Market Insights

One Swallow Does Not a Summer Make

Spring has well and truly sprung, though many currently feel more like they’re being continually pronged by a wayward mattress spring. It has certainly been a tricky few weeks, with stocks and fixed income rallying, and volatility plunging. On March 15th, when the Fed hiked rates for the second time in just 4 months, weren’t we supposed to be on the brink of a brave new era? A “proper” hiking cycle? Inflation back, baby, and you better believe it? Now instead we find ourselves well and truly stuck back to the future, with the dominant narrative being that Carry is King. Climb that wall of worry: buy stocks, buy bonds, sell vol, and keep on picking up the pennies in front of the steamroller.

As the VIX heads to the lows of the year, Bloomberg ran an article flagging up the explosion of interest in sell-vol strategies:

With this as the backdrop, we are once again in the virtuous loop that takes stockmarkets to within a percent or two of their highs of the year, and encourages inflows into bonds. Anywhere, anything with some yield will do. After all, even with that Fed rate increase, global yields are still ridiculously low. Money has to be put to work. But oh, that article from BBRG also flags up that there is still a short base in the US Tsy markets, at least as far as the IMM positions are concerned. This is despite the fact that there was a record cutting back of this position in the 10yr in March:

So let’s get this straight. Into the end of the quarter, specs were moved to massively trim their short 10y exposure, but increase their short in the front end? Sure, there is some rationale to this, if we believe the Fed are hiking in the near term, but we are not convinced the US economy is robust enough to deliver lots more hikes in the future.

You’re sitting there re-reading that paragraph, mulling it over in your mind. You’re wondering if there is indeed enough momentum in the US economy. You’re wondering what Janet Yellen might do, the crazy old dovish hiker.

This is where we need to stop.

That was the old world. This is the new one. In less than a year, Yellen is likely gone. Ahead of that, the new President has several Fed Board places to fill (another one now that we hear Lacker “accidentally” revealed market-sensitive info to Medley Global Advisers (Charlotte Hogg is probably as astonished as the rest of us that this isn’t front page news)). Separate to that, the President is cracking on with his agenda, throwing around new visa rules that prevent IT behemoths from employing immigrants, while his Commerce Secretary writes in the FT that the US “has the lowest trade barriers and the largest trade deficit in the world”. He goes on:

This is why President Donald Trump has directed the US Department of Commerce to report back within 90 days with a comprehensive analysis of the economic realities and the fine details of America’s trade patterns. Once Mr Trump has that analysis, he will be able to take measured and rational action to correct any anomalies.

Yes that’s right, he’s working on it now, and trade is something he can affect by executive order alone. The market is still figuring out how he can deliver tax reform now that the Obamacare Repeal imploded, but it’s so stuck on that, it has failed to spot what else is on the horizon. In fact, its eyes have glazed over, and it’s hit the shift+f9 buttons that tell it to keep on carrying, because that’s what worked for the past 7 years, right?

This inability to incorporate political risk is global. The market only ever put the chances of a Le Pen Presidency at around 35%, and the inexorable rise of charming Blairite debutante Macron has seen this fall back to less than 25%. The betting markets saw Macron catapult up to 70% probability of winning, with Le Pen barely registering as anything with which the market should bat an eyelid:

The EUR/USD risk reversal has concomitantly flipped back higher, with its extreme bid for Euro puts now registering as barely a flicker; less even than we were concerned with during the height of the sovereign debt crisis:

So the options market is now almost entirely ambivalent about the risk of France leaving the EU or the Euro, even though one of the two most likely second round candidates in its election in just 5 weeks’ time has both of those as a manifesto pledge? The Euro may have faced an existential crisis in 2011-12, but as we should now appreciate, it is by crisis that the politically-derived currency is forced closer together. Now, 6 years later, with an economy on its knees, a deeply unpopular President and a country unfortunately beset by several debilitating terrorist attacks, we think the French aren’t having their own existential crisis? Or at least that the risk of that is so small as to be unremarkable?

