December 1, 2017 2:32 pm
Author — Nick Korzhenevsky, senior analyst with AMarkets Company. The anchorman of a TV program “Economics. Day rates”.
- Global GDP growth is at the highest level in ten years with synchronized expansion in most world economies. The economic cycle is nearing its peak.
- Stock and debt assets are entering an unstable equilibria phase with misbalances building up.
- Another leg down lies ahead for the USD, but positive momentum is likely to build afterwards.
- Cryptocurrencies are firmly in a bubble. Daily price fluctuations are now unpredictable.
Back in 1955, former Fed chairman William Martin famously described the Federal Reserve’s role as “to take away the punch bowl just as the party is getting good.” Fast forward to 2017, and the central bank’s current head Janet Yellen has attempted to do just that—Ms. Yellen stopped pouring when the markets had clearly had too much. But it looks like speculators might have brought their own drinks as the Fed’s actions have failed to prompt the usual outcome. The financial party is oddly far from over.
Until recently, the markets’ behavior had been quite logical. The global economy improvements that hadn’t been priced in were being discounted. Up until the middle of the year, nearly every analyst had been very careful with their predictions: those who weren’t explicitly pessimistic at the very least made very cautious remarks. Most speculators acted in a similar fashion.
But the economic cycle is making its way through and today, nearly a decade since the Great Recession, the global GDP growth is at its highest. 90% of advanced economies are growing at faster-than-potential rates. On top of that, the momentum is finally global again and we are witnessing synchronized growth in both developed and developing countries. That is precisely what needed to be priced into bonds, stocks, and currencies.
And so that happened. Stock markets were traditionally the first to leap higher on positive expectations. In the face of tremendous liquidity the rally carried on with very low volatility. The same applies to debt markets. The chief surprise here though was the absence of any significant inflationary pressure, even with a relatively healthy global economy. That is why long-term yields have remained more or less stable for several years. Then again, there is no noticeable volatility here either.
Of course, the same also holds true for currencies. The euro has been gaining relentlessly since April. In our June review we wrote that the Eurozone had seen way more positive economic surprises than the U.S., and it would sooner or later take the euro higher. Now, the currency is nearing the end of 2017 around the 1.2 mark and it’s likely to go even further. In turn, those assets that weren’t lucky enough to benefit from such a strong economic momentum (AUD, NZD, GBP) yielded less spectacular results. And, let us not overlook the strong, unrelenting rally in EM-currencies, which was very clearly demonstrated by the Russian rouble.
Now it is time to stop and figure out exactly where we are in the current economic cycle. That is directly relevant to understanding the market processes and, thus, is crucial for sound investing strategies. Alas, the positive news flow seems to be nearing it exhaustion. From a financial viewpoint, we can already spot a number of red flags pointing to the fragility of the current market equilibria. We will talk a bit more about these anomalies in the current and upcoming editions of this publication.
The first thing that catches our eye is the aforementioned absence of volatility. The CBOE Volatility Index (VIX) has set a series of all-time lows in 2017, falling below the 9 handle to 8.56 mid-year. The index is still hovering around that mark today, which would be absolutely fine had the FOMC not decided to hike. However, considering that the Fed funds target rate corridor is about to be raised to 1.25-1.5%, the low-vol environment is not natural. Markets are in a state of trance, and the awakening is unlikely to run smooth. Looking at the VIX distribution graph, we’re at its furthest left point. The nature of the process alone suggests that the index is both mathematically and statistically guaranteed to climb back to above 20.
The other alarming sign is the debt market activity—or rather, lack thereof. Even with all the good news, long-term yields just won’t go up any further. Fed funds futures are also holding out against pricing in the policy tightening that the Committee has been so vocal about. The non-inflationary environment would be our first explanation here. As prices stand still, the debt market should be able to sit back and breathe. While that is in part true, one needs to understand that devalued debt would not allow U.S. companies to reduce credit pressure, and the business cycle would reverse down.
Another possibility is that inflation does accelerate next year (which we consider to be a very plausible scenario) and long-term yields go up. That’s where the Fed would breathe a sigh of relief. Officials would start talking of increased inflationary pressure backed by a strong labor market, and may speed up monetary tightening. Here, too, the real sector would face credit-related issues, now due to higher refinancing costs. The outcome would be the same: GDP growth rates would go down and could actually turn negative.
The spread between long- and short-term rates has historically been one of the best predictors of a coming recession. And while the yield curve alone is not enough to guarantee the end of economic growth, this indicator now needs to be monitored closely. The difference in yield between the 10-year and 2-year rates is just over 0.5 p.p. Every time the spread has narrowed down to -0.5 p.p., the U.S. economy has entered a recession within 9-12 months, without a single exception. We estimate that the first signs of recession emerged in November.
We will revisit the topic of the economic cycle many times in future. It’s important to understand that the attempts to “take away the punch bowl” are bound to succeed eventually. Growth is largely dependent on financial conditions, but the time global liquidity starts declining draws nearer. The largest central banks will stop expanding their balance sheets as early as next year, while the reverse process is to start by 2019. We remain convinced that it is inherently impossible to discount those events: trying to play out a liquidity crisis scenario while liquidity is at its all-time highs is simply unrealistic. The differences in the central banks’ policy stances, however, will become the main theme for the world currencies, as early as the beginning of next year.
