In his latest note, SocGen’s Albert Edwards turns away from the big macro trends to look at two more pressing, market-driven phenomena, namely the ongoing surge in the US Dollar – or rather what’s behind it – and the threat of an imminent drop in Treasurys yields as the “global recovery” narrative ends with a bang, and then synthesizes it all by laying out his colorful description of last week’s WeWork junk bond travesty.
Edwards begins by echoing virtually every single sellside desk in recent weeks, by remarking that “the dollar’s surge is occupying investor attentions” and adds that after more than a year of ignoring widening interest rate differentials that favoured the dollar, “the market has reengaged.”
Addressing rate differentials, Edwards picks up where his FX strategist colleague Kit Juckes leaves off every morning – and for much of the past year in sheer frustration – and notes that while for the first nine months of 2017, 2y interest rate differentials were becalmed and removed as a currency driver, “only in the final quarter of 2017 did the US 2y upward march resume, triggering a brief dollar rally (which aborted), but has now resumed in earnest.”
One of the key features of this rise has been the explicitly stated resolution of the Fed to stick to its tightening schedule, irrespective of the weakness in equity prices. For much of this tightening cycle, the 2y rate has been anchored close to the Fed Funds rate due to the markets lack of conviction that the Fed would fulfill its tightening promises as represented in its dot chart.”
Adding to the differential story is the collapse and near flattening of the 2s10s, which indicates for most – except a few career Fed economists and macrotourists- that a sharp economic slowdown is imminent.
It is only from Q4 last year that the chart on the left above began to resemble a “normal” tightening cycle where the 2y elevates way above the Fed Funds rate until the curve totally flattens, just like the 1994 period on the right-hand chart above.
The second reason behind the dollar’s strength, according to the SocGen strategist, is simple extreme speculative positioning (or rather its unwind), which is traditionally seen traders as a contrary market indicator.
With extreme speculative bullishness on the dollar already in place at the start of 2017, the risk was that something would come along to cause skittish fast-money to reverse this positioning and drive the dollar lower. To be sure the dollar could have carried on advancing in 2017 (as the oil price has done recently despite huge bullish speculative positions), but it would be like walking up an increasingly steep, icy road where once you lose your footing you slide all the way back to the bottom of the hill.
Edwards here notes something we discussed on Saturday, and highlights that the current extreme bearishness in US Treasuries is one key reason why the 10y has struggled to break above 3% decisively the: quite simply, the fast money is already short.
One of the key reasons therefore that the dollar has now started to rally strongly is because of the huge accumulation of long euro (short dollar) speculative positioning – a stark contrast compared to the start of 2017 (see l/h chart above). But that has been the case for a while, so what has caused the euro to stop rallying now and slip on the ice? I’ll return to that a bit later.
In addition to rate differentials and extreme positioning, there is a third, more direct factor behind the USD surge: good, old-fashioned economist strength, or rather weakness, in this case manifested by GDP surprises (to the downside).
Edwards contends that “it is economic surprises relative to expectations that drives the market, and it appears that investors just got too darn overoptimistic about the eurozone recovery” and here he proceeds to use one of our favorite charts that we trot out periodically: the Citigroup economic surprise index.
In the last couple of months the eurozone Citi Economic Surprises index has plunged, reversing the relative performance from last year that undermined the dollar. Squinting hard at the chart it is possible though to see an uptick in the eurozone economic surprises. Might this mark a loss of energy for the current dollar rally?
Putting it together, Edwards summarizes the reasons why the dollar has broken upwards in the past week is a combination of:
- interest rate differentials accelerating in favour of the dollar since Q4 last year,
- extreme bearish dollar positioning leaving the greenback vulnerable to a reversal in sentiment, and
- GDP growth surprises in favour of the eurozone abating
Of course, what happens to the dollar will, or should, have an instant bearing on US rates, and thus the 10Y yield. Addressing the possible future move of the 10Y Treasury, Edwards brings our attention to another positioning extreme (the same one noted earlier), namely the latest CFTC data showing extreme bearish positioning in the US 10y (see chart below).
Here’s Albert:
As we have said before on these pages, this is one of the reasons why 3% may be presenting such a difficult technical hurdle to vault. A chart from Kit shows speculator US 10y positioning relative to open interest (as opposed to the Counting Pips charts above which show the absolute number of contracts). This suggests a near term decline in 10y yields is far more likely from a technical perspective. Kit thinks that could limit the dollar’s immediate upward impetus
To be sure, one can do extensive positioning or fundamental analysis, or one can just do the opposite of what Gartman just did by going short Treausurys.
In any case, if the US rise in 10Y yields is almost over due to the above speculative excesses and the collapse in eurozone economic surprises recovers somewhat, we are left with two dollar bullish factors (instead of four). We are left, Edwards summarizes, “with the widening of the 2y spread and most importantly how quickly (if at all) extreme bearish dollar speculative positioning gets washed out the system.”
And of course overhanging all of this is how President Trump and the US authorities will react to the stronger dollar. I would expect some aggressive verbal intervention quite soon if the current strength continues. No-one wants an excessively strong currency.
In other words, the dollar surge may soon be over, but until then enjoy the ride. And speaking of the proverbial rides, Edwards notes that a similar possibility where the market has a lightbulb moment may lie in wait for corporate bond spreads that have so far resisted the rise in equity volatility. For an indication of this look no further than the recent junk bond travesty in the form of WeWork’s latest issuance:
And another straw in the wind may be the performance of a newly issued junk bond of a company called WeWork who have invented an entirely new, nonsense valuation metric – “community-” based EBITDA”!
In the context of WeWork, Edwards highlights a recent post by Michael Lewitt’s The Credit Strategist, who profiled the recently issued $700MM in WeWork B-rated junk bonds, which as we noted earlier in the week, in its prospectus included a wondrous new concept termed “community-based EBITDA” in its valuation metrics.
For those with long memories this is surely be reminiscent of that series of spurious valuation metric such as “price/eyeballs ratios” that we saw at the peak of the 2000 tech bubble.
Michael writes, “This financial measure deserves its own place in the Bullshit Hall of Fame. The company defines “community-based EBITDA” in a painfully long footnote, but in plain English, it is earnings before interest, taxes, depreciation and amortization (i.e. conventionally-defined EBITDA) but also before other normal operating expenses such as marketing, general and administrative expenses, development and design costs. This is, not to put too fine a point on it, a joke. It is a disgrace that underwriters allow this type of nonsense to be included in a prospectus.” Well he’s a man who says what he thinks!
And some more:
Since Michael wrote the above, Zero Hedge has posted an update on how poorly the WeWork (re-christened WeCrash) bond has fared since launch.
So what is the link between the sudden move higher in the dollar, the imminent flush of excess Treasury shorts, and WeWork? Here is Edwards’ conclusion:
Maybe this is a sign that we have reached a moment, like 2000, where investors wake-up abruptly from their liquidity-induced slumber and realise they have inadvertently sleep-walked to the edge of an investment precipice. It was market indigestion such as this, with examples of the March 2000 flotation of lastminute.com, that marked the start of the tech crash.
Maybe investors will wake up and reappraise the grotesque corporate debt that has accumulated over the past decade and the corporate bond spreads shown on chart [below] will begin their long widening journey.
Maybe… or maybe, “investors” who these days are mostly algos, will assume once again that central banks will bail everyone out in the last minute – after all, why else inject $20 trillion liquidity in the system just to let it all go? As such the answer will come not from investors, but from Jerome Powell, whose new “Fed Put” strike price the market is actively trying to discover by sliding relentlessly every single day…
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