April Review & Looking Forward (Part 2: Strategy)

Continued From Part 1...

In Part 1 of this note reviewing the eventful month of April, we spoke about how the tide was shifting in many of the developing economies with Europe's economy and financial conditions showing good signs of improvement while the American economy was undoubtedly slowing.

  Reversal Of The Long Dollar Consensus Trade:  According to Cornerstone Macro, there are 5 thematic trades that could be the result of a turn in the dollar's trend. As one of the world's largest one-side trade reverses, several opportunities might evolve.   They include a risk-play trade (risk on vs. risk off), input to output chain trade(commodities vs. consumer), yield curve spread trade (steep vs. flat), volatility trades (low vs. high), and geographical sales trade (foreign vs. domestic).  Most of these strategies involve the dollar somehow, either directly or indirectly, and through cost and sales factors on the micro level or intermarket correlations on the macro level.  What we are certain of is that the long dollar consensus trade has sucked up a lot in its path, and a reversal would mean much more than a weaker dollar but trillions in notional tied up to these sort of positions to be unwound en mass. Not pretty.   Chart courtesy of Cornerstone Macro

Reversal Of The Long Dollar Consensus Trade: According to Cornerstone Macro, there are 5 thematic trades that could be the result of a turn in the dollar's trend. As one of the world's largest one-side trade reverses, several opportunities might evolve.

They include a risk-play trade (risk on vs. risk off), input to output chain trade(commodities vs. consumer), yield curve spread trade (steep vs. flat), volatility trades (low vs. high), and geographical sales trade (foreign vs. domestic).

Most of these strategies involve the dollar somehow, either directly or indirectly, and through cost and sales factors on the micro level or intermarket correlations on the macro level.

What we are certain of is that the long dollar consensus trade has sucked up a lot in its path, and a reversal would mean much more than a weaker dollar but trillions in notional tied up to these sort of positions to be unwound en mass. Not pretty. 

Chart courtesy of Cornerstone Macro

We also spoke about macro economic cycles and how such polarities in the major economies have created exclusive opportunities in the financial markets.

With the current market climate hallmarked by panic, fear, and ephemeral swings, we have identified a couple of opportunities over the last couple of weeks that look promising in their own rights. In the last 2 weeks alone, a few records have already gone down the record books. 

Reading through anecdotes on various news wires reveals the sentiment behind the recent corrections in asset prices. Sentiment that is synonymous with fear, panic, and other esoteric forms of self harm.

We say this because we feel this is heaven for opportunists.

In today's note, we wish to share our views and ongoing opinions on how we view the current market landscape and the strategies that we are and will likely be implementing to take advantage of the substantially different dynamics in today's environment.

Bottomline

For those short on time, we have complied the following key points that outline our baseline views and which shape our strategies going forward. 

In brief, we are compelled to build a short dollar position against a set of currencies we seem to be fundamentally superior, all while being mindful that bursts of volatility in the dollar and dollar-based assets should be expected. 

We are mostly neutral on the euro, and prefer to establish pair trades involving the currency. 

We feel the recent selloff in global equities, notably Europe, should be bought with caution but are bullish in the mid to longer term. American equities will remain bid but might continue to trade in a range for a while.

We are bullish on crude oil as we outlined in our January note calling the bottom in oil prices. For reference, read our March note where we called for an inflection point in oil prices near the end of the last down leg.

Instead of going outright long on crude oil, we prefer to establish a similar exposure with currencies of major oil exporting economies, chiefly the Canadian dollar and the Norwegian Krone. The idea is to hedge out some volatility that is native in commodities, especially energy.

Overall, most of the market moves we saw in April were amplified by strong technical factors such as acute phases of massive liquidations where heavily one-side trades (long dollar, short euro, short oil) were unwound, all inside a market that was thin on liquidity. Fundamentally, not much as changed, but the market makes it seem like a lot has with price action. 

