Seeking Alpha

Risk Aversion Sets In: Falling Yields, Oil, U.S. Dollar Collapse, Gold Rise, Signal Trade News Fatigue

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Includes: DWT, FX-USD, GLD, SDOW, SPXU, TBT, TMF, UDN, UGLD, YCL
by: Robert P. Balan
Summary

Collapsing oil prices, DXY, surging gold, repo rates, yen, and falling 10-year yield are symptoms of risk aversion. It won't surprise us to see equities and risk asset prices weaken further.

Just because China had no immediate response for the US bill supporting the Hong Kong protesters does not mean that they have rolled over dead. China will strike back correspondingly.

It may also be true that the market (perhaps even the algos) is starting to see through this "trade news" ruse designed to push risk assets' prices higher and higher.

The change rate of the liquidity flows has started to decline, and that continues further for several weeks. That's a mathematical function and, therefore, inevitable. Risk asset prices should subsequently fall, and make a trough by late December, as the seasonal liquidity drought bites.

Expect bond yields to respond properly to these liquidity imperatives. The equity market is different, as it was discounting the trade agreement between the US and China. But with Mr. Trump's approval of the Hong Kong bill, the Chinese will shed their heretofore benevolent masks - new rules of engagement ahead. A new risk asset price regime follows.

Collapsing oil and DXY prices, surging gold, falling USD/JPY and 10-year yield are all symptoms of risk aversion. It will not surprise us to see equities and other risk asset prices to weaken further from here.

SPX (ESc1) and Russell 2000 (RTYc1)

DXY, Gold, and 10-year Yield

Crude Oil and USD/JPY

All of these risk assets are inter-related with bond yields (the 10-year yield as proxy), which serve as locomotive to the wagons of risk assets trailing behind (see chart below).

The rails, so to speak, are provided by financial systemic liquidity sources (with the Treasury Cash Balance as proxy, see chart below). If bond yields continue falling as our liquidity models indicate, then risk aversion will travel further. Moreover, it is not only falling yields signaling risk aversion that the general market has to contend with from this point on. A veritable quadruple whammy is poised over the markets.

The China-US trade agreement talks will bog down

Just because China had no immediate response for the US bill supporting the Hong Kong protesters does not mean that they have rolled over and played dead. Assuming that's the case could be a big mistake. China will strike back correspondingly at a time when it is most painful for the US (or for Mr. Donald Trump). It is very risky to underestimate or wish away a Chinese desire to recover "lost face" and their "diminished" sense of honor. These intangibles often feature prominently in China's reaction function to perceived slights.

Today, December 2, Zero Hedge bannered the headline: "Stocks Tumble After Ross Says Trump Will Hike Tariffs If No China Deal By Dec 15."

There will be no deal on December 15, we believe. This is the second "perceived" slight Mr. Trump is hitting the Chinese with. The Chinese had been willing to take tremendous losses to drive home a point and save face. Events during the Korean War may be relevant in this respect.

After Commerce Secretary Wilbur Ross revealed the December 15 ultimatum, the Global Times' Business Source group said that that China will release an "unreliable entity list" soon, which includes relevant US entities. The move is supposedly being accelerated up in response to the expected passage of a Xinjiang-related bill by US Congress that will harm Chinese firms’ interests, "prompting China to speed up the move." Rapid deterioration in diplomacy among the two sides now suggests that a tariff delay of new US tariffs on Chinese exports in two weeks is becoming increasingly improbable.

This particular whammy could contribute to risk aversion through to the end of the impact of the liquidity drought - to the 4th week of December.

We discussed this other aspect stemming from the onset of a seasonal liquidity drought, which should contribute to this new risk aversion phase in this recent Seeking Alpha article: "Seasonal Shift To Liquidity Drought Commences: What To Expect From Risk Assets, Bond Yields."

"Trade Discussion News" fatigue setting in as tweets fail to deliver

It may also be true that the market (perhaps even the algos) are starting to see through this "trade agreement news" rigmarole as merely a ruse designed to push risk assets prices higher and higher.

It has become a regular, even Pavlovian, feature in market events: stock prices fall, and Mr. Donald Trump or Mr. Larry Kudlow comes out with a tweet that the Chinese are just about to sign a trade agreement. Of course, the market has been swallowing that hook, line, and sinker, and so, equities have been rising based on this factor alone. But maybe at this point, we have just about reached the peak point of collective incredulity and self-respect is kicking in. No mas.

Global, US activity data not supportive of current market narrative

The narrative that global risk assets have jumped higher due to a rise of China's PMI to a three-month high is laughable. The Chinese elites already know that it is one-off and outlier. Hint: They already knew that last month, and they also know that situation will not last. Here is why.

The Gross Value Added metric of China industrial output (blue line in the chart above) often precedes the aggregated data on the Chinese PMI by at least a month, frequently by two. Knowing the increase or decrease of industrial output in nominal, CNY amount is tantamount to understanding the incremental change or changes that have taken place in Chinese industry at present relative to the month or two previously. It is easy to keep a currency-adjusted ratio between the Gross Value Added and the actual PMI data, which informs the Chinese elites of forthcoming industry numbers that will not be available to the general market for another month or two.

