"I really think that people never go wrong by telling the truth." - Sydney Pollack
The economy continued to flash warning signals this week. JPMorgan’s global composite PMI reading slipped into contraction territory falling to a 7-year low in the process. Oil (USO) continues its dive towards the $50 mark after sitting at $66 just a month and a half ago. But the biggest gut punch came from the jobs market. Non-farm payroll figures came in way below estimates raising fears that the negative impact of an economic slowdown and trade war are finally showing up in the most closely-watched economic numbers.
Investors have been steadily migrating towards traditional safe-haven assets for weeks out of the S&P 500 (SPY) into areas like gold (GLD), treasuries (TLT) and the U.S. dollar (UUP). Gold and long bonds in particular have been rallying strongly over the past three weeks as mixed signals persuade investors to take risk off the table. There’s been some interesting interplay between these three assets lately and how they’re responding to the current environment.
The U.S. dollar, which had been slowly and steadily moving up over the past year, abruptly broke down after a combination of weak data and comments from Jerome Powell indicating that the Fed was preparing to move more aggressively in cutting rates. This was like a double whammy on the value of the greenback. The dollar is now at a 1½ month low compared to a basket of currencies and a 6-month low against the yen. The weaker dollar is a direct reflection of the Fed’s willingness to continue printing money and could make developed and emerging market equities comparatively more attractive going forward.
While the prospect of lower rates has encouraged equity investors, it raises questions about just how effective such a policy move can be. The Fed futures market is forecasting a better than 50% chance that the FOMC will cut the target Fed Funds rate by 75 basis points before the end of the year. After expectations for 2-3 rate hikes coming into 2019, the fact that we’re potentially looking at 3 rate cuts instead clearly suggests that the Fed is off-balance in achieving a balanced monetary policy. That in turn puts the equity markets at risk for a sharp downturn if economic conditions worsen on the potential for a panic policy move.
Investors betting that interest rates will get slashed and the Fed might institute another round of QE have bid the 10-year Treasury rate all the way down to 2.1%. With the 3-month Treasury currently yielding around 2.3%, those considering a “flight to safety” should decide between trying to capture higher returns if they believe rates will move lower and seeking a true safe haven in ultra-low volatility T-bills. Long-term maturities are nearing extreme overbought conditions and traders may want to proceed with caution.
Gold has also been drawing interest lately as a place to park cash. It’s rarely traded outside a range of about $1150 to $1350 over the past six years but it’s looking like it could finally be making its move. Gold just staged a breakout following a year-long cup and handle pattern and a continued risk-off scenario could push it even higher.
In watching the price action of these assets we can gather a few things. Weakness in the dollar is telling us that the traders are fully expecting rate cuts in 2019. The Fed’s willingness to add liquidity to the economy and possibly unleash another round of quantitative easing suggests that it sees recession as a real threat. A flood of new dollars into the market to help stave off that recession will erode their value.
A spike in the value of both treasuries and gold tell us that traders lately have been using both as a risk hedge. However, they’re not necessarily interchangeable. Historical asset correlations suggest that one can work better than the other depending on what you’re trying to do.
Over the past 15 years, stocks and treasuries have on average had a negative correlation as you’d expect. When stocks fall, bonds can generally be expected to rise in value. Gold, however, is a different story. Its near-zero correlation with equities means it’s an asset that more or less does its own thing. That doesn’t necessarily help with the predictability of forward returns but it’s solid for reducing risk through diversification. Traders looking to generate gains in their portfolio during a correction in equities may want to go with long-term Treasuries although these tend to be risky assets in and of themselves. People looking for more of a pure risk hedge might consider gold instead despite the uncertainty of returns that could come with it.
The trade war, of course, is the wild card in all of this. A resolution to the current trade disputes and the reduction or elimination of tariffs would almost certainly get investors in a risk-on mood once again. At this point, however, it seems more likely that we’re in for a prolonged period of trade uncertainty. That’s probably bullish for both Treasuries and gold but it leaves most of us wondering if it’s accelerating the arrival of the next recession. The dollar’s direction will be an important clue going forward.
Markets aren’t as efficient as conventional wisdom would have you believe. Gaps often appear between market signals and investor reactions that help give an indication of whether we are in a “risk-on” or “risk-off” environment.
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