  • Intermediately bearish US dollar, long term bullish; expect volatility
    • Massive unwinding of long dollar positions, strong inertia remains 
    • Weak US economic data vis-à-vis expectations;
    • Very weak 1Q15 GDP growth, blamed on weather and "transitory" factors;
    • Strong dollar adversely affecting US trade balance; latest data shows largest deficit in 6 years, largest deficit on record ex, petroleum exports;
    • Corporate earnings suffering due to expensive dollar;
    • April FOMC statement leaning more dovish, date reference to rate "liftoff" removed;
    • Long term bullish view on basis of eventual rate hike in October or later
  • Intermediately neutral to slightly bearish euro
    • Improving European economic activity and growth;
    • ECB revised higher inflation and growth forecasts;
    • ECN reference rates will not be lowered further;
    • PSPP on track, firm commitment by ECB to maintain purchases;
    • Remote possibility of enlarging PSPP size will limit euro downside;
    • Comments by Draghi challenging market to short euro seems to have set floor under euro;
    • Largest short euro consensus trade ever winding, technical flows out of short positions continue to put upward pressure on prices;
    • Selloff in European (mostly Germany) stocks and bonds amplifying effect of short squeeze in euro;
    • Greek crisis bears low contagion risks
  • Cautiously bullish global equities with preference of US stocks
    • Selloff in European and Asia-Pacific equities mostly technical, offers buying opportunities but risks remain;
    • Preference of US stocks as dollar rebalancing continues;
    • Timing of Fed rate hike largely irrelevant; rotation from treasuries/bonds to equities will pick up in 2H15, stocks to benefit;
    • Global economy in slowdown but far from being recessionary;
    • Global central bank easing cycle has climaxed, backstops are largely in place, downside risks in equities muted
  • Intermediately bullish crude oil, upside fairly limited
    • Fundamentals slightly changed; production growth in US finally stalling, OPEC policy softens;
    • US oil and petroleum reserves seeing declining marginal increases, first draw in Cushing inventories;
    • Saudi-Yemen conflict places slight upwards pressure on prices;
    • Majority of bullish momentum result of unwinding short positions;
    • Technical price action formations on Brent & WTI puts upper $60s and mid $60s into target, respectively;
    • Original fundamental impetus of slowing global demand amid increasing supply has died off;
    • Weaker dollar to support higher prices
  • Bullish oil & energy currencies as alternate proxy for long oil play
    • Safer to hedge volatility in direct exposure to oil with currencies of oil exporting nations;
    • Preference of Canadian dollar, Norwegian Krone;
    • Fundamentals of major oil exporting economies improving healthily; bolstered by surge in oil prices (WTI +24% in April);
    • Bank of Canada sees strengthening Canadian economy partly due to pick up in oil revenues;
    • Bank of Canada has no intentions to ease monetary conditions with further rate cuts;
    • Canadian economic data improving steadily; inflation expectations gradually rising;
    • Norway also improving economically; propensity of central bank to leave rates as they are;
    • Pick up in demand from Eurozone seen to boost Nordic economies

King Dollar Dead, Sinks All Boats

If the saying is true that a strong tide lifts all boats, then a weak dollar should also sink all boats. Precisely this has happened.

Starting off with currencies, there is no question that market participants across the wold have been fixated on the greenback, more than anything else. The month of April saw incredible choppy trading in the major currencies but it was mostly the result of confusion onboard the long dollar consensus trade, in our opinion.

“At some point the stress on stocks, risk assets, from either earnings fears or higher rates surely has a stalling effect on the panic in the bond market and we say panic with emphatical deliberation. Nothing excuses this rout beyond the emotions of pained positions which, largely, are in markets other than Treasuries,” CRT strategist David Ader says in note.
“Cooler heads, and we count ourselves amongst them, point to liquidity and VAR constraints on dealer desks that make these moves more exaggerated than they might have been a few years ago”
Market is in a mode of “high volatility with no dealer liquidity and easy excuses but not, yet, thematic ones” as “gyrations of the past month or so have thrown people into a tizzy and certainly upset positions elsewhere, like in Bunds and the dollar, but we’re are just the derivative and don’t see that things have changed so much to warrant more of a selloff”
— Bloomberg
  US Trade Balance Ex. Petroleum:  The latest trade figures out of Aerica showed that net trade, exports less imports, fell to a 6-year low of -$51.37bn in March. This was the largest trade deficit since 2009.   Factoring out net petroleum exports, the deficit fell to the largest on record. This is perhaps a sign of the negative effects a strong buck brings.  Chart courtesy of Zero Hedge

US Trade Balance Ex. Petroleum: The latest trade figures out of Aerica showed that net trade, exports less imports, fell to a 6-year low of -$51.37bn in March. This was the largest trade deficit since 2009.

