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JohnDFX

DFX Market Analyst
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  1. 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.
  2. 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. 
  3. JohnDFX
    The Trade War Spreads to More Critical, Global Growth Organs 
    We have been unofficially engaged in a global trade war since March 2018. That is when the United States moved forward with a tariff on imported metals (steel and aluminum) from any destination outside of the country. Since this opening salvo, there have been small actions against countries outside the singular focus of China, but the incredible escalation between Washington and Beijing has drawn most of the global attention. With tariff rates running as high as 30% on over $350 billion in goods between the two economies, it is no surprise that we evaluate the growth-crushing competitive efforts on the basis of these two superpowers alone. As it currently stands, we are still awaiting another wave of products receiving a hefty tariff rate upgrade in approximately two months’ time while talks are set to resume on Thursday between the two parties. That said, reports over the weekend indicated China was not impressed with the Trump administration’s most recent efforts to find middle ground. It is important to keep tabs on the situation between the US and China, but at this point the markets seem to place greater emphasis on the data that reflects the tangible repercussions of their fight. If you want to watch the next stage of painful escalation in this systemic threat, it seems clear that the tension between the US and the European Community is the emergent battlefield. 
    There are already a few active trade levies between these two largest developed world economies, but most of the systemic threats have been reserved to an escalation in mere threats….until now. This past week, the WTO (World Trade Organization) ruled that the United States could raise $7.5 billion in tariffs against the EU for unfair subsidies supporting the region’s principal airplane manufacturer, airbus. The US Trade Representative’s office wasted no time in moving forward with the punitive action. That itself is not a surprise nor even a serious controversy. What was provocative were the details of the United States’ plans. The country announced a 10% tariff on imported airplanes, but it would slap a far more punitive 25%  tax on European agricultural and industrial goods. That is a move that registers more directly as a trade war action, moving well beyond the cover of WTO ‘sanction’ (the group urged negotiations) and encouraging reprisal. To their credit, the EU held back from retaliatory actions this past week, hoping that an understanding could be met. That said, they EC will not wait forever. It was reported that they were ready to react immediately before the ruling, and they have been quick to respond verbally to all of the US threats over the past months. If we go down this route of a trade war even half the scale of what the US and China have committed to, expect forecasts for global recession to change from an outlier of the pessimists to the baseline view of the investing masses. 
    A Near-Daily Update on Recession Fears 
    Until late August, the word ‘recession’ was only uttered by conspiracy theorists or serial pessimists. That reticence was despite a growing wave of economic data, sentient surveys and supranational organizations warning that a stall could be in he not-so-distant future. That isolation has dissipated quickly over just the past few months. The inversion of the US 10-year to 3-month yield curve was the first distinct cue that the market and then media picked up on. With a moniker like ‘economists’ favorite recession signal’, the headlines wrote themselves. Once attention was called to the frailty of the longest running expansion on record (at least in the US), the other holes started to become more overt. In the US, the NY Fed’s own recession indicator listed the probability of contraction for the world’s largest economy over the next 12 months above 30 percent – a signal that has indicated momentum into the genuine article in all but one instance going back decades. Meanwhile, the warnings from global groups have been taken more seriously: such as the OECD, WTO and IMF over these past two weeks – warning of significantly slower growth though not necessarily full contraction. Data has similarly indicated trouble from US and Chinese manufacturing contraction (‘recession’) to some full GDP readings around the world actually printing a negative monthly or even quarterly report – an official recession is two consecutive quarters of contraction according to the NBER. 
    Ultimately, the market determines what is important or market moving. We have seen numerous data points and warnings shrugged off by the markets over the past years because the speculative bias was such that market participants were happy to allow complacency to dictate a capital market drift higher. That does not seem our undercurrent at present however. Since the February 2018 plunge, we have seen a serious struggle among speculative interests to lift the markets back to their previously-set all-time highs, much less beyond them. The US indices were the most bubbly among the traditional risk assets and even they have not progressed far beyond the early 2018 swing high. Most other recognizable benchmarks are significant lower than their respective peaks from that year. In other words, the markets are paying closer attention to warning signs and are more willing to leverage their occurrence into meaningful market movement. With that setting in mind, there are a number of indicators this week that can stir our imaginations for the worst including: China service sector PMI; China foreign reserves; Eurozone investment sentient; Japan household spending; Germany industrial production; US small business sentiment; US consumer confidence; UK July GDP and Germany factory orders among many others. Keep tabs on the economic calendar as well as the headlines (Google search of ‘recession’ is quite informative).
    Gold – When Fundamentals and Technicals Conflict
    Gold is perhaps one of the indicative signals from the market as to the state of the global financial system and economy that you can find from any single source. The precious metal is a well-known safe haven, but its climb this past year has deviated significantly from the performance of fellow measures like the Dollar and sovereign debt not to mention risk assets like US indices. Its position as an alternative to traditional fiat is far more important. With central banks once again turning to expansive policy regimes while economic forecasts barely budge, there is a natural depreciation of all assets that represent this quandary: which includes currencies and government debt. There are few reliable alternatives to these traditional stores of wealth – especially when they are all dropping in tandem (Dollar, Euro, Pound, Yen). One of the very few, historical benchmarks that can meet the test is gold which is global and has played its role as a means for exchange many times through history. Given this unique role, consider the outlook for the economy and markets. Even if you don’t believe a recession is at the door, the threshold for significant expansion is very high at this point. Further, there is not much room for easy speculative gain but enormous room for retrenchment. Where would you seek safety and stability if push came to shove? 
    We – the market at large – were faced with that existential question to some degree this past week. On a technical basis, the precious metal took a remarkable bearish jog, a move that textbooks would place a high probability on fueling an overwhelming bearish trend. This past Monday’s drop cleared two months of range resistance that happened to also stand as the ‘neckline’ on a large head-and-shoulders pattern over the same period. There are few more preferred reversal measures among pattern watchers. If unencumbered by fundamental complications, speculative fear could have readily taken over and guided a more significant move for the bears. Instead, the reversal stalled immediately upon launch. This is the conflict that can arise when two favorite analytical techniques conflict. There is considerable debate over which measure is more indicative and reliable. In reality, they both have their merits and place. The backdrop and depth of catalyst can tip the scales of influence from one method to the other. Yet, if you are a trader willing to considerable a broader picture of the market in order to identify more reliable signals, it is better to find opportunities where the techniques coincide rather than conflict. Yet, in this world of contradiction, it is worth watching gold on a regular basis whether you intend to trade it or simply use it for signaling purposes. 
  4. 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.

  5. JohnDFX
    A Habit of Cutting Down Progress Towards Ending Trade Wars 
    This past week, optimism was dangled in front of the markets and violently snatched away before it became too established. We have been dealing with the escalation of explicit competition in trade policies for the since March, and each hint of progress in turning the major players back from economic stalemate has been consummately dashed. This past week, there were two fronts on which it seemed we were heading for an important breakthrough. The first upswing would come from the NAFTA negotiations. After US and Mexican officials seemed to come to an understanding on bilateral conditions, it was reported that Canada was coming back to the table to see if it could hash out its own understanding with the United States. With a soft ‘deadline’ presented for this past Friday it seemed there was the will and momentum to secure a trilateral agreement that could provide stability in the relationships between these major economies. Instead, Canada’s Foreign Minister announced they had not come to an agreement. In a now-familiar style of reaction, President Trump said the US was ready to go without Canada and said Congress should not interfere in the negotiation. 
    The US President would also dash building confidence that the US and EU would head off a more threatening economic standoff between the two largest economies in the world. EU Trade Minister Malmstrom made remarks earlier in the week saying the Union could cut tariffs on US auto imports to zero if the US would do the same for European cars coming into their country. That was seemingly what the President was looking for in previous remarks, but rather than voice pleasure that talks had taken a favorable turn, Trump stated it was ‘not enough’. These developed world trade threats are ominous for global growth and the healthy flow of capital across the world’s financial centers. However, they are not as yet as intense as the impasse between the US and China. There was no material sign of improvement from which we could garner a fresh sense of disappointment this past week. The previous restart of talks between the two superpowers notably led to little traction according to US leaders. There has been little in the way of encouraging rhetoric from either side in the meantime. 
    Furthermore, there are reports that President Trump is intent on pushing through the next, more onerous round of tariffs on the largest foreign holder of its sovereign debt. The open period for the public to weigh in on a proposed additional $200 billion in taxes on Chinese imports was original set for August 30, but was supposedly pushed back to September 5. Either way, the ultimate decision by the administration is likely soon – with some administrators believing news could come as soon as next week. This begs the question: at what level of total taxes or number of active trade war participants will global investors turn their fear over ill effects into action?
    What to Watch for as We Turn to Fall Trading
    Summer in the Northern Hemisphere doesn’t officially end until September 22; but for most intents and purposes, it came to a close this past Friday. Historically, August is the last month of the doldrums and the week preceding the US Labor Day holiday weekend is the final true week of passive drift. There is not a definitive flick of the switch from Friday August 31st to Tuesday September 4th where markets turn from listless chop back into full-fledged trend. That said, same seasonal factors the market abided by to overlook pressing issues such as trade wars, growing political risks and central bank commitment to normalize monetary policy will transition into active trade for a month that historically averages the only loss in the calendar year for the benchmark S&P 500 and is one of the top standings for volatility according to the VIX. 
    It is possible that anticipation has been building up to this cyclical pivot and the weight of all of the aforementioned risks will come crashing down on the complacent market. More likely, we will see the ill-effects of eroding fundamentals slowly wear away at the speculative resolve that has promoted a situation where the S&P 500 is at record highs while the Vanguard’s World Index ex US fund (VEU) and Emerging Market ETF (EEM) are carving out multi-month bear trends. Important with monitoring the balance of the markets moving forward are the measures of general speculative activity and the relationship across favorite risk assets. Volume is almost certainly to increase over the coming month, and there is a long-standing correlation between turnover and volatility. For those keeping count, volatility has an inverse relationship with risk-leaning assets such as equities and carry trade. Open interest – essentially participation – will also be important to monitor. 
    Are bulls significantly adding to the S&P 500 via cumulative shares, the SPY and eminis as it traverses new records or is stagnating (perhaps even declining)? As markets deepen and volatility increases, the discrepancy between risky assets (and typical havens) will demand reconciliation. If a broad appetite behind speculative benchmarks does not return, the incongruity will draw increasing unwanted attention from those looking to honestly evaluate the risks of their portfolios. 
    Who is Devaluing their Currency and Why
    Not long ago, President Trump lobbed accusations against Chinese and European authorities for devaluing their respective currencies to afford unfair trade advantages. This was likely a means to add further justification for pursuing aggressive confrontational trade policies against these major economies that draw painful retaliations against American consumers and businesses in the process. It could also be the pretext for the US exacting its own FX policies that would categorically touch off a financial crisis as the market re-assesses pricing, reserves and economic relations wholesale (something we’ve discussed before). With big questions ahead of us, it is worth assessing who is utilizing policy currently that can fit classification of currency manipulation or may have in the recent past. The most frequently accused world player is China. And, there is obvious policy adopted just recently that qualifies it for the label. One of the country’s primary FX administrators (the People’s Bank of China or PBoC) announced a change to its pricing method that was clearly aimed at reducing volatility – and not so subtly meant to prevent the continued decline in the offshore Reminibi. That was a move that was likely taken in part to take the wind out of Trump’s manipulation claims sails as well as to head off concerns that there was a building wave of capital flight. These are moves that can be labeled efforts to curb political stress and prevent a financial crisis, but they are most definitely manipulation. And, distortions imposed long enough eventually lead to crises. 
    As for the allegation directed at the Euro, the 2014 monetary policy connection the ECB made to EURUSD at 1.4000 was rather egregious. However, the application of rate cuts to zero and expansion of its balance sheet afterwards didn’t deviate far from many other large central banks – they were just late to the game and thereby less effective. Keeping up the argument recently finds much less weight as the Euro rallied in 2017 despite the Fed’s persistent hike pace while the European bank itself has signaled it plans to normalize in the foreseeable future. If the British Pound has purposefully been devalued to afford it trade advantage in this world of plateauing growth, using Brexit to afford this advantage would have to be the worst possible route. Japan has a long history of outright intervention on behalf of its currency owing to its dependence on trade, but both the Finance Ministry’s direct Yen selling and the Bank of Japan’s (BoJ) indirect monetary policy effort have seen their effectiveness fade after so many successive rounds. Both the RBA and RBNZ have attempted to ‘jawbone’ (talk down) their currencies, but that is something nearly every major central bank has done and it is just as ineffective for all. We could label the groups’ passive monetary policies as moving them out of favor as carry currencies, but that would be a poor plan as well as they will not attract foreign capital to help establish financial stability. 
