- Trade War: An End to China’s Currency Stability
8/5/2019
In mid-May, U.S. President Donald Trump eased some restrictions on the Chinese technology giant, Huawei, and the United States and China agreed to call a ceasefire to their trade war and resume talks.
During the cease-fire, the Chinese Yuan mostly traded between CNY 6.92 and 6.87 versus the U.S. dollar, which was a remarkably narrow and stable range given all that was happening in the world – Fed rate cuts, turmoil in the crucial oil shipping lane along the Strait of Hormuz, Hong Kong protests, and more Brexit drama, etc.
Then, on August 1, as the U.S. trade negotiating team was traveling back to Washington from Shanghai, the U.S. President abruptly broke the ceasefire by threatening to impose 10 percent tariffs on $200 billion more of Chines imports into the U.S. – including consumer goods and holiday toys. The Chinese responded on Monday, August 5, 2019, by devaluing the Chinese yuan through the invisible 7-line, taking the currency toward 7.10 to the U.S. dollar.
The case for an appreciating Chinese yuan always rested squarely on the question of whether optimism for a trade deal between the U.S. and China would emerge. A trade deal would usher in very positive growth expectations in the U.S. and China. The opposite has now happened.
For More Coverage, Visit CME Group’s Trade War Resource Center
The new tit-for-tat developments render the likelihood of any trade deal as extremely low. Indeed, the U.S. threat to impose more tariffs made during the middle of sensitive negotiations sends a strong message that the U.S. does not really want a deal. The U.S. position now seems to be to keep the pressure on China and see what happens to their economy down the road – effectively postponing any deal until after the U.S. elections.
For Chinese President Xi Jinping, the most important point politically for him is not to be seen as being bullied by the U.S. So, taking a strong stance makes political sense. A devaluation also effectively negates the tariff threat, by making Chinese goods cheaper in U.S. dollar terms.
It will be interesting to see how far the Chinese currency depreciation goes. There was an invisible barrier at CNY 7 per U.S. dollar, a line that the Chinese government had previously not wanted to breach for fear of angering the US and leading to even further tariffs increases. Since the tariffs are coming anyway, the Chinese authorities lost their incentive to defend the 7-line and are now using currency depreciation to offset any tariff impact.
Importantly for global markets, the U.S. tariffs now appear to be permanent. This is an extremely negative development for global trade and growth, which was reflected in the sharp downward movement in equities around the world as the trade tensions escalated – possibly beyond the point of no return.
The post Trade War: An End to China’s Currency Stability appeared first on OpenMarkets.
- 50 Billion: The New Magic Number for Initial Margin Rules
8/2/2019
A number of financial firms required to post initial margin on uncleared derivatives received some welcome news in July. The next phase of the initial margin rules – applying to firms that have derivatives portfolios with over $8 billion in notional outstanding – was modified so that the majority of these market participants would have another year before they had to comply.
The regulation for uncleared margin rules (UMR) was set in motion at the 2009 G20 meeting following the global financial crisis. It requires firms using over-the-counter derivatives to post margin on those transactions. Phases 1 to 4 have covered firms with $750 billion+ in notional value.
Industry estimates from a September 2018 letter estimated that over 1,100 newly in-scope counterparties would become subject to initial margin rules by the time Phase 5 came to fruition in September 2020.
The New Magic Number
The Basel Committee on Banking Supervision (BCBS)/IOSCO announcement on July 23 is expected to make Phase 5 of Initial Margin apply to far fewer firms, as it establishes the 50 billion Average Aggregate Notional Amount (AANA) as the new magic number for UMR compliance in 2020. It also laid out a revised measurement period for some jurisdictions such as the United States, where clients will now measure their AANA from March-May 2020 in line with the European Union, instead of the previous window of June-August 2019 for U.S. clients.
200 Affected Firms
An October 2018 analysis by economists at the Commodity Futures Trading Commssion (CFTC) estimates while Phases 1 to 4 capture just over 40 entities, Phase 5 (the old phase 5 of $8B) could bring 700 entities in scope. Based on their analysis of CFTC data, over 75 percent of entities coming into scope in Phase 5 have AANAs less than $50 billion, implying that the New Phase 5 would include at least 175 entities.
