Financial markets are on a tear despite abysmal economic conditions around the world.  Is this case of FOMO, TINA, or just consequences-be-damned YOLO?  And what does it all mean for the ‘safe haven’ US dollar?

The consensus out there seems to be: ‘Don’t worry, the Fed has your back’.  There’s only one problem with that: our analysis says it’s not true.

– Stanley Druckenmiller, Investor and Hedge Fund Manager, May 2020

Is the market high only because of some irrational exuberance  – wishful thinking on the part of investors that blinds us to the truth of our situation?

-Robert Shiller, Economist,  ‘Irrational Exuberance’, 2000

I’ve been humbled many times in my career, and I’m sure I’ll be many times in the future.  And the last three weeks certainly fits that category.

-Stanley Druckenmiller, June 2020

I’m fairly certain YOLO is just Carpe Diem for stupid people.

– Jack Black, American Comedian

Monday was a perfect example of the remarkable divergence between financial markets and the real economy.  While the National Bureau of Economic Research (NBER) officially declared that the US was in recession, the NASDAQ hit a new all-time high and the S&P 500 surged above the 3230 level, recouping all of its year-to-date losses.

Chart I: ‘Risk On’, S&P 500 (Blue) and EURUSD (Orange) YTD

Source: Bloomberg

Markets are ignoring economic fundamentals…

Since the peak of COVID panic in March and April, oil has rallied strongly off its lows, and even interest rates are showing signs of life, with the US 10-year yield approaching 1% on Friday.  Understanding what is behind the decoupling of asset prices from the underlying economic trends that should determine them, and whether it is sustainable, is a crucial component of any attempt to understand the drivers of all financial markets, including currencies, over the months ahead.

Chart II: S&P 500 (Blue) vs. University of Michigan Economic Conditions Index (US)

Source: Bloomberg

A number of possible explanations for this phenomenon have been suggested, including:

  • A surge in (unsophisticated?) retail investor participation;
  • The high concentration of technology stocks, that stand to benefit from the COVID crisis, driving indices higher (the FAANG stocks – Facebook, Apple, Amazon, Netflix and Google –  now make up almost 20% of the S&P 500 index weight);
  • An expectation of a quick COVID cure / vaccine and a ‘V’ shaped economic recovery.
Are the financial markets complacent?

And while all of these reasons have some truth to them, there is clearly more going on here.  The equity options market is particularly interesting.  Despite the fact that we are in the deepest economic contraction since the Great Depression, with demand crushed by a deadly global pandemic, debt levels soaring, and social unrest erupting across the world, investors seem more keen to hedge against rising equity markets than falling ones. 

The US composite put call ratio had fallen below 0.5 yesterday, implying that investors were buying more than twice as many equity call options as put options.  This represents the strongest demand for upside protection relative to downside protection in over five years.

Chart III: US Composite Put Call Ratio

Source: Bloomberg

It is clear from the options market that investors feel as though this is a ‘win – win’ environment.  If we are lucky enough to develop a COVID vaccine in the near future, a ‘V-shaped’ economic recovery will ensue, boosting earnings and valuations.

And if we are not so lucky, then the Fed (and other central banks) will pump enough liquidity into the market that equity prices will be insulated from any economic fall-out anyway.  It does not seem like a coincidence that the rapid increase in the Fed’s balance sheet since March (about $3 trillion) roughly matches in the increase in S&P 500 market capitalisation over the same period.  

What does this mean for the dollar?

On the one hand, the decoupling of market prices from economic fundamentals can be explained by expectations of a ‘Fed put’.  And this explanation is also why the dollar has been weakening following the initial COVID shock.  The dollar’s ‘safe haven’ premium is much less justifiable in a world where downside risk is negligible.

However, if there is a possibility that the current ‘risk on’ mentality is not sustainable, and that, at some point, economic fundamentals will reassert themselves, then the probability of a surge higher in the dollar looks increasingly likely, especially against the euro.

If we look at current positioning data, the speculative market is now extremely ‘long’ euro against the dollar.  In fact, the current long position of over 80,000 contracts is the 3rd highest level we have seen in the last decade. Such extreme positioning levels have only happened four times since 2010, including now.  The previous three occasions have been followed by significant moves lower in EURUSD, with an average decline of approximately 20%.  As long as the Fed is willing and able to backstop financial markets, there will continue to be an upside bias for EURUSD, but it is, almost certainly, a ‘YOLO’ trade. Or, to put it in less colloquial terms, a risky one.

Chart IV: EUR Speculative Positioning (CFTC) (Black) vs EURUSD (Blue)

Source: Bloomberg

Author: Kevin Lester