Post July 25

With regard to the layout of the post, there are a few changes. Unfortunately these are not Napoleonic changes to maintain "superiority." At the Greenwich Library, where I get my Bloomberg access, there are some weird issues with regard to saving charts. Some of my speciality charts like in workbench, do not save in color, while normal GP charts do. Despite this lack of uniformity, I hope they are still clear.

Slight pickup in growth, rooted in USD weakness? (Chinese Imports and Asia Dollar Index)

Here is the first example of my black and white workbench chart, to clarify, it is a ten year times series of the ADXY v Chinese imports (YoY). With that said, the USD is good place to start. I have tried to expand on the dollar liquidity paradigm of this year in prior posts, I revert back to that topic and its timing towards the end. What is clear, since June, Chinese aggregate demand (AD), especially for industrial materials, has perked back up. The relentless selling in USD, across almost all major crosses has seemingly led to "reflationary" pickup. Of course following the 2016 Chinese fiscal boom, we know the knock on effects of increased Chinese AD onto G10 econ is quite profound. However, in this case there is a cyclical difference. USD weakness is fostering economic growth, not reacting to it. To me, the former is a much more sustainable paradigm. The problem is, I still see a big dollar move following normalized Tbill (Sept/Oct) issuance that will negatively impair this pickup in economic activity. For now, there are some trades in rates and FX that have lagged this USD move which offer some decent relative value.

Following the surge in Chinese industrial activity in Q3, as rates, commods and PMIs all surged higher, the USD followed. Of course a lot of this had to do with politics and the excitement of legislative changes in Washington. So while the sell side tripped over themselves to assign higher USD targets, they were coupled with an expectation of escape velocity in DM economies. Economic growth that is coupled with a rising dollar is ultimately a self defeating paradigm, especially as the dollar was already at such an elevated level. Now, as YoY rate of change in the BBDXY is near 2014 levels, world trade in USD can pickup and industrial metals can advance. The dollar is reaching a threshold which is becoming a stimulative force.

Pay KRW curve instead of chasing copper? 2s10s (white) v copper (orange)



Case to be made that copper is breaking out on a multiyear chart. I do not feel comfortable with saying that at this time given how volatile Chinese consumption patterns have proved to be in the past few years. However, if copper is moving north, KRW curve should steepen with it, carry and roll in the swaps curve seems to favor steepeners as well.

Korean Econ tracks Chinese industrial demand. (SK GDP v China copper imports YoY)

Considering Korean exposure to China in terms of trade, makes sense for GDP to correlate well to Chinese industrial activity. Again, I am not convinced that China is looking to reengage a 2016 esk fiscal bazooka, especially as policy rates have tightened slightly this year in some medium term lending facilities (MLF). Credit impulse is much weaker and banking worries remain a concern. The weakness in the dollar does mean better terms of trade for the Chinese, who have done some positive things with regard to structural reforms in the industrial sector. For me, being outright long copper is a stretch, but to get more exposure to the perception of better global growth, I would rather use the lag in KRW rates.

Copper (blue) v its curve. Nearby and Cal '18 (Q17U17 and Z7Z8)



This is more evidence of the dollar spillover. In both the nearby spread and the calendar '18 spread, the curve trades fairly steep contango, especially relative to Q4 of last year. Yes, supply disruptions have continued, but the curve is signaling there is plenty of copper. As I said earlier, it seems that dollar has reached a threshold that has unleashed a stimulative knock on across risk assets, especially ones with positive beta to economic growth and China. OBOR talk has clearly accelerated this year, for me, it is still too soon for that variable to justify a big breakout in copper, even though it will likely one day.

US Rates and the USD

For much of the preceding nine months, there was a positive correlation between yields and the dollar. This had a lot to do with the expected Trump boost, but also, as the dollar rises at these relatively high levels, EME's, especially China, have to sell dollars, which has a positive feedback loop for the dollar. Higher USD forces selling in USD denom assets (USTs) which leads to higher rates, and then a higher dollar. One could argue this pattern has largely reversed but to me the reciprocal is less significant, if it exists at all. The key is, rates will have hard time rallying on USD weakness, even if it is rooted in a lack of DC legislation, as the positive global knock on effect of a weaker dollar is budding.

