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What do we do now?

So we were all waiting for the inauguration. Now we’re all waiting for…. what, exactly? Some kind of confirmation that either a) we should add to the trend of the past few months; or b) get the hell out. And for this signal, we look to what we have always looked to: policymaker intentions or shifts in the data. The latter suggests that we are OK 10-4 good buddy to proceed with a general reflation theme. After all, the world’s central banks are now finally shifting out of “lower forever” while the data shows a genuine and persistent upturn in inflation. If policymakers were only central banks it would be easier.

Or would it? Remember our favourite unreliable boyfriend, one Mr. Mark Carney? Remember how he was keeping rates low until unemployment hit a certain level. Then when we got through that level, it was keeping rates low until a whole host of indicators hit certain levels. Then eventually he ditched all of those and tried to remove forward guidance altogether. He is, as we all know, a consummate politician. And it’s in this vein that we should now look at the actual politicians. At least Carney really only had to be beholden to where markets took interest rates. The actual politicians have to look to the electorate. And if we think markets are volatile bullies, let’s see what happens when their voters take to the streets. On both sides, as we have already seen in the US!

A loyal BM reader sensibly pointed out on the weekend that Trump would spend his first few days simply revelling in his power, kicking back and relaxing at the countless balls and cocktail parties. That’s true, but it didn’t stop him (or rather his people) taking down a number of White House web pages (e.g. climate change), nor making sure the first media conference called by his press secretary involved shouting about “lies” over the size of the inauguration crowd and telling the media what they should be reporting. This would be almost amusing if it were not about to clash hideously with how we started this blog post. We are looking for confirmation, for signals. We have just found out that the new administration’s plan is NOT to signal the truth. It’s to obfuscate, deliberately. It’s to create a climate whereby no-one really knows, thus turning the world into ‘believers’, ‘non-believers’, and ‘too-confused-to-care’. The first set will cement Trump’s power; the second will rail against it, entrenching further the first set. The final set could, if enough division were sown, fall into the first set just because it’s easier. So anyone expecting this to upset the balance of power should be careful.

More significantly for financial markets, it means, and this is a point you’ll keep hearing from BM, that we are not the focus nor object of any policy pronouncements. We will be left to our own devices. We are not going to get regular policy updates, like when you have central bank meetings. If we do, they may leak beforehand. Or when the market is closed. Or be altered afterwards. It’s like the Supreme Court ruling on Article 50 tomorrow morning. It doesn’t really matter, because no MP would really vote down the triggering, given the weight of public opinion. Plus the unfortunate state of our opposition. The House of Lords is a different matter but even then they should struggle to oppose it or add many conditions to its triggering. Theresa May’s speech last week was designed to make it a fait accompli. The debate has moved on. It’s not about triggering, it’s about what Brexit will look like.

This rolling non-linear evolution of political risk is what will cause the market a headache until it adjusts. Time for the developed market world to take a look at how emerging markets do it. (Turkish Lira to US Dollar, anyone?)

Trump Day One

It’s actually not just Day One we need to consider. It’s Days Two and Three as well, given that he gets almost 72 hours to exercise his executive power before the markets get a chance to price all those changes. And yet, as we have seen, volatility measures are low; the belief in both long USD and short UST remains strong (despite the recent correction); and the recent Brexit fandango in GBP suggests political risk is still confined to the realms of “short term noise”.

This is all rather strange. The ratio of investor conviction to investor positioning looks out of whack; and, more worryingly, so does investor positioning to the extent of certainty ahead. You’re telling your buddy in the shoot-out that you’re not sure how many bullets are in your gun as he asks you to cover him…but he heads off into the hail of bullets anyway. IMG_4466

The whole Trump is the new Reagan narrative is about to get blown up. He may indeed drive economic reflation but before that he’s got to strike a whole bunch of new trade deals; get a bunch of American companies to bring business back onshore; and get a bunch of his buddies into the Fed and the Supreme Court. Will there be time to call China a currency manipulator before his bedtime? Doesn’t matter really, because if he decides to on Day Four, he will go for it. (But the Treasury report on currency manipulation is semi annual you say? Ah but presidential power derives from their comments as much as their heavily-constrained actions).

