September 2020 Macro Markets Blog Post

 Recap

Hi all, and thank you for tuning into the September 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 at least until the US elections. Outside of the steepener trade on TY 10s30s I had written about, markets have been quiet through the August summer session period. Now that we've got Jackson Hole out of the way, that might start to change, which will be the subject of this blog post. 

Macro Thesis   

I think that in the current environment, a lot of the early positive news from the reopening story has been played out. Inflation from aggregate demand is going to be harder to come by, especially as we get into the winter season with fears of a resurgence and with news of possible reinfections. The saving grace might be the monetary inflation from dollar weakness as a result of the Fed's guidance at Jackson Hole. In this vein, I see the macro environment being very similar to what it was in the summer, but this time for different reasons - the one exception possibly being equities. 

In the previous blog, I had written about how the passage of European stimulus would power gains in the EU's capital account - that no longer seems to be the case. I think this is the case because case counts have started to rise across the Euro Zone leading to new, softer restrictions. We have seen from the precedent of Australia and New Zealand over the past few months that rising case counts do have an effect on the currency, as until recently both were ranging vs USDs. This is coupled with the fact that the ECB, as well as central banks around the world expect credit extension to individuals and businesses to tighten going into the end of the year, and it becomes possible that the labor market might start to falter. This means that in the absence of more fiscal policy in the EU, which seems unlikely at the moment, it comes down to monetary policy. As we have seen many times before, monetary policy in the EU tends to be not as effective, though can avoid significant deflationary shocks. This might be why DAX and EuroStoxx have traded the way they have for the past few weeks.

This seems to be less the case in the United States, where the labor market is going through an initial revival that other countries had months earlier. However, I don't think this will lead to appreciable gains for USDs because of the guidance from Jackson Hole. I think what's important about this meeting is not the Fed's new inflation targeting framework, rather its expectational consequences. As a rule, it seems unlikely that the Fed can incite meaningful inflation from aggregate demand. This is a function of the Phillips Curve being notoriously difficult to exploit - evidenced by its long-run flattening. What the Fed can control, however, is monetary inflation. Since the 80s, we've had a nominal anchor in inflation targeting that has set expectations. This was further formalized through the introduction of the Taylor rule. Though the Taylor rule is no longer in place, it helped to set rule-like behavior to monetary policy that provided credibility in the nominal anchor. Now, however, that credibility might be getting eroded. This is a result of the Fed not having any clear guidance, or semblance of rules for how inflation averaging might work. As a result, monetary policy becomes increasingly discretionary and can lead to monetary inflation. It's also not certain that monetary inflation leads to aggregate demand inflation. That might be because wages are more a function of globalization, and credit extension might not rise as investment opportunities in the real economy might not exist. The most that can be said is the value of financial assets might rise. As a result, it's possible that we might have continued USD weakening, this time for a different reason than during the summer period. 

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

• It is likely that the early labor market gains have been realized. Caution must be shown as we head into the winter season where the case count might rise once again
• This would have a negative effect on consumption and aggregate demand inflation
• However, we have the positive catalyst of monetary inflation as a result of the Fed's new inflation targeting mechanism
• This will certainly strengthen commodities prices, as has been seen in the precious metals complex. It is possible that it might fan out to the rest of the commodities complex as demand recovers
• This will also bolster US equities for a time. However that will eventually become a story of labor market developments vs monetary inflation. As monetary inflation doesn't necessarily translate into higher wages and consumption, investing in equities will be a function of real yields vs expected corporate profit growth

US 10s30s Steepener/Short 30 year Treasury

Though this trade is increasingly getting crowded, I think there is still value to be had. This is because I think the worries of stagflation and a bear flattening are currently quite a bit away. As we have been in an environment with low inflation, the monetary inflation that we are now seeing might lead to real economic growth as well. That's why I think the steepener trade works for the foreseeable future. Specifically, I like being a payer of the 30 year Treasury as it's giving an excellent technical setup. What we're seeing right now is a classic wave high to 177'17, which will lead to an intermediate term target of 172. Ultimately, I think that if the short dollar trade is to continue, it is likely we will get a break below the 172 level. I think what's also interesting is that we are in a longer term steepening move on 10s30s. Where before it was a bull steepening after the Trump tax cuts, now it is a bear steepening due to monetary inflation. This might mean that the steepening move has room to run.