For More Coverage, Visit CME Group’s Uncleared Margin Rules Resource Center
TriOptima’s triResolve is a portfolio reconciliation service that helps firms measure their AANA. Whilst the measurement period is not until 2020, preliminary analysis of trades currently submitted to triResolve shows approximately 200 clients would be subject to the new Phase 5.
A Change in Trading Behavior Coming?
To borrow some option terminology, having the threshold at 50 billion instead of 8 billion puts a larger number of clients closer to being “at the money” of the threshold level. This increases the value of notional reduction opportunities like switching volume to listed futures and cleared swaps, and utilizing multilateral compression.
Several market participants told CME Group they would have been captured in Phase 4 of UMR because they would be over $750 billion in AANA, but they were able to change the product mix of what they traded in order to reduce their notional and remain out of scope of Phase 4. The latest estimates show that because of these notional reduction efforts, Phase 4 will now only impact approximately 25 clients instead of the 50+ that were initially anticipated.
CME Group has witnessed this with clients who started using FX futures instead of forwards, Equity Total Return Index Futures instead of total return swaps, and clients who backloaded their entire portfolios of Chilean Peso and Colombian Peso interest rate swaps into CME Clearing in order to get their notional amounts below the Phase 4 AANA threshold.
Suffice it to say that since the advent of UMR, there has been a definite movement from clients out of bilateral markets and into futures and cleared swaps.
Looking at the Large Open Interest Holders for CME Group financial products, there has been tremendous growth in holders of CME Group futures with over 1,300 new large open interest holders across equities, interest rates and foreign exchange futures since the start of 2016.
Multilateral Compression
Not all exposures in a portfolio can be expressed via a listed future or a cleared derivative, so most firms will still have a portfolio of uncleared derivatives and the notional of those trades are what counts towards the threshold calculation, along with FX forwards.
With the goal of reducing the gross notional of a derivative portfolio, multilateral compression takes place via cycles where a group of different participants submits the trades they’d like to compress, along with their parameters and tolerances of how much they will allow their portfolio to change.
During these cycles, compression services looks across the submitted portfolios from all participants who want to compress, and it then reduces as much notional and as many line items as possible for all participants involved. TriOptima’s triReduce, the first such compression service, has eliminated $1.5 quadrillion of notional since launching 16 years ago.
Readiness for Phase 5
The trend of clients using futures, voluntary swap clearing and compression to reduce notional are likely to continue, as the start of the AANA calculation period approaches in March 2020.
Even though the size of Phase 5 is now down to approximately 200 clients, there are still a large number of clients that have to comply – particularly when considering they’ll be leveraging the same external resources across infrastructure providers, legal departments and custodians.
The message from the industry echoes what was said ahead of the clearing mandate back in 2013, which is that preparation always takes longer than expected and to get started early.
The post 50 Billion: The New Magic Number for Initial Margin Rules appeared first on OpenMarkets.
- Exchange-Listed Precious Metals Are Absorbing Market Share
8/1/2019
The full range of institutional investors have moved increasingly toward exchange-listed futures and options in precious metals, away from over the counter forwards and options. This trend began emerging around 2000 but has accelerated a couple of times in the ensuing two decades, as market forces, periodic financial spasms, regulatory changes, and structural changes in the buy and sell sides of financial markets have stimulated the move.
Precious Metals Trading Rising
CPM produced a report in June based on a range of detailed market research it undertook over the course of a year. We surveyed hedge fund managers, commodity trading advisors, and commodity pool operators, using both our own internal database and the best available market lists of fund managers.
Trading volumes by institutional investors on CME precious metals futures are rising sharply. Turnover appears to be declining in OTC markets, although the lack of trading statistics and transparency limits the ability to fully measure this.
Gold trading on futures exchanges totaled 10.7 billion ounces in 2018, more than double the 5.2 billion ounces of London OTC clearing volumes. This compares to London clearing volumes of 4.5 billion ounces in 2002 and futures volumes of 1.8 billion in 2002. That’s a 494 percent increase in futures volumes in the last 16 years. Silver futures trading has grown by 664 percent over the same time period, with futures volume (154.4 billion ounces) far outpacing OTC volume (57.9 billion ounces) in 2018.