Factoring out net petroleum exports, the deficit fell to the largest on record. This is perhaps a sign of the negative effects a strong buck brings.

Chart courtesy of Zero Hedge

For a long while now, we have been bullish the US dollar for reason orbiting a rather hawkish Fed and an ECB that was firm in its path of monetary easing. Up till March, the long dollar trade was actually playing out well and bulls were generously rewarded. Back in December 2014, we opined that shorting the euro against the dollar was the easiest trade all year.

However as we transitioned into April, things started to shift; markets were becoming nervous about the overly crowded trade that was being long the dollar. With US economic figures missing like a retired Marine sniper Marksmen way past his prime, we had every reason to bear skepticism. The flummoxing twist had always been what the market was telling us through price action, and what we were seeing through our own eyes.

The straw that broke the camel's back for us was March's extremely dismal non-farm payrolls report in which only 129,000 jobs were added when the market was calling for 245,000. We covered that critical development in this note; readers are encouraged to digest what we said back in the beginning of April because it contains anecdotes that we will be espousing in this outline.

On 5th April, we called on dollar weakness and warned that its intermediate bullish trend had likely climaxed.

For a long while now, we have been bullish on the US dollar. Our premise was mainly based on the relative strength of the US economy, and on the Fed’s guidance and propensity towards monetary tightening while most of the world’s other central banks have embarked on their respective paths of loosening monetary conditions.

However, having been through the volatility in both the financial markets and on the economic front, we are on the precipice of shifting our stance to being intermediately bearish the dollar. We will not discus our premise for this shift in stance, but we will briefly summarize.

We feel the long term trend in the US dollar is still up. Only a significant change in Fed interest rate and monetary policy guidance will be a large enough catalyst to alter this fundamental trend. However, the market looks as though it is heavily imbalanced at this point, especially when we take into account Friday’s dismal jobs report and the flurry of previous misses on consensus.
— Business Of Finance, 4/5/2014

Market calls aside, we foresee continued weakness in the dollar for the intermediate time frame. This bias is founded on the premise that the market should continue adjusting to decelerating economic growth in the US, as well as a cooling labor market, which was once the strongest pillar of the recovery.

April's FOMC statement was also quite telling. The committee decided to ditch any sort of date reference for a rate hike, although they did not reinstate "patient" as part of their language

  US GDP Breakdown:  Preliminary 1Q15 GDP slowed to 0.2% QoQ, down from 4Q14's 2.2% and missing expectations by a mile following a harsh winter in January and February.   The weaker growth overall was attributed to a drop in consumption growth and decline in exports. Offsetting some of that was a surge in private inventories.  Chart courtesy of Zero Hedge

US GDP Breakdown: Preliminary 1Q15 GDP slowed to 0.2% QoQ, down from 4Q14's 2.2% and missing expectations by a mile following a harsh winter in January and February.

The weaker growth overall was attributed to a drop in consumption growth and decline in exports. Offsetting some of that was a surge in private inventories.

Chart courtesy of Zero Hedge

The FOMC cited the weak 1Q15 GDP growth (0.2% MoM vs. 1.2% exp.) as the result of "transitory" factors along side the weather (a colder winter than usual). Recall that in Part 1 we stated that GDP growth figures were backward looking, and that whatever that was reported has actually happened lot ago.

Saliently, the 1Q15 GDP figures cemented the observations across numerous economic indicators, that momentum was decelerating rapidly in private sector and business activity

  Private Fixed Investments:  CapEx growth has slumped amongst US colorations in 1Q15, marking the first negative growth over the previous quarter since 1Q11.    Chart courtesy of Zero Hedge

Private Fixed Investments: CapEx growth has slumped amongst US colorations in 1Q15, marking the first negative growth over the previous quarter since 1Q11.  