Short USD - Long AUD/USD, Long EUR/USD, Short USD/CNH

The thesis for this trade, as described above, is that we are seeing monetary inflation as a result of uncertainty around the nominal anchor because of the Fed's new monetary policy framework. I think it is likely that we will see rates at the ZLB for several years as a result of this framework, which would only compound the case for monetary inflation.

  

I like getting long AUDUSD here for both fundamental and technical reasons. Fundamentally, I think that the resurgence in cases has been priced in. That is what I think caused the ranging action for the past few weeks. However, AUDUSD has an equity market component to it that makes it attractive for now, as I think US stocks are likely to rise. I think these fundamental reasons have led to the action we've seen. That is, that AUDUSD was the first one to break out of its range. As a result, it might have more room to run than other DM pairs. 

I like being long EUR again since its the next best option after USD. This is because of its heft in international trade, as well as the EU's policy inefficacy. I think the situation that might play out is that the United States will export its deflation to the EU for the time being, with the EU being unable to stop it. This is because experience has shown that the ECB's money printing has been unable to increase inflation. At the same time, there is very little chance of more fiscal stimulus. Even if there was, it might be the case that Euros would strengthen, as it did earlier in the summer. So, if the Jackson Hole speech is to be believed, then EURUSD would be a prime trade. The other reason I like it is that is has finally broken out of its range. As we were near a long term resistance, this might usher us into an era of longer term dollar weakness. 

I had written about this trade in the last blog post, and I continue to like it from here. The fundamental story hasn't yet changed. The challenge that China is currently facing is that it has built up huge FX reserves from exports this year after its factories got restarted. However, the challenge is that they have not done nearly enough fiscal stimulus geared towards labor. This is an intentional policy as they are fearful of following a similar policy as developed nations, especially when their debt load from the Belt and Road Initiative has been so high. This has led to deflationary forces acting on the economy after the worries of food inflation were mitigated. As a result, the PBOC's balance sheet has stayed roughly the same whereas other major central banks' have expanded. This is also what's showing up in their interest rate markets as their 10s30s curve has not moved anywhere, nor have their yields. Coupled with the dollar weakening, this trade has outperformed the rest of the currency market, and I think will continue to outperform the rest of the currency market for the foreseeable future. 

Long Commodities - Long Silver, Long Copper   

I had written about this in the last blog post as well, but am now much more confident in these trades working out. This is because the story for silver has been a real yields trade since March. However, the exponential appreciation only happened as the dollar weakened. Now that the short dollar trade seems that it will continue, so might silver. The reason I like gold over silver is that silver also has a real economy component to it, which would be useful as the US continues its reopening. I also think that there might be a gold/silver ratio component to it, as it had reached all time highs prior to the virus. I think that copper is an interesting trade as well as we might be in the midst of a revaluation. Where before, it was dependent on Chinese yields, now it might be because of US yields. This is because the Chinese reopening of factories for the most part has played out. Now the US is coming back online and is driving most of the growth in the world, and might continue to do so into the end of the year.

Here we see that Silver has been ranging around for most of the past month, at the same time that the dollar was ranging around. Now that dollars have broken down once more, we are seeing a similar thing on the action in silver as it has broken above 28.

Here we are seeing a rewiring of the fundamentals in copper. Where before copper had rallied with Chinese 10 year yields, what we are seeing is that over the past month, that has changed. This is because it is now the US that is driving global growth as other countries reopenings have largely played out. This pattern conceivably occur into year end. I also like copper now that it has broken above 3, which allows for a more confident entry into the new wave of the trend. 

Thank you for reading. Would love your feedback and suggestions on how to improve as I am a recent at NYU Stern graduate with a major in Finance and Philosophy and interested in the Financial Services Industry. I can be contacted at snd314@stern.nyu.edu