For the time being, we are struggling to find much to say about equity markets. Generically, they just go up. They go up when bond yields decline; they go up when bond yields rise. They go up when the Dollar declines; they go up when the Dollar rallies. They go up on rumours, expected announcements and the actual announcements. In Jesse Livermore’s classic Reminiscences of a Stock Operator, in his early days on Wall Street he remembers that a number of younger traders used to ask a gentle yet wiley older trader his views on whatever stock of the day. His answer was always the same; “it’s a bull market”. And so it is today…all we can say is that we think it is arguably the most expensive market in history, but with prices trading at all-time highs, “it’s a bull market”.
Moving on, we are much more focused on the Dollar, which is at an important juncture. Having been the worst performing currency year to date through mid-September, prospects have been brightening over the last 6 weeks or so. The breakout against some currencies looks very encouraging, however, against others, the Dollar has so far failed to break obvious resistance. We therefore feel it is still just a little early to declare a new broad Dollar bull trend is in place.
Let’s start with the Euro. There is no doubt that the market judged the outcome of the ECB meeting and press conference last week as dovish. In reality, and as we have been saying for some time, it would appear as if the fast money crowd was just a little too optimistic on the Euro (bearish on the Dollar), and as price momentum has turned against them, they are bailing out of their positions. Chart 1 below shows the daily chart of EUR/USD exchange rate, which is trading below short term moving averages (which are themselves in the process of rolling over) and has decisively broken below quite well defined support.
Chart 1 – EUR/USD exchange rate with 20 & 50 day moving averages
From an interest rate perspective, the argument is quite clear. The Fed are very likely to continue raising rates over the next year or so, whereas the ECB will not. The US already enjoys a significant yield advantage, and tax reform will provide a further boost. Of course, there are negative factors that will from time to time weigh on the Dollar, but so long as the Euro remains below 1.19 we are thinking bearishly. A similar situation is in place for other continental currencies following negative interest rates, e.g. the Swedish Krone and Swiss Franc.
As noted before, the fast money crowd and trend followers were still holding net long positions in the Euro through close of business last Tuesday (last data available); see chart 2 below. Although we are sure that some of this net long position will have been liquidated post the ECB meeting on Thursday, we suspect there could be quite a bit more to go.
In terms of other potential drivers for the Euro, the Catalan situation remains troublesome, and yet so far, it has barely had an impact on the single currency. Nobody can be sure exactly how this situation plays out, and all we can say is that it has the potential to add to what we see as a developing bearish trend in the Euro.
Chart 2 – EUR/USD exchange rate and IMM net speculative positioning
The Dollar appears to be breaking out against some other currencies. In particular, we noted a couple of weeks ago that we felt the Australian Dollar was vulnerable, and the set up here is not dissimilar to the Euro. Price has rolled over in the last few weeks and yet speculative traders remain quite long, as seen in chart 3. Furthermore, Iron Ore prices appear to be weakening, and there are tiny hints that the currently hot Copper market, where speculative positioning is aggressively long, may be losing some momentum. Sterling (charts not shown) may not be in quite the same position, but we would look at a clean break below the 1.30 level as a bearish development.
Chart 3 – The AUD/USD exchange rate and IMM net speculative positioning
Within the EM universe, the Dollar has been strong against the likes of Mexican Peso, South African Rand and Turkish Lira, all of which have had their own negative factors to consider. What we are thinking in EM is that there has been the most enormous flow of Western capital into emerging markets in the last 18 months or so. If some of this were to return home, presumably because prices were heading lower, then EM currencies would have a long way to fall.
One way we are monitoring this situation is the flow of money into emerging market bond ETFs. Chart 4 below shows the share price performance of one of the largest EM bond ETFs that invests in bonds denominated in local currency bonds. From the low point in January 2016, the shares are up nearly 14% and holders will have received an annual dividend of over 5%, making a total return of nearly 25%; or annualised return of 13.3%. What’s not to like?
Well, the vast majority of new investors since January 2016 have bought at much higher prices, and therefore received lower returns. In fact, most investors have bought since the end of Q1 2016 (shares outstanding have risen 3 fold since then), and yet the share price has gone nowhere. These guys have been clipping their coupon, and although that appears to be very nice at a little over 5% annualised, let’s not forget that capital is not guaranteed here. This is an inherently volatile asset class, especially given the underlying currency exposure.
Chart 4 – Vaneck EM local currency bond ETF share price and shares outstanding
Furthermore, the shares have already fallen by 5% from the recent high, and yet investors continue to buy as indicated by the number of shares outstanding still increasing. What if the outlook for EM is worsening and investors decide to sell out, reduce risk (at least currency if not credit risk) and find other fixed income alternatives? Given the previous flow of money into EM, we believe this would be negative for EM currencies in general.
As noted in the title of this week’s commentary, it has not been a clean cut across the board breakout in the Dollar. In particular, the Dollar has so far failed at or around important resistance against the likes of the Japanese Yen and the Singapore Dollar, and remains range bound against the Korean Won and Taiwanese Dollar. Chart 5 below shows the daily USD/JPY exchange rate. We have shown a resistance level that has held back the pair since at least May. It is our expectation that the US Dollar will eventually break higher, but this expectation is based predominantly on higher US bond yields ahead (for reasons we have written about before).
Chart 5 – USD/JPY daily chart with 20 & 50 day moving averages
Chart 6 – USD/JPY exchange rate and IMM net speculative positioning
So here is how we see it at the moment. It appears that the US Dollar is breaking out against a number of currencies – a theme we have talked about for a couple of months or so. Yet, the FX markets have been extremely fickle this year, which makes us more than a little worried about over committing to the bullish Dollar theme at the current juncture. It is a little concerning that with such divergent monetary policies, the US Dollar has not yet overcome significant resistance against the Japanese Yen, although this may just be a matter of time.
In terms of news flow, we can easily imagine that a perceived dove being nominated to the Fed Chair and news of slow progress on tax reform could both knock the Dollar a bit. Yet, we doubt that the Fed will deviate too far from the path currently laid out, and interest rates is one of the clear arguments in support of a stronger Dollar.
We have been positioned modestly long US Dollars over the few weeks, but we have been managing our positions with a tactical mindset given our concerns. We continue to want to be long Dollars, and we are more than a little intrigued by the divergence in positions held by speculative accounts; long the likes of EUR, AUD and CAD and short JPY. If the FX market tries to clear out some of these positions, then positioning short Euros and Aussie Dollars against the Japanese Yen may prove to be a decent trade. However, these trades usually work best when equity markets are going down; something that seems an impossibility at the moment!
Stewart Richardson
RMG Wealth Management
