Sections
- Path vs. destination, the policy "distributional transfer."
- China is in the process of a durable "suck in" of Capital.
- Does Blue Wave = Sell Blue Eurodollars?
Path vs. destination. And the policy "distributional transfer"
As we head into November third, the market is stuck between a path and a destination. The destination is an effective vaccine that can be rolled out over the course of next year, and is coupled with robust fiscal expansion. However, the path to that end game is a bit murky. The virus is still a present and asymmetric risk to economic activity, especially if lockdowns are still part of the policy choice to reduce the rate of transmission. And to go along with this, fiscal policy that has been so key in supporting the economy through this turbulence, has either lapsed like in the US and is insufficient/late in places like Europe.
So the market is stuck. One the one hand, the bigger trade is vaccines+fiscal led recovery, but with that said, the market may have to go through a double dip in the fourth quarter to get to those greener pastures. This is likely why since the end of August the market really has not done that much. The dollar bottomed and stocks topped all around the same time. The market said, yes there is room for the economy to continue recovering on its own but the lapse in fiscal was so key in what I call the "distributional transfer".
The market had hopes in August that we could transition from policy being incredibly efficacious in terms of reducing left tail risk to opening up right tail outcomes. Covid in a macroeconomic sense will likely be most remembered for CARES act/EU Recovery Fund/fiscal funded by monetary. What all of these things did were, they reduced the left tail risk in the distribution dramatically. In the US we said, incomes will be replaced so deflation risk in a perfect storm is out. In Europe, we said the collective will issue to fund the more vulnerable via grants. Around the world, the policy response was effectively as Trudeau in Canada said, the state took on debt so that the private sector didn't have to. This was an unbelievable reduction in what in the academic circles is called disaster risk, and markets reflected it.
Then we hit a sort of stumbling block on our path to the 2021 "destination". Fiscal did not follow through in the United States, European disbursements in terms of Next Generation EU are way too slow, and lockdown risk has reemerged in the West as we head into the winter months.
The extension of all the Q2/Q3 themes, lower dollar, lower real yields and a continued reduction in risk premium got to a level where policy needed to go beyond crushing left tails, but proving itself to not only accommodate a recovery but accentuate it by further rolling forward its policy posture. That did not happen, at least not yet. The "distributional transfer" of policy being excellent at removing left tail risk to opening up right tail outcomes has so far fizzled out.
With all of that said. The balance of risks are not even, and the "destination" should be remembered. Policy puts are still there and politicians are much more comfortable in using them. In that sense, the medium term breaks down as follows: can policy win? And to me the dollar is THE reflection of those distributions.
Mechanics of USD in abundant liquidity/ELB world. Can policymakers get this circular flow going again?
What is so potentially explosive about this process is that it is self-reinforced as there are no policy cutoffs in terms of tightening, which effectively means that a weaker dollar begets a weaker dollar. The opposite of the 2010-2020 decade. So the only question now is, when can the market get back to pricing this ultimate "destination." So while for now, the pressure is, covid, China pushback on FX and fiscal tardiness, the end game is still vaccines, China strength and broad fiscal expansion.
China is in the process of a durable "suck in" of capital
China is in a very interesting spot as the western world faces the prospect of further virus related disruptions. One, China and Asia as a whole, has done a better job in terms of virus mitigation. So while the West is in the process of adding restrictions, China is pretty much getting back to some sense of normal. Secondly, the way the economy works in the covid era, assuming policy via income replacement doesn't allow a second dip, goods outperform services for obvious reasons. This benefits China in an external account sense via the trade surplus. And that is really the story, in terms of the external account, China is in the midst of a durable suck in of capital, both via the trade side and the financial side. So while talk of "dual circulation" will likely be the focus, especially post the fifth plenary, the real story is the external account.
Strength of the Chinese External Account
1) China's bond market is opening up and it is not hard to see why portfolio inflows are one way. China is offering positive real interest rates and a material nominal advantage v G10. This has all added up to over $100b in FPI year to date.
2) The composition of global demand is very goods focused right now. As the global economy continues to struggle with the virus, commodity prices stay low and Chinese outbound tourism also stays low. So China eats everyones lunch on the trade side, and two key weaknesses of the current account stay relatively low.
