Well what do we have? Quite a lot really. I was on the foothold that 2013 was one of the busiest years in terms of geopolitical and macroeconomic developments (material and jawboning inclusive). I was promptly proven wrong. One more month till the closure of 2014 and so much has transpired. Looking back, there has been a vast swathe of events that have stirred intrigue, but what is more amusing to my eyes is the consistency of mass psychology surrounding these events. Be it the disappearance of flight MH370 (which at last check has still not been found after nearly 9 months of extensive search operations), the annexation of Crimea and the other Oblasts by the Russian Federation preluding the now new normal Russia vs. rest-of-the-world malarkey, or the Federal Reserve's Taper (and subsequent end of its balance sheet expansion program), and of course the unprecedented spread of the infectious Ebola virus; these events have one general commonality: the driving mass psychology. Surely the advent of social media and mass mutual communication systems have been prolific tools which collectively expedited the process of like-mindedness.
I'm of course not a psychologist but it doesn't take a rocket scientist to figure out how perverse the herd instinct of humans have become. Gone are the days when individuals act on their own beliefs. We now share an increasingly larger pool of common beliefs which are ironically also shaped by a natural force. This natural force is evident in all social settings, in the financial markets, in politics, and of course in economic management on a grand scale.
A look at how the world's most successful money managers, investors, and traders (excluding those who enjoyed fleeting success only to see their equity curve hit nadir) will reveal one thing. That is they have independent thought processes, and will fully bear the brunt of their decisions vis a vis the markets, regardless of the outcome. Having personally been exposed (financially and emotionally) to the Silver bubble of 2011, and more recently the BitCoin bubble of 2013, I can tell you that there is an underlying reason why humans flock to the perceived safety of collective beliefs. The reason is simple - the herd reaction is the path of least resistance. It is simply wired in our frontal cortex; there is no utility in questioning why. And this is why, ladies and gentlemen, more than 95% of traders will eventually end up loosing money. The losses of the 95% fund the windfalls of the 5%.
Ever wondered why traders and money managers are generally frowned upon by society? Envy, and of course they serve as convenient scapegoats for those that loose money. Granted, I'm generalizing by some measure here, but the gist is true; it has been proven true over the decades of modern finance.
A broad example is illustrated by the CFTC's Commitment of Traders (COT) report published by the commission every week. This report covers the futures contracts that that on America's exchanges and reports the collective positioning of 3 specific groups of market participants: small speculators (retail); large speculators (institutional); and commercials (hedgers). The general observable patterns are hedgers tend to be in an extreme position against the prevailing trend when the market turns over, while the large speculators tend to be in an extreme position with the prevailing trend just before the market turns over. I'd like to phrase it my way: "Specs are right for the meat of the move but not at the turn, commercials are right at the turn but not for the meat of the move"
When you start connecting the dots you might get nudged in the right direction. I hardly see this concept being spoken on forums and blogs so I shall share it here.
Let's use the US dollar as a prime and current example. Everyone knows the greenback has been enjoying strength against just about all asset classes but equities and bonds. Latest COT reports show that traders are most short the € and the ¥ against the dollar and when summed up, the net position on the dollar is near a historic extreme. The impetuses of the long dollar trade is many-fold. The scaling back and termination of the Federal Reserve's QE program and increasingly hawkish forward rate guidance, and the disinflationary pressures in the commodity space coupled with stagnation in Europe and a technical recession in Japan being the strongest of them all.
So let's get this right, the fundamentals are well in place for a long dollar play. Think about it, America is one of the strongest economy (growth and non-farm employment) of the G7, Europe and Japan are seated in their respective economic quagmires while their central banks have been ratcheting up the rhetoric in easier monetary policy accommodation, and the expectations that the Fed will hike rates come mid-2015.
This long dollar play has been escalating for quite some time back, the the chart above illustrates. The chart however only shows the positions of the large speculators. Commercials are, as you would expect, very short the dollar. I've read an increasing number of articles either questioning the dollar's strength or outright calling for a reversal of the trend. All of them have basis but no one will ever know when the "it" will happen, until it does.
Moving to the schematics of why reversals often happen abruptly and catches traders off guard, we marry mass psychology with and logic (2 completely different things when markets are concerned). I'm not expressing my personal opinions on the Dollar, more on this in a separate entry. Assuming the dollar tops out, the decline will probably be more vicious than the preceding run up.
