Opportunities in 2015

It is always a very difficult task to predict what will move markets one year forward, and some would go as far as saying it is futile and impossible. I kind of agree with this point of view, but in financial markets, everything is about probabilities, and understanding macro can tremendously help investors ‘predict’ what would be tomorrow’s most likely scenario.

What macro analysis is telling me about the financial world for next year is all about deflation, and let me explain my reasoning.

First the facts: The data flow out of Japan, China and Europe is bad, strongly suggesting appearance of the twin specters of recession and deflation.

Central banks responses to that fact are again more monetary stimulus. Europe is already accepting some negative interest rates, while his central bank chief Mario Draghi, is giving very loud hints that Europe’s version of QE may be coming. On the other hand, the world’s second largest economy, China, cut interest rates last Friday even as out-of-control credit binges threaten exploding debt dynamics… And last, but not least, Japan took the most dramatic pass out of the 3 regions buy going the equivalent of “all-in” - for poker fans - at the end of October, starting what might be considered a currency war.

Here is the logic chain: Japan, Europe and China all rely heavily on exports. Those stimulus strategies ultimately rely on weakening their respective currencies which in turn makes the dollar stronger. A stronger dollar creates global tightening credit conditions as it is the funding currency of the world economy and thus cancels out global stimulus effects.

You have to remember that the dollar still account for 80% of global trade transactions, and accounts for the most part of global borrowing, for a simple reason: investors prefer the liquidity and strength associated with the world reserve currency tied to the strongest and most dominant economy on the planet.

As an example, Turkey has $386 billion worth of debt payable is US dollars. Chinese companies have raised more than $180 billion worth of dollar-denominated debt, according to Morgan Stanley. These are two examples. Countless other EM has huge dollar exposure. The “US dollar carry trade” has been estimated, in total, at 3 to 5 TRILLION dollars. This means that, when the value of the dollar rises, these USD borrowers (companies and government alike) get squeezed. And what happens when export-focused Japan, China, Europe all attempt to weaken their currencies, directly or indirectly, even as the Federal Reserve stays “neutral”? They fuel strong dollar conditions, which in turn increase the risk of economic contraction, capital withdrawal, and credit defaults. The game is self-defeating.

What seems to be clear for me is that we are entering a negative feedback loop that may impact greatly financial markets. If my theory is correct, some exceptional money-making opportunities are at hands.

Commodities are the most at risk in this scenario and the fact that they already started a break out is confirmation of my theory. A stronger dollar means weaker commodity prices: Intermarket Analysis 101. I was alerted earlier this year by the Crude Oil break down that surprised many in financial medias, who failed to apply the saying “what can’t go up on good news must go down”. The price of Oil refusing to move up during the escalation of 2015 geopolitical tensions (Ukraine, Middle East) was a wonderful hint of what would be coming later in the year… Deflationary forces generated by US Dollar strength was  much stronger forces and not surprisingly commodity prices broke down in tandem after the summer.

But I think this is just a start! I believe that the commodity bullish secular cycle has ended. Therefor I opened a short AUD/USD at the start of November from 0.8720 after the completion of the small October consolidation pattern hoping for much lower prices around the 0.8 figure. I choose this currency pair because AUD is a commodity currency, as its economy relies heavily on exporting its resources to other countries, mainly China… which I am not optimistic about as well. I can also profit from the dollar appreciation in the meantime, so with the price action looking good to me it feels like a good play.

I will try to do some follow up on that position here in the blog and gives as much update as possible.