Andy Krieger's Thoughts on the Market - 12 June 2023

The markets have shifted into a strange, almost eerie compression since my last write-up. Volatility levels in multiple markets continue to drop to multi-year lows. In my nearly forty years of trading experience, I've seen this as always a warning signal of violent fireworks to follow. This compression can carry on for a while longer, but eventually, market conditions will explode in violent moves.

Stocks, for example, have continued their slow, ponderous climb, embracing all news, positive and negative, as yet another justification to buy still more stocks. Higher interest rates get shrugged off as being inconsequential. Tightening credit conditions are shrugged off, as the market couldn’t care less. Now that we have AI as the new market save-all, investors have decided that corporate profitability and efficiency only have one way to go; i.e., higher. Ignoring fundamentals is a dangerous strategy, and wearing blinders – or rose-colored glasses -- is even more dangerous.

Sure, over time, AI can bring economies of scale, but at what cost? We heard the same arguments in 2000 about new technologies not long before the Nasdaq plummeted over 80%. The economy has held up remarkably well so far to the challenges of multi-decade highs in inflation and five hundred basis point hikes in interest rates by the Fed over the past year.

The fact that the market is pricing in unrealistic drops in interest rates over the next year is more symptomatic of the market looking for reasons to be optimistic rather than a market objectively analyzing the facts. Regardless of the market’s hopes, we all need to gird ourselves for a recession that will come within the next year, and this recession is likely to bring some very unpleasant side-effects.

The monetary policy of the past fifteen years has planted the seeds for an almighty unwind of stocks and real estate as these markets have reached bubble conditions of historic proportions. Extremely low interest rates and massive quantitative easing by the central bank have artificially created the appearance of stability and strength, belying the underlying problems that are lurking just below the surface.

The regional banking problems that we have seen so far this year are only isolated precursors of what is to come. I am predicting neither the specific timing nor the specific catalyst which will trigger the popping of these bubbles, but I am sure that the longer the markets continue to behave as if everything is fine, the fiercer the unwinds will be.

This scenario has played out over and over for hundreds of years, and this time will be no different. Markets can be irrational for a long time, and betting against their irrationality can be a very dangerous and expensive strategy, but I would expect to see at least some major cracks in the markets before the end of the year.

It is almost impossible to imagine that all of the major banks have effectively dealt with the effects of the Fed’s aggressive rate hikes of the past year. For sure there are some major cracks in the system, and these cracks will likely manifest in the form of significantly tighter credit conditions as banks scramble to cover up their underlying problems.

These tighter credit conditions will lead to major problems for a variety of borrowers, and worsening economic conditions will fuel a vicious circle of ever-tightening credit and nonperforming loans. Yes, this is an ugly scenario, but it is the most logical one.

One of the reasons that I like using option strategies for playing structural market views like this is that I can pre-determine the amount of money I am willing to lose to place my bets, and I don’t have to worry about getting stopped out of the right position at absolutely the worst time. Plus, there are times when limited-risk option strategies become overwhelmingly attractive in terms of the risk-reward, offering return payouts that are impossible to replicate without using derivatives.

As I noted, the compression of volatility has not been isolated to equity markets. Currencies have likewise seen a huge drop in volatility levels, with the EUR/USD and GBP/USD options now trading at roughly half of the level that we saw six months ago. The volatility levels of nearly every currency pair are now much lower than they were, and this is always a strong signal to pay very close attention to the markets.

In terms of specific forecasts, in my last write-up, I warned that gold was going to move into a corrective cycle, having rallied strongly from $1615 to well above $2000 per ounce. Gold has now dropped over $100 from the high, but I think there is likely going to be another strong move lower. After a bit of consolidation, I still expect the next major move to be much higher.

In my way of thinking, it is not a coincidence that gold is in the process of setting up for another very strong rally, as this would coincide nicely with a piercing of the equity and real estate bubbles. It just isn’t time yet.

In the currencies, I have been expecting EUR/CAD to move sharply lower after testing 1.5100 and failing several times. We have now corrected down to one of my initial targets around 1.4300, and I think that this price adjustment is just about enough for the Canadian Dollar to start weakening again. In the big picture, I am still expecting the Canadian Dollar to weaken significantly.

I also think that the period of Yen weakness is coming to an end. The market has had plenty of time to build up large Yen short positions as many participants have plowed into short Yen carry positions in which they sell Yen versus a basket of higher yielding currencies such as the U.S. Dollar, Canadian Dollar, Australian Dollar, and the Euro.

These carry plays involve the selling of Yen and the buying of higher yielding currencies, creating a Yen liability which can be funded at an interest rate close to zero percent while placing the borrowed funds as assets in the higher yielding currencies to earn the interest rate differential. This strategy works well as long as the Yen either weakens, remains stable, or slowly strengthens only a modest amount against the other currencies.

Yen carry plays have historically worked brilliantly until they suddenly blew up. The Yen carry plays tend to follow the “up the stairs down the elevator” price pattern, as Yen often appreciates in a hurry once the unwinding of Yen short positions starts. At that time, we observe chaotic conditions characteristic of a large exit through a small door.

I am not sure what the catalyst will be to trigger this unwinding, but it will be ugly when it happens. I have been forecasting a period of continued Yen weakness, but as noted, that is likely going to reverse soon. When this reversal happens, prepare yourselves for an explosive Yen rally that will surprise nearly everyone.

In the interim, Dollar Yen will have a hard time sustaining a move above 142.00-143.00, and it may have already done enough with its failed efforts to break above 141.00, but it is a bit early to call the top in Dollar Yen. Once that down move starts, watch out below!

Wishing you all the best of luck with your trading.

Sincerely,

Andy Krieger

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