Trade and Currency Wars

High Yield an excellent leading indicator for the stock market and then the economy

Foreign exchange volatility is not new in modern finance, though relatively speaking it has been reasonably muted in recent decades compared to preceding ones.  Uncertainty around foreign exchange suppresses business investment in that the ability to repay debt from a capital project cannot be quantified when the value of the currency it will be paid back in is unstable and subject to massive fluctuation in value.  It would be like trying to set a weight loss goal but you know that the scale you will use to measure results is significantly unreliable (in both directions); there is no real point in getting serious about the diet and exercise unless a working scale can be found.  Risk assets all benefitted when a coordinated effort was made (worldwide) to limit the volatility of currency movement.

– David L. Bahnsen, Founder, Managing Partner, and Chief Investment Officer of The Bahnsen Group

Q2 hedge fund letters, conference, scoops etc

Federal Reserve Chairman Jerome Powell’s January 2019 “pivot” on interest rate policy moved from words to action on July 31, 2019.  The markets wobbled.  Then the tweet.  Bloomberg put it this way, “The financial markets have been like a mosh pit where these three players bang against one another. Powell, under pressure from Trump to cut interest rates aggressively, sent markets reeling by signaling the central bank’s rate cut last month was a ‘mid-cycle adjustment’ and not the start of an aggressive loosening of monetary policy. The very next day, August 1, Trump exacerbated the sell-off by saying he would place tariffs on practically any U.S. imports from China that don’t already have them, starting in September. The response from Beijing on August 5 caused the biggest waves in global markets, as the People’s Bank of China allowed its currency to depreciate by the most since 2015 and reach more than 7 per dollar, a threshold it had prevented the yuan from crossing in recent years. China also asked state-owned companies to suspend purchases of U.S. crops, renewing pressure on the beaten-down prices of American corn and soybeans. With each of these collisions, the fragility of the global economy and markets is exposed. It seems increasingly possible that something big and important is broken.” (Source: Bloomberg)

Speaking to systemic fragility, good friend, David L. Bahnsen, summed it up in “Threatening Currency War” in his recent blog post:

The announcement (via Twitter) last Thursday that the trade talks with China had (again) broken down, and that 10% tariffs were being implemented on $300 billion of additional imports was unsettling enough.  However, the subsequent (though not surprising) news that China was devaluing the Yuan represents an entirely new source of market distress.  Keeping the pattern going, the announcement that the U.S would label China as a currency manipulator may not have shocked every market pundit, but it added layers to the uncertainty and vulnerability of global capital markets.

Foreign exchange volatility is not new in modern finance, though relatively speaking it has been reasonably muted in recent decades compared to preceding ones.  Uncertainty around foreign exchange suppresses business investment in that the ability to repay debt from a capital project cannot be quantified when the value of the currency it will be paid back in is unstable and subject to massive fluctuation in value.  It would be like trying to set a weight loss goal but you know that the scale you will use to measure results is significantly unreliable (in both directions); there is no real point in getting serious about the diet and exercise unless a working scale can be found.  Risk assets all benefitted when a coordinated effort was made (worldwide) to limit the volatility of currency movement.

The reasonably smooth ride in global currencies has not come without exceptions.  Treasury Secretary, James Baker, in 1987 said that the U.S. would not cooperate with other countries creating divergent rate policy from our own.  The next day was Black Monday, October 1987.  We know of the global distress created in 1997 when the Thai Baht lost its peg to the U.S. dollar.  The Russian Ruble created a similar spike in volatility in August of 1998.  More recently, China’s seeming abandonment of its Yuan support in August 2015 caused a spike in capital outflows and tremendous anxiety in global risk assets.  In hindsight, some of these incidents look globally insignificant, but none felt that way at the time.  All of them share the fundamental story of calling into question the ability of one party to meet debt obligations (denominated in a currency that had turned negative).  And all of these stories share the contagion effect of undermining confidence in global capital markets.