For much of the year I have been die hard with regard to owning duration, especially in the US. However, right now I am painfully neutral on 10s as I could easily envision scenarios where they trade 2.6 or 2 flat. I wrote a piece a couple of months ago about the two competing variables driving yields, especially in the backend. "Flow vs. Data." The argument for me is, on the one hand, inflation is slowing, lending has slowed dramatically, the economic cycle looks old in dog years and the consumer seems exhausted despite high levels of survey confidence. The "flow" side says, the Fed will engage in SOMA changes this year as they are uncomfortable with the shape of the yield curve and the current easing of financial conditions, despite their ongoing hiking cycle. Treasury will have to increase issuance in a big way following the resolution of the debt ceiling, this looks likely to coincide with the early stages of USTs rolling off the Fed's balance sheet. While I continue to believe the ECB will be annoyingly dovish in terms of policy, the parameters of QE will change this year to less accommodation, which means another sucker of term premia will be pulling back. Even if it is small, rates, especially in the belly out, have shown how sensitive they are to Mario being Sintra esk in terms of message. My thinking with Draghi, as it pertains to US yields, even at his most dovish, he could probably only send us back to 2.10ish, but if the buba gets to him, G10 rates as a whole would explode. Despite my frustration with regard to the judging 10s for the next few months, my "flow v data" dichotomy in terms of price does crystalize in this sense. The "data" has largely played out, inflation made the big drop I expected, economic growth has not been as weak as I anticipated in Q1, but still is quite sluggish. On the other side, "flow" could be just beginning..... Hopefully by the time the next post rolls around, I will have a better feel for 10s and 30s.  For now, despite Gundlach's warnings, owning the front end is a better risk reward for me. Despite two hikes, 2s trade around the same level they did in Feb, and now trade 20bps ish tight with effective Fed Funds. The Fed is overdoing it and the bull steepening is about to commence, or a shift to balance sheet is upon us. The Fed has made it clear that o/n rate will be there main expression of monetary policy, but I think the Brainard camp of at least more of a balance sheet preference in the face of falling inflation, will begin to come across in the July statement. There is one thing I know for sure about 2s, a lot of folks are short....... Buy TU's on dips unless FOMC is more explicit about hiking cycle. Also an easy position to hedge in FF's (V7 in FF with only 10% chance of Sept hike) or ED$s, as market has an underwhelming view on Fed path for this year and '18.

CFTC Net Shorts in US 2's



Another example of dollar reaching stimulative threshold, Aussie 10s. 



ACGB's are good bellwether for global growth, given Australia's dependence on Chinese demand. The RBA will likely remain neutral this year in my view, inflation has begun to slow and Lowe doesn't want any part of the A$ trading at 80c. No "coordinated tightening" for Lowe, if anything, he wouldn't mind the Fed doing the lifting for him. While shorts in AUD are tempting, the chart above reinforces this paradigm shift, where USD weakness has fostered weakness in duration. Like USTs, ACGBs traded lower as the dollar drifted higher from Q3 until its peak in January of this year, and as the dollar weakened on weaker growth and political dysfunction, ACGBs rallied. This all sharply changed in June, as this dollar threshold was met and assets with positive econ beta rallied.

GBP and Carney's phobia of pass through

The Pound is one of my fascinations at the moment. While it has been stronger against the USD, against other major crosses, it has been quite weak. It makes sense; domestic data in the UK is poor while every other day there is a headline of a financial firm relocating outside of London. Sterling should be negatively effected by, shockingly low real rates, falling domestic wages, cyclical slowdown in aggregate demand due to high levels of household debt and rising costs, and the prospects of further deterioration in the country's capital imbalance as financial firms relocate. That list does not even include the rapidly deteriorating political economy. Textbook short? Yes, but not yet. In fact, against some crosses, Sterling is a near term buy.  I hope Festinger would be proud of this cognitive dissonance.

The Haldane speech in June was immensely consequential; obviously, gilts sold off 30 bps in 10s. But to me, the significance was not that the Bank seeing it appropriate to pull back their post Brexit easing, but rather there was a shift in priority. Just as the Fed has seemingly shifted from PCE inflation being the priority in justifying mon pol hawkishness to FCI's, the BoE has done the same but by focusing on the EUR/GBP cross instead traditional macro data points. With 40ish percent of their imports from EU countries, weakness in the pound has a profound pass through onto inflation and Carney has noticed. Given this broad Euro rally, which has taken Euro Sterling back to post Brexit levels, I expect the BoE to use rhetoric as a policy tool to keep a floor in Sterling, at least until the Euro stalls out. They are late, but if Carney is in defend GBP mode, at least for now, no reason to stand in his way; despite the plethora of catalysts suggesting weaker Sterling. While inflation is falling and the pass through from Brexit is receding, the BoE will be extra cautious given this magnitude of EUR strength. For now, extra cautious = hawkish.