Even if his first few days are not as frenetic as he had initially suggested, the fact is that the path of future outcomes for the economy is much wider than before. Concomitantly, the amount of risk placed into reflation trades may be too large for the uncertainty ahead.

Indeed, the path of future rate hikes isn’t even the roadmap anymore. We already discussed how Yellen may not be around to do her 6 hikes by 2019… well after the ECB, the German FinMin was straight on the wires with the “disadvantages” to QE, and how, with German inflation edging up to 2%, this creates “political problems in explaining to the German audience”. Will Draghi want to blow up the Eurozone by refusing to taper? The man who said he would do whatever it takes to save it? So, no, the framework that guided your investments for the past few years will not be the one for the year ahead.

Instead, focus on this chart, from Fathom Consulting:

IMG_4467Tariffs down, global trade up (the right hand scale is inverted).

This entire equation, that has lasted for 25 years, is turning. It’s time to look for stocks or currencies that benefit from protectionism, and shy away from the most open economies or those that rely on exports to the US. Short AUD and short CAD, long NOK and even long USD?

Answers on a postcard. You’ve got 3 days to come up with them!

There is always volatility around turning points

The world is shifting on its axis. The markets are realising, after almost 10 years of constant focus upon them, that they’re being thrown to the wolves. Left to fend for themselves. Worse, in the case of Trump, forced to say “how high” when he says “jump”.

But we’re not there yet. Old habits die hard.

Consequently, after Janet Yellen pops up with some hawkish comments, the US Dollar and US yields rally. With the ECB meeting today, that lures back in the EUR/USD sellers, keen to practise some of that monetary policy divergence mojo that proved so magical for the past few years. Janet said:

‘As of last month, I and most of my colleagues – the other members of the Fed board in Washington and the presidents of the 12 regional Federal Reserve banks – were expecting to increase our federal funds rate target a few times a year until, by the end of 2019, it is close to our estimate of its longer-run neutral rate of 3%’

For those who still expect perma-dove Yellen to side towards the lower end of the dots, this was a little hawkish shot in the arm. That’s a few hikes a year, for the next 2 years! Woo hoo! So much, so buy Dollars. And indeed, Blondemoney would have thought the same, were these comments delivered a few months back. But that was before monetary policy died.

The trouble with that end-of-2019 vision is that Yellen herself could be gone in a year’s time when her term expires. Indeed, as soon as President Trump is inaugurated, there are 2 already vacant spots on the Federal Reserve for him to fill. Furthermore, these lovely 3 hikes a year are forecast before taking into account any Trumpian changes to the outlook for the US economy. Note Yellen starts that comment with the proviso as of last month…”. It could all be very difference in just 2 days time.

With this in mind, we should expect the market to run from one side of the boat to the other. On the one hand, Trump might not want a strong dollar any more… with the other, let’s get back to the reassuring world of “Fed hikes vs ECB perma-QE”. As we shift from the old reality to the new one, expect decent volatility.

Then, we must ask ourselves, why is one of the biggest short positions out there the one that is selling the VIX?? [This chart courtesy of a loyal BM reader in Brazil]:

HF conviction positions

Yes just behind being uber short of the US 10yr, there’s being short the VIX.

Absolutely nothing at all on the horizon that might see stock markets, already at record highs, suffer a bit of a wobble?
Nothing?
Nothing at all?

Why we struggle with the new world of risk

So, you’re now thinking, after the biggest rally in GBP in 9 years, what next? What other crazy over-crowded positions could get hosed down after someone repeats what they had always been saying, but no-one wanted to listen? Because we know, don’t we, deep down, that the fundamentals go out of the window when positions are skewed versus the possible path of future outcomes? This chart of the US 10yr was always vulnerable to a correction:

img_4454

No surprise then that in December, “stagflationary collapse in the bond market” was the second biggest tail risk on fund managers’ minds (according to the BAML survey). Let’s just look at how that survey has shifted this month:

BAML FMS Jan 17

Yep, paring back of the bond market worries, but rushing right into the top 2 places, it’s Trump related mayhem. Now, this doesn’t mean that we are about to see a reversal of trades that have been placed to take advantage of this “Trade War Protectionism” – because actually not that many positions have yet been put on to reflect this. The question is whether, after this weekend, and Days One, Two and Three of the hyperactive orange man’s Presidency, will they be?

