As a result of this, I think it's time I wrote a detailed piece on the likely moves if this turns out to be a serious threat which causes many of the restrictions from the past to be considered once more. I think the first thing this mutation does (even though it hasn't been discovered in the G10) is cause central bankers to hold off on any monetary tightening until we know more. That means the Fed probably maintains the taper pace (hence the EURUSD strength this morning) and the BoE doesn't hike in December. But we'll cover all this in more detail in the piece ahead.
In this extended piece, I'm going to do a section on each asset class namely:
1. Equities
2. Fixed Income
3. FX
4. Commodities
And then try and wrap it all together into some kind of coherent conclusion on the methods you can deploy to help weather the risks ahead.
THE EQUITY MARKET:
Ok to kick things off, I'm not going to be doing an extended sector by sector analysis of what to own and sell in a new COVID wave. That will follow in its own individual piece.
Instead, I am going to look in broad strokes at the general equity market performances, and where you might be safest putting your money.
OK, so let's revisit March 2020, everything kicked off with just absolute broad selling of everything, I remember on several occasions we hit circuit breakers (where equity market falls were so great that a "break" of 15 minutes is triggered to try and calm markets). This was naturally a very scary time. Now, I'm not saying that this new variant is going to trigger the same wave of downdrafts in equities, but what is important to remember is that the recovery was triggered by central bank action.
Let's say that this variant is concerning enough that 10% is lopped off the equity market in total before we have more clarity about its prevalence and the threat it poses, I'm not sure what gets the market back up to all-time highs. If new lockdowns are introduced, central banks of the world are effectively out of firepower (except for QE). So this means that a rapid rebound in equities is not necessarily guaranteed.
So my suggestion for the immediate is to take out some downside protection. Buy some puts in the "recovery trade" (names like airlines, oil, commodities, financials etc), and also perhaps add some to the pandemic winners (think delivery companies, tech, WFH trends).
Multiples in the UK also make it look cheap - currently trading below 15 times fwd earnings. This to me is a bargain when we compare to the 20* + earnings seen in other markets. But the most important thing you can do right now... is protect your downside. If you've been a reader of this blog previously, as I outlined in "The Bears Who Cried Wolf" this is something which you should have positioned yourself for recently.
FIXED INCOME:
Again, I am not going to delve too deeply into FI, I will do a more precise analysis in the second edition of "Treasury Tuesday's" where I will look at the outlook for different maturities of yields across markets.
For now, let's just have a look at the damage...
Source: Bloomberg
What's really striking to me is the Asia Pacific damage... AUD 10y down 13bps to 1.73%. Remember that these are the economies which have generally been a bit more hawkish on the inflation side of things - the RBNZ hiked recently to 0.75%, AUD abandoned YCC etc.
So clearly, a dovish reaction is expected from the central banks one more... but they don't have the policy room to cut as much as they did previously, perhaps explaining why the drop hasn't been more considerable a la March 2002. The US 10y down 11bps probably taking a faster pace of tapering out of the equation.
If we look at the 2y yield, we see that's also lost 10bps in the US. To me, this is where there could be the most action. Further lockdowns could put increasing pressure on the Federal Reserve to slow down the pace of its proposed hiking cycle. This is particularly true if restrictions return to the US, but bear in mind that lockdowns elsewhere will have repercussions on the rest of the supply chain. This makes the 2y pretty difficult to call, but the Fed is the Central Banker to the world, and too hawkish a stance will cause a backlash in the financial markets it will try to avoid.
UPDATE: A previous version of this report said the 2y yield had dropped just a basis point. This was incorrect and was due to delayed data. Apologies for any misunderstanding this may have caused. The rest of the logic still holds. The 2y could be in for a real shock down to around 30bps if this weakness persists, in my view.
My view from here is the 10y is probably appropriately priced. It is in the short-end of the curve where we could see a rapid repricing lower. This would be consistent with 2020 but I'd expect to see a steeper short-end curve as we see both bets that there will be a DELAY to the hiking cycle, but also that inflation pressures are likely to continue for longer.
