Worry Indicators Are Rising

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by: FieraCapitalUS
Summary

While many worry indicators are rising today, along with the decline in stocks, the US dollar is weaker.

It will be hard to declare if a risk-off environment has fully gripped the markets without a meaningful surge in the safe-haven dollar (see figure 4), which is well off its recent highs.

The announced increase in tariffs by the US and China is a genuine and growing policy risk that may challenge markets and the economy further if cool heads do not prevail.

Let's start with the good news: while many worry indicators are rising today, along with the decline in stocks, the US dollar is weaker. It will be hard to declare if a risk-off environment has fully gripped the markets without a meaningful surge in the safe-haven dollar (see figure 4), which is well off its recent highs. Now to the analysis:

Last week we noted that while certain worry indicators were rising, others were yet to send meaningful signals. One relationship that we examined was the relationship between TIPS break-evens and gold. When TIPS break-evens are falling, it can reflect the bond market's view that inflation pressures are declining. This view can originate in concerns about growth or the character of growth. When the Fed adopted a hawkish posture in mid-2018, inflation expectations began to fall, moving further away from the Fed's 2% target. This was an early signal that risk markets might be challenged by a hawkish Fed.

In the last months of 2018, the price of gold (which can act as an inflation indicator, a fear indicator, or at times both) began to rally from late August through the start of 2019. Given that inflation was tame and TIPS break-evens were largely falling during this period, the gold rally was likely about fear (namely, that a hawkish Fed would derail growth and destabilize markets). Last week, it was noted that it would be important to monitor gold more closely in this environment. Figure 1 shows that this morning gold broke the downtrend that has been in place since February. This rally in gold can be contrasted with the decline in TIPS break-evens shown in figure 2. We believe a rally in gold, when inflation expectations are falling, is another indicator that investors are beginning to worry more intensely. At the same time, safe-haven moves in Treasuries, wider corporate bond spreads, and rising volatility indicators are all suggesting that the breakdown in trade talks may prove destabilizing unless a truce is declared. Rising problems in the Persian Gulf are adding to woes. While volatility is rising, we believe this may yet be more of an opportunity for longer-term risk-oriented investors.

Certainly, the breakdown of trade talks is a problem. The announced increase in tariffs by the US and China is a genuine and growing policy risk that may challenge markets and the economy further if cool heads do not prevail.

  • Nonetheless: The underlying strength of the US economy, the low level of unemployment, and the recent improvement in industrial data in Europe suggest that this risk-off phase may prove transitory and another opportunity for investors to add risk tactically may be upon us.

Yet, there are levels that need to be watched carefully to determine how sustained this market repricing may last. Figure 3 shows recent price history of China's currency (CNY). As noted in previous bulletins a break above the psychologically important 7 level will likely bring further Emerging Market (EM) declines and stir additional bouts of EM FX volatility. The 2.36% low in yield of the 10-year US Treasury, reached in the last safe-haven move, will be important to watch as well. We are very close to that level. The front end of the Treasury yield curve is increasingly signaling a Fed easing, and we believe the Fed may come to the rescue in the months ahead with a continued softening of language and a revised series of dot plots that stimulates confidence that the Fed will take steps needed to sustain growth. At the same time, we need to acknowledge that if trade talks really break down, opportunity can quickly turn into a threat. Are there positives we can shine a light on? The US dollar is broadly weaker against G-10 FX. A true safe-haven surge could be confirmed by a rally in the US dollar that takes us through the top of the recent trading range - this warning light is not blinking.

Figure 1: Gold

Source: Bloomberg, accessed 5/13/2019

Figure 2: 10-Year TIPS Break-Evens

Source: Bloomberg, accessed 5/13/2019

Figure 3: Chinese Yuan

Source: Bloomberg, accessed 5/13/2019

Figure 4: US Dollar

Source: Bloomberg, accessed 5/13/2019

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.