U.S. Dollar To Strengthen Soon; Precious Metals, Emerging Markets Suffer; Base Metals Have Bottomed: Part 1

Includes: EEM, UDN, USDU, UUP
by: Robert P. Balan

PAM expects the DXY to be on an uptrend up to late Q2 2019. But the volatility of US bond yields will be a big influence on its high-frequency fluctuations.

EM assets are peaking and may perform poorly until late Q2 2019. There should a reversal of fortunes in Q3, but Q4 to early 2020 should be dominated by firm USD.

We look for weaker PM prices in Q2 2019, but outperformance will return in Q3. But that will be followed by weakness again in Q4 until early 2020.

Base metal prices have bottomed, but the rally will soon stall (we take profits in HBM soon), and may be followed by a significant correction. We reinstate long HBM and initiate long copper trades when the correction makes a trough.

Part 1

(This article was first published on January 31, 2019, and is the first installment of a comprehensive report on near-term outlook on various assets classes).

A raft of positive news buoying up risk assets, as the new month of February begins. However, there has been a welter of contradictory news flow recently, that's why PAM decided to try and sort out what issues we as investors should focus at during the new month, and beyond. Here are the issues which we believe will lay the groundwork for risk asset performance later in the year:

  • A dovish Fed is now consensus. A policy rate hike pause in March is a given. However, the second half of 2019 may see a more aggressive Fed if Core CPI surges as we expect.
  • Data in China continues to be on the gloomy side. But China is about to embark on a QE type of stimulus, and it looks to be a blockbuster. Nonetheless, better China data are stories expected only during Q2 2019 and beyond.
  • Like what I said before, with China on an all-out QE style LSAP stimulus, Trump saying his govt will deficit spend $1.3 trillion this year and same amount next year -- I don't see the stock market Armageddon for the rest of the year, that is being purveyed by some authors at Seeking Alpha and elsewhere.
  • The backdrop for Q1 GDP growth is brightening. Chicago Fed National Activity Index posted its first back to back monthly increase since October 2017. Q1 2019 GDP looks to be picking up early in the quarter.
  • Three of the five drivers of our risk-on year-ahead call are therefore priced in: a Fed pausing in March, growth in China later in the year, and the government continuing to deficit-spend its way through the rest of Mr. Donald Trump's tenure of office.
  • Respectable US Q1 GDP growth and rise in Core CPI remain the missing pieces of our risk-on montage for 2019. That looks positive insofar as Tim Kiser (my partner at Predictive Analytics Models) and I are concerned.

We purposely left out the resolution of the China-US trade spats, as it is very apparent that both parties really want a resolution of the two countries differences on those issues. But we don't expect any premature announcement of success any time soon. That would come after a Xi-Trump meeting close to the March 1 deadline.

Here is a brief summary of the likely performance of the major asset classes over the short- and near-term horizon:

The US Dollar (DXY)

The DXY is probably due for a small rebound, but the outsized decline in yields yesterday makes likely a few more days of weakness thereafter. That is, even if yields may find support soon and continue rising, along with equities.

Author's note: In response to reader requests, I have updated the charts to display the nominal data in addition to the change rates.

As for the US Dollar's longer term outlook, PAM is convinced that the DXY will be on an uptrend up to late Q2 2019. But the volatility of US bond yields will be a big influence on its high frequency fluctuations. The fact that the DXY follows the twists and turns of the bond yields after a few days lag has been satisfactorily utilized by PAM members in getting in and out of DXY trades (see chart below).

In the longer run, however, the US Dollar should rise further, even if yields will fall further, as some of our liquidity models imply in the near-term.

The DXY uptrend should tend to go higher based on the distributed lagged impact of capital inflows that took place a few months ago. We speak of the US Capital Account Balance, which reflects the net change in ownership of national assets, and is one of the components of a country's Balance of Payments ledger, the other being the Current Account Balance.

A surplus (or improvement) in the capital account balance means money is flowing into the country, the inbound flows represent non-resident borrowings or purchases of assets. A deficit (or deterioration) in the capital account means resident capital is flowing out of the country, in the pursuit of ownership of foreign assets. These statements are simplification of relatively intricate balance sheet operations, but they describe the flows well.

Changes in the US capital account normally show up in the valuation changes of the US currency several quarters later. The massive inflows of foreign and domestic capital in the past two years will therefore continue to provide strong tailwinds for the DXY (see chart below).

