Time for a Pullback? Get Some Greenbacks!

By Martin T., Macronomics

“If a window of opportunity appears, don’t pull down the shade.” – Tom Peters

As we highlighted in our conversation in May 2012 – “Risk-Off Correlations – When Opposites attract”: Commodities and stocks have become far more closely intertwined as resources have taken on a greater role with China’s economic expansion and increasing consumption in Emerging Markets.

In numerous conversations, we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor’s index and the US 10 year Treasury yield since QE2 has been announced.

Looking at the recent weaknesses in commodities such as oil and copper, one could decently argue that the time might have come to take a few chips off the gambling table.

This feeling of “uneasiness” seems to be shared by Bank of America Merrill Lynch which indicated on the 21st of February the following important points:

“This week’s Thundering Word from our investment strategists reiterates their view that a pullback is likely across risk assets but that this would be very healthy for the longer-term reflation story.

On this basis they advocate buying volatility near term. We highlight 3 key reasons for a near term pullback in risk assets:

-Market complacency: our Global Financial Stress Index (GFSI) is at a multi-year low, while the new BofAML Bull &Bear index which measures market sentiment is at a multi-year high (chart 1).

-Easing has eased: Monetary policy minutes of both the Fed and the Bank of England indicated this week that the era of QE is slowly coming to an end.

-Defensive price action: The two best performing US equity sectors year-to-date are Staples and Health Care. Credit markets have stalled. We remain bullish on the reflation story in Japan but note that domestic small caps, a key barometer of local belief in domestic demand, just dropped 20%.

A longer term trade is to buy the USD which is no longer correlated with volatility and has benefitted from the recent increase in risk appetite. Our house view is that the USD may be embarking on a strong secular uptrend; the only risk being any unexpected derailment of the US house price recovery.

A key element of the USD strengthening story is global rebalancing with Asia no longer deemed the world’s producer and the US the world’s consumer. As a result assets tied to the China production story are slowly derating – note the underperformance of materials stocks versus the global equity market in the past 12 months. However, some currencies also tied to the story such as the Australian dollar and the Canadian dollar are taking longer to derate and hence constitute good shorts against our long USD stance.”

As per our previous May 2012 conclusion, whereas opposite attracts during “Risk-Off” periods, the greenback could still prove to be a powerful magnet should we experience a bout of pullback in risky assets.

“If you are not willing to risk the unusual, you will have to settle for the ordinary.” – Jim Rohn, American businessman

Martin T., Macronomics

Martin T. is a credit specialist with a London based bank. During his career he's had different roles within various banks, covering everything from FX to High Grade Bonds. He has always been passionate about markets and particularly on Macro trends.

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