“Long before I came into the markets I knew that a lot of conventional finance theory didn’t work, but it took me a while to realize that markets didn’t necessarily react in the most rational way to a piece of macro news. What’s more important is positioning and sentiment.”
-Dr. Sushil Wadhwani
The aforementioned quite is sourced from a 2006 interview between Dr. Wadhwani and Stephen Drobny, author of one of my favorite books: Inside the House of Money: Top Hedge Fund Traders on Profiting in the Global Markets.
The book itself – which I’ve read cover-to-cover three times and review frequently – is a series of interviews between Drobny and a diverse array of macro-focused investors, including Dr. Wadhwani, who himself is a former DoR, head of systems trading and partner at the Tudor Group, as well as one of the four initial “outside” members added to the policymaking board of the Bank of England in 1999. He is currently head of Wadhwani Asset Management and was there at the time of the aforementioned interview.
The reason I’ve chosen to highlight Dr. Wadhwani’s interview this morning is because of his unique perspective on the market impact of central bank decisions. Having spent a fair amount of time on both sides of the fence, he is in a distinguished position to opine and his thoughts on the interplay between financial markets and central banking are equally – if not more – relevant today, some 10 years later.
In the interview, he goes on to make the following very important point:
“Within a central bank you realize that the effect of individual pieces of information is often much smaller than the markets think, especially when you get a big outlier which causes a market reaction.”
Back to the Global Macro Grind…
In yesterday’s FOMC statement the Fed finally acknowledged the ongoing slowdown in domestic economic growth, as well as the fact that said deceleration is now being led lower by the continued deterioration across #LateCycle sectors such as services and consumer spending.
Meanwhile, the same statement omitted reference to downside risks stemming from global economic and financial market developments.
Did the Fed’s pivot from being dovish on the global economy and hawkish on the domestic economy to more sanguine on the former and notably concerned about that latter cause a market reaction?
You bet it did:
- The 10Y Treasury Bond Yield dropped from 1.91% at 2:00pm (when the statement was released) to 1.85% by the 4:00pm equity market close. All in, the 10Y declined -8bps on the day.
- The S&P 500 Index rallied 15 points from 2085 at 2:00pm to 2100 by 3:45pm and ultimately closed at 2095. All in, the SPX appreciated +0.2% on the day.
- Brent Crude Oil rallied from ~$46.50 per barrel at 2:00pm to $47.18 by the 4:00pm equity market close. That delta does not include the rally from $45.63 at 10:45am to ~$46.50 by 2:00pm. All in, crude oil appreciated +3.1% on the day.
Clearly bonds, stocks and commodities continue to benefit from the Fed’s ongoing pivot from being explicitly hawkish (in December and January) to rhetorically dovish (in March and April). Is this the right interpretation on a go-forward basis, however?
No. At least we do not think it is. Consider the following:
- The EUR/USD appreciated from a pre-statement trough of 1.1272 to a post-statement high of 1.1362 before ultimately settling at 1.1312 by the 4:00pm equity market close – a mere +13bps higher on the day.
- The USD/JPY declined from a pre-statement peak of 111.75 to a post-statement trough of 111.07 before ultimately settling at 111.56 by the 4:00pm equity market close – which means the USD actually finished +21bps higher vs. the JPY on the day.
In Bayes factor speak, this new information would seem to suggest the Fed is losing its ability to burn the USD further with dovish rhetoric alone. This is a risk we discussed in great detail in our 4/22 note titled, “Reflation Reversal Risk”. Moreover, we continue to see elevated risk that the U.S. follows Europe and Japan in the ongoing breakdown of the central planning #BeliefSystem.
Speaking of #BeliefSystem breakdown, how about the -5.2% intraday reversal in Japan’s Nikkei 225 Index overnight following the BoJ’s disappointing decision to leave its monetary policy unchanged? This came alongside a four big-figure plunge in the dollar-yen rate from 111.88 to this morning’s low of 107.92; the multi-year closing price low of 107.94 may be taken out as we progress through trading today. Inclusive of today’s wild price action, the Nikkei and JPY are now down -12.4% and up +11.2%, respectively, for the YTD.
