🌎💲The Dollar is key in the short term but the big cycles are turning cautious!!
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# In the last few weeks, we have mentioned the concept of the totality of monetary policy.
Everyone focuses on interest rates, but monetary policy is more than that. We need to look also at money supply, the yield curve as well as rates, the Fed’s balance sheet and the direction of the US Dollar to get an overall sense of monetary conditions. A number of commentators will make the point that with US rates at only 2%, how can there possibly be bad times ahead; surely rates would have to reach 5% or more for something nasty to happen? Perhaps they are right, but if we accept the argument that we need to look at the totality of monetary policy, along with current conditions, then the situation has to be more nuanced that “ah, rates are too low for a recession to occur”.
Chart 1 below is from the excellent Lacy Hunt of Hoisington Investment Management. His thesis (and we are massively simplifying this) is that M2 money supply growth has decelerated into 17 of the last 21 recessions (since 1900) and that the totality of monetary policy can explain the four occasions when money supply did not decelerate into recessions.
Chart 1 – M2 Money Stock Annual % change
https://i.imgur.com/sO37gL1.jpg
In chart 2 below, we plot the Fed Funds rate and the US yield curve alongside the year over year per cent change in M2 and stock prices (shaded areas = recessions). What we are trying to show here is a more complete look at monetary policy than purely interest rates, which of course remain at a low nominal reading of 2%. This shows that prior combinations of Fed tightening, as shown by Fed rate rises, decelerating money supply growth and a flattening of the yield curve are a powerful force and apparent prior to recent recessions.
Where are we today? Well, the Fed will continue to raise rates until something changes (most likely something untoward in the financial markets in our opinion) M2 money supply growth is decelerating noticeably and the yield curve continues to flatten. We are of the view that these monetary levers need to tighten further prior to a recession, and that we will likely see the yield curve flatten well before such an event.
https://i.imgur.com/H2JChCP.jpg
Chart 2 – The Totality of Monetary Policy
Because of its global reserve status, changes in US policy are felt at home and abroad. Global markets are also influenced by changes in the US current account (a mechanism by which the US supplies Dollars to the rest of the World thereby helping growth) and the level of the Dollar. So, with the current account about half the level it was pre 2008 crisis, and the Dollar up 7% from the recent low, headwinds for the global economy and more especially emerging markets are becoming apparent.
We think that the Dollar could be an important factor for global markets in the weeks ahead. Any further Dollar gains could easily tip markets over towards bear market territory, or a decline in the Dollar will help markets bounce from here. It is important, because as we show in chart 3 below, the MSCI World ex. US is testing a level of support that has been created over the last eight months, and it is trading below its own 40 week moving average. A break of this support could easily lead to further losses.
https://i.imgur.com/5MrXGvw.jpg
Chart 3 – MSCI World Index ex. US with 40 week moving average (green)
For months, we have been talking of a multi-month topping process, and this is what it looks like on a chart of a broad based index. Our preference at the current time is that this support will hold and that the Dollar could soften in the weeks ahead. We are therefore looking for the topping process to continue a little longer, and for central banks to tighten policy further (obviously led by the Fed) and for economic growth to remain reasonable. But the risks do seem to be growing and investors need to remain alert.
In the weeks ahead, we will continue to look at the current conditions of the economy, and how policy could affect growth in future quarters. As we tried to point out last week, the economy will only start to deteriorate after the turn in leading indicators and financial markets. We should certainly not confuse economic analysis with market analysis as waiting for an obvious deterioration in the economy will most likely mean that investors have overstayed their welcome. That said, we think the combination of both a financial and economic downturn will be comparable to 2008, and so understanding both is extremely important.
