless, don’t fully discount it. Another event to take stock of is the start of the US 4Q earnings season. Banks are the focus with liquidity a more frequent topic of conversation given the Fed’s short-term funding efforts of late. I will also keep tabs on CSX, the railroad corporation, given its influence on trade and proxy nature to growth. Here too, the interpretation of a global growth concern would require a jump. 
    An Appetite for Momentum Rather than Value 
    Last week, I discussed the importance of knowing the collective motivation of the market whether you are a fundamentally-inclined traders or not. When we know that the financial system is on a course set by views of growth, rates of return, unorthodox monetary policy or some other unique but systemic influence; it is easier to spot when market movement will pick up, separate a short-term jolt from a true trend and recognize which scheduled event risk will gain traction versus that will be readily overlooked. An extension of this consideration is the separation between a market that is motivated by a clear drive or one that is otherwise fed by outright speculative appetite. Impetus doesn’t have to be a traditional measure of value like the outlook for growth. It can be the easing of potentially disastrous economic pressure as with the trade wars. Also, there can be a temporary convergence of influences (e.g. Fed cuts, trade tension easing and Brexit breakthrough) that tips enough momentum to look like a singular cause – though such runs usually peter out far earlier as one or more nodes falter.
    Alternatively, there are situations in which a climb or tumble from the market has no basis in fundamental perspective – whether singular or a patchwork. That is more properly defined as a market driven by either greed (when bullish) or fear (when bearish). These phases are not always so overt as to be a universal tacit agreement that we will let our collective enthusiasm or pessimism carry us undisturbed. There is often fundamental justification that is made to give a sense of greater conviction behind the self-indulgent trend, whereby events or themes that challenge the prevailing trend are downplayed and tepid measures of support are given much greater prominence. It is this market type that I believe we are in with risk-leaning assets – particularly US indices. There are various ways to establish this – capital flows, divergences in key assets, erosion of economic potential, etc – but I am currently partial to the reach of specific risk-leaning benchmarks. When base risk appetite is the foundation for investment appetite, there is less interest in seeking value for long-term potential and far more interest in the immediate return to be found in priced-based established momentum. One of my favorite examples of this is the relative performance of US equities relative to their global counterpart. The ratio of the S&P 500 to the VEU is just off a record high, and EPS potential I certainly not that remarkable.
  7. JohnDFX
    The Return of Geopolitical Risk (the US and Iran Again)
    For almost the entirety of this past year, the dominant force of motivation among investors fit within a rotation of just three major themes: trade wars, growth concerns and monetary policy. Even when these matters weren’t under full steam, their influence and too many instances of sudden changes in the fundamental weather meant that they lack of bearing led to a similar absence of conviction in speculative performance – momentum if not direction. All three of these matters stands to hold considerable influence over the global market going forward; but for now, there is a pause in their respective tempest. Just in time for a familiar alternative risk to step in: geopolitical uncertainty. 
    Compared to trade wars or the Brexit which are more specifically a controlled break in economic relations, I consider geopolitical risks specifically issues that threaten the chance of escalation to a full-blown military conflict. The tension between the United States and Iran has been on the rise since the former announced that it was backing out of the Nuclear Treaty (JCPOA). Since then, we have seen plenty of threats and even actions to threaten oil shipping, but the measures were such that breaking the cycle of escalation wouldn’t threaten one side or the losing face. That may have very well changed this past week when the White House approved a drone strike on a convoy in Baghdad that killed Iranian Major General Qasem Soleimani. President Trump and officials stated that the decision was made to head off a planned attack on US military forces, but reasoning doesn’t curb the threat should Iran retaliate. 
    The country has said that it was prepared to attack military targets while the US President said Saturday they were already targeting 52 Iranian sites should the country seek reprisal. The implications of hot or cold wars are extremely variable but the worst case scenarios can be severe for economies and financial markets. Such uncertainty is the very definition of risk. This situation may plateau allowing the market to simply lose interest over a long enough period. Then again, it could also catalyze without warning. How willing are investors to discount the uncertainty and how well hedged are they for greater risk? 
    Central Banks are Trying to Head Off Carry Over Trade War Risk 
    Trade relations seem to be thawing to enter the new year – or at least some of the more potent threats have yet to be acted upon – but that doesn’t mean the economy is imminently positioned to resume the carefree climb that existed before the manufactured hardship was applied. The impact from nearly two years of rising trade barriers has material carry over influence economically and some of the more critical pain absorbed in previous months may very well prove permanent. Consider the agricultural purchases that China is supposedly set to pursue in order to meet the Phase 1 trade deal and for which the government has supplied large subsidies to stabilize the industry during the trade dispute. Farm coalitions have warned that even if the tariffs were fully lifted – a prospect well into the future – they may never see their relationships reestablished. Sentiment (business, investor, consumer) has a lot to do with this equation, which makes the open threats along more established and critical lines like between the US and EU added pressure that we do not need. 
    I visualize this as a large vehicle that is pumping its breaks but momentum continues to carry it closer to a critical cliff (an economic stall whereby external catalyst is no longer the critical ingredient). The world’s largest central banks no doubt see it in a similar fashion. Most policy statements or minutes have stated the concern around trade conditions as a serious external risk and many individual policy officials have expounded upon the unique risks that exist. This is likely the principle motivation behind the largest to add accommodation or hold open existing generous accommodation policies. The ECB was seeing unflattering growth figures and the uncertainty of Brexit, but is that enough to justify restarting QE and pushing benchmark discount rates even further into negative territory? And despite saying it anticipated no changes to policy last year before each meeting, it cut three times. 
    Preemptive policy like this does not offer tangible benefit – rather it is the absence of greater pain that may or may not have been realized. On the other hand, there are very real costs that continue to accumulate like cholesterol in the veins of the financial system. My top concern was addressed in the FOMC minutes this past Friday when it was reported that some of the US bank’s members worried that extreme accommodation was encouraging excessive risk taking. Unlike inflation or employment (their dual mandate until they decide to change the mix), investor sentiment can turn quantitative to qualitative with no warning. 
    Mind the Means for Market Performance to Gauge Persistence 
    Why should we care what is driving markets higher so long as we are positioned to take advantage of the climb? Even dyed-in-the-wool analysts ask themselves this question at one time or another. Many pure technical traders answered this very quandary some years ago with a ‘we shouldn’t’ and likely never looked back. However, whether chart traders, analysts with a crisis of faith or hedge fund managers frustrated that market norms have been upended; everyone should account for the prime motivator of the masses. Knowing what is urging the masses to a bullish or bearish (or neutral) environment can tell us when the a trend will stall, when congestion turns to a break or we fast track a reversal. Timing sudden reversals or distinguishing temporary pauses from a stalled trend can be a serious struggle for many investors that shun the fundamental map. Keeping course doesn’t make you immune to the struggle, but it can certainly help avoid the worst of the pitfalls. 
    I’ve said before, but it warrants repeating: the fundamental overview of the market is a factor of accumulation. There are thousands of motivations among traders to take or cut a position at any given time. Their collective actions renders the prevailing winds. Yet, not all of the causes are wholly unique. There are often dominant themes that dictate the actions of large swaths of investors. Trade wars, monetary policy shifts and recessions can be consuming matters that enough of the market responds to make it a systemic driver. Working out what dominant themes are actively controlling the reins or are lurking on the fringes can make analysis far more effective. Further, appreciating that the vast majority deployed in the system is controlled by participants that don’t have short-term duration and who don’t even consult charts help us to avoid the frequent cry ”these markets just don’t make sense!” 
  8. JohnDFX
    Opening Week Liquidity – We are heading into the first trading days of the new year 
    though it is not the first full trading week of 2020. That is an important distinction for those keeping tabs. Consider the throttling in activity and speculative appetite through the past week. The holiday conditions of the Western World drained market depth to effectively hobble any effort at establishing or extending trends – though there were a few notable sparks of volatility that were the result of the same illiquid backdrop. That is going to be even more pronounced in the week ahead. New Years is a bank holiday for virtually the entire financial system. That will make conviction even more difficult to muster. When trend development (momentum) and follow through on breakouts is difficult to muster, my default is typically to filter for opportunities that are more convincing range trades. However, the shallow markets will make volatility even more a complication to probability-based trading than normal. For anyone with less than a high level of risk tolerance, it may be better to sit on the sidelines until the follow week restores markets in earnest.
    Though market conditions are unusual this week, that doesn’t mean that there is an equivalent lack of technical or fundamental event risk. Consider the Dollar for example. The benchmark currency is on the verge of a reversal to a more-than 18-month bullish trend channel that also sports the most remarkable restraint in terms of activity level (ATR) seen on record. At the other end of the spectrum, you have the US indices which have pushed to record highs both through periods of low and high liquidity. On the fundamental side, there are a number of scheduled events that should register. Proxy growth readings are on tap for the largest economies with the run of Chinese government PMIs and the ISM’s US manufacturing report both due. The former is an overview of a country being pushed on too many sides and the latter reflects an actual recession in factory activity (not an isolated malady for the US). Manufacturing reports for other countries, the FOMC minutes, US trade report and a range of auto sector reports will also register on my radar. However, a more systemic matter to keep in mind is China’s plan to lift a range of tariffs on a host of global counterparts starting on January 1st – though this list does not include the US. Is this a shift towards more growth-supporting open trade or does it end up adding to the provocation with the US? 
