Market volatility tends to come from events that happen in left field when few market participants are watching. Markets are efficient until they are not, and those times come from surprises. Over the course of my career that began in the early 1980s, I have found that the most significant market adjustments or repricing came from currency and debt markets. While most market participants have their eyes on equities because that is where they place nest eggs and savings, global shifts impact debt instruments and foreign exchange relationships. Therefore, governments and central banks are more often than not the cause of periods of wide price variance that leads to change.
The last significant shift from the official sector came in 2014 when the U.S. Fed decided that moderate economic growth was enough of stop fueling a free put on the bond market and that short-term interest rates at zero percent were fueling a flood of liquidity that could have significant ramifications on the global monetary system. The central bank realized that the printing presses needed to slow, stop, and reverse course. Tapering of QE led to the first rate hike in December 2015. This week, the Fed will hike their short-term rate for the seventh time to 1.75 percent. QE has turned to QT as the central bank's swollen balance sheet is slowly letting air out of the liquidity balloon by allowing those debt security purchases to roll off their balance sheet. The Fed had been clamoring for the government to step in and replace monetary with fiscal stimulus. They got their wish last December in the form of tax reform.
This week, there are so many things going on around markets from a macro and micro economic perspective all of which have the potential to create volatility in all asset classes. It is possible that while the world has its eyes focused on one issue, another will be a trigger for price variance and a shift from the recent status quo.
Lots of events in markets this week
As I sit here writing this piece on Saturday afternoon, the first big event has come to an end as the G-7 meeting in Canada's disruptive force departed for Singapore. No matter what your political orientation, I think most of us would agree that President Trump is unique. The United States has never seen a President like him, and the rest of the world has not either. The current leader of the free world has changed the meaning of diplomacy.
The President spent all of his time before and on his way to the G-7 meeting tweeting about the unfair trade policies of the other nations he was about to meet. He taunted the other leaders with ultimatums. The press was all over his comments and built the G-7 into a potential jousting session. I can't help but think that his suggestion to include Russia and return to a G-8 was a strategic ploy to divert attention from his goal, which is reciprocity in trade. Interestingly, as he departed for the next big event of the week, President Trump threw out the idea of doing away with all tariffs and trade barriers to give the other leaders something to think about in his absence. The bottom line, in my opinion, is that the big bluff continues and at the end of the day there will be a series of bilateral trade agreements and compromise. After all, any improvement in the balance of trade will be a victory for the administration and winning is the goal of the U.S. President. As an experienced media star, he knows that the presentation is more significant than the result when it comes to popularity and perception.
The next event comes on Tuesday when the disruptor-in-chief sits down with the despotic leader of North Korea in Singapore. The technique this time has been a cancellation of the meeting and a reversal over recent weeks. President Trump has told the North Koreans and the world that anything but total and complete denuclearization is unacceptable. Aside from the media hype and unprecedented nature of the summit, it is likely that the two leaders will shake hands and agree to work towards something, that is the high odds play. The two men in the room have goals. President Trump wants a Nobel Peace Prize. Kim Jong Un wants money, few or no sanctions, and to retain his power in North Korea. The nuclear weapons that many analysts say he will never give up have already achieved the goal of bringing the leader of the free world to the table. I do not expect any earth-shattering result to the meeting in Singapore. President Trump will not storm out, and Kim Jong Un will capitulate. However, a handshake, a few jokes, and a meal or two will result in another meeting and get the ball rolling for a long overdue end to the Korean War and more stability on the Korean Peninsula. While the world watches Singapore on Tuesday, farmers and market participants in the world of agricultural commodities will watch the June WASDE report for clues on the direction of grain prices. While the monthly offering from the USDA is a microeconomic event, it has the potential of ubiquitous consequences as it deals with the products that feed the world.
The following day, to further exhaust market watchers, the Fed will hike rates by 25 basis points. The statement that follows the move and the press conference featuring Chairman Jerome Powell will likely be more the same gradual approach language and "symmetric" approach to inflationary pressures. I do not think we will get any surprises from Singapore or the Fed this week, but the ECB and BOJ could be another issue.
The surprise could come from Mario Draghi and company in Frankfurt
European economic growth at 0.4% remains lethargic. Short-term rates at negative forty basis points and the ongoing QE program that went one step further than the Fed's by including some corporate debt issues will come into focus as the ECB meets in Frankfurt and discloses their thoughts and approach to monetary policy. Last week, there were subtle hints that the accommodative approach to monetary policy could be ending sooner rather than later. Mario Draghi has repeatedly told markets the ECB will do whatever it takes to stimulate the European economy. I believe that the ECB is in a position where a continuation of the status quo could become problematic when it comes to inflationary pressures. The best chance for a surprise this week could come from the ECB. The euro currency is down from highs at over $1.25 against the U.S. dollar to under the $1.18 level. The stronger dollar and weaker euro over recent weeks could provide the ECB with a window to pivot without sending the euro flying to new highs on the upside, as it would likely only return to the recent peak. A strong euro is a problem when it comes to European exports, but a return to the highs from a few months ago will not rock the economic boat too much.
