Macro and Credit - Poker tilt

"If you're playing a poker game and you look around the table and can't tell who the sucker is, it's you." - Paul Newman

Looking at the tentative rebound in gold prices thanks to the fall of the US dollar in conjunction with some respite for some selected Emerging Markets (EM) as well as the escalating tensions between Italy and the European Commission on migrants with pressure building up on the ECB's "Le Chiffre" aka Mario Draghi, when it came to selecting our title analogy, we decided to go yet again for a poker reference. As we stated in our previous conversation, it remains to be seen who ultimately is going to be the ongoing buyer of Italian government bonds with plans for a reduction in QE in Europe. In the game of poker, tilt is a term used for the state of mental or emotional confusion or frustration in which a player adopts a less than optimal strategy usually resulting in the player becoming over-aggressive (such as Turkey's Erdogan calls on Turks to ignore forex developments and to sell their gold and dollars to support their crumbling lira). Placing an opponent on tilt or dealing with being on tilt oneself is an important aspect of poker. It is a relatively frequent occurrence due to frustration, animosity against other players, or simply bad luck. Experienced players recommend learning to recognize that one is experiencing tilt and avoid allowing it to influence one’s play. In our October 2015 conversation we praised both Le Chiffre and Mario Draghi. Both of them share the same trait, both are poker prodigies hence our title analogy at the time. We wonder if President Donald Trump could be one as well given the pressure he has applied in his various negotiations on numerous issues including trade tariffs. In this current game of high stake poker, particularly with China, one might wonder if Trump is not trying to upset the mental equilibrium of his adversaries which is essential for optimal poker judgment (NAFTA being the most recent example). Though many advanced players (after logging thousands of table-hours) claim to have outgrown poker "tilt" and frustration, many other poker professionals admit it is still a "leak" in their game but we ramble again.

In this week's conversation, we would like to look at the potential for tactical rebound for EM, as we move towards the important US midterm elections.

Synopsis:

• Macro and Credit - Could we see a tactical bounce in EM?
• Final chart - US credit growth still on cruise control

• Macro and Credit -  Could we see a tactical bounce in EM?

Whereas the heat was on during the summer for various Emerging Markets thanks to murderous rampage of "Mack the Knife" (King Dollar + positive real US interest rates), we recently touted MDGA aka Make Duration Great Again. Recently, not only have we seen some small yield compression in the long end of the US yield curve, but as well the dollar has slowed down and fallen a tad ensuring a small bounce in gold prices as well. Also, credit markets in particular US Investment Grade credit have had more favorable returns in recent months. One can therefore wonder, with the latest NAFTA discussions, if indeed some sort of tactical rally for EM is in the cards on the road to the important midterm US elections.

On this subject we read with interest Bank of America Merrill Lynch's take in their Global Liquid Markets Weekly note from the 27th of August entitled "EM climbs out of Jackson hole":

"US midterms a winner for EM

After Jackson Hole the focus this week shifts to EU and US inflation, but the real story for the months ahead will more likely be the US midterms. We think they are about to turn from a bearish to a bullish theme for EM through positive news on trade and a peak in the USD. So we expect a post-summer EM rally – though a tactical one before global risk assets, this time including the US, come under pressure in 2019.

Midterms trigger post-summer rally

Since our year ahead report (“Taxing EM”) we have been looking at EM through the lens of the midterms – now about to turn from a negative to a positive factor. The fiscal stimulus package and trade tensions have been closely linked to the approaching elections and have weighed on EM so far. Trade wars have become by far the most feared risk, according to our monthly investor survey. Now, however, David Woo expects an imminent NAFTA deal and some progress with China, as the polls suggest that the US administration has a strong incentive to present good news on trade. Importantly, we expect the next round of China tariffs scheduled for Sep 6 to lapse as they would be too painful for the US consumer and the agricultural heartland (via China retaliation).

A glass half full – just about

Predictably, EM sold off during our usual August break – as in 8 of the last 10 ones: the 10-year average EMFX return in August is the 2nd worst after November. However, the volatility occurred on low volumes, and neither external nor local debt saw fund outflows over the summer.

The current level of our EMFX carry sentiment indicator implied positive returns in EM carry in 56% of the subsequent 4-week periods since 2004: ie, a glass half full but hardly convincing enough for a big “Back to School” party. 

Softer USD = EM outperformance

Time and again a weaker USD dominates any other EM driver, whether global or local. Chart 2 shows this on the basis of monthly correlations of EM returns with the USD and other potential drivers.

This has also been the case during periods of Fed tightening – as long as other factors have managed to hold the USD down. In fact, monthly EM returns have surprisingly been negatively correlated with the G3 central bank balance sheet.

Indeed, our G10 team now sees the USD rally this year close to its peak. (1) Trade war fears seem to have become USD positive lately, so their easing should be USD negative. (2) The US-EU data surprise differential seems to have peaked too for now. (3) Positioning in US vs rest-of-the-world assets is back to historical highs. Short term, Italy budget fears could still weigh on EUR/USD, but for next year our team targets 1.20.

QT doesn’t matter … until US HY cracks

Quantitative tightening per se isn’t EM bearish: it still comes down to its impact on the USD. If the USD really weakens into 2019, a repeat of the experience of the last cycle is likely: US high yield peaked in mid-2007, then it moved sideways for one year while EM debt continued to perform. However, when US credit finally entered an outright bear market mid-2008, EM wasn’t spared either, and risk-off became USD bullish (Chart 2). A key difference to ‘07 is that EM is unlikely to benefit from rating upgrades (Chart 3).

Consensus says EM fundamentals are still decent: we don't disagree on this specifically, but we do think that the rate of change of these fundamentals is negative, risks are to the downside and spreads are fair rather than cheap even after the latest sell-off.

Best local value: Indo, Mex, SoAf, Thai

Summing up, we see a post-summer rally in EM that benefits local more than external debt as its main trigger would be a weaker USD and less trade fears: it may last for a while, but by 2019 we expect EM debt to crack when US high yield does. To position for a tactical rally in September in Asia we like long THB FX and Indonesia local 10yr bonds. We have turned from bearish to neutral CNY, and local front-end bonds are starting to look attractive after the rebound higher in yields in the past two weeks.

In LatAm we like short EUR/MXN on a better global backdrop and NAFTA. In EEMEA South Africa has the best risk/reward in FX and rates given its high beta to China and EUR/USD. Valuations are good based on the real yield; three hikes priced in; and ZAR near our fair value estimate. EUR/CZK has downside if EUR/USD goes higher.

