Is anything going right in Europe?

Germany reported a monthly trade deficit in May for the first time since 1991 (following the reunification of East and West Germany) as a direct result of soaring imported energy costs. Energy shortages across the Eurozone may result in rationing later this year, exacerbating the current economic slowdown.

The ECB raised s/t interest rates 50bps this week (to zero!) This was their first raise in 11 years as they attempt to slow inflation which is an average of ~9.5% across the Eurozone.

The Russian/Ukraine war drags on, feeding the existential fear of freezing to death in the dark this winter.

You can read the rest of this Doomberg Twitter thread here.

The Euro currency fell below par with the USD last week for the first time in 20 years (as the USD continued its 18-month rally against virtually all currencies.)

The Euro was ~84 when it was introduced in 2001 and rallied to its All-Time high of ~1.60 in the summer of 2008. It has trended lower since 2008, with that downtrend accelerating over the past year as markets expected the Fed to tighten monetary policy much more aggressively than the ECB. The Russian invasion of Ukraine hastened the flow of capital away from Europe to the safety of the USA.

The Euro rallied ~3% this week from last week’s 20-year low. This could be a result of profit-taking on long USD positions (BoA Fund Manager survey sees Long USD as the most crowded trade) and thoughts that Peak Fed is behind us.

What is the Fed going to do?

Very bright analysts with years of experience have decidedly different answers to this question. Some folks believe that a recession is already underway and will quickly get dramatically worse – causing the Fed to “back off” their tightening program. In contrast, other folks believe that a new era of persistently higher supply-shortage inflation has begun after decades of relatively low inflation – which means the Fed will be raising rates far higher and for far longer than the market is currently pricing.

My answer: I think the Fed is determined to get inflation down at all costs, which may take them longer, and require them to raise rates more than the market expects. I can imagine a steeply inverted yield curve, with long rates lower than short rates as the market prices in the future impact of higher s/t rates.

The Fed’s credibility is lost if inflation remains high and inflation expectations remain “unanchored.” Don’t fight the Fed.

What is the macro message across asset classes over the past few weeks?

Since the mid-June FOMC meeting, bonds and short rates have had a good rally, stock indices have bounced, commodity markets have been weak, and the USD has rallied to new 20-year highs but has given back ~50% of those gains in recent days. Based on this macro picture, my guess is that the market sees a recession coming and the Fed “backing off.”

The FOMC meets this coming week, and the market expects another 75bps increase.

Stock indices

The DJIA bounced ~8% from the mid-June lows to this week’s highs. Market sentiment was extremely negative at the lows and hasn’t improved much since then. Last week I wrote that the stock market had a “damned if you do, damned if you don’t” problem. If a recession is looming, then the Fed would be less aggressive (good news), but if a recession is looming, earnings will take a hit (terrible news.)

Stock market sentiment is extremely negative:

Are falling gasoline prices good news for the stock market? Yes, if you see cheaper gas as a sign of cooling inflation (the Fed won’t need to be so aggressive.) No, if you see cheaper gas as a sign of “demand destruction,” consumers are cutting back on their spending, and in an economy that is 70% driven by consumer spending, that’s not good.

I believe the bounce from the June lows has been another bear market rally. I agree with Michael Harnett, CIO at Bank of America, when he writes: “It’s unlikely that Wall Street will unwind the financial excesses of the last 13 years with a six-month, garden variety bear market.”

Concerning that 13-year time frame, I have often wondered what will happen to the Passive Investing cohort if/when the major indices fall more and stay down longer than they ever imagined. (Their thesis: The stock market always goes up over time, so keep buying at regular intervals, don’t try to time the market, buy the whole market, don’t try to pick stocks, be prepared for occasional corrections, and see them as good opportunities to lower your average costs, be patient and you will be handsomely rewarded over the long term.) I don’t believe they have begun to sell yet, but they will at some point in the cycle.

Credit markets

If the Fed is determined to get inflation down, and if that takes longer than the market expects, short rates will rise, bond prices will fall, and quality spreads will widen.

The June 2023 Eurodollar has rallied 100 points since the last FOMC meeting – the market is pricing s/t rates to be 100bps lower than what was priced a month ago. Eurodollar futures will fall if the Fed surprises the market and keeps pushing rates higher.