    The SNB clearly enacted a program meant to devalue its currency with negative rates and a hard EURCHF floor, but that effort failed spectacularly and the central bank now has to deal with the fallout from a lack of credibility. And, then there is the US Dollar. Was the Fed’s piloting the QE program after the financial crisis evidence of an effort to gain trade advantage? Perhaps expanding to a QE 2 and QE 3 even though the economy and financial system was no longer in crisis was the evidence? Or perhaps the Trump administration’s efforts to play down the long-held ‘Strong Dollar’ policy or the President’s ruminations over Fed policy and accusations against other trade partners? In some way, everyone is engaged. 
  6. 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. 
  7. JohnDFX
    Positioning Extremes Grow More Extreme 
    There are a few undisputable and universal forces when it comes to the financial markets. One of those all-powerful winds is the concept of risk trends which is referred to by many names such as ‘risk on, risk off’ or referenced unknowingly when we blindly attribute market wide movement to animal spirits through technical cues, smart versus dumb money, panic to greed. Another of these truisms is the allocation of capital. While total wealth does grow and contract, it is apportioned to some market whether that is emerging market equities to US Treasuries to home mattresses. In a global market, there is also distribution to different regions according to what country or collective economy presents the best opportunities. And, from this parsing of investment preference; we can learn a lot about the market; but one of the most elemental solutions is the global market’s general bearing for sentiment (the risk trends referenced before). There are no easy, definitive measures for allocations across such a wide universe of markets, but there are various measures for specific areas and key ports for which to apply measure such that we come to a good understanding of the markets’ health. 
    One of the most basic measures of preference on a regional basis is exchange rates. We have seen the USDCNH surge the past few months showing capital leave China and enter the US. That is likely a bi-product of trade wars and can signal deeper problems for China if they risk signaling to the world that there is capital flight that can disrupt their efforts to promote stability between economy and market. Given that there is certain control that Chinese authorities have over their systems, we could get more complicated in the evaluations by comparing the USDCNH to the USDHKD, look to derivatives or wait for the lagging economic data like the TICs from the US. Another good equivalence is the performance of ETFs. These derivatives are quickly becoming favorite products for global investors due to their supposed risk reduction through diversification (we heard the same thing with AAA rated subprime housing MBS 11 years ago) and the wide range of coverage they offer. There are measures of capital flowing into and out of specific, liquid ETFs (ie SPY, TLT, FXI) as well as general groups (all equity versus all bond). 
    Another measure of positioning is the use of leverage. We may not know what people are doing with their cash in many instances, but the use of borrowed funds is often better tracked as the ‘investors’ (or lenders) want to know their exposure. As it happens, in the US, there is record use of leverage by investors, consumers, corporations and the government. Further measures of positioning are the sample readings like that on the DailyFX Sentiment page which shows retail traders (who have a very short time frame and primarily fight existing trends) and the CFTC’s COT report of speculative futures. From the latter, this past week has shown a dramatic swing in Dollar interest from the biggest short in 5 years to the heaviest long in nearly 2 (all in a few months), Treasury net short has hit a dramatic record low, and gold flipping to net short for the first time since 2002 among other surprises. There is a lot to learn once you know what to look for and how to put it into context. 
     
    A Lesson from the 2013 Taper Tantrum Applied to a Global Scale 
    Back on June 19, 2013, then-Fed Governor Ben Bernanke announced that the US central bank would begin to ‘taper’ its theoretically open-ended bond buying stimulus program (known as QE3). By the time he stated their intention, the market had already suspected this was going to take place owing to the language of the group and the performance of data coming out of the economy. However, the announcement had a significant impact nonetheless. What resulted was termed the ‘taper tantrum’. In response to this news, US Treasury yields shot higher as the markets largest sovereign debt buyer at the time announced their intention to reduce purchases moving forward. And that had a material economic effect as the cost of US Dollar-based loans – particularly for foreign buyers who had exchange rate risks – started to shoot higher. 
    It therefore comes as little surprise that emerging market corporations that borrowed funds in Dollars shuddered at the news, and the EEM Emerging Market ETF showed the discontent. However, after some months of fear, conditions stabilized and borrowers and investors acclimated to the notion of higher costs. Even if they were exiting the active rate-depression game, they would still be low for a long period of time. What’s more other central banks like the ECB, BoJ and others were still at or near record lows with some pursuing equally massive stimulus programs. As such, complacency returned for some years after. Yet, where are we today? 
    We still have that telltale complacency – as mentioned above – but the foundation of confidence has continued to erode as global central banks have reached the end of the road. Either they are willfully plotting their own exit from their extraordinary accommodative states (like the ECB, BoE, BoC) or they are floundering as the market realizes they have essentially reached the extent of their influence (BoJ, SNB, RBNZ). Financial markets from equities to real estate have performed remarkably well in the interim, but economic activity and inflation plateaued long ago. That has produced an elevated risk exposure without the economics to fund the exposure. So, with exceptional risk, moderate economic potential, external pressures increasing (trade wars) and central banks either easing back or losing tractions; it is worth evaluating that 2013 ‘taper tantrum’ and consider what the possible implications would be if we raised the stakes from one country to the world. 
     
    Jackson Hole Symposium and US-China Trade Top Event Risk
    The coming week carries one of the most deflated expectations for seasonal activity for the financial markets. The Labor Day holiday for the US (September 3 this year) traditional signals a change in ‘Summer Lull’ activity to a more active and liquid Fall trading. These activity levels are as much self-fulfilling prophecy as actual liquidity phenomena, but it occurs nevertheless. However, a footnote here before we analyze further. There are some dramatic examples in our recent past where volatility as exploded in August despite the conventions. The 2015 market-wide tumble triggered by Chinese exposure fears began in August and the same month in 2011 led to global losses for shares and other risk assets as the Eurozone debt crisis unfolded. We should never rely on market parables when we are employing our capital – especially when so many global risks are so plain, such as a possible Chinese crisis arising from the US-China trade war or Italy threatening Euro-area stability to register as echoes of history. 
    This said, the standard global economic docket is particularly thin over the next five days of active trade. It would be fitting to assume the markets are just going to drift down a lazy river if we did not appreciate the broader context. While the biggest risks to our immediate future are likely unknown fundamental waves, there are two themes that are scheduled and we can follow as they unfold. The first is the US-China trade war. The US Trade Representative’s office is expected to hold a public but off-camera hearing on Chinese tariffs throughout the week. It is worth reminding that the Treasury has left public feedback open until early September until they decide on whether or not to proceed with the $200 billion in new tariffs President Trump threated some weeks ago. More promising, US and Chinese officials are due to restart trade talks on Thursday and Friday. It was reported that this meeting will start to build a map that can take the countries back to more favorable terms such that the countries’ two Presidents can agree at the highest level when they meet in November. 
    The other high-level event to watch over the coming week is the Jackson Hole Symposium. The annual meeting of central bankers, business leaders and key financial lawmakers hosted by the Fed can cover crucial developments in global markets and the economy. The official theme of this conference is ‘Changing Market Structure and Implications for Monetary Policy’, but expect the conversation to touch many of the key themes mentioned above: global retreat from extreme easing, the failing effectiveness of stimulus, global pressures via trade wars and the extremely inflated levels of global capital markets.
  8. JohnDFX
    Monday’s Open: Trade Wars Status Quo That Really Isn’t 
    The G-20 Summit has passed and by the accounts of the key players, the results were encouraging. I guess no new fronts have been added to the global economic conflict after the two-day meeting, so that is a silver lining we can hold onto if we wanted to be optimistic to the point of true enthusiasm.  According to President Trump’s account of his meeting with his Chinese counterpart Xi Jinping, their discussion was a success as it reportedly signaled the restart of negotiations between the two countries. To be sated by this news would mean ignoring the fact that they had supposedly never officially broke off talks and being on speaking terms is about as low as the bar can be set. The genuine improvement in circumstance after this summit was the fact that the White House’s threat to put another $300 billion in Chinese imports under the 25 percent tariff. The US President also announced that he was lifting the ban on US firms selling products to banned Chinese telecom Huawei – though the company remains blacklisted and cannot export its wares to the United States. 
    The real question heading into the new trading week is how this news is leveraged: by bulls or bears, to charge conviction or short circuit intended trends. If we do see the market buy into the optimistic perspective of the US-Chinese negotiations, it will prove very difficult to develop any meaningful trend. This outcome is tuned more towards a relief rally. That being the case, there was never a significant discount established in the broader markets. These past weeks have seen speculative assets rise with the S&P 500 and Dow in particular anchored to record highs. That would suggest that the markets may in fact have been pricing in a more significant improvement of circumstances which could completely drown out any low-grade rally that could arise. Further, in this conflicted backdrop, it would be very difficult to sustain a troubled risk-on rally with liquidity under pressure owing to the US Independence holiday on Thursday July 4th. A middling risk rally would very unlikely override shallow markets.
     
    Alternatively, a bearish take on the after-action would likely trigger deeper misgivings in the markets and potentially tip a selloff that can override thinned conditions. This scenario could start as a retrenchment as the excess premium afforded to an assumed reversal in one of the most abstract and wide-reaching fundamental threats registered in years (trade wars). It could further grow into an appreciation of the economic pain that is slowly compounding as the efforts put into place thus far build upon the burden in economic activity. That is recognition of true fundamental struggle that contradicts superficial speculative ambitions that have placed greater emphasis on the expectations around the likes of the Fed rather than the tangibility of GDP. While generating enough conviction to carry risk aversion through the liquidity drain this week, it is far more likely to happen in a fit of panic rather than greed; and this is the type of falling fundamental start that can get the ball rolling. 
    Seasonal Forces Versus Fundamental Winds 
    Generally speaking, there are strong fundamental winds blowing in these markets, but the urge to revert to restrained market conditions as is familiar during seasonal lulls like we are expecting during this ‘height of Summer’ week will prove a powerful deterrent. Seasonally, July is more buoyant for expected volatility (via the VIX volatility index) than June; but that is not saying much for state of turnover throughout the average year. Also, Thursday’s Fourth of July holiday is really only a US celebration; but the expectation for sidelined speculative activity fuels an assumption among the global rank that is often realized by sheer force of will – or want. Looking to the same historical norms, low volatility has also contributed to stronger performance for risk appetite, which fts the assumed inverse correlation between the likes of the VIX and the S&P 500. Given the record high of the latter and general premium-despite-fundamental-trouble for the many other speculatively-linked assets in the open market, it would be difficult to leverage genuine gains through the forthcoming period. 
    Overriding liquidity conditions is difficult to do whether attempted through fundamental or technical means. It is, nonetheless, significantly more probable to mount an offensive when there is a common event or theme for which a wide swath of the market can line up behind. Trade wars referenced above is one such deep well upon which the speculative rank can draw. Another is monetary policy. This past month, the remarkable recovery mounted by the vast majority of risk assets seems to have a very clear connection to monetary policy. In particular, the Federal Reserve’s policy decision and forecast on the 19th was seen as a boon to doves. It should be said the group did not cut rates nor did it indicate any intention of easing through 2019, but the market took what it wanted from the event. That is another point of speculative reach.
    In the week ahead, there are a number of events and data points that could hit at this fundamental disparity, but Friday’s June employment report (NFPs) is the most distinct. If the general strength of the data holds firm, it could sharply drop expectations for a July cut – presently priced at 100 percent according to Fed Funds futures. Then again, if the data drops sharply, the implications for growth moving forward could lead the market to think more critically on the shortcomings of any future central bank efforts, as impotent as they already are. 
    Setting the Course for the Official 2Q GDP Readings
    While monetary policy is a theme that will follow one of the top highlights for event risk in the coming week and trade wars will following the G-20 summit headlines, the most comprehensive matter to hit upon through the breadth of the period will be growth. Interest in the health of the global economy has simmered for months between the cumulative pain afforded to the trade issues, the uneven state of financial assets, questions over the policy authorities’ (central bank and government) willingness to offer backstop, the serious erosion of confidence surveys and specific high-profile market developments like the inversion of the 10-year / 3-month Treasury yield curve. That all builds into greater deference to be paid to the forthcoming official round of 2Q GDP readings that will start to cross the wires in a few weeks’ time. That run kicks officially on Monday July 15th with the release of China’s 2Q GDP figure. In the meantime, there are a host of economic readings on tap for this week alone. 