Industry-Wide Shift
This change is part of a broader, financial industry-wide shift toward regulated, listed products and markets, although there are aspects to the changes in the precious metals markets that are unique to these markets. While many of the changes underway in debt, equity, and currency products, and buy-side and sell-side structures are being heavily motivated by regulatory changes in Europe, the United Kingdom and the United States, with precious metals the key impetus of the changes have been instigated by buy-side institutional investors as opposed to regulators or product development groups.
As these changes are happening, the bid/ask spreads on CME futures contracts are contracting, making futures that much more attractive compared to OTC trading. The average bid/ask spread in a representative sample of gold trades in September 2018 was 55.7 percent less than the spreads in September 2013. For silver, the average spread was down 37.6 percent between 2014 and 2018.
Liquidity The Key Driver
Fund managers stress that their preference for exchange-listed futures and options is not so much driven by cost competitiveness as it is by non-financial benefits. They stress that the liquidity of the futures markets, especially in the nearby active front months, is superior, and that they are more comfortable putting on and modifying positions in the futures markets due to the greater liquidity.
It is not just liquidity, however. Investment fund managers made it clear that the ease of use, the transparency, and the existence of a well-established clearinghouse system that has been operating for decades all factored into their preference of exchange-traded futures and options over OTC derivatives.
As research for the June report CPM conducted a series of detailed interviews with fund managers actively and intensely involved in these markets, many of whom are CPM Group clients. The findings were based on these efforts. Perhaps ironically, CPM Group also trades for client accounts, as a commodity trading advisor. Our own trading patterns mirror the conclusions we found in the broader market. From even before our inception 33 years ago, we used OTC forwards and options for our clients’ hedge and investment positions. Beginning around 2003, we migrated to futures and exchange-traded options, for the same reasons others told us in our survey.
The post Exchange-Listed Precious Metals Are Absorbing Market Share appeared first on OpenMarkets.
- Market Update: Fed Day
7/31/2019
The Federal Reserve followed through on its first rate cut in over a decade. Jack Bouroudjian explains how currency tension and disinflationary pressure from abroad may be forcing the Fed’s hand.
The post Market Update: Fed Day appeared first on OpenMarkets.
- What Will FOMC Do? Just Listen
7/29/2019
After two days of testimony by Jerome Powell in front of House and Senate committees in early July, we knew one thing for certain: The Fed is open to a rate cut or two (or more) and inflation, or lack thereof, is the reason.
Plain English
Powell is becoming well-known for his candor and plain English explanations of economic conditions. Using that style of language, he stated in the first line of the first paragraph of his prepared remarks that the “economy performed reasonably well over the first half of 2019” also noting that the current expansion is in it’s 11th year, which is the longest in history. The justification for potential rate cuts began immediately after with the line “However, inflation has been running below the Federal Open Market Committee’s (FOMC) symmetric 2 percent objective, and crosscurrents, such as trade tensions and concerns about global growth, have been weighing on economic activity and the outlook.”
This quote became more important as the question & answer session began. During that Almost 3-hour Q & A, Chair Powell repeatedly referred to the Fed’s dual mandate. Few people realize that Congress gave the Federal Reserve three key objectives for monetary policy in the Federal Reserve Act: maximizing employment, stabilizing prices, and moderating long-term interest rates. The first two objectives are often referred to as the dual mandate and within that dual mandate is the Fed’s stated inflation target of 2 percent.
Let Inflation Run?
With 3.7 percent unemployment, the job market is near full employment. Inflation has been stubborn and in previous Fed speeches, several FOMC members and Fed Presidents have said it may be wise to let inflation run above 2 percent in order to assure longer-term stability. The chair reinforced this theme when he was asked how to avoid the issues of stubborn deflation that the Japanese Central Bank has faced for decades. “We don’t want to get on that road,” he said, adding that low inflation would likely reduce longer-term interest rates and hurt the Fed’s ability to fight a future downturn.
He would not agree that the job market was hot and pushed back saying “We don’t have any basis or any evidence for calling this a hot labor market. We have wages and benefits moving up at 3 percent, which is good because it was 2 percent a year ago, but 3 percent barely covers productivity increases and inflation.” Wages are a component to prices, which again show a concern for inflation.