3) China's financial markets actually have something to offer global investors that is not just cyclical beta. Chinese tech continues to trend and the IPO scene is booming. One of the more underrated macro events next week given the bloated calendar is the Ant Financial IPO. Ant is currently valued at over 300 billion dollars, making it one of the biggest IPOs ever.
Chinese tech outperformance v cyclical beta is a trade that works in a lot of different policy outcomes.
China is positioned for a continued massive suck in of capital from both the trade and financial side. It is hard to see what disrupts this trend over the coming months even as index inclusion flows slow. China is leading the recovery, has a pretty significant yield gap and unlike the rest of the non-US world, is offering an exciting tech world to the global asset management community.
The key part about all of this is not that the trade is to be long China short everything else. I actually don't think that is the big take-way. The big take-away is that CNH is biased to strengthen from here and maybe in a pretty significant way. Of course, the PBOC will make sure it is in a controlled fashion and we have already seen warning shots with the counter cyclical factor suspension and the risk reserve ratio cut on FX forwards. Also, it is pretty clear that state banks are involved in curbing FX appreciation in the FX forwards market instead of the PBoC balance sheet via adding reserves. Despite all of that, the bigger trend seems to be for RMB strength, especially if Biden wins next week and China is afforded a more comfortable trading dynamic with the US.
When USDCNH is biased lower, the broader dollar typically follows. This is another example of path vs the destination. Yes, we have seen the PBOC shoot and hint that maybe the level is ok, but the pace of appreciation has gone too fast. However, given the backdrop of this dual external account strength from trade and finance, the RMB is biased higher without really significant policy intervention.
Does Blue Wave = Sell Blue Eurodollars?
If there is a trend in fixed income these days it is that treasuries are broadly underperforming other G10 bond markets, most notably Europe. And the narrative is easy to understand, negative net issuance in Europe, and a blue wave is coming to the US. The question is, let's say a blue wave is coming next week, which is something that is not exactly a fait accompli given the senate data seems to be a lot closer than the presidential race. With that said, the modal outcome given recent polling is a Democratic sweep, so that should be the baseline. The question is, can US relative bond market weakness continue?
The problem is, real fixed income weakness is the trade after the trade. As I see it there are two ways in which the market can really entertain hikes in the back greens or front blues:
1) The dollar gets crushed which unleashes a wave of global NGDP that really does see inflation sustainably trend above a level the Fed is comfortable with given their new framework.
2) Global policy is synchronous and the recovery is also. All CBs are able to accommodate meaningful fiscal expansions that result in a path to some form of global normalization in five years.
Both are just not that likely, especially the second path. Under the Fed's new reaction function its hard to see how you get any sort of policy divergence. And if that were to really manifest, the dollar would hike for them, as it did 2014/2018 and what GBP did to the BoE in 2015 (see Kristin Forbes on this topic). As we learned in the last cycle, policy divergence is self defeating off of the lower bound, especially as s r* globally is incredibly correlated.
In a blue wave scenario, Europe will likely find itself dwarfed in terms of policy response. Both nominally and in terms of the multiplier as the US marginal propensity to consume is higher to begin with. So the market is right to think the US can/is more able to generate inflation. But nominals don't seem like the best expression of that. If that is right and for it to continue durably, the Fed would have to accommodate it which would weigh first and foremost on the dollar. The only way this relative dynamic is durably priced in nominals is if the market really entertains a blue wave as a game changer for potential growth and it is hard to meaningfully see that in the short run. I think on balance I would be a fader of fixed income vol.
We know from Schnabel that fiscal policy is especially potent at ELB and actually grows with time.
Putting it all together
It seems like the macro setup is relatively simple despite a lot of cross currents. There are two trades as policy focus will continue to drive a very top down market bias.
1) As charted above, policy makers are able to get the circular flow chart above going or they won't be. Most USD crosses are just a reflection of those distributions.
2) Despite the market being very top down in terms of policy driving the bus, there are some relative asymmetries in terms of both the "path" and the "destination" that can coexist, and I think Asia outperformance is an example of that.
@jturek18
