Behavioral Macro

One of the strongest beliefs in currency markets is if a central bank is hiking policy rates its currency will strengthen. Nowhere is this a more powerful thought than in the US, whose reserve currency is dominant and whose policy rates set the tone for global cycles.

I know none of this is terribly new or groundbreaking, and I’ve oversimplified for the sake of parsimony, but here’s the null hypothesis:

The US yield curve reflects a global equilibrium rate for ‘risk free’ financial assets much more than it does any kind of capital formation equilibrium rate. In other words, it equilibrates financial activity, and economic activity is somewhat of a price taker.

Not only is the yield curve much more driven by financial balances these days, but, within financial balances, the share of price-insensitive demand for risk-free assets has grown sharply. And at the same time the supply of these assets has contracted.

Here are a few reasons why:

• Rating agencies were chastened by the GFC and aren’t slap happy with AAAs anymore
• Derivative structurers are, let’s say, more modest in their issuance ambitions
• Insurance companies and pension funds have endless structural demand
• Banks have higher liquidity requirements to meet
• Central bank QEs

This isn’t to say yields don’t react to economic info or don’t say anything about the state of the economy. Of course they do. But the dominance of financial drivers after 30 years of global financial deepening has made attempts to extract economic information from the level and shape of the US yield curve unhelpful–or worse, vulnerable to false positives.

Single name stocks are not my bailiwick, so get your salt grains ready. But we’ve all seen this movie before: A cult-like stock with crazy, revolutionary technology that loses to the 2nd, better funded, mouse that executes better.

And in the case of TSLA, it’s binary. Elon Musk wants the dream and will risk everything to get there. If the switch is flipped, TSLA could easily become a zero.

This is not something I wish, though I do think it is increasingly likely. Musk’s funding is not infinite, production and labor issues are mounting, and the competitors have finally woken up and are gunning for him.

Technically, we appear close to that breaking point. Investors look to the stock price as a sign of a company’s health–even when they shouldn’t. And when a company has chronic financing needs, a bad signal from the stock price–justified or not–can be fatal. The world of finance and economics can be brutally path dependent.

Here are two charts of TSLA that illustrate why the 300 level is meaningful. You can tell me until you’re blue in the face that round numbers don’t matter, but I know from experience we are not that rational. They matter. That’s why I have so may silly Dow hats (okay, not the only reason). And in this instance the round 300 level lines up with important support ranges on two important time horizons.

First, here is the one year chart:

Now, the 30 day intra-day price chart:

Even a TA tourist like me can see that the round 300 level we keep bouncing off is important support in TSLA’s price pattern.

If we close below 300 for a couple days in a row, odds are we are seeing the beginning of the end of the cult.

Everyone is starting to take a look at oil names, and with good reason this time.

Back at the end of July I posted a quick thought on oil, arguing that we were starting to price in the oil industry’s secular headwinds. We had seen a sharp rise in the price of crude starting in mid-July, yet neither big oil or oil servicer names were following. At the same time, market analysis/chatter was that EVs were inevitable and would be on the market sooner than we thought.

Since then the performance gap between crude oil and oil stocks have continued their divergence.

The blue line is WTI, the burnt orange line is XLE, and the white line is OIH.

The upshot is that we have priced in a lot of secular headwind in a short period of time, investors, desperate not to lag the indices in a super bullish year marked by aggressive sector rotation, are likely to turn to the oil sector, as a laggard, to make up ground into year end.

And the charts are constructive.

Here is OIH, from one and 5 year perspectives:

Now, here is XLE, from the same perspectives:

It probably doesn’t matter for now that valuations are not attractive (i.e. oil names are pricing in a big earnings rebound) and that the secular headwinds haven’t gone away. And it probably doesn’t matter that late last week people already started recommending the sector.

What will likely matter most—unless crude oil ‘closes the divergence’ by itself taking a dive—is that people need performance, oil names have lagged crude sharply, and their chart patterns just turned up nicely.

So much for fundamentals and the efficient market hypothesis.

Jay Powell, the all-but-assured incoming Fed Chairman, had his Senate confirmation hearing yesterday. And the whole drive to extract a hawkish/dovish angle from the proceedings missed the point, in two important ways.

One, we should have learned by now that whether someone is hawkish or dovish at a point in time is far less telling than whether they show ability to evolve over time. Powell showed balanced pragmatism, both on monetary and regulatory issues. This is also consistent with his reputation.

Two, Boris Yeltsin might have been a larger-than-life hero in the Russian constitutional crisis of 1993, but he was an abysmal administrator. Bernanke and Yellen were wartime Chairs, technically deep but pragmatic, with a courage of conviction that only comes from a lifetime immersed in the subject matter. But both were shy on political skills. Hard to forget Bernanke’s quivering lip in his first dozen or so Congressional testimonies.

Powell may not have the technical expertise or the courage of conviction Bernanke showed in the depths of the GFC, but the Fed is not longer at war. The path to normalization is all but set. Financial intermediaries have been defused. The next recession is much more likely to be garden variety than apocalyptic—irrespective of what our lizard brains keep telling us.

The challenges now are political. The Fed now needs someone who can stave off the growing efforts of Congress to politicize the Fed and ‘usurp upon its domain’. It needs someone who can keep Elizabeth Warren and GOP troglodytes at arm’s length while the tweak and streamline the post crisis regulatory framework.

Yesterday, Powell showed great promise that he can be that guy.

My longer-term currency views tend to be dominated by two factors: where we are in the global risk cycle and where the ECB and the Fed are in their tightening/loosening cycles relative to each other.

