This Was A Painful Week To Watch

Summary

• If what happened during the week of February 5-9 was a technical, "one-off" bout of turmoil catalyzed by an anomalous vol. spike, this week was the opposite.
• This week, markets were forced to ponder two extremely disconcerting possibilities.
• The first is that Jerome Powell could well stumble (or be forced) into a policy mistake.
• And the second was of course the Trump tariff announcement.

This was a tough week to suffer through for markets. I'd argue it was much more arduous psychologically than the week of February 5-9, when the short vol. trade blew up.

I've spent a lot of time here (and certainly elsewhere) explaining how the turmoil that swept across markets early last month was technical in nature and thus not necessarily indicative of any further near-term pain. That's not to say that the ubiquity of the short vol. trade doesn't pose further near-term risk (it does) and that's certainly not to say that the unwind in CTAs and the clearing of the proverbial deck in terms of the VIX ETP rebalance risk has definitively defused the multiple time bombs inherent in the proliferation of strategies that are implicitly or explicitly short vol. (it didn't). Rather, it's just to say that the events that transpired from February 5-9 did act as a kind of pressure valve that allowed some steam to escape.

As a reminder, here's what I mean when I say "the deck was cleared" in terms of the VIX ETP rebalance risk:

(Goldman)

That's probably been rebuilt a bit, but the bottom line is that the risk posed by those products was pretty much zeroed out overnight on February 6 and since then, ProShares has changed the rules on the ProShares Short VIX Short-Term Futures ETF (SVXY) and the ProShares Ultra VIX Short-Term Futures ETF (UVXY), in an effort to make them less susceptible to a blow up and, more importantly for the broader market, less likely to catalyze another super-charged VIX spike. That rule change wiped out some options holders, something I believe is pretty egregious, but that's another story.

As far as CTAs (and other systematic strats) go, it was probably a good thing that they were forced to de-risk as it relieved some of what Marko Kolanovic has variously called "quantitative exuberance." The latest update on CTAs from JPMorgan's Nikolaos Panigirtzoglou contained the following chart which illustrates the fact that as a group, they had their worst week in history from February 5-9:

(JPMorgan)

Again, all of that to say that some of the steam was let out early last month and that, at least temporarily, reduced near-term risk.

Unfortunately, this week was characterized not by a technical unwind or by a VaR shock, but rather by two extremely disconcerting events that, together, left markets stumbling off into the weekend in a daze.

First was of course Jerome Powell's testimony on Capitol Hill. That went ok on Thursday but not so well on Tuesday. I wrote a recap of Powell's Tuesday testimony for this platform which you can read here, but suffice to say he made the mistake of answering a question about his take on the rate path in a straightforward way and "straightforward" isn't something you want to be when you're in the "forward" guidance business. Here's the bottom line from Citi:

The main surprise in Powell’s [Tuesday] congressional testimony was his hawkish answer to a direct question about what might cause the FOMC to hike more than three times in 2018. Rather than affirming the ‘gradual’ rate hike committee consensus, Powell left the door open for upward revisions to dots.

He talked that back a bit on Thursday, but the damage was already done. The market now thinks a regime change may be afoot and there are very real questions about whether Powell truly appreciates what he's up against here.

Earlier this week, Goldman interviewed Paul Tudor Jones, and although I've used this quote in two other posts over the past two days, I want to use it again here because despite the somewhat silly attempt to couch it in terms of the Battle of the Little Bighorn, it's still a good summary of the situation the new Fed chair finds himself in. Here's the excerpt from the interview:

Let me describe to you where I think Jerome Powell is right now as he takes the reins at the Fed. I would liken Powell to General George Custer before the Battle of the Little Bighorn, looking down at an array of menacing warriors. On the left side of the battlefield are the Stocks — the S&P 500s, the Russells, and the NASDAQs — which have grown, relative to the economy, to their largest point not just in US history, but in world history. They have generally been held at bay and well-behaved, but they are just spoiling to show their true color: two-way volatility. They gave you a taste of that in early February. Look to the middle and there waits the army of Corporate Credit, which is also larger than ever relative to the economy, as ultra-low rates have encouraged it to gain in size, stature, and strength. This army is a little more docile right now, but we know its history, and it can be deadly when stressed. And then on the right are the Foreign Currency Fighters, along with the Crypto Tribe, an alternative store of value that only exists because of the games central banks are playing; the opportunity cost of Crypto is so low, why not own some? The Foreign Currency Fighters have strengthened by 10% over the past year. Compounding the problem, they have a powerful, ascending leader, the renminbi, to challenge the US dollar’s hegemony as the reserve currency. All of these forces have been drawn to the battlefield because of our policy experiment with sustained negative real rates. So Powell looks behind him to retreat. But standing there is none other than Inflation Nation, led by the fiercest warmongers of them all: the Commodities. He might take comfort that he is not alone on the battlefield. But then he looks over at the Washington, DC, fiscal battalion and realizes they are drunk on 5% deficit beer. That’s what Powell is facing, whether he recognizes it or not. And how he navigates this is going to be fascinating to watch.

Again, if you can get past the belabored attempt to couch this in frontier battle terms, that's a pretty useful assessment.

This week, the market was forced to come to terms with this situation and frankly, folks are missing Janet Yellen already. Remember: you don't have to like Janet Yellen's policies (or the bent that has characterized monetary policy in the post-crisis era in general) to miss Yellen. Indeed, there's a sense in which once you've persisted in an inherently unsustainable policy regime for long enough, just about the last thing you want to do is remove the person who's running it if you don't have to, because then you risk whatever instability comes along with an unwind of that policy regime. Although everyone professes to be in favor of a return to a more normal state of affairs when it comes to monetary policy, a return to that (i.e. the re-emancipation of markets) is going to a very painful exercise and to the extent that exercise is being conducted under the leadership of someone new, the chances of a "mistake" along the way increase.

So Powell's Tuesday testimony and the market response to that testimony (e.g. the sharp rise in yields that unfolded just as he started the Q&A and the accompanying fade in equities) was the first disconcerting event of the week. You already know what the second was: it was Donald Trump's announcement of steel and aluminum tariffs.

I'm not going to get into the details of how this supposedly unfolded (you can Google it and there's a retelling of it on my site, but I don't think it's particularly germane for this particular post), but suffice to say the Thursday announcement was, by every account I've read, off-the-cuff.

Of course, the tariffs were in the cards, and as Wilbur Ross reminded everyone in an interview with CNBC on Friday, the President has been talking about this since he was candidate Trump. But the conflicting reports out of the White House on Thursday demonstrate the extent to which no one save Trump and Ross and maybe Peter Navarro knew what he was going to say just after noon. Here is the sequence of headlines as they appeared on Bloomberg on Thursday:

• 8:53: TRUMP IS SAID TO ANNOUNCE TARIFFS AT MORNING MEETING: CNBC
• 10:42: CNBC: TRUMP EVENT AT 11AM WILL BE ON TRADE, NOT TARIFFS
• 12:30: TRUMP SAYS 10% TARIFF FOR ALUMINUM; TRUMP SAYS 25% TARIFFS FOR STEEL

That whipsawed all manner of assets from the Mexican peso to steel makers, but ultimately, the message from markets was clear: it was not well received neither in terms of what it foretells for the future of global trade nor for what the seemingly haphazard way in which it was delivered seems to convey about whether everyone in the White House is on the same page (Gary Cohn is reportedly not pleased, for instance).

By the close on Thursday, stocks had fallen 1% or more for three consecutive days:

(Heisenberg)

And by midmorning Friday, the Dow was down some 1,600 points from the moment Jerome Powell mentioned his upbeat outlook on inflation Tuesday:

(Heisenberg)

I don't think I have to tell you this, but just in case: the consensus is that the tariff move is, to quote one big bank CEO who spoke to CNBC, "a huge, huge mistake."

It would be impossible to document the entirety of the backlash from the international community here, but here's former trader-turned Bloomberg columnist Richard Breslow summing things up:

Read the responses being expressed, literally all over the world, and there is universal appall at the renewed trade-war threats. Warnings of retaliation, in the baldest terms. And from our allies, too. The dismay at the hostility of the verbiage. The unseemliness of the gleeful Tweet boasting that “trade wars are good and easy to win.”