In contrast we don’t find risk/reward compelling in Russia and Turkey. In Russia we have argued for a while that sovereign sanctions risks were underestimated. We just closed our shorts but want to wait for a sell-off on an actual passing of the sanctions bill pre-midterms before buying ahead of the likely oil-bullish Iran sanctions in November. In Turkey real yields are finally in line with the peers, even accounting for the imminent CPI spike, but they are not high enough to compensate for the political noise (Chart 4).

Long term, sovereign external debt looks cheap with an implied CCC rating, but short-term investors have to brace for further volatility spikes driven by the exchange rate." - source Bank of America Merrill Lynch

Flow wise, this summer has been a bloodbath for many asset classes with no one being spared. These funds outflows have continued recently according to Bank of America Merrill Lynch which is somewhat revealing as well the magnet appeal of the US dollar as per their Follow The Flow Report from the 24th of August entitled "IG, HY, Equities and EM debt all down for the year":

"Outflows continue from IG, HY, govies, EM and equities

It seems that investors have nowhere to hide. Almost all the risk assets we follow recorded outflows last week. We saw outflows from IG, HY, Govies and EM debt; same in equities. Higher risk assets’ volatility, EM FX sell offs, trade wars and Italian political risks have instigated a risk off trend in flows across risk assets.

Rate differentials across the globe are shifting flows away from low yielding and risky markets. Note the significant shift of assets out of euro credit to dollar credit over the past months on the back of dollar strength.

Over the past week…

High grade funds recorded another outflow last week; but arguably more moderate to that of last week’s. High yield funds were hit again by outflows. Looking into the domicile breakdown, European-focused funds recorded the lion’s share of outflows, while outflows from global and US-focused funds were more moderate.

Government bond funds recorded another outflow last week, albeit more moderate to the outflow suffered a week ago. All in all, Fixed Income funds recorded another sizable outflow last week.

European equity funds continued to record outflows for the 24th consecutive week. $56bn has left the asset class over that period.

Chart 1: IG, HY, Equities and EM debt all down YTD (cumulative flows, $mn)

Global EM debt funds recorded another outflow last week, while the magnitude of the outflow more than tripled w-o-w. Commodity funds recorded an outflow.

On the duration front, reach for “safety” prevailed. Small inflows into IG short-term funds, were more than offset by outflows in the belly and the back-end of the curve. Mid-term funds suffered the most last week, with outflows increasing steadily over the course of the past three weeks." - source Bank of America Merrill Lynch

 The US have attracted inflows particularly given cash is becoming more and more attractive on a relative basis and for investors seeking some sort of safe haven in the context of EM gyrations. What is interesting to note as of late is the clear deceleration in some macro outputs in the US such as Existing home sales declining 0.7% to 5.34 million unit pace in July, new home sales falling as well thanks to the issue of "affordability" in conjunction with the softness in Durable goods orders slipping 1.7% in July. This is in contrast to the latest FOMC minutes showing Fed members clearly in the strong economic outlook camp. This is of course ensuring another hike in September.

Yet, some positioning in US bonds remains elevated we think, and if indeed some pundits get poker tilted, then there is a probability of seeing some sizable strong short covering in very short order. Same apply to some shorts in the gold mining space, which have been relentlessly hit by the fall in gold prices but it seems we are not there yet. Returning on the "contentious" issue argued by many on the stretched positioning on US Treasury notes, we read with interest Bank of America Merrill Lynch's take in their Global Liquid Markets Weekly note from the 27th of August entitled "EM climbs out of Jackson hole":

"Extreme positioning elevates risk of bond rally

While we continue to target 10y rates at 3.25% for the end of the year, the ongoing buildup in non-commercial short positioning in the Treasury futures complex does not bode well for our outlook. We studied the connection between positioning – as defined by the Commitments of Traders report published by the Commodity Futures Trading Commission – and subsequent changes in 10y rates and found a relatively high occurrence of 10y rallies after non-commercial positioning hit extreme short levels.

While positioning is just one piece of the duration puzzle, the ongoing trade negotiations and increased political headline risk moving into the midterm elections are also not favorable to our bearish rates outlook. On the flip side, however, we still view the minimal Fed pricing – just 70bp of hikes priced between now and the end of 2019 – as perhaps the most compelling reason to remain in the bearish camp for rates and in the flattening camp for the curve.

Chart 5 shows the net position of traders classified as non-commercial, or speculative, across the curve.

This classification is the residual of the commercial designation, which the CFTC defines as traders who use futures to hedge business risks. We also looked at the newer CFTC designations: leveraged, asset managers, dealers, and other, but found the strongest results within the original data set.

The net spec positions shown in Chart 5 are defined as spec longs minus spec shorts, where the units are 1000s of contracts. This is a measure of positioning within the spec category, and by definition will be offset by positioning in the commercial category (Chart 6).

As a result, a study of non-commercial positioning should show mirror image results in the commercial data, which is what we found.

To each week of reported data we attach a simple z-score of the net position by looking at the current value versus the average over the past 2.5 years. We looked at both raw net positioning and net positioning relative to total open interest for the contract. The results were very similar. The data is reported on Fridays and corresponds to the Tuesday of that week. We tracked the 3-month change in 10y rates starting on the Tuesday of each week.

Go commercial

To summarize: when positioning becomes highly unbalanced between commercial and non-commercial traders, ie when a large net spec positon or equivalently a large net commercial position develops, the market tends to move in favor of the commercial positions and against the non-commercials over the following 3 months. Table 1 summarizes our results for TY contracts. The results for US contracts were similar.

There are 3 key takeaways:

1. When positioning becomes unbalanced, there is a higher occurrence of the 10y rate moving unfavorably for the spec positions. This is based on a comparison of how frequently 10y rates rise or fall over a 3-month horizon in the entire sample versus how frequently rates rise or fall when accounting for positioning. As an example, when the z-score of net positioning is lower than -1 (positioning is below its average by at least one standard deviation), we found the 10y rates rallied 63% of the time versus a full-sample rally frequency of 52%. Similarly, when looking at the net commercial position, we found that a net long position beyond 1 standard deviation resulted in a rally frequency of 60%.
2. The magnitude of 10y rate moves following position buildups increases as the position size becomes more extreme. For example, when short spec positioning is below average (z < 0), the 3-month rate rally averaged 6bp. When z < -1, the average rally was 11bp, and when z < -1.5, the average rally was 14bp. A similar type of tiering was seen for bond market selloffs following buildups of long spec positions.
3. Positioning typically gets partially covered in the 3 months following an extreme buildup. When non-commercial positions get short and commercials get long, the data show that on average, these positions partially unwind over the next 3 months. This position squaring shows a greater magnitude as position imbalances increase. For example, when net specs measure z < 0, the following 3-month cover is on average 28k contracts. But when spec shorts are z < -1, the 3-month average covering move is closer to +50k contracts. This provides evidence that the rate moves are exacerbated by position squaring, both on the spec side and the commercial side.