    As far as comprehensive views go, a Bank for International Settlements (BIS) annual economic update will most likely give a more dire assessment of what the world is looking at heading into the second half of 2019. This group is known as being frank about risks and somewhat pessimistic, with no compunction when it comes to warning over the instabilities developing in the financial markets. They will almost certainly decry the state of global trade and the precarious nature of risk taking. In data terms, the Friday NFPs are a good barometer for the health of the world’s largest economy, however, I put greater emphasis on the ISM’s service sector activity reading for June. That particular segment of the economy accounts for approximately three-quarters of output from the behemoth.
    That said, if the service and manufacturing reports from the group point to the same general direction, the implications are far greater. For a global perspective, there are Markit-observed PMIs are due for Asia, Europe and North America. We are expecting ‘final’ readings for Japan, the Eurozone and US; but the figures for China, Italy and UK are just as important to the overview. As with many fundamental dimensions nowadays, there is a significant bias in terms of impact for different bearings. A firmer showing would act as mild justification for the already optimistic slant from the markets. A worsening conditions will draw further and further on the discrepancy in speculative view and excess market pricing. 
  9. 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. 
  10. 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. 
  11. JohnDFX
    Jackson Hole Symposium Has Too Much to Cover 
    There are two particularly important, multi-day summits scheduled for this coming week. Given the individual market-moving capacity of US President Donald Trump, the G7 Summit from August 24th through the 26th will be particularly important to watch. He has announced remarkable change in policy at or around such large events before – particularly when provoked by flabbergasted global counterparts. There are five general topics on the agenda which are all important but the market-centric among us – and who wouldn’t considering them more dialed in given the state of the economic outlook – will be most interested in the third of the listings which is the conversation on globalization. It is worth noting that as of January 1st, 2020, the United States will take over the presidency of the group. Yet, as far as the impact this can reasonably have on the markets for the week in front of us, there is very limited potential given that the event begins on a Saturday. If anything, anticipation for surprise policy tweets will discourage positioning for fear of another painful weekend gap. 
    The other major gathering on tap from Friday through Sunday is the Kansas City Federal Reserve-hosted Jackson Hole Symposium. This is a gathering of major policy authorities (government and central bank), business leaders and investors whereby they discuss the most important matters for the financial system and economy of the day.  Given the current fragile nature of both dynamics at present, there is enormous pressure on this event and its participants to urge a sense of calm. They will find this exceedingly difficult to achieve. The official topic of the event is the ‘Challenges for Monetary Policy’ which is certainly a concern, but not one designed to immediately provide relief. The politicizing of monetary policy threatening short-term focus and policies that result in currency war- like conditions will likely come up explicitly if not in the undertone. If the Fed and others use this event to warn that the effectiveness of there tools are diminishing as they are already stretched to the max and face diminishing returns in economic and financial influence, that will only solidify reality for so many that have grown to believe that there are only three things certain in life: death, taxes and asset inflation. They will attempt to hedge their language, but market participants are extremely vigilant of cracks in our troubling backdrop. Furthermore, the world will be looking for as much reassurance of a safety net against an increasingly probable economic downturn as can be mustered. This will likely prove a very disappointing event for many. 
    The Inverted Yield Curve vs Sovereign Debt Sliding Into Negative Yield 
    The story of the inverted yield curve continues to gain traction across the market – from bond to FX trader, new investor to old hand. In part, this is testament to the self-reinforcing influence of the financial media and financial social platforms. That is why there is a cottage industry in analyzing the collective views garnered from browsers and tweets, whether for genuine view or contrarian signal. Yet, how much should we really read into such a signal. There is very strong statistical evidence to suggest that certain yield comparisons in certain countries heralds economic and/or market troubles. The 10-year to 3-month Treasury yield curve is an economist favorite and has been inverted for a number of months now while the trader-favorite 10-year to 2-year spread only slipped below the zero mark this past week. Just to be clear, this is essentially a situation where the market demands more return from (virtually) triple-A rated government at the front of the world’s largest economy to lend to them over 3 months and 2 years versus 10 years. Something is systemically wrong if this is the case. Usually, this portends recession as we’ve seen for most similar instances in history. There is caveat in the reality that the sample size is small and conditions do change between the generations that pass between many of these instances. The Fed and other central banks being so active in purchasing their local government’s debt is a very big systemic change. However, there is also very serious data to suggest that we are looking at a stalled economy despite all the unique circumstances and distortions we are dealing with at present. 
    Another consideration with the signals these curves offer is the time gap between the market-based cue and the official flip on the economic switch. Yet, just because there is an average 12 month lag time between the two, does not mean we can comfortably assume that we can continue to press our luck until mid-2020. The official signal of a recession by the NBER and others is two consecutive quarters of economic contraction. What’s more, the speculative nature of the financial markets rarely has investors hold out on their judgement of risk until that lumbering signal has flashed red. I find that the curve is not so personally concerning as the overall level of global yields themselves. The US 30-year Treasury yield plunged to a record low this past week. Globally, an unprecedented amount of government and high-rated debt is facing negative yield. That may seem fine on the face of it from a consumer’s perspective – who wouldn’t want to be paid to borrow money – but it is a reflection of serious problems in the system. Negative yields are an indication that there is no appetite for lending despite the affordability, it creates sever problem for profitability of financial institutions and it means there is very little policy room for authorities to ease conditions to jump start growth whether stalled or collapsing. As you see the headlines continue to flash negative yield around the world, remember that this is a serious problem for the environment in which you are investing. 
    Trump Eased Trade War Pressure but Neither Markets Nor China Placated 
    There was a noticeable waver in the Trump administration’s trade war pressure this past week, which many political pundit zeroed in on from both ends of the spectrum. Perhaps spurred by the market’s sudden bout of indigestion following the reciprocal escalations between the US (announcing the remaining $300 billion in Chinese imports would face a 10 percent tariff) and China (allowing the 7.0000 level on the USDCNH exchange rate give way), the White House backtracked to offer some modest relief in the pressure. It was announced that some small portion of goods would be left off the list all together owing to their importance to health and security while a wider range of consumer goods (clothing and consumer electronics) would avoid the new tax until December 15 to avoid hitting the American holiday shopping season. The half-life of the market’s enthusiasm was even more brief than their shortened bout of fear following the initial one-two punch to global trade. China’s was similarly dubious in its response. The White House lamented that China did not move to ease its own policies aimed in retaliation, but that should not exactly surprise given that the US had enacted a disproportionate escalation and China’s own measures cannot be linearly throttled – to push the exchange rate back below 7.0000 would only reinforce the belief that the PBOC is fully manipulating its 
    Moving forward, we will have to rely on unscheduled headlines to update our standings in US-Chinese trade relations. Perhaps the Jackson Hole Symposium or G7 summit will offer up some key insights, but there is little reason to believe these administrations are plotting it out thoroughly to offer investors genuine relief. Furthermore, it is crucial that we don’t lose sight of the other trade conflicts building up around the world. Japan and South Korea as well as the Eurozone and UK skirmishes are serious problems to the fabric of global growth. Yet, my top concern remains on the risk that the two largest regional economies in the world could see threats evolve into actions. The US and EU have warned each other with complaints and suggestion of policy preparation, but there hasn’t been serious movement yet. That may have changed however when France decided to push forward with a 3 percent digital tax on the largest tech companies in the world – which happen to largely be US-based. Some of these biggest players (Google, Amazon, Facebook) are due to testify to Congress early next week and they will no doubt cry foul. Yet, if they push the volatile government too far; their efforts to reduce their tax bill could trigger a much larger drain on global growth and trade…which will cause a much larger hit to their income. 
     
  12. 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. 
  13. 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. 
  14. JohnDFX
    Trade Wars Update: It No Longer Matters? 
    Seemingly a routine occurrence for the global financial markets, we saw the state of global trade deteriorate yet again through the past week. As expected, the United States went forward with tariffs on an additional $200 billion in Chinese goods. The terms are for a 10 percent rate on a range of imports that will increase to 25 percent by the end of the year. The standard, immediate response from China was quickly implemented, but only on $60 billion in US goods. It is not clear the strategy from China as they vowed a ****-for-tat response to what they have deemed unprovoked trade wars, but the country does not have much more room to tax imports from its major counterpart – and certainly not $200 billion worth of goods. This alone moves us into a new phase of a standoff of escalating cost for the US, China and the world. 
    Will China ease off the pressure? Are they simply plotting an alternative course? Could this be an attempt to prevent President Trump from pursuing his threat to trigger the $267 billion in further duties in the event of a reprisal to the $200 billion? It isn’t clear. With the situation clearly under greater tension, the news over the weekend that plans for further talks had broken down ensures greater financial threat from this already-enormous burden. What is even more remarkable than the state of trade from these two economic leaders is the apparent state of obliviousness from the speculative markets. While certain assets show greater disregard to the threat than others (the S&P 500 is at a record high while the EEM Emerging Market ETF is only modestly off its multi-year low), they have all displayed a measure of neglect these past weeks as the tab has grown exponentially. 
    To suggest that this situation simply doesn’t matter would be recklessly negligent. It isn’t impossible that speculators accustomed to complacency and FOMO, but it would nevertheless increase the scope of risk to stability through the future. Ignoring the dangerous wobble in a tire as you steadily accelerate down the freeway is not a reasonable state even if we can sustain it for the time being. If we continue to build up exposure until a severe economic or financial crisis arises, it will only amplify the eventual collapse. 
    What is Eating the Dollar and How Long Does it Dine?
    The Dollar marked an important technical tumble this past week. Already under pressure over the past months, the DXY’s drop below 94.35 and EURUSD charge above 1.1700 represents the break of ‘necklines’ on head-and-shoulders patterns (the latter inverted). This is pressure not isolated to the trade-weighted aggregate or its heavily represented most liquid pairing. We can see the currency’s unique struggle intensifying distinctly across the spectrum over these past few weeks. But with this evidence of broad struggle, we should attempt to identify its source if we intend to establish the intent of follow through – whether persistent or near its conclusion. Reverting to an old textbook relationship, some are connecting the currency’s traditional safe haven role to the recent rebound in risk assets – including record highs for certain benchmark US indices. 
    That would be a tidy explanation, but is suspicious for its timing considering this haven function hasn’t played a significant role for months. Further reason to question this relationship is the explicit status for the Greenback as the highest yielding major currency. That advantage will likely increase this week as the Fed is expected to hike rates another 25 basis points to a range of 2.00-2.25 percent. It could be the case that the currency’s premium could be deflating under expectation that the central bank is planning to downgrade its pace of tightening at this meeting through the Summary of Economic Projections (SEP) and Chairman Powell’s press conference. Yet, we don’t see that anticipation in assets that more directly relate to such forecasts - overnight swaps and Fed Funds futures. 
    Political risk will prove an increasingly prominent risk through media headlines in particular over the coming weeks, but there is little direct threat to economy or financial markets just yet. This slow reversal of a six-month old bull trend may also have developed in response to the longer-term concerns. Over enough time, the accumulated cost of engaging in a multi-front trade war while increasing the budget deficit during a healthy economic phase will erode the appeal of the United States’ currency’s principal status. It is possible that this long-term pressure is starting to set in; but if that is the motivation, it can readily be sidetracked by more intense short-term concerns (like next week’s FOMC decision). 
    Political Risk Increasing as US Election Cycle Heats Ups 
    Political risk is an abstract fundamental influence on the financial system. Certainly each trade has their political beliefs on policies ranging from economy to social causes; but more often than not, these views only cloud our assessment of the markets. It is generally-accepted market wisdom to remove emotions from our trading; and there are few things in life that more readily trigger emotion than politics. Practically-speaking, however, there is little in the way of policy that can readily translate into significant market movement in the short-term. That said, one of the few outlets with a direct link to financial health and stability is the state of international relations. And, on that front, the danger has grown visibly and exponentially. Perhaps one of the most obvious instances of this pressure on net global growth and capital rotations through trade comes from the United States. 
