Three themes that will

rock markets in 2016

By Greg McKenna, Chief Market Strategist

www.axitrader.com

Table of Contents
Looking back, looking forward ................................................................................................................ 4
Three big themes in the year ahead ....................................................................................................... 6
1. The Fed tightening cycle .............................................................................................................. 6
2. Yuan devaluation and the Chinese slowdown ........................................................................ 8
3. Lowflation ..................................................................................................................................... 11

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Greg McKenna
Chief Market Strategist, AxiTrader
Greg McKenna has been working in financial
markets since 1988. He is a trader and Behavioural
Finance & Economics guy who has run billions of
dollars as a fund manager at State Super, was
Australias first currency strategist at Westpac,
NABs head of currency strategy and Treasurer of a
large building society.
For the past three years Greg has been running his
own economic, trading and banking consultancy at
gregmckenna.com.au and he is Contributing Editor
for Markets and Economics at Business Insider
Australia.
Greg holds a Bachelor of Business (Banking and
Finance) from Monash University and a Master of
Applied Finance from Macquarie University.

Hes also a nice guy who loves his family, his mastiff,
surfing and sharing his knowledge and love of
markets and trading.

Looking back, looking forward

As a year of volatility ends, another seems set to begin
Traders inhabit a world of uncertainty. They must be comfortable making decisions to buy, to
sell, to hold or to pyramid positions without knowing the exact outcome. Traders understand
this and, for the most part, are comfortable with the world they inhabit.
But 2015 has been an uncommonly volatile year for traders and markets.

If they werent fretting about the chances of a Euro implosion and a Greek exit from the single
currency, it was fears about the slowing global economy, the weakness in China, the crashing
price of iron ore, crude oils continued meltdown, stocks red for the year, a Euro below 1.05,
perhaps parity and now a Chinese Yuan devaluation and a Fed tightening in the United States.
Greece may have been resolved but, as we look forward to 2016, the year ahead could be just
as volatile, or worse. Britain is contemplating an exit from the Euro; a Brexit. At the same time,
markets will have to grapple with a US Federal Reserve which looks set to tighten as many as
four times in 2016. Traders have to grapple with a crude oil market still heavily oversupplied,
with prices falling and broad-based commodity weakness. Then, of course, 2016 looks set to be
the year emerging markets may have to face their debt bomb, weaker economies and a clear
signal China wants a weaker Yuan.

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Elsewhere, a US dollar surge is expected. But could it already have been delivered with big falls
across many Forex pairs in 2015? Most pundits say no, but positioning says much is priced in.
Stocks look richly priced in the US and beyond, while bonds rallying as the Fed tightens could
throw a spanner in many predictions.

2016 looks like another torrid year of volatility with three themes set to dominate the global
market backdrop: The Fed, China and the Yuan, and Lowflation. Almost all the trades of
2016 will in some way flow from these three drivers.
With volatility comes opportunity, at least when it comes to trading.

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Three big themes in the year ahead

The Fed, the Yuan and Lowflation

Sailing is a great analogy for markets and traders in the post-GFC environment. Weve had
plenty of perfect days broken by intermittent storms and rough weather, but 2015 felt like it
was more foul than fair. And it seems there are so many cross currents in the year ahead that
its a storm sail and battened hatches that will be de rigueur for 2016.
Amongst these many cross currents, three key themes stand out as being at the intersection of
all the volatility.

1. The Fed tightening cycle

The Fed is about to embark on its first tightening cycle for nine years. Many argue the US
economy is not ready for higher rates. Many argue that the junk bond selloff is the precursor of
a US recession, and many argue that inflation in the US will struggle to get back to 2% anytime
soon.
But what is clear is that the US jobs market is strong. Unemployment is heading back to preGFC levels and, for all of the above objections, the current strength of the US economy is
simply incompatible with zero interest rates.

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The question of how far and how fast the Fed moves rates is important
because of the impact this tightening cycle, has on other markets.
The Feds move will impact the US dollar, Euro, Yen, Pound, commodities and commodity
currencies. In other words, currencies in general.
The pace and aggressiveness or not of the
Fed will also impact the US and global yield
curves. That drives stock valuations in developed
and emerging markets. It could put pressure on
the Chinese Yuan, which could appreciate, or it
could put more pressure on the Chinese to
devalue. A stronger US dollar could pressure the
emerging market debt load. It could hurt stocks
used to not having to worry about interest costs.
My expectation is for the Fed to alternate between official hawkish talk of action and private
talk of calm. Id expect them to hike in December 2015 and then every quarter in 2016 to end
the year at 1.25%.
Thats probably enough to be destabilizing, but not quite enough to crash global markets. But if
the Fed discussion moves to shrinking its balance sheet, all bets are off. That would be
destabilising.

