Values Revised

Can anyone be that surprised
That markets, their values revised?
With trade wars prevailing
Investors are wailing
Meanwhile now the buck’s pulverized

Risk, my friends, is on the run. What a difference a week makes! Just last week, we had seen equity markets regain most of their early February losses and inflows into equity funds exploding. The Treasury market was quiescent, trading in a narrow range and the dollar had edged slightly higher amidst dull market activity. Goldilocks had risen Phoenix-like from the ashes of the early February inflation scare. That was so last week. This morning, the world is a completely different place. Clearly, the biggest issue has become global trade after President Trump imposed tariffs on ~$50 billion worth of Chinese imports and the Chinese retaliated, thus far in a measured fashion, with their own tariffs on ~$3 billion of US goods. And remember, this follows in the wake of the US steel and aluminum tariffs that were imposed late last week. (As an aside, the metals tariffs have been reduced to basically China, Russia and Japan with the Canada, Mexico and Europe being left off the list. Japan is a curious inclusion as I thought the Japanese were an ally as well, but that’s the situation.) However, the latest round is completely different, specifically targeting one nation and of much greater scale. It should be no surprise that investors are reducing positions in their riskiest assets and fleeing to the safe havens of the world, at least as currently considered.

First the yen, which is trading back below 105.00 for the first time since Mr Trump’s election in 2016, looks like it has further to run. We continue to see futility in the BOJ’s efforts to create inflation in the economy. Japan continues to run a massive current account surplus, thus drawing more funds into the country, and the expectations that there would be investment outflows given the growing interest rate gap with the US have been short-circuited, not least by the fact that the 10-year yield in the US has fallen nearly 15bps from its recent peak in the rush to safety. Highlighting the problems that Kuroda-san has was last night’s Japanese CPI data, printing at a lower than expected 1.5% with the core, the rate they target, remaining at just 1.0%. Funnily enough, the one thing that will clearly occur if a trade war begins to expand is that inflation will pick up everywhere. Somehow, though, I don’t think Kuroda, or any central banker for that matter, will be pleased with that outcome. In the end, as long as trade is the lead headline, look for the yen to continue to gain, albeit slowly.

Treasuries, as mentioned above, are also still perceived as a haven and yesterday saw a sharp rally with yields there falling to their lowest level since late January. Despite the increased issuance required, and despite the fact that the Fed will be bidding for fewer Treasuries over time, right now investors are responding to the increase in anxiety due to the trade story and its impact on equity prices. One of the things that has been so interesting during the past 18 months has been the positive correlation between bonds and stocks, a direct result of the Goldilocks narrative. Solid growth underpinning higher stock prices but low inflation keeping interest rates in check. Historically, these two asset classes have a negative correlation, and that historic relationship is reasserting itself. The issue here is that countless portfolio strategies were built on the idea that
Goldilocks would go on indefinitely. As it becomes clearer that will not be the case, all of those strategies will find themselves in increasing difficulty and likely see further unwinding. And this points to further equity market adjustments. The real question is the speed with which these occur, and the trade story has simply accelerated the movement.

The other thing that is back in the news is the increase in volatility. Back in February, it was the unwinding of the short volatility ETF’s that drove the equity market correction. But it seems that was merely the first hit to Goldilocks. One of the points I have maintained for a long time is the fact that market volatility, across asset classes, was likely to come back more quickly than generally anticipated. And I have a feeling that is what we are beginning to see now. The VIX index is back near 25, a level seen in February during the rout, and prior to that last seen after the Brexit vote in June 2016. In other words, options are back in vogue. The real question is how long it can retain this elevated level. Volatility is a mean-reverting characteristic, with mildly trending markets typically punctuated by spikes, like we are seeing now. The thing is, given the extraordinary length of time that volatility was depressed by global QE; it is conceivable that it will take a fairly extended period of high volatility to offset the previous condition. As those Goldilocks based strategies are unwound, odds are that market activity will continue to be quite choppy.

So what does this mean for the FX market? Well, I expect that we are going to see some significant divergence in different currencies. For example, the yen and Swiss franc should likely be strong performers during this period. Both remain safe havens, as does gold, which is up more than 1% this morning, and neither is likely to lose that status. As to the euro, my take is it will wind up doing very little at all. While the Eurozone runs a C/A surplus, which is a clear positive for the currency, there is still little indication that the ECB is going to step up the pace of policy tightening. This is going to continue to undermine the euro bullish position of an accelerated pace, and when contrasted to a Fed that has clearly turned more hawkish, will weigh on the euro.

Meanwhile, the pound has been feeling its oats as traders anticipate that the BOE is set on a path of tighter policy with a 25bp hike almost baked in for the May meeting. I continue to question just how much the BOE will be able to do given the overhang of Brexit, but at this point, based on their recent meeting outcome with two voters looking to raise rates immediately, unless we see a serious equity market correction around the world before they meet again, it certainly appears they will raise rates. And arguably, the pound should hold its own accordingly.

The real action will happen elsewhere in the world, with many emerging market currencies likely to see significant pressure. For example, last night KRW fell 1% as South Korea is right in the crosshairs of further trade tensions. We are also seeing stress in other currencies in this bloc as USD funding costs increase due to technical factors in the US. I’m sure you have heard about the widening of the LIBOR-OIS spread, which in the past has been a harbinger of credit stress (it widened sharply during the financial crisis and the European bond crisis) although this time it seems to have a more benign explanation driving it. But in the end, higher LIBOR means higher funding costs for all those emerging market companies and countries that have used the dollar market to manage their finances. The point is that there will be continued stress in this area and that many emerging market currencies are likely to underperform while this market anxiety persists. This is especially true in LATAM and APAC although less so in EEMEA as many of those companies/countries fund in euros. In the end, I have a feeling a broad dollar index will exhibit limited movement, but that we will see some fairly large activity in the crosses.

As to today’s session, there are two data points, Durable Goods (exp 1.7%, 0.6% ex transport) and New Home Sales (620K). We also hear from four Fed speakers, Bostic, Kashkari, Kaplan and Rosengren, however given that we just heard from the Fed on Wednesday, it would be surprising if the message changed at all. And so, with equity markets around the world under continuing pressure and US equity futures pointing lower, my take is we will continue to see risk be removed. Look for further yen strength and emerging market currencies to remain under pressure.

Good luck and good weekend