While most of the money-making trades of 2022 have been spun into reverse, with stocks and bonds re-correlating and rallying, Whether it’s the time of year or recession uncertainty, few seem inclined to chase the risk rally. Still, there is growing recognition that the consensus view of recession and earnings downgrades could face mitigation from declining inflation.
A lower USD, lower volatility, and the acknowledgement of having to buy early could improve the risk outlook.
China remains hotly debated and polarising on a cross-asset performance basis. The trade is viewed positively through an equity lens but not so much for the currency or oil markets. Bears fear a prolonged property downturn and an inability to kickstart growth like in the past, given debt levels. While others think reopening is but a formality and will be catalyzed by the World Health Organization downgrading Covid to an endemic.
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Crude oil prices collapsed further during Friday’s New York session before recovering into the NYMEX close as the correlation disconnect kicked in. The recent extreme downside in oil is quite head-scratching for many who were seriously wrong-footed, given that China has removed some of the covid-19 restrictions, which should drive up demand. However, the keen driver of the prompt downside momentum is the growing unease that China will not loosen covid lockdown policies because infections are rising again.
And while correlation traders/algos may have thought the move was too large and went too far compared to other China-sensitive assets, price action suggests portfolio investors have abruptly reversed course dumping the China reopening plays in favour of the consensus coalescing around a likely recession next year. Oil prices will bear a significant brunt if such a regime shift plays out.
Calendar spreads are falling, consistent with a recession in Europe and China. The US yield curve is inverted more now between two-year and ten-year maturities than at any time since September 1981.
In addition to recessionary fears building and some physical grade softening, the market is viewing US immunity for the Crown Prince and Prime Minister of Saudi Arabia as a precursor for more oil from Saudi Arabia — although Saudi is already pumping close to its maximum levels.
If you position the dollar wrong, you probably get everything wrong, so the multi-million dollar question on investors’ minds is, where does the dollar go from here?
Having ridden the ‘Fed pivot’ and ‘China reopening’ themes over the past few weeks, the FX market appears to be consolidating. Fed speakers continued the pushback of the pivot gang by signalling a higher terminal rate. However, the diverging stories of strong retail sales and weak manufacturing surveys have left markets scratching their heads on where the USD goes next as liquidity worsens ahead of US Thanksgiving week.
FX seems the best risk-adjusted way to ‘play the pivot’ with duration second, and the market is leaning towards a US dollar crest in about 3 to 6 months when there is more clarity on the Fed terminal rate.
While China’s risk assets may continue to rebound, softening global demand should steer policymakers’ preference for a weaker currency so the Yuan could trade laggard to broader dollar rallies.