Gradualism and JPY
Despite the Fed hitting their dots for this year and achieving a shift in SOMA policy, the market is still pricing in an underwhelming Fed in ed$ for 2018. The question is, given the cyclical pickup we have seen, especially in the global economy, surely 1.5 hikes in ed$ is too few and the Fed is behind the curve... I think this prevailing logic is flawed for a number of reasons as it ignores some key subtleties. First, comparing the current hiking cycle to other post Volcker moves in an absolute sense is incredibly misleading. What I think many at the Fed have missed is, gradualism is a relative term, not an absolute one. 3 hikes in '17 may equal 7 hikes in '05. The Fed knows this of course, or it would not keep lowering r*, however they may be underestimating it's extent and the flatness in reds/greens and even golds is trying to remind them. In a prior post, I showed a chart of Wu-Xia shadow rate for fed funds since Volcker; despite its flaws, it makes a powerful point that this hiking cycle has been pretty normal, I know wild. In a shadow sense we have done 300bps including the pending December hike, and now real rates are positive. Hiking cycles should be compared to the neutral rate of interest not nominal bps in the FFTR. So, oil's rally, NYFRB new UIG inflation indicator, and financial conditions all suggest the Fed should be able to hit its dots of 3 again next year, yet the market is skeptical and by extension the USD is on the offer again. A few things to keep an eye on and why the market will continue to sell the Fed's 2018 dots and likely until inflation numbers turn meaningfully higher after February of next year.
1) As we said, policy may be more restrictive than many think (remember monpol operates on a lag). In 2018, the economy will deal with a positive real rate and a Fed accelerating its SOMA run off, reaching autopilot of $50B a month in September and the lag effect of three hikes in 2017. It should not surprise us that EDU8EDU9 is 20bps with the Fed unprinting $600B over that time horizon and the unknown effects from a change in the liability side of the b/s. If the market won't allocate the Fed potential policy scope, 2s5s near cycle lows, the USD will continue to be on the offer. Also, the Fed is going to force the Treasury to fight for liquidity with a budget deficit over 3% of GDP. This position is a bit of a doom loop as more funding means higher rates which means either larger external debt position and further deterioration of current account, or move higher in savings rate i.e. TSY crowding out. This is why "paradoxically", I do not like duration in USTs but still like JPY. The US doesn't do domestic saving, so deficits are financed by a large external debt position and the Fed's balance sheet. Well, one marginal buyer is stepping back, do foreign savers fill that void as so many think given relative rates in JPY and EUR, I am not so sure. And if not, rates will adjust to attract savers, which will effect consumption. Not ideal. My question is what attracts new foreign $$$ into USTs? 10y JGBs or Bunds are not going much lower than this, i.e. the 200bp relative pick up is likely at a peak. So, in a sense, I should like curve steepners? Well, despite carry and roll, I do not, I like being short USD/JPY as it plays on both potential directions of curvature. If the curve is to steepen on a slower Fed combined with weak fundamentals in duration i.e. positive net supply, then USD will likely be offered. If the curve continues to flatten and the Fed's policy scope is priced in a limited fashion, USD/JPY goes lower as well.
2) One of the biggest consensus out there in macro is, either the curve will steepen or it is a faulty indicator given G4 QE crushing term premia along with increased bill issuance (brilliance of TBAC). I am very sympathetic to the latter argument as I advocated that being a key cause before Brainard's paper in July. 2s30s below 100bps, 2s10s headed to 50, all seem odd given the synchronized pickup in global growth. If there is something markets have taught me, especially in macro is, univariate thinking will kill you, and with everyone thinking G4 QE has killed the YC signal, I would be more cautious. I am not in the recession camp, domestic growth in the US is still pretty good and consumption has hung on much longer than I expected. However, the YC could ALSO be telling us, the Fed has actually been far more aggressive than they or much of the market believes, and two, the Fed is AHEAD of any cyclical inflationary pickup. So ya, the ECB has and will continue to take duration out of the US YC, but what I am saying is, that it is not only the variable at play.
3) As we know, the biggest variable that could upset this paradigm other than a change in ECB policy is inflation. Given the backdrop in commodities, especially WTI, the expectation is for inflation to turn up into the possibility of a March hike, with implieds around 50%. The question is, will core CPI move higher as one offs such as telecom comes off, it is possible, but progress may be slow and that will give the doves increased voice, despite a hawkish tilt in the Fed board coming in '18. As you may recall, post the OPEC run up of Q4 last year, crude put in a big delta move which has now created a very difficult comp for CPI in the coming months. For example, the January y/y comp for CPI will be 0.31%. This comp headwind will likely peak in March and then be quite favorable, but until then, the inflation worriers will continue to be puzzled by below target PCE. Maybe next time we can look at Bernanke's temp price targeting regime, which seems to be gathering steam at the FOMC, with Williams and Evans the most recent to push it. So despite the positive backdrop of the commods rally, inevitable reversal in declines such as telecom, used cars, medical care, increase in core goods from USD selloff, core CPI will likely remain low going into Powell's first potential hike. However, the stage looks to be set for an inflationary move post Q1 2018.