    Top Events for January
    Looking further ahead to the first full month of 2020, there is the regular density of high-level event risk across global powerhouses in both the developed and emerging market worlds. That said, I will keep my attention more actively directed towards systemic themes whose threat has posed serious threat to the long-disputed stability of a ten-plus year bull market. The most representative matter seems to be trade-related concern. Beyond China’s plans to lift tariffs against a range of counterparts this week, we should keep a close tab on release of details on the Phase 1 trade deal. Both sides have hailed their compromise since October yet we are still critically lacking for the practical terms that will usher us to a full de-escalation of economic tensions between the two largest players on the board. According to US Treasury Secretary Mnuchin, the two may sign early January. 
    Trade issues aren’t unique to the US and China relationship. There are a number of active import taxes between the US and Europe at present. The US quickly slapped tariffs on certain provocative European imports (particular agricultural goods) after the WTO ruled this past year that the country could pursue over $7 billion in restitution for unfair subsidies afforded to Airbus. After a ruling earlier this month that the EU has still not lifted support for the airplane manufacturer, the US said it would consider escalating its effort. That decision could come in January. To add further complication, the WTO may deliver its decision on the US’s support of Boeing which could greenlight European tariffs which they would likely pursue wholeheartedly. Further, we are also waiting for the US to follow through on stated plans of retaliation for France’s digital tax that is raising cost to large US tech companies. Yet another front on trade to mind is the Senate’s decision to take up the USMCA agreement which could finally write off the replacement of NAFTA for a clear North American relationship – the first true resolution (for better or worse) of trade disputes. And of course, lest we forget, the extension of the Brexit decision expires on January 31st which is expected to see the previously struck withdrawal agreement push through after the conservative’s victory in the general election three weeks ago. 
    The two other prominent themes that I’ve been following through 2019 find far less top level event risk to trigger provocation – though they can hardly be written off. Recession fears have notably abated since the US and China revived their confidence on the Phase 1 deal. That said, the quality of growth-related data has not improved materially, rather the interpretation of the same data has taken a more notable optimism. That could quickly fade by seeing capital market performance stagger. The markets are indeed that fickle and superficial. As for the effectiveness of monetary policy, there is one particular rate decision that is on my board: the January 29th FOMC rate decision. After reviewing its objectives through this past year, the world’s largest central bank is due to offer its assessment of what may need to change in its targets and policies. Depending on the mood of the market, this could be readily interpreted as evidence that monetary policy has lost its potency – and perhaps even its ability to maintain calm and buoyant asset prices, which would be a disaster if ever realized. 
    Top Events for 2020 
    In the scope of an entire year, many fundamental developments will transpire that take control of both volatility and direction regionally and globally. Through that 12-month span, many of the most meaningful drivers are likely to be completely off the script that we have in scheduled events that we start off with in January. These developments that are related to generally known themes and carrying a significant level of impact can fit into the category of ‘grey swans’. Most are familiar with term ‘black swans’ which refers to extreme developments that were largely unexpected by the vast majority of market participants – and which are readily interpreted and retroactively explained to have been ’obvious’ after the fire is put out and the dust settles. We cannot reasonably speculate and trade around black swans because their extremely low probability makes for very bad trading statistics and worse timing. Grey swans on the other hand are far more reasonable. 
    Through all the open-ended matters, there are a few particular matters with rough scheduling that I will watch as inordinately influential on local currencies and capital markets. The first is the Brexit transition deadline. According to the original timeline for transitioning from member of the Union to independent country with trade relations aligned with EU members, the situation should be wrapped up by end of December 2020. After the delays in agreement to the exit, it would be expected that there also be an extension requested of the transition – a period for which the UK would still be beholden to some unfavorable European laws. However, Prime Minister Johnson suggested after the election that he would attempt to make a request for extension illegal. This is a decision that is far out, but its impact will be felt constantly with interpretations of remarks and negotiation updates, with sudden spells of volatility and proactive restraint in progress for the Sterling. Another matter that is well accounted for is the state of the US-China trade war. Taking the optimistic interpretation and say Phase 1 is finally signed off on by all those that hold sway, we still need to move to Phase 2 which is the real heavy lifting. A demand of full tariff roll back by China and the US requiring committed purchases along with intellectual property protections are difficult to come to terms on. Will they accelerate progress to ward off an unintended recession or will China wait until after the US election before it takes the cost-benefit seriously? 
    Speaking of the US election, this event will likely prove a global event with considerable build up in capital market performance. Generally speaking, the market is agnostic to party, however, the influence of protectionism amid populism that has taken hold in different regions of the world are difficult to miss at this point. Trade wars – at least in their present form – are a direct result of the ruling parties’ policy mix. What’s more in the US, the extreme bifurcation in political norms has created a familiar state of gridlock when it comes to pushing growth-supporting initiatives like the infrastructure investment fiscal stimulus that was part of the 2016 campaign trail while government shutdowns are a near constant threat as the deficit balloons to record highs. These are serious matters, but the market can decide to play the risks down as they have in the past. Yet, with a prominent election ahead, I suspect these matters will draw far more attention in 2020.
  9. 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. 
  10. JohnDFX
    Trump Threatens to Move Forward With Dec 15 Tariff Escalation, Considers Section 301 
    There have been a few critical developments these past few weeks that could have significant deescalated the daunting momentum of global trade wars. However, with each small improvement, we are met with an asterisk that could quickly undermine the good will as well as an alternative stab to weaken the outlook for global trade. For the US-China engagement, the White House backed off of the planned tariff escalation scheduled for October 15th after the countries agreed in principal on a Phase One trade deal. Now over a month since that relief, the two countries have not made any material progress. Sure, there have been bouts of optimistic rhetoric, but the enthusiasm has fluctuated back to cynicism just as frequently. Whether ‘confidence’ or warnings, market participants have grown increasingly ambivalent to the situation. What can carry greater certainty as we move forward is the threat of an escalation in the scope of US tariffs on Chinese imports scheduled for December 15th. It was presumed that if the countries were working towards a first step to ultimate resolution, this jump would be avoided. However, multiple administration officials suggested the pressure would not be removed for fear of the President losing support from his base in an election lead up and to discourage China from pursuing a strategy that is founded on a different US government this time next year. 
    Another seeming miss on the path towards further economic disaster was the passage of the October 14th deadline for the administration’s decision on whether or not to pursue auto tariffs. That date was itself the deferment after an extended review. While the White House has not said definitively that it was laying the Commerce Department’s investigation to rest, many believe that the matter is behind us owing to legal questions if not strategic ones. The European Trade Commissioner stated her belief that the risk has passed. That said, I would not forgot that this uncertainty is still somewhere in the wings. In the meantime, Europe still finds some of its agricultural exports to the US under a hefty 25% tariff rate, deciding whether and how to retaliate – and knowing there is a WTO ruling to come sometime near the beginning of 2020. Adding another layer of trouble, there was suggestion from some close to the US government’s strategy that the a Section 301 investigation may take the place of the 232 in order to keep the pressure on the EU (and potentially other major trade partners) to capitulate under trade pressure. This evaluation looks into broader trade practices rather than specific sectors under a national security assessment. 
    Recession Risks Slowly Recharge 
    Back in August, fear of an oncoming recession had hit troubling levels. With a host of warnings by supranational authorities (IMF), central banks and even governments; search interest in ‘recession’ through Google hitting a decade high; and a surprising mainstream interest in the otherwise wonkish interpretations of the Treasury yield curves; it was clear that there was serious concern about the further reach of the already mature global economy. Yet, with a few disarming updates and a shift in favor towards more speculative measures, the threat seemed to deflate through the subsequent two months. Now, to be clear, the economic trouble never really vanished. The US and Europe are still in extremely tepid course of expansion, there are certain key countries (Germany and Japan) that are oscillating quarters in contraction and China is running its slowest tempo in three decades. Instead, investors, governments and consumers simply just grew larger blind spots. 
    This past week, it was even more difficult to ignore the signs of trouble ahead. The OECD lowered its outlook for global growth yet again to its worst standing in 10 years. The 2019 forecast stood at 2.9 percent with the 2020 projection nudged down another tick to the same pace. That is itself troubling and indicative of skepticism that a recovery is ‘around the corner’. To ensure that the world does not simply hold course on its current mix of beliefs and dependencies, the group extended its outlook to 2021 with a disconcerting 3.0 percent pace. That more distant prediction, it was mentioned, was only possible if significant risks like trade wars and China’s economic struggle leveled out. Warnings like these have come frequently and just as readily overlooked (OECD, IMF, World Bank, etc); but data is a little more black and white. Just this past Friday, the November PMIs crossed the wires with a clear warning in their mix. The Australian, Japanese, German and UK overview readings were all in contractionary territory (below 50). The Eurozone figure slowed to just barely positive territory (50.3) and only the US improved in a measurable way (to  51.9). 
    Some may consider that US reading an opportunity to pursue a further run in the country’s assets to relative return. However, it should be said that a single country – even the world’s largest – would not hold back to the crushing tide of a global economic retrenchment. That is particularly true when we consider the excess built into the system through investment, borrowing and public debt. 

    Trading Against Risk Versus Holding a Position Through Quiet 
    Complacency is a danger in the financial markets just as much as it is in life. However, there is far more threat when we throw caution to the wind and actively pursue a line that attempts to extract ever-smaller rates of return as the risk profile we must adopt to chase it grows larger and larger. The evidence of complacency is abundant. Record high Dow and S&P 500 are perhaps the most obvious and the most aggressively rationalized. Consider the performance of this favorite capital market benchmark should represent some combination of ideal economic trajectory and/or the greatest potential for forward returns. There is nothing of the sort on our horizon, but many are perfectly happy to live on confidence central banks and previously-unmatched stability in the speculative future – the preferred opiates of the masses. Other risk-sensitive markets are not pushing such extraordinary levels, but the steadiness is still a feature. Meanwhile funding pressure is starting to show up even in the US short-term – arguably one of the most liquid areas of the global markets – but the rise in the Fed balance sheet is again putting most at ease. 
