Thursday, August 24, 2017

Connecting the Dots - 8/24/17

With traders setting their sights and ears to what Fed Chairwoman Yellen and ECB President Draghi might say or exclude in their respective Jackson Hole speeches tomorrow, the US dollar index – primarily influenced by the exchange rate of the world’s two largest reserve currencies – has made its way back down to long-term support after consolidating the steep move lower that began at the start of the year. 

As the July inflation data was largely uneventful, another window has opened over the next few weeks to break the respective ranges in gold (up) and the dollar (down). Over the near-term we wouldn’t be surprised if the markets took a slightly more hawkish tone subsequent to Yellen and Draghi’s speeches tomorrow, if only because the palpable dovish leanings going in may not be further nurtured. At the end of the day, Yellen knows it’s easier to walk back policy expectations than to ratchet them up. In the absence of new data or an exogenous influence, we would speculate the symposium is largely a non-event, where a relatively tighter ECB is counterbalanced by a less hawkish Fed. 

That said, the elephant(s) in the room remains the contentious relationship between the President and his own party, as the very real threat of a government shut-down and debt default greatly threatens the last remaining prize of the President's legislative agenda this year: an overhaul of the nations tax system. Naturally, as the legislative deadline approaches this fall these tensions should come to a head.

*Click to enlarge images*

Generally speaking, from a basic technical perspective the downtrend in the US dollar index this year has been defined by characteristic “lower lows” and “lower highs”, typical of a significant momentum unwind with diminishing relative strength imprints as the move unfurls. Overall, we expect the pattern to continue as underlying long-term support is eventually breached, which should register positive relative strength divergences before a more tradable low is reached. 

Among the few touchstones we’ve benchmarked against this year to estimate the dollar’s prospective trend, we’ve contrasted the breakdown in gold in 2013, which also displayed a diminishing momentum signature as it broke underlying support from its broad top range. Notwithstanding our appreciation of the inverse symmetry to the cycle today – in which gold has been rejuvenated as the dollar weakens, the technical similarities have remained prescient for the dollar index as well.
Since utilizing at the start of the year our intermarket leading comparative with long-term Treasuries that accurately pointed towards where the dollar would loose trend line support in April (see Here), we have also contrasted with the cyclical pivot in the dollar in 2002 for more long-term projections  as well as a prospective road map for long-term yields, the euro and gold. 

Our interpretation at the end of Q1 (see Here) was that the dollar was set to follow Treasuries breakdown lead with the last lagged pivot (~5-6 months) of the cycle, which should mark a pattern break (between LT Treasuries and the USDX) as the dollar turns cyclically lower without a corresponding leading move in Treasuries. In hindsight, those expectations appear well founded to-date, as the dollar and long-term yields have behaved quite similar to their respective breakdowns in 2002, where long-term yields reached a positive correlation extreme with the dollar and turned down again with the dollar's cyclical pivot.

From a big-picture cyclical perspective, we’ve pointed out in the past that the dollar has followed major upside exhaustion extremes in long-term yields by 2 to 3 years. The 9/81’ secular high in yields was followed by a secular high in the US dollar index in 2/85’ (monthly). The upside exhaustion in yields in 1/00’ was followed by the cyclical high in the dollar index in 1/02’.

Structurally speaking, the pattern in yields has been to test the previous interim low after the exhaustion high, followed by a sharp secondary move that is rejected below the previous extreme. 

Today, the 10-year yield has worked through the secondary pivot below the previous exhaustion extreme of ~3 percent in 12/13’. Our expectation remains that the US dollar index is following again the long cyclical intermarket lag (3yrs) in yields, which points towards a continuation move lower for the dollar over the next several years.

Similar to how the US dollar index led the subsequent breakdown in yields in the back half of 2002, a fresh break of long-term support in the dollar could bring a retest of long-term yields lows from last summer. 

Wednesday, August 9, 2017

Connecting the Dots - 8/9/17

“Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once unthinkable dosages will almost certainly bring on unwelcomed after-effects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.” – Warren Buffett, February 2009
Looking back at the current decade – in the shadow of the global financial crisis of the previous, one topic has overwhelmingly remained in focus by policy makers, pundits and participants alike. 

Inflation: a general increase in prices and fall in the purchasing value of money.

An paradoxically, for all of the collective attention that’s been paid to the prospects of inflation, by and large, the dire warnings cast by both the brightest and most prudent in finance have appeared misplaced, as inflation has remained subdued and still below the Federal Reserve’s 2 percent long-term target more than 8 years after the final throes of the global financial crisis. 

Last week’s release of the Fed’s preferred measure of inflation – the Personal Consumption Expenditures Chain-type Price Index for June, indicated that core inflation sits at 1.5 percent, down from a high of 1.91 percent in October of last year. And although causality and correlation between inflation and the financial markets is as nuanced and complicated as any intractable problem, when it comes to the equity markets today we believe they broadly function along a binary highway where low to moderating inflation is welcomed and fundamentally expected, with higher realized inflation largely reserved for economic folklore. In essence, we’ve been driving down a seemingly one-way street for so long that participants have ignored the travel risks of oncoming traffic with higher prices. Should the dollar continued to breakdown from its cyclical high – which we believe it will, that’s precisely what will be coming our way. And like most things in life, nothing kills the mood quicker than the surprise realization that you now get less bang for your buck.  

With tomorrow's PPI and Friday’s CPI inflation reports on deck in the back half of the week, we wanted to quickly point out that the markets are now in the window where US dollar weakness – on a year-over-year performance basis, could again begin to positively affect the inflation data. 

From our perspective, the attached two charts imply (we use real yields here as it positively trends with the dollar, albeit with a several week lag) that the YOY performance of the dollar has led the move in real yields, with underlying support of the dollar's broad 3-year top serving as the fulcrum for next major move in inflation (we believe higher) and real yields (lower).   

As we pointed out at the start of summer (see Here), despite breaking down since last December, US dollar weakness was largely obscured from the inflation reports this year, primarily because on a YOY performance basis the dollar had actually trended higher through May, essentially arresting the respective moves of higher inflation and lower real yields that began in the back half of 2015 – which led the cyclical pivot higher in gold in late December of that year.

We’d speculate that if YOY weakness in the dollar fails to bump the July inflation data, it will more than likely show up next month. All things considered, it’s a good bet we see the downtrend in the data reverse course soon, which when it hits could see a more hawkish market reaction over the immediate-term  with a stronger dollar, weaker precious metals and rising yields. While over the intermediate-term we firmly expect gold and silver to break out above their respective highs from last year (with silver once again leading the way), recent strength may give way to weakness as the market considers further Fed action.