All the Bogeymen are Here

I am tempted to use one of the most tired clichés to describe the state of play in financial markets. In his famous book with the same title, Malcolm Gladwell describes a tipping point as "the moment of critical mass and threshold" at which point the parameters and rules of the game—in a market or environment—change radically. As I peer across markets and economies, I am starting to wonder whether we are getting close to just that. The eye of the storm is quite literally the U.S. where the layers of economic and political uncertainty are now so thick that I am not even sure where to start. The tinfoil hat scenario goes something like this. The devastation of hurricanes Harvey and Irma is worse than feared and become a stagflationary hit—negative supply shock and plunge in demand—but the call for decisive action in Washington and the Eccles building go unheeded. The debt ceiling bites right when the economy needs the flexibility the most and the Fed is caught between a rock and a hard place as inflation soars. Pyongyang uses the confusion to show that it means business by firing a missile towards Alaska.

Let's be clear; this likely is a situation where the dollar and spoos fall in unison and where U.S. bond yields rise. In short, chaos. 

The upshot is that if I can come up with this over a beer in the pub on a Friday afternoon, it doesn't qualify as a black swan. But if we pick the different components apart it is not unreasonable to expect at least a couple of them will become reality. The political situation warns of a nasty inflection point in Washington. The agreement to extend the debt ceiling cliff by three months was hailed as a grand bargain, but it was probably the worst exercise in political can-kicking I have ever seen. If they don't get their acts together next time, the economy and markets will suffer real damage. Meanwhile, at the Fed, the departure of the sage Stanley Fisher and the near certainty that Yellen's stint will not be renewed have injected a large degree of uncertainty over what markets are supposed to expect from the Federales. I have to assume that our policy overlords will not drive the car over the cliff, but the risk is a bit too high for my liking.

As I pen this missive, the Irma is making landfall over Florida, sweeping across the state from south to north. Its destruction will be grim. The consensus spiel is that the short-term hit will be severe, but that we will be celebrating the rebuilding-boost to the economy—and the reflation trade 2.0(?)—by Q1. I don't dispute that sequence. But if you combine the size Florida and Texas and assume that their respective economies are simultaneously shocked, there is also the possibility that this turns into an event with real adverse economic effects. My fellow finance geeks on Twitter have pushed back against this, assuring me that this will be exactly like previous instances when large hurricanes have made landfall. The economic data will throw a tantrum in the short run, but rational markets and street smart policy makers will look through this. I want to believe this, but the timing of these two hurricanes is bit a more unfortunate than usual. 


A final deep dive for U.S. yields and the dollar? 

It's always possible to tell tale of fire and brimstone for markets. But the confluence of risks above comes at a critical time for financial markets in the U.S. We have been discussing the dollar in recent weeks, and it is not unreasonable to claim that its fall from grace partly is a result of a combination of the risks mentioned above. The DXY is getting stretched to the downside, but my gut tells me that the pain trade is for further weakness given how bullish the consensus was at the beginning of the year. No matter what chart you look at, it is a dumpster fire for the dollar and if markets and the Fed fail to keep their cool, it likely will be the catalyst for a final capitulation. 

In the sense that the dollar is a recipient of carry trade flows in a world where surplus economies in Europe and Japan are the primary sources of excess liquidity, it makes sense for it to fall as risk aversion increases. But I think it is fair to say that the dollar's weakness has preceded risk aversion. In fact, if we neutralise currency effects, risk assets have not collapsed, even if they have ground to a halt since May. What I am proposing is that they will if the dollar doesn't step back soon, especially if currency weakness in the U.S. coincides with a debt ceiling hiccup. If that happens, we open the trap door into the abyss of extended valuations, the vulnerability of one-way markets dominated by passive investing, lack of liquidity in corporate debt and their derived ETFs and so on. We all know the bogeymen that lurk in these markets.

The trajectory of U.S.—and by some extension global—rates is equally poised on a knife edge. Arguably, the best thing for the Fed probably would be to say and do nothing. But hurricanes or not, they are supposed to be in the middle of a hiking cycle, which has presented markets with a conundrum. The curve has flattened, signalling that markets don't believe the economy can stomach higher rates—the promises of Trumpflation have after all disappointed badly—and that too much global liquidity means the FOMC can't get traction on the long end. Regardless of your favourite explanation, I can't see any easy choices for the Fed. If they valiantly look through the near-term swoon in the data—perhaps even raising rates in December—they run the risk that the curve flattens further, raising questions on what exactly their terminal rate is. After all, a two-year yield of 1.2%-to-1.5% is neither here nor there. It is too low to be the terminal rate, but it also implies that the Fed won't do anything for the next two years. If they kick back from the table, blues and 2-year notes would fly. But wouldn't this also mean that the political uncertainty and hurricane damage were worse than expected and that the dollar will fall further? Are investors getting cornered? 


Always look on the bright side

The good news is that the description of the world above isn't necessarily accurate. Even if it is, there is a silver lining. A mix of hurricanes and policy uncertainty could be a ruse for investors, prompting them to capitulate on any notion of a stronger dollar and a U.S. reflation trade at exactly the wrong time. After all, two devastating hurricanes could also be a catalyst to generate bipartisan support for that infrastructure stimulus we have been waiting for. This is probably a long shot, but it is possible that the world will look quite different in the first half of next year as the rebuilding lift to the economy kicks in. 

The investment implications are clear enough if you believe that version of the story. You should fade weakness in the dollar, sell your bonds, and buy financials and U.S. domestic growth plays in equities. We shouldn't forget the reasons markets jumped on the dollar bull-story after Mr. Trump's victory. The idea was that late-cycle fiscal stimulus in an economy with no spare capacity would lead to a surge in yields and the dollar, widening the U.S. external deficit and boosting global growth. That story is difficult to tell at present, but it could re-emerge. Finally, a weaker dollar, in theory, has an in-built escape valve via its effect on other central bank's reaction functions. The ECB, the BOJ, and the PBOC can only take so much, and eventually will be forced to produce more of their currency—hint; to create more global liquidity—if the greenback weakens further. 


Can we keep the bogeymen contained? 

In their brilliant book on the financial crisis, All the Devils Are Here, Bethany McLean and Joe Nocera start by producing their "cast of characters," which list institutions, traders, mortgage brokers, analysts, CEOs, regulators and politicians whose actions, or inactions, contributed to the disaster of 2008. We already know in part how the cast of characters will look once the story on this cycle is written; it will include corporate bonds, ETFs and passive investment vehicles, among other things. As markets grapple with an elevated degree of uncertainty, investors would be wise to look out for those bogeymen to rear their heads.