    Yet, when we consider these conditions without the benefit of a blind faith in the unique profile of our present market mix, there are plenty of obvious threats that we face: including the trade wars, economic struggle and stretch valuations mentioned before. There is good reason to be concerned about the fundamental landmines that we continuously weave, but my principal concern is not with what straw breaks the camel’s back nor how indicative of the big picture it may be. Rather, the real risk is the collective exposure that the masses have taken. Adding to leverage despite the underlying risks with smaller returns to cushion any unfavorable winds, raises the serious threat of a panicked exodus from the financial markets. When leverage is applied, the losses accumulate much more quickly. I maintain that the best single asset analogy to the present conditions is the speculative interest behind the VIX futures contract. The net position has pushed a record short these past four consecutive weeks…despite the measure of activity already standing at an extreme low of approximately 12 throughout that period. This is a profound lack of reasonable return against an enormous amount of risk and in extraordinary volume. 
     
  11. JohnDFX
    We Have Unresolved Trade War Issues Guided by Rumor or Complete Blackout 
    We closed out this past week to a broad swell in risk appetite. This enthusiasm wasn’t consistent for the global markets throughout the week, however, with most of the asset benchmarks that I follow for scope were struggling until the Friday pop. The exception to the rule was once again the seemingly impervious US equity indices. Whether you were evaluating sentiment for the Dow and S&P 500 through the week or the global bump on Friday alone, the popular justification seems to have been the same: improvement on the trade war front. Given its importance to the course of the global economy, the contentious trade relationship between the US and China was naturally a point of regular speculation over the past week. The announcement of a ‘Phase One’ deal by the two economic powerhouses was announced back on Friday, October 11th. Since then, there has been far more speculation and rumor than there has been tangible policy change. Perhaps the only concrete development since that hailed breakthrough was the deferment of the planned October 15th tariffs escalation by the United States. This past week, the balance of headlines was neither consistent in trumpeting improvement nor did it offer foothold for genuine progress. Concern that China was cooling on agricultural goods purchases and balking at enforcement mechanisms while demanding rollback on existing tariffs contrasted the cheerleader-like language from some US officials (Trump, Ross and Kudlow).
    It is hard to tell which of these headlines gives us the most accurate picture of this important economic relationships, but there is more consistency in the market’s interpretation of it all. Skepticism has set in some time ago and it only deepens with each week that passes without black and white terms for the Phase One deal for Presidents Xi and Trump to sign off on. As an aside, reports that a deal could be approved on the deputy level should raise concern. It suggests that it is not something the leaders would want their names affixed to; which should be a ‘win’ that they would want credit for, but would instead be viewed as either a more mediocre step or capitulation by both sides that could receive blowback by both constituencies. Keep a wary eye on the headlines for updates on this discussion as we pass implicit deadlines and the contentious explicit dates, like the December 15th increase of the United States’ tariff list of Chinese goods. 
    Perhaps even greater a threat of volatility – or opportunity for removing risk – is found in trade spats the US is fostering with the ‘rest of world’. This past Thursday was the supposed deadline for the Trump Administration to decide on the Commerce Department’s Section 232 evaluation for auto imports. This was the deadline after a previous six month extension. Through the weekend, there was still no word on whether import taxes on foreign autos and auto parts would be implemented, avoided or a decision postponed once again. Should it be delayed or completely avoided at this point, it would likely offer little boost to sentiment, but a sudden implementation would certainly trigger a significant slump in the global markets. Another dispute to keep on the radar is that between the US and EU. We have received very little insight on how negotiations are going between these two developed world leaders, but we know the US-applied tariffs on imported European agricultural goods is sowing ill-will among leaders. 
    Dow: Recharged Rally, New Plateau or Blow-Off Top 
    Though there is always room for debate, the performance of the US indices qualifies as one of the most remarkable of the global financial markets this past week. While ‘rest of world’ shares markets, emerging markets, junk bonds, carry and other sentiment-sensitive asset classes were sliding for most of the week, the Dow, S&P 500 and Nasdaq were holding steady or even advancing. This is not an unusual disparity of late. While the performance metrics change depending on your starting point, as a general benchmark for year-to-date 2019, a rolling 12-month comparison or plotting from the beginning of the recovery after the Great Financial Crisis concluded (roughly March 1, 2009), we find the ‘US market’ pacing the financial system. Determining the source of this outperformance can give critical insight into whether the bullishness will continue for local assets and whether it can establish more reliable traction across the world and asset classes moving forward. 
    There are some traditional fundamental measures that can referenced as sources of relative strength. The broadest measure of economic growth for the United States is certainly not roaring by historical standards, but it has held rather steady at its moderately expansionary tempo through the past years. That has in turn afforded the Federal Reserve an economic backdrop that allowed for rate hikes up through 2018 and offers some support for their stated intention to level out the benchmark rate range around 1.50 percent for the foreseeable future. A rate of return from the US offering a substantial premium versus most liquid counterparts while also having room to operate should future risks demand response is also beneficial. However, I believe much of this backing to this climb to record highs is based in sheer speculative appetite. Investors are willing to commit to their complacency, but they prefer to seek exposure where the progress is most consistent as that is where the greatest theoretical return would be made – while some may also justify their decision from a supposition of safety out of that climb. 
    Sentiment is fickle. Sometimes it can bulldoze through troubling updates while others it falters at any supposed crack. I would not, however, consider it reliable when you must dramatically increase exposure in order to extract further value out of the deal. If we consider the US indices’ particular outperformance paired with the lack of tangible fundamental catalyst through Friday, that impressive bullish breakout to end this past week does not look nearly as inspiring. Sure, the Dow gapped higher to clear out one of the most congested periods in the past few years (measured as a nine-day historical range as a percentage of spot), but follow through at progressive record highs requires steadily greater conviction. Unless something more tangible – like the wave off of auto tariffs – occurs, a recharged rally is really low on my probability list. A plateau would likely depend on some ‘catch up’ in other areas of the risk spectrum while pull of risk rebalance will be a constant force. 
    An Steady End-of-Year Coast for S&P 500 and Risk Markets Ala 2017? 
    If the genuine fundamental backdrop isn’t improving to support a stretch higher in capital markets, the next best thing seems to be complacency fueled by a perceived reduction in risk. We measure risk in the volatility of the underlying markets, and it is in that assessment that we find another questionable perspective whereby we seem to be pricing in perfection. The VIX volatility index has slid back to a remarkably deflated level around 12, which is the approximate low back to October 2018. Even more impressive though is the realized (versus implied) measures of activity. The past month (20-day) realized measure of volatility for the underlying S&P 500 is the lowest since the extreme quiet registered in the second half of 2017 – a period of such quiet itself, that we hadn’t seen anything comparable to it in half a century. We have further seen other exceptional readings such as the longest stretch with out a back-to-back loss for the same benchmark in decades and an exceptional record of days with lower than 1 percent registered moves from close to close. It is in other words very quiet.
    With this quiet and the blatant complacency the markets have fallen back upon, it is easy to understand the efforts to ‘justify’ the next steps for a contentious climb. Reference made to the extreme quiet – and still-impressive progress – forged through the latter half of 2017 makes an appealing case study for bulls that may lack a more traditional foundation of conviction. There is another, more common point upon which investors may rationalize their interest in pushing their penchant for steady capital gains that can compensate for lost, reliable income through financial investments: seasonality. November and December are two of the most favorable months in terms of gains for the S&P 500 of the calendar year going back three decades for reference. Volatility also tends to retreat over this period which would add to that same incredible compression through the end of 2017.
    Yet, be mindful of the reassurances you are willing to accept to keep on extreme risk. Just as many market participants will remember February 2018’s explosion as those that recall the third and fourth quarter of 2017. What’s more, there is even greater appreciation as to the exposure that has built behind this controversial speculative perch. A record net short positioning in VIX futures has made it into headline news. So has the general leverage in risk assets across the system – even record debt levels for consumers, governments, businesses and central banks. Suspension of reasonable risk rules paired with great awareness translates into a market that is more likely to be flighty and prone to avalanche. By all means, take advantage of prevailing trends; but don’t blindly continuously build your risk profile for steadily deteriorating return potential. 
  12. 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.
