Dollar and Rates Bounce Imminent?

The dollar's slaughter has been well telegraphed, as US rates have marched lower due to a combination of persistently low inflation and as some market participants deem potential recessionary conditions imminent.

What if I was to tell you that the opposite could be imminent? Would you be interested in reading further?

In the past, we have also documented on Macro Man in a commodity catch-up post that the markedly strong move in copper and other base metals in the past has usually hinted at strong economic growth and inflation.

These two factors being at odds for what seems like an eternity (in trading terms) leads to my belief that we will eventually hit a make or break moment will the divergence between these two correlated asset classes will mean revert.

Let's get into it.

So I am claiming that we probably have a significant bounce in the dollar in the making...

A few drivers that can potentially make this bounce happen:

1) The big one to me is the break of correlation between inflation/inflationary products. Using copper as a proxy, we can see that the returns of the two products show a clear correlation - obviously, this makes sense vis-à-vis economic intuition; the R-squared is a bit low as copper is naturally more volatile compared to breakevens.




We have seen a huge run-up in copper but breakevens have sputtered. I see this correlation maintaining and the gap between the two closing.  If we have a rise in breakeven inflation going into year-end, then that means there would be a corresponding move in rates, and thus a notable bounce in the dollar as well.




2) That transitions us to point number two - rates. I'm specifically looking at fed funds futures where we are pricing in a tad more than a 25bps hike by January of 2019. Whatever outcome materializes in the US economy, it seems to me that the fed funds curve is too flat and investors are being too cautious.

Like I said, whatever the outcome may be, PnL is path dependent - you will undoubtedly have rhetoric, communication, and expectations to shift (at the very least during pockets of time from now till 2019) where we see both a drop in fed fund futures across the curve as well as a steepening of the fed funds curve.

That occurrence should coincide with a dollar bounce.

3) Okay, we've talked about inflation and rates from a correlation perspective. What about the fundamentals? Inflation has been stubbornly low, but there are signs of an uptick bubbling below the surface.

Wage growth has been tepid but a couple indicators show continued increases overall. 



Average weekly hours worked has also spiked. Even if wages fail to materially increase, the increase in hours worked should lead to extra total wage income.



The magnitude of the increase will be amplified by years of QE.

Again, like most markets, corresponding moves aren't always immediately and 1 to 1 in nature. It can take a bit before the market comes to an epiphany - that "Ah ha!" moment.


4) The US economy and the global economy seems to be doing okay. Everything seems safe-ish. 

Looking at some very basic metrics such as GDP and unemployment here. The growth has continued from then till now, and we are still on track for additional growth. I get it. We expected an explosion of growth after Trump and that hasn't really happened, but things are not worse than they were two years ago! Yet rates and USD in real terms have round-tripped back where we were two years ago.


5) Another trigger would come from the rest of the world. With FX these last few years being a game of lemmings where countries deviate little from the lead of the United States. It might be time to wonder if we are due for a pick-up of catalysts and rhetoric from other countries concerning the strength of their currencies, as well as disappointments from other central banks regarding their hawkish policies.


Europe and China need to be the main culprits. With that said, many in the rest of the world are involved as well.

First China: they recently got rid of the deposit requirement for FX forwards - something they implemented two years ago to slow the devaluation of RMB. This should make it less expensive for companies and investors to buy dollars while selling the yuan. And guess what? The dollar is cheaper now.

Although the change itself is mostly symbolic and not necessarily a force to be reckoned with, it can potentially serve as a canary in the coal mine for future attempts to stem RMB appreciation.

Europe growth has been very strong - and the FX market has responded accordingly. This is a bit of a question mark for me - interest rate futures' pricing is hovering around record lows for a ECB rate hike by June 2018.

If we get some convergence there, that would mean Euro sells off a bit - helping dollar bounce - but in terms of the intricacies of the ECB at this point in time? *Shrug*

Now the rest of the world. The most dollar sensitive countries are obviously in EM. Many of the Asian countries have already shown signs of intervention against their strengthening currencies as they start to accumulate reserves, specifically in dollars.