If the US economy does not go into recession, the Fed will push rates much higher than the market is currently pricing.

This is a chart of the 10-year T-Note futures contract. Prices have risen ~5 full points since last month’s FOMC meeting (as yields have fallen.) If the Fed surprises the market and takes rates higher for longer, prices will fall. If a recession hits harder and faster than expected, prices will rise.

Baring some exogenous events, like over-leveraged China having a severe financial meltdown, I think the only thing that would cause the Fed to “back off” would be a sustained sharp rise in the unemployment rate.

Currencies

For the past 40 years, I’ve said that capital comes to America for safety and opportunity. I’ve also repeatedly said that currency trends go “way further” than seems to make any “sense” before turning on a dime and going the other way.

I acknowledge that the USD looks “over-valued” on several metrics (primarily trade imbalances), but if the Fed is determined to cool inflation (while Europe is lurching into an existential crisis and Japan maintains a zero interest rate policy), the USD will go higher against virtually all currencies.

Commodities

The Goldman Sachs commodity index has closed lower (down ~20%) for seven consecutive weeks. Weaker fossil fuel prices have contributed to this decline, but industrial metals and Ag markets have also tumbled. (The Economist magazine cover in May – The Coming Food Catastrophe – signalled the top of the wheat market – see the May 21, 2022 TD Notes.)

Commodities, especially energy, were The Most Crowded Long trade earlier this year. The bullish narrative was a compelling supply shortage story, exacerbated by the Russian invasion.

There has been severe liquidation of speculative bullish positions in the commodities market despite the Malthusian warnings that future supply shortages will be acute and prices will soar from current “bargain” levels.

The Malthusian theory has been wrong for over 200 years. In commodity markets, the “best cure for high prices is high prices.” High prices bring forth supply – from innovation and substitution.

Instead of millions of people dying of starvation due to the world’s rising population, food innovations have delivered an adequate supply of food to a higher percentage of the world’s population than ever before.

That doesn’t mean that commodity prices won’t spike on supply shortages; they will, and that spike will bring forth more supply – from innovation and substitution. If fossil fuel prices spike over the next few years, that will be a powerful accelerant for innovators to deliver alternative energy sources, like nuclear, for instance!

Gold

Gold hit a 15-month low this week, down ~$400 (19%) from the All-Time highs ($2,080) made following the Russian invasion.

The ultra-strong USD and rising interest rates are a significant headwind for gold. Net speculative long positions on Comex appear to be around a 3-year low (the managed money category is net short ~19,000 contracts), and the gold ETF market has seen net selling for the past few months.

My long-time friend and excellent technical analyst Ross Clark (ChartsandMarkets.com) wrote a report this week, seeing major oversold extremes in the XAU, HUI and Newmont and capitulation in gold futures.

With gold in a downtrend, stories will inevitably surface as people try to explain “why” gold is falling. For instance, there has been a story that Ukraine has been selling gold. Maybe they have, I don’t know. But the best story is that Uganda has “discovered” 320,000 tonnes of gold throughout the country. (To put that “discovery” in perspective, the world currently mines ~3,000 tonnes of gold annually.) This massive discovery has depressed the gold price (so the story goes) because there will “soon” be a flood of supply hitting the market!

While the Uganda news was greeted with skepticism, it got me thinking that perhaps Africa will be the source of supply for the mountains of minerals that the world will need in the future.

My short-term trading

I’ve been in summer vacation mode for the past two weeks. I bought gold Tuesday and was quickly stopped for a slight loss. I shorted the S+P Wednesday and Thursday and was stopped promptly for small losses. I missed being short Friday when the market broke. I’m flat at the end of the week, and my P+L is down ~0.2%

On my radar

I think the S&P rally off the June lows has been a bear market rally, and I’ll be looking for price action to allow me to trade from the short side.

I’ll look for opportunities to buy the USD against CAD and EUR.

The FOMC meets Tuesday/Wednesday, so I’ll be cautious about trading into that, but I’ll watch for price action to confirm (or deny) my idea that the market has over-priced a Fed pause.

