The Correction: Don’t Forget To Look Ahead

The Correction: Don’t Forget To Look Ahead

TRIGGER WARNING: This post will include political analysis with very trace amounts of opinion thrown in. As investors so often like to say and rarely actually do, “I am just observing”.


“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” ~ Winston Churchill

The first correction in the final leg (according to me) of the post crisis bull market has begun. Given the tremendous tremendous divergence between market expectations and reality there is likely a bit more downside to come. Positioning, and sentiment are polar opposite to the bottom we saw in Q1 2016.

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Especially, if you consider at what the market was pricing in: record business and consumer optimism as well as a smooth and efficient US government that would pass healthcare and tax reform in short order.

Instead we have a bellicose interventionist President Trump who has sparked geopolitical tensions in the Middle East and North Korea. At the same time, the French elections are turning out to be less clear than the market also predicted (notice a pattern).

In the end, shit is about to get somewhat more real, but that doesn’t mean the highs are in (more on this later). For now the Trump/reflation trades, which have looked weak these past few months are beginning to unwind. The key 2.30% technical level on the US 10 year was finally breached this week.

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The technical breakdown in the US 10 year treasury likely signals further downside in US financials (XLF), a key beneficiary of the Trumpflation narrative.

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The Yen a key measure of risk has been strengthening, blowing through stops, and just generally crushing risk appetite. Now below the 200dma and the 0.618 fib re-tracement level off the pre-election lows.

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Semiconductors, the post Brexit leader, up 50% from the lows, has closed below its 50dma and is testing the super special (sarcasm) 79dma. But seriously. We haven’t seen a close below the 79dma since BREXIT. This will be something to watch going forward.

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There’s a clear H&S pattern on the Russell 2000.

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At the same time, XLE has led oil this year and looks to be headed lower. Given the importance US shale plays in the economy, this could signal further economic weakness.

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Throwing salt on the open wound, retail sales and inflation both disappointed expectations on Friday.

In short: “It’s an ugly planet, a bug planet!” (Video might be broken, but hey! At least you get the reference now).

 

Although the risks, given the lofty valuations, are asymmetric to the downside, it is of vital importance to not get carried away with our bearishness. I made this mistake in 2016. I missed the signs of a bottom. I had been short on the way down, but instead of pulling back, I pushed harder and paid for it. Maybe this is the time to do that, but maybe it’s not (more on this later). It is worth noting that folks are still incredibly scared of a one off event (including myself).

As investors we are in constant conflict with our inner animal which tells us us to sell when we should buy, and buy when we should sell. Not only must we not give in to these primal instinct, we must also be keenly aware of the fact that if we are experiencing these emotions it is quite likely that others are as well.

If this correction continues it does NOT mean equities are about to fall apart. Market tops are long processes that take months if not years rarely ever days. Sure the parallels to a 1987 style event have been shown time and time again. Vol selling is the new portfolio insurance. Passive is only passive on the way up. CTAs have record assets under management. The fuel is certainly there. I get it. I am aware of it, but so is everyone else. Stocks have barely fallen and yet the cost of hedging has already shot up dramatically.

Investors remain keenly aware of any downside risk. Meanwhile the central bank put is still there. The Fed may be hiking now, but with economic data coming out towards the downside, Trump meeting stiff resistance in Congress, and most importantly a falling stock market the Fed can quickly pivot from hawkish to dovish rhetoric. If the sell off does accelerate, I expect talks of balance sheet reduction to give way to QE4.

Perhaps this shift potential shift from hawkish to dovish may already be showing in precious metals.

 

Although I’d likely attribute most of the move in gold to the war premium.

Worth noting, as Luke Gromen likes to remind people smart enough to follow him on twitter: high stock prices are now a matter of national security.  Even with equity markets at at all time highs, pensions remain tremendously underfunded. A fall in financial assets would cripple pension funds. The knock on effects would spiral out beyond the government’s control leading to consumer debt crisis with the Fed forced to monetize an ever widening US Federal Government deficit.

Thus the Fed, and “the powers at be” have a hefty amount of incentive to keep stock prices elevated. At the very least, the Fed, armed with its newly minted ammo, should be able to hold the line for 3-6 months before it has to even think of threatening the nuclear option, QE4. Look for the Fed to buy time while the market narrative adjusts to the reality.

From the WSJ:

“A growing number of forecasters are beginning to reconsider their bullish outlook for the U.S. economy as doubts grow over the extent to which President Donald Trump will be able to implement his agenda.”

Now that price and economic soft data are beginning to reflect the “hard: reality, I find it quite comforting to see economists like rats jump from the sinking ship that is Trumpflation and the hopes of fiscal stimulus that come with it. Ironically, as the mainstream lose faith in any Trump stimulus or healthcare reform, the odds of the passage of said legislation are actually rising, albeit from a very low base.

WARNING: Here be Dragons. You are entering the political analysis section of the blog post.

What the narrative surrounding Donald Trump refused to acknowledge was just how little power US presidents have domestically. This is especially true when Congress is gridlocked to a standstill. Throw in debt and demographics on top of the rigid congress, and the US president’s domestic policy is practically set in stone.

After failing domestically, Trump has turned his focus abroad. He needs to score some quick wins politically and I’d say he’s done just that. He has used missile strikes in the Middle East to threaten North Korea and force Chinese action (at least superficially).

By projecting US military strength abroad, Trump has pulled the war hawk members of Congress on both sides of the aisle closer to his point of view. At the same time, he has allowed more of his policy decisions to be influenced by Jared Kushner a left leaning New Yorker further bridging the wide divide between his administration and the Democrats.

At the same time, as the economic backdrop continues to deteriorate, Trump will be more than happy to lay the blame at the feet of a gridlocked Congress. I can see it now: “Congress can’t pass much needed health care reform while bad Obamacare implodes. Sad!”