If the capital flows are a guide, the US Dollar should strengthen from here until late Q2 2019. But the DXY should weaken in Q3, and thereafter strengthen massively through Q4 2019, and into early 2020 (see chart above). We expect EM currencies and other EM assets to fare poorly during the periods that the DXY is set to strengthen. That holds true for the Precious Metals as well.


EM currencies and equities (EEM) should also pullback somewhat, but the bottom of an extended 5th of a wave 5 in the sequence in the chart below (shown inverted) could come only on Wednesday or Thursday next week, if we go by the indications from the covariance model (see chart below).

In the covariance model, bond yields lead the DXY by a few days and also lead the inverse of EM currencies and the MSCI EM$ (EEM) by the same number of days as well, usually 3 to 5 days (see chart below).

The covariance model is suggesting that the bottom of the DXY and the top of EEM should occur on Wednesday or Thursday next week. The covariance model has successfully made that kind of outrageous forecasts and delivery before, so let's see if it happens again this time.

Often, we see this day to day inverse relationship between the US Dollar (DXY) and EM equities (EEM, MSCI EM$). In the longer run, there is a broad, inverse relationship between the DXY and EEM, and the underlying impetus for this is the outflow of capital from, or capital supposed to be destined for, emerging economies. When the fundamental conditions are ripe, capital flows into the United States instead, firming up the greenback after a time lag.

That is why there exists an inverse correlation between the EM currencies and EM equities (EEM). EM assets should peak out soon, and perform poorly until late Q2 2019. There should a reversal of fortunes in Q3, but Q4 to early 2020 should be dominated by a firm US Dollar.

Precious Metals

Precious Metals have been piggy-backing on the misery of risk assets surged higher after a pause in the rally in yields and the subsequent weakness in the DXY. But with the longer-term outlook starting to gel, with more positive connotations for risk assets, we should start crafting a complete exit strategy for long trades in Precious Metals -- outlook in yields (and outlook for risk assets) will soon become less friendlier to PMs.

However, it does look like we took profits from some long PM positions somewhat early. The PMs are mostly responding to the DXY decline. If the route we described for DXY and EEM is correct, we could a PM pullback in a day or so, but a top in Gold may also occur by Wednesday or Thursday next week -- per the covariance model (see chart below). The gold rally during the past several days was primarily in response to flat yields and sharply lower DXY, so if those factors are reversed, gold prices should suffer.

Our expectations for gold are, of course, the exact inverse of that of the DXY. We look for weaker PM prices in Q2 2019, but outperformance will return in Q3. But that will be followed by weakness again in Q4 until early 2020 (see chart below).

The Trump administration confirmed yesterday that they will borrow another $1.3 trillion this year, and another similar figure in 2020, and ironically, that could help underpin gold prices. The sequence of events in this situation goes like this:

The US public debt rises when the US economy hits a slippery patch -- US public debt is contra-cyclical (see chart below). US public debt and budget balance (deficit) are ALWAYS counter-cyclical; lags behind GDP. US public debt and deficit always rises during recessions, and falls during booms.

So public debt rises to compensate for budgetary shortfalls during economic crises. And that has always been, ironically, very good for gold prices. Both public debt and gold price generally rise, almost in lock step, during major GDP declines.

And to make the picture even starker and more interesting, the US Dollar falls when US public debt rises, and rallies when public debt falls. It has something to do with the Quantity Theory of Money, which says that when the amount of money or money-like instruments in the system rise, the unit value of the domestic currency (i.e., the USD) falls. That is also true, vice versa (see chart below).

Base Metals

Copper prices hit seven-week highs on Thursday as the dollar slipped after the U.S. central bank signaled further interest rate rises could be shelved, but gains were capped by shrinking activity in China's manufacturing sector. Benchmark copper on the London Metal Exchange traded up 0.5 percent at $6,167 a tonne in official rings. Earlier the metal, used widely in power and construction, touched $6,195 a tonne, its highest since Dec. 13.

That's why we are having a good session with Copper (HGc1) and CPER. And HBM is on the way to put in the 5th wave of Wave 3, and Mr. Kiser is waiting up there to exit the HBM trade and then reinstate the long bets after the Wave 4 correction.

The low of Wave 4 in HBM might also coincide with the low of a Wave 4 correction in HGc1 and CPER. That is where we also put in long bets in copper and other base metals when we see it.

Part II -- The Bond Market, Equity Markets and Oil (next up)

Disclosure: I am/we are long EQUITIES, OIL, PMS, DXY. 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.