Updated: Jul 18
There seem to be 3 important developments over the last few days which combined could lead to some new trends in financial markets:
Rise in infections post lock down/extension of lock downs.
HM Treasury leaked discussions on Covid19 debt stabilisation.
Markets are rejecting key supports/testing important key levels.
RISE IN INFECTIONS POST LOCK DOWN/EXTENSION OF LOCK DOWNS
Some of the countries that are perceived to be handling the Covid19 pandemic very well, including Germany and South Korea, have recently reported a rise in Coronavirus cases as their governments have eased lock downs. This news comes as the US West Coast could extend lock downs until July, whilst Brazil and Russia are seeing notable increases in their infections. I am not going to dwell on the science, but the risk is that the market might have to consider that an easing of lock downs could be followed by further new lock downs pretty quickly. This would necessitate a revision lower in economic growth forecasts and a rethink of deficit and stimulus numbers, as well as of corporate and household cashflow projections. A second wave might need to be priced into asset valuations on financial markets.
HM TREASURY IS DISCUSSING POST COVID19 DEBT STABILISATION
For those who follow debt trends acutely , the Covid19 impact on government finances has been quite remarkable, both in terms of size (even by GFC standards) and how global it is in nature. Just as extraordinary is the complete abandon of traditional economic thinking by both present and past central bankers as well as by experienced economists. Nearly all have given backing to Central Bank balance sheet expansion WITHOUT discussing the ramifications of doing so. Even the RBA and Bank of Canada have willingly thrown themselves into debt monetisation without flinching. The issue is not the action itself, as it was absolutely necessary and lets face it, CBs already lost their virginity and independence with their multiple QEs post GFC. The fundamental flaw was the lack of discussion, bar perhaps the German Constitutional Court, to discuss the long term implications of such fiscal largess and balance sheet expansion with some prominent people seeing no negative effects. This no doubt brought huge confidence to the market where once upon a time it would not have.
This is important because a market that believes that there are no consequences is a market that can get complacent about the future, exhibiting that complacency through asset valuations. And here enters the “new news” with Her Majesty’s UK Treasury leaking a document on how to stabilise the deficit, detailing possible income and corporate tax increases as well as public sector spending cuts. This is a huge sharp return to reality for the market - government financial assistance is not free and it does after all have a future cost. Tax and Spending cuts = lower growth/profitability.
Understanding Debt “Supply and Demand” allows for an informed decision on investing. Previous blog posts have extensively covered the dynamics of US Government debt. The UK has also had to contend with a significant increase in its debt following the GFC, which will rise further due to the fiscal policy to confront the Covid19 fallout. The table below shows how since 2007, outstanding Gilts will have tripled by the end of 2020 to finance both the GFC and Covid19 fiscal deficits. Almost 50% of that increase has been funded by the Bank of England expanding its balance sheet (by £660bn), and by foreigners with a sizeable £ 275bn, leaving a “relatively” small amount to be financed by domestic private savings.
Unlike during the chaos of 2008, the market this time has precedent from the GFC to understand who will fund the huge increase in the UK deficit. Chart (left) shows how the BOE became a large holder of outstanding Gilts, whilst the right chart depicts how the BOE bought a fairly substantial proportion of the huge net increase in debt in 2009. Note the very right of the chart, both the size of the 2020 net supply, and how it will again be funded by the Bank of England.
But the charts show something else which is very important for financial markets – the post economic shock deficit trend. Despite “austerity”, debt continued to materially rise for 7 years after the GFC, with the Bank of England taking a less important role, even if still significant in nature. It was only by 2015 that the net supply reducing to pre GFC levels.
This is the cat that the leaked HM Treasury document has let out of the bag. It warns that “it will be important to stabilise the debt/GDP ratio and prevent debt from continuing to grow on an unsustainable trajectory” – debt dynamics indicate the necessity of important fiscal cuts through tax rises/spending cuts – more lower growth/inflation ahead.
MARKETS ARE REJECTING KEY SUPPORTS/TESTING IMPORTANT KEY LEVELS
Cable (GBPUSD) was hammered in March and rebounded with equity markets to then trade in a tight range. It formed a double top with the 200 day m.a as a key resistance. An attempt today to rebound was sold, bringing a break below the previous 1.2250 lows (daily chart left). This price action has caused a renewed decline in weekly RSI price momentum (right), reopening the long term bear trend. This is a classic case of a short term oversold situation being dissipated, allowing for a resumption of the longer term bear trend.