The Democrats have the most seats in contention next year, and will need political wins to secure those seats, else they’ll cede total power to the Republicans and Trump. They can’t do that if they sit by idly as the economy implodes. With some of the Dems coming closer to Trump’s camp, it won’t be hard to leverage the necessary votes for health care reform which would then pave the way for tax reform. Throw in talks of QE4 and the stock market could surge for the final leg of the post crisis bull market.

 


DISCLAIMER: This blog is the diary of a twenty something hedge fund manager who has never stepped foot inside a wall street bank. He has not taken an economic or business course since high school (for which he is immensely proud of) and has been long gold since 2012 (which he is not so proud of). In short his opinions and experiences make him uniquely unqualified to give advice. This blog post is NOT advice to buy or sell securities. He may have positions in the aforementioned trades/securities. He may change his opinion the instant the post is published. In short, what follows is pure fiction based loosely in the reality of the ever shifting narrative of the markets. These posts are meant for enjoyment and self reflection and nothing else. So ENJOY and REFLECT!

 

 

 

Updating The Global Macro Road Map

Updating The Global Macro Road Map

This is a long article, that you’ll find to be more free flowing than previous articles (Aka I was too lazy to trim some of the fat). I don’t apologize for the length. I find writing down my thoughts to be an incredibly helpful exercise. Just like I find publishing said writings to be incredibly cathartic. With that said, this post was originally supposed to be about China, but then it eventually morphed into a more generalized view on the global economy and the major sign posts I’m looking for as the year progresses. Enjoy!


Those who follow me have probably noticed by now the hefty emphasis I put on narrative when analyzing markets. Lately, the market narrative on China has gone “surprisingly” quiet.

This silence has persisted despite a tremendous amount of action going on underneath the surface.

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Like a duck on a pond, China’s legs have been churning a mile a minute. In a country where every financial asset including P2P loans comes with an implicit “government guarantee” there is not much room for restraint. Combine this false sense of security with the PBOC’s almost uncontrolled stimulus in the post crisis era, and it’s not hard to see why the central authorities in China have been so busy over the past year.

Recall that back in Q1 2016, the PBOC and Chinese government launched a massive stimulus program that forced a temporary bottom in not just China’s economy but the global economy as well. With the economy on a seemingly strong rebound, the PBOC began the process of tightening liquidity and imposing some restrictions on lenders.

Unfortunately, when a banking system is as interconnected and shadowy in nature as the Chinese banking system, this process of imposing any sort of discipline is incredibly difficult. From Caixin:

“No one in the banks knows where the money they invested in other banks’ wealth management plans ended up,” an official from the central bank told Caixin earlier. “They could not tell because the selling bank itself used the funds to buy other banks’ wealth management plans.”

So far the PBOC’s tighter monetary policy has gone on without a hitch (unless you count the December panic when a medium size brokerage firm attempted to default on its Trust Beneficiary Rights). As alluded to in the opening paragraph, this relative calm is only surface deep.

Underneath the calm waters, the risks in China’s banking system have merely shifted from one section to another, forcing the PBOC to play a game of whack-a-mole while providing just enough liquidity so that the whole system doesn’t collapse. By now, the ballooning size of Wealth Management Products and their increasing interconnectivity is well known as well known as what they are actually invested in is unknown.

“Along with the surge in the issuance of CDs, more than 15% of bank wealth management products were held by other banks as of June 2016, up from less than 4% at the beginning of 2015, an increase of 3.5 trillion yuan over a period of just 18 months, according to the report.”

What has been less talked about is the burgeoning role that interbank certificate deposits are playing in the Chinese banking system.

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From the Caixin:

“In the first two weeks of March, the issuance of interbank negotiable certificates of deposit (CDs) exceeded 1 trillion yuan ($145 billion), following a record net increase of almost the same amount in February, according to data from Wind Information, a financial data provider. The issuance of CDs in January and February was 990 billion yuan and 1.97 trillion yuan respectively.

One possible reason for the explosion in CD issuance in recent months could be the dramatic increase in rates. Rising from 2.8% last August to 4.77% in March. Banks may be trying to lock in the cost of funding before it rises any further.

The interest rates that banks needed to offer to get funds through the CDs have increased as well, reaching an average of nearly 4.77% on March 22 for a three-month contract. In late August, when the central bank started raising money costs through open market operations by tightening the supply of short-term, cheaper funds, the rate was only about 2.8%.”

At the same time, about 48% of CDs are set to expire by the end of the Q2, further driving demand. Of course, these products will all be rolled over at much higher costs, hurting bank profitability. From Natixis Research:

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To make matters worse, the rising risk associated with interbank CDs is concentrated in the smaller less well capitalized banks. From Caixin (my emphasis in bold):

“Small and midsize banks have been the primary issuers of interbank CDs. According to a research report from Haitong Securities, nearly 90% of the 7.4 trillion yuan worth of outstanding CDs as of March were issued by the national joint-stock banks and city commercial banks.

Just how poorly capitalized are these banks? From Caixin (my emphasis in bold):

“A simplified way to measure the leverage, as provided by the report, shows that, on average, the total assets of depository financial institutions in China (excluding the central bank) have grown to almost 50 times their net capital. The ratio for some midsize banks, which rely more on interbank loans, has reached 60. In 2007, the average ratio was just about 30.”

So what does this all mean? It seems that the PBOC’s runway to tighten liquidity in the interbank market will be significantly limited going forward. The fact that the PBOC has been able to tighten as much it has without incident is more illustrative of the incredible amount of excess liquidity in the system than its resiliency. Arguably no sector in China has benefited from these high levels of excess liquidity than real estate.

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Falling profits and rising leverage against a falling liquidity backdrop is not exactly the ideal mix for a speculative bubble. But if you ask members of the PBOC, they don’t seem very worried at the moment. Apparently they’ve solved that seemingly “impossible trinity” problem.

