Risk Trend Talking Points:
- Risk assets enjoyed a hearty bounce as volatility measures eased as the markets continued to digest trade wars risks without indigestion
- Without financial volatility, there is little pressure on the Fed to accelerate rate cuts and fulfill Trump's demand for a lower USD
- Italian political risks are heating up for the Euro, UK PM Johnson says he is ready for an election, and the Loonie faces jobs data
What do the DailyFX Analysts expect from the Dollar, Euro, Equities, Oil and more through the 3Q 2019? Download forecasts for these assets and more with technical and fundamental insight from the DailyFX Trading Guides page.
Risk Trends Continue to Gain Traction as US-China Trade War Escalation Amnesia Kicks In
It has been the default for some years that when fundamental headwinds are not steadily building, the market has a tendency to take on more risk - in turn signaling risk appetite. That is not so much a statement of a prevailing enthusiasm on the outlook, indeed the forecast for returns and economic activity continue to explicitly fade. Instead, it is a holdover of presumed transference of risk onto entities such as central banks while market participants feel empowered to chase yield in a powerful heat of FOMO (fear of missing out). That norm is once again showing itself just days after the US and China - the world's two largest economies - have escalated their trade war to increasingly eye-watering heights. Through Thursday's close, the S&P 500 and Dow led another rebound in speculatively-leaning assets with neat technical reversals from trendline support. And, just to reassure that this wasn't just an equities or US-centric recovery, we would see similar relief in global shares, emerging market assets, carry and a host of other benchmarks.
Chart of S&P and Rate of Change (Daily)
Chart Created with TradingView Platform
The phrase 'this time is different' is often proferred as rebuke against market participants that continue to doubt a prevailing trend. It is certainly being used by long-standing bulls who have were relieved to see the sharp decline end and question by bears would take the drop seriously. With indices rebounding and implied (expected) volatility measures easing, it would seem a familiar pattern that rewards complacency. Yet, in our current circumstances, the benefits of skepticism should be a little more apparent. Vigilance is warranted when we are contemplating diving into a record high (expensive) market when the outlook for growth an return are already soft and weakening. Certainly, it's possible for the markets to ignore risks for a little while longer - perhaps through this height of summer complacency that we are entering - and earn a few more basis points on capital gains. Yet, that doesn't make for a good return when the risk is that the reality of value dawns. I asked in a poll after this recent S&P 500 rebound whether traders expect we will hit a fresh record high again this year or if the June peak would stand. During the height of the pullback, the majority was prompted by the momentum to shift towards the bears. Yet, a similar question posed after Thursday's rebound offered the same perspective.
Trump Struggles with a Paradox Between the Trade War, Risk Trends and the Dollar
With the ebb in fear taking over through the second half of the week, there is a noticeably retreat in expectations for Fed rate cuts. Given that US inflation is relatively close to forecast and the economy is still running at full employment according to the central bank's preferred measure, prompt for easing would need to come through external risks that could reasonably impact the group's dual mandate. Though the Fed doesn't state it specifically, there is certainly observation of financial market concerns which could translate into tangible economic issues if they persist. In other words, high volatility and/or a strong pullback in benchmark risk measures can spur the policymakers into action. Yet, that equation works both ways. If risk aversion is not building a head of moment, there is no reason the central bank needs to aggressively reverse course on its monetary policy regime. That is an annoyance for President Trump.
Chart of S&P 500 and Fed Funds Futures Contract for December in Red with Correlation (Daily)
The US President has attempted to bully Fed Chairman Jerome Powell and his colleagues into a steep rate cut regime over the past few months to afford a quick Dollar depreciation that could more effectively project the influence of the trade war measures applied against China and various other trade counterparts. The fact that such a course reversal could spark enormous volatility and have long-lasting implications for the credibility of the central bank doesn't seem a particular concern for Trump. This past session, the Leader of the Free World was the wires once again saying that he was not "thrilled" by the high level of the Dollar which he attributed to the stubborn policies of the Fed. Eventually, the administration may decide that the only way to render response from the central bank is to stir volatility, which would be quit dangerous to US and global financial stability. Then again, a government-led intervention aimed at manipulating the world's most used reserve that in turn sparks a currency war could be even more disastrous to our financial stability.