  13. JohnDFX
    Critical Fundamental Themes to Keep Watch For Next Week:
    Volatility Slipping Back into Habit of Complacency as Liquidity Fills [Indices, VIX] US-China Trade War – Beyond the Point of De-Escalation? [AUDUSD, USDCNH, Indices]  A Climb in Risk Appetite as More Fundamentals Fall Away [S&P 500, Dow] Recession Warnings In the Market Converging with Those in Data [Indices, Yields, Gold]  Monetary Policy Ability to Stabilize Growth, Markets [EURUS, ECB, Fed, BOJ, Gold] Politics Increasingly Core to Market Outlook [S&P 500, Yields, Gold] Natural Growth Versus Monetary and Fiscal Stimulus-Led Growth [Indices, Dollar, Gold] UK PM Johnson – Parliament Fight Over No-Deal Cliff on Oct 31st [GBPUSD, EURGBP, FTSE100] US $7.5 Bln in WTO-Approved Tariffs Threatens US-EU Trade War + General Auto Tariffs Back to November [EURUSD, USDJPY, USDMXN, USDCAD] The Threat of Currency Wars [EURUSD, USDJPY, USDCNH, Risk Assets] Gov’t Bond Yields and Commodities as a Growth-Leaning Risk Asset [Dollar, Euro, Yields, Oil] Specific Safe Havens: Dollar, Treasuries, Gold, Yen [Dollar, EURUSD, GBPUSD, USDJPY, Gold] Excessive Leverage / Debt in Public and Private Channels [S&P 500, Yields, Gold]
      US-China Trade Progress: The Boy Who Cried ‘Progress’ 
    My favorite flawed, risk benchmark in the United States S&P 500 index jumped to a record high through the end of this past week. A technicians overview would suggest that intensity of a gap higher, a daily candle that opened on the low and closed on the high as well as the clearance of a long-term rising wedge top added considerable luster to an already momentous achievement. It wasn’t a stretch to assign this thrust – shared by most risk-leaning assets – to either a general state of speculative complacency or perceived improvement in US-Chinese trade relationships (I believe it is a combination of both). After a few swings in rhetoric this past week, investors were bequeathed a rare perspective of enthusiasm in negotiations into the weekend. The headline that charged bulls reported on Chinese sources remarking that the two sides had reached a “consensus in principle” on the ’Phase One’ deal. 
    It is important that this perspective would come from China rather than the US. Beijing has been the most dubious of its counterpart’s intent and commitment since the Washington changed direction dramatically following the G-20 meeting where both sides seemed to have struck an accord. The reported breakthrough in this first stage deal would requires China to purchase US agricultural goods, open financial services markets to US companies and maintain stability behind the Yuan (ironically, what would be technical manipulation). On the other hand China requires the US to ensure it is dropping the planned tariff escalation – to encompass essentially all of the country’s goods – on December 15th. 
    If we see this effort move forward, it would indeed offer a significant measure of relief. How would we judge a step in the right direction without President’s Trump and Xi signing on a finished plan? An official date and time for a summit would represent a tangible milestone for intent. Yet, as important as it is to ease back on the accelerator of growth-killing trade restrictions, we should not treat this as a wellspring of untapped growth. This is avoiding greater pain. To fully de-escalate, we would theoretically need to see the passage of the ‘Phase Two’ which would have far more difficult requirements to agree upon. Agreement would need to be found on intellectual property rights, enforcement, state run enterprises and the full reversal of the onerous tariffs applied to this point. That is a high hill to climb for two countries that are attempting to use their size and position to avoid capitulation. Against this backdrop, we need to consider just how much lift such a first step deserves for something like US equities where it is technically already pricing in perfection. 
    A More Extreme Signal of Risk Appetite Than SPX Record: Record Short VIX Interest 
    I am a considerable skeptic when it comes to the record highs the major US equity indices reflect. From a landscape perspective, the S&P 500, Dow and Nasdaq are significantly higher that global equity counterparts and pushing far greater excess relative to alternative asset types with a risk connection. While you could point to relative yield, an assumption of growth or perhaps an element of safety in US assets; it is more than a stretch to afford this degree of premium relative to counterparts. Furthermore, speculative measures are broadly running far afield of traditional measures of value. We would expect peak growth, peak earnings and/or peak yield to push record highs on capital measures. We are far, far from those milestones. Yet, here we find ourselves. That is the biproduct of speculative conviction/complacency, growing leverage, extremely generous monetary policy and no small assumption that fiscal support will offer a backstop should the other two nodes fail. Should these joists of risk appetite be truly tested, it is very unlikely to hold up. 
    Yet, as we track the fundamental weather between economic health updates, trade wars and monetary policy effectiveness; we are also finding optimists latching on to familiar runs such as seasonal norms. We have entered the month of November whereby the S&P 500 historically averages a strong advance as volume drops. The November/December climb is one of the most fruitful of the year and is often associated to holiday activity and other year-end efforts. Yet, another seasonal norm that raises serious questions is the expected drop in volatility through this month. We are already at extremely deflated levels as investors grow incredibly sanguine on the increasingly discussed risks. To assume we will just ride out with prices of perfection and a horizon with nary a wave of trouble is simply impractical. To give a sense of just how extreme the expectations are in volatility terms, we can look at the speculative positioning on VIX futures. The securitized product of what was meant as a hedge has attracted aggressive trading these past years. At present, the speculative interests in the future market are holding a record net-short position on the volatility measure. That is despite being substantially deflated. That smacks not just of complacency but of outright hubris. 
    Top Event Risk - for Volatility Rather Than Systemic Trend - Through the Week 
    When you are looking for the biggest fundamental impact, it is best to find the systemic undercurrents that can strike a nerve for the entire market and thereby develop true trends. However, those measures are not always clearly directed and properly motivated, as is the case seemingly for the week ahead unless something comes out of the blue. That doesn’t mean however, that we cannot expect event-driven volatility for different currencies and regions’ assets. Here are the events that I think can carry the greatest impact and why through each day this week. 
    On Monday, there are some interesting events like the UK House of Commons voting on its new speaker, but it is new ECB President Christine Lagarde’s first official speech in her new role that is most interesting to me. There is a clear rift at the central bank which either threatens to curb the aggressive support it has issued these past years or threatens to call into question the effectiveness of their efforts – that latter scenario may happen regardless. On Tuesday, I will be watching two key events: the RBA rate decision and US service sector activity report from the ISM. The Australian Dollar is a carry currency and it depends heavily on its comparatively higher rate of return to draw foreign capital – especially now when the health of China is called into question. If this group offers a mere escalation of the dovish rhetoric – and not even a cut, the Aussie Dollar has some pent up premium that can be cut back. Ultimately, the US services report is one of the most important indicators overall because it represents the vast majority of output in the world’s largest economy. The manufacturing sector in the US has contracted for four months and services has been keeping overall growth afloat; but it has been showing signs of wear. 
    On Wednesday, we are due Germany factory activity which is a good proxy for this key economy’s malaise as well as plenty of Fed speak. My top event though is the earnings report from Baidu, the Chinese search company. This is an important business update for the economy (as with the likes of Alibaba and Tencent) which can offer a more reliable gauge of the country’s health than even official and private figures that relate directly. The Eurogroup meeting on Thursday will produce the economic outlook from the European Union which can tell us how one of the largest economies collectives in the world is doing from their own perspective – far more important than a BOE decision and economic forecast which is constantly snowed in by the Brexit uncertainty. On Friday, Chinese trade will be a figure to watch, but I won’t hold my breath for volatility. Instead, the US consumer confidence figure from the University of Michigan can leverage bigger moves in US speculative markets given how aggressively they are priced. 
  14. 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.  



  15. JohnDFX
    UK Parliament Votes to Delay Brexit Deal, Now What? 
    Heading into the weekend, overnight implied volatility behind the Cable and other Pound crosses had charged to their highest level in over two years. That reflected well the fundamental weight represented by the first Saturday sitting in the Commons in 37 years. Parliament convened to debate the government’s withdrawal agreement bill which Prime Minister Boris Johnson managed to hash out with European negotiators during the EU leaders summit. The compromise came at the last possible moment as the law passed by MPs before their proroguing required Johnson had a deal in hand by October 18th or he would be required to send a letter to European officials requesting an extension for negotiations to avoid a no deal outcome. It was telling that the progress towards avoiding a hard Brexit scenario to this point had seen GBPUSD charge its biggest 7-day rally in decades yet anticipated volatility had soared in tandem. That speaks to the level of speculation going on and the very convoluted situation with which we are dealing. 
     
    Ultimately, Saturday’s vote would confound the momentum that had built towards a tangible deal and in turn trip up the speculative charge that had gained such remarkable purchase these past few weeks. The MPs voted 322 to 306 on the so-called Letwin amendment which would withhold approval of the deal until legislation was in place. That would in turn trigger the ‘Benn Act’ which required to the PM to send a letter requesting an extension from the October 31st deadline out to January 31st. The government did this begrudgingly along with a second letter in which Jonson made clear he believed a delay would be a mistake. The impact that this has on the market is inevitability convoluted as the array of scenarios for the ongoing negotiations is itself complicated with options. Though the deal was not pushed through, the effort to delay is principally based on an effort to push back a no-deal outcome in a bid to permanently prevent it from ever coming to pass. Nevertheless, the intensity of the recent charge is compounding speculative appetite that will likely be frustrated by this turn of events. A swift retreat that could then turn to contemplative balance. It is possible that the EU could reject the request to push back the decision date which would send a shock of panic through both the Sterling and capital markets, but that is a low probability. 
    Granting the UK an extension that only lasts a few weeks rather than three months would leave very little time to accomplish anything other than an approval of the offered withdrawal agreement or risk reviving the no-deal scenario. Some European leaders want to know what will be the point of offering an extension – coming to agreement on the given deal, general election or perhaps referendum. The pressure will remain in all of these scenarios, but the intensity will be greater depending on the immediacy of the scenario. Meanwhile, the government officials (the Foreign Minister) have stated their belief that they have the necessary numbers to push the current deal through Parliament. It has been suggested they will call for a ‘meaningful vote’ and possible seek to work through the details of the current deal in order to find the majority that Johnson needs to move forward. To Pound traders and foreign investors, this will look like general uncertainty which is naturally reflected as volatility. Committing to a particular course for a market steeped in such instability will be exceptionally risky. That kind of scenario will draw more speculators than steadfast investors, only compounding the situation. Beware trading GBPUSD this week. 