From the SCMP:

“Chinese central bankers have done the economic “impossible”, finding a way to have a ­stable yuan, a free market and effective monetary policy.

That is the assessment of two central bank researchers, who claimed in a paper published on the People’s Bank of China’s website on Thursday that Beijing would continue to realize the “impossible trinity”.”

How does that saying go? Something something pride before the fall? This is almost as bad as the Latvian central banker claiming to be a “magic person”.  To be clear Latvia hasn’t found itself in a heap of trouble, and the PBOC’s alleged conquering of the impossible trinity is not exactly an indicator of anything other than central banking hubris which let’s face it is always turned up to 11.

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Central bank hubris aside,  it’s true capital flight out of China has stopped… for now.

Which is not entirely surprising, from my post The Reflation Trade:

“I also see incredible potential for the PBOC to defend the psychologically important $3T reserve level this month. Come the release in early February, the market may be shocked to discover that the $3T reserve level has held. The Yuan could strengthen and the narrative would temporarily shift to the masterful job done by the Chinese Authorities, and developed markets would rally on the back of higher inflation.

My oh my how the narrative shifts. Of course, China has not solved any of its problems. If anything they have grown larger, which has forced the authorities to take drastic actions. Like preventing foreign companies from taking their profits out of the country.

These stricter measures on top of a false sense of currency stability has emboldened Chinese corporates to ramp up their offshore dollar borrowing again. From the WSJ:

“Chinese firms have issued some $52.6 billion worth of U.S. dollar bonds in the first quarter, up 72% from the previous three months, according to Dealogic, and nearly five times the amount from the first quarter of 2016.”

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One of the corporations borrowing dollars in the offshore market is one of the most indebted domestic property developers, Evergrande Group.

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The purpose of this money is to “refinance existing debt”, because what else can Evergrande do? If Evergrande can’t get profits offshore (if it even has any) how on earth is it going to pay back this debt, unless it borrows even more dollars. From the WSJ (my emphasis in bold):

“In mid-March, one of China’s largest and most indebted property developers, China Evergrande Group , priced three dollar bonds in Hong Kong within a week for a total of $2.5 billion, which the company says it will use to refinance existing debt.”

All it takes is for a little stability in China and everyone loses their minds. But Chinese corporates aren’t the only ones throwing caution to the wind. As pointed out numerous times on Twitter by Darth Macro, investors are increasing their exposure to Emerging Markets, despite deteriorating macroeconomic fundamentals.

I think you get the point. Investors have looked around, and found the coast to be clear. Which is why I put an emphasis on the subsurface activity in China. Important to note that it is not just in China where the subsurface activity betrays the market narrative. Any China and EM related story would be unfinished if I did not touch on the US dollar, where once again we find the narrative to be in opposition to the underlying fundamentals. The following is a headline from the WSJ:

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“Dollars shortages are now going away, helped by expectations that U.S. regulation will be relaxed, the success of overseas banks in finding alternative sources of finance and greater appetite from investors to pick up what looks like free money left lying around by the global financial system.”

I’ll leave it to Jeffrey Snider of ALhambra Investment Partners to dispel any dollar flow myths. From his appropriately titled article:

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“In 2013, the same sentiments were expressed only with QE3 in mind rather than regulations. It was only after the events of later 2014 forward completely and utterly surprised these mainstream opinions that it was after-the-fact decided regulations just had to be to blame. Even if we assume that was and is the case, the relative comparison of swap spreads (or UST yields, eurodollar futures, etc.) then versus now shows a very different interpretation than a return of dollar flow. Markets were much more excited and indicative of a that four years ago versus now, and given that turned out to be a false assertion, what does that say about the same one being prepared all over again?

For one, it was the 30-year swap spread that turned positive if only briefly in the summer of 2013. Almost four years later, the 30s have like the 10s improved but only in comparison to last year; they are still highly negative.”

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In spite of this shortage of dollars, the Fed in all of its “wisdom”, has decided that now is the time to take away the punchbowl. After two back to back rate hikes the Fed has quickly moved on to balance sheet reduction.

The hawkish shift from the Fed in light of the subsurface problems in China is either hilarious or astounding depending on your disposition (I myself am half astounded half cracked up). Curiously enough, the most recent FOMC minutes tell a different story (my emphasis in bold).

“Some participants viewed equity prices as quite high relative to standard valuation measures… prices of other risk assets, such as emerging market stocks, high-yield corporate bonds, and commercial real estate, had also risen significantly in recent months.”

Clearly they are worried about something, or as the quote suggests… pretty much everything. If high yield corporate bonds, commercial real estate and equity prices are all overvalued then there isn’t much room for anything else.

Perhaps even more importantly, the underlying US economy is not nearly as strong as the Fed’s hawkish rhetoric or the Trumpflation narrative would suggest. US Q1 GDP growth is weak per usual.

The latest jobs number was a dud as well. Amazon’s onslaught on the retail sector is accelerating.

Or maybe it’s more than Amazon’s creative destruction…

And this could just be the beginning of the bursting of a large multi-decade bubble in American retail stores. Retail square feet per capita in the US is 6x more than that of Europe or Japan. For all the grief Americans give China over its real estate boom, we have one of our own.

The bursting of this bubble will hurt and spread through out the economy, where we are seeing other bubblicious sectors suffer under tremendous strain. Auto sales have broken down.

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Used car prices have dropped sharply.

Of course this not all that surprising given the state of the subprime auto loan bubble.

Lastly, lending growth is slowing at an alarming rate.