    The Trump Administration has driven forward with hefty tariffs and economic sanctions on some of the largest economies in the world. Whether we personally view the policies as good or bad / right or wrong, the economic impact is straightforward. As time marches on, attention on politics will intensify with the mid-term elections approaching. While much of the high drama related to the balance of the Legislative branch, threats of Presidential impeachment and the Supreme Court pick has little to do with the kind of direct market implications that we should keep in the forefront; it can nevertheless bolster the appreciation of economic and financial connection by virtue of its mere presence in the headlines. What’s more, this is not a uniquely US concern. There is political pressure rising across the world. 
    Reports of a possible election call in the United Kingdom have followed the failure of progress in the Brexit negotiations at the EU leaders summit in Salzburg. Mainland Europe is not immune to systemic risk via political pressures. Italy is still a massive concern to stability between its enormous debt and populist government. Poland and Hungary pose a threat to core EU beliefs – and have drawn criticism for such – owing to their nationalist governments’ policies. In Asia, financial pressure is starting to show subtle cracks in social contentedness while US sanctions have spilled over from Russia restrictions. Japanese Prime Minister Abe managed to keep his position this past week, but the economic and international diplomatic position or the country has not improved materially. The question investors should ask themselves is whether these relationships improve for compromise or rapidly intensify should economic or financial crisis start to emerge. 
  15. 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.
  16. JohnDFX
    Make or Break for Brexit? 
    There have already been so many twists and turns in the UK’s efforts to negotiate its separation from the European Union that that investors are getting dizzy. It is troublingly difficult to gain a reliable bead on a probable outcome for this stalemate, but the lack of time and dwindling hope of an outcome that will satisfy the majority of those involved raises the threat of a ‘bad’ outcome and even worse market response. This is not one of those events where ignoring the risks can prompt complacent gains. Once again, we are coming up to a key milestone in this saga where conditions can continue with a narrow course forward where the best case scenario still reflects considerable uncertainty and no small measure of market fallout. Or, it can be pitched into disarray. If you are monitoring the march forward of this fraught Brexit divorce – and you should whether you have direct Pound or UK investment exposure or not – highlight on your calendar Parliament’s vote on Prime Minister Theresa May’s proposal Tuesday. 
    The draft was made in concert with EU negotiators which produced a result that theoretically both sides could sign off on. That would seem a viable course forward if not for the level of discord in UK politics. Rhetoric surrounding the Prime Minister deal is distinctly harsh from both the conservatives who found vindication in the referendum outcome as a sign of a clean break as well as Labour and other groups who are attempting to keep economically supportive elements of EU access or do not support the withdrawal altogether. It is likely that Parliament votes the plan down which will open up a range of scenarios – very few of which are will avoid deeper trouble.  After a rejection, the government has three weeks to work another deal, but the EU will be far less interested in an agreement that asks for more and the rapidly diminishing time frame will leave little opportunity to warm counterparts to their side. 
    Parliament voted this past week – after finding the Prime Minister in contempt for refusing to release official legal advice on Brexit – to give itself greater say over the proceedings should her plan be rejected. This is likely to empower the MPs to demand more favorable – but perhaps ultimately unworkable – terms. It may also raise the pressure for a second referendum. Previously May has rejected the option outright, but recently she has floated the idea. It comes off more as a threat for conservatives to get in line, but she has said there is a choice of “my deal, no deal or no Brexit at all”. Two of those three options are considered assured crisis to all the relevant parties involved; and unfortunately, that third lesser evil is different for all of them. Beware Pound volatility and the risk of fast moving local capital markets which can be exacerbated by the waning liquidity in these final weeks of the year.
    This December is Already Bucking Seasonality Expectations
    As we have discussed more and more as of late, there are seasonal norms in capital markets. These unlikely cycles arise through a few different practical market occurrences. Mid-day direction changes in individual trading sessions, summer doldrums, quarterly earnings runs and more draw on reliable conditional developments that can shape conditions – though specifics like direction are still up to the unique circumstances that play out in the given period. In the final weeks of the calendar year, we have one of the most reliable norms in trading. For those that want the scene described in a short phrase, ‘Santa Claus Rally’ usually suffices as they can fill in the circumstances with their imagination. A reduction in liquidity for western holidays and/or a general sentiment is seen as the foundation for a market’s performance. The liquidity aspect is at least correct and conditions earned through collective habit can often fill in the rest. However, when we follow this theme to the assumed bullish-backed trend, there are certain environmental criteria that need to support the outcome. 
    Normally, the pending risks column needs to either be small or populated with issues that can readily be deferred until more convenient market conditions return. That is not the case now with growth forecasts slowing, warnings of financial risks growing more numerous (from the likes of central banks and IMF), trade war consequences kicking in and political risks splashing the headlines. These are not issues that can readily be shelved and they are receiving media attention on a regular basis. With this backdrop, there are frequent sparks that can provoke panic which makes the backdrop all the more threatening. If an otherwise contained crisis arises somewhere in the world, the thin market conditions can amplify the ill-effects of panic to spread well beyond its normal reach. And, while it may not be capable of a lengthy collapse of the financial system through such diluted conditions, it can lay the groundwork for a vicious cycle that begins the process only to catalyze fully when markets fill out – much like a nuclear reaction. 
    In portfolio and statistical theory, it is not advisable to position for collapse against these seasonal norms as the probabilities are still skewed in favor of the norms. However, it doesn’t mean that we need to be utterly complacent with the risks that we hold. Reducing size, diversifying away from ‘risk’ markets or buying hedges reduces your beta exposure, but it isn’t like we are missing out on opportunities through a period that will be ‘dead’ in the base case scenario. The volatility we have experienced this past week, the past two months and in two distinct periods over the year (Feb-March and Oct-Nov) are a reminder that we should be more proactive with our reducing our exposure to the capricious unknown.
    Who Faces the Greater (Probable) Systemic Threat: Dollar or Euro?
    Everything in investing is a probability – that is a mantra I repeat to myself to avoid the delusion of certainty in a view or position. To put belief into action, I try to always lay out the probable scenarios for a particular market, asset, event, etc. Even if I consider a certain outcome more likely, considering the alternatives can help to identify earlier when the theory isn’t panning out and to even help stage an actionable strategy for a lower probability path. Most of the time in trading, the focus is to identify best case (the most productive bullish) scenarios, but there is just as much value in projecting worst case outcomes and their probabilities. This can help us avoid markets with a severe probability/potential imbalance or even identify better trading opportunities – I would rather pursue a short in a productive bear trend than suffer a long exposure in a choppy bull market. In evaluating the majors for their practical ‘worst case scenarios’ (those outcomes that are severe but not wholly unlikely – or qualifiers for a true ‘black swan’ designation) I think the Dollar and Euro deserve closer observation. 
    For the Pound, the market is well aware of the possibility of a bad fallout from the Brexit which puts investors on guard and making moves that help to hedge risk. The Japanese Yen is so inextricably tied to risk trends and the Bank of Japan’s policy so open-ended that other issues struggle to compete for anxiety. For the Euro, a return to existential rumination on the currency union with the Italy-EU budget standoff is a still-underappreciated issue. The bulls in the market likely look back to the situation with Greece and assume a routine path for any future confrontations to be resolved in the same way. That is presumptuous to be negligent. The fact that this is occurring after Greece and during the UK’s bid for a withdrawal (admittedly from the EU and not Eurozone) should raise the level of concern significantly. It hasn’t. Perhaps the lingering premium afforded the currency for the eventual turn from extreme accommodation by the ECB will be the first dashed enthusiasm to awaken market participants of more unfavorable outcomes. If a country were to leave the currency union (EMU or Eurozone), it would fundamentally change the appeal of the currency as a global unit by significantly reducing the size of its collateral (GDP and capital) which would in turn significantly increase its perceived volatility. And, those are critical properties of a currency. 
    The situation is unusually similar for the US Dollar. The pursuit of trade wars inherently encourages the world to redirect funds away from the US Dollar to avoid the policy conflicts that it brings (in trading terms, the volatility). Meanwhile, the rising deficit becomes increasingly problematic as the cost to service the massive debt rises and outside demand dries up. This can lead to a general shift away from the Greenback’s use permanently which the market won’t fully appreciate until much deeper into the situation. Similarly here, the market may more readily recognize something is wrong via monetary policy as the Fed adjusts to some form of the systemic risks by slowing its pace of policy normalization. So, which currency faces the longer-term – but still reasonable – risk? The Dollar. The ubiquity of the currency globally (nearly two-thirds of all FX transactions) means that it has far far more to lose should its use diminish. And that is very likely as the threat of further credit quality downgrades occur owing to its appetite for debt and its withdrawal from the global markets. 
  17. JohnDFX
    Reckless Acceleration of the Trade War
    With the global (including the US and China) economy already straining under the weight of the ongoing trade wars, the two largest individual economies too steps this past week to leverage the pressure even higher. As expected, China felt it necessary to respond to the upgraded efforts  announced by President Trump on a staggering $300 billion more in Chinese goods – the ‘rest’ of the country’s imports that weren’t already facing a tax. It seems the White House considered the phased application of the 10% duty between September 1 and December 15 was a show of good will, but Beijing did not. The response from Beijing of its own staggering of $75 billion in tariffs between those same dates as well as the return of a 25 percent tariff on US auto imports previously paused in April was somewhat surprising as the country is not in a particular strong position to match like-for-like taxes on the other country’s goods, a reality reflected in their allowance of the USDCNH to overtake 7.0000. This automated offset to direct charges from the United States responded as intended with a charge to a fresh record high through Friday’s close, and subsequent strong follow through into Monday’s Asia open to surpass 1.5 percent in a mere three days. It seems Washington’s strategy is following the shock-and-awe model as the President announced a further step mere hours after China’s response to the previous step. He upped the rate on all those tariffs already in place (25 to 30% on $250 billion) and those that are due to be imposed (10 to 15% on $300 billion). Yet, that ‘floating’ exchange rate will remain a point of frustration for the administration as it allows China more cushion to ‘wait out the President’. 
    It is very likely that Trump is intent on forcing China – who it is suggested intends to hold out until the election – to avoid rolling the US economy into a stall out that makes his reelection chances very difficult. While it perhaps seems a war devolving away from strategy, there are absolutely objectives on both sides, they just happen to be very rudimentary. While officials may very well have a cutoff point at which they intend to throw the breaks on the war, I believe we are already passed the point of no return. The leaders of these respective economies likely recognize this inevitability as well – Trump stated recently that a ‘short’ recession would be worth it if it changed China’s habits. At the point that these governments see a near-term recession as a foregone conclusion, they will revert to strategy aimed at safe guarding their long-term status in the global economy. While it may seem the US has the leg up on the trade war scale, China’s leadership has more breathing room against re-election pressure. This is a fight from which the participants cannot easily extricate themselves.  
    The Ominous Approach of a Stalled Global Economy 
    As the fighting in global trade escalates, the outlook for economic activity steadily erodes. There are certainly a number of data points and forecasts that project ominously for key local economies – and the aggregate global health by proxy – but it isn’t the number of flashing red lights that speaks to the inevitability of growth stalling out. It has a lot to do to the awareness of trouble an subsequent anticipation that is formed from these increasingly-perceptible readings. President Trump has repeated the claim frequently as of late that the news outlets are pushing fears of a recession in a bid to push self-fulfilling prophecy in a bid to oust his administration at the next election. While most news agencies work on an ad model that benefits from some measure of panic (‘if it bleeds, it leads’), engineering a regime change is far-fetched. That said, the purveyors of news inevitably play a role in the evolution of sentient among consumer, business leaders and investors. 
    In reporting the subsequent inversion of the 2-10 Treasury yield curve this past Thursday or the troubled mix of data from the global August PMIs (timely proxy for GDP), they are raising awareness of the unfavorable environment in which there is tangible risk in making large purchases, ramping capital expenditures or adding to existing ‘risk’ positions. Falling into step with such troubling forecasts has more to do with human nature than any ploy and perhaps any sense of inevitability. Even though we are deep in an economic and investment growth cycle, it is always possible to stretch it out even further. Yet, pushing those in control of expenses to reach further increasingly marginal returns or gratification (from purchases) at the growing risk of losses to jobs, revenue or capital, requires greater and greater suspension of belief in traditional ‘value’. Unfortunately, the hope for tax cuts, infrastructure spending and monetary policy gearing does not offset the realities of an economy that has run out of traditional fuel and quickly burning through its reserves. 
