The Links That Matter
In a week that saw the US tariff deadline and a UK ‘No Deal’ Brexit at least postponed, slowing US Growth beat expectations, Consumer Sentiment fall again and yet DJIA finished its best first two months of the year since 1987. With such a widening gulf between stock markets and reported reality, it is perhaps no surprise that some markets are becoming increasingly fragmented. It is why forex traders appear confused as the Dollar continues to ping around in what we believe is a slow consolidation top. Indeed, following a lacklustre Canadian CPI and poor GDP release, USDCAD gratified our ‘corrective’ long in one of the strongest reactions to an economic release in a long time.
But why are markets sometimes producing a textbook reaction to fundamental news and other times the opposite? The drop in Michigan Consumer Sentiment from 95.7 to 93.8 (and the worst ISM since Donald Trump’s election in November 2016) prompted an almost 1% drop in NDX only to be completely unwound by the close.
The answer now and for much of a news driven 2018 is that this market is moving in three steps.
The first is to suck in traders with the news, the second is a move against the news in order to stop them out and get them positioned the wrong way. And finally, the fundamentals win with an even larger move with the news.
That is pretty much what US indices did for the entirety of 2018, the positive Trade War News on December 2019 and countless other examples such as USDCAD on Wednesday’s CPI. So many recent trends (or reversals) have started with this set up.
So what is making the market do this?
Traders’ (and not consumers)’ sentiment for the time being as reflected by these fractals which show how markets, on average, react to releases due to the perceived significance of the event or, in short, sentiment. Traders will want to stay with the predominant trend until it breaks by which time is often too late. Canadian Dollar bulls or more accurately, hawks, have stayed with a persistent steady ratchet higher over the last three weeks only to see it unwound in six hours.
Indeed, long term Sterling bears seemed to give up the ghost of a ‘No Deal’ early this week. But for what? As we pointed out in our Brexit Blog, just because a (wrongly?) perceived Armageddon has been averted doesn’t mean the UK is any closer to a Brexit resolution, relatively positive or otherwise. That reality was perhaps evidenced by GBPUSD’s closing sell off that reflected a deep-seated uneasiness about Brexit. But it allowed us to hedge puts and venture cautiously long—short term only.
Sentiment is pretty much everything. Get it right and you nail a market short term. In the medium term sentiment helps or hinders you time a fundamental move. On Friday we covered our structural Bund short and bottom ticked a long for a short term squeeze—as we also did on the DJIA. But only to resell better levels next week.
Sentiment is hard to read at the best of times, even when it is clear consistent and persistent. But it is even harder when it is fickle and mixed. Hence why we bought DAX puts rather than sold cash against the 11670 high on Friday’s open ramp. There was, and remains, a real risk of taking out stops next week.
So what should do when sentiment screws levels in the market we are trading?It is extremely useful to identify what is really driving the market and find cleaner surrogates that either represent or reflect what is driving (or better still) leading our chosen instrument. In other words, find a historical market or current indicator that best reflects the underlying reality and/or sentiment. The US 10-year yield top above 3% in 2018 was a precursor of the December stock rout and the USDJPY/AUDUSD New Year collapse. There is a possibly accurate view that bond traders know best and are more immune to shorter term sentiment or noise. The gap between a bund driven DAX and the yield itself that started mid January has now stopped growing and destined to close. Prophetic for both DAX and the Bund?
The implications for this projected Bund reversal should also eventually be felt for the Euro (note a similar consolidation bottom) but also US yields (current US yield = February 14th Bund yield).
But it is not always easy to make or even understand links between markets (current or delayed). Apart from an inflationary growth=>interest rate link, why would the Chinese Stock market be leading the German Bund? Sentiment. Either way, we are trading it.
How can we best understand and measure the current drivers and associated sentiment? Without wishing to oversimplify, in the shorter term, the current market is driven by optimism over the Trade War for US (and global) stocks and a newly lost Brexit pessimism for Sterling, both with an impact on related markets. In the medium term, deteriorating fundamentals for US (global) stocks, yields and the Dollar and a growing investment gap in the UK that will eventually dent UK economic performance.
In the context of a relentlessly persistent uptrend, the historic template for SPX’s reaction to protectionism would appear challenging.
And yet it is more of a fundamental rather than sentiment driven template and therefore a persistent bullish sentiment have produced a persistent uptrend for stocks and a supported Dollar.
Sentiment, as reflected by SPX short interest, is at its lowest since 2007.
And the bearish sentiment for EURUSD is also in oversold territory.
But we know such excessive sentiment can be prolonged in both time and price particularly if there are new entrants joining the predominant trend.
Perhaps more instructive is the strong link between both SPX and the Chinese stock market and Oil as both indicate expectations of global inflationary growth associated with the outcome of Trade War negotiations.
The correlation between SPX and Oil is stunning with a suspicion that Oil is in fact leading by a day. Similarly, the Michigan Consumer Sentiment Index appears to have an immediate but not lasting effect. But it is in the longer term it is one of the best fundamental indicators even if its impact is delayed.
It feels like one needs a crystal ball to anticipate the developments in the long running Brexit saga. And yet there is a familiar pattern. Until there is a fundamental (ie later Brexit impact) rather than political resolution, short term good and bad news produce a consistent cycle around a perhaps surprisingly economic growth pattern. This is evidenced by both an upward drift in GBPUSD and a seemingly unaffected Gilt market that correlates closely to both US and German 10 year yields.
After the initial impact of the news the market reverts to a stable updrift.
Following the postponement or even removal of a No Deal scenario this has resulted in price action that resembles the run into the pre 1.50 June 2016 pre referendum high.
But neither GBPUSD nor EURGBP truly reflect what is going on. A better indication is the key yield curve (2vs10).Expectations of a Brexit affected Bank of England Brexit reaction continue to rise against a more global economic Gilt.
It is therefore interesting that FTSE, also a blend of Brexit (GBP) and global markets, appears to be leading the key Brexit market with an eventual, how shall we put it, disappointing outcome.
Everyone knows that the trend is your friend.
But the trend is not always as obvious or easy as it would appear, particularly across different time frames.
You can make money reading the tape throughout the day. But it is reading the weekly copy that helps identify the big swings.
Here’s to making the very best.
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