Compelled

Just last week the narrative spoke
And told us the world would soon choke
On dollars they held
Thus, would be compelled
To sell them, ere they all went broke

But funnily, this week it seems
The selling had reached its extremes
So, shorts are now squeezed
And traders displeased
As they now must look for new themes

It had been the number one conviction trade entering 2021, that the dollar would sell off sharply this year.  In fact, there were some who were calling for a second consecutive year of a 10% decline in the dollar versus its G10 counterparts, with even more gains in some emerging market currencies.  The market, collectively, entered the new year short near record amounts of dollars, riding the momentum they had seen in Q4 of last year and looking for another few percentage points of decline.  Alas, one week into the year and things suddenly seem quite different.

The first thing to highlight is that while a few percent doesn’t seem like much of a move, certainly compared to equities or bitcoin, the institutional trading community, consisting of hedge funds and CTA’s, lever up their positions dramatically.  In fact, 10x capital is quite common, with some going even further.  So, that 2% move on a 10x leverage position results in a 20% gain, certainly very respectable.  The second thing to highlight is that if a short-term trading reversal is able to cause this much angst in the trading community, conviction in the trade must not have been that high after all.

But let us consider what has changed to see if we can get a better understanding of the market dynamics.  Clearly, the biggest change was the run-off election in Georgia, which had been expected to result in at least one seat remaining in Republican hands, and thus a Republican majority in the Senate.  This outcome of a split government was seen to be a general positive for risk, as it would prevent excessive increases in debt financed stimulus, thus force the Fed to maintain low US interest rates.  And of course, we all know, that low rates should undermine the currency.

But when the Democrats won both seats, and the Senate effectively flipped, the new narrative was that there would be massive stimulus forthcoming, encouraging the reflation trade.  The thing is, the reflation trade is part and parcel of the steepening yield curve trade based on the significant amount of new Treasury debt that would need to be absorbed by the market, with the result being declining prices and higher Treasury yields.  (One thing that I never understood about the weak dollar trade in this narrative was the idea that a steeper yield curve would lead to a weaker dollar, when historically it was always the other way around; steep curve => strong dollar.)

Last week, of course, we saw Treasury yields back up 20 basis points in the back end of the curve, exactly what you would expect in a reflation trade.  And so, it cannot be surprising that the dollar has found a bottom, at least in the short-term, as higher yields are attracting investors.  But what does this say about the future prospects for the dollar?

My thesis this year has been the dollar will decline on the back of declining real yields in the US, which will be driven by rising inflation and further Fed support.  Neither the US, nor any G10 country for that matter, can afford for interest rates to rise as they continue to issue massive amounts of debt, since higher rates would ultimately bankrupt the nation.  However, inflation appears to be making a comeback, and not just in the US, but in many places around the world, specifically China.  Thus, the combination of higher inflation and capped yields will result in larger negative real rates, and thus a decline in the dollar.  Last week saw real yields rise 15 basis points, so the dollar’s rally makes perfect sense.  But once the Fed makes it clear they are going to prevent the back end of the curve from rising, the dollar will come under renewed pressure.  However, that may not be until March, unless we see a hiccup in the equity market between now and then.  For now, though, as long as US yields rise, look for the dollar to go along for the ride.

Of course, higher US yields and a stronger dollar do not encourage increased risk appetite, so a look around markets today shows redder screens than that to which we have become accustomed.  The exception to the sell-off rule was Tokyo, where the Nikkei (+2.35%) rallied sharply as the yen continues to weaken.  Remember, given the export orientation of the Japanese economy, a weaker yen is generally quite positive for stocks there.  The Hang Seng (+0.1%) managed a small gain, but Shanghai (-1.1%), fell after inflation data from China showed a much larger rebound than expected with CPI jumping from -0.5% to +0.2%.  Obviously, that is not high inflation, but the size and direction of the move is a concern.

European markets, however, are all underwater this morning, with the DAX, CAC and FTSE 100 all lower by 0.5%.  US futures are pointing down as well, between 0.4%-0.6% to complete the sweep.  Bond markets are modestly firmer this morning, with Treasury yields slipping 1.5 bps, while Bunds, OATS and Gilts have all seen yields fall just 0.5bps.  Do not be surprised that yields for the PIGS are rising, however, as they remain risk assets, not havens.