Exhibits below for your entertainment:




Eventually, dollar shorts should notice. Again, I've noticed in the past that these trades in these currencies often preceded moves in US rates. Canary number two for the aviary, anyone?

By the way, shout out to fellow contributor Shawn who shared an article articulating what is beginning to transpire across the world - you can read all about it via the link below.

https://www.cfr.org/blog/few-words-dollar



6) The Donald and the Fed are changing quickly. Stanley Fischer is gone. Uber-liberal Brainard will probably follow. Who's Trump going to nominate? Probably Republican-type candidates - guess what? They are usually more likely to be hawkish than dovish.

To me, that in itself is compelling thought. What can potentially make it more compelling? Well, the Donald seems to have started working well with Democrats as of late. Let's project that further - if they can manage to pull together a deal for tax reform, even if it's not super impactful, it will be symbolic. 

It will symbolize that Donald can get things done - I would think the rates markets would immediately do a 180 and return to the post-election regime. Yes, I am projecting here, but think about the risk reward of your positioning at this point. Should the rates go higher or lower? Should dollar go higher or lower?  

If he does pass through tax reform. What's next? Tariffs? Additional government spending? Again, just projecting here...Inflation?!?! *Gasp*


7) Lucky number 7. I'm big on sentiment - from the eye test, I think people are pretty close to limit short USD at this point. Just a hunch.

Hey! It's free blog okay? Take it or leave it! :)

Are there catalysts?

I hate catalysts. 

It's been a lonnnnngggg post, please bear with me a little bit longer. A lot of what I have detailed are projections - but that's macro trading to me - you have to anticipate in order to correctly speculate. Maybe that's why I'm often a little bit early on these things. Hmmmm.

But often your returns and risk-reward decay swiftly if you wait for a clear catalyst to materialize. So... in my opinion, proceeding with some caution is probably better than proceeding before it's too late.


General House Cleaning:

Stocks short - Yeah threw in the towel like Mcgregor on August 29th. Geopolitic risk is definitely subsiding. Let me explain.

It's not that there can't be another crazy development tomorrow. But the market is just not ready to go down just yet - traders should know what I'm talking about. My Ah ha! moment was when North Korea launched their "hydrogen bomb". 

Along with the hurricane, the market was confronted with a copious amount of "bad" news.  Equities gapped down, but by the end of the day, it actually covered the gap and closed higher!

Disgusting, I know. But looks like the indexers and VIX carry monkeys will get to make money for a while longer.

EM equities - this has been an impressive move. I believe this is a multi-year trend when I detailed it long ago.

With that in mind, it has run up a lot. If the dollar does bounce, we are probably going to get a shake out of the weak hands and late comers to the trade.

Cocoa and sugar - both bottoming nicely. I still maintain sugar might be a tad too early. Cocoa looks really good and I strongly believe it can rip. I even did some work to do a seasonality adjustment. Below is the inverse inventory on a seasonally adjusted basis vs price. Please excuse the poorly drawn arrows.



Anyways, have a good week guys.



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18 comments

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September 18, 2017 at 6:18 AM ×

If there is one thing that pisses me off in this market, it is the theme of the "catch up trade". Seriously. WTF is the catch up trade. Tell me. What happens when you and I are sitting at the trading desk come the last at Happy Valley and I need to get out on the last race. Are you going to help. Or I need a big week of alpha returns in the USA market to balance the books. Please, leave mug alone. Catch up to what... the chlamydia phase 2 trails in that biotech stock your tipping!

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Detroit Red
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September 18, 2017 at 6:42 AM ×

If two assets move but not at the same time - do you consider that a catch up trade?

Specifically, the inflation and base metals relationship I'm focusing on is one where the change of price of one (base metals) can lead to changes in the "fundamentals" of the other (inflation) if that makes any sense?

I'm not saying, oh one country's equity market has run up, so maybe another one will "catch up".

There is a subtle difference there.

