Why is Trump about to have a huge headache?

During the Great Leap Forward in Mao’s China, there was a plan introduced in order to kill four different pests (aptly and creatively called ‘The Four Pests Campaign’).

These four pests were rats, sparrows, mosquitoes and flies; they were to be eradicated to prevent the spread of disease and to stop the destroying of crops.

This was a huge failure.

Documentation shows that this was one of the largest reasons as to why the Great Famine occurred since the extermination of sparrows led to locusts massively increasing in population size as the food chain was disrupted.

This led to locusts destroying crops on a scale larger than the sparrows affected stored supplies of grains, corn and other soft agricultural food items.

The connotation here is a bit crude, I must admit, but one that has some pertinence: potentially well meaning policy to protect people can go entirely the wrong way.

QZ released an article on Friday explaining that Trump’s trade policy has had wildly the opposite effect of what the US president has expected it to have, with China hitting a record $34bn trade surplus with the US this month.

I’m not sure how well this will go down in Washington, with this being one of Trump’s leading policies – that is, if the policy was to less China’s surplus rather than affect demand for Chinese goods to the rest of the world. If the latter is the case, then the policy is actually going rather well since RoW Chinese exports have decreased while US exports have increased by a fair whack.

The quote from the article above speaks about there being a headwind to the Chinese economy – the slowdown in Chinese credit growth.

This may be the case, but I do not think that there is anything for the Chinese government to worry about just yet.

Take a look at the below chart.

This shows the 3M Shanghai Interbank Offered Rate. It’s the equivalent of LIBOR although less used on the international stage as a tool of pricing of some assets.

Something to notice is that China has been easing pretty stealthily since the start of 2018; this was when Trump put his first tariff on Chinese solar panel imports.

PBoC easing was absolutely a direct response to this.

You can see this from the USDCNH relationship too.

A cheaper Yuan pretty much counters Trump’s policy on Chinese trade since goods become relatively cheaper… the party is likely to be short lived for the PBoC though.

Something key that has always popped up is how China has been holding US treasuries for a long time and has dumped some…

But that is irrelevant in a world were the Fed are so adamantly shedding their own holdings of the US government’s debt, which is the main reason as to why yields have spiked and emerging markets have been under the cosh. It’s also relatively a pointless remark to make since if China dump them all then they have 0 leverage at all.

You only have to look at the positioning of traders on US treasuries to see that Fed rate rises are the reason as to why everyone and not just China have sat on the offer of US treasuries through 2018.

Late October 2017 is when we saw the temporary net long position (green line) start to turn long term net short.

This coincided with the Fed beginning their aggressive balance sheet shedding policy, and the USD liquidity issues that we see now.

The pertinence of this can be shown below.

That is 3m USD LIBOR. The upticks (monetary tightening) actually began in 2015 with the end of QE, but the effects on the dollar began later when the rate hike cycle began and increased in velocity when the Fed started to allow their bonds to mature. Naturally, this leads to the current uptick in yields – something which has affected the EMs hugely since they are laden with cheap USD denominated debt through the QE years.

Remember, LIBOR shows the cost of lending between each other and therefore, LIBOR can be a proxy for global liquidity and the corresponding creditworthiness of the interbank market (SOFR is too new a contract for me to have any thoughts on yet).

But back to China.

The LIBOR/SHIBOR spread is increasing, and this ultimately means that with the geo-politicking that is currently occurring we are likely going to face a tough reversal at some point where both parties find that they can no longer withstand the policies going either way (easing vs tightening). By then, Trump’s trade policy will be thrown in the dirt and will not matter one bit.

I see China going first – they cannot survive 305% debt to GDP. It’s untenable.

But so is the situation with USD.

Mehul Daya, an analyst who I think is absolutely bang on with the USD fundamentals, of Nedbank in South Africa reckons that the USD is about to face a collapse once a real risk free rate of return comes back… that is when r > CPI. He refersto it as ‘the straw that will break the camel’s back’.

However, I see it being made up of two factors – the first being that USD funding issues makes hedging too costly so assets are hedged in other currencies (I do not know which ones as I am not that smart) and the second being the issue Mehul raised.

This will lead to decompression of risk assets and a massive repricing/rebalancing of portfolio risk. This in turn will mean a collapse in US yields and therefore the dollar, probably to levels seen when we began QE in 09.

So does Trump have a headache?

Yes, but the answer is much closer to home for him, and that is with the hawkishness of Jerome Powell.

As we know, last week Trump has a bit of a dig at Powell since he knows that Fed tightening is at odds with his China trade policy. I personally think that Trump knows the Fed has created this illusion of a strong economy.

Zombie companies have not gone under since their operational costs are kept low through cheap credit and low (but now rising) financial costs and so unemployment stays low… but so does investment.

This is a surefire reason as to why Trump is so averse to Fed hiking, and is (again in my view) the real reason why he may need something a bit stronger than paracetamol for the inevitable migraine he is going to face.

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OK I’m A Dollar Bull Now…

Just seeing one chart has changed my bias on the dollar totally by allowing a confirmation of a few fundamental concepts.

I have to really thank CNBC’s Todd Gordon for this one.

I read his article and noticed that he is using a different USD gauge.