When central banks around the world coordinated in February 2016 to calm currency markets and address Chinese capital outflows, the result has been 40+ months of very low currency volatility (combined with very low-interest rates, of course).  What could a risk asset investor love more?  The delta between the U.S. dollar and the Chinese Yuan has recently reached that late-2015 level, though, spurred on by the Trumpian trade war and tens of billions of dollars of tariffs distorting trade economics.  That February 2016 arrangement looks vulnerable at best and obsolete at worst.  What could a risk asset investor love less?

China has plenty of economic headwinds which could force them to weaken their currency even apart from the trade conflict with the United States.  China has few options for combatting the impact of the trade battle, and currency adjustment is the easiest tool at their disposal to soften its deleterious effect on economic growth.  But a very important understanding must be had – China’s actions right now are not actively weakening their currency, as much as backing off of their actions to prop up their currency.  Indeed, China has been “propping up” its currency for years (in its own best interests, of course).  China does not meet the three-prong criteria of a currency manipulator, even though they certainly would be willing to do so if it were in their best interests.  “Not intervening to support one’s currency” is hardly the same as “intervening to weaken it,” and while there is no doubt China’s motivations for acting (or in this case, not acting) is to effect their currency in a way that advantages them relative to the trade dispute, active currency retaliation by the United States would be extraordinary in this situation.

How can the United States “manipulate” its currency?  Besides years and years of central bank bond-buying (quantitative easing) and aggressive easing of their target rate, a more direct currency intervention has become a real conversation for the first time in decades.  Should the White House order the Treasury Department to buy foreign currencies in direct proportion to what others are buying of the U.S. dollar, it would undermine the dollar’s appeal as a reserve currency, and certainly weaken demand for U.S. assets.  Furthermore, the ability to even do that (aggressive in its own right) is limited by the amount of money appropriated to the Exchange Stabilization Fund.  The option of declaring a “national emergency” and ordering the Federal Reserve to sell dollars would be a “code red” of historic proportions.

Currency clauses may very well appear in future trade deals.  Markets would appreciate such stabilizing forces in the world of global currency.  But we should expect more turbulence until there is greater clarity on how aggressive each side intends to be in what has become a threatening currency war.  What is at stake to risk assets is not merely one outcome or another in the trade war, but the risk of a permanently damaged scale when measurable weight monitoring is the need of the hour.

I arrived at Grand Lake Stream, Maine yesterday afternoon to meet with more than 80 economists, investment managers and former Fed officials.  It is coming at an important time.

Trade and Currency Wars

Grab that coffee and find your favorite chair. Below you’ll also find my latest Trade Signals post. Stay zeroed in on the trend in the High Yield space, as it acts as an excellent leading indicator for the stock market and then the economy (in that order).  I’ve been trading the trends in HY since the early 1990s and have more recently been warning that the level of leveraged lending and weak protections will be a problem.  In the chart above, Moody’s and Marty Fridson both measure the “Covenant Quality” of U.S. HY Bonds. One is strongest, five is weakest.  We sit at the worst reading ever.  Not all HY trend signals are perfect but this process protected me in 1991/92, 2000 to 2002 and 2008/09.  Risk is more elevated than any time since I began trading the HY debt market.  The opportunity the coming reset will present will be excellent.  Process, process, process.  Lights on.  Thanks for reading.

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Included in this week’s On My Radar:

  • Trade Signals – Trend Extended, HY Sell Signal, Bonds and Gold Remain Strong
  • Personal Note – Gone Fishing Playlist

Trade Signals – Trend Extended, HY Sell Signal, Bonds and Gold Remain Strong

August 7 , 2019
S&P 500 Index — 2,858

Notable this week:

This week was the worst week of the year for U.S. equities (and global equities).  Disappointment in the Fed’s 25 bps interest rate cut was cited.  Monday’s meltdown was triggered by the escalation in the trade war with China.  The Chinese response to a new 10% tariff hike was a currency move and a blow to the farm belt.  China is ceasing purchases of U.S. agriculture products.  The global macro environment continues to worsen.  You’ll find the latest recession watch charts in the next section below.  It is likely a global recession has started.  Probabilities for the beginning of the next U.S. recession point to Q1 2020, though my good friend David Rosenberg is in the press this week saying he believes the U.S. is now in recession.  We sit late cycle in the economy and the market (both are now the longest in history), the bullish trend is over-extended (ramifications of which you will see in the next chart); thus, risk remains elevated.