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I know I’ve gone all over the map right now, so here I’ll try and wrangle some of these ideas back in. China’s economy although swimming in excess liquidity is going to face some headwinds towards the end of the year. Dollar liquidity although better than last year, is nowhere near a level to justify a hawkish Fed. US economic data, is nowhere near the level to justify a hawkish Fed. So why is the Fed hiking? An even better question might be: how have financial conditions been easing in the face of the hawkish Fed?

My answer for this strange development is the short vol crowd.

In this world of passive investing and ZIRP and NIRP, traders and now larger and larger asset managers are just looking for any excuse to sell vol. Every single time the VIX spikes above 13, it is immediately sold. This prevents equities from correcting and leads to a build up of risks in the system.

This is rampant selling of vol will lead to a whirlwind of unintended consequences, because it creates a false sense of security at the Federal Reserve. Historically the only thing that has stopped the Fed from hiking is a falling stock market. The Fed never responds to economic data, or dollar liquidity issues or anything of that sort. It only responds to falling stock prices. And if stock prices are being artificially propped up due to this “rampant selling of vol” then the Fed will keep on hiking or said differently vol sellers have numbed the Fed to its own hawkish policy!

It is quite likely given the rampant vol selling that the Fed has already tightened too much. Especially if you use the Wu-Xia shadow fed funds rate.

With that in mind, I think the odds of the stock market going considerably higher are quite limited. I’ve expressed my bearish views on the stock market for the past few months in a number of posts and believe my position has continued to be supported by the economic data as well as the capital flows. Dumb money in.

Smart money out.

Add the two together and you get record dumb money longs and record smart money (commercial hedgers) short!

Now I don’t have a crystal ball, so I don’t know if stocks go up or down over the rest of the year. I’m just saying the odds that stocks continue to rise is falling at a rapid rate. But if stocks continue to rise, we should expect the Fed’s hawkish rhetoric to continue DESPITE any deterioration of economic data. When the next correction does come, I suspect any talk of “balance sheet reduction” will be dropped faster than Romulan Red Matter (although technically it was created by the Vulcans?).

 


DISCLAIMER: This blog is the diary of a twenty something millennial who has never stepped foot inside a wall street bank. He has not taken an economic or business course since high school (for which he is immensely proud of) and has been long gold since 2012 (which he is not so proud of). In short his opinions and experiences make him uniquely unqualified to give advice. This blog post is NOT advice to buy or sell securities. He may have positions in the aforementioned trades/securities. He may change his opinion the instant the post is published. In short, what follows is pure fiction based loosely in the reality of the ever shifting narrative of the markets. These posts are meant for enjoyment and self reflection and nothing else. So ENJOY and REFLECT!

Trumpflation: The Narrative Is Deflating

Trumpflation: The Narrative Is Deflating

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“I can feel it coming in the air tonight, oh Lord”

~ In The Air Tonight by Phil Collins

“Father tell me, we get what we deserve
Oh we get what we deserve

And way down we go
Way down we go
Say way down we go
Way down we go”

~ Way Down We Go by Kaleo

“The closest thing to eternity on earth is a government program.”

~Ronald Reagan

You would think Reagan fanboys like Donald Trump and Paul Ryan would heed their idol’s words of wisdom, but no. This week, the world’s worst healthcare bill was pulled effectively putting the Trumpflation narrative on notice. To be clear, tax reform is not impossible, just a lot less likely than the market had originally priced. We should see those diminished odds be reflected across the Trumpflation trade over the next few weeks.

I could not agree more with Jawad’s assessment. All the legs of the Trumpflation narrative came under fire this week. First up, long term bond yields are showing no signs of higher expectations of growth. Possible double top forming in the 10 year.

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The 30 year is has fallen back to 3% as well.

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Of course falling interest rates, and a flatter yield curve bode quite poorly for one of the largest beneficiaries of Trumpflation, US financials.

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In this new era of Trump, banks were set to be deregulated allowing them to make more loans. A steepening yield curve means that banks would make more money per loan. On top of making more loans, banks would make more money per loan, a bank bull’s dream. Not only were Trump’s plans of deregulation dealt a sizable a blow and the yield curve flattened to post crisis lows but to make matters even worse, bank lending has been slowing like the US economy is about to enter a recession. In short, this euphoric fever dream has quickly turned into a bad mushroom trip.

From the article:

“We find three key channels that are inhibiting demand growth: 1) political uncertainty, 2) elevated corporate leverage, and 3) Fed policy, both through past tightening and expected tightening going forward. We see little evidence that the slowdown in lending is due to tighter bank or non-bank lending standards.”

Given the embarrassing defeat of the Republicans and Trump administration this week, it appears political uncertainty is far from resolved. Elevated corporate leverage is not going away anytime soon. And the Fed continues to talk a big game despite a lack of data to support their hawkish stance.

It’s not “hard” to see where I’m going with this. It’s 2011 (Déjà vu) all over again.

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The Fed may think it can pull its foot off the pedal but the market knows better.

Which brings me to the dollar or what many consider to be the most crowded trade. If the Fed is reached peak 2017 hawkishness, this crowded traded could be in big trouble.

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Those betting on higher growth, higher US interest rates, a resurgent financial sector and tax reform are also betting on a stronger dollar. Although I think the case for a stronger dollar over the long term continues to build, the short term forces are only pointed in one direction and that is down.

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Lastly, oil closed under the 50 week moving average this week for the first time since last July.

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I don’t think speculators realized US shale could grow production as fast as it did.

Either that or they really did believe US economic growth was accelerating. Which brings me to the rising role that US shale has played in US economic growth over the past year.

 

The trucking and sand industries have been huge beneficiaries of the US shale resurgence. To increase the effectiveness of their wells, companies have been using more and more sand per well.

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“Tudor, Pickering, Holt & Co. estimates the sector will need 120 million tons of sand by next year, more than double the demand in 2014 at the height of the U.S. drilling boom.”

The increased demand for sand has flowed through to increased trucking demand as well.