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2. Yuan devaluation and the Chinese slowdown

Markets feared Chinas slowing growth rate at various times and in various degrees over the
course of 2015. They feared the rate of 7% was nowhere near the real rate of growth.
Australian billionaire fund manager Kerr Neilson even suggested the rate of growth, based on
the indicators he watches, was closer to a paltry 4%.

Certainly the economy is slowing. The OECD expects that Chinese growth is projected to
decline gradually to 6.2% by 2017." Manufacturing is slowing, industrial production has been in
decline, and urban fixed investment is at its lowest level in 15 years.
As a result of the slowdown the central bank,
the Peoples Bank of China (PBOC), has
dropped interest rates and released cash into
the economy by lowering the amount of
reserves that banks need to hold.
On a positive note, however, there are signs in
the reacceleration of retail sales growth to
11.2% in November (the fastest in a year) that
these measures are gaining traction.

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But as the government reforms the economy and tries to chase corruption out of business and
the markets, there are risks to Chinas economic performance. To mitigate these risks the
PBOC is seeking the comfort of a more competitive currency. It shocked the market with a
devaluation of the Yuan in August. That set markets across the globe afire with risk aversion
and uncertainty and lead to Augusts market rout in commodities, stocks, interest rates and
currencies.
More recently, after a period of stabilization, the
PBOC has been slowly weakening the Chinese
Yuan against the US dollar. Thats taken the
onshore rate, USDCNY, to the highest level
(weakest Yuan) since 2011. Thats also pushed
the offshore rate, USDCNH the one most
traded by offshore market participants to its
highest level since 2010.
This move to weaken the Yuan is critical to the global market outlook in 2016 because many
argue that it was the move in the Chinese currency in the 1990s which precipitated the Asian
market crisis. Thats important in 2016 because of the level of emerging market debt being held
at a corporate level and the potential, amid the current sell-off in junk bonds and high yield
generally, that the weakening of the Chinese Yuan puts more pressure on its competitor
countries and the companies within them. Of course, Chinese companies and local
governments are carrying their own heavy debt load and is another source of potential
instability in the year ahead.
In December the PBOC announced a basket peg including the US dollar, Euro, Yen and 10
other currencies as it tried to switch traders' focus away from the bilateral USDCNY and
USDCNH rates. Its clearly a strategy aimed at de-pegging the Yuan from any potential US
dollar buying (Yuan strength) when the Fed tightening cycle begins.
Its also a clear signal that as money flows out of
China, or as the PBOC continues to ease, it will
not be sterilized. Thats better for the efficacy of
policy, the traction of monetary easing, in
helping economic growth. Its also better for the
economy which can get a lift from a weaker
currency. But it's problematic for Chinas
competitors.

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But where exactly is the PBOC aiming the Yuan?
This is the big question for traders, and a big theme for markets in 2016. Too much weakness,
or too fast, and China risks both the ire of its neighbours and the international community
which just voted to include the Yuan, along with the US dollar, Japanese Yen, Euro and Pound,
in the International Monetary Funds central bank currency basket known as Special Drawing
Rights (SDR).
In the lead-up to this decision China promised to keep it currency stable, a strategy it might
appear to abandon if USDCNY slips too far.

Chinese Yuan
(onshore and offshore)
6.8
6.7
6.6
6.5
6.4
6.3
6.2
6.1
6
Oct-10

Oct-11

Oct-12
USDCNH

Oct-13
USDCNY

Oct-14

Oct-15
Source: Reuters
Source:
Source: ABS
ABS

The question is what is too far and what is a material move?

At approximately 6.47, USDCNY is only 2.4% weaker than the post-devaluation lows. Even
against the pre-devaluation level of 6.20/22 USDCNY is only around 4.3% weaker than it was
before the move. USDCNH has moved further as traders bet on a bigger devaluation but the
PBOC has sort to keep this spread under 10 points recently.
But whether its the onshore or offshore Yuan rate when contrasted with the moves we have
seen in the Australian dollar, Euro, Sterling and even Yen over the past couple of years and the
Chinese are on solid ground, and have a strong argument that the currency is the epitome of
stability. Certainly during the GFC and in the post-GFC era they have been an outstanding
global citizen when it comes to the management of Chinas foreign exchange rate

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10


So, Im looking for China to maneuver the USDCNY rate into the 6.8 to
7.0 region we saw before its appreciation began in 2010. Thats a not too
hot, not too cold zone.