    A Serious Escalation of the Global Trade War…Underappreciated
    Despite efforts by the European Union’s trade delegation to negotiate a compromise, the United States Trade Representative’s (USTR) moved forward with slapping hefty tariffs on certain EU imports. The White House will not be easily swayed with this push as it considers the effort to be sanctioned – at least partially – by the global community. The World Trade Organization (WTO) found that the US could pursue corrective measures against the EU to the tune of $7.5 billion for what it considers harm done through unfair subsidizations for the Europe’s principal airplane manufacturer, Airbus – never mind the group found the US guilty of similar practices in favor of Boeing, it just has yet to rule on the amounts that can be pursued. While the lack of ground the US is willing to negotiation is a general problem that the whole world is experiencing, the particular trouble for the EU is in the products that are being taxed. In addition to the expected 10 percent tariff on imported airplanes, the US has also imposed a 25 percent hit to certain agricultural products and there was also reports they were pursuing industrial goods as well (though that isn’t yet clear in the details). These unrelated industries to the initial dispute register as economic aggression that urges retaliation. 
    Remarkably, despite what this situation would insinuate, the coverage around its unfolding has been particularly light. In part that is likely owing to more immediate concerns such as Brexit, the US-China stand off and regular warnings of economic lethargy. Just as crucial to the limited impact is the lack of retaliation from European officials. That is unlikely to last. In a best case scenario – short of an unexpected compromise – would be Europe waiting until the WTO rules on the notional amount it can pursue against the US for the Boeing finding. That could keep this additional threat to the already fading growth forecast at a simmer rather than rolling boil. Yet, there is considerable debate among European officials on how to act. Germany’s Finance Minister has urged his counterparts to hold off on retaliations to allow for negotiations to work and likely to avoid a high probability path of steady escalations that seems routine with the US. On the other hand, the EU’s Trade Minister warned before the official tariff start date that they would have “no alternative” but to take countermeasures if Washington wouldn’t deal.
     
    If Europe moves to counter the US, risk trends and economy watchers will pick up on it readily. We may find some grey area should retaliation be held to what is considered like-for-like for industries unrelated to airplane manufacturing. If that is the case, the US may not be quick to cry foul and escalate, particularly when they are distracted by so many other issues nowadays. Alternatively, if they are spoiling for a fight and looking for a reason to spread their self-labeled righteous efforts to rebalance trade practices around the world, the Trump Administration could make another sharp response in a shock-and-awe approach. Ultimately, we will not be able to avoid that recession that seems to be lurking at the fringes if the two largest economies in the world decide to gouge the trade between them. 
    EURUSD Launches a Rally, But From Where? 
    There is a lot going on in the FX and global capital markets, so it is understandable that some significant movement in some of the less-trafficked corners of our charts goes overlooked. Yet, that doesn’t suit the EURUSD. The world’s most liquid exchange rate (and arguably asset) has accelerate a bullish reversal that began with the month. Technicians would recognize the move for being the strongest two-week advance in approximately 13 months. From there, the technical boundaries that we’ve overcome – like the 3-month descending trend channel – carry some weight of their own. But what makes this effort particularly remarkable in my estimation is the starting point. Through the end of September, the pair was trading at its lowest level in two-and-a-half years. Adding to the interest in the move is the context of a market that has proven remarkably stagnant. Sure, we were plumbing new lows, but the decline was coming in starts and fits with a very gradual descent which reflected well on the broad restraint this benchmark has exhibited for the past 17 months. Are we finally seeing volatility restored to a pair that has successfully avoided large swings for that long? 
    To interpret the probability of a transitional period, we need to understand what has steered the market through its restrained routine thus far. Why has EURUSD been so controlled? While some believe this is an anchor born of two reserve currencies, I suspect that we are witnessing the confluence of multiple competing forces. Safe haven capacity, relative growth and now trade war implications are just a few of the more exceptional forces jostling these currencies. It is very likely that these matters take up a bigger role in their relative performance into the future. Yet, at present, the bullish reversal from EURUSD has a few interesting properties to perhaps highlight what is the most interesting matter at present. This past week, the Euro didn’t show a broad rally across its major counterparts and EURCHF in particularly made no effort to reinforce. Alternatively, the Dollar made a fairly broad retreat. Realization of trade war blow back, recognition of the struggling economic data or political uncertainty may all be contributing to the slide; but I think a more familiar catalyst is responsible: monetary policy. Through the end of the past week, the probability of a third consecutive rate cut from the Federal Reserve rose to 89 percent according to Fed Funds futures. That is a significant escalation from a week ago and up from little more than 20 percent a month ago. If this is indeed the root of this ground swell, thing should get more and more interesting as we approach the Fed’s October 30th meeting.
  16. JohnDFX
    Is This a US-China Trade War Turn We Can Rely In? 
    The market was struck with a broad sense of enthusiasm through the second half of this past week. There were a number of developments – or expectations for forthcoming events – that contributed to this buoyancy. The theme stirring the most optimism was anticipation that the United States and China were finally making progress in their 15-month trade war. Just before the New York close on Friday, officials announced that indeed they had found some middle ground for compromise. The question global investors should be asking is whether this is tangible and significant enough progress between the world’s two largest economies to foster enough confidence in the economic and financial outlook to beat back unrelated systemic concerns that continue to march forward – such as the fears of an impending recession. It certainly draws some measure of concern that the build up to the announcement was answered by a pullback when the news actually hit the wires (‘buy the rumor, sell the news’), though that may be a function of the twilight hour for liquidity. 
    To properly evaluate the heft of the ‘compromise’, we need to first understand what was agreed upon. An agreement by China to purchase $40-50 billion in US farm products was the most tangible improvement – though it will partially be working to offset trade restrictions suffered the past year. The most important agreement is the deferment of the 5 percent point increase in the tariff rate on $250 billion in imported Chinese goods to 30 percent due to take effect October 15, though it was not clear if this was completely off the table. After that, the measures are more ambiguous. The US vowed it would review its entities black list (though Huawei was not part of that consideration) as well as reconsider the decision to label China a currency manipulator. There was also language to suggest discussions would continue over one of the Trump administration’s principal issues, cracking down on intellectual property theft and subsidies for state run enterprises, but there was nothing approaching detail on enforcement. 
    There is certainly material to point to in this agreement, but it falls far short of the milestone whereby the leaders couldn’t just reverse course with little warning as they have done a number of times before, including after the June G20 agreement. The potential of a mere delay in the tariff rate hike isn’t nearly as concerning as the fact that the planned increase in the United States’ tariff list on December 15 was left in place – likely as pressure to speed along a deal. Further, China’s interest to loosen control over its economic and financial influence for IP enforcement, subsidies and American access to the Chinese economy will be very thin as the government faces the slowest pace of growth in three decades. There is significant interest on both sides of this standoff to find a compromise – President Trump wants to avoid a recession before the campaign season heats up and China wants to avoid too severe economic pressure that can further contribute to social unrest – but the struggle to secure superpower status can be powerful and the pain absorbed thus far can prove difficult to reverse. Market performance Monday will be very telling as to where sentiment stands on whether there is enough confidence in these two parties and whether their cooperation is even enough. 
    Hope for a Brexit Breakthrough Mounts Amid General Good Mood Market
    Another ongoing political standoff that both carries broad economic / financial risk and found a seeming break in the cloud cover this past week was the Brexit negotiations. It was difficult to miss the market’s enthusiasm with a Sterling rally that translated into the biggest two-day GBPUSD rally in over a decade. The Pound has shown time and again that while it may feel some of the crosswinds buffeting the global markets, the status of the UK’s separation from the European Union is chief to its bearing and all other matters have their volume turned to zero when there are developments. So, how encouraging was the news this past week? Looking to the headlines, there were updates to reflect upon. UK Prime Minister Boris Johnson and his Irish counterpart Leo Varadkar stirred hope when they both offered enthusiasm after their meeting, saying there was a “pathway” forward as they discussed the contentious border. That was followed by a meeting between the EU’s main negotiator Michel Barnier and UK Brexit minister Stephen after which it was stated they 'look forward to these intensified discussions in the coming days'. Though nothing material has yet been agreed to, this seems like a meaningful break owing to the language alone. Neither side has voiced confidence in their discussions for some time, so this does represent a significant change. 
    With this modest progress, what are the scenarios moving forward? A full compromise on the Irish border would likely set up a true breakthrough for the extended Brexit with an actual deal in hand. If that progress if found, the British currency will continue to climb. While the health and bearing of the UK’s economy and markets will not be able to avoid other known and unforeseen crags, there is a substantial discount to afforded to the possibility of a no-deal outcome. On the other hand, if Johnson refuses to settle on his aggressive position with the country’s withdrawal, there remain certain insurance measures that can forestall imminent crisis. Parliament voted before its court-ordered, shortened suspension period that the PM would have to request an extension from the EU should no deal be struck by October 19. While he has been adamant on the timetable of the exit, it is unlikely he challenges a law, and the EU for its part likely has no interest in triggering a recession in any regional economy by refusing. Keep abreast of headlines that will inform us on the state of talks as well as the planned EU leaders summit on Thursday and Friday. 