“The expense is compounded by the logistics of moving sand from mines to well sites thousands of miles away. Drillers don’t use sand found on a beach. They prefer fine white silica, much of it found in northern Midwest states. Shipping 5 million tons of sand can require 200,000 truck loads, according to a 2013 study by the University of Wisconsin.”

In short, US economic growth is heavily reliant on US shale growth. Lower oil prices not only puts bond bears on notice but US economic bulls as well. The longer oil stays low, the more likely we’ll begin to see a further liquidation of the record long oil contracts.

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Given the fragility of the situation you might expect investors to be a bit more worried about a pick up in volatility, but you would be wrong. Despite the potential unwind of several large speculative trades, investors remain incredibly complacent.

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A lot of this may have to do with volatility being sold short. The fact that this week marked the first weekly close above 12 this year is simply incredible. Which leads me to believe that the sell off we saw this week is likely a prelude to a larger move.

 


DISCLAIMER: This blog is the diary of a twenty something millennial who has never stepped foot inside a wall street bank. He has not taken an economic or business course since high school (for which he is immensely proud of) and has been long gold since 2012 (which he is not so proud of). In short his opinions and experiences make him uniquely unqualified to give advice. This blog post is NOT advice to buy or sell securities. He may have positions in the aforementioned trades/securities. He may change his opinion the instant the post is published. In short, what follows is pure fiction based loosely in the reality of the ever shifting narrative of the markets. These posts are meant for enjoyment and self reflection and nothing else. So ENJOY and REFLECT!

The End of Monetary Policy Divergence: RIP US Equity Outperformance?

The End of Monetary Policy Divergence: RIP US Equity Outperformance?

The past several months I’ve been pointing out that speculators have been increasingly shifting to one side of the boat, long reflation. And then this week, central banks finally joined the party, tightening monetary policy only after these inflationary base effects had peaked.

I think this development is very bad over the medium term for global liquidity conditions. As noted by Johnathan Tepper in his recent Macrovoices interview, higher inflation and economic growth will pull excess liquidity out of financial assets and into the real economy. Throw in the hawkish shift of the world’s four largest central banks, and global liquidity conditions in the second half of the year should not be nearly as elevated as they are today.

With that said, global liquidity will not be the main topic of this week’s blog post (but I’ll touch on it later). Instead, I am choosing to focus again on yet another wobbly pillar of not just the reflation trade but US equity market’s outperformance these past +3 years as well.

In light of the hawkish shift of foreign central banks, the Fed finds that it is no longer the only game in town. Since 2013, the Fed’s relatively hawkish stance was super charged by the incredibly dovish policies that foreign central banks embarked on. During that time the ECB and BOJ increased their asset purchase programs and adopted negative interest rate policies. The combination of these central banking policies pushed capital into the US and strengthened the dollar.

As the dollar is a major source of emerging market funding, the stronger dollar tightened financial conditions in these countries, and hurt their economies which led to a prolonged period of capital outflows and equity market underperformance (vs the US). During this time, the phrase, “the cleanest shirt in the dirty hamper” was commonly applied to the US dollar, economy and stock market, but is that still true?

From a technical standpoint these trends seem to be waning and on the verge of a reversal. SPY / Europe (IEV):

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Despite the parabolic move higher, US equities have gone nowhere against emerging markets for over 18 months and counting. This week, we saw a break below the 50 week moving average as well as the +3 year trendline. SPY / Emerging Markets (EEM):

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SPY / World (VT):

 

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With the central banking divergence set to converge, we could even see the Fed hold steady or shift to a more dovish policy while the ECB and BOJ further tighten monetary policy. Given that the BOJ and ECB are still experimenting with NIRP there is plenty of room for them to tighten their monetary policy. Could you imagine the rally we would see in European financials if the ECB reduced its NIRP tax on the banks?

The Fed on the other hand may have overplayed its hand. If we look at inflation where it seems everyone (except those holding record treasury short positions) is now aware of the falling base effects associated with energy prices.

But in the US, little ink has been spilt over one of the largest contributors to inflation, rental prices.

In short, the inflationary pressures that the Fed has tried to get ahead of are unlikely to develop before the June meeting. Meanwhile, economic growth is also likely to disappoint or at least not accelerate to the upside as lending growth continues to fall.

Corporations have also put their debt issuance on hold as they wait for Trump’s regulatory cuts and stimulus package to form up.

If Trump and Congress cannot get their act together, look for the Fed to lower expectations of a future rate hikes.

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Which would mean that the Fed is unlikely to defend the dollar, and we could see it fall below the 99.5 level, completing this H&S pattern that I’ve been calling for these past few weeks. More importantly, by not defending the dollar, the Fed is essentially giving the green light for capital to leave the US.

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Lastly, any narrative about capital flight would not be complete without the country who has suffered from capital flight the most these past few years, China. And if there is a country that would benefit more from a falling dollar and falling US treasury yields than China I would not know it.

Previously I noted that the central authorities in China were hard at work to blow another stock bubble, Bitcoin: The Rising Tide Pressures The Biggest Leak:

“The stock market which everyone believes left for dead, may rise from its shallow grave and roar like never before. Pension funds will begin allocating additional holdings to the stock market as soon as this week. This is a pretty serious development. The last thing Beijing wants to do, is torpedo the pensions of millions of workers. On the back of this move, Chinese authorities have cut equity margin requirements from 40% to 20%.”

Just last week, the PBOC hiked interest rates. The reason: to apply more pressure on the nation’s out of control housing bubble.

It is likely that the authorities are trying to funnel China’s big ball of money back into other asset classes such as precious metals and equities. The inverse H&S pattern is quite obvious, throw in a weaker dollar and falling treasury rates and a new bull market could in fact be in the cards.

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It’s worth pointing out, that being bullish Chinese equities does not mean I am necessarily bullish on China’s economy, or global growth for that matter. There’s still plenty of warning signals out there.

