Chris Weston, Chief Market Strategist, IG Australia
‘The measure of intelligence is the ability to change’ – Albert Einstein
It’s important to understand the strong consensus trades for 2016. While these may eventuate, having an open mind is essential. The ability to understand the ever-changing dynamics, regrouping and reacting before others will potentially make the difference between profit and loss in the New Year.
There is a view that we could actually see rate cuts coming in late 2016/early 2017 in the US. I guess the structure of this theme would look something akin to this diagram.
Keep in mind that the Fed funds future curve is pricing in 46 basis points of tightening (or two hikes), taking the projected Fed fund range to 75 to 100bp. The Fed are still calling for four, which is not going to happen.
At a simplistic level, if you can forecast the USD and oil correctly, you are halfway to being a step ahead of everyone else in terms of asset allocation.
USD – what’s expected?
If we look at the Bloomberg consensus estimates for EUR/USD in 2016, we can see the median estimate (the white line) is for $1.06. The top estimate is $1.20 (HSBC) and the low ball call is $0.90 (Handelsbanken). I am going to go out on a limb and say EUR/USD finishes the year above parity and the days of rampant USD appreciation seem over.
Looking at the fundamentals, we can see EUR/USD (red line – Bloomberg chart below) is trading at a strong premium to the German/US 2-year bond yield spread (white line). For now, this suggests rallies should be sold and there are short-term downside risks to EUR/USD. However, if the 46bp of tightening priced into the Fed funds rate is priced out, traders will likely go long US treasuries/short German bund as a pairs trades and this spread should tighten. In turn, this should put upside into EUR/USD.
With a compelling current account surplus and signs of credit growth in the Eurozone, EUR/USD could feasibly be higher this year. What would the world look like with a higher EUR/USD?
Watch this spread like a hawk in 2016, it will dictate where EUR/USD trades.
The green line (in the lower pane) shows the ratio of the ECB’s balance sheet versus the Fed’s. Naturally, this is only going to increase as the ECB buys €60 billion and is a EUR negative. How the Fed deals with the $220 billion maturing bonds it holds on its balance sheet is key to fixed income traders – for more information here, please ask.
With EUR/USD making up 55% of the US dollar index (US dollar basket), the analyst consensus estimate is that we will see a subsequent move into 101 by Q3 (currently 98.5). A break of the March highs (100.78) is clearly needed for the USD bull run to continue, but judging by the series of lower lows in the RSI’s, there are downside risks over the coming month or two.
AUD/USD – The consensus is that we will see AUD weakness in 2016, with both Q2 and Q4 averaging 69c (white line). The top estimate is 83c, and low ball is 62c. A lot rides on the AUS/US 10-year bond spread, which has traded in a range of 95bp to 33bp this year. An increased premium in favour of Australian bonds puts upside into the AUD valuation, by way of a rule.
Looking at the technicals for the AUD/USD, we can see a rather interesting picture. The set-up is neutral for now and there is no clear trade or directional bias. The big level to watch in 2016 is the 38.2% retracement and October/December double top at $0.7385, where a break would set of a rally as high as $0.7900, in my opinion. On the downside, a break of the rising trend from September is worth watching for a move into $0.7000.
Staying on the AUD theme, AUD/NZD (red line) has diverged from key fundamentals (ie swap or bond yield spreads). I like the idea of buying AUD/NZD on dips into the October lows of NZ$1.05, given the divergence. The AU/NZ two-year yield spread (yellow line) suggests the pair should be closer to NZ$1.12. The pair looks ‘cheap’ on a fundamental basis.
Oil – There is no immediate reason to be bullish oil, but one thing we can be certain of is that oil prices for a sustained period below $40 is not good for markets. There have been calls from the likes of Goldman Sachs for lower oil prices from here, but I would highlight the weekly chart of Brent is showing strong divergence with price. Is a reversal on the cards?
Fundamentals are still quite bearish with the US rig count starting to increase, US inventory levels some 130 million barrels above the five-year average and some 1.3 million barrels of excess crude being produced each day. What will change that?
The trick is get oil right and you can estimate inflation expectations more accurately. Being long HYG/JNK (high yield ETF’s) trades in a rising oil environment would work well and it would be good for the risk assets in general. A further fall through $30 and short CAD/JPY or even USD/JPY would be my conviction call.
Consensus forecasts currently stand at WTI oil trades at $41.64 and Brent at $42.94.
A trade that has worked really well in 2015 has been long WTI / short Brent, as highlighted by the Bloomberg chart below of the WTI/Brent spread. It seems front month WTI is about to command a price premium to Brent for the first time since January. However, as you can see by the red circles, whenever we hit this equilibrium since 2010 traders are more likely to go short WTI/long Brent. Will this trade work again in 2016? I am not so sure and a break of this ‘resistance’ area would be very positive for the long WTI/short Brent pairs trade.
Australia – The sell-side economists are expecting growth of 2.6% in 2016, driven by another strong contribution by net exports. A 2.8% increase in household consumption and 2% growth in government consumption will also assist. Headline Inflation is expected to increase to 2.3%, which fits nicely into the Reserve Bank of Australia’s (RBA) own range set at the recent Statement on Monetary Policy.
My own personal view is that the Australian economy will likely muddle through in 2016, although there are downside risks.
China – Growth is expected to average 6.5% in 2016, although many will feel the ‘real’ rate is closer to 4%. Watch USD/CNY intently, one of the big consensus trade for 2016 is long USD/CNH (offshore yuan). The USD is key, but a rapid decline in the yuan (a low possibility) holds huge implications for markets.
US – The market expects 2.5% growth with core PCE likely to trade 20bp below the Fed’s own forecasts of 1.6%. This apparently is enough to lift the Fed funds rate twice.
Key risks in 2016
• China slows down markedly. Unlikely in my view, but a risk.
• Japan actually looks likely to create 2% inflation. I am struggling to see how an end to QQE ends well for Japan, and subsequently for global markets too. It’s probably a bigger risk for 2017, but one that could cause a 30%+ crash to global equities.
• Further concerns about terrorism fueling increased popularity for Marine Le Pen’s National Front party. While the French election isn’t until April 2017, markets should become sensitive to the polls around Q3. Short CAC/long S&P would work well here, while EUR may be offered aggressively.
• The UK referendum on EU memberships. There is some discussion that this event will take place in Q2/Q3 2016, but this is speculation. Buying GBP/JPY volatility should work well in the lead up, but I am taking a cautious stance on Sterling in general.
• The USD rallies strongly from here, creating a disinflationary effect in the US and keeping commodities offered.
• The market gets the sense that the Fed made a policy mistake. Credibility is key.
• Credit spreads continue to widen, the US yield curve breaks multi-year lows (see Bloomberg chart below), and financial conditions become deeply restrictive.
• Global markets selloff and central banks have little to assist. Keep in mind, most sell-side analysts are predictably calling for gains in the S&P 500 and ASX 200. With earnings hard to come by, my gut instinct suggests that the ASX 200 will end 2016 at 4950.
It is going to be another hard year for money managers and trying to drive outperformance (alpha) is going to take some very creative thinking. My advice is to not fall in love with a position, directional bias or view. Holding the ability to be reactionary and nimble will keep you in good stead. Perhaps consensus will be correct, but I guarantee we will be surprised.
Good luck, happy Christmas and New Year.