Ignoring the Potent Force of Forward Guidance
As European economic activity has accelerated in a cyclical sense, I found it hard to rationalize the German schatz at -65bps, or to paraphrase Hugh Hendry, everything is fine. However, I contextualized this perceived irregularity a bit differently. My thinking was, the Fed was far closer to neutral, as green and out ed$, US IOER to 2s, 1s2s, 2s5 all indicated; and the ECB was just at the beginning of a paradigm shift in terms of policy as data was reaching its cycle highs. We were about to see a profound mean reversion in the US DE 2s spread. Remember, post EMU creation, the average of that spread is less than 40bps, it is now over 230. I went into that due to periphery funding concerns and the more positive effects of QE on the relevant transmission channels, the ECB would be more inclined to shift its sequencing in the coming months to reflect its desire to move away from NIRP first (get EONIA on a path to 0) and elongate QE. You could say I was half right, but that would be wrong, to be explained later. In a sense I thought at around 208 bps and converging economic and policy moves, this spread would begin to lag the move in EUR, and at a minimum it could not widen.
1y1y EONIA
A few weeks ago, at the Peterson Institute, Bernanke presented his most recent paper, which focused on temporary price level targeting. In the paper he also discusses, forward guidance and the difference between the delphic (think Fed dots type, like a modal) and odyssean approach (ECB "well past" model or more threshold driven). The paper's kind of unsaid theme was about achieving more policy flexibility at the zero lower bound, so in this context, these two subjects overlap quite obviously. Basically, my pontification in light of this paper and watching Mario Draghi comment on it is, the ECB has gone for a more odyssean approach to forward guidance which has capped potential policy scope in the medium term (EUR killer) and in a shadow sense has actually had an easing effects, despite the ZLB, all what Mario intended. The ECB has not been shy about this in recent rhetoric, whether it be Praet, Coeure, and especially Draghi, they have been adamant how potent forward guidance has been as a policy tool. And with this I will revert back to the elongation of QE, the nine month extension just announced. Sure, Mario loves funding the periphery, but it feels to me that at this stage the core desired impact of QE is its ramifications for forward guidance and not its standard transmission channels (spreads, lending etc.). In a sense, the nine months, i.e duration of the APP extension and potential for longer is of much more significance in a marginal sense than the 30B a month number. So back to the nuance in the different forms of forward guidance. I think Draghi learned from the Fed's tantrum in '13 that the market will maintain its curvature if you crush policy scope. Draghi may think where the Fed went wrong is that they set up set up a natural transition path from taper to hikes, i.e. their existing delphic forward guidance in the form of dots, made the market price the whats next, something Draghi has pushed back with "well past." Draghi has swiftly cut out the tail of a tantrum by drilling into the market this "well past", saying ya QE will end, but don't worry, EONIA is going nowhere for a while. So what does the nine month extension + longer if necessary do that is more impactful in the 270B itself, it delays the markets ability to price normalization, as the market has to factor in nine months + possibility of another extension and then the well past. Basically, through forward guidance tools, Draghi has convinced the market that DFR is not getting touched until at least Q3 2019 and probably later. This is what I missed. And all of this in a meta sense, is Draghi capping the EUR/USD at the ECB's staff macro assumption of 1.18. Yes, the ECB is behind and the Euro economy in a high level cyclical sense is doing very well, but I am struggling to find good r/r expression that does not fight Draghi. Open to good ideas as I thought this box in 2s was a winner.