USDJPY Par Looks to be in the Cards
The trade for me continues to be short USDJPY. The Fed take above is USD negative plus the fact that macro has used this cross as a positive carry way to be short duration on an expected pickup in inflation, and thus, longs in USDJPY are very stretched. A potential FX theme I could see occurring over the next few months is a favoring of current account surplus' (c/a) over carry. Despite this cyclical pickup, curves are super flat, i.e no expected policy scope for G10 central banks, so global econ does ok and FX gets rewarded by natural flow. A flat ed$ curve should be very positive for JPY as its fundamentals, c/a, PPP and REER make it super cheap. And in my opinion, given structure of Japans c/a, the BoJ knows JPY is super cheap, which means banking on a BoJ put in USDJPY could be dangerous. There is recent precedent for the BoJ letting the JPY move higher, in 2015, at similar REER levels, Kuroda said the Yen is already very weak and is unlikely to depreciate further. Onto Japan's net foreign investment position. We already know FX adjusted carry in USTs has largely gone, forcing JPY accounts to get carry naked. Foreign assets owned by JPY accounts have gone up over 50% over the past five years and is now close to 8.8T USD, JPY accounts have created a massive long exposure to the US. So there may be limited scope for a further marginal increase in the net foreign investment position. First, given the move in global asset prices, especially in US equities, the net income balance, which already a big boon to the current account, should only expand in the coming months. This is a fundamental problem with CBs driving investment outflow, CHF will likely have this problem as well. JPY foreign investment looks like it will not be able to keep up with the income balance, meaning the c/a will only expand. Another point, which has arguably come up on recently, is the end of policy divergence. It is getting some attention now, but Kuroda's November 13th speech in Zurich was very interesting.....While he was quite positive on the prospects for inflation to finally pickup given a lack of capacity (good luck with that), his take on QQE and YCC's effect on the sentiment channel via long term rates was eye opening. "An excessive decline in long-term and super-long-term interest rates may give rise to concerns about the rates of return on insurance and pension products, which may have a negative impact on the economy through a deterioration in people's sentiment." Kuroda's mention of the reversal rate also makes it seem this is the lowest and flattest curve he will tolerate. Does all of this mean that Kuroda will move up the YCC target in 10s, not necessarily but it does create a powerful FX narrative going into "The Banks Review" at the end of January with 5s10s likely steepening. JPY could gravitate towards this in the coming weeks. Remember, all of these positives are happening with market super long USDJPY...... Another thing is, I am not sure a move to 105 or 100 has to coincide with a downturn in global growth, but one would of course help.
Did the Market Misread Carney, Again?
Going into the BoE November hike, I sort of found myself in the consensus. GBP twi is now fine and CPI will lag lower, also the fact that such senior MPC members were against it in Ramsden and Cunliffe, I felt Carney would go one time just to show the market he could, in case Brexit turns south. And this is how the market interpreted it, reading a lot into the "limited extent" language with regard to future hikes in the forward guidance. Now I am not so sure the market got it right. For context, I have liked GBP v JPY/CHF/USD since July as I thought Carney had to lag that EUR/GBP move given inflation was already 100bps above target. Now, despite my inclination that the BoE could hike earlier than expected, I would rather express that view with puts in short sterling rates, not GBP, as policy scope looks very limited and I have no edge on the politics. So, back to Carney and why L Z7H8 at 7.5 looks wrong, especially given backdrop of this global cyclical pickup in growth. Carney's emphasis on a lack of remaining capacity poses some interesting questions. First, if spare capacity is gone and potential has been drastically reduced (big assumptions indeed), then a period of upside data has to be interpreted as increasing the policy path quicker than the market is currently priced. Or said in another way, periods of increased economic activity in the UK relative to expectations could be interpreted as excess demand. Which in a sense, just adds juice to GBP on outsized data prints. So while the market thinks the BoE set up a dovish hike via the "limited extent" language, by narrowing potential, they actually increased the near term policy path as the threshold for upside data is now narrower, i.e. a lowered bar. So ya aggregate hikes is still super low, but the second and maybe even last move, likely could be quicker than most expect. In sum: if potential is kept at this crazy low, 1.6, BoE tolerance for outsized data prints will be limited and thus increasing policy scope at the beginning of the the forecast period. That is not so dovish. If you are targeting FX, the key is to have threat of outsized moves relative to STIRs pricing, unless Carney is as dumb as everyone is saying. I expect hawkish BoE rhetoric to continue into the next inflation report in February, which will lift Q1 implieds from these low levels.