Let’s first take a look at what the S&P 500 long-term trend can tell us about coming 5- and 10-year returns, review our Dashboard of Indicators and and then take a deeper dive into the charts with explanations.

History presents many data points that can help us measure periods of opportunity and periods of risk.  The chart below looks at the long-term trend of the S&P 500 Index in relationship to its long-term trend line from 1928 to present.

  • Focus in on the middle section of the chart.  The black line is the S&P 500 Index price line and the dashed red line is the long-term trend line of the S&P 500 Index.  You can see over time the market moves above and below the long-term trend line.
  • The lower section measures the deviation from the long-term trend line.  The yellow circles in the middle section highlight periods above the trend line (note the red “We are Here” arrow.  The bold yellow highlight in the lower section highlights the “Top Quintile” of deviations above the trend.  Simply, the periods when the stock market is farthest above its trend.  I’ve notated prior periods.  Excessive investor speculation bids up prices or investor panic sends prices lower.
  • Over time, we should expect to do well with our equity investments and slope upward in line with the trend.  This measure is informative in terms of periods of excess.  Best to be aggressive buyers below trend (the bottom quintile: “We’d be better off Here” green arrow).  Best to be cautious (risk manage and underweight equities) when in the top quintile such as today (the red “We are Here” arrows.
  • Finally, take a look at the data box in the upper right.  This supports this reasoning.  Note the returns five and ten years later when in the Top Quintile vs. the Bottom Quintile.  Top Quintile: five years later, a return of just 10% ($100,000 grows to just $110,000) and ten years later grows only 38.48% ($100,000 grows to $138,480).  That’s an annualized 10-year return of less than 3% per year. Now note the returns in the Bottom Quintile: five years later — a return of 127.41% ($100,000 grows to just $227,410) and ten years later a return of 363.02% ($100,000 grows to $463,020).  Clearly, there are times to be more and less aggressive.

Trade and Currency Wars

The proprietary CMG HY Trade Signal moved to a sell signal this week, suggesting an allocation to Treasury Bills vs. High Yield bond funds and ETFs.  Daily Investor Sentiment moved into the extreme pessimism zone, which is historically short-term bullish for equities.  The equity market trend signals remain bullish yet weakening.  Keep a close eye on signals for change in trend.  The bond market signals for high grade bonds and Treasury bonds remain bullish.  Gold remains in a buy and is having an exceptional move higher.

Not a recommendation for you to buy or sell any security.  For information purposes only.  Please talk with your advisor about needs, goals, time horizon and risk tolerances. 

Click here for this week’s Trade Signals.


Personal Note – Gone Fishing Playlist

I promised a link to my newly created “Gone Fishing” Spotify playlist.  If you are a Spotify subscriber, you can search cmgsteve361 and then look for the “Gone Fishing” playlist.  If you don’t have Spotify, here is the link to the list.

I packed a Bluetooth speaker and will be playing the music out on the lake.  Grand Lake Stream is located at the northern tip of Maine.  It is a beautiful and peaceful place.  The people are wonderful.  I’ll have a few photos to share with you next week.  Stay tuned, I’ll be sharing what I learn.  It’s time to head to the lake – I hope the fish are biting.  Dinner tonight: fried fish and fine wine.  Yum!

Wishing you the very best!

Subscribe to OMR

Best regards,

Stephen B. Blumenthal

Executive Chairman & CIO

CMG Capital Management Group


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