Things That Keep Me Up at Night

A strong USD and an end of globalisation simple exasperate the issue. Anyhow, happy to be shot down, so feel free to critique, and respond with views.

Houston, we have a problem. Well, actually if we look across the financial landscape, there are many, and the cross-currents through which traders have to navigate are perilous, to say the least.

We can take Brexit, the Hong Kong protests, a likely German recession, an unfolding European banking crisis, future Italian elections and their inevitable budget showdown with the EU, or trade tariffs – in fact, it’s a surprise we haven’t seen an absolute collapse in risk assets .

Is the USD too high?

My own view is that the two most pressing issues are that Fed policy is too tight and that the USD is too high. But don’t just look at the USD index, which sits at the top of its multi-month range, where a break will get a lot of attention in the market.

Do absolutely focus on the trade-weighted USD, which resides at all-time highs, and one can only imagine how much worse things would be if bond yields weren’t collapsing. Emerging markets would be taken to the cleaners. But bond yields are collapsing; yield curves are inverting and globally, over $16t of bonds are trading with a negative yield.

US-China trade tensions have put USDCNH at the heart of markets and have been the must-watch currency pair, offering an ever-greater impact on China proxies, such as the AUD and NZD. Despite all the calls of ‘manipulation’ from the US trade team, if we look at the set-up on the weekly timeframe, the pair has traded with an air of predictability. And if the USD continues to grind higher against the CNH (offshore yuan), then rallies against the AUD will be sold.

Rising protectionism is not helpful

Clearly rising protectionism and an end to globalisation are not particularly helpful, especially when both the Fed and the ECB lack any real urgency to get in front of the aforementioned issues. Certainly, Trump’s strong desire is for the Fed to act as his hedge against economic fragility, but thus far, he isn’t getting the required support. Regardless of whether we see a Democrat or Republican win in late 2020, Jerome Powell days are numbered and he is not going to see a second term.

In actuality, what I think is at the heart of everything, and truly underappreciated is the impact on the US and global economy of nine Fed rate hikes from December 2015 to December 2018, married with $730b in balance sheet tightening (quantitative tightening or ‘QT’). The strong USD exasperates this and monetary policy is too tight, the market knows it and if the declines were seen in planned investment and trade volumes filter into broader economic indicators, notably the soft data, then the market will take its pound of flesh. Just like we saw in Q418, where markets forced the Fed and the world’s central banks to act.

Much will depend on the data, but should we see a re-run of Q418 it will have huge implications on FX markets, especially for the counter-cyclical or ‘funding’ currencies, which are commonly known as the EUR, JPY, and CHF. As we can see, the CHF and JPY have performed well over the past month, and this could be a glimpse through the looking-glass, to see how things could play out if the market really forces the world’s central banks to ease aggressively.

For those who trade using fundamentals, or adopt a more tactical approach to trading, in this chart, I have overlapped the Deutsche Carry Index (red) against the 1-month implied volatility of 30-year US Treasury futures (green). Here, we see volatility increase in US bonds; we’ve seen carry positions being closed aggressively.

How do I read that policy is too tight?

Well, aside from the more traditional yield curves (such as UST 2s vs 10s), I look the differential between the US 3-month Treasury & the US 5y5y forward rate. The US 5y5y forward rate being the markets best indication of where the neutral rate sits. That being the rate which is neither stimulatory nor restrictive, given the expected levels of future inflation, and growth. Currently, we see ultra-short-term rates 44bp above the implied neutral rate, so it tells me the fed need to cut almost twice just to get to a neutral setting.

The Fed has a communication problem

A US central bank behind the curve and seeing the US economy in ‘mid-cycle’ is dangerous, but, so too, is a Fed that has a communication problem – which it does, especially within the inner sanctums, with the market having seen multiple mishaps from chairman Powell and NY Fed President Williams. What’s worse, is there is a growing view that monetary policy, be it through interest rates taken to zero, or even if we see quantitative easing, will not work should the economic wheels fall off.

Let’s hear what Powell and others have to say at this week’s Jackson Hole Symposium, and whether they see the 12% chance of a 50bp cut priced and look to guide on this.

If the world is sceptical of the ability of central banks to meet their objectives, especially when all central banks, bar the Norwegian Central bank have pretty much laid out their path for further easing, we have to turn to fiscal policy here. There is a growing movement that in the next downturn, we will almost certainly see fiscal policy play a far great role. Potentially using the central bank and the government together to expand base money and target funds to specific areas of the economy.

Fiscal stimulus to play a greater role in the next true downturn

We’ve already heard of a €50b fiscal stimulus proposed from the German Finance Minister, possibly breaking away from the discipline of a balanced budget, which would be a huge political development, but this would be reactive, and not pushed out until the economy reached a maximum pain point. It all suggests to me that ‘real’ (or inflation-adjusted) rates are going far lower, which has huge implications not just on FX markets, but gold and all facets of the capital markets.

The idea of combining monetary policy and fiscal policy is a world away at this stage, but what is important is that market participants believe there is a genuine circuit breaker if things get a bit crazy. A weaker USD would be very helpful, but that would require the Fed look to get ahead of the curve and chop away at rates faster than priced, or even intervention from the USD Treasury department, selling USDs in the open markets, and that is also an unlikely prospect.

Watch the EURUSD set up on the weekly timeframe for guidance

Looking at the current set-up in the USD index (weekly), the current structure doesn’t suggest a crash is coming. Although, the RSI is failing to print the higher highs seen in price. With the EUR offering a 57% weight to the USD index, we keep a close eye on this pair. We certainly haven’t seen the sort of strong trend conditions seen in the GBP or JPY cross. But that could change. This pair will break out of this consolidation pattern, and when it does, it may come up on more trend-followers’ radars.

I guess the other positive catalyst is a scenario where we see a full trade deal, although this seems unlikely before the 2020 US election, or we see global growth somehow improve. The irony in this scenario would be that rates markets price out the aggressive rate cuts, the yield curve flattens, with short-term yields rising faster than the long-end, and again we see risk aversion plague markets, with the JPY, CHF and gold the beneficiaries.

A change of personal at the Fed

All roads led to a world of worry, although the goldilocks scenario is a Fed that goes hard and the data improves slowly but surely. Now consider that in 2020 the Fed will turn structurally far more dovish anyhow with Judy Shelton and St. Louis Fed research director Christopher Waller fill the two vacant Fed Governor positions. Similarly, the dissenters we saw in the July FOMC meeting (George and Rosengren) will be dropped to non-voter status. While the biggest dove on the FOMC, Minneapolis Fed President Kashkari, will have also gain voting status.

The battle lines are there for all to see, but it’s the USD I am watching most closely, and I have little doubt if the USD continues to grind higher there will be a point when market volatility ramps up again and tests global central banks.

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Chris Weston, Head of Research at Pepperstone.

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