The Writing on the Wall
Why Markets don’t melt in overheating
This was a important week in the life of markets. Not because of the price movement. After all the best description with the continued exception of oil is a market going nowhere fast: the projected two way volatility.
The significance lies in the real world, the narrative and how this fits uncannily into an historical perspective. It easy both to overstate and understate any event in any continued saga. The potential collapse of the UK government following a Brexit deal promises weakness potentially the best buying opportunity in GBPUSD in a long time (along the lines of 2000-2003) but doesn’t mean it will be this week. So what if a crypto hung over NVDA disappointed the market at the end of a very strong earnings season. Once weak longs have capitulated it will then (in our opinion follow other similarly hit stocks) rejoin the rest of the market and claw its way back up. More happily the dent then is an opportunity.
But the real story, almost as ever, came from US poltiicians and took the two most important global narratives one step further to an inevitable conclusion: a predominant US stock market blowout that will affect most markets to a varying extent and a stock market crash that will move all markets together.
This week was noteworthy as we saw the historical writing on the wall in two respects.
The first clearly is the rumbling trade war that saw the week start with Trump’s intellectual property tariff and the consequent stock sell off. But it was an important marker. Not only was Mnuchin saying the US will continue to escalate until China puts forward concrete written proposals that amount to a (Trump perceived) capitulation but he was also expressing the same frustration and creating the same set up as the specific 1987 crash. The key trigger we are waiting for into the actual crash (not top).
On Sunday October 18th 1987 (the day before the Black Monday crash) the then Treasury Secretary James Baker tried to force resolution by the telling the Germans he would collapse the Dollar if they did not agree to fall in line. Are we there now? Possibly but probably not. Although it is easy to take the details of an analogy too far, until we such an overtly aggressive threat, the market should remain in trade war limbo and therefore driven by economic fundamentals rather than political gestures, rhetoric or real.
The second writing on the wall this week came from the Fed.
“You’ve seen a bit of a slowdown—not a terrible slowdown,” Powell said Wednesday evening. “You still see solid growth, but you see growing signs of a bit of a slowdown. And it is concerning.”
Despite a strong economy and good intentions going forward, both Fed Chair Jay Powell and two other Fed members expressed concern.
Those fundamentals driving the current global market, predominantly US led, are simply strong but not growing at the same, or if you believe Fed Chair Jay Powell, universal rate. “We know there are a lot of (US) people around the edges who have not benefited yet from the recovery.” Remember it is not a downturn that has historically caused a (Dollar first then) stock market top into a crash. The crash has previously been caused by a deterioration and increasing fragmentation in the rate of improvement that falls behind both market expectations and most importantly expectations reflected by US yields. So until politics blows the increasingly fragmented US and global economy apart, the dominant narrative will remain how the real economy and in turn markets (and in particular the bond markets) react to US Fed tightening.
We have and will therefore continue to highlight what markets typically do during and (we believe more saliently) at the end of a tightening cycle into a causal stock market and Dollar top. We know NDX and notably its bellwether AMZN is following the end of quantitative easing cycle in 2014.
But in case you understandably think QE and Taper and their impact was unique then you need to think again. The similarity extends to other tightening periods most notably 2006 into the sub prime blowout and crash. Indeed the comparison between the economy and market that confronted a newly appointed Ben Bernanke faced and the current that Jerome Powell faces is not just interesting but instructive and helps explain why Ben and Jerry’s (ice cream) market will crash at some point but can take a lot of heat first.
Ben (2006) & Jerry (2014) Comparison
The similarity between tightening 2014 NDX and tightening 2018 NDX is strong, and tightening 2006 NDX and SPX compare fairly well even though the scale appears larger in the more recent decline.
But the comparison between SPX and DAX/CAC in this period in scale structure and projection is striking and clearly matches the same ‘end of tightening phase’ illuminated by 2014 NDX and AMZN.
But why? Are the Ben and Jerry periods and narratives that similar?
