Can Global Fiscal Make the Great Transition

Overall: The market seems to be breaking down between two time horizons, and I think we are approaching an inflection point in terms of knowing which side it will choose. Of course, the vaccine news has been very positive and the delta change of, earliest in 18 months to now likely getting one in 2021, has been worth a lot of spoos points. However, in terms of the broader macro dynamics, the market will soon tell us which side of these two dynamics are at play. Was the market underpriced for a pickup in activity or has global fiscal changed the macro landscape going forward.

side one:

- The market was completely offside for what both data and CBs are saying, the depth of the downturn is less than originally feared. The market got a decent opening in the backdrop of positive Chinese industrial activity and immense fiscal buffers to consumption.

side two:

- Global fiscal/monetary policy is a changed beast, the only question now is staying power. Will South Korea follow through with a "new deal" post covid, will Germany actually make investments that change domestic growth composition away from just exports. There is no question that this global policy impulse has changed the distribution for "bad" economic outcomes, the question now is can policy transition from something that is filling a demand hole to being the train of renewing domestic demand.

This is what the market is fighting against. The first side, will likely run out of room in terms of driving a cyclicals rally (usd/curves/EM etc.) However, if the second side of this formulation is real, the global economy could exit covid with a much more balanced and synchronized growth dynamic and that would have immensely positive spillovers to things like EM. As always, I believe the answer will lie in USD. As the broad dollar retests certain key levels, we will get the answer if this move was just the market offside for better than expected activity levels or has something more fundamental shifted.

Sections:

- Global fiscal transition and USD

- Risks of a Chinese "W", will CBs let it run

- A few trade expressions

Can global fiscal make the transition, USD will tell us

I want to focus on two key things driving the transition from markets pricing liquidity to markets pricing reflation.

1) Chinese industrial activity has been "V" like. The proof of that has been in things like iron ore over $100, Chinese oil demand back to 11mbd, and Aussie above its 100 week moving average for the first time in over two years.

2) Europe got its act together and the EC recovery fund proposal has reduced a lot of left tail risk in EUR which in turn has weakened USD safety premia. It is no coincidence that the dollar broke its consolidation pattern downward three days after the Franco/German proposal was put in motion during a joint press conference with M&M. Between an upsize of PEPP last week and the current EC proposal, fragmentation risk in Europe is off the table. Is it perfect, is it big enough, these are valid questions but both miss the bigger point, the precedent has been set and the train has left the station.

The way these two factors have coexisted has really changed the macro landscape over the past few weeks. The key reason being, both on their own right take air out of the US dollar and together have hit it hard.

Both affect the dollar in different ways. China being able to get its industrial activity back much quicker than the market thought has been dollar bearish because in a comparative sense the dollar is much less exposed to Chinese industrial activity than the rest of the world is. Europe reducing left tail risk has been huge in changing the trend for the dollar also. EUR is a key part of the broad dollar index and given fragmentation risks it was on a steady path of being dragged lower by rising spreads and political vulnerabilities. As Europe traded with left tail risk from rising government spreads and fragmentation risk, this pushed the Euro to the weaker side and dragged a lot of currencies with it. However, as some of this left tail risk comes out, there is a rebalancing in FX and the dollar loses some safe haven premia it was previously trading with.

So the combination of these two factors have been huge in breaking the dollar consolidation lower. The question is, are both of these things enough to send it past its previous breakout level. What is the catalyst for the dollar move to turn into a more medium term sustainable trend instead of this potentially just being a retest.



Maybe its global fiscal policy finally getting its act together

One of the things that will determine the sustainability of this dollar move, past this current reflationary episode, is the global policy impulse post covid. The reality is, for this current market move of cyclicals leading, EM rallying and curves steepening etc. a lot of it is a big delta change in implied probability, not necessarily a change in the baseline. Basically, the market was completely offside for any signs of reflation. Now the market is entertaining how big global policy stimulus is in the backdrop of what the data & CBs (RBA/BoC last week) are saying, the depth of the downturn is less than originally feared. This narrative shift happened into one sided positioning, so it is very likely this cyclicals led bounce is largely being amplified by positioning.

However, it is possible for these current shifts to be part of a new broadening trend, and seeds for such a market shift are being planted.

What is very interesting to see over the past few weeks is, countries who traditionally run tight fiscal policy are starting to embrace the potential for an expansionary fiscal position even post covid.

- Japan is onto its second supplementary budget with Abe's cabinet approving over $1.1t in new measures.

- Europe is embracing the Commission playing a role in fiscal transfers as part of the Recovery Fund, effectively expanding EMU fiscal scope. Germany is onto its second fiscal package, worth 130b Euros.

- South Korea is starting to talk about a fiscal stance that lasts beyond covid, which Moon has talked about being "new deal" like.

The question for markets going forward is, does fiscal make the transition from serving as an economic cushion to an economic accelerant.