    Jackson Hole Symposium: The Vows of Unlimited Economic Support Ring Hollow 
    With global investors showing obvious concern at the state of affairs around the world where governments are pursuing policy aimed at fostering growth at the expense of others and bursts of volatility continue to flash danger on many account statements (the S&P 500’s three worst single-day declines this year were all in August), it is natural for traders to seek out a savior. In textbook terms, a rise in risk would encourage a proportional response from market participants in reducing their exposure. Yet, that is clearly not the regime we have been operating in these past years – and frankly that has rarely ever been the case as speculation is an inevitability (and why I do not ascribe to the efficient market hypothesis). Often, the stalwarts of the financial system suggest their views of optimism or pessimism are based purely on the backdrop of economic growth, but their assessments are necessarily more complicated than just a single GDP projection pulled out of thin air. The scenarios of trade wars (both benefit and detriment), diverted capital flow owing to background policy change and monetary policy are more informative of our course moving forward than the linear projections of dated indicators like the quarterly growth figures from governments. So, when we are pressed to evaluate the heaviest influences for surprising risk and sustaining positive growth, there is no greater power than the world’s largest central banks. 
    For a decade, they have flooded the system with cheap funds with a stated goal of encouraging growth, but through a less-often admitted means of what amounts to ‘trickle down wealth’. There was actually a point during the Bernanke era that the Fed Chairman stated clearly that they were attempting to spur underlying economic growth by supporting financial venues. Well, over the past years, this mechanism to support expansion has clearly diminished in power. A Dollar, Euro or Yen of stimulus has translated into increasingly infinitesimal growth. Most investors recognized this diminished capacity but were willing to overlook the traditional conduit of performance so long as these same central banks could reduce their personal risk through their efforts. It is the unmistakable failing on that implicit effort that poses more significant threat to market’s moving forward. That is why there was so much attention being afforded to what the leaders of the financial and monetary authorities would say at the weekend Jackson Hole Symposium. It is also why it was virtually impossible to truly live up to the demands of market participants. Their assurances to do ramp up a weak response to another downturn with extremely limited capabilities certainly does not.
  18. JohnDFX
    Happy New Year everyone!
    Coming to Terms with a Bear Market
    We have experienced a remarkable level of volatility recently, which is particularly incredible from the past few weeks considering markets were distorted by holiday trading conditions. When volatility meets thin liquidity, the results can prove explosive. That said, the intensifying fluctuation in the global financial system is not just a phenomenon that could be attributed to shallow markets as we have seen both the price-based results and the explicit sensitivity to fundamental triggers increase through the months preceding the official holiday season. Through the past three months, we have seen a number of specific instruments that have stood as baseline for general asset classes tip into official ‘bear market’ territory – which is defined by a 20 percent correction from a recent peak. Appreciation for the changing tide really didn’t start to peak the sense of panic however until equities started to hit the critical, technical milestones. 
    When key US indices started to trip 20 percent – first the Russell 2000 in mid-December and then the S&P 500 Christmas Eve – the few that may have been oblivious were put on alert and diehard bulls started to feel a true sense of dread creep up their spines. Sentiment has notably shifted from unshakable confidence that the markets will bottom and return to their decade-long bull trend to a sense of desperation that buoyancy will hold out long enough to erase some of the losses late-comers had incurred since October or keep the window open long enough to simply exit. The bounce this past week with the S&P 500 moving back above 2,520 does play to the sense of hope. It is possible that we have found a low for the time being having only just technically hit the bear market milestone for a single day, but that seems improbable. Even with the retreat in this market – not to mention the rest of the world’s speculatively-inflated assets – we are still far from previous cycle peaks. Prominent fundamental themes from slowing growth to failing monetary policy effectiveness to deteriorating international relationships are not going to simply reverse course anytime soon. 
    Further, rising volatility is looking more and more a permanent feature of our landscape. Market’s struggle to calmly inflate already-expensive assets amid tense periods of possible instability. It is possible that we have seen the low, but it would not be wise to assume that is the case. Instead, the better approach for market participants would be acclimatize to a world where we are in a bear market or on the cusp of one. Just as bull markets have periods of correction before they reassert themselves, the bear markets can have interludes of recovery. That does not mean we should commit to the about face just because it is desired. Though some people prefer longer duration, systemic positioning; I still favor taking trades with shorter duration and closer targets until it is clear that momentum has returned to the bears. 
    Fed Fund Futures are Now Pricing in Rate Cuts 
    Through 2018, the Fed’s steady tightening (also fairly described as normalization) efforts accelerated. The fact that the US central bank was tightening at a regular clip while the rest of the developed world’s policy authorities were still contemplating when to make their first move, or at best attempting to take bites when conditions were ideal, became almost mundane. If we were to evaluate the benefit to the Dollar from the contrast in the textbook fashion, we would assume that the Greenback should continue to climb against its major counterparts for as long as it enjoys a yield premium – especially as the spread continues to grow. Yet, we know in speculative markets that investors will move to price in the advantage as soon as it seems feasible – and they did. While they couldn’t full price in the benefit to the USD of a Fed hike regime against such a cold backdrop, it could price in a considerable advantage. 
    After that high water market was set, it would be increasingly difficult to confer greater benefit – perhaps if other central banks were forced to revert to ever more extreme easing techniques while the Fed kept course – but it would be far easier to disappoint. This is what is referred to more generally as discounting the outlook. It also goes a long way to explain 2017 where the Dollar dropped steadily versus the Euro despite the fact that the Fed hiked three times and the ECB had yet to nail down a time for its first move higher. Fast forward to today. We have seen markets slump and economic forecasts drop significantly. As would be expected, the forward guidance from the central bank has cooled materially. The shift is clearly apparent to the broader market as Fed Fund futures and overnight swaps have completely reversed course on the hawkish outlook for 2019 – that at one point was fueling debate on whether they would hike three or four times through the year – with no further tightening expected. 
    In fact, the next move priced into the markets is a cut with the greatest weight afforded to 2020, though 2019 was clearly being assessed as a possibility given contracts through December. NFPs and the rebound in US indices through this Friday have cooled the dovish build up, but the shift has been dramatic. It will be difficult to lift speculative enthusiasm so high again especially after key Fed officials have suggested the need for forward guidance has waned significantly.
     
    What Flash Crashes Say About Market Conditions Rather than the Afflicted Asset 
    One of the more remarkable episodes from this past week’s extremely unorthodox opening play at a new trading year was the flash crash that struck certain currencies (and even a few capital assets). Much of the focus was on the Japanese Yen, but it was not the only currency to exhibit extreme price fluctuation. The Australian Dollar exhibited even more extreme fluctuation in historical and percentage terms (its intraday reversal was the largest I found on record) while the ripples readily expanded out to the British Pound which didn’t even seem to connect to the purported spark to the move. 
    Afterhours to Wednesday’s New York session saw headlines light up on news that Apple (one of the principal firms in equity investors’ portfolios) was lowering its revenue guidance owing to the US-China trade war. Paired with the downgrade in Chinese activity readings earlier in the day and the ongoing US government shutdown, and it was no surprise that fear would hit. With the Tokyo markets offline for a holiday, the thin-liquidity-high-volatility conditions were once again triggered with a subsequent tsunami. This time however, the market response would not play out over days and weeks with a pervasive trend but instead struck all at once with extreme intraday volatility. The catalyst did matter as any lit match would, connections to risk trends are important and certainly automated trading influences (stops, limits, algorithms) no doubt contributed. However, boiling what happened down to these elements is a misleading – but common – psychology effort to regain a sense of comfort. 
    If this unforeseen disaster can be attributed to these elements, then we can feel more comfortable that it is unlikely to happen again and we can keep an eye out for the same environmental triggers. This is not an unusual development in the global markets, even for the most liquid. The Japanese Yen  saw rapid rallies followed by abrupt reversals (Yen cross tumbles followed by rebound) multiple times between 2009 and 2011 brought on by risk aversion, then monetary policy distortion and the intervention efforts of authorities (BOJ and the Ministry of Finance). The point is that conditions facilitated multiple such ‘fat tail’ events through that period, and they could continue to do so for us moving forward. It is the confluence of deteriorating investor sentiment, recognition of excessive exposure, fear that authorities cannot fend off any future financial crises and the abundance of threats to the collective complacency that currently colors our markets. While we may not see another 3.5 percent-plus swing from the Yen specifically in the near future, expect to see more developments that were considered unthinkable over the past 10 years. 
  19. JohnDFX
    And Now, the Fed
    The market has monetary policy on its mind heading into the new trading week thanks to the actions of the European Central Bank (ECB) this past Thursday. One of the world’s largest central banks, the group is making a bid – perhaps unintentional and perhaps not – to be the most accommodative group of its size. Already sporting a negative rate, a large balance sheet and a T-LTRO program; President Draghi steered his team back into an expansionary phase of dovishness despite his retiring in a few months. Testament to their forward guidance efforts, the market largely expected the 10 basis point cut to its discount rate (to -0.50 percent), the restart of quantitative easing or QE (20 billion Euros per month starting Nov 1) and the introduction of tiered lending aimed at helping banks struggling with profitability. In fact, the move was so thoroughly baked in that the Euro’s initial tumble reversed to gains and capital markets seemed little charged after the effort was made official. On the one hand, the ECB will be happy that it avoided triggering a volatility event which could create more difficult conditions to support moving forward. Alternatively, there is more than a little ‘wealth effect’ assumption to the transmission of current monetary policy. Underwhelming response from the markets could signal monetary policy is reaching the limits of its effectiveness. That is the unpredictable scene we are met with as we approach the Fed’s policy event.
    The Federal Reserve’s policy event is scheduled for Wednesday at 18:00 GMT. Even putting aside the existential crisis traders are facing with the concept that monetary policy may be losing its effectiveness, this was due to be an important meeting. September’s meeting represents one of the ‘quarterly’ events whereby we are due the Summary of Economic Projections. That includes the updated forecasts for interest rates that the markets watch so closely. Even more pressing with this particular meeting, is the question as to whether the Fed will follow up with its first rate cut in a decade this past July. After that meeting, Chairman Powell said the move was a ‘midcycle adjustment’, a phrase repeated in the official perspective of the group in the meeting minutes. That would insinuate that the next reduction – if there would be one – depends heavily on data. As it happens, recent jobs figures weren’t gangbusters but the trend is still the best in decades. Further, core inflation registered by the CPI was accelerating above target. These are not the developments that would signal easing is urgently necessary. Nonetheless, we are facing a serious difference of opinion on the subject with the market still pricing in a robust 80 percent probability of a rate cut  - though down from certainty just a week ago. Does the Fed dare disappoint the market and trigger capital market fear that will in turn necessitate central  bank support later regardless or will it cut despite its explicit remarks that it was unnecessary and tarnish its credibility?
    Many market participants – especially those that have benefit from the zombie-like complacency bid these past years – would advise protecting market gains to avert any speculative slump that can make more tangible the economic pain. Yet, the long-term risks of satisfying risk takers can be severe and irreparable damage to credibility and ultimately an inability to fight serious fires in the future. The global market is struggling under trade wars and the natural flagging of the economic cycle. There is certainly appetite for the world’s most hawkish, large central bank to make a more consistent distribution of support, but satisfying these appetites would only draw attention to the state of dependency growth and market performance attached to stimulus and negative rates – not to mention dissuades fiscal powers from taking on the responsibility themselves. If the Fed refuses to act and there is investor fallout globally, those central banks already all-in will find their own credibility razed to the ground. A lot rides on the Fed, and not just for the Dollar or Dow. 
    Good Will and Rumors of Economic Pressure Points in Trade Wars 
    There is an unmistakable enthusiasm around the state of the US-China trade war over these past two weeks. It started slowly enough with the suggestion that the two sides would return to the negotiation table in earnest early next month with leaders from each camp suggesting they were optimistic. As far as inspiration goes, that doesn’t even rank as a far-fetched cue for optimism. We have seen far too many slow starts of this exact type flame out and ultimately result in a worsening of relations between the two. Thankfully, there were more tangible efforts of good will to build momentum upon. China announced that it was waiving tariffs on 16 US imports that were previously taxed – the first such course reversal since the trade war began. Despite the relative minimal move, the US responded by announcing that it would delay the increase of tariffs on $250 billion in Chinese imports from 25 to 30 percent by two weeks, pushing it from October 1st to the 15th. Looking to surpassing that frequent trip point after the first round, China then followed up with the announcement that it would exempt US pork and soybeans from tax at the ports. 
