June 25, 2021
The Bond market is trying to front run the Fed (as usual), while traders trying to front run China are finding a more determined adversary. As we used to see with FX markets, monetary authorities will intervene to push markets in the direction they want, but only when they are already going that way. Meanwhile, long term investors can take advantage of distressed selling by speculators to buy on the dips.
Short Term Uncertainties
Short term traders had an exciting week or so as the bond markets reacted to the Fed’s latest projections and we saw a flattening of the US curve between 5 years and 30 years. Hair trigger trading elsewhere saw a sell off in commodities and other aspects of the ‘reflation trade’ and the bond bulls appeared to declare the inflation story dead. More realistically, the point is that the Fed are going to keep buying long bonds in, while issuing at the short end. The market is not making any predictions about inflation, rather it is trying to front run the Fed. Meanwhile, Gold, which had been following the yield curve steepening closely since mid 2018 but which had somewhat curiously moved out of synch year to date, selling off heavily in q1 before rallying aggressively in q2, also joined in last week’s selloff with the yield curve flattening and now looks vulnerable, both on technicals and also our own risk models.
Bond Market gave up six months of steepening, taking Gold with it
The dollar, meanwhile, also following the 2012 temper tantrum playbook, jumped back to the top of its short term 89-92 trading range on the trade weighted basket DXY, and while technically it looks inconclusive on the basket, the Euro, Sterling and the Yen all look weak technically on the pair trades. By contrast the weakening trend against the offshore Chinese Yuan (CNY) looks intact, as do other EM pairs, suggesting this is driven by financial markets chasing yields rather than any view on economics.
A lot of the trading looked similar to the beginning of April and it is perhaps not a coincidence that last Friday, in addition to the timing of the Fed’s commentary, was also a quadruple witching event in the derivatives markets, meaning there were a whole series of market mechanics at work as well. As such, the question as to whether this is another buy on the dip moment like early May, or if indeed the trend has changed. needs a little more time to settle, although we suspect that the price actions of the week since the Fed/quadruple witching tends to suggest the former.
Medium Term Risks
The big medium term question remains about the reflation/inflation trade and obviously a key part of this is the potential short term mismatch between supply and demand resulting from pent up demand post Covid. While a lot of people are crediting the pick up in demand for oil with increased travel, it is also worth noting the point (picked up from energy Economist Philip Verleger) that the widely commented upon ‘Summer Driving Season’ in the US is in reality the ‘Summer Construction Season’ and it is this that really drives the demand for gasoline. It also drives demand for other construction materials like copper and timber. There is a widely quoted statistic from Bill Gates that between 2011 and 2013 the Chinese poured more concrete than the US did in the whole of the 20th century and while this is a staggering number, it also obscures the fact that most of the houses built in China are concrete while most in the US are built with Timber, the latter helping explain the sharp rise in Timber prices this year.
Of course, commodity prices tend to be self correcting, if prices rise too fast, then demand slows until supply catches up, but in contrast to even a decade ago, we would point to the important role of China in the commodity markets. The last time the Fed tried to move interest rates higher (and produced the ‘Taper Tantrum’) was back in 2012, when China’s GDP was, quite literally, half the size it is today. Up until that point, the concept of ‘The China Price’ was that, whatever China was buying went up in price as demand exceeded supply and whatever they were selling went down in price as supply exceeded demand. Of course, less than a decade later the dynamics are different and it is this that needs to be incorporated into the models. Today, whatever China starts buying, the financial markets seek to ‘front run’ in the same way they try and front run every large buyer of every financial product. China is not only aware of this but also now appears to be actively playing the traders at their own game and thus it is worth noting that the sell off in some of the commodity space was already underway before last Friday, it’s just that as the Japanese used to do in the past with speculative pressure on the Yen, the Chinese authorities intervened to push the commodity markets in the direction they were already moving, with the intention of hitting the speculators as hard as they can. Timber, Copper, Bitcoin; all subject to speculative runs, all knocked down by China.
Longer Term Themes
The intervention by monetary authorities in financial markets is not new, but looks to be more concerted and here to stay. Against this background it is very important to recognise that, essentially, Central banks are no longer independent. They are political – and in the US in particular Janet Yellen is arguably more important than she was at the Fed as she appears to be running both Fiscal and Monetary Policy. This is very important as Central Banks seek to launch digital currencies (and hence ultimately drive out Crypto) since such tools in the hands of politicians can lead to some potentially alarming issues. This week was the anniversary of the launch of Libra – the digital stablecoin – by facebook. It didn’t take off, but something like it will and the implications for FinTech, Banking and privacy remain significant. In line with the discussion above, one fast growing area has to be Digital Security. As the Internet of Things, Cloud Computing, AI, working from Home, 3D printing etc all flourish as themes, the need for security in a world of Zero Trust, will only grow.
Meanwhile, as we discuss in our pieces on Thematic Investing for CitiWire (Market Thinker), longer term thematic investing can be thought of as focusing on those companies benefiting from Economic Tailwinds and avoiding those facing economic headwinds. Once identified, they still need to be managed in a portfolio fashion to take account of risk and return. . The following graphic from Bloomberg illustrates this point by looking at the % of ETF categories beating their benchmark in the last three years. Leaving aside what is actually a key point – that the benchmark should actually be the ‘index’ for the strategy they are pursuing rather than equities generally – it is nevertheless interesting to see how, Thematic and ESG have struggled to repeat the success of last year, while Smart Beta/factors and Multi Category have done rather better. We have had a similar experience with our model portfolios – the Thematic Model Portfolio, after a stellar 2020 (up more than 50%) is up only modestly this year, having gone down in q1 and recovered in Q2. By contrast, the core, factor portfolio, which was up less (but still more than the benchmark) last year is up more than the index again this year. Different approaches – different risk reward. Different outcomes.