EUR/GBP v UK PPI Input


GBP/CHF, good expressions of GBP other than long Cable




Going into the July ECB meeting, I liked this from the short side as a relatively asymmetric expression on a less Sintra like Draghi, but also acknowledging the possibility of rates fireworks show. Now, with Jordan's recent comments about CHF strength hitting, shows me SNB is not looking to play in this "coordinated tightening" game either, not even a little! Besides carry, this structure could be the best way to express this GBP thesis, especially since much of it is EUR related. The key to this cross is their common beta to ECB policy risk, i.e. both central banks are expected to lag the ECB in some sense. However, with Jordan and the SNB putting more emphasis on dealing with a CHF they feel is too strong, the better way to jump on the overdone EUR boat, is to be long sterling/swissy. The concept is simple, if the Euro continues to rally, on whatever reason, QE changes, economic growth or increased capital flows, the BoE will be in full chase mode. The SNB on the other hand, will have to come out in the opposite way, talking down CHF. One CB has an annoyingly strong currency while the other has frustratingly weak one, I expect their respective rhetoric to reflect that over the coming months. Pretty cheap to execute and easy stop at 1.225. This will be a great short when Draghi disappoints the Buba and Euro bulls in the fall, but until then, BoE is in Sterling defense mode.

GBP/JPY



Anytime it seems easy to be Yen bearish, is usually the exact time you do not want to be, especially with broader JPY positioning quite short. With this cross, I would let the price action dictate positioning, maybe a knock in at 142? This GBP cross is not as "connected" to the ECB dynamic as the swissy trade is, but it is another example of being long a currency a central bank wants to talk higher vs short one that wants to talk it lower. Over time, I like this trade from the short side, but for now, I expect it to breakout or bounce off this uptrend.

Do relative levels in STIR spreads boost GBP? 



At least in 2018 spreads, short sterling rates trade outside its European peers in euroswissy and euribor rates. While there is a probably a relative value trade here, I do think this signifies something, given the above context. Yes, if the above thesis is true and the BoE is in Sterling defense, short sterling rates should probably track euribor, especially in reds. Despite the weakness in the economy, especially in a relative sense to the broader Euro economies, it's "easy" for Carney to stick 25 bps back in the curve and still say policy is incredibly easy. The larger point here is, Carney has the flexibility to pull a move like the BoC, remove the extra emergency part of QE, i.e. the second part of rate cuts, stick some bps in the OIS curve, and in doing so strengthen the currency. One "misunderstood" Draghi speech in Sintra, and we tantrumed in rates, BoE dealing in a different ballgame.

Paying front end rates, has lagged big EUR moves



Current state of inflation is eating into the economy

Relatively high levels of inflation have left a mark on the UK economy in recent months. Since the end of last year, real wages on a 3m basis have gone negative, with much of the weakness in the "real" aspect. In a sense, the UK economy cannot afford inflation to eat into household incomes as there is a quick pass through into spending and there is very little buffer. This is the case for two unfortunate reasons, first, household debt is over 140% of GDP, so it would be difficult for credit to smooth over the weakness in incomes, second, UK households have already brought forth demand by depleting their savings. So credit and savings cannot save consumption, which means to "stimulate," Carney needs to save real incomes.

UK Real Wages are negative



UK Savings Rate has collapsed



Time to fight Poloz and BoC?

BAZ8/FFZ8 at -28bps (Chat below is spread between the two)



I think this an interesting expression of fading the BoC as it allows for two things to happen. First, it lets the market assess the path of the funds rate after the FOMC starts SOMA changes. Second, it gives the market time to realize the expected BoC rate path is overdone. I already suggested fighting the BoC with 6m1y receiver in CAD rates, given the c&r of the position I would let it play out further. In my view, the loonie ripfest has begun to slowdown, the market could begin to bring down its aggressive BoC path faster than people expect as the pace in which Poloz and Wilkins got hikes in the curve affords the BoC flexibility with timing. Maybe patience is a virtue, especially as inflation came in weaker again in June, now at 1% in core. Also, market seems to be quite short BAs, OI has surged (bottom panel of chart above).

False breakout out in CAD/JPY in the making? 



Here I get some long Yen exposure back. I originally wanted to look at something like short CAD/NOK to remove the oil input, as the KSA strategy of capping exports to the US seems to be working with US inventories drawing at relatively high rates. So while I think a position like that is valid, the shorts in yen look overdone and the CAD short covering seems to be ending. This is also an intriguing structure as a way to fade "coordinated tightening." If the market discounts hawkish CB rhetoric as more bark than bite, or if Draghi pushes the breaks and gives duration a big boost, loonie/yen will do poorly.

