A Look at Global Markets - Where are we now?

This post is a follow up on last year's assessment of global markets.  By reading that entry as well as this one from June, you will notice that many of the themes often discussed today where very much present throughout the first half of 2015 (whether that may be the tightening of global dollar financial conditions to the correlation of certain global market price trends).  The question now is whether there are signs that the dominant price trends of the last few year are on the cusp of reversing or not.  

From the time that the Fed announced their desire to taper QE in 2013, market participants began to anticipate the eventual commencement of the post GFC rate tightening cycle.  In actuality, these very expectations induced market participants to rebalancing their portfolios in a way that ushered in the tightening of global dollar financial conditions years before the Fed's December decision to increase short term policy interest rates.  This is evident in the evolution of global price trends as well as in the Atlanta Fed's Shadow Fed Funds Rate.  By allowing these expectations and market conditions to take hold, the Fed has been passively enabling monetary policy to tighten.  Importantly, this has occurred during a backdrop where foreign central banks have eased their stance resulting in policy divergence.  

As the shadow rate turned positive, the Fed increased the rate paid on excess reserves in December.  From that point, fed funds futures have priced in only one rate increase for all of 2016.  Due to the presence of the zero lower bound constraint, it appears that the Fed has only increased their policy rate by .25%.  However, the shadow rate shows this not to be the case as the Fed's stance has lead to a tightening of over 300 basis points.  

Dollar, US yield curve, Yen, Euro, Gold, and Oil

To corroborate the rise in the shadow rate, the dollar appreciated during a time when short-term outperform long term treasury yields as the Fed telegraphs the first rate hike.  

Although not to the same extend as in previous cycles, dollar appreciation and higher short-term rates have coincided with widening corporate credit spreads.  Short-term interest rates are the cost of leverage where long-term rates are the rate of return on bonds.  As the cost of leverage rises, leveraged buyers of corporate debt incrementally reduce their exposure particularly to the riskiest issuers.  Again, this is a sign that a passive tightening of financial conditions had taken hold prior to December 2015.

Yen, Euro, Gold, and Oil

Are market participants reducing their leveraged long dollar trades as the risk of future policy convergence may be upon us sooner than previously expected?

Given the BOJ and ECB's policy stance relative to the Fed, the Yen and Euro have both been ideal funding currencies for the global carry trade.  The dollar's correction not only reflects changing expectations concerning future Fed policy but also the reduction in short Yen and Euro positions.  With the fall in not only Japanese, European, but also global equities more generally, a rising Yen and Euro may be symptomatic of risk-off positioning.  This sentiment is made clear by the rise in long-term US treasury bond prices.

Gold's relationship with not only the Yen but the shape of the US yield curve has also held up well.  A potentially prolonged period of lower nominal and real treasury rates going forward coupled with the paring of dollar longs may be creating the necessary conditions for at least an intermediate term bottom for precious metals.

However, at the moment the correction in the dollar is still very much just that.  Despite the recent short-term fall after a rejection at resistance, the dollar's long-term uptrend is still in place at least until multi-month support is broken.  Seeing as US interest rates are still above those found in Japan and Europe, long-term arbitrage conditions may lead to an expected depreciation of the dollar.  

It's also difficult to declare the dollar's recent price moves as anything more than a correction in an ongoing bull market until oil and inflation expectations put in a bottom.  Regardless, the current relative weakness of oil and inflation expectations compared to the Yen, Euro, and precious metals hint that both may underperform the latter even if eventual bottoms are made.  This all remains to be seen.

Continued policy divergence, risk-off, or reflation?

This is a monthly chart comparing the relative strength of treasuries to the VIX.  A twenty period moving average is applied to smooth out the trend.  The notion is that periods when the VIX persistently outperforms treasuries are symptomatic of risk-off.  Will this period more closely resemble 2011-2012's pause before new highs or a more pronounced cyclical correction?

Unlike 2011-2012, this correction comes at a time when equity values in relation to AAA corporate bonds are above their 2007 levels.  This certainly doesn't preclude the possibility that equity price will once again attain new all-time highs on any subsequent rallies, but that caution may be warranted. 

The ECB, BOJ, SNB, and a plethora of other central banks have instituted negative interest rates while fed funds futures have begun to price in a much more gradual future path for US monetary policy. Despite this, falling global bank shares may be warning that these measures are either adversely impacting their profitability (by compressing net interest margins) or failing to gain traction.  If falling long-term treasury yields (white line) are another indication that market participants are pricing in the possibility of weaker future global growth, then it's only rational for bank shares to fall along with yields as bank asset quality would be expected to deteriorate in such a situation.  Furthermore, global investors that are forced to reduce their balance sheet risks but unable to easily sell illiquid positions may be shorting bank equity shares as a hedge.  Considering the interconnected nature of the global credit system, global bank stocks can be seen as a proxy for risk-taking or risk-aversion as well as an assessment of the overall health of the financial system.  

Eurozone periphery stocks have all declined alongside the 10 year treasury security yield as well.  This should not come as much of a surprise considering the current stance of Fed policy.  Where Fed QE spawned a search for yield typified by falling treasury bond and rising risky asset prices, a tighter stance has reversed this prior risk-on positioning.  Seeing as EZ peripheral bond spreads have also widened, greater stress would only amplify the "doom-loop" between EZ governments and their respective banking systems.  Unless a rebound occurs, it may be only a matter of time before periphery shares test their lows not seen since 2012 when Draghi pledged to do "whatever it takes." 

