The prospect of a hard Brexit and the drop in oil

Outlook:

The cur r ency and fixed income mar kets r espond to the same fundamental factor s, including institutional and political factors, but they also influence one another. The drop in yields and the dollar over the past few days is occasioned by the prospect of a hard Brexit and the drop in oil, but of equal or greater importance is both markets having been stuffed to the gills with historically big positions, making them vulnerable to a pullback.

The WSJ article notes "Last Thursday is a case in point. Wagers on stronger dollars were pared back as the Chinese yuan rallied, which drove investors to cut their bets on higher stocks, higher Treasury bond yields and weaker gold prices.

Cause-and-effect or coincidence?

"The 10-year yield sank by 0.08 percentage point that day, the biggest on a one-day basis since June 2016. The WSJ Dollar index, which measures the U.S. currency's value against a number of its peers globally, fell by 1% Thursday, the biggest one-day selloff since September 2016."

"Some investors say any pullback in bond yields won't last for long as they see higher yields as part of the process for the bond market to normalize after record lows. The 10-year Treasury yield Monday was less than half of where it traded in 2007."

One analyst told the reporters: "We've had eight years of near-zero short-term interest rates, and a lot of investors [had flocked into long-term bonds] to capture yield. The sharp upward move in yields since November occurred very quickly, and I'm skeptical that eight years of investors moving further and further out the curve to pick up yield can be unwound in such a short period of time."

Oh, dear. If the unwinding continues, we could be in for a lengthier pullback in yields and the dollar than the conditions, or rather expected conditions, warrant. It's not just the duration of the corrective pullback we care about, it's also what triggers the end of it and resumption of the rise in yields and the dollar—or an outright reversal that vindicates the direction of the correction.

Quite often the end of a corrective move comes from left field—something we knew might happen but didn't really expect. This time we have a long list of risks and need to start putting them from the "risk" pile to the "expectation" pile. We should single out two—Trump and China.

We probably will get corporate tax reform this year, for example. It may not be applicable until the following year, but the announcement effect could be powerful. (This is one good reason among many not to abandon the stock market, by the way.) Another Trump initiative is supposedly de-regulation. Will tax cuts and dereg goose the economy and especially wages and thus consumption and inflation? The connection is a bit iffy but faith in generally faster growth is probably not misplaced.

That doesn't mean the prospect of higher growth will rule markets. Sentiment is trickier than that. It's influenced by headlines like Bloomberg's today—"Dollar falls again as euphoria over Trump's politics fades." Bloomberg then takes away the punchline by first naming May/Brexit/sterling, indulging in journalistic bait-and-switch. The point is observers want to hear about policies in tomorrow's press conference with Trump. Dream on. Let's note that Trump doesn't actually have "policies" and doesn't have a team that can devise policies. We will not be getting policies tomorrow. We will be getting sound-bites. Trump doesn't have an ideology, either, and may just let the conservatives do as they wish (until he runs into the deficit problem, which can just about guarantee).

Also unhappy is China falling on hard times, presumably from over-indebtedness and a shaky financial sector. This one is really hard to judge from a distance because reports of zombie housing, zombie companies and zombie banks are anecdotal. We can't trust any of the data, either. Last fall Morgan Stanley estimated the debt to GDP ratio rose to 276% in the third quarter. Earlier, The Economist wrote that nearly doubling debt in a decade is usually followed by a crash.

"China will not be an exception to that rule. Problem loans have doubled in two years and, officially, are already 5.5% of banks' total lending. The reality is grimmer. Roughly two-fifths of new debt is swallowed by interest on existing loans; in 2014, 16% of the 1,000 biggest Chinese firms owed more in interest than they earned before tax. China requires more and more credit to generate less and less growth: it now takes nearly four yuan of new borrowing to generate one yuan of additional GDP, up from just over one yuan of credit before the financial crisis. With the government's connivance, debt levels can probably keep climbing for a while, perhaps even for a few more years. But not for ever." China has indeed taken actions to reduce indebtedness but at this point, the national debt is $5.5 trillion but adding state-owned enterprises, somewhere over $26 trillion, which is more than the combined GDP of the US, Japan and Germany.

The other China problem is a trade war started by Trump that leads to Chinese retaliation. This is almost certainly going to happen. Trump may practice on Mexico first but it's one of the few campaign promises we expect him to keep. The dollar is vulnerable to the very idea of a trade war and its prospects worsen as China starts talking about dumping Treasuries. How does a trade war intersects with excessive debt? We can imagine several scenarios but it's premature to go there. Suffice it to say a currency war swiftly follows a trade war, i.e., each party trying to devalue more than the other guy. Think France circa 1965.

To return to the Trump story, he will be president in two weeks. Sane and reasonable people are appalled at the idea of anyone so obviously unqualified representing the US and having any authority at all, let alone nuclear authority. The biggest problem right now is that the Trump transition team has spent hardly any time preparing for office. Candidates for cabinet and other high posts are being vetted by Congressional committees without benefit of all the usual documentation, including the stuff the Office of Ethics demands, like tax returns and signed commitments to avoid conflict of interest. The attorney general and head of the CIA are up first today and have not submitted the paperwork. Obama's team had it done well ahead of the hearings. Indeed, the Plubs required it be done before the hearings. They are holding Trump to a softer standard—actually, no standards at all. This is just one instance of the abuse of power we can expect. The NYT editorializes that "The spottiest disclosures have come from the people most in need of a complete ethics review."

Crony capitalism. Conflicts of interest. Unseemly (childish and petty) tweeting. The voters knew they were voting for a bully. Did they think he would stop bullying anyone who criticizes him to bully only Mexico and China? We are going to get the biggest case of buyer's remorse ever imagined.

Weirdly, it's not all bad. Look at sterling, down the most in years—but the FTSE is on an 11-day winning streak and making new record highs every day since Christmas. Brexit has its bright side.

As for US yields, Bill Gross says we are an inflection point and we never argue with him. He expects yields to stabilize and start rising again. The impetus may well be inflation expectations. The FT reports "US five-year break-even rates, a measure of expected inflation, are 1.87 per cent, near their highest since August 2014." The fixed income trade may be overcrowded and positions overly extended, requiring a pullback, but the Big Picture is still in place. The question for us now is how strongly Draghi denies tapering intentions so that the differential can widen out decisively. Look at the 2-year differential vs. the euro/dollar. Notes were overbought/yields oversold. The correction has a way to go.