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The Real Bain of Equity Markets is Actually a US Dollar Problem

The Real Bain of Equity Markets is Actually a US Dollar Problem

2016-02-05 16:59:00
James Stanley, Currency Strategist
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Talking Points:

- Global stocks are working on synchronous bear flag formations as more and more signs of recessionary forces present themselves to the global economy.

- Stocks put in a strong day on Thursday after comments from Mr. William Dudley were construed dovish-ly to indicate that the Fed may yield to global pressures and back off of four rate hikes in 2016. But it doesn’t appear as though that’s near a consensus at the Fed just yet, as both Ms. Esther George and Ms. Loretta Mester talked up higher rates separately throughout the week.

- This exposes the prospect of further USD-strength as the US is one of the few economies looking at higher rates, even if the market does doubt that.

- Potential for volatility remains extremely elevated. Make sure your risk management has been addressed, and if you’re looking for ways to generate trade ideas based on crowd positioning and sentiment, check out our Real-Time SSI. It’s free.

Sometimes it’s dangerous to stick out from the crowd. As traders, it’s a near necessity to have at least somewhat of a contrarian mindset, but you also have to know when to blend in with the environment if you ever want to survive. But even if you’re riding in a strong trend, you have to question when it might end. You have to manage your risk and you have to adjust your stops regardless of how strong the move is, or else even your best laid plans will prove ruinous. But when we can find a trend, or perhaps more accurately described as a ‘theme’ in a market, well that’s something that we can plan around.

A good example of this was Abe-nomics coming to play in Q3 of 2012. As Shinzo Abe took power in Japan and brought with him an aggressive plan of economic revitalization, the Yen weakened massively on the expectation of a massive QE program. This also brought the Nikkei higher, and for the better part of 3 years those trends in the Yen and the Nikkei remained strong and traders could simply wait for a pullback, load up the position, and scale out as price action moved in their favor. Wash, rinse and repeat. These types of trends can make the trader’s life a lot easier because analysis can be reduced to ‘buy low, sell high.’

Chart 1: A Weak Yen Provided a Huge Boost to Japanese Stocks

The Real Bain of Equity Markets is Actually a US Dollar Problem

Created with Marketscope/Trading Station II; prepared by James Stanley

Unfortunately, it doesn’t always work this way. But when it does, you can bet that hedge fund managers around the world can hardly contain the drool from dropping on their keyboards. It just makes life as a trader or portfolio manager that much easier. It looked like we may have one such trend as we came into this week, as much of the world was bracing for an impact of a slowdown or a recession, and there was one notable exception that was sort of ‘sticking out’ in the market. And that was the Fed’s continued expectation to continue raising rates while much of the world is looking at ways to lower their own.

And this brings up the real issue for global markets right now: At its lowest common denominator the problem that the world has been unable to solve that’s been brewing all along is a currency problem. Devaluations are getting more and more competitive, and Mr. William Dudley of the New York Fed tipped his hand this week when he said that continued strength in the US Dollar threatened the prospect of a continued recovery in the world’s largest national economy.

Most major economies, right now, are looking at ways to avoid capital flows into their currency. A strong currency means weakness in trade. If the value of the Yen moves up by 20% against the US Dollar, well Toyota is getting back 20% less for every car they sell in the United States. They did nothing wrong here and yet they’ll still get hit by 20%; and it’s just because of the USD/JPY spot rate. So analyze Toyota all you want, look at their EPS growth and market share – it’s all pointless if the Yen strengthens by 20% because people will likely not purchase a Toyota for 20% more and Toyota likely can’t go and just cut 20% of its budget to protect its margin (especially with Japan’s onerous labor laws and lifetime employment offered by many companies in the hey-day of the 80’s); so like it or not Toyota (or other Japanese exporters) will probably take a hit.

Chart 2: Japan’s ‘Lost Decades,’ a Strong Yen brought significantly lower stock prices as exporters faced mounting pressure

The Real Bain of Equity Markets is Actually a US Dollar Problem

Created with Marketscope/Trading Station II; prepared by James Stanley

Analyzing a company without looking at currencies and trade exposure is an antiquated model that will soon be as dead as the dinosaurs. Welcome to a truly globalized economy.

So, just from these simple two examples you can probably see why a strong currency is such a threatening thing. Because even with the most expertly-designed plan executed with the daft maneuvering of a cheetah, it’s unlikely that an economy will succeed if constant pressure is being added to their trade flows with a stronger currency. With the heavy stock and share focus around the world, a lot of people lose sight of this fact. But it’s like trying to swim up-stream, or, to put it in a more relevant manner, it’s like a trader trying to fade every move on the chart. If you constantly sell when prices go up or constantly buy when prices go down, you’re probably going to have a bad time.

This is probably why Japan made that move to negative rates last week, and this is where the drama begins to thicken. Europe made the move to negative rates last year to go along with their QE program because, frankly, the economic situation on the continent is rather dire. Depression-like symptoms are continuing to be seen in Southern Europe with rampant unemployment, and there are some very legitimate questions about the sustainability of the single currency as the stalwart of the zone, Germany, begins to see political volatility.

So, when the ECB went negative, this was a clear deflection of capital flows to Japan and the United States. Capital only has so many places to flow, so when the ECB started charging Euro banks for deposits, the design was to get those banks to go and loan that money to individual people in the effort of re-invigorating their economies. Instead, the banks just moved that money into the US or Japanese Central Banks. This is why that Yen weakness all of the sudden came to a halt last year, and this is why the US Dollar continued to throttle higher throughout the year despite the fact that we didn’t get a rate hike until December.