The latest data point was observed on 17 August for positioning as of 14 August and we will get an update this afternoon for positioning as of 21 August. The latest z-score for TY specs was -2.2, which occurred in only 4% of the days we looked at back to early 2003. The one bright side for bond bears, however, is that 10y rates have already rallied about 8bp since 14 August. But if the z-score remains high, it would not increase confidence in our 3.25% target for year-end.

- source Bank of America Merrill Lynch

One would therefore wonder if it's time to put back on your MDGA (Make Duration Great Again) hat on given their is a higher probability that the speculators at the table might at some point in the near future get poker tilted and start short covering massively should the macro picture deteriorates sensibly over the course of the coming months due to internal or geopolitical factors coming into play (the known unknowns). The key to putting on your MDGA will be the direction of the US dollar in the coming weeks/months. Right now it's still "risk-on" and we continue to favor a US overweight over the rest of the world, yet there could be some relief rally continuing for some oversold EM countries in the mix.

Returning to our poker analogy, us being fond of game theory, we read with interest Bank of America Merrill Lynch's Global Economic Weekly note from the 24th of August entitled "What good is a poker face if you aren't playing poker?":

"What good is a poker face if you aren’t playing poker?Last week we discussed the wide array of risks that the markets will have to navigate in the coming months. This week we focus on a common theme in what we view as the three headline risks on the horizon: the US-China trade war, the Iran oil sanctions and the risks emanating from Europe (Brexit and Italexit). These are all conflicts that live at the intersection of economics and politics. Political economists and other commentators have sometimes depicted such conflicts as games of poker or “chicken,” in which both sides use confrontational rhetoric to signal a position of strength, in the hope that the other side will capitulate. Here we argue:

• The “game of chicken” view of political conflict assumes a zero-sum outcome: serious accidents are avoided.
• But aggressive rhetoric increases the political cost of backing down. Mutual escalation might be the only feasible outcome.
• In other words there is a risk of stumbling into a “prisoner’s dilemma,” in which both sides incur serious economic costs.

The devil is in the details

The “game of chicken” and the “prisoner’s dilemma” are two popular game-theoretic frameworks that are often used to describe real-world situations. They are similar in many ways. Using terminology from our previous work, in both settings, two countries (or any two sides in a conflict) must choose whether to escalate or de-escalate a potential conflict. Mutual de-escalation preserves the status quo but mutual escalation results in a “lose-lose” scenario that leaves both sides worse off than they were under the status quo. And in both settings, a country “wins” when it escalates the conflict but the other country de-escalates.

There is only one real difference between a game of chicken and a prisoner’s dilemma, but it has important consequences. The framework represented in Chart 1 becomes a game of chicken when the unknown variable c, which is the cost of capitulation (losing when the other side wins), is not very large (c inferiror to 10). In this case, if one country is certain to escalate the conflict, the other prefers to de-escalate. That is, countries would rather “hand the other side a win” than pay the price of mutual escalation. As a result the
game of chicken typically has a relatively benign outcome or “Nash equilibrium.” One
country wins and the other loses, but barring some miscalculation, the mutually-painful scenario is avoided.

By contrast, Chart 1 represents a prisoner’s dilemma if the cost of “letting” the other side win is so high (c superior to 10) that both sides prefer the lose-lose outcome instead. Since they both have incentive to escalate the conflict regardless of whether the other side escalates or de-escalates, the only possible result is mutual escalation.

No one wants to be chicken

We think this simple framework provides broad lessons for many of the political risks facing the global economy. The first is about rhetoric. In a game of chicken, strong rhetoric is helpful in signaling commitment to a confrontational stance. Examples include:

• The Trump administration’s threat to put tariffs on another $200bn in imports from China and raise the tariff rate to 25% (from 10%), even though the prices of consumer goods such as electronics will likely increase.
• China’s unwillingness to compromise thus far, even though economic activity appears to have slowed slightly because of the trade war, and the Shanghai Composite Index is down almost 20% year-to-date. China has responded to the latest US threats by promising to retaliate with tariffs on $60bn of US goods.
• The strong statements that have been made in the US-Iran conflict. For example, President Rouhani recently said that “war with Iran is the mother of all wars,” even though military conflict is not a realistic possibility.
• The UK government’s claims soon after the Brexit vote that it had a strong negotiating hand. More recently, Brexiters’ insistence on a clean break from the EU, even though a ‘hard’ Brexit would be economically very damaging for the UK.
• The euroskeptic Italian government’s proposals for aggressive fiscal expansion, even though it would run counter to EU rules, which call for a reduction in the structural deficit. Chiara Angeloni and Gilles Moec expect the 2019 Italian budget to target a deficit of less than 2% of GDP. This would be modest relative to campaign promises but would still be about double the previous government’s 2019 target.

In each case we think the goal is to make the other side blink in the face of aggression. However, the risk is that these conflicts will morph into prisoner’s dilemmas. How so?

First, very strong rhetoric increases both sides’ political cost from backing down. In our view, China would be willing to make some compromises to the US, including increasing its purchases of US agricultural and energy products, and taking stronger measures to protect the intellectual property of US firms operating in China. And in a game of chicken, given China’s exposure to US demand, such compromises would be in China’s economic interests.

But it is difficult for China to make concessions when the US is dialing up the rhetoric. The Trump Administration’s chief economic adviser Larry Kudlow recently stated on TV that China is a “lousy investment” and is “in a weak economic position,” which is “not a good place for them to be vis-à-vis the trade negotiations.” This sort of language makes compromise tantamount to an admission of weakness. Little wonder then that President Xi’s confrontational stance against the US remains popular in China.

