Research, Views & Articles
Is A Market Crisis Coming? 3 Important Signs To Watch
Talk of global recession is gaining momentum as we begin 2023. Here are three signs which will indicate that a broad market selloff is imminent.
Before we begin, it is important to note that a broad market selloff occurs when all markets are aligned on a cyclical basis. This means that the general idea behind looking out for indications of a coming selloff rests on understanding where important markets are trading in their own cyclical patterns, as well as how they normally trade just before inflection points.
1. The Dollar Strengthens, Or Remains Strong
As you can see from the chart, the Dollar (DTWEXBGS) was the first market to turn, way back in mid-2021, signaling that USD funding conditions were beginning to tighten across the globe. This is the precursor to all global recessions.
As we begin 2023, the USD has sold off, but remains much stronger globally than it was compared to its weakest levels in 2021. In other words, the Dollar is still signaling that a global economic contraction is on the horizon.
2. Eurodollar Futures Turn Higher
Eurodollar futures are one of the main ways participants in the global financial system hedge against changes in short term US Dollar interest rates.
From the chart below, you can see that they have spent the last few months selling off, as the Fed has been hiking rates. Conversely, should Eurodollar futures prices turn up, it means that the market is beginning to price in lower short term USD interest rates (remember that interest rates run inverse to prices in fixed income instruments).
Put another way, Eurodollar futures getting bid implies that the market is expecting the Fed to start cutting rates.
Lower short term USD interest rates, projected by the Eurodollar market, would bring it into alignment with global Dollar strength. This is due to the fact that lower rates, especially during times of market turmoil and economic crisis, do not actually indicate an abundance of liquidity. On the contrary, low rates in crisis periods indicate hoarding. For more information on this, refer to our articles on the Interest Rate Fallacy.
Bear in mind that the Eurodollar yield curve is currently inverted, just like the yield curve for US Treasuries. Both markets are massive and global, and both are indicating that liquidity conditions around the world are getting very tight.
3. Equities & Commodities Moving Lower
Equities have already turned lower in the current cycle, which is unusual, as they normally are the last, if not one of the last markets to turn, just before the global economy tips over into contraction and possible crisis.
However, should the world economy continue to move towards recession, it is quite likely that equities will rally, possibly quite strongly. This behavior is normal and is simply due to the fact that many equity market folks hold strongly to the paradigm that lower rates are good for stock prices, and higher rates aren’t.
The factors that determine stock prices (and in every other market) are myriad and complex; reductive statements claiming simple causal relationships between one factor and how it affects prices tend to be more folksy than accurate.
Should Eurodollar futures start to move higher (implying lower rates), equities start to rally, and the Dollar strengthens, it would be advisable to not bet too much on a sustained trend higher in stock indices. In fact, should such a scenario materialize, it might be wise to look into ways of getting short equities.
Other markets you can use as indicators of an impending slide towards a broad market selloff include the price of oil and copper. Both are sensitive to global growth conditions, although micro factors are important to consider in commodities markets.
Oil for example, is currently affected by Russia’s war in Ukraine, which naturally acts to keep its price elevated. With this in mind, should oil begin to trend firmly lower, it would indicate that global economic conditions are rapidly deteriorating, to the extent that even war-related supply disruptions cannot keep prices high.
If you would like to know how to prepare and profit from trading a crisis, you can learn to do so in our course on How To Make Money Trading A Crisis. The course will teach you about the market cycles mentioned above, how this relates to financial markets, and most importantly, which markets to trade and why.
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Why you Should NOT Follow the Dollar Index (DXY)
The Dollar rallying out of its summer weakness is beginning to catch the attention of mainstream commentators.
Unfortunately, their focus isn’t on the Dollar per se, but rather the Dollar Index, which is not a very good indicator of USD performance at all.
What should you be looking at instead?
Before we take a look at the different methods of gauging Dollar strength or weakness, it is important to understand why we need to be looking at the USD at all.
Obviously, the USD is the world’s reserve currency and is thus of global importance. Everyone knows this, but they don’t really understand why.
The common belief is that the Fed controls the supply of Dollars around the world, because the Fed can print USDs at will.
However, this isn’t accurate.
The Fed controls the supply of USD denominated bank reserves, which, contrary to popular belief, are not really money. They are a settlement currency which can only be used by banks.