What does this do to American and Japanese companies? Well, it makes it harder for them to sell goods outside of their domestic economies. This is/was additional pressure, being borne from the ECB’s move to negative rates as capital flows left Europe and looked for new homes at banks that weren’t charging them money just for staying in cash. But Japan’s seen this story before, right? For a +20-year period, the Yen strengthened as an aging and retiring population repatriated their Yen. Abenomics provided the first real ray of hope, and this was like a gift to Japanese companies as the Yen weakened and made for a very amenable export-environment. But as the prospect of a stronger Yen came back into the spotlight, all of that work over the past three years began to look questionable. We had discussed this last year in the article, the Yen as the safe-haven vehicle of choice. As we shared in that piece, continued weakness in the Chinese economy would likely lead to further capital flows out of the country. Likely, a good portion of that would’ve aimed for Japan as the two nations are close trade partners.

But Japan looked to proactively offset that by making the move to negative rates. This left the US as one of the few attractive areas for safe-haven flows to run towards. The United States was not only paying interest on deposits at the Fed, but they were even looking at hiking a full four times in 2016 while the rest of the world was looking for ways to weaken their currency.

The United States and the US Dollar stuck out in a very obvious way. If you’re a bank in Europe or Asia – why wouldn’t you funnel money into your American branches in order to deposit it at the Fed in order to make money as opposed to being charged?

This just leads to more USD-strength. Sure, Toyota’s happy and Europe is happy because their currencies are weakening; but that American economy that both are depending on in order to recover, well it’s going to take a hit because of that stronger dollar. Because now American exports come under fire and American companies take the hit as Japanese and European companies have clear competitive advantages with a weaker currency.

And until this week, we didn’t really have any buffer or response from the Fed on this fact, and this just led to even more USD-strength as investors continued to direct safe-haven flows in treasuries and US bank deposits. We warned that something along those lines might be coming in the article, Stocks Still Falling, Fed Still Talking. On Wednesday we saw this finally happen when Mr. William Dudley, president of the New York Fed, said as much. He indicated that higher rates would lead to a stronger dollar which, may eventually, put the US economy on a recessionary track as well. This was largely being construed as the much-awaited sign of submission from the Fed that four rate hikes in 2016 were probably not going to happen.

The dollar weakened dramatically for two days, and ran directly into support of a bull pennant formation that we discussed yesterday (updated chart shown below):

The Real Bain of Equity Markets is Actually a US Dollar Problem

Created with Marketscope/Trading Station II; prepared by James Stanley

So is the Dollar Ready to Fly or Die?

This all depends on the Fed, and likely, Mr. Dudley is the one sticking out from the crowd right now. In separate speeches this week, both Ms. Esther George and Ms. Loretta Mester discussed how rate hikes are still very much on the table. So, the Fed backing off is far from a foregone conclusion. As a matter of fact, there is a very strong case to be made for their motivation to raise rates, as six years of ZIRP and low rates have added massive and significant pressure on pensions and retirees.

But this will likely not end well. Continued talk of higher rates will only bring more and more strength into the US Dollar until, eventually, the American economy is recessing right along with the rest of the world. And if the Fed does back down, well all of those other problem areas that are looking to solve their ills with export-led recovery and weaker currencies get that pressure right back on their table. It puts precarious areas like Japan and Europe back into the spotlight, as companies in these economies get to struggle with the banes of a strong currency.

And further to that point – even if the Fed did have a magic button that they could press to un-do the rate hike in December and remove some of this stress from global markets, would that necessarily be a good thing? It’s becoming increasingly obvious that QE did more to inflate asset prices than it did to generate growth in the ‘real economy.’ Doing another round of QE would simply add more air into the numerous potential bubbles in the global economy, and this would likely just increase the pain factor down the road when a slowdown inevitably hit the global economy.

So there is no easy answer here. Stocks hang in the balance because the world has a massive currency problem to deal with. Every economy wants a weaker currency to turn the corner and it doesn’t appear as though we’re close to any element of coordination between Central Banks. This brings up the risk of even further competitive devaluations.

One area of attractiveness for such scenarios is often Gold, as gold can’t be debased. This doesn’t mean that Gold is *always* attractive as many ‘gold-bugs’ would allude to, but in an environment where inflation is flagging, interest rates are under pressure and the world is getting more and more frightened of a recession, Gold has traditionally performed well. We wrote up an extended piece on Gold yesterday that you’re more than welcome to delve into.

In regards to the US Dollar, the trend is still up and will likely remain as such until we get more confirmation of dovishness from the Fed. These Central Bank speeches and pieces of commentary are getting harder and harder to deduce, so an easy way of following this theme is just watching price action on the chart. USD is still trending higher, so look for ways to ‘buy low and sell high’ in the hope that this trend continues to develop.

If it breaks, no sweat; that’s what stops are for. And as soon as that USD up-trend breaks, look for ways to get short (sell resistance at old support). The chart below illustrates a nearly-identical scenario from Q1 last year.

The Real Bain of Equity Markets is Actually a US Dollar Problem

Created with Marketscope/Trading Station II; prepared by James Stanley

--- Written by James Stanley, Analyst for DailyFX.com

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