Similarly, it is probably not in the US’ economic interests to enforce its sanctions on Iranian oil to the strictest degree possible. As we argued last week, driving supply out of Iran to zero would likely push oil prices above $100/barrel, which would be a headwind to growth. But the threats out of Iran raise the political costs of reconciliation and make the US-Iran conflict more like a prisoner’s dilemma. A mutually—and in this case globally—painful outcome could be in the offing.

The second, related concern is that strong rhetoric increases one’s own costs from backing down. Over the course of the Brexit negotiations, it has become increasingly clear that the EU will drive a hard bargain because conserving the single market is more valuable than undermining it to keep the UK in the EU. Moreover, the EU committed itself to a tough stance by publishing the EU Council’s negotiation mandate before the start of the negotiations. The mandate is all but impossible to change because all 27 countries and the European Parliament would have to unanimously agree to do so.

Some UK leaders, including Prime Minister May, seem to have realized that the UK is in a position where it must compromise, not least because of the looming March 29, 2019 deadline. This may be why they presented a Brexit deal last month that was economically negative for the UK—free trade in goods, the EU’s comparative advantage, but not in services, the UK’s comparative advantage—but was still economically better than no deal.

However, the proposal sparked rebellion among the Brexiters in her party, with threats to bring down the government. May’s “Chequers deal” proposal now appears to be in serious trouble. Brexiters have made the overly-ambitious promise to leave the EU but somehow continue to trade frictionlessly with the region. Now their political credibility concerns may be raising the risk of a no-deal Brexit.

Is talk cheap?

It might be possible to win a game of chicken by “bluffing,” i.e., convincing the other side that you are likely to escalate the conflict even if that is not the case. This is not an ideal outcome for the other side but at least there is room for compromise while avoiding an accident. In a prisoner’s dilemma, however, there is no value in bluffing or posturing because the other side will always call your bluff.

The conflict between the Italian government and the EU is in its early stages. It is possible that Italy will be able to elicit some compromise out of Brussels on budget targets and immigration by essentially bluffing on its willingness to leave the Eurozone. But to achieve this outcome, Italian leaders will have to reduce the political costs to the EU from making concessions. There should be room to sell any deal as a compromise rather than a repudiation of the EU.

Similar lessons can be applied to the trade war, Iran and Brexit. In each case there is room for compromise and the question is how much each side will give up. To a degree, strong statements can help because they might push the other side to make more concessions. But if the rhetoric becomes too strong, the only deal available is no deal at all." - source Bank of America Merrill Lynch

The questions remain whether the Trump administration will need to tilting or not with their current skills. The jury is still out there when it comes to trade negotiations taking place. Overall markets remain highly supportive, particularly in the US even if some weaknesses have shown up as of late in some macro data, although the Fed is tightening, lending surveys still point out towards economic expansion, even if we are late in this credit cycle.

• Final chart - US credit growth still on cruise control

The most predictive variable for default rates remains credit availability. The latest Senior Loan Officer Opinion Surveys (SLOOs) point that credit remains plentiful still. SLOOS report does a much better job of estimating defaults when they are being driven by a systemic factor, such as a turn in business cycle or an all-encompassing macro event. Our final chart comes from Deutsche Bank Strategy Update note from the 28th of August entitled "The bearish bias returns" and shows that the latest Fed SLOOs remain supportive of domestic demand (yes US consumer are using their credit cards...):

"Data supportive of higher rates, political risk remains a headwind

Since early August, the data has remained supportive of higher rates. In the US, the bank lending survey has improved and is consistent with domestic demand remaining comfortably above potential (left graph below). GDP trackers for Q3 are consistent with ~3% growth (right graph below), which is broadly in line with our economists' forecast.

It is worth noting that capex has upside relative to a series of indicators (graph below).

This could compensate a negative impact from trade wars on investment. On the inflation front, the latest data was generally encouraging. Our economists continue to expect core PCE and core CPI at 2.3% and 2.5% at the end of next year, which is broadly consistent with leading indicators such as the ISM or the NY Fed Inflation Gauge (graph below).

The recent USD strength could be a concern for the medium term inflation outlook. However, (a) it has been relatively modest so far and (b) given the lead/lags it should become a headwind in H2-19 at the earliest." - source Deutsche Bank

If indeed over the coming months inflation does indeed accelerates thanks to transfer of rising costs from the producers to the consumers, then, we think Jerome Powell the other poker player at the Fed will not be bluffing when it comes to hiking more aggressively and this might still catch quite a few pundits off guard.

"When people use the word 'science,' it's often a tell, like in poker, that you're bluffing." -  Peter Thiel

Stay tuned ! 

Macro and Credit - Hypertonic surroundings

"The advancement and diffusion of knowledge is the only guardian of true liberty." - James Madison

Watching with interest the numerous convolutions in Emerging Markets, with Gold taking the proverbial sucker punches thanks to the bloody rampage of "Mack the Knife" (King Dollar + positive real US interest rates), when it came to selecting our title analogy, we decided to return to a biology one, namely "Hypertonic surroundings" given our global macro reverse osmosis theory we discussed in our conversation "Osmotic pressure" back in August 2013 seems to be playing out for the weakest EM "cells" out there:

"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013

 This is the theory we put forward in terms of biology analogy at the time:

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.

We also added in our July 2015 conversation the following: 

"More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike." - Source Macronomics July 2015.

A good illustration of our "reverse osmosis" and "hypertonic surrounding in our macro theory playing out in true Mack the Knife fashion has been the pain in EM most recently with the usual suspects such as Turkey and Argentina being first in the line of the murderous rampage of "King Dollar". 

Nota bene: Hypertonic

"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia

What we are seeing in true "biological" fashion is indeed tendency for capital outflows to flow out of an Emerging Market country in order to balance the concentration not of solutes, but in terms of "real interest rates" (US vs rest of the world). Animal cells lack rigid cell walls. When they are exposed to hypertonic environments, water rushes out of the cell, and the cell shrinks. The resulting cells are dehydrated and lose most or all physiological functions while in the shriveled state. If cells are returned to isotonic or hypotonic environments, water reenters the cell and normal functioning may be restored. Cells without cell walls (capital controls) can burst when in a hypertonic condition. Too few solutes (US dollars) and the environment will become the hypertonic solution. There goes our reverse osmosis global macro analogy for you.

In this week's conversation, we would like to look at the main reasons for the start of the "unwind" of the carry trade and the pain inflicted to EM macro tourists, namely that Mack the Knife is a consequence of financial conditions tightening for many leveraged global players. 