The reversal of the prior search for yield phenomena is also evident when one takes into account the sell off in EM dollar denominated bonds since 2013.  With the exception of US treasury issuance, it has been non-US dollar lending and debt issuance driving capital flows in the post-GFC credit cycle environment.  When US domestic debt issuers and financial institutions have had difficulty servicing their obligations, the Fed has reacted by easing policy whenever they perceived that any ensuing potential financial instability risked adversely slowing down the US economy.  Although the Fed has taken note of financial developments emanating from abroad, they have not been nearly as willing to backstop the global dollar credit system as the offshore dollar leverage cycle has turned into a scramble to delever dollar liabilities.  A rising dollar exchange rate against a broad basket of currencies is not only indicative of this dollar deleveraging and tightening of global dollar credit conditions, but also exacerbates this impulse given the currency mismatch on the balance sheet of foreign issuers who do not earn dollars.  Moreover as declining oil and commodity prices result in falling dollar revenues, foreign commodity producers have been under pressure to delever as well.  Consequently there are greater risks of default on dollar obligations from foreign corporations, governments, and residence in this cycle.  Problematically this perceptions coupled with falling dollar income/reserves have forced sovereigns to sell their global assets in order to at least temporarily alleviate funding gaps and/or manage their FX rates.  This may be manifesting itself partially through the sell-off we have witnessed in the financial markets of developed economies. 

These developments have also at least temporarily discredited the idea that the foreign central bank selling of dollar reserves would lead to a "quantitative tightening" characterized by rising long-term treasury yields.  Presumably central banks would be doing so amid a weak global growth backdrop.  Since last year widening high yield US credit spreads, falling global risk securities, commodities, currencies, and inflation expectations have all coincided with shrinking global foreign exchange reserves.  This combination of factors has produced declining treasury yields as one would expect in a risk-off environment.  

If the dollar were to break upward resistance in an ongoing bull run then those trends should persist as US securities continue to beat EM.  To see a return to risk taking, my expectation would be for all or most of those aforementioned trends (in bold) to bottom and reverse.  If the dollar were to break support and correct against a broad range of currencies, a reflation trade may be in order as inflation expectations stabilize and treasury yields rebound.  In this scenario the dollar squeeze would dissipate allowing EM to outperform US securities.  However, if the dollar were to correct or reverse only against the Euro, Yen, and precious metals while treasury yields continued to fall, then a more long lasting risk-off phase may be underway.

Conclusion:

Judging by the current state of the markets, it's clear that market participants have already begun to price in a much easier path of monetary policy than the Fed is still advertising.  As expectations concerning the eventual terminal rate of this rate cycle decline along with the long end of the US yield curve, it strongly suggests that traders believe that the Fed's current stance of monetary policy will lead to a need for a more accommodative stance in the future.  In other words, markets may be pricing in the risk that the Fed is getting ahead of the recovery.  Unless real GDP growth re-accelerates and inflation expectations rebound, higher short-term policy rates will ironically increase the likelihood that monetary policy will confront the dread zero lower bound in the future* (and by extension introducing the possibility of negative policy rates**).  Therefore, those that have persistently been calling for higher interest rates ("normalization") have been actively undermining themselves by pushing the Fed to prematurely tighten policy.***  

Moreover if the Fed has been acting in such a way in order to stem financial instability, getting ahead of the recovery risks creating the very instability which they would be attempting to deter.  Rising long-term treasury bond prices, widening credit spreads, falling global equity prices all work to suggest that this may be starting to happen or at risk of doing so.  To the degree that monetary policy predominately works through private dollar credit and asset markets, a world where elevated global private sector leverage risks creating financial volatility whenever the Fed hints at tightening strikes me as one that is overdependent on monetary policy.  The post-crisis period and recovery may work to show that monetary policy cannot be the only policy lever being pulled if the hope is for faster real economic growth, financial stability accompanied by private sector deleveraging, and durably higher interest rates. 

*The ECB increased the interest rate on the main refinance operation (MRO) and the rate on the deposit facility twice in 2011.  That year the MRO and deposit rates reached as high as 1.5% and .75% respectively.  Since then the MRO rate has been cut to 0% while the deposit rate -.30%.  This is a clear example of how premature rate hikes in an economy plagued by (potentially chronic) deficient aggregate demand risks leading to lower future NGDP growth and by extension lower future short-term interest rates.

**Due to the current political opposition to such a move, it's understandable to perceive the current possibility of a negative interest rate regime as being entirely unrealistic.  However, the post-crisis experience has taught market participants that central banks will act in a way that many would have considered impossible beforehand if they feel they need to.  At one point the ECB's OMT and version of LSAPs/QE were thought to be not only politically implausible but illegal (See here, here, here, here).  Also, what was the likelihood that the BOJ would engage in this degree of balance sheet expansion before the crisis?  It was very likely quite low.  This is not an attempt to justify NIRP or promote its efficacy.  On the contrary if the Fed were to need to resort to such measures in the future, it would again point to the idea that the global financial system is too reliant on monetary policy.

***Until private sector investment improves, those that desire materially higher and durable long-term treasury yields should be in support of accommodative monetary and fiscal policy that is accompanied by a productivity enhancing full employment agenda.  Without consistently higher nominal and real GDP growth rates, it's doubtful that any rise in longer dated treasury yields will be anything but ephemeral.