A year-defining week
The strong US economy and the Federal Reserve’s signalled rate hike on December 16 — which is now all but certain — was already “in the price”, as was the onetime contrarian view that China’s currency “shock” in August was a welcome liberalising reform, rather than a dangerous competitive devaluation. On the other hand, last Thursday’s ECB announcement triggered some of the biggest currency and bond moves since the 2009 crisis, and the consequences of Friday’s OPEC meeting were still playing out over the weekend as oil prices threatened to plunge through their August lows. Why did Europe and OPEC create great volatility last week, while events in the US and China hardly provoked a shrug?
Conventional wisdom says that investors were fully prepared for the US and Chinese news, whereas ECB President Mario Draghi deeply disappointed market expectations and even the OPEC meeting was surrounded by political uncertainty. This explanation is unconvincing. OPEC’s inaction on oil production was at least as predictable as the IMF’s action on the renminbi. By contrast, there was genuine uncertainty about Friday’s US payrolls, which could easily have been as low as 100,000 purely as a result of statistical noise.
Most strikingly, the “disappointing” ECB announcement was really nothing of the kind. Once Draghi made clear that the ECB intended to intensify its QE programme, the most logical way to do this was always to extend the period of bond buying beyond September 2016 and to cut the ECB’s deposit rate. The idea of increasing monthly purchases never made any sense, since the ECB was already creating astonishing levels of excess reserves and the credit crunch in the periphery was already over, with credit growing at a very decent pace in Italy, Spain and France.
Draghi may have made a minor tactical error by allowing some analysts to predict even more dramatic actions, but by any objective standards, what the ECB announced last Thursday was one of the biggest stimulus moves in the annals of central banking. Putting all these four events together, the vastly differing scale of market reactions cannot be explained by surprises contained in the news.
A better explanation lies in the market’s own positioning. Bulls and bears in the US bond and equity markets are reasonably balanced, which is why small changes in expectations about US interest rates are unlikely to have much market impact. Similarly, the bets against China are no longer near the summer’s extremes. But positioning in the currency and oil markets is a very different matter. Thursday saw the biggest move in EUR-USD since 2009 not because the ECB’s announcement was a bigger shock than anything that happened during the euro crisis, but simply because US dollar bulls and euro bears were more overextended than at any time in living memory. This kind of positioning suggests a turning point in the US dollar bull market, which has been running for more than seven years. In the oil market, positioning was also one-sided, though less extreme. While speculative long positions (476,000 contracts on NYMEX) were somewhat lower last week than their highs in May (531,000) or October (494,000), they still exceeded speculative short positions (267,000) by almost two to one. That sort of positioning does not suggest a turning point in the bear market in oil which has lasted only 15 months (so far).
All of which points to some conclusions about market prospects for the year ahead. In currency markets the effects of monetary divergence are now fully discounted, as we have argued in the past two months. If you accept our view — and the evidence of history — that diverging interest rates are not the only determinant of currency moves (nor even the most important one), then it now pays to become a contrarian and bet on a stable to somewhat weaker US dollar versus a stronger euro and yen.
Moreover, if the US dollar starts to weaken after the Fed rate hike, as we expect, then contrarian bullish bets should also start to work in emerging markets. But contrarian trading only works at market turning points. Being a contrarian makes no sense in the middle of a powerful trend. That still seems to be the situation in oil, where OPEC’s monopoly pricing regime is disintegrating, for reasons that we have discussed over the last year. Yet paradoxically it is in the energy markets that investors seem most determined to catch the proverbial falling knives.
As long as the unbalanced market positioning in energy and currencies continues, oil prices and the dollar will probably keep falling—and other assets will keep going up.