The clearest way to see that bank reserves aren’t money is to realize that banks do not lend them out when making loans.
In other words, the supply of Dollars is controlled by banks.
When they decide to loan more Dollars, the supply of USDs in the world increases, and when they do not, it stays the same or decreases (as loans mature).
Consequently, the USD is the world’s reserve currency because the banks in the global financial system have chosen to use it as such, which makes the supply of USDs around the globe the world’s de facto money supply.
This in turn makes the USD the most important market to watch, as its value directly tells us whether or not the world is being supplied with enough Dollars.
If it is, the global economy can keep growing, or at least hum along; if not, recession or crisis lies around the corner.
If you want to learn more about the USD’s importance to the world’s economy, as well as how the system works, check out our course on how to make money trading a crisis.
Unfortunately, observing the USD’s value is not as straightforward as one might think. As currencies are always quoted against another, this means that the Dollar has different values against different currencies.
There isn’t a single number one can look at which comprehensively tells us the value of the Dollar.
Which is why folks like to use the Dollar Index (DXY), as it provides the convenience of a single number that they can look at.
Unfortunately, the Dollar Index does a poor job of showing us the USD’s value versus its peers. This is because:
- It is comprised of only 6 currencies, the Euro (EUR), Japanese Yen (JPY), British Pound (GBP), Canadian Dollar (CAD), Swedish Krona (SEK), and Swiss Franc (CHF)
- These 6 currencies do not represent a wide spectrum of the world’s economies
- It is too heavily skewed towards the Euro, which bears an index weight of 60%
Simply put, the scope of the DXY is too restricted.
In order to get a decent understanding of the Dollar’s performance versus the world’s currencies, we need to track its value against currencies which represent different types of economies, from all over the world.
A decent alternative to the DXY is the Broad Dollar Index (DTWEXBGS). This index is constructed by the Fed, and measures the Dollar’s value against more than 20 currencies.
While this makes it a much better alternative to the DXY, the DTWEXBGS isn’t calculated and made available on a real time basis; the latest reading of the index made public by the Fed tends to lag by a few days.
As such, the DTWEXBGS will give a much more accurate picture of what the Dollar is doing over a period of time than the DXY, but not a real time one.
On the other hand, the DXY can give us a real time snapshot of Dollar performance, but not a very broad one.
Of course, you could also follow a variety of individual currency pairs to gain your own view on Dollar performance. This method would give you the best of both worlds – breadth and a real time perspective, at the expense of ease and convenience.
If you want to learn how to use the Dollar’s strength, or weakness, as an indicator in a broader trading framework, we teach you how to do so in our course on how to trade global macro.
Ultimately, pick whichever suits your needs better, or use one in conjunction with the other.
Just make sure that you are following the USD!
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Focus On Markets, Not Headlines! Macro Trading Opportunities
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A high CPI reading reversed last week’s rallies, reiterating the bearishness that has been in place, while increasing volatility and correlation between markets – which isn’t good news.
- Global markets were rallying strongly before this week’s US CPI print, which drove everything into reverse. Inflation is a problem, but focus on markets instead of headlines
- Macro markets and equities have begun to really move in tandem, which together with rising volatility and how macro markets have aligned over the past few months, does not bode well for risk appetite
- Although UST yields are rallying, the US yield curve remains deeply inverted at multiple points, base metals are still weak, and breakevens remain low
- USD strength remains broad based
- Stress levels in USD funding markets are obviously high, and still increasing. Global USD funding conditions are critical to how far financial contagion spreads, and how deep the recession is
- CNY has broken out vs the Dollar in a bad way, and is now approaching the key 7.00 level. If CNY continues to weaken vs the USD, expect more selling in global risk assets
- Commodity markets are aligned with the USD and the US yield curve, signaling serious deterioration in global conditions
- WTI has fallen below major support, Aluminum has fallen to make new lows for 2022, Copper is way off its highs for the year, and Iron Ore remains stuck in consolidation
- US 10y and 30y yields have bounced strongly after breaking below key support in early August, with the 30y making new cycle highs over the last week. However, UST yields can fall sharply given poor global conditions, and how other markets have been trending
Trading Ideas – Performance
Trading Ideas – Commentary
- Re-entered Dollar longs against EUR, GBP, AUD, and CAD, as broad USD strength continues
- Entered a short position in Copper’s December 2022 contract in anticipation of further weakness given deteriorating global economic conditions, and bearish indications from other macro markets
- US long yields continue to rally, and our long TLT call position is still in the red, but we purchased a year long expiry for this reason, to give the market time to make a top (if it does!)
