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It’s Not Panic if You’re the First One Out the Door

It’s Not Panic if You’re the First One Out the Door

James Stanley,

Talking Points:

- The US Dollar has been extremely volatile since last Friday’s comments from Mr. Eric Rosengren, who is considered to be a ‘dove,’ surprised markets with a hawkish outlook ahead of next week’s FOMC meeting.

- Central Banks around-the-world are heavily engaged with elevated asset prices across many macro risk markets; and the simple threat of that support waning or being removed has a tendency to provoke selling as years of build in asset prices unwinds very quickly.

- If you’re looking for trading ideas, check out our Trading Guides. And if you want something more short-term in nature, check out our SSI indicator. If you’re looking for an even shorter-term indicator, check out our recently-unveiled GSI indicator.

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Lael Brainard spoke at a widely-awaited speech yesterday in what should be the last prepared remarks from a Federal Reserve member ahead of next week’s rate decision: This is known as the ‘blackout period’ for FOMC, in which the bank attempts to limit public appearances and planned speeches in the effort of not tampering with market expectations around a rate decision.

And while Ms. Brainard’s comments were relatively dovish, it would appear that she wasn’t as dovish as what markets were looking for as the US Dollar has continued to run higher since she spoke; and that furthers a theme that’s been rather prevalent since last Thursday when the Greenback bounced off of a key zone of support. We looked at that setup in the US Dollar last week in the article, Is the US Dollar Done Until December; and as we said, despite the fact that a hike in September looked very unlikely, the Dollar was likely going to remain volatile as driven by FOMC commentary around near-term rate decisions, particularly next week’s meeting on September 20-21.

Shortly after that article was published we heard from another Fed member that seemed to catch markets by surprise when Eric Rosengren of the Boston Fed alluded to the fact that low rates may be bringing on more risk in the Fed’s outlook than an actual rate hike. This may be seen as somewhat similar to Alan Greenspan’s ‘irrational exuberance’ comments near the top of the tech bubble as the prior head of the Federal Reserve tried to explain the outlandish valuations that were being traded in technology stocks at the time. The Fed is aware that loose monetary policy can drive risk markets higher; and should policy stay too loose for too long, moral hazard can increase as investors, banks and even pension funds take on considerable risk under the guise that the Fed will continue to support the trade with low rates.

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

But when the bank does inevitably hike or attempt to ‘normalize’ policy; that can produce a cascade of selling as investors built-in to that trade all rush for the door at the same time. We saw a hint of this in American equities on Friday after Mr. Rosengren’s comments, and this is very similar to the selling that we saw in the beginning of the year after Ms. Yellen had shared a similar comment in December, alluding to the fact that more risk may be present, longer term, with low rates rather than with a path of ‘normalization.’ This gave markets the idea that the Fed was going to hike even with slowing data, and within two weeks of that comment coupled with the first rate hike in nine years, we saw risk markets collapse at the beginning of 2016 and the selling continued until Ms. Yellen appeared to capitulate on rate hike plans at her twice-annual Humphrey Hawkins testimony in February.

As a hypothetical, we can look at the German Bund which is actively being bought and supported by the ECB. If you’re a hedge fund manager and German Bunds are trading at 2%, and the ECB says that they’re buyers until yield goes to -.2%, well you have a pretty good idea that a big market player is going to be supporting the trade and buying right behind you. As long as the ECB is long and still buying, you can probably feel pretty comfortable in the trade. But, of course, you’re not the only one with this bright idea, so the collective effort of the market will likely move that yield pretty close to the ECB’s target rate in short order (which is exactly what happened).

And this is all fine and well – that is, until the ECB decides to no longer buy German Bunds. When markets get the slightest hint that the ECB will stop buying (and supporting) and that yields may rise, we’ll see investors beginning to sell. And then losses get the attention of other long positions, and that can elicit even more selling. And without the Central Bank there as a support structure, there isn’t really anything to stop or stem the selling. This is the hallmark of a ‘bubble’ on the verge of bursting as a pivotal support structure gets removed from a built-in trend of a longer-term trade.

This can get so profound that even a simple lack of additional buying from the ECB has elicited selling in the Bund. On the chart below, we’re looking at Bund prices over the past couple of years, with annotation of price action since last Thursday’s ECB announcement in which the bank did not extend their €80 Billion/month bond-buying program. We’ve also plotted the past four interest rate cuts deeper into negative territory from the ECB, with each cut provoking more and more buying in the German Bund.

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

The big question here, and this is what the world doesn’t yet know, is what happens when a major globalized economy attempts to ‘normalize’ policy after years of QE and low rates have driven asset prices to historically astronomical levels. The simple act of the Central Bank no longer buying bonds can create selling in risk markets, just as we saw with the ‘taper tantrum’ when the Federal Reserve whittled-down their QE purchases. But once the bank begins to raise rates, or, to put it in another way, once the bank actively starts trying to work rates in the opposite direction of the trade that they just supported for 5+ years, we’re likely to see some fairly aggressive selling as investors all try to rush for the door at the same time.

Nobody knows how all of this will pan out because quite simply the world has never seen this situation to this degree, which is probably one reason why we’ve seen so much risk aversion around potentially hawkish Central Bank moves of recent. But as clues and innuendo point to additional tightening out of the Federal Reserve, we’ll likely see further selling in key risk markets such as equities. And should the Federal Reserve go with the widely-expected ‘hawkish hold’ at next week’s meeting, we may just see a recursion of last year’s September FOMC announcement, in which the Fed didn’t hike rates but warned that hikes were coming; and the market response was even more risk aversion.

The next FOMC meeting kicks off in one week, and that next policy announcement takes place next Wednesday at 2PM ET with the press conference starting 30 minutes later. This is a meeting that you don’t want to be caught flat-footed for.

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

--- Written by James Stanley, Analyst for

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