We are due a reality check. The tremors are there. The 13% sell off in the South African Rand over the past two weeks is more than enough to panic those trying to gain access to its 3 month yield of 9%. The Rand is always our bellwether for the insanity of the Keep On Carry Crew: they just got a nasty burn. Meanwhile, market fragility has nicely been shown up in the wobbles in the semi-pegged Czech Koruna ahead of their recent central bank meeting. The central bank’s commitment to keep the floor in place expired at the end of March, and ahead of its meeting on 30th March we saw a few punters try their luck at anticipating the removal of the floor. The CNB had no intention of doing anything, but the activity was enough to see volumes increase over 6x more than normal:

Well, maybe these can be written off as idiosyncratic, country-specific risks. We have seen enough flash crashes over the past few years not to worry, right?

But those happened without the backdrop of a reshaping of the global political order. They happened before central banks became an irrelevance. They happened when we could still try to plot the path for the global economy with some kind of certainty. Not when Britain chooses to leave the embrace of its largest trading bloc; or when a political novice becomes leader of the free world; or when France and Germany face existential elections for their heads of state.

So, one swallow does not a summer make. The summer is more likely beset by a market coming to terms with how fiscal policy works; what the Separation of Powers actually is; how trade negotiations take place; rather than its usual quantitative play off between risks of inflation and the risks of volatility.

Until then, carry on carrying the spring-time swallow.
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When Politics Into Finance Won’t Go, Part 3

Those years of monitoring central bank activity are well beyond us. Blondemoney herself got drawn into that most recent Fed meeting, but from now on the focus is firmly on the politicians. You can’t have a debate over how the Fed will reduce its balance sheet, without keeping an eye on how Trump will populate the Fed with His People, just to get something done. You can’t really expect the Bank of England to have a coherent 2year view on inflation now that the deed is done, Article 50 is signed, and we’re on a rollercoaster whose path no one can predict. Not least of all, the people actually driving the rollercoaster. Soon we will long for the days we could do something as simple as pore over a central bank statement for whether they slipped in the word “appropriate” or “gradual”.

No, now it’s all about how the world of politics actually works. And the reality is that it is messy. This isn’t time for you to roll your eyes about how those blasted politicians need to Get Things Done, and If Only They Worked In Business They’d Know A Thing Or Two. It’s exactly this attitude that leaves the VIX languishing at multi-decade lows. The abject refusal by markets to engage with the politics is why volatility measures are so low. Once investors realise the entire framework of their analysis has to change, there will be a lurch. We are starting to see it, with stocks coming under pressure. Those 114 consecutive days in the S&P without a move bigger than 1% have been broken. There is even a narrative that now suggests stocks should feel a bit wobbly: if they were bought on the premise that Trump would be delivering bold tax reform, that thesis looks more than shaky. There is a dawning realisation that a “clean sweep” for the Republicans doesn’t mean “The Executive branch can get done whatever it wants”. America may have a two party system but each party is a broad church. Two parties doesn’t mean only two opinions. It just means the system was set up such that only two parties would ever be able to survive. The Separation of Powers, where the executive (President) is institutionally prevented from dominating the legislature (Congress) means that you have to corral factions just to get things done. Ironically, the French institutional system creates a much stronger President, as they possess both executive and legislative power: but that’s a story for another day. The story for today is that the so-called “Trump Trades”, such that they ever existed, should be almost dead and buried.

Now, this doesn’t stop the fact that the world economy is doing OK, thank you very much, and that reflation is alive and well. It doesn’t stop the fact that most countries can therefore step back from the unconventional emergency monetary measures they took when deflationary doom was all around. That secular shift in the macroeconomy is done. Higher yields, they are a-comin’.

Hence, the Buy the Dip crowd can merrily fill their boots on assets that prosper in a reflationary environment.

That is until volatility comes back to scare them. This is where we go back to the only nascent appreciation that politics will provide that volatility because it is almost entirely unquantifiable; and it DOES have an impact on the real economy. The UK has been doing quite well since the Brexit vote precisely because of the rebalancing impact of a significantly weaker pound. So the question from here is whether the pound will recover, or take another lurch lower? And that will depend on how the Brexit negotiations proceed. We don’t know, but we do know that we need to factor in these scenarios:

  1. New governments in France and Germany either support or reject the British position
  2. The UK can’t marshal its own government and there’s either a new government or its negotiating position collapses
  3. Negotiations become so heated that both sides are forced to walk away: Theresa May’s ‘No Deal is Better than a Bad Deal’.