Stocks made new highs and the inverted yield curve steepened to near flat, so whether the market agrees that a rate cut is needed, it clearly believes there will be one or even a series of cuts. With such a articulate Fed chair delivering such a clear message, perhaps its time to stop commenting on what the Fed should do and react to what it is telling us it’s going to do.
The post What Will FOMC Do? Just Listen appeared first on OpenMarkets.
- Market Update: A Disrespected Rally
7/26/2019
Jack Bouroudjian explains why the rally of the last six months has been disrespected, and why a large amount of capital has been held back. That could change in the near future, he says.
The post Market Update: A Disrespected Rally appeared first on OpenMarkets.
- Two Threats Remain for This Record U.S. Economic Expansion
7/25/2019
On June 30, 2019, the current economic expansion tied the old record from the Clinton decade of 40 quarters, and as each month passes without a recession it will be setting new records for duration.
As we have pointed out many times, economic expansions do not end because of old age. It takes a policy mistake.
Previous expansions were ended by much higher short-term rates: for example, 5.25 percent in 2007, 6.5 percent in 2000, 9.8 percent in 1989, 19 percent in 1981, and the 1960s expansion ended with federal funds at 9 percent in 1969.
Our point is that it is pretty hard to argue that 2.4 percent short-term rates will be the straw that breaks the back of this record-long economic expansion. So, what are the prime candidates for a policy mistake this time around if the Fed is not going to be the culprit? Here are three threats that could combine to be the trigger.
Weaponizing Tariffs
Tariffs are a tax. The Trump Administration has used tariffs as a weapon in its trade wars to attempt to force concessions from countries around the world – China, Mexico, Canada and now the focus turns to Europe.
The U.S. and China are the number one or number two trading partners of most other countries, and both the U.S. and China are seeing their imports decelerate or even decline in some cases.
When global trade slows, so does global growth. We doubt the trade wars and weaponization of tariffs are enough to cause a U.S. recession, but slower real GDP growth does seem to be in the cards.
Declining Business Investment
Our perspective is that the seeds of an economic deceleration from a 3 percent real GDP path back down toward 2 percent and maybe a little weaker have been sown by all the uncertainty over the trade war and weaponization of tariffs. And, lowering short-term interest rates from 2.4 percent to 1 percent or even back to 0 percent will make no difference for business investment decisions.
This is a heavy burden for the global economy, and all multi-national corporations have to manage these risks, and lower short-term interest rates are not going to help.
The post Two Threats Remain for This Record U.S. Economic Expansion appeared first on OpenMarkets.
- Market Update: Downtick in Global Growth
7/24/2019
Jack Bouroudjian discusses how equity and treasury markets could react to the IMF report that global GDP is slowing, while the U.S. forecast remains strong.
The post Market Update: Downtick in Global Growth appeared first on OpenMarkets.
- Market Update: The EFP Market
7/23/2019
Earnings, The Fed and politics are driving the market, says Jack Bouroudjian. Between earnings reports, an upcoming FOMC meeting, trade tensions, a budget resolution and other factors, this is an important week for where bonds and stocks go for the remainder of the year.
The post Market Update: The EFP Market appeared first on OpenMarkets.
- Another Way to Approach Earnings Reports
7/22/2019
Earnings season can offer a great trading opportunity as individual stocks and the broader market generally see an expansion in volatility. However, even veteran traders may feel a bit uneasy trading a stock only one or two days each quarter as the increased volatility causes larger than normal price movements.
Moving the Entire Market
Stocks such as AAPL, AMZN and MSFT, to name a few, are components of numerous industries and a sharp move in any one of these particular stocks may have an overall impact on the entire market. Netflix began the most recent tech earnings season with a disappointment, sending shares lower. While the Nasdaq 100 still closed higher that day, the disappointment no doubt had an intraday effect on the broader index.
An example of how to approach these kinds of quarterly situations comes from something I wrote about in May: using micro e-mini contracts for an earnings situation that have the potential to move the market. Rather than trading NFLX, AAPL, AMZN or MSFT, an investor could use the Micro E-mini Dow Jones, Nasdaq 100 or S&P 500 contract to take advantage of a market-changing move in either direction.
Equity Index Futures
There can be cost advantages to this approach. If an active trader wanted to trade 100 shares of MSFT stock, the cost would be approximately $14,000. The cost of using a Micro E-mini contract would be considerably less.
