On Monday, the dollar went higher
Though stocks, people still did acquire
So riddle me this
Is something amiss?
Or did links twixt markets expire?
The risk-on/risk-off framework has been critical in helping market participants understand, and anticipate, market movements. The idea stems from the fact that market psychology can be gleaned from the herd behavior of investors. As a recap, observation has shown that a risk-off market is one where haven assets rally while those perceived as riskier decline. This means that Treasury bonds, Japanese yen, Swiss francs, US dollars and oftentimes gold are seen as stable stores of value and see significant demand during periods of fear. Similarly, equities, credit and most commodities are seen as much riskier, with less staying power and tend to suffer during those times. Correspondingly, a risk-on framework is typified by the exact opposite market movements, as investors are unconcerned over potential problems and greed drives their activities.
What made this framework so useful was that for those who interacted with the market only periodically, for example corporate hedgers, they could take a measure of the market tone and get a sense of when the best time might be to execute their needed activities. (It also helped pundits because a quick look at the screens would help explain the bulk of the movement across all markets.) And, in truth, we have been living in a risk-on/risk-off world since the Asia crisis and Long Term Capital bankruptcy in 1998. That was also the true genesis of the Powell (nee Greenspan) Put where the Fed was quick to respond to any downward movement in equity markets (risk coming off) by easing monetary policy. Not surprisingly, once the market forced the Fed’s hand into easing policy, it would revert to snapping up as much risk as possible.
Of course, what we have seen over the past two plus decades is that the size of each downdraft has grown, and in turn, given the law of diminishing returns, the size of the monetary response has grown even more, perhaps exponentially.
Overall, market participants have become quite comfortable with this operating framework as it made decision-making easier and created profit opportunities for the nimblest players. After all, in either framework, a movement in a stock index was almost assured to see a specific movement in both bonds and the dollar. Given that stocks are typically seen as the most visible risk signal, causality almost always moved in that direction.
But lately, this broad framework is being called into question. Yesterday was a perfect example, where stock markets performed admirably, rising between 0.75% and 2.5% throughout the G10 economies and at the same time, the dollar rose along with bond yields. Now I grant you that neither increase was hugely significant, and in fact it faded somewhat toward the end of the session, but nonetheless, the correlations had the wrong sign. And yesterday was not the first time we have seen that price action, it has been happening more frequently over the past several months.
So, the question is, has something fundamental changed? Or is this merely a quirk of recent markets? Looking at the nature of the assets in question, I think it is safe to say that both equities and credit remain risk assets which are solidly representative of investors’ overall risk appetite. In fact, I challenge anyone to make the case in any other way. If this is the case, then it points to a change in the nature of the haven assets.
Regarding bonds, specifically Treasuries, there is a growing dispersion of views as to their ultimate use as a safe haven. I don’t believe anyone is actually concerned with being repaid, the Fed will print the dollars necessary to do so, but rather with the safety of holding an asset with almost no return (10-year yields at 0.54%, real yields at -1.0%), that correspondingly has massive convexity. This means that in the event bonds start to sell off, every basis point higher results in a much more significant capital depreciation, exactly the opposite of what one would be seeking in a haven asset. Quite frankly, I don’t think this issue gets enough press, but it is also not the purview of this commentary.
Which takes us to the dollar, and the yen and Swiss franc. Here the narrative continues to evolve toward the idea that given the extraordinary amount of monetary and fiscal ease promulgated by the US, the dollar’s value as a haven asset ought to diminish. Ironically, I believe that the narrative argument is exactly backwards. In fact, the creation of all those dollars (which by the way has been in response to extraordinary foreign demand) makes the dollar that much more critical in times of stress and should reinforce the idea of the dollar as a safe haven. The one thing of which you can be certain is that the dollar will be there and allow the holder to acquire other things. And after all, isn’t that what a haven is supposed to do? A haven asset is one which will maintain its value during times of stress. This encompasses its value as a medium of exchange, as well as a store of value. Dollars, at this point, will always be accepted for payment of debt, and that is real value. In the end, I expect that recent market activity is anomalous and that we are going to see a return to the basic risk-on/risk-off framework by the Autumn.
Today, however, continues to show market ambivalence. Other than Asian equity markets, which were generally strong on the back of yesterday’s US performance, the picture today is mixed. European bourses show no pattern (DAX -0.4%, CAC +0.1%), US futures are ever so slightly softer and bond markets are very modestly firmer (yields lower) with 10-year Treasuries down 1.5bps.
However, along with these movements, the dollar and yen are generally a bit softer. Or perhaps a better description is that the dollar is mixed. We have seen dollar strength vs. some EMG currencies (ZAR -1.35%, RUB -0.9%, MXN -0.5%) all of which are feeling the strains of declining commodity prices (WTI and Brent both -1.5%). But several Asian currencies along with the CE4 have all continued to perform well this morning, notably THB (+0.45%) as investor demand for baht bonds continues to grow. In the G10 space, the picture is mixed as well, with the pound the worst performer (-0.3%) and the Swiss franc the best (+0.25%). The thing is, given the modest amount of movement, it is difficult to spin much of a story in either case. If we continue to see eqity market weakness today, I do expect the dollar will improved slightly as the session progresses.
As to data for the rest of the week, there is plenty with payrolls the piece de resistance on Friday:
|ISM Services Index||55.0|
|Average Hourly Earnings||-0.5% (4.2% Y/Y)|
|Average Weekly Hours||34.4|
The thing is, while all eyes will be on the payroll report on Friday, I still believe Thursday’s Initial Claims number is more important as it gives a much timelier indication of the current economic situation. If we continue to plateau at 1.4 million lost jobs a week, that is quite a negative sign for the economy. Meanwhile, there are no Fed speakers today, although yesterday we heard a chorus of, ‘rates will be lower for longer and if inflation runs hot there are no concerns’. Certainly, that type of discussion will undermine the dollar vs. some other currencies but does not presage a collapse (after all, the BOJ has been saying the same thing for more than two decades and the yen hasn’t collapsed!). For the day, I expect that the market is getting just a bit nervous and we may see a modest decline in stocks and a modest rally in the dollar.
Finally, I am taking several days off so there will be no poetry until Monday, August 10.
Good luck, stay safe and have a good rest of the week