End on dollar liquidity 

For the past two posts I have spent a lot time going through my H2 dollar thesis. I am still of the view, the tremendous surge of dollar liquidity since December, has been a large contributor to some of the interesting dynamics we have seen in markets this year. Large narrowing of dollar funding in cross currency basis, low cross asset vol and a loosening of FCI's despite a Fed hiking cycle; the common denominator seems to be in the plethora of dollar liquidity. As I have tried to explain, as the debt ceiling hurdle is cleared and Treasury bill issuance is forced to pickup, dollar liquidity will become much more scarce. I will return to this topic in the coming months, as the Treasury may be forced to act faster than they think, 3s6s in bills are already inverted and the deficit is looking quite precarious.


This seasonality chart shows that budget deficit in June was the biggest in five years. Typically, June is month of narrowing and July/August, is when the steepest deficits occur. If that trend is still the case, the US budget could get pretty nasty over the next few months, as people and firms still try and differ tax obligations under guidance to wait for tax reform. Mnuchin may need to push congress quicker than he thinks.


Thanks for reading,

Jonathan Turek

July 6

As the Fed has seemingly transitioned from being focused on returning PCE to target, to FCI's, the board is ignoring negative credit developments for the sake of a liquidity wave they are struggling to understand. One thing I have noticed this year is, both the Fed and the street seem to have bundled "credit" and "liquidity." The reason I want to deal with this topic is I think it is fundamentally rooted in my dollar thesis from last post. The emergence of dollar liquidity has clearly confused signaling metrics across markets. The Fed is thinking they are behind the curve in FCI's and with U3 so low, they feel they have the rope to play some catchup. The fear now is, as they usually do, the Fed will overstep as they incorrectly read these liquidity drivers and move to remove accommodation despite slowing PCE. What makes this worse is, if my dollar thesis is correct, by instituting their proposed SOMA adjustment policy from the June addendum, the Fed will be doubling down on what will be receding liquidity as the Treasury rebuilds their cash balance through increased Tbill issuance. In my view, this brings us back to a world that is structurally dollar challenged. So, the topic of this post is, why liquidity and credit are sending different messages, and by bundling them the Fed and the street are missing significant nuance and context in their respective outlooks.

The Fed has been befuddled by two key things thus far in 2017. First, as they outright mentioned in their June minutes, why are FCI's loosening despite 75bps in policy tightening since December? "According to some measures, financial conditions had eased even as the Committee reduced policy accommodation and market participants continued to expect further steps to tighten monetary policy." The other concern, which has largely been expressed by Bullard is, if LSAPs reduced longer term rates, why is term premia also coming out of the curve in this tightening cycle which should encapsulate expectations of SOMA changes? The latter seems to be largely inflation driven, especially as duration has no fear the Phillips curve is about to make a late 60's type surge in slope. However, for this post, I am going to focus on the first question bothering the Fed. As I tried to explain last post, In my opinion, FCI's loosened as dollar liquidity became more available, but that does not mean policy rates have not tightened credit. Liquidity and credit are not the same.

Credit vs Liquidity 

Global credit has been slowing for some time (PIMCO)



Global credit impulse has been falling for almost a year now, with China obviously making a large contribution. So while G4 QE continues to have a very meaningful effect on liquidity, credit is slowing and quite rapidly.

Same thing in the U.S., Fed hikes in'17 have exacerbated the slowing trend 



If we look at traditional credit channels in the US from commercial banks, they have been in contraction on a YoY basis for some time. What is clearly evident is, the rate of change in the slowdown has gone up significantly this year, as the Fed's tightening path has advanced, 75bps since December. Of course there is a demand side to this equation, and as corporate leverage is quite high, it makes sense for credit demand to slow as the Fed moves rates higher. However, on balance, the Fed's tightening cycle is clearly impacting credit growth and the money supply, which have respectively worsened so far in 2017.  In a sense, the economy is tightening, while financial liquidity is not. So the Fed is either prioritizing FCI's over this clear contraction in credit and inflation or they are ignoring the effects of their tightening. One of my mentors, who has been dead on with Fed policy this year, said it best: in their view, they are removing accommodation not tightening policy. Rates are approaching r* and credit is clearly tightening, yet the Fed is wondering why this tightening cycle is not "working"....... The yield curve conveys this message.