Interestingly, Brexit risks were considered a low tail risk last month and low this month. So price action is not always about the long-term part of the market – and this suggests that the risk of a disorderly Brexit is thus far underappreciated.

Yes, it’s a game of poker, but where every round the chips are all thrown up in the air and no-one is quite sure where they’ll land…

Think! Part 2

Blondemoney enjoys how this blog collates threads because it shows how themes seep through markets (even if it does also show up where she was wrong as well as right). How investors start to come to a realisation of what the driver is. We have had “Hands up if you’re not easing“, “Inflation” and even the esoteric “How volatility eats itself” …. the point is that new drivers turn up which shape how assets are priced: What happens if interest rates are low forever? What happens if inflation is back? What happens when volatility spirals downwards as well as upwards?

But now the theme is an even bigger one.

It has been perplexing to see just how confident everyone became in the narrative that Trump was the new Reagan, but trying to fight it would have led to short-term losses. It has been perplexing to see how Brexit fell off the radar. It has been perplexing to see how Le Pen hasn’t really got onto that radar. What’s been going on?

The market has the wrong rule book. 

It’s no longer about economics. It’s about politics. But the market hasn’t appreciated that yet. Trump fit into the steeper yield cure narrative because the Republican clean sweep was due to deliver a fiscal stimulus. Brexit didn’t matter so much because the UK had delivered better economic data. France similarly isn’t an issue as European PMI data was turning higher.

For each of these, the focus on the politics was purely on how it might affect our standard economic view. Which is shaped by the central bank. To be fair, central banks have been the main actors for 10 years, the only people with the immediate tools to pull us from the abyss. Their mandates determined market moves. The ECB had to do QE to fight its inability to reach its inflation target. The politicians were all sidelined anyway, hamstrung by the markets, who would apparently refuse to fund those countries without sensible fiscal plans. Even when politicians did flare up, such as Tsipras in Greece, it was so that they would play ball with plans to bailout their bond markets.

Markets, markets, markets. We were on top. Primus inter pares. We drove it all. We were the tool to boost animal spirits after Lehman fell. We were the heart of the problem and we were there to solve it. We were Master and Slave of all central bank and political action.

But Blondemoney has to break it to you. We’re not any more. We are no longer driving how economies change; we aren’t dictating how economies must be run; we aren’t being manipulated as the only tool left in a threadbare emergency box. We are not the central hub.

So, now, we have to get used to this.

We are going to be the effect, not the cause, of a whole bunch of policies that are coming down from our political leaders. Currencies to be smashed up in trade wars; interest rates to ebb and flow with a return to normal monetary conditions; stocks to shift depending on tax policies.

If anything, all that buy-the-dip, low-vol from the last few year has just emboldened politicians to forget us. Of course, one day it will come back to bite them, but at this point we have to adjust to the new world order first.

This means understanding that their actions are not rational. Not quantifiable. Not designed just to avoid market mayhem, nor to lever off market positivity. “But the UK can’t agree a trade deal with Trump, it’s not legal!”, “If they do, GBP will get smoked and they’ll have to raise interest rates!”, “the EU won’t let the UK go easily”, “Trump will cut taxes and repeal financial regulation as first priority”, “There won’t really be a trade war because no one wins”……………………….. all of these thoughts might seem terribly sensible. Particularly if you have spent 10 years dealing with the simple equation that “policy makers will always cut interest rates to make things better; they hate volatility”.

Today’s US dollar sell-off is just the start. Trump might want to manipulate the dollar but more likely he just likes to throw it in there as one of his many tools to pick a fight and win the deal. Note, however, that it is his Treasury department that is in charge of dollar policy. He could meddle in currency markets far more than just naming someone a currency manipulator. Who’s to say that one day he doesn’t create a Moscow-Shanghai Accord that sees Russia and China’s central banks uniting against the ECB and the BOE to trash the US Dollar? Who knows – but the point is that the dollar will not then be driven by a rational response to monetary policy. It’s just another policy lever for the ascendant politicians. And who are they beholden too? Well, it’s the people to whom they owe their power.

The voter stood up and told them they wanted change. A change is gonna come.