If you've just read the Q4-2010 issue of Automated Trader Magazine, you'll no doubt have picked up Marc H. Malek's description of Conquest's strategy as "systematic with a discretionary overlay". Here's Marc's analysis of the current macro picture.
It is tempting to highlight the performance of equities, commodities, and even fixed-income instruments as evidence of the continued resuscitation of the markets. Certainly the appreciation of most dollar-denominated assets at the expense of virtually none indicates that more money was put to work. However, the steep decline in the dollar makes us reticent to embrace September as a victory.
We think the real September story lies in the movement of the Dollar Index. The dollar witnessed its eighth largest monthly decline since 1967. This dollar weakness accounted for the relative performance of domestic equities versus European equities and dampened the gains realized in commodities.
Cross-asset correlations have been at unprecedented levels for the past five years. [See "Perfect Storm?" From the Q4-2010 issue of Automated Trader for more on cross-asset correlations]. Over this period, asset performance has exhibited a close relationship to the change in level of risk appetite, with asset-specific factors having less of an impact. Now we see a second factor moving to the forefront: the relative strength of the dollar.
The relationship between the dollar and other currencies is multifaceted and fluid. It encompasses a number of factors, including interest rates, risk appetite, trade balance, and regional considerations. The relationship between the dollar and equities is also fluid. Sometimes a strong dollar is indicative of domestic strength; other times it foreshadows economic contraction. Figure 3 presents the correlation of the S&P 500 to the Dollar Index since the Dollar Index began to be published daily in 1972.
The chart shows that the correlation has reached its most negative level in nearly 40 years, eclipsing lows that occurred around the Volcker Recession and the 1991 recession. However, this period is distinctive inasmuch as the correlation has actually remained at this level for over a year. During prior spikes, both to the upside and downside, correlations quickly returned to zero. Such has not been the case this year.
Although recent inflation has certainly buttressed the equity markets, the drop in the dollar is becoming more and more significant. Table 5 presents the 10 largest declines in the Dollar Index since 1967. The table identifies three periods during the past forty-plus years in which inflation has been concentrated and rapid:
1. Inflation leading to Volcker Recession: October 1978, April 1980
2. Unwinding of Volcker interest rate hikes: February 1984, March 1985, July 1985, June 1986
3. The current cycle of liquidity and intervention: December 2008, May 2009, September 2010
It has unquestionably been the intent of the Federal Reserve to reduce the real value of mortgages and other debt obligations over time by devaluing the dollar. However, the risk of accelerating inflation becomes much more tangible when these moves occur quickly. Rising inflation limits the ability of the Fed to continue intervening and could cause the premature termination of quantitative easing.
Furthermore, although the inflationary forces were equally strong during the prior two periods, the global economy was significantly more stable than it is today. Despite economic difficulties in the 1970s, that era could hardly be compared to the narrowly-averted depression that appeared inevitable just two years ago. The United States is not the only major economy engaged in a devaluation program, either. Japan just cut its near-zero interest rate to effectively zero; with a few notable exceptions, developed economy deposit rates are at or below 1%.
These observations make recent market activity even more puzzling, if not disconcerting. Investors have been flocking to Treasuries despite the Fed's overt goal of reducing the real value of debt. Equities responded positively to the announcement that another round of quantitative easing was on the horizon even though the need for such measures highlights the weakness of the underlying economy. Central banks are intervening directly in the markets in an effort to weaken their currencies versus the dollar despite the dubious track record of these practices.
This type of bizarre behavior is indicative of a highly-charged, perturbed environment. Although we expect there to be continued erosion in the economic fundamentals, intervention forces and extended leverage will continue to buffet the markets. With these factors in play, we think that the two primary pricing drivers of all macro-type securities will continue to be risk appetite and dollar strength.
Although we cannot predict the month-to-month movements of the markets, we expect that the high correlations will continue, leading to higher volatility-of-volatility. We believe this type of environment will be favorable for a conditional long-volatility strategy. There are typically bumps along the way in these types of environments, but the current regime should continue to be beneficial for Macro over time.
Read the full Automated Trader Interview from the Q4-2010 issue HERE