Accommodation is getting stale and dangerous
My grandmother lived to 99 years old and attributed her longevity to moderation. There are so many examples of how moderation is a healthy approach to many aspects of life and economics is no different. The ECB's policies have not changed in years, even as the U.S. Fed has gone the other way almost four years ago. European monetary policy has been stuck in neutral, and even though economic growth on the continent is nothing to write home about these days, it does not justify the never-ending printing presses and over liquification of the economy. QE and negative interest rates were a novel approach to stimulus but they have become stale and moss is growing on Europe's dovish status quo which creates a rising danger of inflationary pressures. There are many voices in Europe looking for a change in monetary policy. Germany and other members of the EU understand the historical consequences of inflationary pressures and are looking for an opportunity to end the unprecedented level and period of accommodation. The markets have become comfortable with European monetary policy, and a hawkish pivot would likely catch some off guard and could provide lots of action in the currency markets this week. The recent political events in Italy likely resulted in a perception that Europe cannot afford to pivot towards tightening credit a bit. However, this could be the perfect time for action from the ECB.
Gold is a barometer of inflationary pressures, and the quarterly chart of gold in euro-terms speaks for itself these days as the yellow metal is not far off its highs. While gold in dollar terms is around $620 off its all-time peak, in euros it is only $275 euros off its highest nominal price.
Southern Europe will always be an issue - it's cultural
The economic and cultural divides between northern and southern European countries dates back centuries. A few decades of the EU will not change the vastly different orientations to corruption, spending, and economic management of economies across the continent. Greece, Italy, Spain, and Portugal march to the beat of a different economic drummer and have become increasingly impatient with political decisions in Brussels and economic dictates from Frankfurt. Nothing the EU or ECB can do will change the divide. The euro currency has installed a German-style monetary discipline on the south that the drachma, lira, peseta, or escudo never could.
However, the price has been little or no economic growth and hardship for many citizens. The Italian debt issues are the result of an uprising at the ballot box where anti-euro and nationalistic parties have been gaining strength and a voice in the future. Brexit occurred two years ago, and the potential for a rejection from the south continues to grow. The Brexit was an easier divorce because the U.K. never adopted the euro as their currency, a divorce with Italy could spread quickly and threaten the future of the Union. Meanwhile, the ECB is in the unenviable position as it needs to choose between inflationary pressures and tightening credit which could make resistance from southern members worse.
Time is coming close to loosen the dovish noose
The ECB headquarters are in Frankfurt, and while Mario Draghi sits at the head of the table at the central bank, the influence of Germany is a potent force when it comes to monetary policy. The ECB has been kicking the can down the road for too long, and the time has come for accommodation to ease. While a hike of ten or twenty basis points will keep short-term rates in negative territory, and tapering QE will allow for some purchases of debt, it will send a signal that the ECB is serious about preventing inflationary pressures that can eat away at the value of the euro. I believe that Europe is already far behind the curve when it comes to inflationary pressures and that the continent will be ground zero for a wave of higher prices in the future. There is a price to keeping the printing presses going for far too long, and the sooner they send a signal to the markets the better. This week, we could see a first step that would come as a surprise to markets.
When it comes to the BOJ, the Japanese are in the same boat as Europe as they have become addicted to liquidity. The aging population has caused productivity to decline, and increasing health costs and pensions continues to weigh on the world's third-leading economy. While the BOJ will likely stay the course this week as the market expects, a surprise could also rock markets. While the golden barometer in Europe is threatening inflationary pressures, Japan could have an even more significant issue with which to contend.
The chart of the price of gold in yen terms shows that it is very close to an all-time high. The bottom line is that liquidity comes at a price, and the longer the liquidity faucets keep running, the higher the danger of an inflationary spiral that could cause years of problems for the world's central banks.
If there is going to be a surprise this week, my bet is on a pivot towards "tightening light" by the ECB. However, lots of evidence points to creeping inflationary pressures which is the price tag for a decade of dovish central bank policies. If the inflationary chickens are coming home to roost, commodities could be the perfect place to hide. As the economic condition eats away at the value of currencies, raw materials prices tend to rise.
DBC has traded in a range from $11.70 to $46.62 since 2006. At $17.84 on June 11, the diversified commodities ETF product is a lot closer to the lows than the highs over the past dozen years. A move by the ECB would likely cause weakness in the dollar which is support of commodities prices. I continue to believe that the world's central banks have sown the seeds of inflation and that commodities price will be a beneficiary as they slowly realize that they have fallen way behind the curve.
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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.
Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.