Synopsis:

• Macro and Credit - The Fed is tightening its financial conditions tourniquet 
• Final charts - So you want to be bearish? Oil-price spikes have preceded most recessions

• Macro and Credit - The Fed is tightening its financial conditions tourniquet 

While every pundits around the financial sphere are pointing the rise of the US dollar as the main reason for the ongoing bloodbath in the EM space, we think that the rise in the greenback is a manifestation, not the main cause of Mack the Knife's rampage. The reality as pointed out by David P. Goldman in Asia Times on the 16th of August is that financial conditions are getting tighter as per his article entitled "It’s all about financial conditions":

"The collapse of the copper price by 20% from its June peak evidently is not an economic phenomenon driven by demand. Rather, it is an expression of risk aversion.

The world has gotten riskier during the past few months, for two primary reasons:

1. There is a low-level trade war between the US and China underway that could turn into a high-level trade war; and
2. The Italian elections put a bunch of unpredictable firebrands in charge of an economy with US$2.3 trillion in foreign debt and a dodgy banking system.

Heightened risk translates into a greater desire to hold cash balances (and that means a higher dollar, because most people pay bills in dollars and therefore hold cash balances in dollars). To get higher cash balances, market participants sell things like raw materials.

Turkey is utterly irrelevant to this shift towards risk aversion. The Turks may make the mistake of thinking that they matter but no-one else should encourage them. Turkey’s whole stock market is worth about US$30 billion at current prices, roughly the market capitalization of Monster Beverage Co. The big issues are European disintegration and Italian dyspepsia, and the US-China trade war." - source David P. Goldman - Asia Times

Because of fears of dollar scarcity, thanks to QT and the Fed turning off gradually the monetary spigot, the commodities rout has been about raising dollar cash/playing defense as indicated by David P. Goldman. As well there are the usual "known unknowns" everyone and their dog have been talking about, namely the risk of trade war escalation and of course the potential brewing internal rift between the European Commission and Italy. It's going to be interesting to say the least to see how Le Chiffre at the helm of the ECB aka Mario Draghi is going to deal with the Italians and their budget which will no doubt necessitate some helping hand in buying their bond issuance. This is what we wrote in our October 2015 Le Chiffre conversation:

"While in the movie Le Chiffre pretty much made a game out of it with nothing on his cards in the first game, in similar fashion Mario Draghi made a game out of it with his "OMT" and "Whatever it takes" July 2012 moment. In the movie it made Bond surmise that Le Chiffre was in desperation to get the money and resorted to bluffing (It was exactly our thought at the time). Le Chiffre and Mario Draghi share the same trait, both are poker prodigies hence our title analogy." - Macronomics, October 2015

 But, hey whatever it takes...as we wrote as well in the same conversation:

"While Le Chiffre has been a prodigious  Poker player when it comes to "bluffing" his way out of the "bond vigilantes" in Europe setting their sights on weaker European government bonds, when it comes to both "credit growth" and "inflation expectations", we think Le Chiffre has indeed been "overplaying" it." - Macronomics, October 2015

So while the US dollar is indeed on everyone's mind when it comes to EM woes and the Turkish side show, still the big European elephant in the room remains Italy. The current Fed normalization process is making Le Chiffre's balancing work even more complicated we think if he intends to remain a "forced" marginal buyer of Italian BTPs with of course Merkel's German consent.

But, moving back to our recurring themes in recent conversations, we discussed rising dispersion and large standard deviation moves. This late cycle phenomenon is attributable we think to liquidity being withdrawn thanks to QT and global financial conditions being tightened. As we saw earlier one the short-vol pigs house of straw blown away, obviously the next levered candidate were the macro-tourist pigs house of sticks such as Turkey and Argentina. 

In our March 2017 conversation entitled "The Endless Summer" we concluded our missive at the time asking ourselves how many hikes it would take before the Fed finally breaks something. As well we commented the following in our February missive "Buckling":

"The difficulty for the Fed in the current environment is the velocity of both the rates rise and inflation, because if indeed the Fed hike rates too quickly then it will trigger some other avalanches down the capital structure (short-vol complex being the equity tranche or first loss piece of the capital structure we think). If inflation and growth rise well above trend, then obviously the Fed will be under tremendous pressure to accelerate its normalization process. It is a very difficult balancing act." - Macronomics, February 2018

The Fed is still relentless on its hiking path, particularly in the light of US CPI coming at 2.9% year-over-year, unchanged from June; the fastest pace in more than six years. As we repeated in numerous conversations, for a bear market to materialize you would need a significant pick-up in inflation for your "buckling" to occur and to lead to a significant repricing of risky asset prices such as equities and US High Yield. In recent conversation "Bracket creep", which describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation, we indicated that with declining productivity and quality with wages pressure building up, this could mean companies, in order to maintain their profit margins would need to increase their prices. To repeat ourselves "Protectionism", in our view, is inherently inflationary in nature. At some point there might be a confrontation between the Trump administration and the Fed we think.

A clear sign of financials conditions tightening we think has been the unwind of the EM carry trade to the benefit of our friend "Mack the Knife" aka the US dollar. This is clearly indicated by Bank of America Merrill Lynch in their Liquid Insight note from the 16th of August entitled USD in the FX carry driver's seat:

• "USD has been a top yielder in G10; a fundamentally-strong USD with asset status supports FX carry and further dollar gains
• USD on the asset side and SEK on the funding side has upended correlations; FX carry beta risk is low and investors own vol
• After the momentum surge in February-April, FX carry looks poised for another leg higher; will AUD & NZD stand in the way?

The shifting dynamics of FX carry

The US dollar resides firmly on the asset side of the FX carry spectrum, currently occupying the top yield rank (Chart of the day).

Its presence atop the yield ranking is historically atypical and a reflection of a robust US economic cycle and a steadily hiking Fed, attributes that have supported USD higher since 1Q18. USD asset status alongside SEK liability status (displacing JPY) has also sharply shifted historical FX carry correlations, resulting in long carry positions now having very low traditional “beta” (risk-on/risk-off) exposure as well as long exposure to implied volatility. FX carry investors now actually get paid to own tail risk in a robust economic cycle, which has traditionally supported carry returns. These are important shifts that enhance the attractiveness of both FX carry as an investment approach in an uncertain world as well as support the USD as principal currency beneficiary. After a strong surge in momentum through mid-April, event analysis suggests FX carry is poised to make another run higher in the weeks ahead. Of key importance will be whether recent sharp depreciation in AUD and NZD – the two other asset currencies aside from USD – moderates.

