King Dollar

Somewhere, Larry Kudlow must be smiling. King Dollar has returned.

The U.S. dollar rally is throwing the accepted inflation narrative into reverse, with collateral damage virtually everywhere. Hard assets have turned soft in a hurry. Gold and Copper fell to the bottom of their increasingly tenuous ranges. Oil, after being levitated by the spectre of renewed Iran sanctions, is fading, setting up another sell-on-news scenario. Despite the over-hyped threat of sanctions, Iran will still sell all the oil it wants as long as China is around. Gasoline typically peaks around Memorial Day.

The G7 currency weakness last week was pervasive. The Pound got pounded, the Euro rolled out of a three month top and the Loonie got plucked. Nobody is yearning for Yen. Record level dollar shorts are being squeezed.

The proximate cause for the U.S. dollar rally was, ostensibly, U.S. bond yields reaching new highs on rising inflation expectations. Also, trade concerns are easing. Trump's damaging threats are turning out to be 'all tweet, no meat" as the White House backs off the throttle. He softened his stance on Rusal and extended the metals tariff exemptions to key allies. NAFTA negotiations are grinding to a conclusion.

Meanwhile, weaker data in the Eurozone and dovish commentary from Mario Draghi sent EURUSD interest rate differentials to new highs.

All this, while Trump turns his limited attention span to events on the Korean peninsula. Unthinkably, Donald Trump is actually gaining in the war of public opinion. His trade rhetoric is playing well with his base. Whatever comes from NAFTA, he will instantly tout as "a great deal...it really is". Wilbur Ross is now working constructively with the EU. China could actually hand him a further win as they concede on the intellectual property issue in upcoming trade talks.

And after the North Korean back-down, Prez Cheeto is being touted for a Nobel Peace Prize. This for a guy who threatened "fire and fury"... peace prize... really?

My head hurts.

But dollar loves it.

Meanwhile, the equity market is suffering from the mother of all 'sell the news' reactions to strong Q1 profits. A series of strong earnings reports has failed to excite stock players. It seems nothing is "working". Quant guys are apoplectic. But this seemingly perverse reaction is rational, when viewed through the behavioural lens of 'expecting the expectations of others'. We paid for these profits last year. Catepillar has called them "peak earnings". The consensus has moved on.

Tech stocks are all over the map. Amazon and Netflix flared and fizzled after announcing a spectacular quarters. Microsoft similarly failed to launch on a solid quarterly report. Apple and Alphabet are grovelling at the bottom of their ranges. Only Facebook (in my case rip-your-Face-off-book) has had any sustained bounce as short coverers, including me, took their medicine. I still expect FB to retest the $150 level. FANG is so 2017.

My favourite trade, the Banks, also held their fire, seemingly mesmerized by the market gyrations in tech-land and a stubbornly flat yield curve. Loan demand growth has to accelerate for that group to rally.

Confusion and frustration abound on Wall Street in stark contrast to the hyper-confident melt-up that marked the start of 2018. It would have been better if January had never happened. The subsequent whip-saw in February, on the 'short vol' unwind, is still weighing on sentiment. Many 'bad longs' are smarting from chasing the index. Now the crowd is selling the rip instead of buying the dip.

Fed watchers are now universally convinced that 4 more hikes are inevitable. Current data is providing strong justification for monetary normalization. But the failure of inflation to meaningfully accelerate in the face of the strongest employment conditions in twenty years is troubling. We are currently lapping the 'easy comps' of Q2 2017's price declines and price data, while rising, are still comfortably within the expected range. Disappointing!

And what will inflation look like in three months, when oil prices run out of seasonal headroom, and the stronger greenback hands importers more flexible pricing options? This economic cycle seems unable to produce above-consensus inflation no matter what you throw at it. The seasonality for commodities is about to peak. Sell in May and go away - for inflation.

In the Seventies (the last decade with good music), Fed policy was faced with a perverse combination of slow growth and strong inflation. Coined "Stagflation" it hamstrung the Fed into keeping rates lower for longer, culminating in a torrent of inflation in the late seventies. In the current cycle, it seems we have the opposite condition. This time, the more troubling component of the dual mandate is inflation, not unemployment. But the effect is the same, lower rates for longer.

Shortly disinflation will be on the Fed's radar yet again, courtesy of the dollar.

Does this set up a surprise threat to the current consensus for interest hikes? The Fed will soon be faced with a conundrum if inflation data weaken materially, as I'm now postulating. Otherwise, they risk over-tightening, potentially creating a premature end-of-cycle inversion.

It could only take two more hikes to completely flatten the Treasury curve between 2s and 10s. The recent breaking of the psychological "barrier" of 3% was short-lived, as it triggered only buyers. But what is holding the bond bear market back?

The strong technical bid to longer dated treasuries has been hard to remove. The current U.S. deficit is being funded mainly in the short end of the curve so the supply of long issuance is well covered. Pension plans, the natural buyers of the long end, are currently racing to take advantage of favourable tax treatment of accelerated funding decisions that expires next year. Corporate treasurers are sopping up long dated product in order to immunize their exposures. Bond ETF flows have also been strong.

These factors, combined with insatiable foreign buying, results in a flatter curve than would have been expected during prior cycles. The Fed and other central banks are reaping what they sowed after creating an extended period of low rates. When there is $11 Tn of world government debt is yielding less than 5 bps, 300 looks pretty good..

This reduces administered rate flexibility as the combination of the strong technicals and stubbornly tame inflation expectations hold longer dated issues in a new type of liquidity trap, only at the longer end of the curve. The 10's - 30's curve is a paltry 16 bps. Term structure distortions, while they can be explained away technically, will ultimately have significant real world effects. Negative carry is always a depressant to asset values, not something the Fed wants to happen.

The Fed is running out of runway to hike and the market hasn't figured that out yet - but they will. Thanks to 'King Dollar' the consensus interest rate scenario of four hikes is about to be tested.

There is good news for markets in all of this. The scenario is self correcting. Should the Fed change its narrative to accommodate the current inflation pause, short bond prices should rally, driving the stock market higher. As well, it would forestall an early demise of the bull. But that day is not here yet. Meanwhile a "time" correction is upon us.

I've exited my cyclical and hard asset trades for now.

Golf season has come just in time.

Risk Model: 2/5 - Risk Off

The bounce in AAII sentiment has not yet put it into green mode. The Copper/Gold ratio has failed, and both are suffering a negative momentum phase - not good for the cyclical trade. The 3 month Vix remains elevated.

Time for the "Golf Portfolio"! Beta down- comfort up.