At the Same Time, There is a Trade in Bunds
I don't think I'm the only one to use AUD/JPY as decent gauge for broader econ growth, especially in light of the worlds beta to Chinese credit growth. Chinese macro in general has been rather tricky this year and I have been on both sides of the fence. On the one hand, I liked paying duration in KRW curve as a lag to the rise in copper prices, but I have also been skeptical about copper's rally (relatively steep contango despite rally in spot) and more broadly the sustainability of China's doubling down of credit growth. TSF (Total Social Financing) continues to reach astronomical levels, up 21% ytd, but on the positive side, industrial profits have surged higher. Are the supply side reforms working or is this just a doubling down pre the NPC, which has come and gone? That question is above my pay grade, but the question of sustainability re these policies in the light of rising consumer price pressures is worth looking at. I have been thinking about this for a little bit, but post NPC and Zhou's goodbye comments re deleveraging, it may be worth to explore. So, we know the Hayman argument that China is not immune to laws of economic gravity and they are about to go through a credit loss cycle. I am highly sympathetic to that case, but timing it is far beyond my capabilities. However, a key framework for me, especially in looking at global economic activity, is looking at lags to Chinese credit and output, i.e. the G10 cyclical pickup makes a lot more sense lagged to the Chinese budget deficit growth, CRB RIND Index (which is a better reflection of physical demand) and Chinese PMI's. So China has been full throttle for the past 16 or so months, what has the potential to slow that down, outside of a credit event? I have been thinking that not nearly enough attention has been paid to rising Chinese inflationary pressures on the consumer side. Of course, everyone talks about PPI as much of the developed world imports those costs. However, CPI has been quietly rising all year and hit a 7 month high in August. This is hardly warning of an imminent problem as CPI is still below 2% and well inside its recent variance levels, but the trend since January is higher. First, while the highest political sensitivity is to food prices, they do distort the data. In September, headline CPI came in from 1.8 to 1.6, almost entirely driven by food prices. Pork prices fell like 12.5%, which weighed heavily on the numbers, and distorted gains in milk and eggs, which both rose. Now, ex food, CPI grew 2.4% up from 2.3, services increased by 3.3 from 3.1 and politically sensitive costs such as fuel, rent and utilities rose by 2.8% from 2.7. I think part of the reason Chinese CPI has been ignored, is because the headline number is deceiving, inflationary pressures, especially in non elastic sense, seem to be on the rise. If that is the case (granted that is a big if), policy makers may be inclined to slow supply side reforms and credit growth which will have a negative consequences for commodity prices and likely global growth. Yes, China has somewhat tightened mon pol in the sense of creating carry and getting CNH bid, but of course in a general sense for domestic borrowers, credit is in overabundance. Couple this with signs of slowing housing prices, maybe there is a near term hiccup for the "synchronized global growth" narrative. Given speculative activity onshore, short copper is tough to hold, even if you could find some mid curve contracts that roll down positively. AUD/JPY will be my gauge of how this plays out, as it happens to have positive correlation to bund yields. I think in general, inflation is on the rise in Germany and the ECB is willfully behind a real pickup in domestic growth, but with that said, there looks to be a seasonal slowdown in inflation coming in Q4 for Germany. This could be coupled by slowing Chinese industrial demand, which I have showed previously correlates very well to German HICP inflation. I think a nibble at RXZ7 makes sense with a stop at 50 bps in yields. Not gonna pay the bills, but could be a bit of a pain trade if bunds trade sub 30 bps again in the coming weeks. The other thing is how bunds have reflexively been reacting to the EUR. Of course this makes sense given German econ beta to its current account, stronger EUR caps future growth which the long end discounts. So in a sense, bunds have three driving variables in the near term which all seem to be positive, at least for the time frame of this tactical position. First, inflation/data both seem poised for a temporary drop, inflation due to base effects and survey data is at cycle highs. Second, either ECB rhetoric is persistently dovish or it gives the EUR a bid back +1.18, bund reaction should asymmetrically positive. Third, is this beta to Chinese industrial economy which could see a shift due to rising price pressures. Would love to hear comments on this, because pricing the China variable has been the hardest but most important macro variable this year.