FX carry revisited

Traditional FX carry strategies involve going long currencies offering the highest yields, funded in currencies offering the lowest yields. The number of currencies on respective asset and funding sides can vary but often is symmetrically three (particularly in G10). For the sake of simplicity, our analysis uses Bloomberg’s G10 FX carry index, which uses a simple top three/bottom three construction and, in our view, is representative of the approach used by many FX carry-themed investors.

The general historical pattern of FX carry positions should be unsurprising to those familiar with the strategy. On average, since 2000, the highest ranking carry currencies have been NZD, AUD and NOK, in that order. The lowest ranking carry currencies have been CHF, DKK and JPY. Historically, USD, EUR, GBP and CAD have been positioned somewhere in the middle.

The carry spectrum today: What’s wrong with this picture?

Chart 1 shows the current FX carry spectrum based on implied three-month yield. A simple top three/bottom three FX carry strategy would currently be long USD (2.32% yield ), NZD (2.31%) and AUD (2.19%), funded in CHF (-0.80%), DKK (-0.59%) and SEK (-0.49%).

The position of USD on the asset side of G10 FX carry clearly represents a major departure from the past (Chart 2).

Moreover, its position at number one represents a full five rank positions above the historical average (about number 6). This is by far the greatest discrepancy with respect to current FX yield rank vs historical average across G10.

Additional anomalies worth highlighting are SEK, currently squarely on the funding side and two positions below its historical average; and JPY, now approaching middle-of-the pack status and two positions above its historical average (no longer a funder). Nonstandard monetary policy measures and forward guidance put in place by the ECB are responsible for low European yields, in particular that of SEK. Indeed, the Riksbank responded with aggressive measures of its own aimed at preventing unwanted exchange-rate appreciation, the practical result being relegation of SEK to the FX funding bin. Negative funding yields have clearly enhanced the spread of high yielders.

Factors affecting carry performance

FX carry has traditionally been a risk-on and implicitly short volatility strategy, essentially a reflection of relative yield providing compensation for relative perceived risk (Chart 3).

High yield also provides an incentive to fund external deficit currencies, often on the asset side of an FX carry strategy historically. Conversely, low (currently  negatively) yielding funding currencies usually exhibit safe-haven status, often due to external surpluses and correspondingly high international investment positions (IIPs). FX carry investors earn a positive return in one of two ways: (1) exchange rates remain stable or decline by less than the yield spread between the asset and funding currencies; or (2) asset currencies increase in value relative to funding currencies, hence producing capital appreciation additive to the positive carry differential. The latter scenario is the ideal one for carry seekers. FX carry investors lose money (ie, experience negative total return) when depreciation in asset currencies vs funding currencies exceeds the positive carry earned. Losses have been severe at times, as was the case during the Global Financial Crisis (GFC), when financial markets convulsed and global growth dove into recession.

Investors are likely aware that FX (forward) markets are priced such that the expected rate of depreciation in high yielding currencies relative to low yielding ones equals the positive carry earned (interest rate parity), meaning long carry investors implicitly think the FX market is incorrectly priced (generally too ‘pessimistic’). This is a key reason why FX carry traditionally suffers when risk tolerance takes a dive. With global risk appetite heavily influenced by global growth (Chart 4), FX carry performs well in periods of cyclical strength.

This makes tepid performance of the strategy all the more perplexing, particularly considering strength of the US cycle, particularly this year.

Carry momentum to re-assert

FX carry experienced a surge in momentum back in mid-April. After a protracted four month consolidation period, history suggests another leg higher in the weeks ahead. Back on 13 April, the 50-day information ratio of FX carry returns rose above 4.0, a two standard deviation event indicative of a significantly high level of carry momentum (Chart 5).

Readings of this magnitude have only happened 19 times since 2000. Of those 19 instances, 17 were higher after 100 trading days for an average total return of about 3% (vs currently only about 1% after day 87) (Chart 6).

Within this sample, 26 November 2012, stands out as having strikingly similar price action to today. This instance is 70% correlated over the last 60 trading days and 80% correlated over the last 20 trading days and suggests an impending 4% surge higher in the FX carry index to peak levels over the next few weeks. 

Carry caveat: will the antipodeans cease plummeting?

We believe USD will contribute to another leg higher in FX carry for fundamental reasons (strong cyclical position, monetary policy divergence). Our confidence in AUD and NZD – the other two currencies currently on the asset side of the strategy – is lower. Recent sharp slides in the antipodeans have been amplified by elevated global trade war, China and EM-related uncertainty. At a minimum, the pace of depreciation needs to moderate. So far, our LCBF flow data, which show four-week flows recently crossing into negative territory, for now do not support potential cessation of selling pressure. That said, speculative positioning as measured by CFTC and other data sources is very short AUD and NZD, potentially helping to contain a continued downside slide.

Note that in the recent February-April FX carry upswing, AUD and NZD trended moderately lower. But because of sharp USD strength and SEK weakness the strategy produced strong positive returns anyway. Resumption of AUD and NZD strength against SEK would clearly bode well for the FX carry strategy looking forward.

On a relative basis, our views are constructive AUD vs NZD (Greater AU and NZ divergence 15 Aug 2018). Of the three currencies currently included on the asset side of FX carry, NZD is clearly the weak fundamental link" - source Bank of America Merrill Lynch

There you go, if the USD is on a rampage, not only do we have rising dispersion among asset classes such as credit and equities but, now there is indeed a "hypertonic surrounding" situation when it comes to the swelling US dollar carry. This of course is the manifestation rest assured of QT hence the reason for the commodities bloodbath with many players busy raising their USD cash levels for protective measure.

While in our previous conversation we indicated we remained short term "Keynesian" and starting to become "Austrian" from a medium perspective, there is no doubt in our mind that there are clouds lining up on the horizon that warrants close attention. For instance from a "flow" perspective the latest Follow The Flow note from Bank of America Merrill Lynch from the 17th of August is aptly entitled "Nowhere to hide":

"Outflows from IG, HY, govies, EM and equities

It seems that investors have nowhere to hide. Almost all the asset classes we follow recorded outflows last week. We saw outflows from IG, HY, Govies and EM debt. Same in equities and even in money market funds. Higher risk assets volatility, EM FX sell offs, trade wars and Italian political risks have instigated a risk off trend in flows across risk assets. Will risk aversion abate any time soon? Should the aforementioned risks not disappear, we struggle to see a structural shift in flows back to Europe especially amid dollar strength and global interest rate differentials.