And as I noted earlier, the Chinese authorities are actively working to deflate their booming real estate bubble. If successful in their efforts, the deflationary effects, will reverberate across not just emerging markets but the globe. And this in my view would likely mark a great opportunity to be long the dollar. As global liquidity begins to dry up around the world approximately 3-6 months from now, the dollar should bottom and begin to build up a head of steam for all the wrong reasons, There Is No Alternative (TINA).

 


DISCLAIMER: This blog is the diary of a twenty something millennial who has never stepped foot inside a wall street bank. He has not taken an economic or business course since high school (for which he is immensely proud of) and has been long gold since 2012 (which he is not so proud of). In short his opinions and experiences make him uniquely unqualified to give advice. This blog post is NOT advice to buy or sell securities. He may have positions in the aforementioned trades/securities. He may change his opinion the instant the post is published. In short, what follows is pure fiction based loosely in the reality of the ever shifting narrative of the markets. These posts are meant for enjoyment and self reflection and nothing else. So ENJOY and REFLECT! 

Mirror Mirror On The Wall: Is The Reflation Trade About To Fall?

Mirror Mirror On The Wall: Is The Reflation Trade About To Fall?

 

On Friday, Grant Williams announced he was working on a new presentation and asked the twitter-verse what they thought the craziest chart in the world was.

If you haven’t read the responses, I highly recommend that you do. There are a lot of really great charts (although Bitcoin is not one of them, give it a few more years folks). Of course, being somewhat of a reflation trade fanatic, I threw out a rather expected response.

I also forgot to add one very important component to this trade which is for speculators and hedge funds to be very long US stocks and short volatility, but we’ll get to this bit later.

 

Arguably the most overextended, and most talked about leg of this trade is the speculative long oil position. In 2017, we’ve seen speculators add to their net long position by about 200,000 contracts.

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With oil below its 200d ma (dark blue line) and at its lowest point this year, even without counting the cost of rolling these positions over, AT LEAST 40% of these contracts are in the red.

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Students of history will recall that the last time speculative positioning was this extreme oil tumbled over 70% in the following year. During this time (2014), Hedge Funds and speculators operated under the false assumption that OPEC had their back.

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Once again, OPEC has warned the US shale and more importantly the speculators that OPEC does not have their back.

The poor fundamentals supporting higher oil prices only gets worse from here. US oil inventory is at a post WWII record high.

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Meanwhile, US gasoline demand has also been “unexpectedly” soft.

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At the same time, US shale producers currently holding an extreme short futures position making them well prepared for a downturn in oil prices.

 

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On top of being well positioned for a downturn, US shale breakeven prices have collapsed in the last two years.

In order to cripple the growth of the US shale industry we’ll need to see oil prices below $40 for a prolonged period of time. That’s not exactly music to the ears of these record long speculators…

Which brings me to the crux of my argument: If the price of oil continues to fall, hedge funds and speculators will take incredible losses. These losses will begin to weigh on their other positions which they also have levered themselves to the hilt on and force them to unwind these positions as well. Taking into account that the fundamentals supporting their extreme positioning have continued to deteriorate, any potential unwind could become incredibly violent as the markets return to reality.

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In the past month I’ve written counter arguments for two of the reflation trade positions (long US dollar and long US stock market) and given that oil base effects have played a key role in driving inflation higher I believe we are about to see a tremendous amount of pressure applied to yet another one of these speculative positions, short bonds.

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Recall that oil prices bottomed in February 2016. With base effects firmly behind us, and the price of oil set to head lower, we could see oil quickly go from an inflationary pressure to a deflationary one.

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And if we give the recent rise in rates a historical perspective, we find that we are at the top of a 30+ year channel… and people make fun of me for betting against an 8 year trend.

I couldn’t have said the following better myself.

AND YET this is the exact opposite positioning that we see from hedge funds and speculators, who are not only short bonds but extremely long stocks!

Since my bearish post on US equities, the technical deterioration of the US stock market has only gotten worse.

Investor appetite for junk bonds appears to be waning.

At a very key juncture I might add.

Insiders are running in terror from the market.

But don’t worry, hedge funds aren’t alone in their foxholes, retail investors have finally joined the party.

So much for the most hated bull market in history. Retail have responded to higher prices and Donald’s rhetoric. They’ve heard that Donald Trump is going to enact some super stimulus and tax cuts that would transform the US economy into a soaring eagle that shoots laser beams out of its eye sockets.

Of course, the reason retail investors are in the stock market has nothing to do with the underlying fundamentals of the actual reflation trade or US economic health for that matter. I hate to sound like a broken record but here is a quote from The Reflation Trade:

“But investors have become so accustomed to the US driving the global credit cycle that they have missed the origin of the reflation trade. The dollar, commodities and inflation have all risen together for the first time in over a decade which has left investors scrambling for a narrative to explain this paradox. Fortunately, the recent US presidential election has provided just that. Despite the “coincidence” of commodities bottoming with China’s economy in February of last year, investors have latched on whole heartily to the “Trumpflation” narrative. Or to use another analogy, investors have entered the Jade City, but they have become distracted by the Giant Green Floating Head.”

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If we examine the underlying health of the US economy, we find it is quite weak. Despite this Trumpflation narrative, loan growth over the past two months has actually been negative.

Consumer lending standards are tightening.

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3-month LIBOR continues to hit post crisis highs.

And even with the tremendous growth we’ve seen in US shale, the US economy has continued to slow. Going from 1.9% in Q4 to just 1.3% in Q1.

The accelerating growth in employment we’ve seen, although enough to spook the Fed into hiking, has diverged dramatically from the underlying fundamentals of GDP growth.

