Out of the woods yet?
First published on 2022-11-23
Markets in Focus
Since reaching an all-time high at the end of 2021, US equity has spent most part of 2022 moving lower, despite several interim bear-market rallies. The year-to-date performance of the four major indices has diverged substantially. The Nasdaq is still down more than 28%, while the Dow has recovered most of its decline. This suggests a typical Growth to Value rotation within the US equity market itself.
The VIX, known as the Fear Index, is still sitting comfortably at the low 20s, suggesting the options market is relatively calm, especially given the recent bounce in the equity market. However, we do note this year’s repeated episodes of the VIX making higher lows, followed by sharp rises to above 30.
The October CPI miss, which came out on November 9th, was the final straw that broke the trend line of the relentless rally of the US Dollar this year. It remains to be seen if the October high was the peak of this cycle or if the greenback is just taking a much-needed breather after such an extended move.
The short-term Dollar weakening has been a tailwind for precious metals. Take silver, for example, it has completed an inverse Head-and-Shoulder (H&S) bottom, which generally suggests a reversal in price. However, it has run into a significant support-turned-resistance level at 22. If the US Dollar resumed strengthening and market sentiment changed back to risk-off, it would be very challenging for silver to climb above this level.
With the October CPI miss, US long-duration treasury bonds turned around and completed a small double-bottom pattern after three months of steady decline. From a technical perspective, it usually suggests an end or at least a pause to the prior trend, and price reversal could happen after the double bottom is completed.
Our Market Views
October’s headline Consumer Price Index (CPI) number came in cooler than expected. This CPI miss seemed to have given the market renewed hope that, finally, the aggressive tightening has helped to tame inflation, and the worst is already behind us. However, this is but only the second CPI miss in 2022. When the July CPI number came out on August 10th, risk assets rallied, and the US Dollar sold off. Unfortunately, that knee-jerk reaction turned out to be very short-lived. Within a few days, the S&P reversed and subsequently declined another 17%, and the US Dollar bounced right back at the trendline and rallied from 105 to 114 in the following month.
This time, CPI is notably trending lower from the high of 9.1% in June. Although the absolute level remains elevated, it is encouraging that the acceleration has slowed down. Combined with skewed market positioning, i.e., many investors are on the same side of long US Dollar and short treasury bonds for the better part of the year, the magnitude of the price reversal in many assets has been substantially larger than that seen in August.
We believe it is still premature to give the all-clear as the market jumped to price in the slowdown of rate hikes and even potential rate cuts in the recession scenario. We do not think inflation is going to fall back to 2% any time soon. A more likely scenario is that both inflation and rates will stay high for longer. As we have already laid out in the previous edition, we believe the Fed would be among the last to turn dovish. This keeps us on our toes to carefully watch the current pullback of the US Dollar. There is no certainty whether it is a genuine and cyclical reversal point or merely a pause before the next move higher.
Meanwhile, we find long-duration treasuries becoming more attractive. If inflation has been truly put under control, given the turmoil in many risk assets right now, getting a risk-free yield of close to 4% is not a bad choice for long-term asset allocation. In addition, if the US Dollar keeps its relative strength, foreign investors will also find it increasingly attractive to own US treasuries, even on an unhedged basis, to enjoy both the yield and the underlying currency advantage.
How We Express Our Views
We consider expressing our views via the following hypothetical trades1:
Case Study 1: Short Silver Future
We would consider taking a short position on silver future (SIZ2) at the present level of 21.35, with a stop-loss at 22.85, which could bring us a hypothetical maximum loss of 1.5 points. Looking at Figure 4, if the resistance holds this time and the inverted H&S fails, silver has the potential to fall back to 18, a hypothetical gain of 3.35 points. Each point move in the silver future contract is USD 5000.
Case Study 2: Long US Treasury Bond Future
We would consider taking a long position on T-Bond future (ZBZ2) at the present level of 126, with a stop-loss below the double-bottom neckline at 122, which could bring us a hypothetical maximum loss of 4 points. Looking at Figure 5, if the uptrend continues and the next resistance levels are reached at 132 and subsequently 144, we could see a potential gain of 6 and 18 points, respectively. Each point move in the T-Bond future contract is USD 1000.
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EXAMPLES CITED ABOVE ARE FOR ILLUSTRATION ONLY AND SHALL NOT BE CONSTRUED AS INVESTMENT RECOMMENDATIONS OR ADVICE. THEY SERVE AS AN INTEGRAL PART OF A CASE STUDY TO DEMONSTRATE FUNDAMENTAL CONCEPTS IN RISK MANAGEMENT UNDER GIVEN MARKET SCENARIOS. PLEASE REFER TO FULL DISCLAIMERS AT THE END OF THE COMMENTARY.