Overall, we are likely set for a classic scenario: first, the bubbled-up market has to experience a correction of sorts. Those investors who missed out on the rally will happily buy into the market which means risk-related assets will surge to new highs. Only after that, in H2 2018/H1 2019, would a full-fledged market turmoil (causing a multi-month bear phase) be possible. That’s the strategic aspect. Tactically we would also advise investors to start looking into ways to move their assets into safe havens such as the dollar and the franc. At this stage RV-strategies look particularly attractive.
Now, by tradition, a few words on cryptocurrencies. November brought no news here: the asset class continues its relentless trend up with consistently high volatility. A simple analysis on Bitcoin shows that its next target lies just above the $12,000 mark. Here we draw attention to the activity among second-tier assets. Similarly to the dot.com bubble of 2000, at this point people would buy anything that is called a cryptocurrency without bothering to study the potential and specifics of each asset. It is notoriously difficult to estimate when the frenzy around Bitcoin will end. But one thing’s for sure: the current prices will seem fiction as soon as liquidity tightening starts.
USDCAD: still mispriced relative to oil.
We go short USDCAD at market, stop-loss at 1.2935, take-profit at 1.2505.
The Canadian dollars remains undervalued versus oil. We pointed that out last month, and the market attempted to balance itself out over the past month. However, by the end of November the USDCAD went up, and is now again at the levels attractive to sell at. We are going short the unit, for both technical and fundamental reasons.
Brent oil continues to boggle the mind. The blend has settled above our highest target of $62 and is now targeting $67 per barrel. Since the price surge is mostly explained by the geopolitics — specifically the tensions in the Middle East — the muted impact on oil-related currencies is understandable. Oil prices rise due to specific short-term risks, not increasing demand. Should spot prices remain high, it may eventually trigger a slowdown in the global economy and a decrease in demand for commodities. Which is why there is no significant rally in CAD, NOK, MXN, RUB, etc.
The oil market itself proves our viewpoint. Near-month futures are the only ones trading above $60. Longer-term contracts are being offered at a discount (i.e., there’s a backwardation), meaning that the markets are expecting supply risks to fade. Having said that, oil-related currencies are still significantly undervalued short term. USDCAD is the easiest strategy here, but one can also make use of the good old oil-vs-rouble short.
CHFJPY: a battle of safe havens.
We go long CHFJPY, stop-loss at 112.2, take-profit at 121.8.
The franc-yen cross continues to paint a very clear technical picture. The asset has been stuck in a prolonged corrective phase since mid-2016 and is ready for another leap up. Wave analysis suggests that the pair is targeting levels just above 122. Traditional technical analysis similarly says the prices are pointed at the upper bound of the ascending channel, again targeting 122 yen.
And the rally would make sense. First, the franc has got massively oversold. EURCHF is at its highest since the Swiss National Bank abandoned its 1.20 floor for the cross. The growing in confidence for the euro had triggered a reversal, and some of the money fled back to the common currency. The scale of the CHF correction can be partially explained by fundamental reasons. First, the Swiss currency was significantly overvalued (by about 20-22% on a PPP basis). Secondly, the yen is acting illogical as well: the country’s fixed income warrants a weaker Japanese currency. Together those factors underpin the technical idea.
Copper: the party’s likely over.
We close out our position in this asset completely.
Back in the summer, and then early in the fall we wrote that copper had picked up some good momentum. And sure enough, the metal has since gained over 10% and managed to touch the $7000 level. There is still some potential left in the asset, but now risks are starting to pile up as well. As you remember, copper traditionally correlates with global GDP growth rates. Considering what was outlined in the beginning of this review, it appears that fundamental support will exhaust itself next year. And if global economy is at the peak of the economic cycle, its gradual slowdown should limit the potential for all commodities.
This is where the peculiar problem of financial analysis is most evident: there isn’t any certainty about when exactly the market euphoria will end. Either way, holding the long position which was anchored to economic growth now looks unreasonable. Even assuming there will be another final burst of growth, one needs to find a worthwhile entry point for it. Technical analysis shows that 6555 should be a possible level for a very cautious re-entry.
Bitcoin: now that’s a party!
We hold off from trading cryptocurrencies; will wait for CME Group’s derivatives launch to buy put-options.
If traditional financial platforms are having a punch party with just a little too much alcohol, then the cryptomarket is nothing short of an insane, drug-fueled rave. Not much elaboration is needed here, especially considering that November brought nothing new in this regard. You could quite literally take the paragraph on cryptocurrencies from our last month’s publication and paste it here—and it would fit perfectly. In a nutshell, Bitcoin is a massive bubble, which is sucking more and more people in as it grows. They don’t have much idea about what they are getting themselves into, but they seem to enjoy it.
From the pragmatic viewpoint, there’s only one target change: Bitcoin is now eyeing the $12,000 mark (the cryptocurrency is trading at about $10800 as we are writing these line and it is possible that it will have broken through the $12,000 target by the time this review is out). The growth in Bitcoin has long been on an exponential trajectory, and if you model the currency based on Metcalfe’s law, the rally should be over soon. Nonetheless, going short on a market this uncertain is still a suicide mission. The speed and rate at which Bitcoin could accelerate at any moment are too unpredictable. We are looking forward for the CME Group to launch a futures marketplace for cryptocurrencies. That’s when we’ll be ready to come up with our shorting strategies.
Analytical materials and comments reflect only personal views of their authors and can’t be considered as trading advices. AMarkets is not responsible for losses as the result of analytical materials usage.