The Bank of America Merrill Lynch Global Fund Manager just released a picture that's as gloomy as any year since the global financial crisis of 2008-2009. About 53% of respondents now expect growth to weaken over the next 12 months. That's the worst outlook on the global economy in a decade. But is this period really as bad as how things looked in 2008? If anyone traded the markets back in 2008, they know fully well that today's markets are nowhere close to the volatility and chaos we saw back then.
This year has been all about knocking the most extreme positions and darling of asset classes. We started the year with the short volatility trade, but then subsequently crushed all the darling trades one by one; Technology, Commodities, China, Emerging Markets, Credit, Oil, Credit, and Bonds. Who is the next victim? According to this survey, long Dollar trade is the most favored trade as of now. According to the latest CFTC speculative positioning report released this week, the Dollar is most overbought vs. almost any currency (Euro, Sterling, Swiss Franc, Aussie Dollar, Kiwi Dollar, Brazil Real, etc.). Although this past week showed a slight moderation, as some profit taking was seen. Dare I say it, could this be the start of the Long Dollar trade unwind?
There is an inordinate amount of pressure on the Fed going into the FOMC meeting that starts tomorrow. The S&P 500 is down 12% since its highs reached in September, when President Trump was gloating about his "Trade War victory" against China as Chinese markets were down 20% year to date back then. Little did he realize that when China catches a cold, the rest of the world sneezes. Rattle the cage long enough, there will be consequences.
In the Fed's defense, the market has deteriorated considerably over the past couple of months. U.S. data is still showing robust economic growth, but financial conditions have tightened considerably and a "neutral rate" is not as high as was once thought. Inflation is no longer a problem, but deflation might be, given how low commodity prices are, including oil prices right now. The U.S. 5-year break-even inflation rates also suggest that inflation is no longer rising. The Fed is way behind the curve as the market has priced in less than one rate hike for next year. Let me not even comment on the likes of sell side banks who after calling for 3-4 rate hikes, are now capitulating on their calls. So why would the Fed insist on tightening still?
The dilemma facing the Fed is that if there truly is a recession, or things get as bad as 2008, how on earth will they be able to provide the monetary boost they did back then when balance sheet is 3-4x more levered now, and rates only at 2.25% vs. a starting level of 5.25% back in 2007! After 10 years of providing free money with the economy on a solid footing, this was perfect year to slowly relieve investors of the addiction of free money. Asset classes were slowly recalibrating from their high levels to more normal levels. Things were all going smoothly until trade wars and political shenanigans started. This caused volatility, resulting in chaotic trading taking multiple asset classes and hedge funds as victims. People forget what the wealth effect does to the impact of the entire economy, indirectly. It becomes a self-fulfilling prophecy. What does not start with having recession implications can ultimately cause one.
The market has priced in a 25 bps rate hike for December. If for any reason, the Fed gets worried and holds off, rest assured the market will not rally, it will puke! If the Fed panics, that is when markets panic more. The logical move would be to raise rates by 25 bps tomorrow and then decide to hold off for 2019. Keeping a dovish bias for the future would help markets, but it would KILL the Dollar!
Usually at times of global uncertainty, the Dollar rises due to its safe haven status. But one of the most important drivers of Dollar is real interest rate differentials. This has helped the long Dollar trade as it has been the only Central Bank that has been tightening rates when others have been flat to easing. If the Fed is done with its rate increase bias, the Dollar will be sold. And everyone is long, #ouch!
This year has been all about extreme positioning and one-way bets. We know how all those ended. Given the risk-reward here, would you rather be long or short the Dollar? This could be the next shoe to drop.