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Trader thoughts - the long and short of it

There feels like a certain fatigue playing through US markets in the session and it warrants paying attention to price action, as always, as a pullback of sorts is a growing possibility.

Market data
Source: Bloomberg

I say pullback ‘of sorts’, as this is a market where participants are willing on a fall, firstly, so they actually know the index can fall. Secondly, so they can buy at lower levels. However, given the trend in the so many global equity markets, and the backdrop of low inflation and what is likely to be.

Decent Q3 earnings in the US, pullbacks seem limited and that suggests an elevated possibility that the S&P 500 can build on its 14.2% gain year-to-date (16% on a total return basis). However, as mentioned, the risk of a 1-2% pullback is somewhat elevated here and while earnings are a near-term driver and high yield credit spreads are at multi-year highs, I would most closely look at the US treasury market for inspiration and certainly wouldn’t be advocating short positions here just yet.

Economic data has been fairly light, with the market not really focused too greatly on the New York Empire manufacturing print. It has rather preferred  to view the moves that have resonated from the far stronger, 6.9% YoY, producer price inflation (PPI) from China, which some have suggested seeing strong flows into LME and CME copper, while many are also likely prepositioning ahead of Thursday’s China Q3 GDP print (consensus +6.8%).

Take a look at the daily chart of high-grade copper, with price having firmly broken out and trading at the highest levels since July 2014. If this is a reflection of global economic trends, then the world is a happy place right now. Oil has also been fairly well bid, with Brent and US crude closing up 1.2% and 0.8% respectively, with traders seeing disruption stemming from tensions and fighting between Iraqi troops and Kurdish troops. Iraqi forces capturing oil fields in Kirkuk, with estimates (source Bloomberg) that disruptions here could affect 275,000 barrels a day.

It’s interesting that the moves in crude haven’t really seen much of a bid in the S&P 500 energy sector, which closed up a mere 0.2% and this suggests small support for Aussie energy names on open. It’s also interesting that there hasn’t been any move higher in inflation expectations, in fact, we have seen a very modest drop here. This has pushed up US ‘real’ (or inflation-adjusted) bond yields fairly markedly, given nominal bond yields have moved higher across the curve, with strong selling seen in the front-end of the curve, which has resulted in a bear flattening. US 5-year ‘real’ treasury yields, therefore, have increased a sizeable seven basis points (bp) and at 20bp are at the highest levels since 17 July. It’s no wonder then that precious metals have struggled (given their inverse relationship with bond yields and the USD), with gold and silver losing 0.9% and 1.8% respectively.

I mentioned earlier to focus on bond markets, as a continued move higher, specifically in ‘real’ yields, while clearly good for the global reflation trade (buy US banks here, notably with Morgan Stanley and Goldman Sachs reporting tonight), will pose a risk for equities. This will be specifically for companies where analysts look closely at future cash flows and discount these cash flows back to the present, in order to derive a net present value (NPV). The higher the risk-free rate (or in this case, a US treasury bond), the less compelling (on a relative basis) the future cash flows from these companies becomes and this could pose an issue to sentiment, although we are some way from the tipping point yet.

We have also seen a modest move higher in the USD, with the US dollar index up 0.3% and while this is a small absolute move, the USD is actually up against all G10 currencies on the day and performing well against most emerging market currencies too and it’s no surprise then that AUD/USD has dropped 0.5%. One key talking point, which has garnered much interest has been the emergence of John Taylor as a prospect for the Fed chair. His odds of taking this position has increased to 18%, just below Janet Yellen (at 20%), with both candidates leaping ahead of Kevin Warsh in the betting stakes.

Jerome Powell remains the clear front-runner here, but reports that John Taylor had a strong interview with Trump did cause some support from the greenback. Trump is set to meet with Janet Yellen on Thursday, so we could see headlines from this meeting. Naturally, if they are upbeat and positive, then we could see the USD under small pressure, with a slight bull flattening of the treasury curve.

We have just seen good numbers from Netflix and the stock is currently up 2.6%, with compelling projections of Q4 net streaming ads, revenue and support sentiment. Although obviously, it’s weighting on futures is very small. Still, the stage is set for somewhat firmer open in Asia, with the ASX 200 eyeing an open at 5860 +14 points), with BHP indicated to open around $27.13 (+0.8%), suggesting miners could do ok. Although Dalian bulk futures are a worry, with iron ore, steel, and coking coal lower by 2.5%, 1.9% and 2.9% respectively. Spot iron ore did close up 0.7% though. Financials seem key today, so if the ASX 200 is going to find buyers after the unwind of the auction then this is the sector to watch.

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