For me, the dominant long-term view today is investors are moving out the risk spectrum because US valuations seem full. This phase of the global risk cycle tends to be bearish the dollar as flows go from core to periphery in search of yield and more attractive valuations.

Pushing in the same direction is the relative cycles of the world’s two most important central banks. The US has raised rates a number of times and is about to do it again next month. It has also started to let its balance sheet run off. It is closer to the end of its hiking cycle than the beginning.

The ECB, in large part due to Europe’s poor and begrudging policy response, is several steps behind in the normalization process. They are very much at the beginning.

This too tends to be bearish the big dollar.

However, these processes are not straight lines. Up until September, the market had been skeptical of the Fed’s willingness and ability to normalize policy along the lines of its forecast. After all, the Fed has systematically over-forecast the pace of policy normalization for years. And as a result of this skepticism, the dollar, correspondingly, remained under pressure. But in September, when it became clear the tapering was going to happen as projected, this all changed, taking the attention away from the ECB’s normalization process and putting it back on the Fed’s. The market, basically, had to play catch up. From then until now, the two-year Treasury yield soared by nearly 50bps, and the odds of a December rate hike went from around 20 percent to 92. And, of course, this triggered a fairly strong counter-trend move in the dollar—one that, admittedly, chopped my currency trading up pretty well in September and October.

Here’s the time series of December rate hike odds:

But the bottom line here is that it looks like the counter-trend dollar rally is now over, and the downward trend is resuming. There are three reasons why I think the narrative of normalization is in the process of shifting back to the ECB. One, Chair Yellen last week expressed more concern than ever before that the stubbornly low US inflation may have a structural component. What’s more, this sentiment was echoed in the Fed Minutes also released last week. Two, the ECB’s Benoît Cœuré dropped a surprisingly heavy hint (one of, I suspect, several to follow) that they may have to move forward the beginning of policy normalization. And he says this against a backdrop of an ECB running out of FI assets to buy and European PMI that are moving from strength to strength. And three, the move in short term US rates and in rate hike expectations have been sharp and have lost momentum, and many currency charts are once again showing dollar weakness.

Here’s the 5 year chart of the BBDXY:

And the 1 and 5 years charts of the euro:

Now, here’s the 5 year chart of El Perro:

And,  the 5 year chart of the Brazilian real:

I have spent the last 3 weeks vacillating between signs on the one hand that the dollar is starting to roll over, and signs on the other that precious metals are on the verge of a big break down—two somewhat contradicting views. But now, at least to my eye, it looks like we have a decision in favor of a weaker dollar.

That said, it is conceivable though not likely, that we get a weakening dollar and weakening precious metals, since the crux of the narrative is that we’re now entering the European leg of global monetary tightening. At a minimum, precious metals should be an excellent funding leg for short dollar positions.

EUR in gold terms looks to be breaking out:

All these charts look to me like a new leg of dollar weakness is upon us. And it seems lined up nicely with the monetary policy normalization narrative shifting back to the ECB.

Good luck, and don’t forget to manage your risk—no matter how strong your conviction.

I’m really excited to roll out the new blog. I have been setting up the locked access functionality for a couple of months now, and linking it back to twitter. Pretty sure this twitter-blog link is a first. Subscribers to @Behavioralmacro will have access to all content on the blog, while non-subs will be able to see unlocked content. I can now seamlessly use both twitter and the blog to share my thoughts and experience.

It’s really easy for subscribers. All you have to do is be logged into Twitter or Tweetdeck (on the same browser), and then, with a one-click log-in (just like any other Twitter app), you’re in. From then on, the access should be seamless and invisible.

Those who don’t subscribe, will see the link to the subscription page if the post contains locked content.

Now, gotta get to it…

(Quick post from the road)

This is a difficult juncture.

For the past few weeks, market breadth has been deteriorating and new lows expanding, as most indices have been grinding higher. Typically, these are signs one sees before a market corrects or rolls over.

We have also started to see price weakness in some areas where investors often reach for risks: the Russell, pockets of emerging markets and EM ccys, MLPs, Agency REITs, treasury curve flatteners, high yield bonds and even vol has ticked up a little. There were a few points last week when you wouldn’t have been blamed for feeling it was just a handful of tech stocks holding the whole market up.

On the positive side, we have entered the strongest season for risk taking. Fundamentals at home and abroad are solid. Earnings on the whole have been good. Significantly, gold and gold miners appear to be cracking. This year has been characterized by strong rotations disguised at the onset of corrections, and this could just be another one. Lastly, I should add, the pain trade still feels higher.

But perhaps the trickiest part right now is investors’ short-gamma mindset. When you’re short an option, the size of your exposure increases as the market moves against you. To hedge or reduce your exposure you are forced to continuously buy if the market goes higher, and continuously sell if the market goes lower. In other words, you’re chasing, rather than fading.

The short-gamma mindset happens every year at this time as the final stretch intensifies performance anxiety, but especially so in big up years. If you are lagging–as many are–and the market powers higher, you have to be in. The FOMO is overwhelming. Some guys will play the laggards, others will want to make sure their end of year balance sheet shows healthy positioning in 2017’s winners. Either way, they chase.

But there is only one thing worse than lagging all year and then missing the end of year push higher: lagging all year and loading up for the end of year push just before the market finally corrects. If this has never happened to you have no idea how mercilessly savage this can be. And since we haven’t had a correction in so long, if one were to come it’s easy to imagine it being larger than the garden variety sort.

In essence, it feels as if traders are short at-the-money straddles and are poised to chase any sharp move that lasts more than a day. Be careful. Now, got to hop.