I generally look at the dollar index as a function of equal weights.

However, just by looking at a more-applicable-to-reality trade weighted dollar, it has generated new thoughts and perspective on my macroeconomic view, as well as currency risk view.

Take a look at the TW dollar…

We have indeed breached a 30 year trendline and have found some support here at just below 85.00.

I’m not saying that we are going to rally off from here into 110, since I think we are still due a dip down to 75, but my very long term view is now bullish.

This is supported by various different other background events.

Let’s look at the 10 year yield.

This is following the same path as the trade weighted dollar (naturally).

With the Fed unwinding, I think that a situation such as in 1994 will occur again.

Bonds sold off in 1994 and yields rallied by 46%.

If yields move to where I think they will, that would be a 75% move from current price.

Why are yields moving up? The Fed is shedding assets from their balance sheet after having undergone the fantastically functional QE programme of the last 9 years (sarcasm).

See below. I have added 3M USD LIBOR onto here as well.

fredgraph (1)

You can see that when the Fed underwent their QE programme, USD 3M LIBOR fell a huge amount. This meant that USD was very liquid and interbank borrowing costs were low. Basically, everything was nice and liquid.

Since the Fed has started hiking in late 2016, 3M USD LIBOR started pushing up. Markets knew that this was in preparation for the Fed to start their great unwind. You can see this in the gradual decay in assets owned by the Fed (blue line) since 2016, with a slight acceleration in late 2017 when they announced fully that they will be shedding their ‘assets’.

But what does this mean for the dollar?

Well, a rising LIBOR should indicate dollar demand/supply constriction.

Take a look at this chart.

3M USD LIBOR is lagging spot USD by a large amount.

If we go back to our yield and dollar index charts, we can see that a broad upside move is not that crazy an idea if it holds that we are going to face a dollar funding problem. This dollar funding issue also leads to another problem and that is to do with liquidity.

We’ve already seen some flutters in the TEDRate, an indicator of liquidity risk.

When the Fed announced their unwinding, we saw a gradual rise in the Ted Rate which led to the highest level since 2009. Essentially, this priced in that liquidity risk was higher than the European debt crisis in 2012.

This indicator shows the credit worthiness of our biggest banks – LIBOR is the price that they lend to each other on the interbank market. A spike in the TEDRate means there is more ‘risk’ on the interbank loans market. That is not good.

The Bank Index has probably reflected this occurrence.

The drop off in price from the run up to the 2008 high could have some meaning in this case, especially since before the 2008 crisis we faced USD funding cost issues as well.

USD 3M LIBOR moved up pretty rapidly pre crisis then… it’s exhibiting the same characteristics now.

fredgraph (2)

Essentially, I feel the dollar is currently heavily under priced if we follow the underlying money market fundamentals. I think that there is some downside left and the current move is a short squeeze, but there will be a more broad based dollar upside move in the next year to 18 months, and much of it will be driven by dollar funding issues.

 

 

 

 

 

 

In FX, simplicity is best… #fx #btc #audjpy

K I S S

Keep It Simple Stupid

Probably what you hear about everything.

In trading, it’s genuinely hard to keep things simple.

First, you pick up bad habits.

Next, you try to create a fantastically amazingly filtered strategy with loads of different variables, because you’ve been told you should be able to measure your hypothesis, and science normally says to filter until you get a valid conclusion, right?

After that, you become frustrated and feel pain.

Emotions get the better of you and you lose your head.

You lose money…

Then you repeat the process when you’ve calmed down.

It’s a vicious circle.

The issue with many comes down to the lack of understanding of price and the interpretation of it, which transfers into the understanding of risk.

Slight tangent re: risk. I saw a tweet describing spotting valid risk parameters as being an executable entry with ‘positively asymmetric’ risk:reward.

I’d never heard it be described with that phrase but I like it.

Technical analysis only works when you can interpret price.

The best FX traders are able to understand that TA and FA alone are limiting in their nature.

There’s a reason why interbank dealers make money – they can see the market… and well, they are the market.

We have to interpret price as we see it on our trading platforms to have a best guess as to what these guys are doing (well that’s what I do anyway).

One way recently that I have further simplified my trading is to just look at Heikin Ashi candles (and I mentioned this in my ‘What I have learnt after 7 years of trading‘ article the other day).

This has made my life easy.

Previously, I’d have to determine where the valid zone is that I’d expect a bounce from and then place up to 10 orders across the whole zone.

Heikin Ashi has changed that… and I can’t believe that it’s taken 7 years to find this out.

This is how simple it’s made my strategy…

I ask myself, ‘where was the last supply before it broke the low? Where is the untested demand that broke a prior high?’

Then I place my orders.

Below is AUDJPY and I mentioned I was selling it here.

That’s how simple it is, or at least how simple I personally find it.

There are other nuances as to whether I want to take it or not (I’m not going to say them all), but that’s the barebones – and Heikin Ashi has made where I want to do business so obvious it’s scary.

Arguably, it’s irrelevant as to what your filter is, but I’d say find something that makes it as obvious as possible. I have found it after seven years… seven years of thinking a chart display was a broker’s trick…

As I said, you learn something new everyday, so thanks @ForexCobain