A year-defin­ing week

Financial Mirror (Cyprus) - - FRONT PAGE -

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.

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