    The IMF Updates Growth and Financial Stability Forecasts
    While some cracks in the iron walls of global trade disputes seem to be providing a foundation for speculative enthusiasm heading moving forward, there are still serious fundamental encumbrances to a genuine bullish view of the future. Perhaps the most critical of the risks on the horizon is the threat that the global economy cannot avert its impending stall out. While trade wars have exerted material pressure on growth (the IMF director estimated the US-China fracas was going to cost the world $700 billion in GDP) and even more detriment through investor, consumer, business confidence; there are other – more natural – matters throttling growth. With the US enjoying its longest expansion and bull market on record, a moderation is overdue. I do not fully buy into the belief that periods of growth do not die of old age as there is limited resources that can be utilized to support such a period. That is especially true of the period we have experienced this past decade which has experienced bouts of extreme pace helped along by external and temporary influences such as monetary policy. Fed and other central banks have set their expansionary policy as a key strut to the health of the global economy. What is worrying is that this measure finds as much influence through self-reinforcing speculative belief as it does through genuine distribution of productive capital. That is why it is so troubling that recent waves of stimulus have not been met with the same conviction from market participants and disagreements among the policy setters threatens to further invite scrutiny. 
    In this fragile backdrop, we are expecting an important update on the economic health of the globe this week. In truth, there are important milestones on a weekly basis at this point – from monthly PMIs to sentiment surveys to warnings from supranational groups like the OECD. Yet, what we have on tap is both comprehensive and targeted to perhaps the most contentious situation in the global market. In the latter case, we are due the 3Q GDP reading from China. Though hope for an improved trade relationship with the US is warming markets, the absorbed effect of months of tariffs will show through in this lagging indicator. A poor showing is very likely (whether a new 30-year low or near the previously set figure) or otherwise the markets will treat it with deep skepticism. The only favorable aspect of this update from a trading perspective is that it occurs on Friday, so more anticipation in price action than actual discounting. As for the comprehensive view, we are awaiting the IMF’s updated forecast on world’ growth through its semi-annual WEO (World Economic Outlook). The week long meetings are anchored around this particular update and the new Managing Director, Kristalina Georgieva, has already signaled that the update would downgrade the perspective to the worst course since the Great Financial Crisis. Have her warnings already led the market to fully price in the pain? I will also be watching the groups GFSR (Global Financial Stability Report) very closely. Stability of the markets is one of the more critical accelerants to crises when things start to fall apart and the discussions around the effectiveness of monetary policy are starting to push these questions to the forefront.

  17. 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. 
  18. JohnDFX
    A G20 Meeting of Extreme Consequence
    As far as summits for leaders of the world’s largest economies go – in other words, an already very important affair – the gathering in Argentina this coming Friday and Saturday is crucial. There are a host of global conflicts that will inevitably be addressed at this gathering, but certain aspects will preoccupy the market’s immediate focus. It will be important to recognize what will carry the weight of speculative interest. On the one hand, there are discussion points of great consequence socially and culturally, but those issues will not show their economic consequences much latter and therefore will be largely ignored but for niche corners of the market. An example of this type of discussion point is climate change which has taken on greater importance with countries pleading with the US following its withdrawal from the Paris Accord and the strong of recent, dire scientific reports. In contrast, trade wars, is an ongoing threat to global economic and financial health inevitably drawing an inordinate amount of attention from market participants. 
    Of course, the elephant in the room will be US President Donald Trump who has pushed ahead with the most consequential conflicts on international trade. There will inevitably be numerous pleas made to the leader of the free world to rethink his aggressive approach towards peers. That said, he likely has little interest to hear out there concerns. The mid-term election results will likely redouble his commitment to his current course. To be fair, nearly any outcome would have rendered such a result. Had the GOP swept the polls, it would have been taken as America showing its support. Yet with the outcome that was realized, there is a greater interest in pursuing those courses of action for which he can affect change without the of a divided Congress. And trade is just one such outlet. Alternatively, finding a course out of a discounted crisis could be registered as a political win – though what it would earn for the US markets is another matter. Avoiding a crisis (some would argue one self-manufactured) is not the same as inspiring genuine enthusiasm and speculative run. 
    In particular, this summit should be watched for official and sideline commentary from the US-China discussions. Leaders of the two countries (Trump and Xi) are scheduled to discuss trade at the summit providing an ideal high-level opportunity to afford each an opportunity to claim a political victory. If they change decide to reverse course, it could offer considerable speculative relief and perhaps no small amount of recovery. This could very well be the strategy as Trump has voiced increasingly confident views of the relationship these past weeks that have been walked back by his administration – perhaps to build pressure. If we do see these two countries make nice and start the path towards recovery, yet markets do not translate the news into recovery, I would be concerned about what it reflects for sentiment. Alternatively, no encouraging course correction would be a ‘status quo’ outcome and keep our troubled outlook on its wary course. If the politicians involved want, they can render this event an obfuscated non-mover even without an official communique. Yet, subtly seems less and less standard a virtue of late. 
    Liquidity Restored, Seasonality Conditions and Key Events
    The liquidity tide will roll back in over the coming week. As expected, the drain of US speculative interest this past week due to the Thanksgiving holiday played an effective role in sidelining a concerted effort to mount a system-wide advance or retreat in risk trends. However, the period didn’t end without its troubling signals for the future. The S&P 500 closed a thin Friday trade session with one of the least encouraging candles possible – a gap lower, larger ‘upper wick’, no ‘body’ between open and close and anchored to a noteworthy trendline support. The losses leading up to the US holiday reiterate a troubling frequency of painful losses for the benchmark US indices this year. What’s more, it serves to remind us of the fact that many other corners of the financial system – both in terms of region and asset type – have already trekked much lower. A retreat in US equities would be a general convergence towards significantly weaker global if that were the course that we took. 
    Yet, there is still the natural hold out for seasonal mood disorder – otherwise assumed to be a holiday rally. There is good statistical data to give weight to such expectations but of course there are exceptions to this norm. And, if there were ever a time to worry about a passive climb in speculative positioning, it would be amid a wealth of overlapping and systemic financial risks. From trade wars to the collapse of ineffective monetary policy regimes to growing evidence of excessive leverage (loans, debt, investor exposure), we are dealing with a potentially-toxic environment. As more factions in the global markets recognize the precarious environment for which we are exposed, there is greater threat to fragile stability in key event risk. There is a range of key global events and data due over the coming week.
    In the US, the Fed’s favorite inflation reading (the PCE deflator) will work with the FOMC minutes and Fed speak to set expectations for rate hikes in December and the pace in 2019 which have already suffered in recent weeks. In Europe, the Euro-area sentiment surveys and BoE’s financial stability report will anchor the focus on the region’s quickly fading sense of stability. Chinese and Japanese PMIs will give good proxy for recent GDP in Asia while actual quarterly updates are due from Brazil and India. Now is not a good time to embrace the comfortable warmth of complacency. 
    As the Clock Winds Down for a Brexit Deal, Events Look More Ominous
    There have been a number of notable reversals in fortune for UK Prime Minister Theresa May and the course of the Brexit deal over the past month. And, with each successive ‘breakthrough’ the market has hardened its skepticism over the authenticity of a favorable path for the country’s divorce. We will see just how cynical the speculative rank and general public are at the start of this new active trading week. Over the weekend, May attended the EU27’s summit to discuss the Brexit proposal backed by the Prime Minister. European Council President Donald Tusk announced on twitter that the collective supported the bill, but enthusiasm was held in check with both lawmakers and observers alike. Top EU negotiators reportedly met May on common ground the week before, and the effort was ultimately doomed owing to PM’s own cabinet failing to offer up necessary support to move the effort forward. After the shakeup forced by the resignations of multiple cabinet members, there is little to suggest that she will have any easier a time of navigating the straights. 
    In a few weeks, Parliament will put the deal to a vote; and confidence amongst its members has been shaky at best. Some – even key members to the Prime Minister’s support network – have suggested the current proposal would be not make it through. Should the deal be voted down, the clock will look beyond dangerous to the safe and stable withdrawal for the UK. At that point, May could stick it out and attempt to return with small tweaks latter which may not sway her government or will be too substantial and knock out the EU’s support. That would leave little-to-no time to earn agreement from all parties and scramble to get the passage approval with all governments along with the technical groundwork to set the dissolved relationship up for the March 29th cutoff. Either this course or an explicit refusal to back down on key items can push forward a ‘no deal’ outcome which Parliament has said it will rule against on – though it is not clear what the course will be from that point with so very little time left. 
    There are also a variety of possible courses that end with May be ousted: from her offering up resignation, being pushed out by backbenchers, Labour mustering enough weight to force an election or the PM calling a general election herself in an attempt to gain support. All of these would burn precious time that they negotiations do not have. And, then there is the outlier chance that Theresa May finally entertains the idea of a second referendum which she has adamantly rejected so many times before. That would stop the clock if it were to end with a vote against Brexit or perhaps be used to strategically reset the clock. Whatever course we take, the clock has dwindled and all developments that are genuine progress register as a step to serious pain. 
  19. JohnDFX
    Another ‘Brexit Breakthrough’ Falls Apart
    Yet another potential breakthrough in the Brexit stalemate seemed to be hashed out at the beginning of this past week following hours of legal negotiation and closed doors discussions. Supposedly, a draft bill was worked out that both the Prime Minister and top European Union negotiators were comfortable moving forward with. If there were only two parties which needed to be satisfied in this divorce, that would be that. However, there are multiple parties whose needs in this debate are collectively at opposite ends of the spectrum. And, that inability to satisfy all these necessary groups once again torpedoed hope of progress. After hours of one-on-one meetings with her cabinet, the PM announced that she had received the support of her council only to see the foundation crumble again when a number of her senior cabinet members suddenly resign. And so, the confusion remains and time to work out a viable solution winds closer and closer to zero. It is important to remember the complexity involved in withdrawing from the EU – a move that has never happened in the collective’s history. Approval of the deal is only the first stage. Consent needs to be offered by all member governments and the technical steps need to be implemented in preparation for the first day of the actual split (March 29, 2019). 