    This is indeed tangible progress, but recall that the higher level officials are not due to meet until early October. Further, there have been frequent false dawns whereby the absence of a compromise has not resulted in status quo but rather an escalation.  Nonetheless, there is clear evidence that both sides are interested in boosting market sentiment – such good will reciprocation would never have occurred previously as each would have deemed it an overdue step by the liable party. For China’s part, it is concerned about the state of its local economy and financial system already under significant pressure. In the US, the Presidential elections are over a year away, but the campaign is already starting; and the rising fear of recession is posing a serious problem for Donald Trump. Fully reversing the trade war actions and striking a trade agreement would take serious time and capitulation from states and personalities not commonly known to ‘surrender’. It is still possible however. The real question we should ask though is: will the lifting of trade wars recharge growth or investment appetites? The absence of a ballooning crisis is not the same thing as seeding GDP or returns. Trade wars have taxed an already threadbare global economy while highlighting the dependency on external sources of support like central banks simply to keep the masquerade going.  It is not a good point in time to look at markets through rose colored glasses.
    Repeated Accusations of Currency Manipulation Will Spur a Currency War
    There were a number of skeptics of the value added and intent from the ECB’s decision to escalate the support this past week – including some of the key bank members themselves. However, one person’s criticism that was fully expected as they took their rates deeper into negative territory and announced the restart of the QE program was US President Donald Trump. He has reflected on their efforts more often these past months as a platform to critique the Federal Reserve. Rather than decry their efforts as purely manipulative in a bid to earn growth at the expense of more virtuous trade partners, he has held their course up as a template for which the Fed is falling behind on. His berating of Chairman Powell has been relentless, but the haranguing hasn’t changed the central bank’s course – well, not as much as intended considering the President’s policy mix has weighed markets which the Fed is less capable over ignoring. At what point will a President frustrated by slowing growth and a central bank that is unwilling to supplement for the pain the trade war is causing – and ultimately incapable of holding back any serious collapse in economy – decide to take exchange rates as a tool into his own hands? 
    The ECB’s moves will raise his ire, but the rebound in the currency will frustrated his claims that they are principally a move to devalue the currency. Such details haven’t held him back before however. With the Dollar holding near two-year highs with Euro, Yen and Yuan at the very lease employing serious policies that have at least a secondary result of FX depreciation; this will stand out as a genuine option in the event of emergency (a fading campaign in the face of economic struggle). Adding to the pressure, the Swiss National Bank (SNB) and Bank of Japan (BOJ) will likely hit upon the POTUS’s radar in the week ahead. Both are due to deliver policy updates. The SNB is not expected to cut rates further, but it is already hovering at a -0.75 percent rate and attempts to simply keep pace with the ECB so as not to allow EURCHF to drop. Meanwhile, the BOJ is similarly expected to hold course, but recently its officials have stated they were looking into the option of plumbing negative rates in a bid to finally earn the policy response they have failed to render thus far through a dovish mix anchored by an open-ended stimulus program. 
  20. 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.
  21. JohnDFX
    Trade War Rumors are Generating as Much Reaction as Official Announcements 
    The trade war remains one of the most far-reaching and economically-threatening themes currently assailing the global markets. After more than a year of escalation whereby the market has acclimated to a steady flow of stories detailing the malaise this conflict has sown, it should come as little surprise that the market has grown somewhat deadened to hints that conditions may grow marginally worse. Yet, in contrast, any budding suggestions that a demonstrable improvement in the relationship may be around the corner are being met with far more speculative enthusiasm. This past week, two such reports dotted the headlines and played no small role in helping push US equities beyond levels that technical traders would consider weighty (2,645 for the S&P 500 and 24,325 for the Dow). 
    First, on Thursday, it was reported by WSJ that President Trump was debating with officials whether to lift tariffs on China. That would be a complete 180 on their negotiation tactic thus far, but it wouldn’t be exactly far-fetched given the President’s penchant to change course when his priorities change and to offer help to a struggling market since the Fed has shown little willingness to comply with his demands. Equities responded to the headlines with a smart rally to the midpoint of the October to December tumble. However, before traction could be fully secured; the US Treasury’s spokesperson rejected the news, saying neither the Treasury Secretary nor US Trade Representative had advised such a tack. While the market slipped on the official correction, the hope of an eventual breakthrough was appealing enough that Friday’s trading session opened to an official ‘breakout’ beyond the aforementioned barrier. 
    To follow up Friday, Bloomberg issued a new report that China had offered the United States a plan whereby it would dramatically increase its purchases of US-made good (to the tune of $1 trillion) in a bid to close the countries’ trade gap in six years. This plan was not clearly and quickly rejected – perhaps because China is not as concerned with the favorable impact it can have in cooling financial markets. And, with that additional fundamental push, the indices closed out its fourth consecutive week advance strong. It is inevitable that we face another round of trade war updates in the week and weeks ahead; and whether they signal deeper divide or possible mending, they will likely be market-moving. That is because we are in a limbo where the general health of the global economy is crumbling, and this remains one of the more consistent drains. Further, the market sense of urgency over this state will increase as more reliable sides of economic health continue to degrade. We’ve seen a host of signals these past weeks – US consumer sentiment, Chinese liquidity conditions, etc – but this week’s 4Q Chinese GDP update will serve as a direct status update. 
    The World’s Top Concerns, Monetary Policy and Recession Fears
    The economic docket has a few high-profile listings (China 4Q GDP and ECB rate decision among them) over the coming week, but the traditional fare doesn’t give the proper scale of the broad fundamental themes that we are dealing with moving forward. There are far more systemic issues under consideration by the world’s market participants, and a few items give perspective of the themes better than others. It is important in fundamentals to first and foremost assess what carries the greatest weight with the largest faction in the markets. With our laundry list of unfolding issues, no one would begrudge you uncertainty over that question. This week, we will have the rare opportunity to gain some insight into what most concerns the leaders of the world’s largest economies at a summit in Switzerland. The Davos World Economic Forum will cover topics that are no doubt top of our mind, and perhaps some that are under the market’s radar, but from the discussion, time dedicated and sideline comments, we will be better able to ascertain what issues are considered the most troubling. 
    And, while social troubles are of great importance, leaders are disproportionately fearful of economic troubles. No confidence votes, failed re-elections and general discontent more often follow economic troubles. Politics in the meantime will be another great timekeeper for traders looking for the next jolt of volatility. There is upheaval across the world from the US government shutdown to Brexit running out of maneuvering room to the Yellow Vest protests in France extending to a tenth week. Monetary policy will likely earn little for directly-linked currencies, but the sense of the underlying current can materially affect confidence in active support for growth and financial stability. On tap are two of the developed world’s most dovish major central banks. The Bank of Japan (BOJ) sees little chance of altering its active effort to keep QE pumping into the system, but the recognition of its inability to influence change in inflation or economic condition grows clearer with each week. 
    In contrast, the European Central Bank (ECB) took the significant move to end its stimulus program last month – in a first step to normalize from an extraordinary dovish policy-setting. Yet, those intentions may not be fulfilled in the foreseeable future if concerns of economic struggle deeper. Beyond the warning on growth for China with trade wars, US via the shutdown (now cutting off 0.5 ppt), Germany drawing out recession concerns in data like factory activity, Italy risking it far more readily with the local central bank’s own forecasts, we are seeing the world bow under the maturation of a decade-long cycle and the eruption of numerous cuts in fundamental efficiency. If a slowdown becomes an overt reality, will we find relief from the world’s central banks (already at the extreme of their policy setting) or governments (struggling to function and certainly not cooperating well with each other). 
    Where to From Here on the Brexit? 
    As of Monday, the countdown will drop to 67 days until the UK is due to leave the European Union according to the two-year timeline dictated by Article 50. And, despite our dangerous proximity to the official divorce, we seem to be no closer to a plan on how this separation will play out than we did six months ago. That is troubling. This past week, Prime Minister May offered up a proposal in the Commons on how the country may severe ties with the Union. The defeat Parliament delivered May was the worst seen in British history. On the back of that popular discontent, opposition leader Jeremy Corbyn tabled a no-confidence debate that took place shortly after. This time, the majority sided with the PM – though the margin was far smaller than the one she lost by with her plan. Due to votes pushed through in previous weeks, May now needs to issue a Plan B on Monday the 21st. It had also been previously discussed that should the no way forward be found by the PM’s efforts by this date, that Parliament could take greater control over the process to avoid a ‘no deal’ outcome. This will help delay that pressure. Though it is always possible that the EU will take the mandate of the crushing defeat dealt the UK’s leader to offer more concessions, it is more likely that the program she ends up with will still not pass the approval of Parliament. 
    Nonetheless, with debate still to be had, the vote on it will take us out to January 29 (Tuesday). It is worth noting that May’s threats to choose ‘her Brexit, no deal Brexit or no Brexit at all’ have been trumpeted far less frequently as of late. It is not clear whether that is because she is genuinely softening her position and ‘red lines’ or perhaps just because there is a little less urgency with a few more days. The days are steadily ticking down and polls of Brits’ stance on whether to leave or not or what kind of approach to pursue (no deal, May’s deal or more concession) remains markedly mixed. With so much confusion throughout the country on how to proceed, it comes as little surprise that the state of the negotiations are as opaque as they are. Continue to monitor for Pound volatility. 
  22. JohnDFX
    In the Aftermath of the Fed
    The baton has been dropped. The Federal Reserve was by far the most aggressive major central bank through this past financial epoch (the last decade) to embrace ‘normalization’ of its monetary policy following its extraordinary infusion of support through rate cuts and quantitative easing (QE). Over the past three years, the central bank has raised its benchmark rate range 225 basis points and slowly began to reverse the tide of its enormous balance sheet. As of the conclusion of this past week’s two-day FOMC policy meeting, we have seen the dual efforts to level out extreme accommodation all but abandoned. A more dovish shifted was heavily expected given the statement in January’s meeting, the rhetoric of individual members as well as the state of the global markets and economic forecasts. Yet, what was realized proved more aggressive than the consensus had accounted for. No change to the benchmark rates was fully assumed, but the median forecast among the members accounted for a faster drop than the market likely thought practical. From the 50 bps of tightening projected in the last update in December, the median dropped to no further increases in 2019 and only one hike over the subsequent two years.
    The Dollar responded abruptly Wednesday evening with a sharp tumble, but there was notably a lack of follow through where it counted – the DXY Dollar Index wouldn’t go the next step to slip below its 200-day moving average and break a ten-month rising trend channel (a hold that confounded those trading an presumed EURUSD breakout). Why did the Greenback hold – for now – when the move was clearly a dovish shift? Likely because the market is already affording for an even more dovish forecast as Fed Fund futures have set the probability of a 25bps cut from the Fed before the end of the year as high as 45 percent. What’s more, if you intend to trade the Dollar; it is important to recognize that even with a more dovish path ahead, the Dollar and US assets will maintain a hearty advantage over its major counterparts. That would particularly be the case should other groups extend their dovish views to more actively explore deeper trenches of monetary policy.
    Looking beyond the Dollar’s take, however, there are far more important considerations for the global financial system and sentiment. The Fed was the pioneer of sorts for massive stimulus programs designed to recharge growth and revive battered markets. It was also the first to start pulling back the extreme safety net when its effectiveness was facing deserved scrutiny by even the most ardent disciple of the complacency-backed risk-on run. In other words, its course change carries significantly more weight than any of its peers. The question ‘why is the Fed easing back and so quickly’ is being posed consistently whereas in the past market participants would have just indulged in the speculative benefits. The overwhelming amount of headline fodder – from trade wars to frequency of volatility in the capital markets – makes for a ready list of considerations. Yet, the group’s own economic forecasts brought the reality home far more forcefully.
    Though we have seen numerous economic participants downgrade the growth outlook (economists, investors through markets, the IMF, etc), to see the median GDP forecast in the SEP (Summary of Economic Projections) lowered from 2.3 percent to 2.1 percent for 2019 made the circumstances explicit. We’ve considered multiple times over previous months what happens if the market’s start to question the capability of the world’s largest central banks to keep the peace and fight off any re-emergences of financial instability. Now it seems this concern is being contemplated by the market-at-large. That doesn’t bode well for our future.
