Higher for longer?

As 2022 comes to an end, investors should be mindful of the low liquidity in the market during the holiday season, which could exaggerate market moves in either direction.

Equity bull’s last hope of breaking this ominous downtrend channel before 2022 ends seems to have vanished. The S&P went briefly above the 4000 level but was rejected hard. The weekly close has formed a long shooting star candlestick pattern that usually suggests a reversal of the prior uptrend.

US Dollar’s recent decline has been just as furious as the runup. The DXY has dropped almost 10% since early October. Unlike the old saying that the market takes the stairs up and the elevator down, the greenback has been in the elevator all year long. However, it has reached a significant resistance-turned-support level at around 104. Would it be a rebound and renewal of the uptrend or an accelerated breakdown?

On the US Dollar’s weakness of recent, precious metals have finally gained some upward momentum. Silver has completed an inverse Head-and-Shoulder (H&S) bottom and reclaimed the territory above 22, which has been a significant support level since 2020.

The Secured Overnight Financing Rate (SOFR) market has priced in some very aggressive easing of Fed policies in 2024, as we see the spread between SOFR December 2023 and December 2024 dropped to -1.25, suggesting the interest rate by the end of 2024 will be more than 1.25% lower than that of 2023.

Loyal readers must have noticed our recent obsession with Chairman Powell’s comments at each post-FOMC press conference, which in our opinion, have clearly conveyed the central bank’s intentions regarding rate hikes, inflation, the labor market, etc. To us, these words carry much more weight than a few weaker-than-consensus CPI prints.

A case in point is that the US equity market has rallied more than 10% since the recent low registered on 13 Oct, the same day the September CPI number was released. Admittedly, inflation in the US has been slowing down for six consecutive months by now. Does it mean that inflation is a story of the past? Does it mean the Fed will immediately switch gear into easing mode to fight the coming recession? Chairman Powell argued otherwise: “The largest amount of pain, the worst pain, would come from a failure to raise rates high enough and from us allowing inflation to become entrenched.”

In other words, after reaching the terminal rate north of 5% next year, the Chairman told us that the Fed is likely to keep the policies restrictive for longer than most expected in order to put the inflation genie back in the bottle. It will entail some pain, but this outcome is the lesser of the two evils, compared to prematurely loosening the policies and risking having inflation back more sticky and severe than before.

That brings our attention to the Short-Term Interest Rate (STIR) market. The overall financial conditions have loosened substantially over the past few weeks due to several factors, such as the equity rally, the weakening US Dollar, and the US 10-year yield retracing back to the 3.5% level. A loose financial condition is not helping the Fed cool down the economy and tackle inflation. Yet, the SOFR market is still pricing around 125bps of rate CUT in 2024! This extremity has left us utterly bewildered. Meanwhile, it does present a very asymmetrical setup if our interpretation of “Higher for longer” is correct.

On the other hand, we do acknowledge the possibility that the current risk-on sentiment is not quite over yet. After all, the equity market was pretty beaten up throughout the year, and the US Dollar’s rally has been relentless until very recently. It is perfectly reasonable for the counter-trend move in many assets to last a bit longer, especially given the low liquidity market environment during the year-end holiday season. We find precious metals to be a suitable asset class to play this scenario out if the US Dollar weakness continues.

Lastly, as we wrap up 2022, a year marked with the “unexpected,” we wish all our readers a joyous holiday season with family, friends, and loved ones. 2023 will be both exciting and challenging. We will see you again in the New Year!

We consider expressing our views via the following hypothetical trades¹:

Case Study 1: Long SOFR December 2023 – December 2024 Calendar Spread

We would consider taking a long position on SOFR December 2023 – December 2024 calendar spread futures (SR3Z3-Z4) at the present level of -1.30, with a stop-loss at -1.60, which could bring us a hypothetical maximum loss of 0.3 points. Looking at Figure 4, if the market begins to price in fewer rate cuts in 2024, this spread has the potential to climb back to -0.25, a hypothetical gain of 1.05 points. Each point move in the SOFR future contract is USD 2500.

Case Study 2: Long Silver Future

We would consider taking a long position on silver future (SIH3) at the present level of 23.3, with a stop-loss below 21, which could bring us a hypothetical maximum loss of 2.3 points. Looking at Figure 3, if the inverse H&S bottom holds and the reversal continues, silver has the potential to reach the recent high of 27, a hypothetical gain of 3.7 points. Each point move in the silver future contract is USD 5000.

¹ Examples cited above are for illustration only and shall not be construed as investment recommendations or advice. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios. Please refer to full disclaimers at the end of the commentary.

A look into history could help us position ourselves better for the future. This section provides a rundown of market moves across major asset classes between July and September.

The great rotation from growth to value continues, as we can see from the ratio of the Nasdaq index to the Dow Jones Industrial Average index collapsing. The last peak of this ratio was the DotCom bubble. After 2001 the ratio completely retraced back to the pre-bubble level. It looks like we are still in the early stage, as tech stocks have started to underperform. If history is any guide, the rotation may need to continue for a while more. 

As suggested by the Russell 2000 index, the US small caps also spent the second half of 2022 chopping around without going anywhere. It is still around the pre-pandemic level of about 1800 and stuck between the 50% and 61.8% Fibonacci retracement levels. 

The USD/CNH pair had decidedly broken the Heand-and-Shoulder (H&S) top on China's re-opening news coupled with general US dollar weakness. It is currently consolidating just below the psychologically important level of 7. Continued Dollar weakness would allow this pair to retrace further to around 6.8.

Even though the DXY has declined nearly 10% in recent months, the USD/BRL pair is still trading near the top of what seems to be a two-year bull flag, suggesting the relative weakness of the Brazillian Real, as the market still has conerns reagrding the new Brazilian government’s potential fiscal and budget management. These multi-year patterns usually do not break easily, but when they do, the ensuing moves can be substantial both in magnitude and time. We are watching closely.

AUD/JPY has been traditionally regarded as the risk-on/risk-off pair by investors. Since the late 1980s, it has been trading in a well-defined range with horizontal support at around 60. Due to recent monetary policy divergence between the BoJ and RBA, this pair is currently trading at the top of the range. If BoJ turns more hawkish or the RBA slows its tightening path, we could potentially see this pair falling back to 80.

Copper has broken out from an ascending triangle bottom, but the path forward is still unclear. On the one hand, China re-opens, which is usually bullish for copper, but on the other hand, global recession fear is bearish for this base metal.

Platinum is trading nearly the upper resistance of a multi-month bull flag. Further US Dollar weakness and risk-on sentiment would potentially lead to an upside breakout of platinum.

Palladium also suffered a great loss this year from the high registered in March. The downward momentum seems to have exhausted as palladium consolidates above the multi-year support line. If the support holds, we could see a strong comeback.

Soybean meal has been in a rising wedge since late 2021. It is currently trading at the upper resistance. Usually, a rising wedge is considered a bearish chart pattern that leads to a reversal after a bull run. It will be confirmed when the rising support is broken down.

Wheat has dropped almost 50% since the recent high. It gave up the entire gain since the Russia-Ukraine conflict broke out. It is currently consolidating at the neckline of a Head-and-Shoulder top. The long-term price range of wheat is between 200 to 600. It is still trading on the high side in historical context.

The US yield curve has inverted further as the 10y2y reached negative 74 bps, something we have not seen since the 1970s. Curve inversion has been a reliable leading indicator for recessions. However, it is surprising to see few people talk about it now, compared to 2019. Perhaps because the coming recession is more certain and  predictable?

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