- Went long TLT calls with 1 year expiry, as strong bids for USTs look to be on the horizon as the global cycle shifts
- Stronger USD, with significantly weaker CNY, is a huge warning signal
- Re-inverting yield curve, plummeting breakevens, base metals breaking lower, and now even tumbling oil prices, are all ominous signs
- Closed the straddle on GLD for a net profit of 115%
- Decision to straddle gold using GLD options, instead of putting on an outright long position, has paid off handsomely, with gold tumbling down to ~$1700 after failing its retest of 2000
Trading Ideas
- Long USD
- Well established trend, in place for >11 months in most major currency pairs
- Recent sharp increases in the Dollar’s value signals that global economic growth is going to take a turn for the worse. Global USD funding markets will tighten even more, driving the USD even higher
- US yield curve’s inversion in early April, and mid June (even as the Fed turned hawkish) is a clear warning sign
- USDCNY has started to move higher rapidly, indicating high levels of stress in global USD funding markets
- USD longs in general should do well, but of the G7 currencies, look to go long the USD vs:
- EUR
- CAD
- GBP
- AUD
- JPY
- Long 10y or 30y US Treasuries
- Yield curve re-inversion (2s10s, 5s10s) signals the coming end of the current economic growth cycle, which means that nominal yields will start to turn down soon
- Monthly & yearly trends in yields are bearish, and looking for an opportunity to short yields is in alignment with long term trends
- 10y yields have broken below key 2.71% support – keep an eye on whether the breakout is sustained
- Trade can be expressed:
- Long TLT, or long TLT Calls
- Long US T Note/Bond Futures, or long Calls on Futures
- Short Commodities
- Short oil, copper, aluminum, iron ore, given that so many macro markets are indicating more macro weakness to come
- Oil and copper are the most liquid and accessible markets to trade using futures, or E-mini futures
- Can express the short oil trade by shorting XLE, or purchasing puts on XLE (see ETF Edge)
- Short oil, copper, aluminum, iron ore, given that so many macro markets are indicating more macro weakness to come
Charts for this week’s report can be found in the slides at the beginning of the article.
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95% Of Retail Traders Fail. How Can You Succeed? 4
While the disposition effect accounts for much of the emotional pitfalls we face when we have open positions in the market, it doesn’t account for the emotions we experience, and their effect on our decision making when we are out of the market.
If you are wondering how developing your emotional awareness when you aren’t trading can be important, consider the blackjack player who, in an effort to make back his losses, doubles down every time he loses a hand.
From an objective outsider’s perspective, it is clear that the gambler is playing with fire. His insistence on quickly making his money back is only exposing him to even larger losses, significantly increasing the probability that he will walk away from the table with nothing.
This same emotional reflex, driven by the desire to quickly exit traumatic emotional states, affects traders as well.
This should sound familiar to you if you have even a little experience trading – just think of the times you exited a trade at a loss and felt the impulsive need to immediately get back in the market again.
The feeling is even worse if you have been on a losing streak.
The feelings of failure and anger, probably mixed with a little sadness, form a combustible emotional cocktail that can drag you into a negative spiral of knee-jerk trading, which will only compound your losses.
Needless to say, this is a spiral that you will want to avoid falling into.
The best way to avoid it is to, again, have a predefined process in place. One that has specific criteria setting out conditions which must be met before entering a position.
If for whatever reason you don’t have such a process in place, then you must, at the very least, be aware that your emotions can and will affect your decision to re-enter the markets after taking a loss.
This awareness will allow you to take the time to reassess market conditions and logically think of what to do next, instead of knee-jerking back into the market trying to recoup your losses immediately.
However, even having a process in place does not preclude you from making trading decisions which are fueled by emotion.
While a process can, to some extent, mitigate the disposition effect and knee-jerk trading, it can’t shield you from impatience and the feeling that you must always be doing something.
