The dollar has had a small rebound off its 3 year low and many are wondering if this is a good sign to buy into the greenback strength. Many of the indicators point to a higher Dollar, stronger economic growth, Higher interest rates in the US, and (so far) low inflation. Looking at a one month chart of the dollar index to the price of the 10 year treasury, you can see that the movement of the dollar to other currencies was in high correlation to the price of US bonds. Because yields move inverse to bonds, it could be assumed that lower bond prices (and higher yields) make the dollar become an attractive place to put money relative to other currencies. This trend should be watched to see if investors are using this as a short term trading catalyst or if the introduction of equity risk increased the relationship between bonds and the dollar.
Looking over a longer term trend there is a story to be told. The movements between the dollar and the yields in the past have been in sync (as you can see by the opposite movements in the chart) until the last 6 months where yields have dropped and the dollar followed suit. The cause of this could be a combination of many things, such as inflation expectations getting revised higher, or the political gridlock we have seen over the tax cuts and budget bill. It is certainly an adjustment to the expectations of that yields will not be lower for longer like we have seen in the past. Where is the 'proper' level to bring yields back to an attractive level that investors are bullish on holding dollar debt? Shorter term the answer looks like now, longer term we have to watch, inflation, the fed, and politics to determine what will make the US debt market investable again for large foreign buyers.
US CPI came in higher than expected at 2.1% year over year. Core inflation came in at 1.8% vs the 1.7% est., this caused futures to sell off in the US. Since last month when the markets sold off after wage growth came in higher, the markets have been closely watching for signs of inflation that could cause another adjustment in interest rates.
Longer term this will matter as adjustments are made to the valuations of equities to be able to compete with higher bond yields as well as higher borrowing costs for companies. This squeeze on companies could keep the US equity markets at a flat level for the year, with higher volatility as a new fact of life.
This week started with more selling around the globe. The US futures look like they are going to take on more losses today. It is a good time to start to panic and wonder if there is more to this than a simple consolidation. The strength of the individual investor is that they have time and it should be used. So lets looks over a few shorter term theories that could be the start of a larger trend that would require action.
Consolidation: Markets have had a spectacular 2017 with December and January of this year seeing nearly in-stoppable gains each day the market was open. Markets were past due for a correction and this has occurred all at once. Despite the news coverage these losses takes the market back to the beginning of December of last year. Too many people running for the door could overshoot the selloff and we will eventually find a balance and start the focus back on the data.
Bond Yields/dollar: The equity market notices the bond markets were starting to price in more inflation and higher rates in the future. A declining dollar also stoked the fears of more inflation in the US as the economy progresses. With the Equity market not accounting for as much of a rate increase from higher inflation and a stronger economy it would makes sense there would have to be a value adjustment to reflect the future that is seen in bond market yields.
Total collapse: The end is truly here and losses are mounting everywhere (look at the VIX). Listen to the news 20 hours a day to get the best understanding of how bad it really it. Constant negative reinforcement will provide the insight needed to make sure you hold on till the lowest possible moment to sell.
Paying attention is important and knowing when to sell can help pare losses, but the key is to understand why the market is behaving the way it is and determining then if portions of your assets are ripe for selling. Times like this, when the VIX is this high, almost all assets are being sold off, which is more a time to start to look for key assets to buy as the market continues to panic. Emotionally counterintuitive, but in time a more desirable play in the long run.
This week will be one to keep an eye on the bond market. This morning in Europe the PMI numbers came in better than expected for Europe and less than expected for the UK. This had a negative effect on both currencies and didn't help in reversing the downward trend that we saw at the end of last week. For the rest of the week there will be more economic health indicators coming out for Europe and the US but the main events will be central banks talking.
Today Draghi, the head of the ECB, will be speaking. With the strong growth in the Euro zone it will be important to see if there are any changes in his outlook for the asset purchasing program or when rates will need to start an upward rise. Any concerns about inflation will be another point the markets will be looking at. On Thursday the BOE will have an interest rate decision. Many are expecting no change in the interest rate but the central bank's outlook for inflation is going to be important.
Financial conditions between the UK and Europe will play into the Brexit talks as businesses pare back expansions in the uncertainty of a deal. When looking at how market are perceiving the news coming out of the two countries and the progress of a deal, look at the spreads between inflation prone countries in the Euro zone, like Germany and the UK. In Germany the inflation threat is pushing rates up all across the yield curve while in the UK many are skeptical that Inflation will be as big of a threat in the post Brexit world.
Earnings season is showing many positive signs for the oil industry. The earnings quarter vs quarter show improvements and expenses are down year over year. This good news could help with the explorers over the near term but weakening demand for oil globally could keep the companies in a declining pattern for longer. Fracturing in OPEC's willingness to cut more production and a fracking resurgence in the US should keep a lid on oil prices, and subsequently share prices of oil and gas explorers.
