Over the past couple of weeks three new “for sure” investment themes have emerged. Stocks will rise, bonds will go down, and the US dollar will continue its ascent. Although you should never say never, it will be difficult for these three trends to continue for much longer.
A stronger US dollar and higher rates will weigh too heavily on the global economy for stocks to rise much further. The tightening of financial conditions eventually matters. You can’t have expanding P/E’s in a rising interest rate environment with what will most likely be declining earnings. Something has to give.
Most traders’ knee jerk reaction is to assume stocks need to be sold. Although I am sympathetic to that view, I wonder if this conundrum might be solved another way.
If I were to rank the market’s conviction about these three new “for sure” trends, I would say the stock market rise would be the theme with the least confidence. Then would come the bond decline. And finally the US dollar would be the trade the market is most sure of.
After all, we are bombarded with constant research pieces about the serious problems of the lack of US dollars in the overseas eurodollar market. And if that isn’t enough for you to strap on a huge US dollar long position, then we have the repeated highlighting of the record spreads between US and other G7 interest rates. Strategists are quick to point out US monetary policy is set to tighten while the rest of the world is still easing. Yup, there seems to be no reason in the world not to own US dollars. That must be the trade that will “for sure” work.
Even the Economist has figure it out. Have a look at this week’s cover.
While this seems absurd, I respectfully submit that when everyone is sure of something, then no one is sure of anything.
I don’t have a good reason why the US dollar long will not work, but I would much rather bet on a declining US dollar than a meaningful stock market correction or a bond rally. As I write it, I realize that sounds insane, but the fact it is so hard to put down on paper only makes me more sure.
Markets often go where they would hurt investors most. Given the massive flight into US assets, I suspect the last thing anyone is expecting is a US dollar decline.
At this point you are probably saying to yourself, “there you go again MacroTourist, fading just for the sake of fading- you are incorrigible.” Yeah, maybe you are right. This might be way too cute for my own good.
But since no one seems to be able to come up with a scenario in which the US dollar falls, how about I give it a try?
Most strategists are focused on the large interest rate differential between the US and most other developed markets. They also correctly note the Federal Reserve is tightening and has long stopped expanding its balance sheet. All of this should mean less US dollars are being created when compared to foreign currencies. ECB and BoJ are buying bonds, creating Euros and Yen, while the Fed is raising rates. But all of this analysis is focused on Central Bank policies.
Since 2008 money velocity has only gone one way - down. This has wrecked havoc with traditional monetary multipliers.
As the Federal Reserve pumped money into the system they expected it to result in a corresponding jump in economic activity. Yet the declining velocity meant the monetary stimulus had way less effect than would have been expected.
Yesterday I wrote about the possibility Trump might have lit the monetary bonfire. What if all of his free market deregulation and other market friendly policies work?
Too many strategists have forgotten money supply is not simply the result of Central Bank actions. There is a multiplier affect. The so called animal spirits part of the equation.
If the banking sector starts to lend again, the US money supply might explode, even with slightly higher rates. And if more US dollars are created, it will cause the US dollar to go down… not up.
I could envision a situation where the US yield curve gets real steep as credit is created (demand for loans sends the price of those loans up - yields rise), the Fed, worried about tightening too quickly, leaves the short end too low (only encouraging more lending), stocks rise on the expanding money supply and the US dollar falls.
I know that seems counter intuitive to the past eight years of stop and go economic activity, but if Trump is at the forefront of a fiscal spending bank deregulation movement (a trend which I think will expand throughout the developed world), then Central Bank policies will mean less than the reaction from private sector participants. Everyone will be staring at the Central Bank policies, missing the fact that credit creation is also dependent on the private sector.
Of course this all depends on this truly being a change in global government policy. If Trump finds himself hamstrung with tea party budget balancers, or if the Germans refuse to loosen their purse strings and insist on austerity as a way to deal with low growth, then we will return to the old days of Central Banks being the only game in town.
But if governments have finally woken up to the fact that monetary policy can’t solve the problem of low economic growth, then we need a new play book as to how financial markets react.
I am shorting the US dollar. Call me naive, but I think governments have finally figured it out. The market is overly confident about a continued rise in the US dollar. By the time it is on the cover of the Economist, the trade is over.
Quick note about this weekend’s Italian referendum. Many investors are worried about the potential for another Brexit/Trump surprise.
I would argue this is an entirely different situation. With both Brexit and Trump, the market expected the opposite result than what actually happened. In this weekend’s Italian referendum, no one is expecting Renzi’s reforms to pass. There should be zero surprise when his measure fails.
If there was ever a sell the rumour buy the news set up, this is it. I am selling bunds short and buying US notes against it. This spread has blown out to stupid levels.
Thanks for reading and have a great weekend,