It has been said that the economy is one dog with two owners, the government and the central bank. The problem for the dog is which one has the best treats and which one has the leash. In the last 10-years it’s been the FOMC to lean on, now it’s the US President. For markets, it’s the balancing of bonds against stocks. The cost of money matters as it sets the value of future cash flows, puts a number on growth potential and solves for the base case for profits.
We had a one dog market last week as the bond market rout drove down equity prices, put fear in credit and lifted the USD back higher despite doubts about the US trade and fiscal policy. US 10-year yields touched 3.25% back to 2011 highs. If the last week brought expectations for US economic outperformance with unemployment at 39-year lows and Services ISM at a record, then the next week brings a return of China/US trade worries and US C/A doubts with a $230bn deluge of debt sales.
The dogged equation of higher real growth means higher real rates hits globally. The reality check next week will be US CPI along with more reactions from Fed speakers. Rates are the dog that wag the tail of the economy after the bone of price increases change the business cycle. Whether the Fed is ahead or behind the curve becomes the likely new obsession which won’t mix well with the threat of a prolonged trade war with China, rising doubts about EU politics and jitters about higher energy prices into winter. The problem in the week and month ahead maybe best described by the removal of the central banker’s accommodative policy that intrinsically supports risk-taking.
The chart of returns for risk-parity programs makes this clear with the January turnaround fully reversed into October but recently and perhaps most troublingly, unwinding last week. There is no Powell S&P500 put. As for the CTA models in markets, the run-up in oil, USD and rates has helped trend followers regain some ground but they remain well off the January highs. Perhaps the only safe bet is that volatility will follow as systematic approaches to trading face a Fed less inclined to trust their models.
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