Russia might be having Turkey for Thanksgiving

Summary

• Lay of the land — Let the good vibes proliferate.

• Federal Reserve — QE enters the octagon.

• ECB — The house is divided.

• Geopolitical developments — One crisis away from war.

• The week ahead — Dealers are now long-gamma.

This week was choppy, as expected, but the good vibes took over towards the end of the week. The rumor mill was operating at full throttle throughout the week, with news coalescing around the idea that China was not going to budge on key sticking points, preventing a trade deal from being reached. As the week progressed, markets began to put a positive swing on things, culminating in a “mini” deal being struck between the two nations on Friday. The deal was comprised of an agreement on China’s part to set up agricultural purchases and concessions on intellectual property, in exchange for the US delaying tariffs hikes next week. Although this marks the largest breakthrough since the start of the trade war, on the surface, there is not much there. Particularly, there is nothing relating to Huawei, which is a key point of contention. Earlier last week, the US commerce department blacklisted 28 Chinese public security bureaus and companies due to national security and human rights violations. That is not the first time this has come up. Earlier in the year, Vice President, Mike Pence, was expected to deliver a barn-burner of a speech marking the 30th anniversary of Tiananmen Square. The speech was directed at human rights violations and was expected to infuriate Beijing given the tense situation with the Huawei ban — President Trump canceled the speech amidst the trade talks (article here). It has become increasingly clear that there are bigger ideological barriers at play in this trade war, making a comprehensive deal even more elusive. (For basketball fans, I’d read this article about how the Houston Rockets landed in China’s doghouse to get an idea of the ideological differences we’re dealing with). Although this limited deal may set the stage for a broader agreement, the Huawei issue will be the real challenge, and on that front things have not changed. With that in mind, markets rallied on the news, with US equities up around 3 percent from their lows and US bond yields roughly 20 bps higher. A similar story unfolded in the UK after Leo Varadkar, the Prime minister of Ireland, announced that Ireland is open to proposals that take into account the wishes of Northern Ireland. For those unaware, this man is now the most important person in the Brexit saga, as the entirety of Brexit relies on the deployment of a customs border along Northern Ireland. The problem is, any sort of border violates the Good Friday Agreement from 1997 which put an end to Ireland’s troubles with the IRA (This involved dozens of bombings). Johnson's threats to leave the EU regardless of a deal would completely undermine its purpose by leaving one border unguarded. Although the news is positive on the margin, this is a very sensitive issue and the odds of a resolution remain low. In any event, markets took the news in stride with the British Pound hitting a 4-month high and UK bonds (aka Gilts) rising the most in 2 years. The good vibes kept spreading, with the market focusing on the upbeat in German industrial production, ignoring the miss in factory orders. Generally speaking, market participants were looking to take on risk, equities rose nearly 4 percent in Europe and 2 percent in China. Bond yields were higher in most jurisdictions and yield curves steepened. Many market participants took out insurance this week, expecting things to get worse. Many of these hedges were set on fire as a result, leading to an orderly unwind in the ViX (1-month implied volatility in S&P500 options). What this means is that anyone that was long VIX futures was incentivized this week to sell those positions and lock in a profit as the news was coming in better than expected. The VIX was down 12 percent as a result. All this good news was amplified by the Fed, which announced that it would start building its balance sheet next week at a rate of US$60 billion a month. How much you “need” to know about this program is largely a function of how much you “want” to know. The reason the Fed is building its balance sheet comes from the spike in funding markets that happened a few weeks ago (for more info read Repo markets in the limelight). In plain English, the balance in the US economy’s chequing account got too low and now, the Fed is topping up the account to avoid going into an overdraft. This is grossly oversimplified but it’s enough to grasp what's going on. The Fed Chair, Jerome Powell, delivered a speech on Tuesday emphasizing that this program is targeted at stabilizing money markets that have been behaving radically as a consequence of the ballooning US budget deficit. The news pushed the US dollar lower and, should it continue to decline, may price foreigners back into the market for US debt, creating some relief in the Treasury market. In the meantime, the Fed will, once again, be funding government deficits (something I touched on in my previous email) via the purchase of T-bills, government debt with less than 1-year maturity. This policy should steepen the yield curve, bringing down the front end and having little impact on the long-end. Of course, that is predicated on the market believing that what Powell is pitching is in fact reality. In that respect, I think many of Powell’s comments will fall on deaf ears. The argument that investors shouldn’t reengage in “classic” quantitative easing trades (like the ones I highlighted in Momentum massacre) is a tough sell for some market participants. Estimates show that the Fed will need to purchase some US$ 300 billion in securities in the first year just to bring things back to the “safe zone” in the funding markets. The chart below is from Bank of America’s Mark Cabana and shows his estimates of the buffer or “safe zone” in the market.