The Confusion is in Dollar Liquidity 

The recent effort to prioritize FCI seems to have been fostered by Dudley. In his most recent speech at the BIS he said, "when financial conditions ease - as has been the case recently - this can provide additional impetus for the decision to continue to remove monetary policy accommodation." This sort of language either argues for persistence in tightening policy rates or playing catch up. The Fed is not happy with current equity valuations, but they see the bigger picture, cross asset vol suppression should not be occurring as the Fed tightens. Thus, for Dudley, it looks Fed policy needs to shift into neutralizing this liquidity wave. In my opinion, the Fed now believes the the culprits are either G4 QE or the prospects of regulatory reform in the US for banks. This has begun to manifest itself in the past few weeks, especially in CB rhetoric. One week after the Treasury report on deregulation was published that suggested bank balance sheets could expand by the trillions, we saw "coordinated tightening" or "QT" from core CB's. From the Fed's perspective, a more "coordinated" global front hits both of these perceived culprits. First, rates across the curve have to reprice timing of less G4 QE, as ECB rhetoric seemingly has more duration beta than Fed hikes do. Second it makes the market price in less QE liquidity spill over across asset classes, in theory bolstering vol. While these factors are likely contributors to this liquidity surge we have seen this year, to me, it still seems largely Treasury driven and the lack of Tbill issuance which should normalize post debt ceiling.

Growth in CP has coincided with sizable rally in Asian currencies



As I stressed in my last post, where I attempted to go into some of the intricacies of the current dollar liquidity paradigm, this correlation/move epitomizes the plethora of dollars the market has been hit by since the Treasury's debt ceiling move in December. The interrelation of Asia FX and CP is that banks across the Pacific rely heavily on CP for dollar funding. As Tbill issuance is lower, banks fill the demand by expanding CP issuance, which has very positive spill over effect for risk assets. Last year, the BIS famously pontificated that the dollar is the new VIX, while I think in generality they are correct, the real message seems to be, access to dollar liquidity has a distinct positive relationship with cross asset vol, but especially in FX. My early inclination is, the combination of SOMA changes and more sustained Tbill issuance will reverse this cheap dollar paradigm, which looks already to be topping out. Lets also remember, EM has rebuilt its massive short USD, as dollar denominated issuance has soared in the past year, according to the IIF. All of this despite 3 Fed hikes.......



Asia Dollar Index Breaking its YTD Uptrend?



USD actually offers some asymmetry if the Fed ignores inflation 

I am coming to the conclusion that at this juncture USD positions are much less binary in terms of risk profile relative to receivers in core rates. I will attempt to outline this case via a list of scenarios. This is excluding my core thesis with regard to dollar liquidity and the reemergence of a dollar shortage. More traditional FX, flows and rate diffs.

1) Reals argue for higher USD. In effect, my core macro view on the US continues to be the data will underwhelm as the pass through from oil continues to negatively effect inflation and HH spending remains frustratingly weak. As the Fed looks pretty set in dealing with taming the animal spirits and FCI's in markets, real rates should continue to edge higher with inflation slowing. Because of the move in reals, USD can sort of act as a curve flattener without the weak carry+roll the curve is currently giving receivers.



2) In the near term, it is hard for me to envision a macro environment, where the relative CB tightening moves into other G8 players. The market has priced a lot more absolute hikes in aggregate for developed market CB's in the past few weeks. To me, while it seems possible the BOE and BOC, could hike rates this year (why, beats me) any environment that allows them to put 25 bps back in o/n rates, is an environment which the Fed can fulfill their dots. And to me, we have gotten a bit aggressive in thinking how hawkish some of these CB's will be, Im lookin at you Poloz and Wilkins..... There is also a high likelihood of a reversal in policy rhetoric in these countries, which is USD positive.

CAD curve gone wild, 6m1y. Receiving kind of tempting, C&R is decent too.



3) USD would also benefit in a return of the Trump trade. Given how low U3 is, the Fed will be aggressive in rates if Trump is actually able to get something stimulative passed. The Fed is worried since U3 is so low and the inflation derivative has not arisen from higher wages, that it may come in a non linear fashion (think this is weighing on them currently, hence them moving ex ante to Kashkari's chagrin). USD should work in an environment in which either the econ is boosted by Trump or the Fed moves OIS curve closer to their dots like in December of 2016. This to me is the relative asymmetry of the trade which protects me in case macro is wrong.

Has the economy been fixed since CB's went hawkish, guess not

US5s30s kinda close




Thanks for reading, happy summer.

Jonathan Turek