Ben Bernanke’s first term started in February 2006 when the hiking cycle was already quite mature. Less than two years earlier, in June 2004, the Fed funds rate had only been 1%, but by the Bernanke took over from Greenspan it had increased steadily to 4.5%. He soon took it to 5.25% by July, but this was as high as it ever went.
Bernanke got off to wobbly start, and soon found out he has to choose his words and audience carefully. In early May CNBC anchor Maria Bartiromo quoted Bernanke as saying “It’s worrisome that people would look at me as dovish and not necessarily an aggressive inflation-fighter.” This was interpreted as hawkish when markets had been anticipating a pause in the hiking cycle. Bonds sold off and equities fell 8.3% from May to June. But Bernanke learned his lesson and by 2007 was much more in tune with the market, even cutting rate in August 2007 as the S&P500 made a steep sell off. This helped markets limp to new highs, but was only a short-term fix as it led to the October 2007 top, and we know what happened next …
The new Fed Chair Powell is also off to a challenging start. What used to be a Goldilocks economy is at risk of overheating as massive fiscal stimulus is implemented when there is already full employment. Powell, like Bernanke, wants to be seen as an inflation-fighter, and insists on being data dependent, but this isn’t what the market wants to hear right now. When he delivers post-meeting news conferences, the typical S&P 500 loss is 0.44 percentage point, while his other public comments have come with 0.4 percentage point drops. In fact, JP Morgan said in October that Powell’s remarks have cost the stock market $1.5trn this year.
Just like 2006, the market wants a pause in the hiking cycle, and sees multiple reasons for this. Pressure from President Trump, from the trade war, a too strong dollar, crashing emerging markets and a rout in bonds all gave Powell an “out.” Yet he has been steadfast, as has the message from other Fed speakers, and talk of reaching an even exceeding the neutral rate (i.e. 3%) has caused some heavy selling in equities and bonds.
However, this week we have seen a very subtle (but we believe truly significant) change. As markets continue to sell off and, to many, seem destined for the October lows and beyond, Powell and other Fed speakers have shifted ever so slightly dovish.
“You’ve seen a bit of a slowdown—not a terrible slowdown,” Powell said Wednesday evening. “You still see solid growth, but you see growing signs of a bit of a slowdown. And it is concerning.” Will a data-dependent Powell keep raising when he is concerned about growth?
The, in our opinion, all important US yield charts, provide the answer.
We also heard from two regional Federal Reserve presidents (Atlanta and Minneapolis) that urged some caution in raising rates given the weaker growth abroad.
We could say perhaps this is paving the way for a pause. And we could go one step further. Like in June 2006 we have seen the last or possibly penultimate US rate hike. The implications would be widespread not least in the Dollar.
Indeed the Dollar comparison for this period and the end of tightening generally is no less compelling and stems partly from not a dissimilar twin (trade and budget deficit) that challenged the US administration at the time.
And given the importance (and lead) that the typically yield driven USDJPY represents as the first market to turn down (in 1987) our continued reference to the 2006 comparison highlighted on our analysis pages is worth noting.
Depending on circumstances, next week we will start a series on what really generally moves Forex markets but particularly now. The simple answer is many factors with a varying impact. And before you cite the recent aggressive sell off in Oil as a possible justifiable and variable challenge to a 2006 comparison, take a look.
All asset classes and instruments move for varying reasons over time. It is why we attempt to highlight what (of the four FITS pillars Fundamental, Intermarket, Technicals and Sentiment) is driving the current market most. The expectation by the Fed and market of US inflationary growth continues to drive the (globally variable?) Bond market blowout and therefore the Dollar. The reason why we believe stocks remain stable before a major blowout before the crash is simple: sentiment. We all or rather most of us like ice cream as we do profits. Even if some (notably Oil and a few US stock and global indices) are melting, that doesnt mean there will not be a feast to come in some places in the world (US indices) from Thankgiving into Xmas. As Chris Partt said “You can pour melted ice cream on regular ice cream. It’s like a sauce.” I must try that … flambéed ice cream!
Here’s to making the very best.
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