Chart of DXY Dollar Index and 5-Day to 20-Day ATR Ratio (Daily)
As Liquidity Thins and Systemic Themes Like Monetary Policy and Economic Health Worsen
Through the month of August, liquidity tends to flag through a self-reinforcing expectation of holiday-bound market participants that encourages the speculators still present to set their portfolios to autopilot. Separating performance by calendar month, August is by far the lowest average volume (trading day adjusted) month of the year for the S&P 500. In turn, speculative performance measured by the index's average change is also exceptionally modest - though with a bullish slant. Against this backdrop, fundamental swells can exert far greater influence. Where the Fed is still considering how fast it can turn tail without losing credibility, we are seeing a host of other central banks committing to softer policy regime attempting - to some extent - to leverage greater effect by being more dovish than counterparts. Just this week, we saw the RBNZ cut rates by 50 basis points, the Reserve Bank of India drop its benchmark to an eight-year low and the Central Bank of Thailand shave 25 basis points off of its own baseline. The curve is shifting lower.
Chart of Seasonal Change and Volume by Calendar Month for S&P 500
A more rudimentary pain is coming through the state of global economic activity. The outlook for growth is fading fast against a backdrop of competitive economic policies Looking for market-based health reports, the 30-year US Treasury yield sunk close to its record low this past session which bodes poorly for the outlook for the world's largest economy. Further, the Wall Street Journal conducted a survey of economists which found a third of its participants expected a recession from the US economy within the coming year while nearly 88 percent of the group said risks were tilted to the downside. Elsewhere in the world, Japan's economic sentiment survey dropped deeper into negative territory while the ECB's economic bulletin flashed familiar warning signals. Ahead, the Japanese and UK GDP figures will speak to official readings of economic health that will come loaded with skepticism.
A Return to Local Fundamentals for the Euro, Pound and Canadian Dollar?
Not all that is fundamental will converge on the systemic. One of the fringe benefits of a market that is agnostic to the systemic issues owing to liquidity pressure is that more rudimentary issues can wrest control of localized currencies and regional assets. The Euro may finally play more than the role of the Dollar's principal counterpart through the close of this week. Late this past session, news crossed the wires that the Italian Deputy Prime Minister Matteo Salvini seemed to signal that he would call for an election as his coalition government struggles for a way forward. This may put EURUSD back on pace for following the Italian-German 10-year government bond yield spread.
Chart of EURUSD and German to Italian 10-Year Yield Spread (Daily)
Meanwhile, the Sterling is still drifting in the wake of headlines that show a UK government that seems dead-set to push a no-deal outcome unless its EU counterparts repent. Yet, issues like the backstop are drawing out trouble locally for Boris Johnson and crew. It was reported this past session through sources that the PM was ready to hold an election should any no confidence vote brought to vote succeed. There isn't really a need for further uncertainty in this already harried market, but it will carry its weight nonetheless. Through Friday, Brexit headlines are always on the radar, but we also have a range of data that should be considered. On tap, we have June (and 2Q) GDP along with trade, industrial production and construction figures for the same month - a good outline of the economy's health.
Chart of EURGBP (Daily)
A sleeper currency that could tap its own fundamental docket for volatility is the Canadian Dollar. With the RBA and RBNZ taking center stage for their very dovish monetary policy actions and statements, the Bank of Canada remains one of the very few 'commodity bloc' central banks still holding course against the dying light of normalization. That puts a greater emphasis on key data like the monthly employment statistics that we are owed through Friday. I won't be looking for systemic updates from the data, but substantial deviations from forecast are always good for at least a jolt of volatility. We discuss all of this and more in today's Trading Video.
Chart of USDCAD (Daily)
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