That, in conjunction with economic growth slowing on a trending basis across every key category of high frequency economic data, reported inflation trending lower and long-term inflation expectations collapsing in Japan, as well as Japan’s ongoing corporate profit recession would seem to suggest that even if Kuroda did agree to allow the JPY to strengthen vs. the USD at the late-February G20 Summit, his patience with any such “Shanghai Accord” is wearing ridiculously thin after today’s reminder of the dire consequences of policy coordination. Expect him to pull an about-face and ease policy in a material manner at the BoJ’s June 15-16 meeting.
Oh and by the way, the same negative developments are occurring across both economic data and financial markets in the Eurozone (CHART #1, CHART #2). How thin has Draghi’s patience become with any such accord in light of these consequences? After all, monetary easing is effectively a zero-sum game whereby growth and inflation are either being imported or exported via relative currency fluctuations…
So what if the Fed can’t burn the USD any further from here? Simply put, we think that would be bad for risk assets. Consider the following trailing three-month cross-asset correlations vs. the U.S. Dollar Index (DXY):
- S&P 500: -0.88
- VIX: +0.82
- MSCI Emerging Markets Index: -0.87
- CNY/USD: -0.89
The latter market is very important to keep an eye on to the extent that China maintains its policy of keeping the yuan “basically stable versus a basket of peer currencies”. Specifically, higher-lows in the USD are likely to equate to lower-highs in the PBoC’s CNY/USD reference rate. The latter should reignite capital outflow pressures on the mainland, as well as a resurgence in bearish headline risk surrounding the Chinese economy.
Consider the following cross-asset correlations between the 1Y CNH (offshore yuan) non-deliverable forward spread versus the CNH spot price (a proxy for CNY tail risk) and the following reflation assets since the aforementioned spread troughed on January 18th:
- Brent Crude Oil: +0.84
- USD High Yield OAS: -0.83
- S&P 500 Energy Index: +0.85
- S&P 500 Industrials Index: +0.93
- MSCI Emerging Markets Index: +0.91
- JPMorgan EM FX Index: +0.91
Ipso facto: yuan down (from here) = reflation down (from here). That’s fairly straightforward.
Moving along, you may ask what gives us conviction that the Fed may lose its ability to fight off gravity with further U.S. dollar debasement. We offer the following three very simple research conclusions in support of this view:
- Contrary to general intuition, the USD tends to appreciate meaningfully in #Quad4 (CHART);
- The Fed has yet to surmount economic gravity with monetary easing as the economy traverses the depths of the cycle as we expect it to over the next 3-6 months (CHART); and
- The Fed is not going to opt for QE4 with the SPX in striking distance of ~2100 and five-year forward breakeven rates now a mere 7bps shy of where they were when the Fed hiked rates in December. Recall that the 5Y5Y had collapsed 39bps from December 16th to its February 19th low of 1.34% (CHART).
Regarding #3 specifically, it is our view that for the Fed to get even more dovish from here, we need to see another collapse in both growth and inflation expectations that weighs heavily upon asset prices.
We recognize that this is the most risky view to take because the Fed can do whatever it damn well pleases. It’s a board of unelected, unaccountable bureaucrats and, for all we know, President Obama gave Janet Yellen (a known Democrat) marching orders to keep the stock market inflated into the general election.
Who knows? Anything can happen. But fading what is already priced in is where the money will be made from here.
Re-engaging the quote of the day, we strongly believe that investor sentiment is overwhelmingly skewed towards a dovish Fed and, as a result, positioning has become rather crowded on the bearish side of the USD and on the bullish side of reflation, in relative terms. Said differently, in one way or another, most investors have already positioned their portfolios for a dovish Fed.
So who is the marginal buyer of risk assets from here? Those implicitly or explicitly long of both growth and reflation factor exposures risk overstaying their respective welcomes on a tired “dovish Fed” catalyst as fundamental data likely deteriorates at an accelerating pace over the next 3-6 months.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 1.70-1.90% (bearish)
SPX 2060-2104 (bearish)
EUR/USD 1.12-1.14 (neutral)
YEN 107.02-112.04 (bullish)
Nikkei 16101-17602 (bearish)
Oil (WTI) 40.98-45.84 (bearish)
Gold 1225--1265 (bullish)
Keep your head on a swivel,