We've all heard the age old wisdom about markets changing over time and the need to test a system in multiple environments. If you started your trading career in the last 3 or 4 years, you've probably assumed that those market sages were referring to the day to day oscillation between ranging and trending markets. However, those of us who have been at this for a long time know better… and today I would like to explain what the wise traders of old really meant.
In a previous article I discussed my expectations for the pending congressional debt ceiling fight, and while it remains to be seen how that will all play out, there is one thing I'm absolutely sure of; when it's over, there will be a dramatic shift in the factors that drive market activity.
Why? Well, the economy is poised to transition to the next phase of the business cycle, and markets behave differently depending on which phase the economy is in.
For those who don't know, the business cycle is defined as the recurring and fluctuating levels of economic activity that an economy experiences over a long period of time. The five stages of the business cycle are growth (expansion), peak, recession (contraction), trough and recovery. We can plot a representation of this cycle as follows:
If you were to ask an American "Average Joe", you would find he is of the opinion that the united states has been in a perpetual state of recession since the housing crisis of 2008.
However, according to the National Bureau of Economic Research – which is the official arbiter of when a recession begins and ends – the US recession ended in June of 2009. Since that time we have been in a period of recovery.
Of course, by definition, the recovery can only last until the economy eclipses the previous peak in Gross Domestic Product (GDP). At that point the business cycle transitions to the expansion phase and continues on until the development of a new peak.
This is important to understand because the previous GDP peak was eclipsed back in mid 2012. So technically the economy is already in the expansion phase of the cycle. And as soon as these lingering political issues like the fiscal cliff and debt ceiling are wrapped up, the market will be joining the party.
So what is it that will change?
In a nutshell, the big change will be in the relevance of data and interest rates.
For the last several years, markets have been dominated by the dynamic known as "Risk-On/Risk-Off" or RORO.
Unless you've been banging around trading with indicators, or hiding under a rock, you already know that RORO was the movement of capital in and out of risk assets based on the likelihood that some systemic risk would bring about the end of the world.
From the Housing crisis, to the banking crisis, to the sovereign debt crisis, it seemed like we were always moving from one potential catastrophe to another. As information came out about each of those crises, the end would look more or less likely.
All one had to do to make money was follow the news related to the crisis of the day. When things looked good, buy risk assets like AUD, Equities, or Junk Bonds. When things looked bad, you could sell those assets or buy USD, Treasuries, or Utility Stocks for some quick profits.
For many of us it was a fun time, but sadly it's all coming to an end. With Europe and the banking system stabilized, the housing market returned to life, and global GDP expanding, were quickly running out of potential crises to worry about.
And in case you haven't noticed, the RORO correlations have completely broken down.
Since at least the beginning of the year, economic data has returned as the primary market driver, and that dynamic is likely to become far more apparent after the debt ceiling issue is resolved. Although, it may not be in the way you would assume…
At the moment, the data is being interpreted through the prism of the recovery phase. Good data prints for employment, inflation, and capacity utilization are all seen as moving us farther away from recession. As such, this good data is providing a huge boost to equities, commodities, and other growth assets. However, this isn't likely to last either.
One thing you need to understand is that the expansion phase is marked by sustained GDP growth. With that sustained growth expected in the system, the natural inclination for market participants will be to spend every spare dollar they have on growth assets. As a result, growth assets should be poised to enter a state of perpetual price appreciation.
The only problem is; interest rates. When interest rates rise, it has a dampening effect on economic activity. So anything that shows an increase in the probability of a rate hike will be seen as a negative for growth assets.
This sets up a dynamic where asset prices will rise every day, unless something happens that has the potential to increase interest rates. And that "something" will be the strength of economic data.
The first of many examples of this new dynamic will likely come in the form of good employment numbers tanking the US equity market.
From an economics perspective, this makes no sense because higher employment means more people with money to spend. More money to spend means better corporate earnings and a virtuous circle of growth. That should INCREASE the value of stocks.
It's not going to happen though. The stock market is actually going to drop, because good employment will mean a hastened end to the Federal Reserve's Quantitative Easing program, or QE as it's commonly known.
See the Fed told us in their last policy statement that they would begin unwinding QE when the unemployment rate reaches ~6.5%. So the closer we get to that number, the more the market will worry about the end of QE.
As most of you know, QE was implemented because the Fed had already lowered interest rates to 0%. The lowering of interest rates typically has a simulative effect on growth, but the economy was in such bad shape, that even at 0% things weren't getting any better. QE allowed the Fed to effectively lower interest rates below 0% in order to increase the simulative effect.
So if the point of QE was to stimulate growth, it only stands to reason that when it ends, growth will suffer.
How much it will suffer is open to debate, but the one thing we can all be sure of is that growth won't be as good without it. That will lower the implied value of stock market assets and lower the price people are willing to pay for them.
Now I'm not sure exactly when this is going to occur, so don't just go shorting good employment numbers willy-nilly. That's a recipe for disaster. No, the point I'm trying to get at is that you need to keep an eye out for this transition of focus. When you see the above happen, you'll know that we have entered an environment dominated by the Feds interest rate cycle and that its time to adjust your trading behavior accordingly.
For order flow traders, this transition isn't likely to cause much consternation. After all, we just follow the flow of orders and no matter which way they flow, were happy to go along for the ride. However, traders of the technical and fundamental variety are likely to see serious losses over the next several months while they figure out how and why the world has changed.
And that's ultimately what those old market sages were trying to warn us against.