August 13. Limit to the Level of Skirmishes
The violence that erupted at the ‘Unite the Right’ rally in Charlottesville is a demonstration of how growing tensions can spin out of control in a hurry. In the global arena, Trump now is threatening trade retaliation against China in an attempt to force Xi’s hand on North Korea. At the same time, China is involved in a border dispute with India which could devolve into military conflict. The South China Post suggests an “…aim to limit any conflict to the level of skirmishes”, while the Times of India says “…diplomatic and military channels are being utilized in a bid to defuse the almost 2-month old crisis.” As China prepares for its National Congress, goals of strength and stability are being tested.
Global markets reacted this week to geopolitical events, with N Korea at the top of the list. A Google Trend search for “Military options” unsurprisingly has shown an increase to a new high, with Trump now casually tossing out the phrase in connection with Venezuela (Chicago is next). It’s clear that the odds of a mistake, somewhere, are increasing. So VIX, for example, jumped from 10 to 15.5 on a Friday to Friday closing basis. While treasuries didn’t make new highs, Eurodollar contracts from EDH19 to EDU20 (essentially the last 2 reds and greens), posted their highest levels since the November election. Odds of Fed hikes are being further squeezed out. All near Eurodollar calendar spreads are making new recent lows. For example, EDZ17/EDZ18 closed at 24.0 on Friday, on heavy volume of 75k, down 5.5 bps on the week, but down 15 from the high of 39 set in early July. In Fed Funds, the Jan’18/Jan’19 spread closed at 20.5, just better than 80% odds for just ONE hike next year. It’s getting to the point that the possibility of an EASE is going to have to enter into the equation. If I’m short Jan’19 FF at Friday’s close of 9856.5, just how confident can I now be that the upside risk is only 28 bps to 9884.5?
Adding to the mix were disappointing inflation data on Thursday and Friday, with Core PPI -0.1 and Core CPI +0.1 and +1.8 yoy. What is somewhat interesting is that while some inflation measures are muted, industrial metals are quite strong. Copper last week hit its highest level since June 2015. Aluminum since late 2014. Zinc is testing highs made late last year and in February and Nickel has had a strong bounce. Is this just a reflection of strength in just aerospace and defense, or a larger manufacturing rebound? Gold (GCZ7) has rallied 6.5% since the low close in July, reacting to both N Korea and a softer USD. Continuing on the topic of inflation and the missing link, i.e. wage inflation, note that the Fed unceremoniously dropped its Labor Market Conditions index (LMCI). From the Fed website: “…the measurement of some indicators in recent years has changed in ways that significantly degraded their signal content… average hourly earnings as an indicator did not provide a meaningful link between labor market conditions and wage growth.” I don’t know exactly what that means, but the Atlanta Fed wage tracker, while having decelerated to a small degree this year, still seems to be in an uptrend (+3.3 in July as 3-month MA), and a trade war with China will almost certainly be inflationary at the margin. If the Fed isn’t certain that wages are being properly measured, is it fair to say that inflation in general might also be in question? There have been several high profile recommendations of US treasury inflation-indexed bonds recently. Ten year tip ended the week at 39 bps, while the spread to 10y UST was 180 bps.
It now seems to be the case that even if the situation in Korea de-escalates, tensions are likely to remain elevated between world powers, and there are negative implications for global trade. For example, we hadn’t heard much about China building military islands in the South Sea for a while, but that issue is likely to flare up again. Additionally, it’s not clear that US domestic politics are getting more cooperative with respect to the Trump agenda. The debt ceiling problem is right around the corner, the US deficit is worsening, and an infrastructure and tax package is murky at best. At the same time, Mueller is turning up the heat on his investigation.
With markets having been priced for steady growth and low volatility until this past week, it’s little wonder that relatively small moves are creating pockets of angst. A fairly large move in VIX has shaken the idea of complacency, though US treasury vol was more or less immune. US hi-yield ETF’s took a large tumble, though I saw a chart that indicated that European junk yields had basically converged (prior to this week) to US treasury levels! There hasn’t been much in the way of ‘risk-cushion’ priced into assets, and the re-set can be jarring. Some time ago there was hand-wringing over the idea that China could roil US bond markets with sales of reserves. Headlines that have been shunted aside can return to the main track rather quickly.
What does tend to happen in periods of uncertainty is that markets trade technically. An old high or low will be tested and instantly rejected. Fibonacci retracements become more important guides. The opportunities for scalping gamma increase.
This week’s news includes Retail Sales Tuesday, FOMC minutes on Wednesday, Philly Fed Thursday.