Chart courtesy of Zero Hedge

Looking into the components of last week's GDP print, private consumption grew only by a tiny amount, partially offset by a surge in healthcare spending (à la Obamacare). The juggernaut however was the collapse in fixed capital investment growth by private sector corporations (CapEx, or capital expenditures); such a downturn in capital expenditures normally signifies weakening confidence and outlook by businesses.

Apart from macro economic fundamentals, we should not underestimate the effect of technical factors. Said technical factors being the unwinding of one of the most crowded consensus trades ever to bestow the modern financial markets. 

Futures and options data from the respective US exchanges show that net positioning amongst speculators had reached extreme longs on the dollar, especially against the euro. It came to a point where both sentiment and positioning reached such a fever pitch that the currency markets (EURUSD) became hugely imbalanced, and unstable.

While open interest in long dollar positions have come down in the last 3 weeks, we suspect the market will now be faced with a dearth of committed buyers. The sheer unpredictable nature of the markets has deterred many market participants. In fact, we actually anticipate the arrival of fresh dollar bears

Technically, price action of the dollar index tells us that the trend is incontestably in bear territory for at least the next 2 months.

As such, we are compelled to shorting the dollar with caution and prefer to do it against fundamentally strong currencies whenever we get tactically corrections in the currency crosses we watch. Notably, and as stated in the onset, we like going long oil currencies such as the Canadian dollar and Norwegian krone; both of which have been stellar performers (read the aforementioned Bottomline for details). 

We suggest diversifying risk across a basket of currencies to muffle out volatility.

Ultimately, as we near year's end the dollar will likely start to regain the bullish composure that has been lost in the current flurry of developments. Until then, we favor a weaker dollar.

Euro Rebalancing, Offers Attractive Premiums

One of the strongest currencies in the second half of April was the euro, and that has left many traders exasperated. 

  EURIBOR Goes Negative:  The cost of unsecured interbank lending is now in negative interest rates for up to 3 months.   The EURIBOR, or Euro Interbank Offered Rate, is the average rate which banks charge each other and is deemed to be most important reference rate in the European money market.  The average cost of borowing for 1 month in the euro money markets stands at -4.6bp, 7/5/2015. This means banks get paid interest to borrow, and pay interest to lend.  When we talk about the fundamentals of the euro, this is what we actually mean. There is almost too much liquidity in the euro banking system, and a relatively strong euro does not fit this bill.  Chart courtesy of Zero Hedge

EURIBOR Goes Negative: The cost of unsecured interbank lending is now in negative interest rates for up to 3 months.

The EURIBOR, or Euro Interbank Offered Rate, is the average rate which banks charge each other and is deemed to be most important reference rate in the European money market.

The average cost of borowing for 1 month in the euro money markets stands at -4.6bp, 7/5/2015. This means banks get paid interest to borrow, and pay interest to lend.

When we talk about the fundamentals of the euro, this is what we actually mean. There is almost too much liquidity in the euro banking system, and a relatively strong euro does not fit this bill.

Chart courtesy of Zero Hedge

With the ECB etched firmly in the path of QE, it makes little fundamental sense to be bullish the currency apart from technical reasons

We believe the reason for the euro's strength is the mammoth short squeeze in the last 2 to 3 weeks, coupled with improving European economic data and comments from Mario Draghi which served well to defend bulls.

The capitulation in the currency market was the single most impactful event that rattled markets all over the world, we believe. Global stocks and bonds have all corrected sizably as a result of this colossal shift in market sentiment and positioning. 

In such a case, we feel that the euro now trades at a fair discount to what fundamentally-link models (such as the swap spread model) imply. 

Our bias is slightly bearish to neutral for the intermediate future. Although we favor shorting the euro, we are selective about the counter currencies that the euro should be sold against. 

We are bullish on the EURUSD pair and would not suggest traders try to time a short there. Our preference is to short the EURCAD and EURNZD pair once upside momentum weakens.

It is a prerequisite that the euro should only be sold against a fundamentally strong currency, preferably of countries whose central banking policies lean towards tightening.

More Strategies To Come...