    A Sudden Fixed Income Interest When ‘Recession’ Warnings Take Hold
    Except for fixed income traders and economists, the yield curve is rarely mentioned in polite trader conversation or in the mainstream financial media. Its implications are too wonky for most as it can be difficult to draw impact to the average traders’ portfolio and given the considerable time lag between its movements and capital market response. Yet, when it comes to its most popular signal – that of a possible recession signal – the structure of duration risk suddenly becomes as commonplace a talking point as NFPs.
    On Friday, the headlines were plastered with the news that the US Treasury yield curve had inverted along with a quick take interpretation that such an occasion has accompanied recessions in the past. There have actually been a few parts of the US government debt curve that have inverted at various points over the past months, but this occasion was trumpeted much more loudly as it happened in the comparison to the 10-year and 3-month spread (what has been identified as a recession warning even by some of  the Fed branches themselves). First, what is a ‘curve’? It is the comparison of how much investors demand in return (yield) to lend to the government (for Treasuries specifically) for a certain amount of time. Normally, the longer you tie up your money to any investment, the greater the risk that something unfavorable could happen and thereby you expect a greater rate of return. When the markets demand more for a short-term investment than a longer-term one in the same asset, there is something amiss. When the markets demand more return from a three-month loan to the US government than a 10-year loan, it seems something is very wrong. Historically, the inversion of these two maturities has predated a number of us the recessions in the United States – most recently the slumps in 2008, 2001 and 1990. 
    First is the lead period the curve reversal has to economic contraction. The signal can precede a downturn in growth by months and even years. Preparation is good, but moving too early can ‘leave money on the table’ for the cautious or accumulate some serious losses for those trying to trade some imminent panic. Further, there are certain distortions that we have altered the course in normal capital market tributaries that could be doing the same for Treasuries and therefore this reading. More recently, the revived threat of the US government shutdown through December and the unresolved debt ceiling debate put pressure on the asset class. At the same time, though, few believe the US would do little more than allow for a short-term financial shock in order to make a political point. Far more complicating for the market and the signal is the activity of the US and global central banks. The Federal Reserve has purchased trillions in medium-dated government debt as part of its QE program. They only started to slowly to reduce holdings and push longer dated yields back up a few years after they began raising short term rates in earnest. Their recent policy reversal only adds to the complication.
    Now, all of this does not mean that I believe the US and global economies will avoid stalling out or even contracting in the near future. Between the dependence on capital markets and stimulus, the heavy toll of trade wars and nationalistic policies, and the pain for key players in the global web; there is a high probability that we will see an economic retrenchment in the next few years. That said, that wouldn’t make this particular signal a trigger (causation) or even correlated through the main forces that would bring on a recession. Nevertheless, yelling ‘fire’ in an a panicky crowd on foggy day can still yield volatile results.  
    Brexit, Just Winging It
    Another week and another upheaval in Brexit expectations. Through much of the past year’s anxiety over the withdrawal of the United Kingdom form the European Union, there was at least some comfort to be found in the finality of the Brexit date (March 29th, 2019). While it could end in favorable circumstances for financial markets (a deal that allows considerable access for the UK) or acute uncertainty (a no-deal), at least it would be over. Well, that assurance is as clouded as the expected outcome from the negotiations themselves. Shortly after I wrote the Brexit update last week whereby there was a clear timeline for another meaningful vote on the Prime Minister’s proposals – after Parliament voted for an extension of negotiations – the Speaker to the House of Commons thwarted the effort when he said the scheme would not be reconsidered unless it was materially different. It is likely that see another significant change in this drama any times (and even multiple times) this week.
    At Prime Minister May’s request, the European Commission agreed to an extension of the discussions beyond the original Article 50 end date for this coming Friday. Yet, where the PM intreated a postponement out to the end of June, the EU agreed only to May 22nd – the day before European Parliamentary elections. Beyond that date, the UK would theoretically remain under the regulations and laws of the EU but would have no say in their direction which wouldn’t appeal to either side. So, now we are faced with another ‘fluid’ two months of critical deadlines. 
    This week, it has been suggested the government will try to put up once again for a meaningful vote – though it is still not clear whether the proposal will be meaningfully different (the EU has offered no further concessions) or there has been a successful challenge against the Commons speaker. When this could be put up to vote is unclear, but it has been suggested between Monday and Wednesday. If the proposal is approved, the timeline to May 22nd will remain and we will start to see a genuine path form. If it is not, then the following week Parliament will have to indicate that “they have a way forward”. If they do not, an extension or no deal will likely be considered for April 12th – out to the previously mentioned May 22nd date. If we pass April 12th without a clear plan, the probabilities of a ‘no deal’ or ‘no Brexit’ will rise significantly. Those two scenarios are extreme and on the opposite end of the spectrum. From a Pound trader or global investor considering UK exposure, you can imagine what a situation where the probability of diametrically-opposed, market-moving outcomes are considered balanced would do to the markets. It will curb market liquidity and leverage uncertainty. That would translate into divestment, difficulty establishing trends and serious volatility. If that isn’t your cup of tea, it is best to seek opportunities elsewhere for the next few months until this is sorted. 
  23. JohnDFX
    It’s Okay, This One is On the Fed 
    There has been a notable shift in the market’s mood in just the past week. A sense of dull complacency that traders who were active during the first wave of the large scale, central bank stimulus infusions would recognize has bolstered key assets. After the benchmark S&P 500 and Dow topped at the beginning of May, a steady slide in the indices encouraged the same sinking feeling in conviction that was dependent on complacency. Evidence that we are the late stages of the economic cycle, the business cycle and the market cycle is piling up. Normally, as the pace of expansion flags, we find the market’s tolerance for lowered speculative potential is partially offset by higher rates of return as the demand for funds drives yields higher. However, the record-breaking bull trend that we have enjoyed over the past decade defied that particular convention as its initiation and extension was supported through extreme accommodation from central banks – first lowering interest rates to record levels and then adoption quantitative easing measures. While this would help stabilize financial markets and help stimulus growth, it would also necessarily lower rates of return to be expected from the investing. 
    After a while, it grew more and more apparent that the latter waves of support produced less and less traction towards economic objectives (bolstering economic output and inflation) but they nevertheless ensured a lower baseline for expected returns. With a presumption of indefinite support by monetary authorities and a highly competitive financial market, it should come as little surprise that moral hazard would thrive. It is that base assumption that exceptional risks taken in recent years to drive assets of questionable value to record high prices (like the S&P 500) would be discharged by the Fed and its international peers. The anticipation is impossible to miss in the markets with Fed Funds futures pricing in an 85 percent probability of a 25 basis point cut by July and a healthy chance of multiple cuts before year’s end. Considering President Trump has called out the central bank multiple times over the past months and economic warning signs like the inversion of the 10-year/3-month yield curve have garnered greater attention, the assumption of more assistance comes as little surprise. Language from the Fed Chairman Jerome Powell, other board members and even official communiques have also made clear a willingness to step in should growth stall. 
    My concern is not whether the Fed and others will step in should we lose traction, but rather what happens as we realize their limited capacity to extinguish further financial fires. The Fed arguably has the greatest capacity of the major central banks as it has tightened rates around 200 basis point  since its first hike in December 2015. Yet, that isn’t a particularly sizable arsenal when we consider how little economic amplitude we leveraged from the massive stimulus programs and given how much more premium in capital markets they are expecting to keep propped up – the S&P 500 rose another 39 percent beyond 2015’s peak. If actions by the Fed fail to steady the market, it would do far more damage to sentiment 
    Don’t Forget the Trade Wars Are a Thing 
    With the recent rebound in speculative market benchmarks, there is an innate tendency to seek out favorable fundamental winds in order to justify the prevailing bias. Anticipation of further support from the Federal Reserve is one such rationalization for speculative lift, but another potential source of confidence heading into the new trading week is the Friday evening news of a trade war breakthrough. Following the week’s end market close, President Trump announced in a tweet that a deal had been reached with Mexico for the country to take action on stemming migration through the country destined for the United States in order to avoid a 5 percent blanket tariff on all Mexican exports destined for the US. This warning was made less than two weeks ago and it was roundly criticized by members of Congress, US business leaders and (reportedly) even White House senior staff. That means the market likely maintained a hefty skepticism that the threat would ever be put into action. As such, we now await the new week’s open to see if there is a flush of relief rally to play out or if the markets will struggle despite the faux breakthrough. 
    Meanwhile, progress on one front of trade dispute for the US could be used as justification to escalate tensions on another in a bid to force capitulation. The last official action in the US-China standoff was a hike in the tariff rate by both countries on each other’s list of target goods ($200 billion and $60 billion worth respectively). Treasury Secretary Steven Mnuchin said over the weekend that the President would be “perfectly happy” to fulfill his vow to expand the list of taxed imports to all of China’s trade – over $500 billion in goods and services. If imposed at the prevailing 25% rate, that would translate into an incredible 250% jump in the notional bill of the trade war on just one side of the battle line. Perhaps even more troubling would be China’s inevitable retaliation. The country has already maxed out the like-for-like goods for which it can impose a tax. That would mean it would have to resort to further unorthodox means. 
    With the US already moving to ban Huawei, it seems inevitable that the Asian giant would move to blacklist a number of important US technology companies. It is also very likely that it would throttle shipments of rare earth materials – for which it is the world’s largest producer – to hit the production of cellphones and other consumer technology. While that bill will add up over time, it is likely that China will pursue additional means of pressure in order to have a more pointed effect. A concerted selling of US corporate assets is the next logical line, but many are watching for Yuan depreciation or a strategic selling of Treasuries. Those are unlikely however as the financial repercussions would be too severe with necessary losses in their own capital exposure and a high probability that other countries rally to the United States’ cause. 
    An Inconvenient Time to Worry About Eurozone Stability 
    With the US Dollar losing viability owing to its pursuit of trade wars that undermine global stability, the Pound plagued by a directionless Brexit and the Japanese Yen lost in a deflationary quagmire, there is an acute need for a stable benchmark currency. Despite its many fundamental shortcomings, the Euro showed itself willing to offer an outlet for liquidity over the past few years as the recovery from the region’s sovereign debt crisis between 2009 and 2012 seemed to offer a sense of hard-fought stability that was prized above all else. When the European Central Bank (ECB) veered off its course to normalize policy following the December cap on its open-ended stimulus program – by implementing a new targeted-LTRO – the Euro’s appeal deflated significantly. With a renewed sense of dubiety, we have seen attention turn to other cracks in the Euro’s perceived durability. Perhaps the most tangible of the unique risks facing the shared currency is the pressure brought by its third largest member: Italy. 
    The coalition government of staunch anti-EU parties has struggled to find a common cause outside of the general revolt against the European cause. After the Prime Minister threatened to resign over infighting by his government, the coalition parties seemed to settle their differences for now but that would not translate into any renewed support for the Union. In fact, the unifier between these extreme parties seems to be their agreed-upon discontent. Last week, one of the deputy Prime Ministers stated clearly that Italy would not change course from its plans to offer its citizens relief through tax cuts. In the meantime, the European Commission found the country warranted a preparatory document on disciplinary action over its financial position. According to deputy PM Salvini, this could amount to a 3 billion euro hit. The country and Union leadership can draw this fight out for some time before we reach the limits of financial stability as Greece showed us nearly a decade ago, but the market is unlikely to allow the pressure to build up for that long before it starts to price in a systemic threat. In the week ahead, the Eurozone and European Union finance minister meetings will no doubt discuss this situation, and any uniform positions will not pass unnoticed. 
    Generally-speaking, the Euro would not retain the same global reserve that it represents today if one of its core members were to make a credible threat of withdrawal. That is still very unlikely, but there are first stage cracks that are being threatened that could build an unplanned head of momentum: It has been suggested that Italian authorities are considering the use of an ‘alternative currency’ to service its debt, a move that naturally ushers in reasonable speculation of a stability concerns underlying the Euro. As the second most liquid currency comes under pressure, it is natural to keep tabs on the only more ubiquitous benchmark – the Dollar – but I believe gold is the best measure to our particular set of financial uncertainties as the 2009-2011 period surge stands out for those seeking alternatives to the traditional currencies.  
  24. JohnDFX
    Is There an Effort to Keep Markets Uneasy in Trade Wars?
