The biggest threat to the USD is not the stock market pullback

Outlook:

The biggest threat to the dollar is not the stock market pullback. It’s Trump’s response to it. He saw the stock market rally as a validation of himself personally and therefore the current drawdown as an insult to himself personally. As we write above, our biggest fear today is not that the stock market “cycle” is ending—it’s not—but rather than Trump will fire Fed chief Powell and install somebody who swears fealty to Trump personally. Heaven only knows where Trump would find someone of that ilk the Senate would approve and the Establishment would accept, but such a person must exist somewhere. Trump wants his party to win the midterms. Getting rid of that meddlesome Fed chief would be wildly popular among the ignorant, er, the base.  

But before we get to Trump’s narcissistic self-image and firing Powell, we should review some of the commentary. At a minimum, it illustrates vast ignorance of history among newspaper and wire reporters. Maybe they are just too young, not having lived through routs and crashes before.

To start off, both the stock and bond markets posted losses yesterday, instead of equity sellers going straight into bonds. Good heavens, what can it mean? CNBC tried to drum up some hysteria by noting that it’s extremely rare for both to fall simultaneously. Over the past 20 years, “whenever the S&P 500 lost more than 2 percent in a month, Treasurys outperformed.” Actually, one of the sources said both have fallen at the same time but only four times since 2016. We say 2016 was already in the grip of stock market mania and probably doesn’t count. Yesterday the Dow fell 3.2% and the S&P, 3.3%, the worst day for the S&P since February. The Nasdaq 100 had its worst day in seven years.

And at the close yesterday, the 10-year yield was down to 3.167% at 5 pm from the high only two days before at 3.258%.

The WSJ joins the chorus with a headline saying the “Scary Divergence Is Worrisome” and “the bond market is failing its haven role.” One day marks a failure? Really? Still, “on days of sharp stock market tumbles, it is almost unheard of for 10-year note yields not to rally. For example, during the biggest one-day stock-market decline in history, in 1987, the 10-year yield fell to 9.4% from 10.15%. One of the only exceptions was a particularly scary day in 2008 when stocks plunged on fears that the global financial system would unravel.”

Not to be silly, but if the equity sell-off were really a big deal and not a normal correction, if awfully big, then you would have flight to safety and you would have people buying bonds and driving yields down a lot more. The absence of a bigger drop in yields means the equity sell-off is not a panic. In fact, we’d like to know the yield level that experts think is commensurate with an authentic crash?

Implying that the move has legs to continue, though, the WSJ writes “Investors are starting to realize how dependent the longest bull market in history has been on cheap money. That is particularly true for the riskiest segments of the market. While the Dow didn’t even suffer its biggest loss of 2018, the tech-heavy Nasdaq Composite had its biggest drop since Brexit in 2016. Those stocks, traditionally more dependent on investor risk appetite and a lack of satisfactory income-producing alternatives, have been the drivers of the late stage of the bull market.”

Moreover, “For a decade now, the Fed has been willing and able to keep a leash on yield breakouts, saving the day for stocks time and again. Wednesday’s market action is a sign that neither may be the case any longer.”

The WSJ is trotting out the old argument—that cheap money fuels bubbles—but we are pretty sure they have the Fed wrong. If the Fed was “saving the day” for stocks, it was not for the sake of equity investors. That’s just an unintended side-effect of goosing the economy. Now that we are looking at growth at around 4%, mission accomplished.

This focus on the Fed is wrong and dangerous. Stock markets—all markets—have their own internal dynamics. Positioning is driven by greed and fear, and to be sure, monetary policy is a factor, but not the sole or even driving factor. All financial crises lead to recession, but honestly, what’s the financial crisis behind the stock market rout today? The only economies in truly awful conditions are failed states like Venezuela and perpetual messes like Argentina. Recently Turkey got added to the mismanagement list. But no one would say Europe is mismanaged, or Japan. Britain, maybe, but that’s mostly politics. On the economics front, devaluation is a juicy boon.

The US economy has very little that is negative (housing). WE think Mnuchin is a creep, but he is not wrong when he says “the fundamentals of the U.S. economy continue to be extremely strong.”