In the commodity space, oil is under modest pressure, -0.65%, while gold is essentially unchanged, although I cannot ignore Friday’s 2.5% decline, and would point out it fell another 1.5% early in today’s session before rebounding.  Since I had highlighted Bitcoin’s remarkable post-Christmas rally, I feel I must point out it is down 17% since Friday, with some now questioning if the bubble is popping.

Finally, the dollar continues its grind higher, with commodity currencies suffering most in the G10 (NOK -1.1%, NZD -0.7%, AUD -0.6%) as well as the pound (-0.6%) which is feeling the pain of Covid-19 restrictions sapping the economy.  In the EMG space, we are also seeing universal weakness, with the commodity focused currencies under the most pressure here as well.  So, ZAR (-1.0%), MXN (-0.85%) and BRL (-0.8%) are leading the pack lower, although there were some solid declines out of APAC (IDR -0.75%, KRW -0.7%) and CE4 (PLN -0.75%, HUF -0.7%).

On the data front, this week brings less info than last week, with CPI and Retail Sales the highlights:

Tuesday NFIB Small Biz 100.3
JOLTs Job Openings 6.5M
Wednesday CPI 0.4% (1.3% Y/Y)
-ex food & energy 0.1% (1.6% Y/Y)
Fed’s Beige Book
Thursday Initial Claims 785K
Continuing Claims 5.0M
Friday Retail Sales 0.0%
-ex autos -0.2%
PPI 0.3% (0.7% Y/Y)
-ex food & energy 0.1% (1.3%)
Empire Manufacturing 5.5
IP 0.4%
Capacity Utilization 73.5%
Business Inventories 0.5%
Michigan Sentiment 80.0

Source: Bloomberg

Aside from that, we also will hear a great deal from the Fed, with a dozen speakers this week, including Powell’s participation in an economics webinar on Thursday.  Last week, you may recall that Philadelphia’s Patrick Harker indicated he could see a tapering in support by the end of the year, but the market largely ignored that.  However, if we hear that elsewhere, beware as the low rates forever theme is likely to be questioned, and the dollar could well find a lot more support.  The thing is, I don’t see that at all, as ultimately, the Fed will do all they can to prevent higher yields.  For now, the dollar has further room to climb, but over time, I do believe it will reverse and follow real yields lower.

Good luck and stay safe
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A New Paradigm

Awaiting a new paradigm
The market is biding its time
Will Brexit be hard?
Or will Ms. Lagarde
Do something that’s truly sublime?

And what of next week and the Fed?
Are traders now looking ahead?
Will Jay make a change?
And thus rearrange
The views that are now so widespread

Come with me now, on a trip down memory lane.  Back to a time when hope (for a vaccine) sprung eternal, the blue wave was cresting, and investors were sidling up to the all-you-can-eat risk buffet with a bottomless appetite.  You remember, November.  Reflation was on the menu, along with a massive fiscal stimulus bill; progress was concrete with respect to Brexit negotiations; and the prospect of another wave of government shutdowns, worldwide, was just a gleam in petty tyrants’ politicians’ eyes.  Well, it turns out that those expectations were somewhat misplaced.  While we did, indeed, get that vaccine announcement, with the milestone first injection made today in the UK, many of those views turned out differently than expected.  As we are all aware, there was no blue wave in the US election.  Regarding Brexit, it appears that the time has finally come for the leaders of both sides to sit down and hash things out.  This morning brought news that Boris and Ursula will be meeting tomorrow to see if they can agree on what each side is willing to accept as their top negotiators have clearly reached their limits.

As to risk appetite, certainly November was beyond impressive, with massive risk rallies in equities around the world while haven assets, notably Treasuries and gold, suffered significant losses.  Since then, however, the euphoria has been far less prevalent, with some sessions even winding up in the red.  Lockdowns?  Alas, those have returned in spades, with seemingly new orders each and every day by various governmental authorities around the world.

The upshot of this mixture of news is that the market is now searching for the next big thing.  Don’t misunderstand, the 2021 conviction trades remain on the table.  Thus, expectations for a much weaker dollar, huge returns in emerging markets, both bonds and stocks, and continued strength in the US market are rife.  Just not right now.  The short-term view is more muddled which is why the price action we are currently experiencing is so mixed and until that new view develops, choppy markets with no net directional movement is the most likely outcome.  For instance, let’s look at today’s activity, which is a perfect example of the situation.

