July 2020 Macro Markets Blog Post
Recap
Hi all, and thank you for tuning into the July update from MacroSquawk. If you were able to read the previous month's update, I think it is going to be indicative of the kind of environment we will be in for the next few months. We got the rally in commodities and stocks I had described, along with the selloff in dollars that I have been writing about for the past few months. Interestingly enough however, the rally in commodities has been largely contained to the metals complex. I think that this is interesting in the context of the macro environment we are seeing, and I think it is laying the foundations for an extremely inflationary move in the next few months to a year out.
Macro Thesis
Right now the most important things to note are the guidance coming out of the Federal Reserve, the signals coming from global rates, as well as the passage of European stimulus.
Firstly, as has been described in previous updates, the passage of stimulus in Europe would be a very strong bearish catalyst for the dollar. This is something that has been realized. However, it remains to be seen whether this is a longer term move. If this is the case then, along with the continued subpar virus policy response from the US, this could lead to a longer term sell-off in dollars as the differential in real growth between the US and the rest of the world widens. This move might be even more sustainable if the plan to create a yield curve of joint European debt is realized. This is because USTs would certainly lose their monopoly status as a safe-haven asset.
Though this has been something that has already started to play out, one of the troubling things about this move is that Treasury yields have barely moved, and have even gone down! I think that there are a few reasons for why this is the case. On the one hand, we are having an increase of economic activity that in theory should be leading to a selloff in bonds. However, on the other hand consideration must be given to the starting point we came from. Remember back to March of this year. We had a massive deflationary impulse which was only mitigated by the Federal Reserve's buying of Treasuries and other credits. Since then, yields have barely moved. This should be taken as an indication of the pain in the real economy which has been masked in financial markets, which has been a constant complaint of late. Therefore it might be for this reason that we are seeing little movement - that even though it's an improvement, it's not nearly enough to move the needle on rates which have been manipulated by the Federal Reserve.
However, there might be a catalyst over the horizon to correct this behavior in rates. This catalyst is the steepening that is currently happening in Chinese bonds. It is the case that for most of this year, TY 10s30s has lagged Chinese 10s30s. This might have to do with the fact that they have been more adept at slowing the virus down. As a result, it might be the case that we can expect to see meaningful steepening in TY 10s30s as well at some point in the future as economic activity picks back up.
So far, the fact that we might get steepening on 10s30s, as well as the possible long-term weakening in dollars already leads to an inflationary environment that we would find at the beginning of an average business cycle. The reason that this time could be particularly inflationary is because of the shift in guidance from the Federal Reserve. This is because now they are indicating that instead of targeting inflation expectations, they will be targeting realized inflation. The other interesting point is that they are also expecting to let inflation run hotter than the 2% target to around 3% - 4% so that they can average out long-term realized inflation. This could possibly lead to a highly inflationary environment due to inflation's nonlinear nature. It is argued that below 5% inflation still acts linearly, but the fact that the Fed is targeting actual inflation rather than expectations might lead them to being behind the curve. That might lead to ineffectual policy to mitigate inflation which could eventually lead it into a nonlinear curve.
As a result, this time inflation might be reflected in the commodities markets instead of the stock markets. I think this is because inflation from deficit spending in the US finds its way into the stock market. This is because the increased money supply can be largely absorbed by dollar-denominated assets, which is why it doesn't show up in core prices and doesn't lead to a rush out of dollars. This time however, inflation is happening the other way around via the dollar and commodities channel. It is something we have already seen happen in the precious and industrial metals complex. This might be because they act as a store of value, and are more driven by supply-side rather than demand-side considerations which this year have been ahead of consumption. Eventually, when economic activity is restored, all of the factors are in place for a huge inflationary move in commodities. The current hurdles to this outlook are the buildup of supply from months of inactivity. Whenever this is overcome, there could possibly be a large move in the commodities markets. It might also bode well for certain, well-managed Emerging Market countries. This is more of an opportunistic trade as many EMs have had to contract large levels of debt that might inhibit any kind of strengthening move they might enjoy.
