This summer we saw the end of the winter’s equity market recovery in April, followed by big market fluctuations through the summer months. This was driven in large part by the interplay between the US Federal Reserve and the Trump Regime as well the good news-bad news-good news-bad news cycles of the US-China trade negotiations.
Bonds and Interest Rates
If we look back over the past two years, as illustrated in Figure 1, the bond market’s slide ended last November for government bonds and investment-grade corporate bonds and in last December for high-yield bonds.
Figure 1: Bond ETFs: Governments (XGB), Corporates (XCB), High Yield (XHY) – 2 years
While government and investment grade corporate bonds have continued their slight but steady march higher in price (lower in yield) since November, we can see that high yield bonds followed a slightly different path. Sure they pulled back out of the gutter in January but after that they basically flat-lined. The gap between investment grade corporate bonds and high yield (i.e. high risk) corporate bonds has widened dramatically. Why? This communicates how the high-risk investors were migrating towards the safety of governments and investment grade bonds over the first half of the year. For example, if you use the US 10-year Treasury bond yield as an example, yields have plummeted from 3.2% to the sub-2% zone and that’s when there is not even a recession present.
The key driver is the array of trade/political wars facing the US. Not only is there the confrontation with China, but also tensions are high between the US and Europe, and there are a myriad of other political and economic hot spots around the world. While President Trump continues to badger Federal Reserve Chairman Powell about the Federal Reserve not dropping interest rates enough to stimulate the economy, recently Powell has clearly conveyed the message that it is not likely possible for the Federal Reserve to be stimulative enough to offset the economic negatives of Trump-initiated trade wars. You could say this is a Federal Reserve “shot across the bow” for President Trump to say that President Trump should not plan to continue waging economic wars everywhere with the expectation that the Fed will bail him out.
Figure 2: US 10-year Treasury Bond Yield Trends – 3 Years
The Trump calculus in these trade wars (Canada, China, Japan, Europe) is essentially that those economies are much weaker than the US economy. Even though the tariffs may temporarily hurt the US, he expects they will hurt other countries worse and negotiating counterparties will fold and “cry uncle” before the US needs to. That is a high stakes game of chicken for two reasons.
First of all, even if foreigners’ pain is greater, other countries (China in particular) may be more willing than the US to endure the pain if faced with an adversary they feel is threatening their sovereignty. Democratically-elected politicians must often kowtow to short term popularity in ways communist leaders don’t. Surely the Chinese negotiators see this, especially with the US elections around the corner.
Secondly, the entire global economy relies on consumer spending, which hinges on consumer confidence. The American consumer is the most powerful driving force in the entire world economy. If consumers get spooked, turn tail and run, it is extremely difficult to reverse that consumer fear until it has run its full course. Thus the question is not just which country in the negotiation blinks first but also, will the foreign negotiators blink before the US consumer blinks. Will a negotiated settlement be achieved while there is still a chance to revive tepid consumer demand?
With President Trump looking for success before election time I expect there will be some sort of calming of the rhetoric, some partial agreements, and a steering away from the security of certain bonds. This shift may be short-lived IF the consumer fades and investors realize that the bilateral accords cannot rejuvenate the economy. Once “success” is announced and there is a market response, the consumer will become the focal point of investor attention.
In talking about currencies I have generally focused on the Canadian Dollar-US dollar exchange rate but this time I have also added the US dollar index. What is the point? When we just see one currency against the other (CAD:USD) we can’t tell if the shift is due to events in Canada or due to events in the USA. The US Dollar index helps us understand that. The US Dollar Index tracks the movement of the US Dollar against a basket of 6 major currencies (Euro, Yen, Pound, Swiss Franc, Canadian Dollar, and Swedish Krona). The idea is that if the US Dollar moves against that bundle of currencies, it is not because of one of the currencies; it is due to the US Dollar moves. On the US Dollar index a higher number means the US Dollar is strong and a lower number means it is weak.
When we compare the Canadian Dollar to the US Dollar, sometimes people say it is trading at a number like 75 cents. By this they mean that $1 CAD would give you 75 US cents. On the other hand some people say the exchange rate is a number like $1.33. By this they mean just the opposite: 1 USD would give you $1.33 CAD. In the currency chart here, we use the second convention.
How to read the chart
Roughly the two lines move in tandem most of the time. When both lines are going up or both are going down we are witnessing a USD driven behaviour, for better or worse. When the lines are moving in opposite directions we are witnessing a non-USD-driven behaviour. For example way back in the beginning of 2018 we can see that the USD index rose a lot but the USD-CAD did not. That illustrates the USD carrying the CAD along with it while other currencies around the world weakened. In Nov-Dec 2018 we saw the US Dollar Index rise as investor fears set in and investors charged into the USD and out of other currencies. It was followed in December-January by a quick turnaround with major currencies strengthening against the USD. Then in May-June of 2019 the USD weakened dramatically against major currencies but not against the CAD. Lastly, late this summer the US Dollar has strengthened.
Versus the CAD a two-year trend has established: the USD has been steadily marching higher and stronger against the CAD since September 3, 2017 when it was 1.21 CAD/USD (82.6 US cents/CAD) to the current 133.15 or 75.6 on the reciprocal. As I have mentioned in the past, Canada has somewhat of a “petrocurrency” and when there are signs of global economic weakness, oil demand gets questioned and if oil prices decline petrocurrencies decline.
Figure 3: US Dollar Index and Canadian Dollar versus the US Dollar – 2 years
While the winter did witness stock markets around the world recovering from their December 2018 lows, most markets experienced a double peak in April and June/July with strong retrenchment in May and again in August.
Figure 4: Equities: USA-purple, Canada-blue, Japan-red, UK-yellow, Germany-green – 2 years
The assurances from President Trump were very influential in the winter market’s rise but recent volatility has been triggered by the realization of investors of just how deep the US-China trade dispute goes and that there are no quick fixes. Furthermore, the Federal Reserve’s Powell recently gave speeches downplaying the notion that the Fed would essentially rescue the economy from President Trump’s tariff wars.
A reduction of trade friction will definitely be warmly welcomed by the market and likely propel the market higher but for how long? The key question is whether consumer spending gets revived. That is what I will be watching in the months ahead.
Paul Fettes, CFA, CFP
Portfolio Manager, RN Croft Financial Group
CEO, First Sovereign Investment Management Inc. and Efficertain Corp.