EURCHF declined 4% between December and March, reaching very oversold levels on short term momentum metrics. The absolute lack of any meaningful bounce, not even above the 50 day ma, is perhaps a reflection of the seriousness of the Eurozone political situation, resulting in no dominant CHF sellers coming to light. The range trading has dissipated the Short Term “oversoldness” and the price is closing at the lowest levels since July 2015, close to 105. A break of this key support could lead to a further step down in the cross. Price action in Jan15 should be a reminder of what could happen given a potential large supply/demand imbalance – to that end current 3m implied vol pricing looks too low.
Much has been made of the S&P recently rejecting a break above the key 61.8% Fibonacci retracement of the Feb – Mar sell off. What has been less discussed are the other important longer term signals that bearish sentiment has now taken hold. Just as in 4Q18, a Bearish Evening Star was formed between Dec19 and Feb20, indicating that participants were no longer buying on strength, but sellers had gained the upper hand. Like during 4Q18, prices sliced through the long term 20m ma support, but this time the price is struggling to resurface above it (which happens to be the 61.8% fib level!). Indeed this price level has recently been sold. Just as important, prices rose with lower momentum (RSI), a classic end of trend divergence signal. A failure to close this month above the 20mth ma would be the first bounce failure since the rally started in 2009, suggesting that buyers on dips are not as strong as sellers on strength, leading to the risk of deeper corrections as bears take charge.
There are other markets which have or are looking to roll over, including some highly indebted EM currencies which are outside the “circle of trust” of being able to debt monetise their deficits without impacting their currency. $TRY has already moved and $BRL is moving. $MXN price action is getting interesting – is there a classic “head fake” lower out of the corrective pennant that will eventually lead to even higher $MXN prices? Note how prices rejected the 50day ma and how momentum has not moved lower but is now flatlining - $MXN is no longer hugely overbought as it was in March.
There are other interesting price movements (charts available upon request) :
VIX, has bounced off the 200 day ma with a rising daily and weekly RSI which are no longer very overbought,
Itraxx XOver Credit as well as CDX HY Credit seem to want to rise again (spreads wider), which is quite disturbing given that the Fed has just announced that it will purchase corporate bonds. This could be a classic “buy the rumour sell the fact” moment.
SX7E (Eur Banks) and S5BANKX (US Banks) price action looks almost identical to EURCHF, tonight closing near the 2020 lows. This should not come as a surprise given the developments decribed in my extensive post on how Covid19 will hurt banks of all denominations (including the supposedly “well capitalised” US institutions).
All in all, there are enough price movements across different asset classes that suggest the April trading ranges might be coming to an end and new trends will take effect.
Much has been made of the divergence between what bond markets and equity markets are pricing, long term low growth and disinflation versus some alphabetical recovery. As I have demonstrated before, the two can coexist simply because the market does not expect an exit of investments from private sector assets to fund huge government deficits.
This should remain the case, but as I explained recently in Central Bank Evergreening, risk rewards in private sector assets is low. These assets are at risks of revaluation from changes to growth expectations due to further lock downs or from expected changes to tighter fiscal policy, which reaffirms that there is indeed a cost to the Covid19 bailouts and that the aid is not simply money from a magic tree. Recent price action suggests that this revaluation might be about to or has already started taking place.
My expectations remain that
a private sector deleveraging climate will keep an unhealthy bid on the USD, propelling it higher,
long end US and UK rates will continue to price Japanification of their economies,
gold will be a better counterbalance to equities compared to fixed income,
bank equity (especially the very overpriced Aussies) will devalue further.
Likewise, economies with very over leveraged household sectors tied to extreme real estate markets which are in the midst of popping, should see significant declines in interest rates (especially forward rates) and weaker currencies. On top of Covid19, they could ALSO have a financial crisis from real estate lending (more on this another time). As an example, below are the 5 “SNACS” (**) 5 year swap rates - spot the odd one out, which unsurprisingly has just registered a 0.1%yoy CORE rate of inflation.
(*) The UK Gilt data is compiled from the DMO and ONS databases on outstanding NOMINAL Gilts and Gilts holdings, as well as DMO announcements of future debt issuance and the quite excellent Citi Fixed Income Strategy debt supply publications that show future gross and redemption profiles.
(**) SNACS = SEK, NZD, AUD, CAD, S Korea