In other words, the Fed will act to protect the economy, at the expense of more longer-term inflation.
Final comment on the UK: This new variant and the closing of UK borders to some nations is probably a sufficient condition for the BoE to delay hikes. When we couple this with Bailey's recent comments effectively saying that forward guidance is dead, I now believe that the December rate hike is increasingly unlikely. My favourite trade therefore (what a surprise) would be to short GBP - I'm currently playing this through FX Options. Please do reach out for any details. Below is the UK yield curve... something weird is definitely going on.
FOREIGN EXCHANGE:
Now we get to the juicy part. Let's start off by looking at the broad USD and EURUSD performance back in March of 2020: Notice that the Green line has an inverted axes, this is so it is more clear that when the USD strengthens the EUR weakens etc.
We can see that the USD got sharply stronger as the pandemic worsened as it utilised its "safe haven" status. As the Fed slashed rates and global policymakers provided stimulus, this was quickly reversed even in the face of global lockdowns!!
This was the "Risk Aversion" principle which saw the USD move in the opposite direction to equities. Within this "Risk On - Risk Off" (RORO) framework, when equities went up the USD went down and vice-versa. This can be seen most clearly in the following chart:
This paradigm worked well through 2020, however this year there has been a divergence as the focus has shifted onto inflation and therefore the rate hike path cycle. This 2021 paradigm is more in-tune with the "traditional" economic view that higher rates leads to stronger currencies.
So, the likelihood is, and we have seen this today, that a increasing risk aversion environment will lead to a stronger USD. Emerging Market currencies have been hit particularly hard.
The interesting part:
However, today in the market we see something very, very interesting: EURUSD is going up!
Source: cTrader FxPro
What this is clearly telling us is that the market is pushing back Fed rate hikes into the future. We all know that the ECB is ultra dovish and is never going to hike, but therefore rates are already at rock bottom. This means we see a convergence between USD and EUR rates, and EURUSD has risen commensurately. In the rest of the world, there are more hawkish bets being priced, so these currencies are weaker, but not for the EUR.
What's the trade?
If we really believe that this variant will cause more dovishness from central banks and a delay to hawkish actions, then this can only be a good thing for the EUR. There are a few other currencies with exceptional dovish policy which will benefit, but most of the gains should be present for EURUSD. GBP will struggle as this is one of the most hawkish CBs, as will NZD and AUD, but for the EUR, it could be time to shine. And this is exactly what we saw coming out of the extreme March volatility where the EUR just grinded higher and higher.
HAVENS: CHF or JPY?
Well let the market tell you... I also thought this was interesting this morning to see CHFJPY really moving lower - USDJPY aggressively moved on the back of "haven" demand. Gold is higher, and all-in-all I would rather play with the JPY as a haven bet than the CHF - this is simply because the CHF has strengthened so much already.
COMMODITIES:
Well Brent is another story of the day, plunging 6% lower or so... guess Joe gets his lower gas prices... but at what cost?
Clearly, this section doesn't need much elaboration. If we start to see more lockdowns (this will particularly be the case in China where the government has its zero tolerance approach to COVID), then we will see demand for commodities crushed.
Source: FxPro MT5
Think back to April 2020, oil prices touched a low of -40USD per barrel. Yes negative 40 USD per barrel. Is this likely to happen again? Definitely not. However, we saw back then just how quickly crude can move when demand dries up. Even if we see only a couple of million barrels per day of demand drop, then this could rapidly become a problem for stockpiles around the world.
GOLD:
BUY BUY BUY. I know this is what I have recommended forever, but as I've said many times recently, if you expect the Fed to be more dovish, then you have to get long gold since we are also facing higher inflation. It is a haven, it has been our currency for ten thousand years, just go out and buy some. You'll be grateful for it one day :)
That brings a wrap to this rather long piece. Congratulations to those who got to the end but hopefully this is useful to you.
I've tried to prioritise speed in getting this out (and hopefully beat many banks research/compliance departments), so I offer apologies for any mistakes, but hopefully this has helped, and do reach out with any questions.
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