3. Lowflation
Lowflation is what the world is suffering from in 2015 and what it looks set to suffer under for
at least another year. That is, the inflation rate most of the developed world and parts of the
developing is experiencing in terms of consumer and producer price inflation are under the
central banks targets. Thus, we have lowflation as opposed to the outright deflation weve seen
in Chinese PPI for close to four years.

Inflation - Quarterly 2011 2015 (Source: OECD)

Lowflation is important for markets because central bankers worry about a lack of inflation, and
ultimately deflation, for two primary reasons.
First, low or falling prices mean consumers dont lose anything by not spending today. They
assume prices will be around the same level in the future and so can delay purchasing. That
hurts economic growth as low inflation can lead to a negative feedback loop with growth.
The second reason central banks worry about low inflation or deflation is this economic growth
aspect. A lack of inflation, and pricing power, could signal a weak economy and a lack of
aggregate demand. Much of the developed world, and China, is in this very situation right now.
Almost universally, inflation across the world is below central bankers target rates or comfort
measures.

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11


As central bankers are fond of telling traders,
this is because the crash in the price of crude
oil, and commodities more broadly, has
depressed prices at the moment. They argue
that these forces are transitory and that
inflation will soon be back above 2%.
They may be right. But the trouble with this
thesis is the Japanese experience. Through a
cycle of depressed energy prices and the
boom that took oil well north of $100 a
barrel, Japan has steadfastly remained well
below the OECD average inflation rate except
for a period in 2014.
If Japan is a benchmark worth noting for central banks, something former Bank of Japan
Governor Shirakawa asked and answered in the affirmative at the BIS1 in 2013 when delivering
a speech asking whether Milton Friedman was right about inflation being an always and
everywhere monetary phenomenon. Then the notion that inflation will swiftly, and sustainably,
revert above 2% around the world is questionable.
Shirakawa also argued, there is a technological element to lowflations persistence around the
globe. Shirakawa said the relationship between money and prices was broken in many
economies due to subsequent deregulation and technological change.
The basic premise of the technological
argument for lowflation is that technological
advances drive prices down. That can be
either through a lower cost of production, and
hence cheaper prices, or because
technological advancements mean you get
more for the same price. Think Smart TV for
the price of your old dumb TV. Thats
lowflationary.
Technology, Google, Baidu, E-bay, Amazon, smart phones. They are all lowflationary because
they are turning commerce, at a retail and business level, into almost perfectly competitive
markets. How do they do that? Because all this technology drives transparency, gives pricing
power to the buyer and makes business more efficient.



1

http://www.bis.org/publ/bppdf/bispap77e.pdf

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12

Thats important in understanding whats going on right here and now in economies and in
markets because it might mitigate the Fed tightening in 2016. It could certainly stop the Bank of
England from easing and it could even see the RBA ease rates. Crucially though, if lowflation
does not stay or slow the Fed, the divergence in policy between US interest rates and the rest
of the global central banking elite can drive some potentially huge moves in markets.
Higher rates in the US could drive the US
dollar higher. That can depress profits for US
companies and will continue to weigh on
commodity markets, most of which are
denominated in US dollars. It may also
accelerate the PBOCs push toward a weaker
Yuan. That will not be easily dealt with in
emerging markets and, as we saw in August,
whatever the PBOCs protestations that it is
not pursuing a weaker currency, actions speak
louder than words and market ructions are
almost guaranteed.
Crucially, what lowflation has done over the past few years is undermine faith in central bankers.
Like the child brave enough to call the emperor naked, lowflation has exposed central bankers
as mere mortals and not the prescient gods of markets many observers thought them. As Bank
of Canada governor Poloz said in December, "2015 was another year in the series of serial
disappointments".

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13

The Trades of 2016

These three themes intersect across so many markets that even though 2016 looks set to be
another volatile year, a number of macro trade opportunities become obvious.
Whether in Forex, precious metals, oil or stock market indices, opportunities abound.

In my next report I will outline my top six macro

trades for 2016.
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