Can fiscal make the transition from supporting business' and employment to making structural economic changes in terms of growth composition and competitiveness. If countries like Germany, South Korea etc. economies that have previously been focused on their export sectors, almost at the expense of domestic demand (see prior post) that changes the macro economic landscape in a paradigm shift sort of way. And the dollar doom loop of the previous decade, where global trade slows/relative US economic outperformance, self reinforce each other, finally gets turned on its head as global growth becomes a lot more balanced and synchronized.

To me, this chart is a sign that the market is taking this shift very seriously.... 30y JGB yields back to summer 2019 levels.



The spillover of a more balanced growth level can by itself positively impact EM, even if many of those countries that still lack relative policy capacity. So yes, EM still has domestic growth challenges and no carry to attract flows, but dollar weakness can cover over a lot of those cracks.

A weaker dollar can solve a lot of the global economy's ills.

The IMF financial stability report estimated dollar impact on cross border lending to EM. We saw in 2017 how this works in reverse, it's pretty powerful.



The risk of Chinese "W", will CBs let FX run

One of the interesting dichotomies in macro right now is, Chinese activity has been a key reason for the V like feel in markets but Chinese policy has not been that expansionary, especially in a relative sense. Chinese policy making post NPC seems to be focussed on targeted measures and despite removing "flooding" from communiqué, nothing Li has said makes it seem they will revert back to flooding. Infrastructure spending is up as the Chinese authorities are at least establishing a baseline for growth while not targeting a specific level this year. The question now is, what legs does China have as a growth driver if the things that have gotten markets here are implicitly capped. Yes, the market was completely offside for Chinese industrial activity to pick up as quickly as it did, and the added juice of increased infra spending has nudged the global cyclicals trade, weaker USD, steeper curves etc. The problem is, by itself, what scope does it have.

A few things:

1) The Chinese only seem to be using infrastructure as a way to plug growth holes, not some new fiscal campaign.

2) The Chinese industrial machine is back on, at what point is it too much for the global consumer to absorb, as they will likely be backed by fewer fiscal buffers.

Without a commensurate follow through from global econ with fiscal policy that transcends just making up lost demand and takes a more decisive role in growth going forward, the Chinese industrial train doesn't have that much steam. It was easier than priced to turn the Chinese industrial machine on, it may be harder than priced to fully turn on the global consumer.
The other question is, do central banks get the joke on FX

What is also interesting, especially in light of how far many of these currencies have run is, will central banks let the system heal. The reality is, part of a reflationary world is a +75c aussie dollar, +70c kiwi, +1.15 euro etc. The joke now is that terms of trade don't really matter when there is no trade. However, will people like Adrian Orr decide to reintroduce NIRP risk to get kiwi off its highs. For now, there isn't talk of Lowe or Debelle coming in scared about how high AUD is. It will be key for this dynamic to last. It would be unfortunate if CBs decide to fall back into their old traps of falling for FX at a time when potentially some of the Chinese demand impulse that got us here is beginning to come off.

This is the potential for this weak USD trade to get circumvented. Chinese industrial demand slows at the same time export CBs start to worry about FX. It hasn't happened yet but it is worth watching for.

Some potential trades:

- One of the trades I have liked the past few months is, being long good outcomes in Spoos and bad ones in FX, via EM. That trade had worked great until a few weeks ago. With that said I think there is a similar concept at play now. One of the things I have been doing is effectively an RV trade between risk products as a way to gauge what is the nature of this rally, temporary/or regime shift. A trade I like in that regard is also an equity v FX trade where you sell NK1s against the highs to buy upside in things like KRW. The point basically is, if Nikkei makes a new high, that is very telling in what the market is saying about the global economy going forward, however in that world, USDKRW at 1200 is just the wrong price. And if this is a rally on underpriced factors and faces a coming cliff in the form of fewer fiscal buffers and less Chinese demand, NK1 could reprice a lot faster than KRW.



- To me there are three potential outcomes for the spread between 10y French OAT v 2y German Schatz.

1) reflation, spread will steepen
2) deflation but no EUR risk, flatten
3) deflation with EUR risk, steepen

This balance of probabilities is pretty suggestive of a steepener. Of course its possible the market just grinds back to 50bps as EUR risk is completely taken out of distribution. However, that seems like a worthy 10bps as the two other possibilities contain likely +50bp moves.



- Another trade that seems interesting is long EURTWD. Basically this trade encapsulates two pretty interesting domestic factors. One, USDTWD has probably run a bit too far for the CBC's liking, and if this dollar move lower were to continue, it would be fought. So off the bat being short TWD right now, you get carry from the negative points (thanks lifers) and the CBC will likely begin to lean against. The other side of it is, something has changed in EUR with this EC proposal. Is it perfect, likely not, but the precedent is a game changer. And as fragmentation is reduced as part of the distribution, that should change how this cross trades in risk off.




All the best and stay safe. @jturek18.