This kind of buying makes the ECB’s program look like peanuts but, once again, it has a different goal. This week's announcement marks a clear shift in Fed policy, highlighting a realization of how hard it is to observe the unobservable so to speak. No one has a hot clue how much “money” the Fed needs to keep in it’s "chequing account”. If anything, this creates an even greater demand for a standing repo facility, something that many market participants now expect the Fed to announce in 2020. A standing repo facility should help alleviate some funding pressures... for now, we will have to wait and see. The meeting minutes from the ECB told the market that there was everything but consensus at the last policy meeting and emphasizes the tensions surrounding monetary and fiscal policy. As a quick reminder, in September, the ECB announced a full-fledged easing package, checking all the boxes from an interest rate cut to a promise to buy bonds in perpetuity (with plenty in between). This was, even at the time, controversial, and many ECB council members spoke openly about the dangers of providing such an accommodative stance. Well, this week's meeting minutes show just how divided governing council members were during the meeting. Some policymakers wanted a 20 bps cut and no restart to asset purchases, while others were pushing for no interest rate cuts at all. There were plenty of issues around the open-ended nature of the asset purchases, especially the part about tying the end date of such purchases to a rebound in inflation. The concern is that this opens the ECB up to a potential scenario where if inflation does not rebound, the market may be left wondering why the ECB isn’t ramping up their monthly purchases. At the current pace, a few analysts at UBS mentioned that the ECB can continue to purchase assets out until mid-2022 without hitting existing debt limits (which they have imposed on themselves). As I've mentioned time and time again, monetary policy is at the limits of what it can do and it is time for fiscal policy to take the batton. What the ECB minutes show is a debate about the best way to incentivize politicians to start spending. Mario Draghi thinks that the optimal route is to promise to fund government spending for the foreseeable future until inflation starts to become a problem. Bank of America’s Barnaby Martin has been barking about this for quite some time. If the size of the asset purchases from central banks is large enough, it has the power to transform debt to GDP ratios. You don’t have to have a 30-pound brain to wrap your head around this idea. If someone is willing to lend you money, regardless of your credit (keeping interest rates lower), chances are you will take out more debt and have a higher debt to income ratio. The chart below shows how central banks are increasingly holding more debt as a percentage of total debt.

The bottom line is, this is a very “new” thought process and the ECB is divided on how to incentivize governments to spend. Mario Draghi thinks that promising to support the bond market and offer to purchase debt is the best way to do this. In some ways, that may be true. However, that same plan could send the signal that the ECB will always come to the rescue and stimulate markets — this would result in less need for fiscal stimulus to step up. Whatever camp you fall under does not matter, Christine Lagarde, the former head of the IMF, is about to take the reigns from Draghi and with a divided house, it will be interesting to see if policy changes in the coming months. The withdrawal of US forces from the Syrian border has given Turkey-backed forces the green light to invade, creating a fresh new humanitarian crisis and much more. It has been less than a week since President Trump decided to remove US forces from the Syrian border. Since then, hundreds of people have been killed and over 100,000 have been displaced. War crimes have begun surfacing following the execution of Hervin Khalaf, a Kurdish politician who was regularly in contact with the US. Khalaf was the secretary-general of the Future Syria Party and was working to unite Arabs, Christians, and Kurds in Northeast Syria. Social media is being flooded with videos of unarmed captives being executed in broad daylight and there have been mounting pressure on the US to do something. Well, news broke on Sunday that the US is now planning to remove another 1000 troops from the region after hearing that, to nobody’s surprise, Turkish-backed rebels are planning an even larger scale invasion. That’s going to make things orders of magnitude worse. Republican lawmakers are furious as this has the potential to greenlight a full-blown massacre of Syrian Kurds who have fought alongside US troops for some time. Oh, and it turns out the Kremlin is starting to get nervous about this invasion too, particularly the fact that militants have been shelling prisons that hold ISIS captives, increasing the odds of them escaping. On top of that, Syrian Kurds are considering asking Assad and Russia for protection. Yea, things are getting harry. Russia is walking on a bit of a tightrope here given that they need a tri-party agreement with Iran and Turkey to stabilize Syria. The last thing they need is a repeat of 2015, where Turkey accidentally shot down a Russian jet. Fingers crossed that Russia won’t be having Turkey for Thanksgiving this year (it’s Canadian Thanksgiving, I had to make a Turkey joke). Europe is also probably shitting its pants at the threat of Turkey allowing 3.6 million refugees into the bloc. To no one's surprise, the Turkish Lira is down on the week and seeing as this is a financial markets newsletter, I’ll tie to this to a few more Turkish assets in the simplest way imaginable. If Erdogan gets assassinated, impeached (LOL) or in any way shape or form gets removed from power everyone, should buy EVERYTHING Turkish because there is no one out there who could do a worse job of a running a country than this man. As for oil, news broke on Friday of an Iranian tanker was hit by missiles in the Red Sea and was spewing crude into the sea. Iran was quick to blame the Saudi's for the attack, highlighting just how complacent the market has been on pricing in the threat of a full-blown war in the region. We've got a relatively quiet week ahead of us on the data front and with dealers back into long-gamma, markets should be well behaved. Chinese GDP will be coming out this week along with a string of activity indicators to give the market a pulse on how the trade war is impacting China. Small and medium business confidence has been drifting lower as of late and many analysts expect more accommodation from the PBOC (Peoples Bank of China). Although the CNY (China’s currency) has been out of the news lately, there is still a risk that further accommodation will weaken the currency and may strike a nerve in Washington, prompting a barrage of attacks that China remains a currency manipulator. Although a currency pact is a key component of the partial trade deal, many view it as a low-cost pledge for China, particularly given that they have been supporting their currency to stop Washington from blowing up. In Europe, we’ll be getting German economic sentiment and string of data out of the UK. Meanwhile, in the US, we will get an update on the US consumer and housing data. A succession of positive news last week caused markets to move higher, putting market makers back into long gamma. The chart below shows that gamma should flip negative around 2940 and that there is lots of gamma at 3000. This sets things up for a pretty nice grind higher next week, with CTA’s likely starting to build up longs as spot prices are above the 50 and 100-day moving averages.

Tiago Figueiredo