Not all of this should be seen as bad news. A longer term outlook is starting to show the deterioration of production capacity as a result of the cuts in capital expenditures that took place at the end of last year. Oil inventories are decreasing in the US which will eventually result in more volatility in the price of oil during any pick up in demand. The fracking story is also not the same as in the past. While record wells are being dug, there are issues with infrastructure to start pulling oil. Completion and Production revenues from Halliburton's recent earnings release shows the profitability of renting equipment that is in short supply.
In short the outlook for the macro space is not favoring a surge in oil prices in the near future, but oil service companies keeping growth reigned in through less Cap Ex will be able to weather a slowdown easier than in the past and provide a great entry point for a longer term outlook.
With congressmen in the US splitting from the party lines in another vote for the Healthcare bill, republicans are having a hard time remaining united, and the markets are starting to notice. The dollar dropped on the news that the republicans ability to pass the new healthcare bill is waning and the dollar index is suffering as a result.
The inability of the US government to pass bills or show signs of cooperation have the world taking notice and looking for better regions and currencies to place their money. The talk by the Fed and their concerns on inflation has contrasted other central bank's hawkish outlooks and started the dollar decline. We could now see an acceleration as the much anticipates (and baked in) prospects of fiscal policy padding the withdrawal of monetary policy looks less likely.
Today the Bank of Canada (BOC) is likely to raise its benchmark interest rates by 25 basis points. Many are looking at the language as the true determinate of the direction of the Canadian stock markets, bonds, and the dollar (CAD). The current rate hike has been priced in but markets are going to look for a conciliatory tone in the report that will determine how likely further hikes are to be. Many of these worried are around the high debt levels in the Canadian economy, some estimates around 170% of GDP. The central bank is likely to say further hikes are 'data dependent' and not have as aggressive of a tone as some fear. The board should look to see if the slowing economy is accelerated by this first hike before looking to adjust policy further. In terms of seeing how this will affect the private consumers one has to just watch the performance of the large banks.
Many of the banks have outrun the overall market in the anticipation of greater profitability in a rising rate environment. That performance can quickly change if we start to see loan delinquencies and a slowdown in lending as a result of these higher rates. A quarter basis point increase should not be the tipping point of the entire lending economy in Canada but how the bank react to the longer term prospects of more increases, especially in their management of in house prime rates on mortgages, will be the deciding factor.
Over the past 24 hours the Euro has hit a year high, the markets saw a drop in value (especially in tech), and volatility in most asset classes spiked. It was a very central bank heavy day but there seemed to be something more to the movements in assets.
Mario Draghi of the ECB came out more hawkish than expected which resulted in many investors taking notice and adjusting their assessments of the Euro. There could also be a larger trend that could be starting to take form. The ECB is yet another major central bank that is now taking away the punch bowl of easy monetary policy, and much sooner than the markets were expecting based on the shockwaves. Over time the markets will have to find the best places to invest based on fiscal policy and unassisted economic growth. This trend makes sense with the selloff in tech stocks as a lot of cheaper money was chasing growth.
The Dollar rally from the Fed's moves to raise rates and discuss balance sheet reduction could be coming to an end. The Eurozone is in an earlier stage in the growth cycle than the US and already looking at the potential for less stimulus. With US growth starting to wane from being in a later stage of the cycle, the ability for rates, and the Euro, to move up in relation the Dollar.
These are one day moves and could be reverted with any news confirming the former trend but it is important to be aware of these trends and look for confirmations, flaws, and adjustments.
After the record setting highs of the US markets last week, the futures look to be closing the gap to start this week on a positive note as well. This has the VIX index back near multi year lows. Couple this with a light week in terms of US economic news and you have the markets at the whims of politics. With more news sure to come out from the repeal of Obamacare, and talks of an ambitious tax plan to follow, it will be interesting to get the market's likelihood of a meaningful deal.
The lack of greater economic news will provide a clearer link to the talks of a revised tax deal and the removal of Obamacare legislation to how much the market is still pricing assets to a deal. Political exhaustion will come at some point, but as seen in the VIX it looks like strong economic news may take over as a driver in the near term. one thing that investors can be sure of is that low volatility makes bets on larger swings in asset prices less expensive to hedge against. Not a bad idea given the conditions.
Crude oil has been struggling to maintain its gains since the start of the year, nearing the lows that it has seen in early March. The rise we have seen in oil was from the OPEC members (and others) agreeing to output cuts to shore up prices. This has faded over time as inventory levels started to creep back up, but not all of this is to blame on the Cartels.
The US onshore producers have increased production with the rise in oil prices making many of their fields profitable again. This spike in production can stop almost as easy as it started. Longer term, many oil companies are locking in contracts for oil, sacrificing price for stable cash flows. Should this trend continue it could be the start of major oil companies starting to put more of their revenues into longer term offshore projects and exploration.
This could be a good thing for ETFs like the SPDR S&P Oil & Gas Exploration & Production (XOP), which have been underperforming along with the oil market. As oil contracts get locked in prices and we see a stabilization in prices from a lack of investing in replacement wells, the yield on this ETF could start to justify higher prices in the future.