    So, even though politicians continue to voice optimism and time, the reality is that their initial assessment was the deal was necessary months ago in order to facilitate a reasonable transition. Moving forward, each week that passes without agreement is going to be met with exponentially greater concern by global investors and businesses. Inevitably, to make the critical breakthrough, one of the major vested parties will need to capitulate on a key point of their position. Remaining in the customs union for the indefinite future for work around on the Irish border is one primary sticking point. It remains an outcome of a hard break or soft withdrawal that keeps the United Kingdom one foot in the Union against the wishes of the Brexit supporters with a black-and-white interpretation of the referendum back in 2016. In my view, there are two general outcomes for this standoff: a compromise or no deal. There are many different possible variants for how the separation can look – with their pros and cons, virtues and vices. Yet, each would represent a plan. 
    Alternatively, a failure to find common ground will disadvantage the United Kingdom and the European Union (more the former than the latter if you really want to keep score). An agreement – any agreement – is needed to prevent a European crisis from developing. And, a crash out would almost certainly start a crisis for the region. Global economic and financial conditions are already tenuous as it is with numerous other threats prodding our over-inflated, speculative balloon including trade wars, Italy threatening EU fiscal stability and recognition of the limits of effectiveness for global monetary policy. A recession-inducing and short-term credit crisis arising from a messy break in this event is certainly one of catalysts broad and acute enough to start the wheels turning on a global scale. 
    Remembering the Volatility and Volume Relationship for Thanksgiving
    We are heading into a known draw in global liquidity this week. The Thanksgiving holiday is distinctly a US market closure, but the break in liquidity from a major financial hub is so well-known – and inconvenient – that the world tends to accommodate the drop in market depth. There is an important measure of habit that fulfills seasonal expectations in performance and activity level year in and year out. If you believe a speculative run that is starting to form will hit a road block because the subsequent session will drain half of the world’s liquidity, would you take the outsized risk exposure in hopes that the drive is so remarkable that it will overcome the disruption? There is one particular scenario for which I believe that an exception to establish an explicit trend despite a thinned market would actually occur: a panic-induced risk aversion. 
    Greed is difficult to gain foothold as opportunities are not often seen as so fleeting as to require such a quick reaction as to override a contented sideline exposure. That said, a sudden crash in the market that puts in jeopardy a fund manager’s or individual’s capital can certainly override confidence in a quick burn. Ultimately, there is a distinct relationship between volatility and volume – or, in more universal abstracts activity level and participation. In a bit of a ‘chicken and the egg’ parable, it is somewhat self-evident that volatility and volume move hand in hand; but not which leads the other. So long as there isn’t an overwhelming threat to the global financial system for which European, Asia and North and South Americans (who are not the US) are driven to flee regardless of America’s participation; the low volume will inspire low volatility. 
    And, for those that have not kept tabs on the VIX or other implied volatility measures, this aspect of the market is considered a ‘risk’ measure with an inverse correlation to benchmark capital market exposure like a long equities index position. If, on the other hand, there is a sharp increase in volatility, it will either draw more volume in to facilitate the development of a trend or cause an extreme response in the market similar to a tsunami gaining height as the water’s depth decreases heading into shore. Normally, I would be little concerned about conditions ahead, but given the list of systemic threats that circle just outside of the market’s comfort zone, it would be risky to assume quiet. 
    A Trade Deal – No Trade Deal – No Credibility 
    It is getting difficult to believe updates on the United States’ position in the global financial system and the prospects of the country’s growth moving forward. It has been a feature of the landscape for years (well into the past administration) to see the promise of an economic improvement crushed by political gridlock. However, the defusing of confidence is happening more rapidly, arising from within a single party and the stakes have grown so much larger through subsequent years of speculative build up. A good example is the infrastructure program that has been touted since the 2016 Presidential campaign for which both Republican and Democratic front-runners vowed to pursue to accelerate growth. Now passed the mid-terms, we have not seen progress made on the fiscal stimulus (though the tax reform and regulatory rollback did earn some points for the buoyancy). 
    President Trump referenced his willingness to return to the effort this past month, but Senate leader Mitch McConnell threw cold water on market hopes when he said the program would not be considered unless it paid for itself – very difficult to do after a tax cut. An infrastructure bill would be an ‘addition to the economic outlook’, while an end to the trade war would reflect the ‘removal of a threat’. Said removal has been something the market has harbored some measure of hope would occur and likely one of the key reasons risk assets like US equities have not imploded. Trump seemed to give traction to that confidence earlier this month when he said that progress was being made in negotiations with China and a deal was on the way after a phone call with his Chinese counterpart, President Xi. The rally that followed those remarks however were quickly stifled when his chief economic advisor outright contradicted the President’s assessment and instead said he was even more concerned about the future than he was previously. 
    One false dawn is enough to undermine the market’s confidence in taking such remarks in the future at face value, but a second time within a few weeks will almost ensure it. This past week, Trump again said a deal would be done with a short list of items left to work out and the need to apply the last tranche of tariffs against the country perhaps not necessary. Before those remarks could take any serious traction, White House officials followed up by saying the market should not read into his remarks. They seemed self-explanatory with no interpretation necessary, so the check reads as outright contraction – a move that will certainly curb the use of forward guidance into the future. If you want to see the fallout from losing the ability to direct market’s to views for the future, look to Japan or Switzerland.
  20. 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. 
     


  21. JohnDFX
    Remove the Political Bias, Focus on the Volatility 
    There has been plenty of political risk keeping the markets at a steady simmer these past months. Some situations like Italy’s budget stand-off with the European Union and the Brexit negotiations are more overt concerns. However, the general rise of populism and the erosion of cross border diplomacy (trade wars, sanctions, failed trade deals, etc) represents a more systemic risk. Yet, despite the ubiquity of this fundamental influence, there is an explicit focus on this theme through the coming week in the form of the United States’ mid-term election. The discourse in the country has become toxic, which will leverage the domestic market’s attention and ensure a broad evaluation of influence to encompass the factors that can steer the economy. Further, given the pressure the United States has exerted on the rest of the world via tariffs and sanctions largely via the Trump Administration’s executive powers, the election takes on global significance. 
    While there is little doubt that the world is watching, there is considerable ambiguity over exactly how it will impact the markets. With tariffs or another break down in Brexit negotiations, it is easy to draw the lines to market influence. In the US election, there is far more social stake and clash of personalities than direct financial implication. That is not to say the ultimate effect on the economy and market are not significant – they are. However, it can be difficult to separate these elements. Nevertheless, it is crucial that we do so. The foundation of successful investing is removing emotion from the equation as much as possible. Besides religion, there is probably nothing more likely to elicit emotion than politics. When we put aside the anger and mania that radiates out from this event, we are left with few possible scenarios that can translate into key domestic and global policies that can impact the markets (see Christopher Vecchio’s article on this for more detail). This election will only translate to the legislative branch when we account for federal reach on key positions. 
    If the Republican party retains both the Senate and the House, that would be seen as the ‘status quo’ as it presents continuity to the situation we’ve had this past two years. It is far from a happy and functional government, but it would still be possible to generate short-term growth via a planned second tax cut plan and perhaps reviving the discussion of an infrastructure spending program. Yet, the growing debt load over the long-term paired against the risk of a slowing economy will loom. If the one or both of the houses of Congress flip to a Democrat majority, pressure will increase significantly. That will lead to difficult progress on programs and likely lead the President to fall back on executive powers to approximate his desires. Overall, that will punctuate the uncertainty and volatility in the markets moving forward – perhaps securing and hastening a more systemic risk aversion for which the market has been threatening since February. 
    The Asymmetric Potential in the Fed, RBA and RBNZ Rate Decisions 
    When there is an event like the US mid-term elections on the docket, it is easy to overlook event risk that is scheduled for release after – and even before – the systemic distraction. Exploiting a very different theme of speculative interest and source of growing concern over the coming week are three major central banks’ rate decisions. Each is expected to end in no actual change to their benchmark rate or other unorthodox policies, but the market is effectively tuned to the nuance for which they were reference in their accompanying reports. Before we consider the potential of each, it is important to consider the wholesale influence that they have on financial system. Whether individual market participants appreciate it or not, the stability and reach of their markets are heavily dependent on the extremely accommodative policies the major central banks have committed to over the years. 
    The abundance of cheap funds has lowered the assumption of risk while also deflating the rate of return – necessitating riskier and leveraged exposure in order to make a competitive rate of return. That translates into considerable risk taking. Should the spectrum continue to slowly shift away from easing to early tightening – following the lead of the Fed – the more readily the masses will recognize the risk in their exposure. That will raise the sensitivity to risk trends and encourage de-risking that can accelerate into a crisis. As for the individual events themselves, the Federal Reserve’s decision will garner the greatest global attention. Despite – or perhaps exactly because of – the Fed’s tempo of tightening, the market’s do not expect a hike at this meeting. The fourth hike the majority of the FOMC forecasted in the September SEP was given a December timetable by the market’s. No change, but language that confirms a fourth hike would leave the Fed untouchable as the most hawkish central bank for carry purposes, but the market will treat it as status quo. The most feasible surprise would come in more restrained language that would curb established rate expectations which would in turn sink the Dollar (and likely risk trends). 