And yes, let’s not forget the Fed is prepared to hike interest rates for the 2nd time in just 3 months. This dramatic tightening has put a great deal of pressure on China’s slowing economy.

 

And to top off this cluster fuck of speculative positioning, it is important to note that the VIX has been sold shorter than Tyrion Lannister.

Fortunately as we all know, a Lannister always pays his debts.

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Or just watch and wait for oil volatility to spread to other asset classes.

So while hedge funds and speculators are watching Trump for false bull signals, they are missing the underlying weakness. To make matters worse, investors and speculators have not been this positioned for a move in the global economy since the world was supposed to end in 2009.

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666 becomes 999 which some how becomes 1999 but wait the year zero didn’t actually start till the year 10, which makes the year of the devil 2009!

OK bad Arnold Schwarzenegger movie references aside (I’m optimistic to think that 3 people will get that reference), my point is that investors are levered to the hilt in almost all the wrong places: Long dollar, long commodities, long US equities, short volatility and short US bonds.

Until now, these levered positions were a powder keg in search of a spark. If the price of oil continues to fall we could witness a forced unwind of these extremely levered speculative positions which would come at a time when the market is incredibly fragile and the Fed has been uncharacteristically hawkish.

 


DISCLAIMER: This blog is the diary of a twenty something millennial who has never stepped foot inside a wall street bank. He has not taken an economic or business course since high school (for which he is immensely proud of) and has been long gold since 2012 (which he is not so proud of). In short his opinions and experiences make him uniquely unqualified to give advice. This blog post is NOT advice to buy or sell securities. He may have positions in the aforementioned trades/securities. He may change his opinion the instant the post is published. In short, what follows is pure fiction based loosely in the reality of the ever shifting narrative of the markets. These posts are meant for enjoyment and self reflection and nothing else. So ENJOY and REFLECT! 

Toro: Dollar Bulls Charging At The Fed’s Red Cape

Toro: Dollar Bulls Charging At The Fed’s Red Cape

The dollar story is a very interesting one. As the global monetary system’s reserve currency the dollar does not behave like any other fiat currency. The history of other monetary systems typically lasts around 40 years. At 46 years, our current post-Bretton Woods system (beginning in 1971), is old, rickety and fraught with danger. These instabilities have created powerful structural forces that have propelled the dollar higher. The most recent episode was the 2014 rising dollar story that crushed oil and other commodities as well as the Emerging Markets that depend on them.

These forces are still at work. They haven’t gone away, and neither have the bulls who are aware of their presence, no matter how far in the background they may be. I consider myself in this camp, but at the same time, as I indicated in the previous sentence, I believe these forces to be mostly hidden in the background, waiting to be thrust again into the light.

On the other hand, I see a confluence of bearish dollar forces at work. Despite the amazing soybean quarter of 2016 which almost puts TSLA’s Q3 “positive cash flow” to shame, US GDP growth has been sub 2%. Q1 2017 is likely to come in under 2% as well.

It is important to note that these two quarters will have taken place before the effects of rising interest rates and the stronger dollar will be fully felt. These sub par GDP numbers also include the incredible growth we’ve seen from the US shale industry. Is some other US industry going to magically contribute to GDP going forward? It is hard to imagine a scenario where US economic growth will surprise to the upside.

And yet the Fed still finds reasons to hike interest rates. Janet Yellen, looking through her rearview mirror points to the fantastic economic strength we’ve seen in the larger foreign economies.

First off, China does not look as healthy as Janet Yellen’s rearview mirror suggests. The GDP growth target in China has fallen to 6.5% and, more importantly, M1 growth has rolled over which suggests China’s best days are now behind it.

Part of the readjustment in China’s growth is due to the unstable nature of the country’s real estate boom. Xi’s approach to a tighter monetary policy and more stable growth should slow the real estate boom and have far reaching effects for not just China’s economy but commodities and Emerging Markets as well.

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As for Europe and Japan, yes it is true their economies have responded positively to the reflation trade. Because these economies have been trapped in deflation the longest, it makes sense to see them be the largest beneficiaries of inflation (at least in the short term). Eurozone’s PMI is at its highest point in over 5 years.

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We haven’t seen a Japanese PMI this positive since Abenomics’ heyday in 2014.

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Meanwhile, warning signs have piled up in the US, and the ISM manufacturing survey despite being elevated could peak as early as this month.

But we know the real reason the Fed is prepared to hike. The global reflation trade has certainly given Janet and her ilk a false sense of comfort, but the odds of a fed rate hike were incredibly low until a week ago.

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That is, until The Donald gave his State of the Union address.

There was no US economic news between mid February and now to suggest such a rapid rise in March rate hike odds. Trump spoke, and the Fed panicked. If everything Donald said was in fact going to happen and at the pace he implied, the Fed would have undoubtedly fallen behind the curve. But is Trump really going to get the things he desires as soon as he suggests? From my November blog post, It’s A Trap!:

“In order to win the election, Donald Trump successfully united a diverse group of people and yet he didn’t win the majority vote. And although the republicans may have won congress, Donald is hardly a republican president. Donald Trump is akin to a battle commander who has charged too far ahead of his troops. He will need to wait to gather the army before he can launch an effective attack.”

However, eloquent and well spoken his State of the Union address may have been, it is of vital importance to realize that Trump does not write the bills. Trump does not pass the bills. The fractured and incompetent Congress does. A large portion of Democrats are still sore from “their” loss in November, and are opposing Trump on every issue imaginable. Meanwhile, the Republicans are split between a Border Adjusted Tax, repealing Obamacare, and a number of other issues. Republican Senator Rand Paul hasn’t even been allowed to see the current bill.

Trump’s stimulus is further out than the market and more importantly the Fed anticipates. It is more likely that the Fed is hiking into weakness than strength. Speaking further to probabilities, it is likely that the March rate hike will mark the peak in Fed’s hawkish stance for the year, and yet Hedge Funds are positioned for further US economic strength and inflation.

