Speculative positions across macro asset classes seem very one-sided in the markets right now and there is a very clear pattern -- the dollar long bias.
We can profess to be fundamental specialists quoting valuations, price to book, real yields and purchasing power parity, but none of it matters. All that does matter is the answer to the question, "Which way is the dollar headed from here?"
U.S. Treasury positions held are at all-time shorts, gold speculative positions are at record shorts, U.S. dollar accounts are extremely long, and we're seeing long U.S. and short China/emerging markets. See the pattern? Now the more pertinent question is, "What can cause the rubber band to snap from these extreme stretched scenarios?"
The United States and China are to hold a new round of trade talks on Aug. 21 and 22, albeit at a lower level. It will be interesting to see what comes out of this and whether President Trump and/or China back down and reach a compromise of sorts. If there is, there will be a relief rally in Chinese markets and all sectors/stocks linked to global economic slowdown fears.
More importantly, the Federal Reserve's annual policy symposium in Jackson Hole, Wyoming, takes place later this week. Fed Chairman Jerome Powell is scheduled to deliver his keynote speech this Friday, Aug. 24, and that is the one we need to care about most.
The last time Powell made an appearance, he remained committed to raising interest rates gradually "for now." A lot has changed since the last Fed release, with emerging market turmoil and hints of the data weakness filtering into U.S. economic numbers. The former can be reason for the Fed not to follow a U.S.-centric rate path as the U.S. will be affected by the slowdown seen elsewhere, including through lower inflation, which is the Fed's key concern.
The Fed is expected to raise rates in September and again in December. Those moves have been priced in by the markets. After all, the U.S. data call for higher rates given GDP growth and inflation around 2%. But have we had a chance to factor in the latest carnage, the latest deflation, into the numbers?
If we look at the recent Citigroup Economic Surprise Index, it has started to turn lower. Five-year consumer price index (CPI) core inflation expectations have started to fall below the 2%, the Fed's main gauge. Does this warrant a change in language or perhaps a mention of waiting a bit to raise rates?
If there is any change in his language or direction, it could prove to be a massive turn of events. The dollar will collapse, no doubt. The question I ask is, when everyone is so well-positioned one way with all the data in hand, how much worse can it get to see it moving in that same direction? Indeed, the prudent thing would be to say "thank you," close the bets, be flat, and stay on the sidelines observing how the events play out. The ones with guts made of steel will bet against this massive herd mentality. It can prove to be a feasible strategy with a 5:1 hit ratio -- not bad odds, eh?
The U.S. dollar's strength has been hurting all emerging markets and their respective current accounts given their U.S. dollar debts. Commodities demand is being sold as the dollar rallies given the inverse relationship. If the dollar even hints that its upward path is stalling, there can be a massive squeeze in all assets China/commodities-related. Gold, which has its fate tied to the path of U.S real rates and currently is facing an all-time record short, would see a big squeeze as shorts scramble. Copper would display similar dynamics, and so on.
Perhaps the Fed has ammunition to wait on raising rates given it has the economic justification to do so, unless Chairman Powell is not worried about markets collapsing around him between 20% and 40% and he takes the view that U.S. indeed is an isolated economy that can grow at 3.5% without needing anyone. Has the world become that polarized already? In the future, perhaps, but for now we are all linked thanks to the globalization of trade of the past decade.