This feeling, and the discomfort it brings, either out of FOMO or the uncertainty of waiting, is particularly acute when you have just exited a position at a loss and are waiting for the next trading opportunity to present itself.
While acting out of impatience and putting on a trade in the absence of an optimal setup may not lead to a loss, it will have a reduced probability of success.
Considering that we have precious little control over the outcomes of our trades to begin with, we must do everything we can prior to entering a position to ensure the highest probability of their success.
This means waiting for the right time to trade, and not succumbing to impatience.
Ultimately, developing emotional self awareness only comes with experience, and experience in markets means losing money.
We all need to lose money in order to gain insight into ourselves, pinpoint areas in which we need to improve, and then not repeat the same mistakes in the future.
Think of the money lost in this endeavor as tuition, although paying this tuition does not come with a guarantee of future returns.
After all, most people don’t even make back the amount that they initially lose; they either give up and don’t participate in the markets again, or fail to learn their lessons and keep throwing money away in the markets.
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Bearish To Bullish In A Week? ETF Trading Opportunities
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Markets have gone from looking bearish to bullish in the space of a week. However, medium term trends remain bearish.
How will this bounce end?
- Markets have bounced strongly off last week’s lows, with many markets reversing breakouts below major support levels that occurred over the last 2 weeks
- SPY, QQQ, IWM, XLI, XLP, XLY and EZU have all rallied strongly
- Continue to pay attention to EEM. If it breaks decisively below its recent range, it could signal further weakness in risk assets
- Remember that changes occur at the margins first, then spread to the core
- Energy stocks (XLE) are an exception to the current selloff in stocks, and while they have come down a little, could still be headed for a test of its current cycle highs. Oil prices are back in the high $80s, but this is still too high with macro conditions deteriorating all over the world
- Fixed Income ETFs are in a precarious position
- TLT has broken below its range, and is close to testing its June lows. But if it rallies again, and manages to break out to the upside decisively, be prepared for more turbulence in markets
- EMB’s (Emerging Market USD denominated debt) rally has started to reverse, falling sharply to indicate that the global USD shortage is getting worse, and pointing towards a further sell off
- LQD, HYG, and EMB are not mechanically tied to UST prices. Should a financial or economic crisis arise, UST prices can rise even as other fixed income assets sell off
Trading Ideas – Performance
Trading Ideas – Commentary
- Exited straddle on XLU (strike 72, expiry Sep ‘22) for a net profit of 4.38%
- XLU had quite a journey over the 5 months that we held a straddle on it. It collapsed from its then all time high ~77 in April, to testing its Russian war lows ~64 in June; a period of time which coincided with the height of the selloff in equity markets. Since then, it has rallied back to make new all time highs ~78
- Re-entered short in IWM at 186.95 after it gapped lower on the open
- High beta small cap stocks are primed to suffer heavy losses given equities’ bearish trend, and deteriorating macro conditions
- Re-entered short position in EMB after it broke below major support ~88
- Trade aims to capitalize on EMB’s bearish trend, as well as deteriorating global macro conditions
- EMB can still fall even if prices of USTs keep rising (yields fall), if macro conditions get bad enough
- It has already broken below its 2020 COVID low, signaling increasing stress in the global USD funding market
Trading Ideas – Long
- TLT
- This trade is covered in our Macro Edge reports
Trading Ideas – Short
- IWM remains vulnerable to deteriorating macro conditions, especially with how bearish 2022 has been for small cap equities
- The trade can also be expressed via other high beta ETFs, like QQQ and XLY
- LQD, HYG, EMB
- LQD, HYG can still make a large move lower, with a test of COVID 2020’s lows a real possibility, especially with EMB having already done so
- XLE looks like an increasingly attractive short
- Global economic conditions are rapidly deteriorating
- Oil prices are off their peak even with global supplies tight, and Russia’s war dragging on
- Patience is needed here for XLE to make a decisive break lower, as it has managed to rally strongly in recent weeks
- EEM and FXI are good short candidates, as their charts are looking weak even as the summer rally progresses
- Remember that change starts at the margins and spreads to the core (learn more about this in our Global Macro course). In market terms this means that weakness in EM (EEM, EMB, FXI) often presages weakness in DM
Charts for this week’s report can be found in the slides at the beginning of the article.
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