Quote of the week

The Barney report

Barney is leading the good life. He is well fed but gets so much exercise that he looks lean. He is well-loved at home; everywhere he goes, people pet him and say he is a beautiful dog.

We were at the ocean again this week, and he was swimming like he’d been doing it all his life. He loves to chase a ball, whether I throw it in the dog park or the ocean and when he comes home, he can fall asleep anywhere, without a worry in the world. Does it get any better than that?

A request

If you like reading the Trading Desk Notes, please forward a copy or a link to a friend. Also, I genuinely welcome your comments, and please let me know if you’d like to see something new in the TD Notes.

Listen to Victor talk about markets

I’ve had a regular weekly spot on Mike Campbell’s extremely popular Moneytalks show for >22 years. The July 23 podcast is available at: https://mikesmoneytalks.ca.

I did my monthly 30-minute podcast with Jim Goddard on July 9 and talked about macro markets, Dutch farmers, and risk management. You can listen to This Week In Money – A Howe Street Radio feature.

Victor Adair retired from the Canadian brokerage business in 2020 after 44 years and is no longer licensed to provide investment advice. Nothing on this website is investment advice for anyone about anything.

“Don’t fight the Fed,” they say, but what will the Fed do?

The markets understand that the Fed is determined to cool inflation by raising interest rates another ~125bps between now and December. But then what? The forward markets see the Fed beginning to cut interest rates in early 2023, likely in response to recessionary pressures. But if inflation stays high and employment remains strong, the Fed will keep raising rates.

Markets are searching for the “Peak Fed” moment

If you believe markets have “fully-priced” future Fed tightening, the Peak Fed moment was the June 15 FOMC meeting (when the Fed raised rates by 75bps) despite the Fed’s forecast for many more hikes to come.

That FOMC meeting may have been Peak Fed because the market had already priced in those increases and started reducing future rate expectations following the meeting – thinking that the path of Fed tightening would produce (or amplify) a recession.

If you believe inflation will stay “higher for longer,” Peak Fed is somewhere in the future. This week’s CPI (9.1%) and last week’s strong employment report suggest inflation may be “higher for longer.” (Falling real wages may create pressure for higher wage demands.)

Markets are searching for Peak Fed – when the Fed pivots away from continually raising interest rates – because Fed policy is THE driver of price discovery across assets. If markets get the idea that Peak Fed has passed, then (all else being equal!) things that were shunned during the rising rates period will be embraced – without fighting the Fed!

10-year T-Notes have rallied from the 12-year low made on June 15 – FOMC day

The 10-year Treasury yield hit a 12-year high (3.5%) on June 15 and has fallen since then (currently ~2.92%.) Do bonds see a recession coming, or do yields ~3% offer an excellent alternative to a soggy stock market?

Equity markets have a “dammed if you do, dammed if you don’t” problem

Rising interest rates have been a problem for stocks this year, but if interest rates start falling because the market decides a recession is coming, that’s bad news for earnings. The major stock indices have chopped up and down since the FOMC meeting.

The US Dollar hit another 20-year high this week

The prospect of an aggressive Fed has helped drive the USD higher against all major currencies, with the Euro dropping below par for the first time in 20 years – down~12% YTD. (The DXY US Dollar Index is mostly the Euro and other European currencies. The Eurozone has been struggling with geopolitical and energy issues, but all US Dollar indices show a strong USD.)

Commodity indices peaked a few days ahead of the FOMC – and have closed lower for six consecutive weeks

The prospect of the Fed tightening into a recession has not been good news for commodities – a recession would likely mean demand destruction. Commodities (especially energy) were the “hottest – most crowded” sector of the market YTD and were vulnerable to a “positioning adjustment.”

Gold has dropped as much as $385 (18%) from March All-Time Highs

Historically, gold has rallied on high inflation, but the soaring USD and rising real interest rates have been toxic for gold – in US Dollar terms. Comex gold futures have fallen for five consecutive weeks – down ~$175 from last month’s highs. This is the lowest weekly close in 16 months.

(Actually, gold has held up reasonably well. The last time real rates were at current levels, gold was ~$1,500. The last time the USDX was at current levels, gold was ~$350!)

