By Eric Coffin
Over to you, Draghi and Yellen.
This month, like many other months recently, it’s the
intentions of central bankers that are dominating the markets. It’s widely expected that the ECB and US Fed
will drift even further apart in their basic policy stances this month. I’m pretty sure that view will turn out to
be correct though as always the devil will be in the details.
Increasing certainty about upcoming policy moves has
traders increasingly certain about how different markets will move and they are
placing bets accordingly. Traders in
New York are expecting Santa to deliver new all-time highs. He may grant that wish on momentum alone but
if we get many more sub-par economic readings the jolly old elf may decide to
break out the coal lumps to stuff stockings with.
Traders are behaving with even more certainty, alas, in the
gold market. It’s been all short gold
and long dollar since the middle of October. There has been no respite
yet. I continue to believe we may in
fact get some if the Fed raises rates as expected. The key word here is “expected”. This has to
be the most anticipated, front run and telegraphed interest rate change in
history. It’s hard to believe that
anyone interested in trading the outcome hasn’t placed their bets already. That being the case there is still potential
for a sell (dollars) buy (gold) on news trade the market is not expecting.
Eric Coffin
A lot of things are going to happen in the next
two or three weeks that could set the stage for the entire 2016 market and
determine if 2015 is a winning or losing year for the big board.
The combination of decision makers at the ECB and
US Fed this month loom largest for near term market direction for both equities
and currencies. The monthly payroll
report and the latest decision by OPEC on cutting (or not) oil production will
also impact. Some of this will be coming
at you immediately after you read this editorial. The Fed meeting, arguably the most important
data point is furthest away but only two weeks out.
We’ll start with an updated US Dollar chart since
its value is a distillation of trader’s beliefs about central bank intentions
and relative strength of different economic blocks, the US and Europe in
particular.
As you can see from the chart below
the USD continues to strengthen, though less than the dollar bulls expected so
far. The index has been unable to break
through the spring high. I find this
interesting as the Euro has weakened and conviction about a Fed rate increase
continues to grow. I’ve noted before how
one-sided the dollar trade is and, if anything, it’s even more crowded now.
You can see the impact of the surging dollar in
the gold chart below. Gold is hitting
new lows and trading around the upper range of the target I had for longer term
bottom. Charts for many other metals and
other commodities look similar. For gold
to make that bottom the USD has to stall out and preferably reverse and start
heading lower.
Virtually everyone expects the Dollar to continue
powering higher as the Fed starts raising rates. I’m in a very small minority (a minority of
one as far as I can tell) that believes a rate increase may mark at least an
interim top in the dollar.
Why?
Several reasons. The first and
simplest is how one sided the trade is.
Currency traders trade charts.
Chart patterns are the reason for the 120 target and I agree that target
looks “logical”. That said, the main
reason longs keep piling on is the upcoming Fed decision. Once that decision is announced traders will
have to decide whether to “sell on news”
and take profits. I expect many to do
just that.
The Fed made a mistake not raising rates almost
two years ago. They know it. They also
know that there is virtually no inflation in sight and they are starting a
tightening round very late in the economic cycle.
I do think rates get raised this month but I
think the FOMC will go to extraordinary lengths to convince the market the pace
of increases will be VERY slow. For all
the outward bullishness the markets are shaky and growth is slow. The Fed can’t afford to spook traders now. If
the Fed succeeds in soft peddling this increase the odds of currency traders
locking in profits increases.
A second factor that could cap the dollar is the
ECB. Its meeting comes first. Like everyone else I expect Mario Draghi to
be dovish, the question is how dovish.
He has reason to be lax.
Deflation continues to stalk the Eurozone and bond yields are getting
increasingly negative. The rate
differential has decimated the Euro and Draghi is totally fine with that. The cheaper currency has been a boon for
exports. PMI, employment and production
levels have all been better than expected.