We get the important CPI data today, but as we wrote yesterday, we have a madly imperfect understanding of inflation and inflation expectations. What we can count on is market pricing, and the bond market is sending the message that whether attributed to inflation-someday or some other factor (e.g., the deficit), sellers are going to come out of the woodwork and yields are headed for 4% next year.

It’s probably not the inflation data or measured inflation expectations driving sentiment—it’s the growth rate. And the growth rate has embedded in it a form of inflation expectations. One analyst wrote yesterday “It was just a matter of time before a 4.2% GDP growth rate crushed the fixed income market.” We can’t really name a tipping point—there’s Nafta 2.0, the services PMI at a decades-long high, even Amazon’s new minimum wage of $15.

And indeed, the Atlanta Fed GDPNow came in at 4.2% yesterday from 4.1% on Oct 5. See the chart and notice the Blue Chip is rising, too. We get another estimate next Monday. The Atlanta Fed names, among other things, inventory investment up from 2.09% to 2.20%. Hoarding ahead of tariff-driven shortages or animal spirits optimism? It doesn’t matter. We postulate that we can forget surveys like the Atlanta Fed’s business inflation expectations and the TIPS spread—look at GDP forecasts instead.

If so, what should we make of the NY Fed and it’s forecast of only 2.27% (as of Oct 5)? Well, it’s an outlier. The Congressional Budget Office has 3.1%. The OECD has 2.78%.  The point is it will be higher by some significant amount from 2.3% in 2017.

A puzzle is whether gold should follow yields (inflation and worrying deficits) or should fall because gold has no yield and in a rising yield environment, a rising yield is better than no yield. Logic fails, so look at prices. We found this little table at goldprice.org. We also found the chart for the past two years. We can’t blame or credit Trump—during his administration, gold has gone both up and down. Notice at as of noon yesterday, gold traders were ignoring the PPI (higher) and may have been an alternative parking lot for money exiting stocks, although somehow we doubt that. Kitco opines that the bottom may be in and all those hedgie short-sellers are going to get squeezed until they cry Uncle. “Now that the hedge funds have poured tons of resources into shorting gold, it’s only a matter of time before the big breakout to the upside begins. Yes, the metals are still stuck in the misery of consolidation, but the shorter the funds get, the more bullish the pattern becomes.

The range in gold remains $1,180-$1,220, but the dynamics behind include the huge short interest in gold that can only lead to one thing -- a short squeeze. We can’t predict when or what will cause the squeeze, but we are willing to bet on it and will continue to do so as long as gold stays above $1,180.”

Well, that’s kind of fun but what does it have to do with us in the FX market? Maybe not much, unless and until it is recognized that the bottom is in and gold starts rising in a serious way. A big fat gold rally will not go unnoticed and then we start to get worries about why it’s rising, beyond short-covering and Asian seasonal demand. This always includes the old saw “gold up, dollar down.” We have demonstrated many times over the years that this is not actually a good correlation, but never mind. Hoary old adages die hard.

To wrap it all up, unless Trump fires Powell, the stock market rout will calm down and start to reverse by next week. Bottom-fishing can begin as early as today. Some of the bigger rally names, especially tech and FANGS, might not fully recover. Non-earners in the Russell may be toast, too. The stock market was due for a sanity check and now we have it. But the sanity check includes only somewhat reduced earnings prospects, not broken ones. We will get the famous “sector rotation” that favors high dividend names.

See the chart of the S&P 500 with the green 200-day moving average. Because there is no real reason to suppose the market is terribly overpriced—highly priced, but not excessive—the classic “long-term” measure embodies in the 200-day is as good as any. Over long periods of time, it has no predictive value. But in the short run, everybody and his brother watches it. We may get a dip below the 200-day—see the predecessors—but recovery is more likely than a bear market.

Meanwhile, some EM’s may bite the dust as the Fed continues to raise rates, although it’s smart enough not to say so in the immediate future. The dollar will recover, too. It may take quite a hit in the meantime. But the trend is your friend. 

 

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