Just to kind of drive the point home, virtually no one has a sanguine take on this. Let me just run through some of the commentary for you.

Here's Goldman:

We remain constructive on global equity markets and continue to be overweight within our asset allocation on a 12-month horizon. One potential risk to our central case is that global growth slows, or profits are hit, by increased US tariffs on trade and the possibility of an escalating global trade war. While this is not our expectation, this topic has once again become a focus for markets and could take centre-stage at the forthcoming G20 meeting. In terms of the potential direct effects, the impact of tariffs would likely be felt most acutely in Asia and Latin America, given the rapid growth in their exports to the US and the high labour content in the production of these exports. However, European equity markets would not be immune, given their high sensitivity to world growth. While we would expect the US to be the least affected directly, it would become vulnerable to retaliation from its global trade partners.

Here's BofAML:

Looking towards next week, we believe a series of uncertainties persist, including the following: US consumers will in all likelihood have to pay higher prices, making it also more difficult for manufacturers to compete with e.g. Chinese operators. In our view, this highlights a clear trade off the President is facing: aluminum buyers stand to lose, while producers are the winners. Countries including Canada and Europe are key suppliers and also competitive economies/ NATO partners, but they would still fall under the blanket tariffs.There are concerns that steel/ aluminum shipments could be diverted from the US to e.g. the EU, potentially forcing another round of trade restrictions ex-US.

And here's GMO:

Thursday's announcement by President Trump of imminent tariffs on steel and aluminum imports was taken poorly by global stock markets. Perhaps in an attempt to convince investors this was an incorrect response, early this morning he tweeted that “trade wars are good, and easy to win.” He is wrong, and beyond the simple fact of his wrongness, a trade war is probably more dangerous for investors at this time than at any other time in recent history given the implications it would have for inflation, monetary policy, and economic growth.

And what about Moody's?

Tariffs Warn of Even Faster Price Inflation and Slower Growth

February was a stormy month for financial markets. Worse yet, March got off to a horrible start in response to President Trump’s intention to impose import tariffs of 10% on aluminum and 25% on steel despite how costlier aluminum and steel will diminish the global competitiveness of those U.S. manufacturers using these materials. Remember, after having incurred back-to-back monthly setbacks in January and February, auto sales were expected to decline in 2018 prior to the statement on tariffs.

Markets question the need for such tariffs given how employment opportunities have increased considerably over the past year. In addition, such tariffs will add to already elevated worries surrounding price inflation that stem from the considerable upward pressure put on product prices by higher rates of resource utilization.

I think you'll trust me when I tell you that this just goes on, and on, and on.

Again, there isn't enough time in one Saturday to document all of the commentary on this, so I'll just save you the time by noting that while there's considerable disagreement about what the impact of the tariffs themselves is likely to be, there's (virtually) no disagreement about the broader notion that the second-order effects of this would be bad. And that's just from an economic standpoint. That is, it doesn't even consider what this would mean in terms of fostering political ill-will on the world stage.

One thing I would ask you to note in particular. Go back up and scan the GMO excerpt again. The implication there is that this is going to exacerbate the above-mentioned quandary for Jerome Powell by potentially driving up inflation. Worse still, it could eventually serve as a drag on corporate profits if it mushrooms into an all-out global tit-for-tat. If that happens, you've got a recipe for stagflation.

The bottom line here is that we've skipped straight from a technical selloff driven almost entirely by the short vol. unwind and the subsequent forced de-risking by systematic strats to a situation where the specter of a monetary policy mistake is colliding head on with the threat of an imminent trade war. And all of that at a time when valuations are still stretched and earnings growth projections are particularly rosy.

This isn't a great setup. I would strongly encourage you to do some digging this weekend regarding the likely blowback from the tariffs if you are at all concerned about the near- to medium-term outlook.

One caveat: it seems entirely likely that the administration will walk back the rhetoric next week in light of the reaction in global markets.

Additionally (and I'll get to this in another post), Kuroda raised some eyebrows on Friday when he suggested the BoJ could begin to roll back accommodation in 2019. That wasn't digested well by the yen and you can expect him to try and walk that back next week as well, which could be bullish.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.