Draghi has every reason to cut rates and expand
QE as he hinted he would do. The market expects it and is pricing it in. Now he has to live up to expectations. He might meet or beat them but remember that
there are ECB board members that are inflation hawks and hate the idea of
QE. There will be pressure to temper
Draghi’s enthusiasm even though he’s been right and QE is definitely helping economy.
I don’t pretend to be privy to the internal
decision making of the ECB board. Maybe
the markets are right but there is a realistic chance the ECB
does less than expected given how high those expectations are. If that happens the Euro gets a boost and the
dollar a haircut.
The third and perhaps most
important reason is also one I have touched on before. The strong dollar is doing a lot of damage to
corporate profits and the wider economy.
The chart below comes from a presentation given by none other than
Stanley Fischer, vice-chair of the Fed.
He’s an inflation hawk and has been pretty consistent in his calls for
higher rates.
The presentation centered on the impact of a
rising dollar on the US economy. The
chart shows the negative impact of a 10% appreciation in the USD over
time. Note that this chart is tracking
the negative impact on GDP—the percentage decrease in growth over three years
after a 10% move in the currency. 
The impact is not small. A 10% currency move can
cut GDP growth by 1.5%. The move in the
USD so far has been about 15% and plenty of currency traders expect another 15%
plus going forward. That implies a decrease
in GDP growth of up to 3% from an economy that wasn’t booming to begin
with. Perhaps this explains why the US
economy has been decelerating this year and not hitting the “liftoff” Wall St
keeps expecting?
We’ve seen plenty of ongoing impacts lately. Exports, manufacturing PMIs and spending
numbers have all come in below consensus. You can see how those low readings
are impacting the latest estimates for this quarter’s growth. Like in Q3 the current GDP Now estimate is
far below Wall St consensus. The latest
reading is a meagre 1.4%. Keep in mind
that this reading has been more accurate than Wall St consensus lately.
So far this quarter consumer
spending has been a big disappointment.
We just passed the Black Friday kick off to the holiday spending
season. Sales were way below estimates. I don’t think any of this will dissuade the
Fed. If they blink again at this month’s
meeting their credibility will be destroyed.
At the end of the day that credibility is the main source of the “moral
suasion” a central bank exerts. The Fed can’t afford to lose that even if
raising rates is dangerous.
Weak sales are leading to high inventory buildup
and this is one of the first danger signs of a potential recession. The chart below shows how much the inventory
to sales ratio has expanding since mid-2014.
Unless consumer spending accelerates soon we’ll start seeing businesses
cutting production to try and get this ratio back in line.
The big board indices are a couple of percent
from their highs. The “Santa Claus”
rally is one of the most dependable and it may finally allow new highs to be
reached. Do not underestimate the
dangers though.
Many market internals have continued to weaken
and the economy has continued to slowly decelerate. Broader and equal weighted
indices continue to struggle. It’s still
a small number of companies carrying the entire rally. The potential for a
major top in the markets is as high as it was three or four months ago. Optimism could still prevail but the next
month or so will be tricky.
The bottom line is I agree with the consensus in
terms of what will happen in the next two weeks but disagree on the impact it
will have. I think there is a good
chance the dollar tops when the Fed lifts rates and the potential for a policy
mistake overwhelming the market is high.
That backdrop could mark a final bottom for gold
prices. It won’t do base metals or other
commodities as much good. A falling
dollar will help but in the absence of much better and broadly believed
readings from China it will take mine closures to convince traders base metals
are bottoming.
Gold is in the danger zone. The central bank
meetings could generate a spike lower, though we’re running out of sellers. The positioning in the futures market is as
bearish as it has ever been. That’s
scary but also a classic contrarian signal.
When the market is this bearish it’s due for a bounce. Whether that is a bounce of the dead cat
variety or the start of something more important will depend on the USD. If I’m right about it topping out soon we
should be set up for a rally in gold and gold stocks. Stay vigilant. We could see some resolution
to this endless bear run very soon.
Ω
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