Another reason why this outlier PMI data cannot be sustained lies in the very pervasive impact of China's Total Social Financing (TSF) construct. And TSF is far from supportive at this point. China's Total Social Financing may still fall over the next months (see chart below).

The TSF is led by government spending, and so, TSF will likely fall from here (green line, chart below) until early Q2 2020. TSF follows the path of China's government expenditures (dashed blue line, chart below) with a lag. A real recovery in China should take place on late Q1 or by early Q2 2020.

Systemic liquidity starts to tighten

The change rates of the various US systemic liquidity flows have started to decline, and that will continue further for several weeks. That's a mathematical function and, therefore, inevitable. Risk asset prices should subsequently fall, and make a trough by late December, as the seasonal liquidity drought bites.

We can reasonably expect the bond yields to respond properly to these liquidity imperatives. The equity market may be different, as it was discounting the most noteworthy news flow - the trade agreement between the US and China. But with the Mr. Trump's approval of the Hong Kong bill, and now a December 15 ultimatum, the Chinese will shed their heretofore benevolent masks - there will be new rules of engagement ahead. A new risk asset price regime follows.

Signs of risk aversion setting in

With the fall in Treasury Cash Balances, repo rates are exploding higher (see chart below); we can expect accompanying decline in bank reserves to follow shortly - and that is not good for equities. Repo rates are one of the major baseline benchmarks of funding cost for the shadow banking sector when acquiring risk assets.

Also, since both Treasury Cash Balances and Bank Reserves are both liabilities on the Fed's balance sheet (but have radically opposed polarities), this may mean that SOMA transactions may also wane soon (if these have not actually declined already). We will get further details in the Fed's POMO operations today, December 2, which may or may not confirm our thesis that the "No QE" stimulus program is going on autopilot for a while.

Yields, SPX, DXY, Oil lag behind the changes of the Treasury Balance Model

What to expect from here

There is an interesting note written by Nomura's Masanari Takada last week, which captures the current tension between the stock market and the bond market as they set on divergent courses. We explained the likely cause of the current divergence as the variation in the timing of the liquidity flows in and out of the Treasury Cash Balance and that of the NY Fed's aggregated SOMA transactions (here).

Nomura has a different take on the subject, one that parallels our own, and also provides a plethora of details. Essentially, their take is this: if the Fed pauses or puts the Not QE stimulus on pause, risk asset prices will collapse. If China retaliates over the US Congress pro-Hong Kong bill, the collapse will even be faster and deeper. I highly recommend it.

CTAs Caught In A Tug Of War Between Bonds And Stocks As Year-End Looms

"According to Nomura's Masanari Takada, amid the ongoing market euphoria - a consequence of the Fed's QE which has pushed the Fed's balance sheet and stocks higher for 7 of the past 8 weeks... it is now high time to look more cautiously at the steady accumulation of long positions on US equity futures (S&P 500, NASDAQ 100, DJIA) by trend-following CTAs that is one of the factors behind the strength of the US equity market (perhaps the explanation is as simple as that CTA buy if the Fed's balance sheet rises, and vice versa).""Looking at the action in the last days of last week, CTAs were in wait-and-see mode, but Nomura expects them to continue to lean toward buying, especially since their long positions have already reached the levels last seen in mid-October 2018, and they have been steadily hiking their leverage ratios (re-leveraging)."

Nomura's take on the bond situation is very perceptive in our opinion. And we share the same conclusions that the have reached.

What about bonds? As we wrote three weeks ago, when bond yields peaked just shy of 2%, that's the time that CTAs stopped selling Treasurys, and sure enough, 10Y yields promptly dropped by over 20 bps. Fast forward to today, when 10-year TSY yields can be found around 1.76%, a level that Nomura says is "a key strategic line for CTAs", as it represents the cost of cumulative net buying since June.

As a reminder, CTAs have already unwound nearly 80% of their long UST (TY) positions, and it is more difficult for them to unwind these positions in the interest of avoiding losses with yields at 1.7-1.9%. If anything, if trade war fears re-emerge and deflationary worries bubble up to the surface again, it is more likely that CTAs will start buying here again, potentially sending 10Y yields south of 1.50% in a hurry.

Of course, position adjustments within the range of what can be justified by actual market conditions cannot be ruled out, but as Nomura notes, there now seems to be little risk that CTAs will unilaterally sell off their long positions unless 10-year UST yields were to break above 1.9%."

PAM looked at Nomura's numbers and we can't find serious issues with the conclusions drawn.

In the case of bond yields, even if the China-US trade news ruse continues, the other three whammy factors may be enough to send yields to the 1.50% area by late December.

This article was largely derived from this PAM Report.

Disclosure: I am/we are long BONDS EUROS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.