Summary of Macro Thesis
US 10s30s Steepener/ Long long-dated 30 yr vols
Here we see an overlay of UST 10s30s vs Chinese 10s30s. It seems that for most of this year, Chinese rates have reliably led US rates by a few weeks. The fact that we have recently started seeing steepening in China might be cause to think the same might happen in the US. This might be due to the fact that we are seeing a resumption of economic activity, along with the recent weakening in dollars. Another way to express this trade is through vols, as they are currently extremely low. This trade has been around for months now and might seem like a consistent money-loser. However the Chinese steepening might act as a reliable catalyst for the vol trade soon. The vol trade also has the benefit of not requiring good timing , which might become important in lead/lag trades such as this.
Short USD - EURUSD, USDCNH
EURUSD
Above, we are seeing that EURUSD is getting close to a years long downtrend. This might act as a resistance in the intermediate term against which opportunistic longs might be taken. If it is the case that we are actually in a new historical period for the Eurozone, we can expect this trendline to break. If that were to happen, it's likely to add much more fuel to the commodities fire, which should also show up in the previously described rates trade.
USDCNH
Hi all, and thank you for tuning into the July update from MacroSquawk. If you were able to read the previous month's update, I think it is going to be indicative of the kind of environment we will be in for the next few months. We got the rally in commodities and stocks I had described, along with the selloff in dollars that I have been writing about for the past few months. Interestingly enough however, the rally in commodities has been largely contained to the metals complex. I think that this is interesting in the context of the macro environment we are seeing, and I think it is laying the foundations for an extremely inflationary move in the next few months to a year out.
Macro Thesis
Right now the most important things to note are the guidance coming out of the Federal Reserve, the signals coming from global rates, as well as the passage of European stimulus.
Firstly, as has been described in previous updates, the passage of stimulus in Europe would be a very strong bearish catalyst for the dollar. This is something that has been realized. However, it remains to be seen whether this is a longer term move. If this is the case then, along with the continued subpar virus policy response from the US, this could lead to a longer term sell-off in dollars as the differential in real growth between the US and the rest of the world widens. This move might be even more sustainable if the plan to create a yield curve of joint European debt is realized. This is because USTs would certainly lose their monopoly status as a safe-haven asset.
Though this has been something that has already started to play out, one of the troubling things about this move is that Treasury yields have barely moved, and have even gone down! I think that there are a few reasons for why this is the case. On the one hand, we are having an increase of economic activity that in theory should be leading to a selloff in bonds. However, on the other hand consideration must be given to the starting point we came from. Remember back to March of this year. We had a massive deflationary impulse which was only mitigated by the Federal Reserve's buying of Treasuries and other credits. Since then, yields have barely moved. This should be taken as an indication of the pain in the real economy which has been masked in financial markets, which has been a constant complaint of late. Therefore it might be for this reason that we are seeing little movement - that even though it's an improvement, it's not nearly enough to move the needle on rates which have been manipulated by the Federal Reserve.
However, there might be a catalyst over the horizon to correct this behavior in rates. This catalyst is the steepening that is currently happening in Chinese bonds. It is the case that for most of this year, TY 10s30s has lagged Chinese 10s30s. This might have to do with the fact that they have been more adept at slowing the virus down. As a result, it might be the case that we can expect to see meaningful steepening in TY 10s30s as well at some point in the future as economic activity picks back up.
So far, the fact that we might get steepening on 10s30s, as well as the possible long-term weakening in dollars already leads to an inflationary environment that we would find at the beginning of an average business cycle. The reason that this time could be particularly inflationary is because of the shift in guidance from the Federal Reserve. This is because now they are indicating that instead of targeting inflation expectations, they will be targeting realized inflation. The other interesting point is that they are also expecting to let inflation run hotter than the 2% target to around 3% - 4% so that they can average out long-term realized inflation. This could possibly lead to a highly inflationary environment due to inflation's nonlinear nature. It is argued that below 5% inflation still acts linearly, but the fact that the Fed is targeting actual inflation rather than expectations might lead them to being behind the curve. That might lead to ineffectual policy to mitigate inflation which could eventually lead it into a nonlinear curve.