 

Somewhat paradoxically, funds are also incredibly long commodities.

The long dollar and long commodity trade is also known as the reflation trade. Rising global growth pushes up demand for commodities, which props up prices which in turn pushes up inflation thereby leading to a rise in bond yields. US bond yields rise higher than those in EU and Japan due the QE and NIRP policies further propelling the dollar higher.

But the reflation trade is not only old and well known but perhaps most importantly is likely turning. As I believe the origin of the reflation trade is found in China (not Trump), it should worry these reflation bulls that China’s economy is slowing not accelerating. It should be even more worrisome that the Fed is hiking not because of improving Chinese economic data but Trump’s rhetoric. From my post The Reflation Trade:

“But investors have become so accustomed to the US driving the global credit cycle that they have missed the origin of the reflation trade. The dollar, commodities and inflation have all risen together for the first time in over a decade which has left investors scrambling for a narrative to explain this paradox. Fortunately, the recent US presidential election has provided just that. Despite the “coincidence” of commodities bottoming with China’s economy in February of last year, investors have latched on whole heartily to the “Trumpflation” narrative. “

The base effects from reflation should peak this month (the data from February is released in March). The Fed with its well polished rearview mirror should fall hook line and sinker for the inflationary data just as it is peaking. Meanwhile growth from the EU (if the specter of Le Pen disappears) and Japan could surprise to the upside while the US lags. Going forward, we should expect Fed dovishness, not hawkishness and dollar weakness not strength.

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DISCLAIMER: This blog is the diary of a twenty something millennial who has never stepped foot inside a wall street bank. He has not taken an economic or business course since high school (for which he is immensely proud of) and has been long gold since 2012 (which he is not so proud of). In short his opinions and experiences make him uniquely unqualified to give advice. This blog post is NOT advice to buy or sell securities. He may have positions in the aforementioned trades/securities. He may change his opinion the instant the post is published. In short, what follows is pure fiction based loosely in the reality of the ever shifting narrative of the markets. These posts are meant for enjoyment and self reflection and nothing else. So ENJOY and REFLECT! 

 

Warning Signs Pile Up In The US

Warning Signs Pile Up In The US

In a follow up to my previous post, Trump’s First Stock Market Correction: Coming Soon, I am going to outline a growing list of warning signs that suggest the US equity markets are fast approaching a correction.


Damn do markets love inflation. They say hunger is the best sauce, but wow just wow, after 5 long years of deflation, PMIs around the globe have started to roar.

What is most incredible about this rally is how broad based it has become. Price action in Emerging Markets is incredibly bullish.

Brasil has clearly been eating its proverbial Wheaties as well. To think I wanted to short it last March…

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But in the land of the longest running bull market, despite what the Tweeter in Chief, Donald Trump, says the stock market does not reflect reality.

Exactly… we don’t even have a tax plan yet… or a functioning legislative branch for that matter. Jawad Mian of Stray Reflections adds:

“The political uncertainty so apparent in both the US and Europe has not really dented market optimism yet but the global equity rally is extremely stretched, with record levels of speculative long positioning in the Russell 2000 and the S&P 500 pricing-in a staggering 30% earnings growth for 2017.

Of course S&P 500 earnings have been falling for the past 8 months…

Cognitive dissonance indeed. Although you can’t entirely blame them given the elevated levels of economic surprises.

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It’s hard to imagine conditions will continue to surprise to the upside, in the US, especially, where most of the surprise has been in the form of soft data or sentiment.

Further compounding the peak in economic surprises, is the movement in US treasury bonds which typically has a negative impact on the economy.

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And yet the move higher in interest rates has not been enough to counteract the rise of inflation.

This has helped fuel the price of gold, as well as has Marine Le Pen’s rise in the polls.

As we approach the French elections which have the most binary outcome of any election, we should expect a pick up in volatility. At the same time, US equity markets have been historically calm.

To put this level of calm into perspective, the chart below shows the number of 1% down days out of the last 200. At just 5, we are at the all time lows last seen in the summer of 2007, when the dollar was about to fall off a cliff, while EM and commodities soared (we’ll get to this bit later).

The indicators only get worse from here… The VIX which has been sold short like never before is starting to mis-behave.

At the same time we are seeing further warning signals from inflation and bonds.

From a liquidity standpoint, the US is also at risk.

This can also be seen in the DXY forming a potential H&S pattern that would take us to the election night lows.

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And perhaps this is why EM is behaving so bullishly. If the dollar falls, EM could really rally further. This is further reflected in the momentum divergence in SPY/EEM. We’ve also broken the 4+ year trendline. This is something to watch going forward.

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I will caution this last statement with the fact that the reflation trade has thus far been a dollar positive story. As inflation rose, so too have interest rates in the US, which is the only large DM economy that is not undergoing some massive form of QE. This interest rate spread drove dollar strength against other DM countries as well as some EM countries (albeit initially).

We’ve seen currency strength out of places like Mexico, Turkey, South Africa, China, Chile, Brasil and quite a few others. Could the dollar strength be a DM only story going forward?  Gold mining companies have begun to prepare for such an event and have liquidated the majority of their RECORD short position.

 


DISCLAIMER: This blog is the diary of a twenty something millennial who has never stepped foot inside a wall street bank. He has not taken an economic or business course since high school (for which he is immensely proud of) and has been long gold since 2012 (which he is not so proud of). In short his opinions and experiences make him uniquely unqualified to give advice. This blog post is NOT advice to buy or sell securities. He may have positions in the aforementioned trades/securities. He may change his opinion the instant the post is published. In short, what follows is pure fiction based loosely in the reality of the ever shifting narrative of the markets. These posts are meant for enjoyment and self reflection and nothing else. So ENJOY and REFLECT!