Oil/Copper Ratio is Bottoming
This is a chart that has been of great interest to me over the past few weeks. On the one hand, this commodity move looks overdone as the post NPC adjustment in China re financial conditions has led CGBs lower to move over 4% in 10s, which will pressure WMPs. However, I cannot discount the fact that global growth is still solid, there is a solid inflation hedge bid in markets and I am pretty negative USD. So.... Well, absolute commods exposure given positioning and Chinese credit impulse, yours. However, playing commods in a relative sense, seems a bit more tolerable, especially as the derivatives in FX make a lot of sense to me. Given oil's more diversified demand base and improving supply situation, especially relative to copper which still is in pretty steep contango, the +oil -copper trade could make sense in the coming months.
We can start with copper. As is the case in crude, spec longs are very stretched on the back of increased industrial activity in China. Yes, I've heard the EV narrative, but kinda seems like something a few guys came up with at LME dinner to justify the recent move. To me, China industrial bid was brought to life in a massive way beginning over a year ago, as Kyle Bass showed, China's fiscal stimulus is now bigger than its post '09 move. This is all occurred while copper along with the base metals complex was under owned in general, leading to a reflationary rotation. Post NPC, financial conditions are tightening a bit, which will effect WMP flows into base metals and domestic credit creation. What also should be troubling for copper bulls is, we have had a massive fiscal push from China, which makes up over 40% copper demand, supply disruptions in Chile and Indonesia, despite all of this, the contango continues to be very steep in nearby and calendar spreads..... Crude seems to have a much better supply picture. Backwardation has persisted with OPEC cuts moving storage levels lower, US shale growth is likely overstated, and political tensions between Iran and KSA are bubbling. Of course demand has also benefited from increased Chinese investment and industrial activity, but in a relative sense, China is less than 20% of global crude demand. I also think this year there has been, and will continue to be, a big inflation hedge trade in commods that will likely persist as central banks are perceived to be behind the curve. Oil markets are really the only ones deep enough to accommodate that bid. Risk parity, spoos/blues crowd can hedge in tails but buying crude is another way for them to hedge inflation risk in some size. Yes there is a hiding of crude in products and it is unclear how long KSA will let Iraq (in US) and Russia (in China) take market share, but given domestic political considerations such as budget deficit/austerity and Aramco, KSA may have no choice. Simply, oil has better fundamentals, a bottom in this ratio should have some interesting FX ramifications.
AUDRUB Short
We will look at AUD (below in CAD chart) and everyone knows the structural credit story, but in a cyclical sense, what I keep coming back to, despite China's fiscal push and subsequent rally in commods, Lowe was not able to get a hike in this year. If this terms of trade couldn't overcome domestic credit situation, what will. RUB in general looks kind of interesting and is another way to trade this +oil-copper expression. CRB is still at relatively early stages of easing cycle, terms of trade are improving with brent and the trade balance picking up again. With CRB cutting likely again December taking key rate to 8%, recent positive trend in private sector lending should continue. Of course the story is inflation, which has now reached a post Soviet era low and is over 100 bps below the banks 4% target. Given that backdrop, one would think Nabiullina should be more aggressive in releasing the clamps of higher lending rates, and RUONIA is sort of pricing that over shorter term. Even though it may be net econ negative, I think the CRB will continue to be excessively gradual. Recent policy statement described the key rate as "moderately tight" and in what is the key point, inflation expectations remain elevated. That does not sound like a central bank that will do a neutral real rate below 3-4%. Despite that, real income is picking up leading to positive increases in the service sector and of course the brent pass through will continue to benefit other elements of the economy in the coming months. Another element for RUB is the relative strength of its biggest trading partner, EUR. EUR makes up over 25% of exports, given their cyclical uptick, demand should be resilient; continued uptick in trade balance should continue. In a sense, being short this cross is thematically positive EUR econ beta and short Chinese industrial demand, which is kind of where I want to be.
Short AUDCAD
A lot of structural noise in this cross given each country's respective household debt and housing bubble, but in a terms of trade sense, it is a decent outlet for this trade expression. Yes there has been some policy divergence this year has the BoC has done 50 bps while the RBA has done nada. However, the BAs have been bid as Wilkins and Poloz have both been quite dovish in terms of expectations for the next rate move, saying the bar is much higher for the next hike. It is also worth contextualizing this rhetoric with the pending changes in BoC macropru in RE that is supposed to kick in 2018, likely adding to the BoC's hesitancy to move in rates. So while the improvement in terms of trade will be CAD positive, the credit loss cycle could be finally near. This is certainly possible, but that possibility is also the case in AUD. AUD should probably be on the offer v most major crosses, as it looks like an even bigger piece of shit than CAD, which isn't easy. Think about it, over the last 16 or so months China has engaged in a massive fiscal splurge which has been heavily focused on the industrial side, and Lowe has not been able to hike once, not even get any real steepness in OIS. Wage growth is stuck at around 1.9% and the RBA is still looking to get AUD lower. While in CAD's case there is a sighting of a phillips curve with wage growth picking up, which has justified their relatively hot retail numbers this year. Ya, the structural stories suck in both economies, but in a relative CB sense and in terms of trade, CAD should be favored.
Or Just Long EURCLP
Next time back with more charts. Thanks for reading. Best way to reach me with comments or questions is via email: jonturek@gmail.com