AUD/JPY v German 10y Bund
USD/JPY
In this context, it makes sense to talk about USD/JPY. If you recall, I posed at the end of last post how the UST/JPY correlation post YCC could be under threat in the coming quarters. This drew at a lot of responses, mostly critical actually. While I understand why this is contentious, as the BoJ has functionally made the JPY a response function to USTs. At the same time, what I'm thinking about is not that radical. I do not have a strong view on the economic spillovers from tax reform, although this sort of fiscal push at potential is questionable, especially from a multiplier effect. Anyway, my focus has been on the deficit side. Yes, the US economy seems to have positive tailwinds from deregulation and buoyant survey data especially re capex. I am actually in the camp that growth in the US will stay above trend in the near term, around 2.5ish. Can we escape (sustain 3), eh, not so sure as the consumer scope doesn't look to be there with wage growth sub 3. Does productivity make a move in '18, maybe, but if it doesn't, the scope for a new consumption acceleration is not there with savings rates already coming in and household debt if anything deteriorating. So how do I rectify my bias that the long end could trend higher in yields and USD/JPY may actually underperform? It's credit. My mentor has actually opened me up to this view, but I'm not sure he would agree with this expression. Nominal GDP is around 4, U3 is 4.2, the economy is operating above trend and the output gap is gone. Yet, with all of this, US fiscal deficit is running over 3%. Yes, sure some of this is due to differed tax receipts as advisors have pushed clients to wait for tax reform. But still, seems wide given the economic environment, and especially since gov't expenditure has actually been a drag on GDP. With all of this, it looks like the WH is going to push through its deficit financed tax cuts. Ya, you can call me skeptical they are going to pay for themselves, especially as they are dynamically scored under a 3% yearly GDP assumption, something we have not done in over eight years. The Blanchard crowd can say r<g so borrowing capacity is "free," maybe in "theory." And yes, JPY accounts have massive UST exposure, will they feel uncomfortable with the direction of US fiscal policy, tough to say, also, typically the big accounts are hedging liabilities, i.e are held to maturity, so no MTM. Despite that, I could envision a case where a rates sell off in the long end on worries about the US deficit and that encourages USD selling, which will be quite pronounced v Yen and thus break the UST/JPY correlation. Reversal in capital account within this cross has serious potential. Another thing is, USD/JPY positioning is stretched again, with the market very short JPY, which gives me the confidence to put this on already. I will also expand in the Fed section why I have trouble buying this recent pickup in the USD in a general sense, despite the upswing in growth and expectations, both seem quite real.
Long USD/SEK, for some USD beta, and NOK/SEK
Alright onto SEK, which still offers some interesting opportunities following the kixs strength this year. Growth and inflation have both been above Rix estimates but as they have effectively outsourced monpol to the ECB, the Rix staff estimates still don't expect a repo move until Q3 of next year. Actually a decent theme in the macro community has been trying to play sort of vigilante on the Rix through the ccy. Of course they are behind, plus you get the global econ beta as SEK being an open economy does well in these periods. However, a bit of a reversal looks to be upon us and I want to look at it in the NOK and USD crosses. Yes the Ingves reappointment has already been priced but there are still a few catalysts. To me, NOK/SEK looks to be a nice long as inflation convergence should begin. NOK inflation has been on its ass all year after a profound drop, but with PPI picking up, thanks to the rally in brent, there has to be some trickle into the consumer side, even if beta is smaller than most DME's. Norges isn't going anywhere, Olsen in recent speech targeted 100 bps of tightening by 2020. However, given brent rally, domestic data should pickup and inflation as well. Also, CESI in NOK looks due for a mean reversion. USD/SEK long also should have divergent inflationary pictures in Q4 as CPIF in SEK looks like its rolling on the lag to kix strength. Of course both Norges and Rix have ECB beta, but it is interesting with market priced for Rix being behind but at the same time is pushing out EONIA, a bit of dissonance. If the ECB is still doing QE in '19, which seems distinctly possible as Draghi said it will not come to a sudden halt, will Rix really be moving repo into positive territory? I doubt within the context of their constant guidance that is plausible: "For inflation to remain close to target, it is also important that the krona exchange rate does not appreciate too quickly. This could happen if, for example, the Riksbank's monetary policy deviates clearly from that of other countries." Rix hiking into ECB QE extension next September, eh, does not sound like it. So, for this trade, you get the inflationary lag from pick up in terms of trade for NOK while SEK CPIF comes in below 2, should be a nice Q4 trade.