This last point is the most significant when people now say the starting gun has been fired on two years before we leave. What if we leave long before that? Why two years? This hasn’t been done before, it could get extended or dropped entirely. Just like a divorce where it plays along amicably until someone realises they can’t bear to let him get away with the family dog, the terms can change in a heartbeat.

What we should be prepared for from this point onwards is that the focus will shift from the UK’s position, to that of the remaining EU 27. Silent up until now, they can let loose and unleash the toughest stance they want. Markets will likely take fright at this, and that “No Deal” scenario will start to loom onto the horizon.

Ladies and gentleman, please take your seats on the political rollercoaster. Sick bags may not be provided.

Climb that Wall of Worry

The Fed must be delighted. Their second hike in a quarter has been greeted as a dovish hike. This week at least 9 of them are giving speeches: will they pour oil on this becalmed water? Or will it be a case of carry on carrying, as it usually is in the (perceived) absence of event risks… Our favourite blind-pile-into-high-yield, the South African Rand, is at the highs of the year – in fact of about two years.

This is the disquieting fact about markets since central banks got unconventional: the status quo isn’t a flat line, it’s an upward slope. Just as equities always had a long bias, with money needing to be put to work, now bonds, commodities and carry currencies experience the same upward momentum in the absence of anything else going on. So events pass by, positions are shuffled, and then volatility is completely smashed – driving the daily wall of money into higher yielding assets. With negative interest rates out there, why wouldn’t this happen?

Ah but those negative interest rates will not be with us forever. In fact, the interest rate pile is fast shifting from those falling over themselves to cut, to those trying to erase the easing. And thus the Fed must indeed be delighted that their dot plot for the next two years would take them above one of the previous kings of carry, the Australians, without anyone noticing.

This is allowing those uber doves, the ECB, to sneak out their hawkish feathers unnoticed too. We are used to comments from hawks like Nowotny, who last week popped up to argue that the deposit rate could be raised before ending QE.

But now one of the doves, Italy’s Visco  has also said that the time between hiking rates and ending QE could be “shortened”.

The exit debate is clearly furiously afoot at the ECB. Maybe that explains Draghi’s almost exasperated attitude as the last press conference. He referred back to other statements so often that it’s clear he doesn’t want to stamp his voice on the official ECB communications yet.

Other developments over the weekend should also give carry-hunters pause for thought. For the first time in decades, the G20 couldn’t agree that “refraining from protectionism” was A Good Thing. We all know the elephant in the room is orange, and he wants bilateral trade deals as the only way to ensure his country gets its way. But this creates significant risks ahead for those who are in line for a deal and for those who are not. Not just the US: note that Merkel’s main response to her meeting with Trump was to emphasise the need to get the EU/Japan trade deal confirmed ASAP.

This is a paradigm shift from the shibboleth of the past two decades. Previously the equation ran: Globalisation good = trade up = EM growth = DM growth = commodities up BUT inflation down as new labour came onstream and technology made us more productive. Thus the Great Moderation. Now many of those forces are going into reverse. Does this mean growth down but inflation up?

Let’s keep climbing the wall of worry until the stagflation demons make themselves known. Oh, and while we are at it, let’s not forget the monetary policy divergence rankings are rearranging themselves too.

The Ides of March are almost come; but not yet gone

Tomorrow is going to be a long day. Its shadow already looms large and may cast far. Within 24 hours we get the Fed, the Dutch elections, the Swiss National Bank, the Norges Bank, the Bank of England, along with US inflation, US retail sales and UK employment data.

But when history looks back upon this day, there is really only one character who will make it so notable. One Caesar, or perhaps from the market’s perspective, one Brutus. Step forward and bootless kneel, Ms Janet Yellen!

Yes, the Fed should finally deliver their next rate hike and all the focus is on what they signal from this point forward. The Dots are back in vogue. The market is pricing just over 2.5 hikes by the end of the year; the median dot in December was 3 for the year and they’re just about to give us 1 of those 3. The big question is: Can they really claim they’ll do another 3 before the year is out?