The adage "markets take the stairs up and the elevator down" really does out a grin across my face sometimes. When we see a reversals, long positions of the large speculators (think banks, trading desks, money managers, and hedge funds) will start being liquidated for obvious reasons (risk and correlation parameters and stops being filled). Liquidations, depending on their velocity and magnitude can lead to a capitulation where the initial sell-off quickly morphs into an exodus, sometimes senseless; this is also know as panic selling, and the herd reaction instinct immediately kicks in the accelerate the vicious process. Smarter traders and most momentum-based systems should have by then already initiated fresh shorts on the dollar against other assets, further accelerating the decline and adjusting the equilibrium of longs to shorts. Another thing to add, as speculators are a major source of liquidity and open interest, when huge liquidations occur, liquidity is often thinned. An illiquid market is the last thing traders wish for in such a sell-off. Generalizing and simplifying, speculators act collectively on panic, rushing for the exit at once, we know the adverse effect of that behavior.
Commercials on the other hand will begin to reduce their hedge against a strengthening dollar by squaring their short dollar positions but in a more orderly fashion as there is little speculative element to their operations (commercials are hedgers for the most part). Actions of this group of participants serve as fodder to support some of the speculators' liquidations (i.e. taking the other side of the trade).
This was precisely what happened when global equities experienced a sizable correction that started late September. That episode was rather short lived mainly because there weren't strong fundamentals unlike what we saw in previous corrections. Fear was also at an extremely level at the height of the decline, and that climaxed the play. The ensuing reversal was almost as ferocious and that left many much less exposed. Job well done indeed.
The topic of market psychology too profound for a single entry. But hopefully it has provided insight into how the concept functions. Following entries will seek to speak about how we can better our performance through deeper understanding of such dynamics.
This coming Thursday, 23 June 2016, the United Kingdom will vote on a historical referendum deciding on the status of its European Union (EU) membership. For the last 2 years since 2014, the UK parliament, led by acting Prime Minister David Cameron have promised a public referendum on Britian's EU membership. Britain's relationship with Europe has always been one of contention, and many have long been awaiting this once in a generational lifetime opportunity to voice their opinions through the democracy of a vote.
The global financial markets have also been eying this key event risk for some time, and since events have heated up recently as we enter the final week before the ballots are cast, there has never been a more important 4 days for English markets (that's including the pound sterling, GBP) since the "Black Wednesday" of 1992 , the day the Bank of England was broken by the markets.
We are not usually pessimists but when we see the writing on the wall getting bold redder each week that passes, we can't help but to take serious note. Just last week, we warned readers that markets might be about to get nastily volatile during the summer. So far so bad. May hasn't started well at all. The S&P 500, as of the week ending this past Friday, posted its first 3-week losing streak since January.
Recent macro developments both in the U.S. and elsewhere have however strengthened the bearish case for risk, in our opinion. It might have reached a point where downside skews in risks make a derisking maneuver potentially more rewarding than chasing beta.
As such, we have shifted our bias to the short side of risk. The positions in our portfolio (which we keep private) have partially reflected this change in view and will continue to do so as the situation evolves.
It is a known fact that credit cycles often lead business and economic cycles. It makes sense on paper and even more sense in practice. This is a subject that we havehardly yet touched on, but will be doing so in this piece. For a majority of the investing community, the topic on credit cycles remain much of a novelty.
As of March 2016, total default volumes on HY bonds (high yield) and institutional loans in the U.S. hit a 6-year peak of approximately $16.2bn, almost half that seen in the entire of 2015. Just this past week alone, we saw at least 4 corporate defaults with 3 in the energy sector.
So far in 2016 (Jan-Mar) default volumes have reached a jaw dropping $32.4bn. To put this in context, 2015's default volume (which was already abnormally high) stood at $37.7bn. If this trend were to continue through 2Q and beyond, we are talking about a full-fledged wave of defaults.
For the first 3 and a half months that have already elapsed in 2016, no asset class has seen the consistent volatility that currencies have. Central banking has been busy, almost too busy, all while the macro fundamental landscape has hardly moved an inch. With all that drama, noise, and play in monetary policies throughout the global economy, one would expect sizable trends in FX. But that hasn't been the case.
For instance, when the ECB first lowered its deposit rate to zero back in the first half of 2015, that sparked a major bear market in the euro, and a bull market in risk assets including euro bonds. When the Fed announced it planned to gradually taper QE3 and eventually end it late in 2014, the U.S. dollar began building up into what we now recognize as one of the most fervent dollar bull markets ever.
Monetary policy divergences used to herald the alpha and omega of huge trends. But not today.