Over the past week…

High grade funds flows dipped further into negative territory. Further euro weakness (vs. the dollar) has pushed more outflows out of euro funds over the past week. High yield funds were hit again by outflows, erasing the inflows we have seen over the previous two weeks. Looking into the domicile breakdown, Global and European-focused funds have recorded outflows while US-focused funds recorded inflows.

Government bond funds recorded a strong outflow over the past week; almost reversing the inflow we saw a week ago. All in all, Fixed Income funds recorded a sizable outflow; the largest in eight weeks and the first after three consecutive weeks of inflows.

European equity funds recorded outflows for the 23rd consecutive week. $55bn has left the asset class over that period.

Global EM debt funds recorded another outflow last week, amid a rapidly weakening
trend in EM FX land. Commodity funds recorded a small inflow.

On the duration front, there were outflows across all parts of the curve. It feels that outflows were more sizable on the back-end of the curve." - source Bank of America Merrill Lynch

No wonder, the winner take all mentality is taking its toll flow wise and the US powering ahead in true "Dissymmetry of lift" fashion. But good news might indeed be history as we move towards the fall. While we recently wondered about MDGA (Making Duration Great Again) from an exposure point of view, we think that it is the time to reduce some risk and starting playing defense we think. On that specific point we read with interest Bank of America Merrill Lynch's take in their Securitization Weekly Overview from the 17th of August entitled "Risk off stew: QT, rate hikes, refi's dead, declining breakevens, expensive housing":

"Risk off stew: QT, rate hikes, refi’s dead, declining breakevens, expensive housing

Risk off signals are escalating. In our view, the only positive note this week was the trade war news that China will send a delegation to the US to try to resolve differences. We’re doubtful that a meaningful “fix” to a situation that has been brewing at least since China’s entry into the WTO in 2001 will be reached, but we’ll see. The Shanghai Composite closed the week at 2669, the lowest level in over two years, so market skepticism about trade war resolution appears intact. Meanwhile, the list of negatives for markets, away from trade, is getting longer, creating a risk off stew in our opinion.

QT has been accelerating: the Fed’s balance sheet is now down by $219 billion in 2018 and the 4-week rolling change of $64 billion is by far the largest decline in a 4-week period since the unwind started. 10 years after the crisis led to dramatic expansion of the Fed’s balance sheet, the unwind is picking up steam; we look for another $175-$200 billion by YE 2018. On top of that, another rate hike in September seems fairly certain, consistent with our Economist’s views. Jackson Hole or the upcoming Fed minutes seem unlikely to offer any meaningful change from the Fed’s somewhat autopilot policy tightening plans. But these events will be worth watching, as a dovish shift could alter the risk off conditions.

Another negative is recent declines in the 10-year breakeven inflation rate, which has dropped down to 2.08%. While the breakeven rate has stabilized above 2.0% in 2018, the Fed’s continued policy tightening may well challenge that stability. BofAML technical strategist Paul Ciana is now highlighting that the 10y breakeven rate is at risk of a bearish breakdown to 1.91%-1.98% in the months ahead. Based on our breakeven inflation valuation framework for securitized products, this would be consistent with our view that spread widening risk now dominates for the sector. In mortgages and housing, things are not great either. The MBA Refinancing index dropped to an 18-year low this week. Long gone are the days that increased refinancing activity provided a savings stimulus to the household sector. Instead, declining refinancing activity is consistent with policy tightening from the Fed. Meanwhile, the latest UMich consumer sentiment reading reported “home buying conditions were viewed less favorably in early August than any time since August 2006.” This is consistent with the recent sharp drop in the MBA purchase index and is even more negative than the affordability index, which is back to 2008 levels, would suggest; given the changes in mortgage credit availability since the pre-crisis era, affordability is probably more constrained than the nominal time series suggests.

As we noted in “Soft housing data piling up: prepare for risk-off,” the mortgage/housing market could use a 10Y rally back to the 2.25%-2.50% range over the near term. If the trade war and Fed remain on their recent, market-unfriendly paths, the chances seem increasingly good that a sharp risk off rally in bonds is coming, as is more pronounced spread widening in securitized products. We’ll watch for change in the coming weeks, but, in our view, now is the time to become more defensive. We doubt either the Fed or China will meaningfully change course without more pronounced market turmoil as motivation. Most likely, spread widening in securitized products has only just begun."  - source Bank of America Merrill Lynch

From a contrarian perspective, two things stand out, not only the consensus short US Treasury Notes is stretched but if indeed we are starting to see a fall in breakevens, there could be a potential for a rebound in gold which has been relentlessly impacted by the surge of "Mack The Knife" though one could argue that given the momentum in USD FX carry, it might be still difficult to time your entry. 

In their notes Bank of America Merrill Lynch highlights the different factors pleading for a more cautious stance in the weeks ahead of us:

"This week, we survey a number of factors that argue in favor of a more pronounced risk off phase for markets in the period ahead. We began warning of this phase back on July 27 in “Soft housing data piling up: prepare for risk-off.” This week provided a hint of what we think is in store for markets in the next 2-3 months. In our view, spread widening risk in securitized products now dominates. We think defensive positioning is warranted.

Two factors could change this: a sudden change in tone from China on the trade war and the Fed on tightening policy. We think more downside in markets is likely need to create such changes, but we will watch in the weeks ahead, particularly in the upcoming Fed minutes and Jackson Hole, for signs of a shift.

Factor 1: the trade war

The simple trade war gauge we have been watching is the Shanghai Composite index. While it is heading lower, we see risk that weakness in China spills over and increases global recession risk, which will be reflected in wider credit spreads. Chart 1 shows the index closing this week at the lowest level since 2016, down 25% since the January high.

Chart 2 shows the index inverted against the IG corporate index spread. Our point with this chart is that at least some of the trade-related weakness in China is spilling over to the US.

As we write, there is a report of a possible high-level US-China trade summit in the months ahead. While this is positive news, it is a long way from resolving a host of issues that date back at least to 2001, when China entered the WTO. More downside pain in markets may be necessary to lead to true resolution.

