Sunday, May 7, 2017

Are the Fed and PBoC taking away the punch bowl?

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Risk-on*
  • Trading model: Bullish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.

Tightening into an approaching storm?
William McChesney Martin Jr., who was the longest serving Fed chair, famously said that the job of the Federal Reserve was to take away the punch bowl just as the party gets going. In the past week, there has been rising angst over two separate central bank actions that may indicate that the "punch bowl" is leaving the global party.

The first set of actions belong to the Federal Reserve. The tone of the May FOMC statement and the strength of the April Employment Report makes a June rate hike a virtual certainty. Barring further "data sensitivity", the Fed is well on its way to raise rates three times in 2017, and to begin reducing its balance sheet either late this year or early next year. At the same time, the Citigroup US Economic Surprise Index, which measures whether macro releases are beating or missing expectations, has been tanking. These readings, along with the weak Q1 GDP growth figures, raise the risk of a Fed policy error as it tightens into a weakening economy.

At about the same time, Beijing has been taking dramatic steps to contain credit growth and reduce leverage in China's shadow financial system. These liquidity tightening measures have caused commodity prices to collapse and create heightened market anxiety.

The combination of a newly hawkish Federal Reserve and a PBoC intent on reining in excesses in the Chinese financial system have raised fears that the global economy may come crashing down as a result. Ambrose Evans-Pritchard summarized these fears in a recent Telegraph article:
Equity investors across the world are positioned for the nirvana of synchronised and accelerating global expansion led by China and the US.

What they may instead get is a synchronised Sino-American slap in the face. Analysts at UBS say the international credit impulse has already "collapsed". The two interlocking economic superpowers are both tightening policy into an approaching storm.

The US bond market has been signalling for two months that the US economy remains uncomfortably close to a deflationary relapse, an implicit judgment that the US Federal Reserve is about to commit a policy error...

Meanwhile, the Fed is in "another galaxy", to borrow an expression in vogue this week.

It shrugged off signs of weakness as "transitory" at this week's meeting and seems determined to pack in a clutch of interest rate rises while the coast looks clear...

There must be a risk that they will do exactly what they did at the tail end of the pre-Lehman boom, when monetary indicators had already turned down. Bureaucratic over-tightening caused a manageable downturn to morph into a banking crash.
In addition, China is raising the risk of a global crash with its shift in with a credit restrictive policy:
Beijing began stealth tightening six months ago. This is turning into a full-fledged effort to rein in the $US8 trillion shadow banking nexus.

"The Chinese economy peaked in the first quarter and is set to lose steam for the rest of 2017," said Danske Bank. Caixin's manufacturing index is the weakest in seven months. Steel output has dropped to 2015 levels. Planned investment is even lower. Housing curbs are biting with a delay. China's credit impulse has turned negative.

Saxo Bank says the contractionary forces are so powerful that the Chinese economy may slide towards a "full stop" later this year, with tremors through the commodity nexus and with risk of outright falls in world GDP.

"The markets are pricing in a 20 per cent chance of a recession, but after returning from China, we think it is more like 60 per cent," said Saxo's Steen Jakobsen.
Are the US and China tightening into a synchronized global recession? Let's examine the bull and bear cases.

The full post can be found at our new site here.

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