Feeling Groovy

Feeling groovy.  Equity markets were looking for fun and feeling groovy yesterday as good vibes flowed in from all fronts.  Hopes for an end to the budget stalemate and the possibility for progress on trade talks with China gave traders the thumbs up for a risk-on day for equities.

WHAT YOU NEED TO KNOW:

1) Capital Hill lawmakers have submitted a proposal to the White House and the President seems reluctantly ready to sign off on the budget, avoiding another shutdown.  Stocks liked that.  Though the budget is not yet signed, it is expected that Trump ultimately will agree to the terms.  The big question that remains is what will the Administration do to make up for the lack of full funding for the border wall and unfortunately all potential answers point to further drawn out battles between lawmakers.

2) A deal with China may be progressing.  President Trump indicated in a cabinet meeting yesterday that he would be willing to let the March 1 deadline for negotiations slip “a little” if both sides were close to a deal.  Stocks liked that.

3) Crude oil traded up yesterday as Saudi Arabia announced that they would cut crude production in an effort to limit supply.  Surges in the commodity helped propel equities in yesterday’s session as there is a direct impact on the energy sector.

4) The US Dollar continues to rally despite the Fed’s strategic shift.  A currency typically weakens as rates go down but that has not been the case for the greenback indicating that either the rally is speculative and short lived or that the Dollar remains the best of the faltering group of sovereigns… or a little of both.

Equities traded up, up, up throughout yesterday’s session as more and more positive news surfaced regarding traders biggest fears.  Hope for a signed budget and an end to the trade war helped the S&P 500 rise by +1.29% bringing it just a hair above its 200 day moving average, which is positive for the index (see chart 4 in my attached daily chartbook).  The Dow Jones Industrial Average traded up by +1.49% closing just above its session high right in an area of light resistance (see chart 6 in my attached daily chartbook).  The Russel 2000 gained +1.27% surging through resistance in a third day of gains for the small cap index (see chart 7 in my attached daily chartbook).  The NASDAQ 100 was yesterday’s winner gaining +1.53%, placing it right on a resistance line and just below its critical 200 day moving average (see chart 8 in my attached daily chartbook).  Bonds in general were flat in yesterday’s session but the 10 year treasury slipped a bit bringing yields to 2.68%, still near the lower end of their recent range.  There has been much talk about the US Dollar recently, particularly with respect to its behavior in the wake of the Fed’s policy shift.  The dollar typically rises when interest rates are going up as capital flows into the country for carry trades.  The demand for the currency strengthens it relative to its lower interest rate counterparts.  The opposite is typically true when rates are expected to recede as capital moves out of the country in search of higher yields.  This has not been the case since the Fed announced its dovish rate policy for one principal reason:  there is no better alternative rate environment as other countries are experiencing similar softness in their economic outlooks.  To get a better understanding of the dynamics of currency moves I thought it might be good to provide a refresher on currency carry trades.  It is, after all, geek-out Wednesday.

GEEK OUT WEDNESDAY:

A carry trade is a passive investment strategy which involves borrowing capital at low cost and investing the proceeds in a higher yielding investment.  For example, if you are able to borrow money at 2% and then turn around and lend it out for 5%, you would expect to collect the 3% difference for as long as the borrower continues to pay the 5%.  Of course this is an overly simplistic example but it is the basis for many trading strategies of investment banks and hedge funds.  One of the most common carry trades is a currency carry trade.  The trade involves borrowing currency in a country with lower interest rates then converting it into a currency in a higher interest rate country and lending out that currency.  Let’ start with another simplistic example.  Assume that you notice that you can borrow British Pounds Sterling (GBP) and pay a 1% interest rate and you can lend out United States Dollars (USD) at 2%.  To take advantage of the 1% difference, you borrow GBP and convert it into USD and once you have your USD in the bank you lend it to the bank or buy USD denominated bonds.  By holding the trade, you make the 1% difference.  This transaction in which you sell British Pounds and buy US Dollars (GBP/USD) is a common trade and is referred to as “cable” by traders.  Let’s go through the calculation on how a trader will actually make (or lose) money on the transaction.  The calculation is as follows:

C = N * ( ( iL – iS ) / 365 )

Where:

C = Daily carry

N = the notional value of your trade.  This is the actual value that the position controls factoring in leverage and contract size.

iL = interest rate received on the long currency

iS = interest rate paid on the short currency

In our example, we can borrow Pounds at 1%, lend US Dollars at 2% and you decide to put the trade on for 100,000.  The numbers for our trade look like this:

C = 100,000 * (( 2% – 1%) / 365)

= 100,000 * 0.0000274

= $ 2.74 per day

Seems straight forward right?  You probably know that my question is a set up.  The calculation for how you make money is, in fact simple, but making money on the transaction is a bit more complicated and comes with some risks.  Remember that somewhere in our example transaction that we have to convert GBP into US Dollars, and we do that at the currency exchange rate at the time of the transaction.  The current exchange rate between the pound and the dollar is currently 1.29, which means that for every 1 GBP you get $1.29, but that exchange rate changes constantly and at this same time last year the exchange rate was around 1.4, which means you would have gotten $1.4 if you put the trade on a year ago.  The dollar has weakened against the pound in the last year so paying the interest on the pound based loan goes up which diminishes your return.  This is precisely why carry trades work well when the long currency is expected to either stay the same or strengthen relative to the borrowed currency.  Another risk is interest rate risk.  Interest rates change constantly and while most currency trades rely on the short term rates set by central bank policy, carry trades turn over on a daily basis which means that even slight fluctuations can impact the larger trades, as most are leveraged.  When traders put on currency carry trades they typically do so with a longer term outlook, therefore countries in which interest rates are expected to go up offer lower risk and higher profit potential.  This is precisely why the dollar strengthened against most currencies during the Fed’s hiking cycle – demand for dollars in carry trades between lower interest rate countries.  By now it should be clear what the underlying dynamics of currency carry trades are and, most importantly, that they are riskier than they may appear on the surface.

TODAY:

This morning we received the Consumer Price Index from Bureau of Labor Statistics and it showed that prices increased at a greater than expected year over year rate of +1.6% versus last month’s +1.9%.  The more important Ex Food and Energy CPI came in at 2.2% flat from last month.  The numbers back up the Fed’s recent “patience afforded by under control inflation” stance.   It should be noted however that average hourly earnings are beginning to creep up a bit, which is good news for workers but not so much for the employers who have to pay them.  Wage growth is the strongest driver of inflation.  We had a few pre-market earnings releases which included a miss by Dish Networks and beat by Hilton Worldwide.  After the market we will hear from Yelp, Cisco, and AIG amongst others. The market seems content with the positive feelings that drove equities in the last session and we will hear from a number of Fed speakers today and though they will most likely continue to toe the dove line, they will be closely watched.

daily chartbook 2019-02-13