Insurance cuts

Summary

• Narrative update — ECB debrief.

• US dollar funding pressures — The case for a rate cut.

• Positioning in markets remains stretched.

The developments over the week did little to change the broader market narrative, however, funding pressures in the US money markets are starting to raise a few eyebrows. Economic data over the week came in relatively mixed if not tilted to the downside. The IMF helped worsen the mood by making another downward revision to their growth forecast marking the fourth consecutive revision in less than a year. The update wasn't so much news in that it reflected more of the same; trade tensions continue to weigh on growth and raise the risk of a large sell-off in markets, tightening financial conditions and potentially exposing vulnerabilities that have built up over a decade of lower interest rates. The latest manufacturing and business sentiment data out of Germany made it seem like Germany was headed for a recession, making it pretty hard to be optimistic about anything out of Europe and, if anything, justifying the aggressive push for more stimulus by the ECB. The market now expects Mario Draghi to announce some form of asset purchase program as well as a cut to the overnight rate at their next meeting. There has also been speculation of a new tiered interest rate system to help offset the burden of negative interest rates on the banking system. Although details are limited, there's a belief that we may get a system similar to the one in Denmark where interest rates are zero on overnight deposits and negative on everything else. A push for such a system highlights that the ECB is cognisant of the damage negative interest rates have done to European financials. If you need convincing, look at the chart below showing the relative performance of Europe against the US.

Meanwhile, in the US, the Federal Reserve is largely expected to cut interest rates this week, pitching the cut as insurance against a slowing global economy. My concern is that by coaching this cut as nothing more than just "insurance" the Fed runs the risk of leading the market to believe that this interest rate cut does not signal the beginning of an easing cycle. Markets are only pricing in a 10 percent chance of a "one and done" rate cut by the end of the year and there is anything but consensus on where the Fed ends up by years end (Look at the first chart in Market update # 16 - There are no solutions; there are only tradeoffs . Let's not forget what we owe our good fortune to my friends. The year to date rally in everything has been predicated off of the promise of perpetual liquidity and anything that serves to undermine rate cuts can cause a serious pullback in riskier assets. With that in mind, there appears to be more to this rate cut than just "insurance" as the Fed would like to put it. Last week we began to see some pressure in the US dollar funding markets after the passing of the government debt ceiling. With the debt ceiling lifted, the US Treasury is now able to issue more debt to fund the government, however, the concern is that there is an increasingly tighter supply of US dollars in the system. The chart below shows how the total reserve balances at the Fed have continued to decline this year -- something that shouldn't be surprising given that the Fed has continued to unwind its balance sheet. For those of you in tune with the US money market -- This may help explain the whacky dynamics we're seeing in the Fed Funds as well as the interest on excess reserves.

Why does all this matter? Well, last week I attributed the stronger greenback to "tourism" in financial markets. The idea that US assets remained the cleanest dirty shirt in the market and that for foreign investors to purchase US assets, they would need US dollars (creating more demand). Financial market tourism coupled with the increasing shortage of US dollars will continue to provide support for the greenback and has given the Fed a more technical reason to cut rates rather than just insurance against a global slowdown. Remember that the USD is a global reserve currency and impacts financial conditions across the globe. Some analysts have argued that the funding pressures have increased the odds of a 50 bps cut at the next meeting and, while I see merit in it, I don't think the market is prepped for such a large move.

Investors have piled into longer duration/interest rate assets and, although we've seen some profit-taking, positions remain stretched.The prevailing dynamic in markets has been the promise of central bank easing, which has given support for equities while stoking fears of a global recession, giving support to bonds. Investors have generally moved out of equities and into bonds, the traditional allocation when investors are expecting rate cuts (bond prices rally when interest rates are cut). The fear of a recession combined with the dovish pivot of global central banks has pushed bond yields lower and, in regions like Europe, has pushed yields into negative territory. The rapid rise in the amount of negative-yielding debt has created a powerful "search for yield dynamic" which has forced investors into markets they typically would not invest in. For credit investors, there are two options; they can either take on more credit risk (invest in riskier companies) or, they can take on duration risk (invest over a longer time horizon which exposes them to interest rate risk). In the equity space, investors are preferring secular growth stocks which are companies that will grow regardless of the business cycle and also benefit from lower interest rates (think tech stocks). There has also been a push into momentum strategies which involve buying more of the stocks that are doing well and selling the ones that are doing poorly. As I've highlighted in Market update #14 - Depth charge  the lack of participation in the equity market has made it relatively easy for equities to grind higher(think of the farmers market example). As equities move higher, investors eventually get dragged into the market due to the FOMO (fear of missing out) dynamic given that asset manager performance is based on a benchmark (typically the S&P500 for large-cap). So, where do the risks lie? Ultimately it comes down to the Fed being able to keep the dream alive so to speak in that they deliver a rate cut and don't imply that it may very well be the end of the hiking cycle. After all, this rally has been based on the promise of rate cuts.