The scepticism inherent in that question is strong, and with good reason. Ever since the dots were introduced, the Fed has failed to deliver. They were introduced in Jan 2012 alongside the forward guidance about keeping rates low until unemployment hit 6.5%. The market has consistently underpriced the Fed. Here’s the 2yr rate, with each horizontal line showing the median dot for 2 years from the date of the Fed meeting:

So in 2013, the median dot saw rates in 2 years’ time at 2% (white line), then in 2014 it was up above 3% (red line). In the most recent set of projections in December, the 2 year rate was expected to be around 2%. So, the market still underprices the Fed, but by less as the Fed has come down to meet the market. Some of the shift lower can be attributed to a new reality. After oil prices hit their precipitous decline at the end of 2014, the world’s central banks fell over themselves to keep things easy; and unimpressive global growth kept yield curves under control. “Secular stagnation” was all the rage.

This narrative is important to bear in mind as we head towards the Ides of March. “Secular Stagnation” is about to be sacrificed at the altar, because reflation is real, it’s here and it’s happening.  Chinese producer prices are now up almost 8% YoY – just 12 months ago they were in deflation, at -5.9%. That’s one heck of a rate of change. Commodities are moving higher, and even inflation is even managing to move higher in the uber-deflationary doomsayers Japan and Europe:

This was happening absent the Trump effect. But if he can get an infrastructure build through Congress, and jumpstart the animal spirits, well… there’s only one way this can go. Let’s not forget that optimism surveys are printing staggering new highs:

So, the world is changing. But markets can sometimes be slow to spot it. Particularly as central banks have been dictating the game for the past decade. They had to. As lenders of last resort, they were the only people able to keep the game going. But the baton has passed. They did their work. But it’s time for them to remind us of what we cannot see.

You might argue that the Fed have disappointed you one time too many. Yellen is the uber-dove isn’t she? Scarred for her tenure by the Taper Tantrum mishap that took place just months before she became the Chair.  Handed the poisoned chalice of exiting from unconventional monetary policy into one of the weakest recoveries the world has ever seen. Why wouldn’t she be cautious?

Ah, but the calculus has changed for her too. Before November 8th, she could be relatively happy that she was handling the poisoned chalice with aplomb, and that President Clinton would no doubt give her another 4 years to make sure the job was done. But then she woke up on November 9th and realised that President Trump, a vocal opponent of the Fed, would now determine her fate. She would only have 8 more meetings to set up her legacy. And perhaps even less than that, with 2 seats already vacant on the Fed for him to fill, plus the chance to fill another 3 in her final year. (NB: When the market looks at pricing 2018, it should really realise that 6 of the 7 member board will likely be completely different by then).

So, she has 8 meetings, but only 4 with press conferences and the Summary of Economic Projections. For some of those meetings, Trump supporters may be sitting across the table from her. So she had to act.

First, though, she had to see how the 100 days panned out. After about 40 days, Trump hadn’t stirred up a tweet-storm about the Fed. She saw her opportunity and went for it. In the first week of March, Fed speakers were falling over themselves to run to the hawkish side of the boat. Pricing of a hike in March, which had been assumed a relatively dull meeting until the Trump administration got their fiscal plans up and running, moved from ~25% to ~80% chance of a hike.

So this explains why the sudden rush. She had an opportunity and she took it. But it also provides insight into how the March meeting is likely to pan out. Yellen has got to signal a decent number of hikes ahead. Just think in a couple of years from now, if there is another financial crisis, Trump will be the first to point out that the blame lies with the failure of the Yellen Fed. That she deliberately sowed the seeds of the next crisis by keeping rates too low for too long. Sure, she will also be prey to risks that too much hawkishness now runs the economy down, but with stock markets at record highs and the data in pretty good shape, she can afford to take some of that heat. She can always dial it down in the run-up to the June meeting if required. We get a lot of data in the Summary of Economic Projections – keep an eye on the forecast for long-run rates. This has edged down from above 4% when they began to 2.9% now. Even if the dots remain the same, this could now move higher as she balances out the message.

In any case, it’s not the dots that are the only source of any hawkishness. Balance sheet reduction has to be the name of the game, given she was tasked with exiting from unconventional policy. This will naturally increase the effective interest rate. Her own exit has sped up her calculations of the Fed’s exit. On the Ides of March, the assassination of ‘lower for longer’ will be complete.