As a result, this time inflation might be reflected in the commodities markets instead of the stock markets. I think this is because inflation from deficit spending in the US finds its way into the stock market. This is because the increased money supply can be largely absorbed by dollar-denominated assets, which is why it doesn't show up in core prices and doesn't lead to a rush out of dollars. This time however, inflation is happening the other way around via the dollar and commodities channel. It is something we have already seen happen in the precious and industrial metals complex. This might be because they act as a store of value, and are more driven by supply-side rather than demand-side considerations which this year have been ahead of consumption. Eventually, when economic activity is restored, all of the factors are in place for a huge inflationary move in commodities. The current hurdles to this outlook are the buildup of supply from months of inactivity. Whenever this is overcome, there could possibly be a large move in the commodities markets. It might also bode well for certain, well-managed Emerging Market countries. This is more of an opportunistic trade as many EMs have had to contract large levels of debt that might inhibit any kind of strengthening move they might enjoy.
Summary of Macro Thesis
- The passage of stimulus and fiscal transfers in the EU might lead to a longer-term weakening in USDs
- This, coupled with the US' poor policy response to the virus might lead to a widening in growth differentials between the US and the rest of the world
- This move has already been somewhat realized, and might cause monetary inflation. However we have not seen any indication of inflation from the bond market yet
- This might be because the bond markets signaling has been muted due to the Fed's purchases during the virus crisis. Where the economy might just be coming out of deflation, the bond market isn't showing that yet. The fact that Chinese 10s30s is also steepening might be a near-term catalyst for such a move in USTs
- This might mean that the rally in commodities, which has so far been largely contained to metals, might spread out to the rest of the commodities complex as inflation picks up, and consumption growth comes back to life, creating real economic growth. Commodities might also be an out-performer to stocks as inflation is happening more due to dollar weakening rather than deficit spending finding its way into the stock market.
- Of particular note is the fact that the Federal Reserve is being extremely accommodating towards high inflation. Since this time it seems to be coming from commodities, it might lead to a larger rally in the entire complex over the next few months and year than we had seen immediately after the GFC.
US 10s30s Steepener/ Long long-dated 30 yr vols
Here we see an overlay of UST 10s30s vs Chinese 10s30s. It seems that for most of this year, Chinese rates have reliably led US rates by a few weeks. The fact that we have recently started seeing steepening in China might be cause to think the same might happen in the US. This might be due to the fact that we are seeing a resumption of economic activity, along with the recent weakening in dollars. Another way to express this trade is through vols, as they are currently extremely low. This trade has been around for months now and might seem like a consistent money-loser. However the Chinese steepening might act as a reliable catalyst for the vol trade soon. The vol trade also has the benefit of not requiring good timing , which might become important in lead/lag trades such as this.
Short USD - EURUSD, USDCNH
EURUSD
USDCNH
This is a trade I had written about in the April blog post. At the time, I thought it was an opportunistic trade on the policy responses to the virus in the US vs China. Now that it has broken through this years long uptrend however, I feel it encapsulates a lot more macro variables. For example it captures the widening growth differentials between the two. It also might be capturing reduced flows into USTs from China as a result of their deepening capital markets. It might also deal with the fact that the CCP would want a strong CNH right now. This is because their ability to pursue fiscal stimulus policies has been very limited as a result of their overextended credit cycle due to their Belt and Road Initiative. They might want this because much of their current fiscal and monetary policy has been directed to infrastructure projects, which are much better at stimulating supply. Now that China wants to become a consumer-oriented economy, this might be a move they would want to help provide stimulus to bring that about.
Long Commodities - Silver (opportunistic), WTI/ WTI Vol
Silver
Above we see the chart of silver. The reason that I cite this as more of an opportunistic trade is because much of the move has already been done. Therefore the way I would trade this is either if it breaks through 25, or if it pull back to 20. Longer term, there might be a case to be made for it surpassing its post-GFC highs. This is because of the unique nature of the inflationary period we might find ourselves in a few months to a year out.
WTI
Here we see the front month of WTI. The reason that I think this might be an interesting trade again is because it would be a primary cause and beneficiary from inflation. Though right now there is yet a lot of supply out on the market due to buildups over the past few months, once those get worked off we might see large run-ups. I also like this because it is offering a great near-term setup. On the 4 hourly chart, it seems to have broken out of the ascending triangle its been in, which might be providing evidence for this hypothesis. It also seems that the next target is around 50. Outside of trading front month futures, another way to trade this might be through options. This is because it is unknown when the current oversupply will be removed from the market. As implied volatility is currently cheap, it might be a good opportunity to load up for a longer term move later in the year.
Comments
Post a Comment