No Bed of Roses

For those in the stock market’s grip
A common plan was ‘buy the dip’
But for the past week
Which has been quite bleak
It’s lost some of its sponsorship

A sample of markets exposes
That China’s been no bed of roses
The yuan, late last night,
Caused many a fright
As that bubble now decomposes

The dollar is broadly stronger this morning as markets remains far more volatile than we had gotten used to over the past several years. Equity markets remain quite uncertain, as evidenced by yesterday’s 500 point range in the Dow. Consider this, the VIX index, which is a measure of S&P 500 volatility, had been trading around 10% prior to the recent activity. Meanwhile, a 2% daily move in the underlying market represents annualized volatility of ~32%. It should be no surprise that the short volatility trades are under pressure here, given what has actually occurred of late. If your position basis is 10%, then a 32% outcome is quite painful. Nowhere is that more evident than in China, where the Shanghai Composite has fallen more than 4% in the past week, and started to raise some red flags. Of direct interest to us is the Chinese yuan, which fell nearly 1.0% last night, its largest one-day loss since the PBOC devalued the currency in 2015. It seems that the combination of local stock market declines, weaker than expected trade data (Imports jumping 36.9% and the Trade Balance falling to a $20.3B surplus from $54.7B last month) and the approaching Chinese New Year (which has raised concerns over liquidity) has conspired to undermine some of the currencies recent gains. The cynic in me wonders whether the much reduced Trade Surplus is real or simply a more acceptable political outcome given the current angst between the US and China on the subject. But the market response to the data should be no surprise. Will the renminbi continue to fall? My view is that over time, that will be the case, but that is in the context of my view the dollar will continue to rally as the year progresses.

Elsewhere, however, the dollar’s rise overnight has, thus far, been far less robust, averaging something on the order of 0.3%. German trade data, which was essentially the only notable release, was right in line with expectations. As well, there have been no comments from ECB members, so the euro’s continuing slide is really a dollar rally. This is also in evidence vs. the yen, which has fallen despite the reduction in risk appetite that has become evident around the world. In other words, the dollar seems to be benefitting from other issues.

Arguably, the news about a budget agreement in the Senate is one of the key stories. If the House follows through, this will remove the prospect of a government shutdown as well as talk about the debt ceiling. When the headline hit yesterday afternoon, the euro fell almost 90 pips within minutes and has continued slowly lower since. But something else underpinning the dollar is likely US interest rates. Yesterday’s 10-year auction was lackluster and the yield has risen back to 2.84%, essentially its level Monday morning, before the real equity market fireworks went off. Nothing has changed my view that 10-year yields have further to climb, that inflation remains a growing problem and that the Fed is going to respond accordingly. It was heartening to hear yesterday’s Fed speakers Dudley and Kaplan both ignore the recent stock market gyrations with regard to their views on future rate hikes. It appears that the Fed’s reaction function toward equity market declines has been somewhat reduced, or in other words, the Fed put is much further out of the money than it has been in the past. What this means is that a further equity market corrections (which I believe is coming) will not be met with any change in rhetoric, let alone action, unless it becomes a real rout, something like a 25% or greater decline. And so, I continue to look for the dollar to benefit from this set of circumstances.

The last thing of note is the BOE, which has just released its statement, along with its updated growth and inflation forecasts. Ahead of the release, the pound was essentially unchanged on the day, but the remarkably hawkish sentiment put forth by the MPC inspired a nearly 1% gap higher with the pound touching 1.40 again. The essence of the statement was that growth was picking up in the UK, albeit at a somewhat slower level than the rest of the world. However, slack in the economy was shrinking and they explicitly said that rates would likely rise faster than had been expected in November when they last updated their forecast. Market expectations are growing for a 25bp rate hike at the May meeting, although I remain concerned that the ongoing Brexit story will prevent that action. However, for now, that is the scoop and the pound should benefit in the short term.

One other thing to take away from this is that a more aggressive BOE simply adds to the story of central banks taking away the proverbial punch bowl. The point is that asset valuations that have been so reliant on excess liquidity are going to find themselves with some ‘splaining to do when that liquidity dries up. In fact, this is the key reason I believe that recent equity market price action is just the beginning of the correction, and that dip buyers are going to need to be more discriminating in the near term.

As to the rest of the day, the only data here is Initial Claims (exp 232K) and we hear from two more Fed speakers, Philly’s Harker, and the uber-dove, Minneapolis’ Kashkari. There is also a 30-year Treasury auction, which if it disappoints is likely to add further downward pressure across the curve. In the end, I think the dollar will hold its own, and very likely edge higher from here.

Good luck