    How many times does something unusual have to occur before it is considered a planned? I have noted a number of times over the past month that some unexpected policy development was announced hours before the markets closed for the weekend. There is an unspoken commitment by central bankers and global leaders to prevent volatility in their respective financial markets. Volatility is the general definition of risk, and there is a clear connection between financial market and economy. In other words, no one wants to trigger speculative rout that could turn into tangible economic pain. And yet, that typical preservation of self-interest doesn’t seem to worry some of those in power looking to stir norms.
    One of the more common culprits of this push against norms is US President Donald Trump and those in his administration. Announcements of new tariffs on Fridays are now commonplace. And this past week would not deviate from that new norm. Two people in the administration with knowledge of the plans said the President intended to push forward with the proposed $200 billion increase in tariffs on Chinese goods despite the effort to revive talks this past week. This is not exactly surprising given the United States negotiation approach of late. They seem to prefer discussing terms after exerting pressure on their counterparts in an effort to leverage a more favorable outcome. It is also the case in this instance that the remarks are not official – as in they do not come from the President himself. Typically, Trump prefers to announce such things himself to signal he retains final say over such matters.
    Leaks are another increasingly common feature of the US political landscape which unexpectedly adds more uncertainty to an otherwise surprise-oriented policy approach – but at least one where we know to focus for answers. Whether intentional or not, the major announcements in policy from the US and other major economies into the twilight hours of the week creates a resting state of increased uncertainty for financial markets. We do not need any more reason to question our already excessive exposure to risky assets between the dependency on excessive monetary stimulus which is starting to correct, exploding levels of debt, increased speculative leverage and obvious efforts by superpowers to promote local growth through policies that curb others’. A frequency of last minute and troubling headlines just before the markets close is yet another reason traders could naturally want to curb their exposure. 
    Evaluating Fundamental Themes for Both Their Probability and Pace of Progress
    Trading fundamentals can be overwhelming for many. While there are many different motivations for market participants the world over to place or remove exposure, there are typically key reasons that draw many – if not the majority – to alter their views in tandem. If there were a first rule for trading using fundamentals, I would say it is to first establish what is most important to the market-at-large. Another functional application of this broad analysis technique (perhaps rule number 2) is to establish the nature of the theme or event itself. Is it complex or straightforward? Is there a distinct time frame for it to render its verdict or is the outcome something that can be debated through time?
    Depending on the circumstances surrounding these fundamental matters, we can determine what kind of contribution they can make towards our trading – or how effectively they can otherwise complicate the opportunities that may otherwise seem complete. We can use examples to illustrate. The Federal Reserve’s next rate decision is scheduled for September 26th. There is clear anticipation for yet another 25 basis point rate hike by the policy authority with swaps pricing in nearly 100 percent probability. That is clear time and outcomes (hike or not). Such simplicity can make for straightforward Dollar or risk trends – though it will also drain the market-moving potential of an outcome that meets deeply discounted scenario. There is still complication in the forecast for another hike around December, pace in 2019, concern over external factors and more; but those clearly are not the primary interest.
    A significant step up in terms of fundamental complication are the ongoing NAFTA negotiations between the US and Canada. While there have been a few dates of confidence thrown out by officials, there is no definitive end date. There is also substantial discrepancy in the outcome for these talks such that a compromise or dissolution of trade relations can render significant market moves. This is an even that is far more difficult to predict for timing and outcome, but it renders far more market movement. And, then there are those events that can continue without resolution for considerable time and the full impact cannot be readily be predicted until long after it is implemented. That is the situation with an event like the US-China trade wars. There are no milestones for furthering the tensions or reducing them and it can prove a systemic threat that directly leads to a global recession and/or financial crisis. Yet, without clear guidelines, the practicality of trading around it is exceedingly difficult. 
    And Now, the Central Banks with Failing Credibility
    This past week, the European Central Bank (ECB) and Bank of England (BoE) delivered their respective monetary policy decisions. These are important policy groups whose decisions carry far beyond their respective economies. The ECB marks one of the most aggressive dovish central banks amongst the majors and carries significant responsibility for sustaining the belief that market enthusiasm is borne out of the extraordinary support these groups are offering to the system. Perhaps recognizing the position they hold and uneven health of its member economies, it is struggling to decide its course. The BoE is one of the most hawkish major players with a course of inflation that is above target and could be used to evaluate the central banks’ commitment to the ‘rule of law’ for targeting price growth as a determinant for monetary policy. Of course, they are dealing with the uncertainty of Brexit which is a situation not uncommon across the world’s largest economies. So this group is acting as an unexpected template for how to deal with external pressures. These are important groups whose moves will be monitored and likely mirrored by other central banks.
    The upcoming two rate decisions this week will not be evaluated for the guidance they can offer others. Rather, they will instead be used as lesson on what to avoid. The Swiss National Bank (SNB) and Bank of Japan (BoJ) have failed to apply policy that renders the deserved effect for promoting growth and price stability – not to mention unstated goals of financial health. They are in fact both groups that have lost significant credibility in the markets, which makes their job all the more unmanageable. The SNB will no doubt keep its rates firmly in negative territory, yet the desired depreciation of the Swiss Franc is unlikely to follow years of unchanged policy. Given the dependency on exports of goods and services – and particularly to the EU – they are primarily concerned with the unfavorable level of the EURCHF exchange rate. This will not change materially until the ECB itself follows a course that allows for more appreciation of the Euro.
    While the BoJ has not done anything so dramatic as the SNB’s implementation and sudden removal of a floor on its key exchange rate, the central bank has clearly embarked on a policy course that has consistently fallen short of its mark. Interest rates in Japan have been kept near zero for decades, and the rise of QE programs was eagerly adopted by the group in an effort to stoke price growth. Despite a steady escalation of this downpour of funds, price pressures have not solidified and the markets have increasingly discounted their ability to even move the Japanese Yen for secondary favor. What we should worry about from these two is what the market response is when such groups are forced to capitulate or the recognition of how exposed the system is should another crisis arise where such groups have no hope of averting collapse. 
  25. JohnDFX
    Ending a Trade War is a Windfall for Growth? 
    US and Chinese trade officials met this past week to lay the groundwork for another attempt to push for a breakthrough in the superpowers’ ongoing trade war. These are lower level meetings aimed at finding concessions and terms for which Trump and Xi would eventually sign off on. With over $350 billion in goods from both countries saddled with import taxes, the economic toll the engagement is exacting is starting to show through in data. In the US, trade figures have shown a rise in the deficit and sharp drop in exports to China, costs have risen for a range of goods normally curbed by cheaper foreign production, and confidence metrics have reversed course. The NFIB small business sentiment survey for example has fallen back to the level it stood at during the Presidential election. China’s economic updates have also marked multi-year lows in GDP, industrial production and more. While they are generally all firmly in positive territory, there is likely a ‘premium’ China attributes to its data.
    A growing number of institutions and economists are warning that the world’s second largest economy may be on the path for a stall and/or the collapse of its excessive low-quality debt market. The Trump Administration seems to have gotten whiff of at least one of those analyses as they have made repeated remarks about the strained position of their counterpart’s health when justifying their steadfastness. Officials jawbone (or talk a market or asset to a higher or lower level) for a number of reasons. Some central banks have attempted to talk down their currencies (BOJ, RBA, RBNZ), the Fed turned it into a tool (forward guidance) and economic leaders are constant cheerleaders for their own economies and markets. Yet, it is highly unorthodox, to say the least, for leadership in one of the largest economies in the world to stoke fear in a global peer. And yet, that is what President Trump, Chief Economic Adviser Kudlow and Treasury Secretary Steve Mnuchin have done over these previous months.
    If neither of these countries were to blink, it would inevitably tip a financial or economic crisis for at least one of them. And, if one slips into the abyss, it will pull the other in with it. Perhaps this recognition is starting to sink in, or the ‘game of chicken’ is simply too dangerous now with the US equity markets sliding with the President starting to take some of the blame. It has been reported that Trump has told his team that he wants a deal to be struck to help stabilize the markets. It wouldn’t strain belief at all to imagine this was a serious demand from the President. There were some boilerplate remarks of optimism this past week which were largely overlooked, but the Chinese Vice Premier’s planned visit on January 30-31 may indicate they may be close to resolving their issues. It is worth evaluating a future where a resolution is struck. Yet, putting the scenario to the test, would pulling out of a destructive economic policy in turn translate into a windfall of growth and investment opportunities? No. It would remove a manufactured threat that has already inflicted permanent damage and would allow the focus to shift to a host of other unresolved issues. Preventing further damage is the best the two sides can hope for in this situation. 
    The Lasting Effects of a Record Breaking US Government Shutdown
    We have broken a record over the weekend. As of Saturday, the partial shutdown of the United States government surpassed 21 days to count for the longest closure on record (surpassing the 1995-1996 stretch during the Clinton era). This is not a record to be proud of as it will translate into weaker economic growth, a drop in sentiment and the complicated progression of lower sovereign credit quality. The general economic implications are perhaps the easiest to envision. Government supported industries (such as airlines) will see their costs and revenues suffer while the 800,000 federal employees that are furloughed will not be paid. It is estimated that every week, the US economy will lose between 0.05 and 0.1 percentage points of growth owing to the situation.
    Even three weeks of that is significant given the state of economic conditions when this factor is excluded. Perhaps a (small) silver lining was the strong bi-partisan vote by Congress to provide backpay for those same federal employees – though that doesn’t offset the ultimate pain. Sentiment is another victim of this situation. We have seen consumer, business and investor sentiment sink the past months for a few reasons, but this shutdown is no doubt a contributing factor. If the country can’t come to an agreement on a basic stop-gap funding, what is the probability that they will be able to fulfill the infrastructure investment plan touted ever few months for years? My greatest concern for this situation is the damage it does to the United States credit quality. All of the three majors have issued some sort of warning on pursuing this path, but the most recent official statement came from Fitch this past week. There are those that don’t believe a downgrade is possible for the US sovereign rating, to whom I say it already happened when Standard & Poor’s cut the country one step to AA+ back in 2011.
    There are far more that believe it wouldn’t matter if another cut was made – and they would use the 2011 example as their evidence. When S&P cut the US rating, there was a distinct and severe move in credit and risk assets. Eventually, the market’s did stabilize and push the concern to the background because exceptions were made for the event. Even though many covenants only allow for top credit rated assets as ‘risk-free’, most agreed to make accommodations so as not to completely upset a financial system that relies heavily on the haven status of T-notes. Add a second, third or more cuts, and it looks less and less like a one-off. It registers as an absolute need to diversify. It may be hard to appreciate how systemically important this is, but the tipping point could fundamentally change the financial system and US standing in the world.  
    Breakthrough or Not, A Brexit Vote that Can Charge the Pound 
    We are just over 75 days away from the official date that the United Kingdom is due to separate from the European Union. If all that was necessary was to come to terms with an agreement between the two parties on their relationship post-split, this would perhaps not be so frightening. Instead, there is considerable preparation that needs to be done before that date even comes around. Most would agree, that the time table for an accord and steady transition was some months ago. Now, with each passing week that infighting persists, the consideration and appreciation of painful scenarios increases. We have the opportunity to finally find agreement from the UK’s side this week. On Tuesday, Parliament is set to vote on the Prime Minister’s Brexit proposal. You may recall that a vote was called on a previous plan, but May called it off at the last minute when it became clear that it would be handily defeated.
    It is nowhere near as clear time around that the MPs will deal the PM another rejection, but that is the leading consensus. If the proposal is accepted and the UK can return to the table with the EU, it would certainly be construed as lifting a significant weight off the Sterling’s shoulders. There are still a host of unknowns including cross boarder investment, financing and banking liquidity; but at least there will be a viable path the markets can follow. If however, she is rejected, the markets will grow increasingly agitated, fearful that an accident will happen. Following recent votes, Parliament passed law that if the proposal was rejected, the government would have to produce a ‘Plan B’ within three sessions (Monday as Friday is closed) rather than the standard 15. They had also previously ruled that if the country were heading for a ‘no-deal’ Brexit, that Parliament would have more say over the ultimate path.
    As it stands, there seems less risk of a crash out; but the hurdle for an agreement between the government and parliament remains very high. Uncertainty is a bearish pressure on the Sterling. An agreement would remove a considerable amount of that fear and perhaps help stoke a recovery. Looking at the CME’s Pound Volatility Index, fear remains troublingly high relative to other currencies and even other assets. Outcome or no, be prepared for Pound volatility. 

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