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# A Tired Dollar May Give Risk Assets a Breather
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Back on 22nd April, we said that we thought the US Dollar was on the cusp of an important move, and that it was time to sit up and pay attention. Since that time, the Dollar has risen by the best part of 5% in just over two months, not a bad move in FX markets. We now think that this move is getting a little tired and we would not be surprised if the Dollar experienced a period of softness ahead. Given the weakness in emerging market assets as the recent Dollar rally progressed, we think that risk assets generally will enjoy a period of Dollar weakness. What we are not entirely certain about is how big a correction the Dollar may endure here (if any at all) and therefore how big a bounce to expect in risk assets.
https://i.imgur.com/sygHRuK.jpg
Chart 1 below plots the US Dollar index on a daily basis. What we see here is that from late April and through May, price advanced steadily with only shallow corrections. Since the end of May, price is basically flat and price action is much more choppy. The recent highs in the last week or two were not confirmed by momentum (green histogram) and stochastics (lower panel) are beginning to roll over. This type of price action is indicative of a period of consolidation ahead, in our opinion.
Chart 1 – Daily US Dollar chart with 21 day moving average
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If we step back and look at the weekly chart, there is some resistance in the 95+ area that has so far held the recent advance. As we said above, we are not sure exactly what path any consolidation may take for the Dollar, if one were to occur, but our working roadmap is that this is just a consolidation in a larger uptrend. Perhaps a consolidation will be orderly and find support in the 92 area, before the Dollar bull market resumes. Of course, a lot will depend on what path the major central banks will take in the meantime.
On this point, we expect the Fed to maintain the current trajectory of gradual rate rises (we’ll go with two more this year) and quantitative tightening, which increases from $30 billion per month in Q2 to $40 billion in Q3 and $50 billion in Q4. Every other central bank wants to be more dovish than the Fed, and nobody wants a strong currency. Perversely, nobody wants the Dollar to be too strong either (including president Trump), and so policy makers face a bit of a dilemma at the moment, given the cracks emerging in some corners of the global markets after only a modest move in the Dollar.
Chart 2 – Weekly US Dollar index with 21 week moving average
https://i.imgur.com/0qRG3Nr.jpg
When we look at positioning of the speculative crowd, we see that they have finally jumped on the bullish Dollar story. With markets seemingly trying to hurt the most people most of the time, will this recent surge into Dollars prove to be a tactical error, or is this just the start of a larger trend of Dollar buying? As we have noted, our roadmap for the Dollar is consolidation followed by further advance, so for long term players, we think it’s buy the dip for now.
In terms of crowded trades, despite US yields moving lower and signs of global wobbles, speculative accounts have barely reduced their record short position in the 5 and 10 year part of the curve. So, as we sit here thinking about what would cause the Dollar to soften a little in the short term, we don’t think it will be global central banks suddenly becoming more hawkish than the Fed. It is more likely that either the Fed backtracks a bit, Trump verbally intervenes or economic data soften a bit. If any of these things happen, we think that US yields could move a bit lower as speculative accounts close out their short positions.
So, how do we play this upcoming Dollar consolidation in the markets? Well, we will stick with our larger multi-month topping process for now. If we are right about both the US Dollar softening and US yields drifting lower, then we think equities can rally a bit. But, we still think it’s a matter of selling rallies rather buying dips in this asset class. We will hold our high quality US bonds for now, and although we would expect credit spreads to tighten a little bit, we are just not that interested in owning these assets longer term as the spread is just too tight from an historical perspective, especially given the maturity of the economic cycle.
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We would be cautious about actually selling the Dollar here other than for a very tactical trade. In fact, it would need a complete reversal from the Fed to a dovish path for us to think about selling the Dollar longer term.
So, the message this week is that we may see a reversal of the trend apparent in some markets in recent weeks, but we don’t think this is necessarily a strong reversal; more of a consolidation. There are times in markets when it is right to press your trade ideas and times when doing nothing is the right thing to do. Boring as this may seem, we think that we may be moving into a summer lull in markets. When we discussed this potential internally last week, there was definitely some push back. Given the ephemeral nature of liquidity in markets today, it is certainly possible that something happens in the weeks ahead to shatter the calm in markets that we think we see coming, and price volatility could pick up quite substantially. As such, we all need to remain alert, especially if our multi-month topping process is correct.
So, to wrap up this week, we have been of the view that the Dollar has been taking the role of the pied piper in recent weeks, and therefore a consolidation for the Dollar should help risk assets. But we are not advocating a big shift to risk on at all. Any rally in risk assets should prove relatively muted and should be used to raise defensive positions for those that have not yet done so and are worried about a potential multi-month top in markets.
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0.000 SRY