Risk Aversion Taking Hold
I have written pervasively about the dollar-equity correlation and the causality behind it, given the literal trillions in liquidity (if accounting for fractional reserve leverage) gifted to primary dealers (aka Wall Street banks & their prop trading arms). The carry trade that spawned from this correlation has driven risk assets higher as the funding currency, with its 25bps interest, declines to finance it.
"The dollar is now driving risk assets, including Gold and Credit assets."
-Rick Rieder, Managing Director, Blackrock Fixed Income Alternatives
The risk asset carry trade funded by the USD only works as long as the cost of borrowing for the dollar remains low (check) and the dollar continues depreciating on a relative basis to other, higher-yielding, currencies. And this is where things start to get interesting.
The trade-weighted US Dollar Index (/DX) surged on December 4 (which also happens to be Jay-Z's birthday) on record volume in the futures market (with over 40,000 contracts traded) and in the subsequent trading days it broke out of its long descending channel (defining the USD's downtrend since May) and through its significant 50DMA resistance line (which had been providing perfect resistance the entire way down the channel). Meanwhile, pairs with higher-yielding currencies (such as EUR/USD & AUD/USD) sold off (with the EUR/USD down over 4000 pips from highs). Meanwhile, the Bank of Japan announced a fourth stimulus, which sent the Yen plunging and the revival of the Yen carry trade at hand into a sizable rally in the currency (after perpetual decline for over a decade due to the Yen carry trade), to replace the dried-up USD carry trade. Indeed, the USD/JPY posted its biggest weekly gain since 1999.
With the dollar finding a newfound bid (deleveraging is a bitch), the implications for risk assets are tremendous. Equities sold off from highs and are approaching a pivotal move from their monthlong tight channel, which could spell huge trouble if the move is down (as I expect and am trading off of). Beta equities led the decline, and leading indices and stocks are pointing down as well (Goldman's lower highs and lower lows come to mind). Commodities also sold off, particularly precious metals. The GLD ETF posted record volume on a huge plunge in price on Friday.
The risk aversion driving the possible (short-term) bottom in the USD & driving the carry trade toward implosion is an obvious instance of mean reversion, as the POMO liquidity fueling the carry trade has dried up (last POMO was late October) and the real economy's issues take stage once again. Dubai concerns led equities down during the holiday week last month and talk of liquidity extractions via reverse repos scared more equity longs (otherwise known as bagholders at this point).
Today, the Treasury announced the results of a $29B 1-mo Tsy auction with an astounding bid-to-cover of 5.33 and a 0.000% yield. Apparently primary dealers thought it prudent to tender over $120B in bond bids for literally zero yield. The suspects? Debt deflation and debt monetization. And now that the Treasuries part of QE is over, the sole reason PDs are picking up $29B in 28-day bills for no yield is risk aversion. Bond markets continue to imply deflation since June, while CDS spreads (particularly sovereign, clustered strongly in Europe) widen substantially for the first time since March lows. Fixed-income is a great leading indicator for equities, and divergences in the different markets almost always prove stocks wrong. Zero (and even negative briefly while last week) yields on 1- & 2-mo Tsys as equities print year highs is a clear divergence between reality (credit) and perception (equities) primarily allowed by the unprecedented liquidity injected directly (and almost exclusively) into risk assets.
Both China and America are addressing bubbles by creating more bubbles and we're just taking advantage of that. So we can't lose.
-Lou Jiwei, Chairman & CEO, China Investment Corporation (China's sovereign wealth fund)
The S&P 500 is pricing in absurd growth prospects (with perpetual 120+ as-reported P/Es) at these levels, as insiders continue selling at record paces (82:1 sell-side ratio last week). The Citigroup Economic Surprise Index, after bottoming in January (less than eight weeks before the equity market low in March) topped out in September and has been plunging in recent weeks, showing new data and reports are not meeting priced-in expectations. The sharp drop-off is analogous to the Surprise Index's performance in the weeks leading up to the fall 2008 meltdown.
Japan reported a 1.3% annualized GDP growth for Q3 yesterday, substantially missing the 2.8% revision estimate and the 4.2% preliminary figure. The sequential QoQ figures came in at 0.3% act vs. 0.7% rev est vs. 1.2% prelim. The lack of an inventory bounce led to the downward revisions. This of course provides BoJ more political capital to phase in more liquidity injections. An eerie analogue may manifest in the United State's GDP figures, as reactionary government stimulus wears off and the President's 47% approval rating (and central bank's 21% approval rating) necessitate much more fear and uncertainty before more spending is permitted.
Technically, the S&P has finally broken down from its rising wedge but remains in its monthlong horizontal trading band. A breakdown of the channel's support implied a sharp selloff, given the lengthy duration the channel has held up. This is a precursor to a pivotal move and the downside risk remains high. A break below roughly 1085 would be a technical short trigger for that trade thesis, with the 50DMA right below to offer another potential breakdown trade trigger.
The Nazzy has been in a rising channel since April, but the highs have been getting sluggish in recent weeks, and a rising wedge is forming inside of the channel, as the index enters a long-term resistance zone. This is very bearish and is a leading indicator to the S&P.
While the S&P and Nasdaq have been testing recent highs yet failing to make new ones, the leading small-cap Russell 2000 Index has printed a lower high and lower low, as it approaches a breakdown of its rising channel that has defined its rally since April. A divergence like this is not to be ignored.
The most important bellweather in equities, of course, is Goldman Sachs (GS). It has started a downtrend while the S&P is stuck in choppy action. This has extremely bearish implications for equities.
Silver & gold have had strong rallies since the big technical breakouts in early September but they are weakening as well as the carry trade reverses course. Expect silver to underperform gold as they correct, as liquidity premia increase. Silver's failed breakout at $18 is cause of concern, and suggests liquidity is drying up fast. Oil & copper, two big barometers of aggregate demand, have printed technical breakdowns, as well.
Again, as I have been stating, breakouts in the Dollar Index & in the VIX ETF (VXX) through their 50DMAs are huge short triggers for me in equities & commodities, particularly high-beta equities and bubbly hoarded commodities. The Dollar Index has already spiked through its 50DMA and VXX is approaching a possible breakout soon.
This search for returns has already started a new asset-price boom - an echo bubble – in stock and commodities markets, setting the stage for the next bust when the relevant financial data disappoints. The Fed’s current stimulus program is helping to push securities higher, but is not producing much benefit for the economy.
-James Melcher, President & Founder, Balestra Capital
In other news, happy 20th birthday to me. Officially no longer a teenager.
Disclaimer: although the author may be long or short any of the securities mentioned above and none of the material above may be construed as investment advice or recommendation, the author's current positions in the securities mentioned above are: long /DX, VIX; short /ES, /NQ, /HG, /CL, EUR/USD, AUD/USD, GS.
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