Erratic Price Action Within a Period of Change

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With summer vacations at their height, perhaps it is to be expected that price movements could become a little erratic. Political, economic and central bank headlines seemed to come thick and fast with price action indicating increasing nervousness amongst traders and investors. Stepping back from the coal face, we continue to think that, after months of calm “risk on”, we are entering a period of change.

On the central banking front, we note two pieces of news. First, Bill Dudley, the influential New York Fed Governor, said last week that he expects the Fed to start reducing its balance sheet in September, and that if the economy evolves as expected, the Fed could raise rates again in December. We also saw the minutes from the last Fed meeting, which essentially confirmed the imminent move on the balance sheet, and that the committee expects that rates would continue to rise gradually over time. We think the key point here is that the Fed wants to continue normalising policy on two fronts. At the moment, the market is barely pricing in one rate rise in the next year or so therefore we think the Fed could over deliver compared to market expectations, assuming financial markets behave themselves.

Second, we heard from ECB officials that they are worried about the Euro becoming too strong. Or course, the ECB does not target exchange rates, but they will be releasing updated economic forecasts next month and in theory, recent Euro strength could reduce their inflation forecasts by several tenths of one per cent. We think the ECB has a very tough task ahead of them. The Euro Area economy is performing well, and they feel that the need to take some policy action to remove some of the extreme accommodation (less QE from early 2018 but not likely any rate rises). However, they will want to replicate the Fed’s achievement of dovish normalisation, not upsetting the financial markets and not causing a too strong Euro. They may be have to hide behind lower than target inflation if they need to indicate more dovishness.

So, in pure central bank analysis, we remain where we have been for most of this year. The Fed will be more proactive in normalising policy in the months ahead whereas the ECB will take baby steps at best, and will want to give an aura of dovishness around whatever they do. On paper, this should be supportive of the US Dollar as yields move higher on an absolute as well as relative basis.

However, the theory has been very different from the practice this year. The chart below shows the US Dollar index, which has fallen approximately 10% since late last year. This is a big move for a major currency, and as indicated, the Dollar is testing an important area of support. We can debate the reasons why the Dollar has fallen this year, but we would be silly not to admit that the performance of Donald Trump has been a headwind. There are fundamental reasons to expect a stronger Dollar between now and year end, including a modest acceleration in inflation (presumably this will please the Fed). Will stronger fundamentals be offset by political concerns?

Chart 1 – The US Dollar Index (weekly)

Frankly, we can’t quite believe Trump’s behaviour of late. Aside from the obvious, the fact that the White House has alienated business leaders and politicians from both sides makes us wonder whether Trump will be able to implement any pro-growth domestic agenda at all. Given his recent performance, we fear where he goes next. Yet, something interesting may have occurred last week, and we are open to the view that it simply cannot get much worse for the President, at least for a while.Why on earth would we say this? Many of you will have heard of the magazine cover indicator – a theory that once something hits the front cover of a popular mass journal, then the trend is about to change. Just this past week, we have seen basically the same message on the front cover of The Economist, The New Yorker and Der Spiegel as shown in exhibit 1 below. Clearly Trump has had a very bad week, and is held in very low regard, not just by these publications, but the majority of Americans as measured by his record low ratings.

Now, we don’t have to like the guy, but we think the combination of these magazine covers is some sort of indicator that it can’t get much worse for Trump as President; at least for a while. Furthermore, the fact that he sacked Steve Bannon on Friday just might be a sign that Trump is listening to the more moderate voices in the White House; at least for a while. So, we are beginning to think that Trump becomes less of a headwind for the US Dollar in the weeks, even months ahead.

Exhibit 1 – Magazine covers depicting potential peak Trump animosity?

To help give the Dollar a bit of a tailwind here, we need to see US bond yields nudge higher. It appears to us that the US bond market is not expecting much from either the US economy nor the Fed, and that yields have remained suppressed a bit by the flow of liquidity from global central banks. But this is slowly changing. The Fed will start to reduce their balance sheet next month, the ECB will be printing less money each month from early next year and the BoJ have recently scaled back bond purchases. We think the bond markets may be underestimating the change coming from central banks and that, together with slightly better economic data, could easily be sufficient to see US yields rising back to the top of the recent range.

Chart 2 – The US 10 year bond yield (daily)

If US yields do rise, the big question for equity investors will be whether equities can tolerate higher yields, perhaps as a sign of improving growth (not our preferred scenario). Or perhaps bond prices and equity prices can fall at the same time; which would no doubt be named some sort of tantrum (the scenario we are leaning towards). Although equity markets were erratic last week, rising through mid-week before succumbing to modest selling pressure, we view as bearish the increase in declining shares compared to advancing shares, the increase in new 52 week lows, the increase in stocks trading below their own 200 day moving average and the widening in credit spreads. We will have to take the price action as it comes, and although we know we are fighting the trend a bit on this, we retain a bearish bias so long as recent highs remain in place.