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September 18, 2017 at 6:50 AM ×

Well, if we are going to be "subtle" in our analysis here at Macro-Man.blogspot.com than you may have taken the "phase 2 trails" as a long term evolutionary trade suggestion that is only at the beginning of its life span.

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September 18, 2017 at 7:46 AM ×

You know what "phase 3" is don't you?.....Your portfolio is infected with stocks that carry the "germ", and your the only one that doesn't know it.

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September 18, 2017 at 7:50 AM ×

You know what "phase 4" is?.....Everyone is infected except you, and you get to watch them live with it.

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September 18, 2017 at 10:00 AM ×

I must say you had done a tremendous job,I appreciate all your efforts.Thanks alot for your writings......
Packers And Movers Chennai

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September 18, 2017 at 10:23 AM ×

Red Detroit.If you disagree with my analysis, then I suggest when I die you save my mitochondria for future generations. It has been in overdrive since 2012 fighting off virus's and diseases and keeping them at bay to live for another trading day.

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IPA
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September 18, 2017 at 2:13 PM ×

Detroit Red,

We may get a few days of bounce with Fed meeting (if that). The only thing going for DXY is the inverted head and shoulders with 91.50-60 as a lifeline. New low by weekend or next midweek if it breaks. Until the weekly chart reverses and shows life (specifically the close above 8 ema that I've been yapping about here) I think buying DXY is a fool's errand.

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September 18, 2017 at 2:34 PM ×

IPA, you have a choice. You can invest in the American market and be stuck in hedge funds that compete for the biggest AUM and get invited to foundations every week. Or tell them fuck off....and go find your own alpha. I'm lucky, I only need a couple big trades here and there and I'm on a beach in Thailand.

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September 18, 2017 at 2:48 PM ×

Wall Street is the last place on earth I'll ever invest time and effort in. There are better opportunities around the world to find alpha returns than that shit hole. If I speak bullshit than what are we doing here. I'll back myself to find alpha returns living in the hills of Myanmar before that place.

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September 18, 2017 at 2:54 PM ×

I think its time for me to leave this blog. Chow.

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IPA
admin
September 18, 2017 at 4:37 PM ×

@amps, don't leave yet, tell us what you are on. I need to unwind sometime and seem to lack the formula.

You guys checking out the little oil flush we just had? Had some volume behind it too. I see no immediate news that would grant it but I ain't a big news junky. I mean you could start getting worried about Saudis with Prince policing activities last week, but I seriously doubt it results in reversal of cuts. Sure, he may revolt against OPEC and pump his way into oblivion (which is highly unlikely). I dunno what to make out of it just yet. What else? Brent is looking at tighter supplies, BH rig count was lower and charts are not exactly pointing to a major junction until $52-ish on WTI. I say it's a fluke, fast money getting out after a nice run, yet here it's down 1.45% and oil equities are starting to notice it more as I type. RBOB didn't even blink but it has its own song to sing for a while.

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IPA
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September 18, 2017 at 7:01 PM ×

And a fluke it was indeed. Unless some crap starts to fly in the next 30 minutes NYMEX WTI pit will close at UNCH.

This being said, look at Nat Gas today! 3.10 is finally cracked. This leaves nothing but a clear path to 3.40 to burn the shorts on a blue flame (pun totally intended).

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Leftback
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September 18, 2017 at 8:39 PM ×

LB is inclined to think that we may even see new lows in vol following the FOMC meeting and statement this week.

At which point he will once again become interested in setting up some trades in UUP (from the long side), TLT, IWM or SVXY (from the short side), the details as always depending on how the price action develops.

For now it's that old adage: "Don't just do something, Sit There!"

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IPA
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September 18, 2017 at 9:04 PM ×

LB,

SVXY chart reminds me mid-Sep of 2014. Stopped just shy of a new high and cratered 45% in 4 weeks. I am loading put spreads here.

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September 18, 2017 at 11:05 PM ×

Piss off, IPA. They are all full of shit on Wall Street and New York for that matter. I don't want their money nor their lifestyle. I'm out of here.

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