Now, thanks to a comprehensive piece by Bank of America Merrill Lynch, we can provide readers with a glimps of what might be the next big trend in FX.
Last week, Bloomberg broke a story which greatly fascinated us. It involves a mysterious "specter", one which we have no clue about, flooding the Turkish stock exchanges with massive buy orders, massive to the tune of some $450mn in a single day.
Turkish locals refer to this entity (whoever or whatever it is) as "the dude", crowning the figure with an amphibious demeanor worth of a chapter in Slenderman. We have no idea, absolutely no idea who or what "the dude" is, how it specifically operates, and what its motives are for slamming a relatively illiquid market with order sizes so large, they scare the living daylights out of even the staunchest of permabears.
All we know is that local authorities have been rattled, investors shaken off to the sidelines, and a stock market that is now a stellar outperformer in the emerging market (EM) space. Even with the gruesome terror attacks in Istanbul over the weekends, an attack which has killed at least 37 people the last we checked, the Borsa Istanbul Index has now rallied for the 9th straight day.
That's right, we need the U.S. dollar to be BOTH strong AND weak at the same time for continued upside in equities. Much has been said about the greenback ever since the end of the Fed's QE3 program in late 2014. It was then all about king dollar leading up to the Fed's first (in a decade) rate hike in December 2015. Speculators kept piling in on the the freight express train that was the long dollar trade du jour, creating what has become one of the most crowded trades in modern history.
It's likely going to be a tug of war between these forces we've highlighted in this piece. Again, we make no predictions as to direction. We do however expect this conundrum to continue until a novel catalyst emerges that alters the way market participants trade and position. What this novel catalyst is, we don't know.
This conundrum is big, as we shall explain below.
The top 0.01% of the erudite elites control more than 60% of the world's wealth, while the 80% of us have a collective net worth less than the top 1% of society. In a world decorated with such gaping inequalities, risk and opportunities present themselves. While problems may be plentiful, there are also long term opportunities to capitalize on the mother of all trends: A globally aging demographic.
Which is what Janus Capital's Bill Gross, well revered as being called the "Bond King", is driving at in his latest investment outlook. In the race between the tortoise and the hare, the former analogous to a gradually aging population, the latter to technological advancements, the tortoise eventually catches up. Time isn't on our side, and we're sitting in a ticking time bomb.
It's a known fact that a large majority of the world's baby boomers are not adequately primed for retirement, lack the financial resources to meet mounting healthcare and insurance obligations as they further age, and are more dependent on the state's hospitality than ever before. But who pays the ultimate price?
The prospect of $20 oil prices has been raised thanks to this one Black Swan. A Black Swan is also known to statisticians as tail risk, or events that are highly improbable but are of great significance. One can liken such an even to a large meteoroid making its way through the Earth's protective atmosphere and impacting land or sea; an extremely unlikely event but if actually true, mankind's existence would be threatened.
Low oil prices have been the bane of many oil producing and export nations, whose currencies and economies have taken incessant hits every cent crude continues to plunge. The ruthless combination of a huge supply overhang and waning global demand has led to a deadly concoction oil producers and exporters have no choice but to drink. What other choices would they have anyways?
Whatever we said on 5 November came true. For the first time in 9 years, the Fed hiked the Fed Funds target interest rate by 25bp to 0.25-0.5%, ending an eon of zero lower ground rates and marking the start of a new paradigm. A paradigm that is, much as most would hate to admit, unprecedented in terms of scale and bredth.
As we approached 16 December, markets had increasingly discounted a Fed liftoff, but there was still some element of uncertainty. That uncertainty now shifts to what the Fed will do in 2016. Will it continue to gradually hike rates? Will it reverse on its path of monetary tightening and start to ease? These are but a multitude of questions that everyone is asking, but no one can really answer.
Does dovish rhetoric from Europe's ECB, continued stimulus from China's PBoC, the reluctance of Japan's BoJ to step up QQE despite headwinds, New Zealand's RBNZ policy being put on hold signal a soon imminent Fed rate hike?
While correlation might not necessarily be causation, especially in the ubiquitously tangled web of central banking, we believe this development is too significant to turn a blind eye on. Ironically, market-based odds for a December Fed rate hike have never been higher.
Do central bankers know something about the Fed's near term actions which the general market doesn't? If anyone knows what the other will do, it's probably them.
We'll leave this up to you to decide. The proof is in the pudding, and this one's pretty dense. So take it for what it is, we're playing it cautious but not holding our breaths.