    In contrast, the Australian (RBA) and New Zealand (RBNZ) policy events are expected to end with no change and language that reflects the same ‘neutral with a modest dovishness’ that they have maintained for the past few years. Both the Australian and New Zealand Dollars have deflated for months to the point where they have significantly reduced their responsiveness to their detrimental yield bearing. Even if the groups raised the stakes on their dovish views, it would likely translate into a small market response. Alternatively, should they offer any improvement in their view and possible intentions, there would be a disproportionate rally from their currencies. 
    He Said, He Said: US-China Trade War, Brexit, Italy 
    Though we do not have the benefit of specific events and time frames on updates for some of the other more systemic concerns lurking in the financial system, that doesn’t make them any less potent a threat. Though the coming week, there are three general themes of ongoing concern that will remain on my radar. The First is the US-China trade wars. This situation has managed to avoid a clear path much less a genuine resolution to the point that markets are starting to grow wary of any remarks that could be considered signs of an improved path. This past week, we were reminded of the importance of this cold economic war when conflicting views were espoused – this time on the same side of the negotiation table. The US President voiced his optimism that a corner was turned in the negotiations after a call with his Chinese counterpart with reports that he had called on his cabinet to draft a proposal to find a solution. That helped extend the capital markets’ rebound. Yet, that optimism was quickly muted when Trump’s chief economic adviser said he was not given direction to come up with a plan and that he was less confident about the future of the relationship than he was in previous months. And, just to ensure we were fully confused on the point, the President made further remarks soon after the adviser reiterating his initial statement. 
    Look for any mentions of production discussions before the G20 summit over the coming week first as campaign rhetoric and after the election as planning. Across the pond, the Brexit situation seems to find itself steeped back into despair after brief interludes of optimism charged by supposed progress. At this point, the holdup is finding agreement on the UK’s side. Last week, the earlier reports that the Prime Minister was willing to make concessions on an important point of disagreement to make a breakthrough, progress yet again stalled as her cabinet revolted. There is a cabinet meeting on Tuesday. Theresa May will need to get an agreement from her own government under the new parameters whittled down with the last EU Summit rejection. In the background, there are rumors that a solution is being honed in on, but their rhetoric in public certainly isn’t doing them any favors in market and business sentiment terms. 
    Then there is the clear contrast in perspective between the Italian government and other European Union leaders. There is no ambiguity in this contentious disagreement. Italian leaders have repeatedly committed to increase spending well beyond what the EU considers acceptable. European leaders and central bank members have shown little interest in making an exception to the austerity rules for the region (and a backstop should market’s punish Italy in the latter’s case) for fear of losing stability internal and confidence externally. If capitulation is not found from one side, there is really no alternative solution as they head towards an existential crisis for another member finding its way out of the Union. And, unlike the UK, Italy is more deeply integrated as a member of the monetary agreement that shares the same central bank and currency. 
  22. 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. 
  23. JohnDFX
    The United States and China Jostling for Economic Supremacy
    The world’s largest economies are starting to update on the status of their health. And, though it may not seem to be the case in these speculatively charged markets, financial performance relies heavily on a healthy global expansion. This past Friday, China reported its third quarter GDP reading. The 6.5 percent clip would be an enviable pace for most of the developed world, but for this debt laden country, this is slowing to a pace that is more likely approaching ‘stall speed’. In historical context, the reading represented the slowest clip of expansion for the country in 9 years – a period that was plagued by a global recession that had in turn prompted the government to plow funding towards infrastructure spending to buy it more time. Time is crucial for the world’s second largest economy. It needs to be balance its relatively rapid pace of growth with financial stability long enough that it can solidify its position as one of the dominant economic superpowers. 
    For decades, the country has relied on the rapid growth that is borne from trade, financing, speculative appetite and practices that emerging market countries often utilize that are considered unacceptable among their developed counterparts. That said, it is odd that the second largest economy is still classified as an ‘emerging’ market and one of the roots of contention from the United States and others. Over the past three to four years, China’s intent and timeline have become more clear. Having avoided a the Great Recession, they had seen their standing in the global economy move up to a more stable plateau. To ensure they secured their position, the government has attempted to turn towards a more accepted growth plan and to reduce capital borders in order to become a full-fledged member of the globalized community. Without interruption, that initiative would have succeeded. Unfortunately for the Politburo, the Trump Administration has exerted enormous pressure on the country and threatens to undermine growth and/or tip the financial stability balance to create a permanent hurdle. 
    The question of how successful this effort to stymie the economic engineering effort will be is only one facet of the equation, there is also the question of how much fallout the US itself will suffer along the way. The United States’ effort to bring trade pressure against its largest economic peer will come with an economic cost to the instigator, which they are attempting to offset by fostering investment and business growth through tax cuts and fiscal spending – a combination that breaks norms of its own (deficit control). In the week ahead, we are due the United States’ 3Q GDP update. This is the period through which the trade war truly ramped up, and it will be used as an evaluation of whether the polices are boon or burden at home. Should this and other more timely economic readings head lower, buoyant sentiment readings over the past year will start to flag and make a self-fulfilling prophecy of financial concern. 
    The Euro’s Fundamental Path is Growing More Complicated 
    For the most part, the Euro has spent the past 18 months either in a fundamentally enviable position or simply a neutral bearing that could take advantage of weaker counterparts. Economic activity has been slow but steady with members bearing extraordinary austerity following the Eurozone sovereign debt crisis finally turning a corner. Further, the initial threat of the region having to pursue the same costly economic war against the United States was averted when EU President Juncker agreed with US President Trump to avoid further tariffs so long as both sides continued to negotiate. Meanwhile, the mere anticipation of a rate hike from the European Central Bank leveraged the kind of speculative front-running appeal for the Euro through much of the past year that so closely mirrored the Dollar’s own charge in 2014 and 2015. That passive state of speculative appeal is starting to falter however. While growth readings still seem to be following a stable path, the commitment to slower growth to achieve fiscal improvement through austerity is starting to break down. Populism is spreading across the continent. 
    Chief concern in the evaluation of Euro-area conviction is Italy. The country’s government has applied pressure and backed off in regular tide of ebb and flow; but through these phases, ever increasing the tension. It seems we have reached the point of no return where rhetoric will no longer be enough to satisfy markets. Heading into this past week’s EU Summit, the leadership of the Italian government made clear that it intended to rebuff budget restrictions to support growth and fulfil campaign promises. There was no mistaking the Union’s perspective on Italy’s intended path: they said the spending and deficit projections in their plans were unacceptable. This standoff remains unresolved, but the financial markets are starting to pull back to curb their exposure to the risk. The FTSE MIB is suffering more acutely than its large counterparts and Italian sovereign bond yields are climbing rapidly. A 10-year yield spread of over 400 basis points over the Germany bund equivalent is considered a level akin to serious financial pressure.
     We were just above 300 basis points to close out this past week, but that was before the news after the close that Moody’s had downgraded the country’s credit rating a step to Baa3. That will have an inevitable impact on funds that have to abide credit quality when dictating their exposure. In the week ahead, we have another assessment of Italy’s financial condition coming from Standard & Poor’s. This fundamental impact on the Euro is not the only theme competing for influence. Monetary policy is another fundamental strut that could buckle or hold the currency strong through the growing pressure. There is no change expected from the gathering Thursday, but there is growing concern over the internal and external risks for the Eurozone. If they cool expectations for the first hike coming mid-2019, there is still premium for the Euro to give up. A further complication to consider: if the Euro drops materially, expect the Trump Administration to raise its pressure on the regional economy. 
    Brexit Risk Jumps after EU Summit, Rumor of Border Breakthrough, Protests and New Credit Ratings 
    The Brexit countdown is taking on a Edgar Allen Poe-level resonance. The European Union summit this past session was specifically targeting discussion between the UK and 27 leadership to see if they could make a high-level breakthrough on the divorce proceedings. The primary hold up at the end of the gathering remained the border issue and the complications that it invites. It may seem that there is plenty of time to negotiate with a little more than five months until the official split, but there is considerable work to do in passing the proposal through so many different governments and working out the technical aspects thereafter. So long as this situation is unable to pass the critical step of an acceptable draft agreement between both sides, the Sterling is likely to see steady retreat as capital funnels out of the country to avoid the uncertainty facing London’s financial center specifically. With the risks growing, the attention on progress will intensify. 
    With that said, there seemed a possible breakthrough in the closing hours Friday when it was reported that Prime Minister May was prepared to drop their Brexit demands on the Irish border issue in order to earn a breakthrough. Such a move would likely earn the ire of Brexiteers who would balk at likely permanent participation in the EU’s customs union. It remains to be seen if the UK’s government would back such a appeasement, but it doesn’t seem enough for many Brits. Over the weekend, a protest in London calling for a second EU referendum drew reportedly between 600,000 and 700,000 participants – one of the largest in the capital’s history. It is unlikely however that the government will return to the polls on the issue unless there are a number of political turns that force the issue. Ahead, we will have to keep a very close eye on the headlines to see what transpires in the political environment in England as well as between the UK and EU. That doesn’t mean though that there aren’t any meaningful milestones on the docket to mark on our calendars. 
    At the very end of the coming week – after the close Friday – we are due two credit rating updates on the United Kingdom from Standard & Poor’s and Fitch. These groups have generally maintained a wait-and-see perspective until it became clear that there would be a compromise scenario or a crash out. However, time is a factor that they can no longer ignore in this equation. With each week that passes without a breakthrough, the economic and financial ramifications deepen. More stark warnings are likely if there is not a confirmation of the border issue and a downgrade is not impossible.  
  24. 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.
  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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