NOK/SEK
USD/SEK
Fed Chair, Balance Sheet and FCI's
Hard for me to go a whole post without commenting on the Fed, especially in light of all the headlines. For me, at the end the day, the market dictates what these guys/gals can get away with, sure I'd prefer to see Powell than Taylor but I'll say two things to calm down the spoos and blues crowd. First, even Taylor's bias would find it hard to be more "hawkish" than Yellen and co have been this year. Met the median dot, started SOMA adjustment, every presser meeting was live for a policy change, and the curve is at post '07 lows, pretty hawkish..... Second, the market is too powerful and global debt is too high for Taylor to price his bias in ed$, sure we can steepen, but there is no paradigm shift. With that said, back to policy expectations.
FCI's
I have been thinking about this a lot this year as Financial Conditions have clearly become a key factor in determining policy. The question is, is monpol the tool to deal with it, or is macro prudential the one to keep asset prices in line; its the Blanchard, Haldane v Borio and BIS, "leaning vs cleaning" debate, if you will. I happen to think the old guard will continue to thwart off the rebels (BIS) and be hesitant to apply monpol as a tool to keep equities and credit spreads in check. Does a Powell Fed change that, maybe, but still think with regard to FCI's Dudley is in charge, and he prefers forward guidance/macropru approach. I think the biggest reason against it is, monpol does not act on a reciprocal basis when it comes to stock markets. Yes, they react using monpol if markets tank, but the inverse has not and should not assume a reciprocal response. First, valuing overvaluation is easier said than done; Greenspan and "irrational exuberance" was four years prior to the Nasdaq top in 2000. Asking CB's to time markets has had limited empirical evidence of being effective or even useful.
Balance Sheet and the USD
As many of you probably remember from my last post, I made what seemed like a peculiar call on what I perceive to be the interrelation between a lack of vol in long end of the yield curve and the tightness in ed$ spreads, reds and out. And based of this I saw limited potential scope for further tightenings and thus a capped USD. Well....... ehhhh, reds/greens have begun to steepen and the USD rally has picked up steam on the back of it. We are probably not done yet, so if we get meaningfully above a hike and a half in U8U9, it will be a great trade to flatten. Basically my thinking is, and why I like looking at September is, SOMA changes will begin autopilot in Sept of next year. This means between U8 and U9 the Fed will "unprint" $600B at $50B a month. Now, I do not expect this to be symmetrical in a transmission or a lag sense as printing that amount had, but I do think it is fair to be skeptical that they can get hikes in and take out this much liquidity, especially from a liability side (reserves). To sum, the basic bet is, this USD rally is somewhat capped, unless you think the Fed can meet dots and have a full year on autopilot with regard to SOMA. So, can USD catchup to this steepener in ed$, yes, can it rally meaningfully back to its highs, yours. To be honest, I am sort of in the Stein camp on balance sheet, and not sure I see the rush. G4 QE has seemingly had the biggest impact on term premia, as I thought and now Yellen has confirmed, not SOMA holdings as Bullard suggests. The other argument, which I think has been a core one for broader policy this year has been retooling. The Fed wants a higher marginal effect of QE for the next recession, as there is little doubt they will be capped by the ZLB. The question is, if the Fed thinks this HQLA shortage is keeping curves and back end yields repressed, then won't this demand just offset their selling? To end, I will reference Brainard's recent speech regarding balance sheet and rate hikes as I have been thinking along her lines in recent posts. First, the Fed cannot continue to move the neutral rate lower and then wonder why FCI's are so loose, its policy oxymoron. Second, reason two, other then having a response mechanism, why the Fed waited to touch SOMA until we were well of the ZLB is that it served as a buffer in a shadow sense, i.e. allowing the Fed to retool in FFTR a bit more easily. Of course in a marginal sense, in '18 when the Fed tries to go to 2, that will be more impactful than the 25 bps from 50 to 75. However, there is a double whammy now as the buffer from the stock of the b/s will be less impactful. Just another thing to keep an eye on.
EDU8EDU9 vs DXY
Maybe for next time:
Too what extent will "retooling" be a force in '18 for the ECB, worth pondering as the markets have pushed positive rates in EONIA out until 2021-22.
Thanks for reading. If you want to reach out, email jonturek@gmail.com, is the easiest way for me to respond.