Equity markets around the world are softer, but not aggressively so.  Asian markets sold off modestly last night (Nikkei -0.3%, Hang Seng -0.75%, Shanghai -0.3%), but look simply to be consolidating what have been impressive gains since the beginning of November.  European markets are also a bit softer this morning, led by the CAC (-0.65%) although the DAX (-0.3%) and FTSE 100 (-0.4%) are drifting lower as well.  We did see some data from Europe, with ZEW readings from Germany turning out bi-polar (Expectations were strong at 55.0, Current Situation was weak at -66.5), thus showing how financial markets continue to focus on the post-covid economy while ignoring the current situation.  Meanwhile, US futures are all pointing a bit lower, between 0.4%-0.5%, after a mixed performance yesterday.  In other words, all that risk appetite from last month appears to have been satisfied for now, although we are, by no means, seeing serious risk reduction.

In the bond market, surprisingly, 10-year Treasury yields have actually edged higher by 0.7bps this morning, despite the modest risk-off theme, whereas in Europe, we see marginal yield declines across Germany, France and the UK. Bonds from the PIGS, however, are definitely feeling a little stress as they are trading with yields nearly 2bps higher than yesterday.  And that is a bit surprising given that Thursday, the ECB is going to announce their latest expansion of monetary policy, thus guaranteeing to buy yet more debt from these nations.  (We will cover the ECB tomorrow).

Commodities?  Well, gold has been rocking since its nadir on November 30, having rebounded more than 6% since then, and while unchanged on the day, remains in a short-term uptrend.  Oil, meanwhile, is ever so slightly softer this morning, just 0.5%, but also remains in its powerful uptrend, which has seen it rally more than 33% since its nadir on November 2nd.  In fact, metals and energy overall remain well bid and in strong uptrends.  Clearly, they are looking ahead to stronger growth (or possibly higher inflation) once the pandemic finally fades.

And lastly, the dollar, which can best be described as mixed today, remains the linchpin for many market expectations in 2021.  Remember this; given the dollar’s place in the world economy, as the financing vehicle of choice, a too strong dollar is generally associated with broad economic underperformance.  As debt loads worldwide have exploded, even at remarkably low interest rates, the need for foreign issuers, whether private or government, to acquire dollars to service that debt is perpetual.  When the dollar is strong, it crimps the ability of those foreign debtors to both invest and repay the outstanding debt, with investment suffering.  So, while a strong dollar may signal growth in the US economy, given that the US economy now represents only about 20% of the global economy, well down from its previous levels, and that trade continues to represent such a small portion of the US economy, just 12%, these days, a strong dollar simply hurts foreign economies without the previous benefits of knock-on global growth.  This is the key link between the views of a weaker USD and strong EMG performance next year, the two are tightly linked on a fundamental basis.

But as for today, the proper description of the dollar would be mixed.  In the G10, SEK (-0.45%) and GBP (-0.45%) are the leading decliners, with the latter clearly under pressure from the ongoing concerns over Brexit while the former seems to be feeling the sting of hints from the Riksbank that ZIRP will remain longer than previously expected.  On the plus side, the gains are less impressive, with CHF (+0.2%) the leader, while the euro has edged higher by 0.1%.  However, trying to explain a movement that small is a waste of time.

EMG currencies, on the other hand, are showing a little life, led by ZAR (+0.55%) and RUB (+0.5%) as commodity prices continue to hold the bulk of their gains.  INR (+0.5%) also had a good evening after the FinMin there explained that there would be no reduction in fiscal support for the economy for the foreseeable future, and that the government would continue to work with the RBI to insure a return to sustainable growth.  On the downside, KRW (-0.3%) is the laggard after the president there urged people to cancel holiday plans and stay home.

On the data front, NFIB Small Business Optimism fell to 101.4, a bit weaker than expected, but given the stories of closures around the nation, this cannot be that surprising.  A little later we get Nonfarm Productivity (exp 4.9%) and Unit Labor Costs (-8.9%), although neither is likely to excite the market.  There are no speakers on the docket, so the dollar will be taking its cues from the equity markets in all likelihood.  Right now, with futures pointing lower, that implies the dollar may have a bit of a rebound coming.  However, until that new narrative forms, I don’t anticipate too much movement.

Good luck and stay safe
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