So to try and wrap things up here, we think that markets are in the process of change, and that the trends of recent months are at risk of reversing. If we are right, this would mean both lower equity and bond prices and a stronger Dollar. This would look very much like some sort of tantrum, and could get ugly if a degree of panic sets in. We have already positioned our portfolios for a bearish outcome in equity markets and have dipped a toe in terms of positioning for lower bond prices and a stronger Dollar. We are looking for opportunities to increase exposure to our key themes in the weeks ahead.

Summary of trade ideas highlighted in our weekly commentaries

Last week, we noted that we had increased the stop on both our S&P 500 PUT option and our long Gold position to our entry price, with our strongest desire to protect capital and not let winning trades turn into losing trades. Unfortunately, we were stopped out of our S&P put option on Monday last week, and at the same time, took the discretionary decision to take profits on our Gold position. These two trades have therefore moved to the “closed trades” section in the table below.

As noted above, we maintain a bearish bias on US equities, and after thinking of various ways to implement this view, have decided to buy a Call Spread on Vix (Volatility) futures. Specifically, we bought a Call option on the November Vix contract with a strike price of 16, and sold a call on the same contract with a strike price of 24.

The level of the November Vix contract was 14.20 at the time we entered the trade. The cost of the spread was $0.97 per contract and the maximum return is $8 per contract, so basically a maximum 7:1 reward to risk ratio if the November Vix contract expires at or above 24. For the purpose of our trade idea “notional portfolio”, we have bought 300 Contracts for a cost of $29,100 which represents our maximum potential loss on the trade, or 58.2 basis points of capital. The maximum Dollar gain is $210,900 or 422 basis points.

 

RMG Trade Idea Summary – Initial Notional Portfolio of US$5 million
OPEN TRADES
Trade
Date
Trade Entry
Price
Stop Loss Level Loss to stop Local Curr Loss to Stop US Dollar Bps Risk to Stop Last Price Open P/(L)% Open P/(L) Local Curr Open
P/(L) US Dollar
26/07/17 Short 100 Contracts  Sept Schatz 112.03 112.3 -27000 -31725 63.4 112.17 -0.12% -14000 -16450
15/08/17 Long 300 November VIX 16/24 Call Spread 0.97 0 -29100 -29100 58.2 1.2 23.71% 6900 6900
Unrealised Totals -$60,825 -$9,550
CLOSED TRADES
Trade
Date
Trade Entry
Price
Stop Loss Level Trade
Closed
Close
Price
Realised
P/L
US Dollar P/(L) Last
Price
Open
P/(L)
14/07/17 Long 10 Contracts Sept Cocoa 1892 04/08/17     2047.7 8.2% 15570.00
14/07/17 Long 10 Contracts Sept Cocoa 1892 01/08/17 2068 9.3% 17600.00
14/07/17 Long 20 Contracts Oct Sugar 14.099 04/08/17 14.174 0.5% 1680.00
14/07/17 Long 10 Contracts Sept Coffee 132.10 04/08/17 139.4 5.5% 27375.00
19/07/17 Long 20 Contracts Sept Cocoa 1943.10 28/07/17 2035 4.7% 18380
19/07/17 Long 20 Contracts Oct Sugar 14.42 01/08/17 15.0245 4.2% 13540.80
20/07/17 Long 10 Contracts Sept Coffee 136.175 01/08/17 138.65 1.8% 9281.25
09/08/17 Long 10 Contracts December Gold 1274.4 14/08/17 1287.4 1.0% 13000.00
02/08/17 Long 40 SPX Sept 2400 Puts 12.7 14/08/17 12.3 -3.1% -1600.00
Cumulative Closed Profit/(Loss) $114,824.05
This is not meant to be a model portfolio and it is not meant to constitute any investment advice. This is purely a way of keeping track of specific trade ideas that we highlight in our weekly investment commentaries. These ideas will consist of the more important or higher conviction ideas that we implement in our multi asset macro fund. We have chosen to have a notional starting portfolio value of US$5 million; the reason being that we can also illustrate how much risk we are taking on each trade as well as keeping a cumulative track of how our main trade ideas are performing. This is a notional portfolio only and does not represent any portfolios that we manage. However, for the sake of clarity and consistency, we do put these trades into our multi-asset macro portfolio alongside other trades that we do not make apparent here. The prices we show in the table above are the prices we transact at for our macro fund, not including any trading expenses.

Stewart Richardson
Chief Investment Officer

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