Factor 2: the Fed balance sheet and rate hikes

It’s almost 10 years since the financial crisis led the Fed on a path of significant balance sheet expansion. 2018 has seen the start to the unwind (Chart 3): down $219 billion YTD in 2018, with the last 4 weeks seeing a drop of $63 billion.

The unwind is accelerating, as the balance sheet should see another $175-$200 billion decline by YE 2018. On top of this, the Fed maintains ambitious rate hike plans relative to the market (Chart 4).

The upcoming minutes release and Jackson Hole meeting provide opportunities for the Fed to offer new views on policy. Our rates and economics colleagues Mark Cabana and Joe Song suggest the Fed will provide “updated guidance on the longer-run operating framework, which will have implications for a potential end date to the balance sheet unwind.” See “The week in fedspeak,” 17 August 2018. Whether this will be enough to signal a meaningful shift in tightening plans remains to be seen. For now, as with trade, we’re skeptical.

Factor 3: breakeven inflation rates are declining once again

The combination of trade war and tightening policy has reversed the rise in the 10yr breakeven inflation rate (Chart 5).

We’ve seen this movie before in the past few years (2015 and 2016-2017): inflation expectations move higher and then roll over. This year has seen more stability above the important 2% threshold, which is why we have retreated from frequent discussion of our breakeven inflation valuation framework for securitized products.

Now, as the breakeven rate has dropped to its 200d moving average, BofAML technical strategist Paul Ciana is highlighting that the 10y breakeven rate is at risk of a bearish breakdown to 1.91%-1.98% in the months ahead. Our valuation framework suggests this is consistent with spread widening risk for securitized products.

Essentially, it appears as if the market has reached a critical, potential break point on factors 1 and 2 above, the trade war and Fed tightening. If there is no capitulation by either the Chinese or the Fed, the chances are good that breakevens will indeed head meaningfully lower, undoing the work that has been done to stabilize inflation expectations above 2%.

Factor 4: mortgages and housing – refi’s are dead and housing is expensive

This week saw the MBA refinancing index drop to the lowest level since 2000 (Chart 6), nearly 18 years ago.

Gone are the days when an increasing refinancing incentive created a savings stimulus for household. Instead, the Fed’s policy tightening is showing one additional sign of stimulus withdrawal, in the form of declining refinancings. Higher rates have mattered.

Similarly, the MBA purchase index has rolled over sharply in recent weeks (Chart 7), as high home prices and high mortgage rates have hurt affordability.

Confirming this, the latest University of Michigan consumer sentiment reading reported “home buying conditions were viewed less favorably in early August than any time since August 2006.”

The sentiment is interesting, as affordability is currently at 2008 levels, which were actually better than 2006 levels. Chart 8 shows affordability along with the MBA’s mortgage credit availability index.

2006 was the lowest level of affordability in the history of the index. But it was also the year of maximum credit availability that acted as an “offset” to low affordability.

While we see potential for some loosening of mortgage credit, we see little chance of a return to pre-crisis levels of availability. The best solution to low affordability is lower rates. As we noted in “Soft housing data piling up: prepare for risk-off,” the mortgage/housing market could use a 10Y rally back to the 2.25%-2.50% range over the near term. Given the risk off stew that is brewing,  a risk off move in markets may give the mortgage and housing market what it needs." - source Bank of America Merrill Lynch

Sure housing would indeed get a respite from lower yield no doubt. It's all about Wall Street versus Main Street. Given the amount of known unknowns in these "hypertonic surroundings" we would rather take a more cautious tone and raise cash levels in dollar terms within our allocation tool box, given cash in the US thanks to the rise of the front-end is appealing again.

Finally, as per our final charts below, what could really trigger a more recessionary and bear market outlook to the current scenario would be rapid rise in oil prices with an escalation with Iran we think. As we pointed out earlier one, for a bear market to materialize you would need a significant pick-up in inflation and oil could be the match that triggers the lot. 

• Final charts - So you want to be bearish? Oil-price spikes have preceded most recessions

What matters is the velocity of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years.  It is worth closely paying attention to oil prices going forward with the evolution of the geopolitical situation with Iran. Our final charts come from Bank of America Merrill Lynch Global Economic Weekly note from the 17th of August entitled "the law of large numbers". The first chart displays the surge of the US dollar since tariffs were imposed in March and the second chart displays the risk posed by oil shocks in post-war recessions:

"Since the steel and aluminum tariffs were imposed on March 1, the dollar has strengthened against many currencies (Chart 1).

Iran: oil slick?

Oil sanctions against Iran pose an almost equal risk to global growth. Recall that oil shocks have played a role in most post-war recessions (Chart 2). Given the steady shrinkage in Venezuelan supply, the large gyrations in Libyan supply, and the fact that OPEC and US fracking supply is already high, a cut-off in Iranian oil could have a major impact on prices. Iran currently exports about 2.3mn barrels of crude oil per day (b/d). Francisco Blanch and team estimate that a reduction of 1mn b/d in Iranian supply would increase Brent prices by about $17/barrel. This means that if the Trump administration pursues its stated goal of cutting Iranian oil exports to zero, Brent could rise above $100/barrel. This would be a major headwind to global growth, especially since dollar strength is pushing the non-dollar price of oil up even faster.

The Iran story is not just about global oil supply. It has created yet another split between the US and many of its allies. The sanctions could also worsen US relations with major importers of Iranian oil, including China and India, which together have purchased nearly 60% of Iranian crude oil exports this year. Although the sanctions have been imposed unilaterally by the US, they would apply to any shipping or insurance company that deals with Iranian oil. This gives the US the power to effect substantial cuts in Iranian exports globally, should it choose to do so.

A final striking aspect of the sanctions is their timing. Full sanctions on Iranian oil go into effect on November 5, just one day before the US midterm elections. In our view, this is a sign that the Trump Administration views getting tough with Iran as a winning political issue. The timing argues against a common view that the Trump Administration will moderate its policies—and reduce the risks to the markets and the economy—in the run-up to the election." - source Bank of America Merrill Lynch

We do live indeed in interesting "hypertonic surroundings" times, with of course many known unknowns to keep us entertained for the weeks ahead. What's always more worrying is the unknown unknowns but that's another story and we ramble again...

"Knowledge is not simply another commodity. On the contrary. Knowledge is never used up. It increases by diffusion and grows by dispersion." - Daniel J. Boorstin, American historian

 Stay tuned!