Micro e-mini contracts allow an active trader to participate in strategies to capture market moves or to hedge more precisely since they are one-tenth the size of regular e-mini contracts.
NFLX reported much weaker than anticipated subscriptions and the stock declined over 10 percent. Other tech heavy names and FAANG stocks, such as Amazon.com and Alphabet Inc. (Google), moved in tandem on this news. This was a prime example of how a position in the Micro E-mini Nasdaq 100 could have either hedged a position or a new position could have been executed prior to the earnings release at a substantially lower cost than just trading a $350 stock.
Earnings season is a mainstay of market activity and has the potential to move the overall market in either direction. Since futures can be traded nearly around the clock and either just prior to or following a big earnings report, they may just be one of the best avenues for market participants to use when looking for earnings season opportunity.
The post Another Way to Approach Earnings Reports appeared first on OpenMarkets.
- Why Copper Is A Trade War Indicator
7/19/2019
Market participants are always scanning every credible source of information to find that one piece of data that can change the outlook and move markets. In this context, many participants looking for the future direction of the global economy look to copper, often called by its nickname “Doctor Copper”. This suggests two questions; Does this epithet make sense intuitively and, can the direction of copper prices predict anything else?
Copper is one the of most widely used base metals. 65 percent of the copper that is mined is used in electrical equipment such as wiring and motors, 25 percent is used in industrial machinery and the balance is used in construction for things like roofing and plumbing. It is almost exclusively a manufacturing and industrial base metal. In this context, it’s easy to understand the importance of copper as a leading indicator of the manufacturing side of the global economy.
Predictive Powers Weakening?
The United States, however, is becoming less and less of a manufacturing economy so it is feasible to think that copper may have less predictive ability for the U.S. This weakens the predictive power of copper for the global economy given that the U.S. is the world’s largest economy. Below is a chart of global GDP growth over the last 10 years along with the price of CME Group copper futures.
Copper Meets The Trade War
There is some similarity to the shape of these line graphs, but it’s hardly Ph.D. level work. Has Doctor Copper become Mr. Copper? We say no, the Doctor has not lost its predictive ability, but has become less of a general practitioner and more of a specialist. Copper may now be a specialist in manufacturing economies and specifically a specialist in the Chinese economy. Below is a comparison of copper futures prices to the change in Chinese GDP over the past 10 years.
For More Coverage, Visit CME Group’s Trade War Resource Center
The similarity is undeniable because China is by far the world’s largest consumer of copper. In 2017, when China was experiencing 6.2 percent GDP growth, the country consumed more than double the copper of the rest of Asia combined and more than four times the U.S. The only time frame in which the correlation appears to break down is late 2017/early 2018.
Copper had risen significantly, but in March 2018, President Donald Trump asked Robert Lighthizer, the United States trade representative, to investigate applying tariffs on $50–$60 billion worth of Chinese goods.
As you can see in the charts, China’s GDP did pick up slightly in the first half of 2018, following along with the large rally in the price of copper, but leveled off and fell for the balance of the year after the U.S. President’s request and the subsequent commencement of the ongoing trade war. Copper has been falling ever since, save for a brief rally at the end of 2018, as planned increases in the initial tariffs were postponed and negotiations between the two economic powers began. Copper prices ticked up and so did Chinese GDP, albeit mildly. Both have since reversed course and are headed back down.
A Measure of The Trade Talks
Given the trade war involving the U.S. and China and all the various opinions on the progress of negotiations between the two nations, copper is likely the best indicator of the state of the trade talks. If copper breaks out, then the Chinese are likely buying copper again and the probability of a deal getting done is increasing. If copper continues to decline, the probability is falling. While there currently is no official CME Trade Deal watch tool (like there is with OPEC production and Fed rate policy), consider using the price of copper futures as your indicator as to whether the trade war is nearing an end or not.
The post Why Copper Is A Trade War Indicator appeared first on OpenMarkets.
- Market Update: Valuation
7/18/2019
As we enter earnings season, it’s a good time to discuss valuation. Jack Bouroudjian explains how to gauge where the value of the market should be based on where earnings might go. He also discusses the importance in how CEOs are going to approach upcoming earnings calls.
The post Market Update: Valuation appeared first on OpenMarkets.