My short-term trading

I started this week with a small S+P position I bought last Friday. I covered that for a slight loss as soon as markets opened Sunday afternoon. I bought the S+P five times Monday to Thursday, looking for a bounce. I traded small sizes with tight stops and lost money on four trades. I missed the 140-point rally from Thursday’s low to Friday’s close (the rally I had been trying to catch!)

I bought the CAD twice, breaking even once and losing a bit on the other trade.

I bought gold Wednesday when it bounced off 10-month lows and was nicely ahead on the trade at one point, but I was stopped overnight for another slight loss.

It was a frustrating week with very choppy price action. I lost money but using small size and tight stops saved me from getting destroyed as I tried to catch a turn in market sentiment. I was flat at the end of the week; my P+L was down ~0.5% on the week.

What does risk management mean – how do I apply it?

The essence of risk management is protecting your capital so that you can live to trade another day.

My friend Dennis Gartman used to say that there were two kinds of capital: the money in your account and mental capital. In his opinion, mental capital was the most important. If you lost your trading capital, you could always find some more money somewhere, but if you lost your mental capital, your willingness to keep going, you were done.

Another way to understand “protecting your capital” is to ask yourself, “What will I do when I’m wrong?”

That question implies that you clearly define what “wrong” means and have a contingency plan to protect your capital when you’re wrong.

Another question that helps identify risk management is, “Am I trying to make money or prove that I’m right?”

Many traders develop a “good” reason for taking a position in the market, and they get their ego involved in the decision-making process. They “have done their homework” and have determined that “X” must go up because of “Y.” If they have used this process before and it has produced profitable results, they will likely be determined to be proven “right” once again.

I’m willing to acknowledge that I don’t know what will happen. I “do my homework” and take risks, but I understand that there’s better than a 50/50 chance that I’m wrong on every trade, so it is “routine” for me to have a plan, and to stick with my plan, to limit losses on every transaction.

I spent decades as a commodities broker and watched 100s and 100s of people lose millions and millions of dollars. There were two main reasons; they used too much leverage, and either didn’t have a plan to limit their losses or didn’t stick with their plan. (We called that a cancel-if-close order!)

I believe every successful trader finds a “way” to trade that suits them. Some people are day-traders; others have a much longer time horizon. Some people swing for the fences; others are content to hit singles. Some of the “big names” are willing to confess that they made horrible mistakes during their early days and are grateful to have survived – but they have set rules for themselves never to make that mistake again.

I wish every trader success, whatever your style, but it truly is a marathon, not a sprint, and if you don’t conserve your capital, you won’t succeed.

Quote of the week

The British Open

It is the 150th Open this week, and Tiger missed the cut. I won’t watch it as much as I watch the Masters, but I had the pleasure of playing the Old Course several years ago in a two-club wind, and I’ll remember that experience forever.

The Barney report

Barney came to us from a lovely lady (Laurel Pickels in Pemberton, BC) who had great success breeding pure-bred Golden Retrievers for many years. But a Border Collie “jumped the fence” at the wrong time, so Barney is part Golden and part Border Collie, which means he is an amiable dog who can run like the wind (and instinctually tries to “herd” me when I take him for a walk.)

I took Barney to the beach twice this week (record low tides), and he had a great time playing in the ocean with two Goldens. He could barely walk back to the car after 30 minutes in the water and curled up in Papa’s chair for a nap as soon as we got home!

(The painting on the wall is an original watercolour of the Merc floor in 2001 – painted years ago by the wife of a long-time friend and commodity broker.)

A request

If you like reading the Trading Desk Notes, please forward a copy or a link to a friend. Also, I genuinely welcome your comments, and please let me know if you’d like to see something new in the TD Notes.

Listen to Victor talk about markets

I’ve had a regular weekly spot on Mike Campbell’s extremely popular Moneytalks show for >22 years. The July 15 podcast is available at: https://mikesmoneytalks.ca.

I did my monthly 30-minute podcast with Jim Goddard on July 9 and talked about macro markets, Dutch farmers, and risk management. You can listen to This Week In Money – A Howe Street Radio feature.

Victor Adair retired from the Canadian brokerage business in 2020 after 44 years and is no longer licensed to provide investment advice. Nothing on this website is investment advice for anyone about anything.