What if covid was the top in the risk premium bull market?

Sections:

1) Q2/Q3 2021 is setting up to be a clash between the Fed's new reaction function and upside risks. The Fed will likely lean into "opportunistic reflation."

2) 2010-2020 was a bull market in risk premium, what if covid and the massive policy response since was a turning point in distributional terms?


The Fed wants to lean into "opportunistic reflation."

The Fed finds itself at an interesting juncture. The backdrop is pretty simple, the very near term is highly uncertain while the medium term looks far more robust than the September dots show. The problem is, FCIs are about as loose as they've ever been, so while things like WAM extensions have been thrown around, they don't really accomplish much. So the Fed will likely stay put, as Clarida said at Brookings, policy is in a good place.

With all that said, this will likely not be the focus of the market outside of some on the day knee jerk reactions. The real Fed message the market needs to see is that AIT means business. The Fed going forward will be much more about adding barriers to any form of tightening as opposed to looking for new ways to ease.

As has been discussed in many market and academic circles, the middle of next year is setting up as a "cage match" between the Fed's new reaction function and the upside risk of a faster than expected cyclical normalization. So the question for the market right now is, with rates hugging key technical levels and the belly beginning to cheapen on a relative basis, what if the Fed blinks?

In 2019 the Fed threw the Phillips Curve orthodoxy out the window and was cutting rates into an economy that had an u3 rate decently below most estimates of NAIRU. The post DSGE era arrived pre covid. Realized outcomes matter more than expected ones when it comes to upside risks. And if the market thinks the Fed will be startled by a comps based rise in inflation during the middle of next year, Brainard was already hoping for things like that to materialize, even pre covid. The Fed wants to lean into the upside scenario.

"the Committee would make clear in advance that it would accommodate rather than offset modest upward pressures to inflation in what could be described as a process of opportunistic reflation."

"Stabilization to accommodation"

One of the key themes that we have learned from Brainard this year is how she is thinking about the reaction function in light of the shock and policy constraints at the lower bound. Something she highlighted in a September speech is that policy should begin to transition from "stabilization to accommodation." This may have been the most descriptive three words explaining the Fed's reaction function going forward. The Fed sees itself as a line of defense, or a buyer/lender of last resort in a shock. And in a recovery it sees itself as an exponent allowing the recovery itself to cyclically expand the easing posture of policy. Thus "accommodating" a recovery via accelerating it. Which is something we have already seen through this divide between breakevens and real yields.



At the ZLB, the balance sheet stabilizes, forward guidance accommodates.

In terms of thinking about how the Fed will navigate this cyclical transition, the Fed will be much more worried about the destination and not the location. Which is to say, policy will be judged by where the economy is relative to the Fed's longer run goals, not where the economy is relative to the size of policy accommodation.

"As we move to the next phase of monetary policy, we will be guided not only by exigencies of the covid crisis, but also by our evolving understanding of the key longer-run features of the economy, so as to avoid the premature withdrawal of necessary support." - Brainard July.

Fed guidance has to evolve to continue enforcing it

The question now is, how does the Fed enforce this, as the bond market is clearly itching to play catchup to these massive moves in cyclicals across asset markets. This is likely where forward guidance has to go into overdrive to make sure the Fed can continue this powerful duality of real yields lower, breakevens higher. And because many CBs are currently/have already put into place similar sorts of guidance, the Fed will have plenty of academic and real world policy work to lean on.

In terms of reinforcing the CBs reaction function and making sure that the recovery is not affected by any sort of financial market tightening, the Fed will likely have to be more clear about balance sheet guidance as that is so key in a policy sequencing sense. Benoit Coeure spelled it out in 2018.

"asset purchases are necessary at the lower bound to reinforce forward guidance."

"we have also seen that, as the outlook improves, the signal that asset purchases send regarding the likely date of a first rate hike becomes increasingly important for anchoring the medium to long-term segment of the curve."

The Fed wants to communicate to markets that despite the positive developments regarding the vaccine and the potential for upside risks in 2021, policy will not budge until the goals explained in the updated MPF (monetary policy framework) are met. QE is a big part of that policy calibration.

In March of 2016, Peter Praet of the ECB also explained the key policy linkages between BSP and interest rates, especially at the effective lower bound. At the time, the ECB had adjusted the forward guidance on the key ECB interest rates to imply a "sequencing" between rate policy and APP.

"The APP enhanced the effectiveness of our forward guidance on policy rates via the signalling channel, underscoring our commitment to keep rates low for as long as necessary to achieve the stated objective of our policy."

This sounds awfully similar to what Brainard was saying in February with regard to interest rate caps, well QE can act as de facto rate caps.

"To strengthen the credibility of the forward guidance, interest rate caps could be implemented in tandem as a commitment mechanism."

So what does this all look like?

Whether the Fed statement looks more like the BoC, "Bank will continue QE until recovery is well underway" or even more aggressive and ECB like by linking QE to the policy rate, the Fed will look to link BSP to longer run goals and not see it as an emergency tool. So while many on the street are looking for the Fed to respond to an upside risk scenario, the Fed will likely lean into it. For that to fully happen, preventing a taper tantrum is key and having balance sheet guidance is the best way to prevent one. The Fed can use BSP to reinforce its forward guidance stance and have it serve as a form of commitment mechanism which Brainard talked about. In market terms this means that rates will continue to be an inferior expression of positive economic outcomes. And because they are inferior, positive outcomes can have a more outsized effect on cyclical beta than they usually would have. 

2010s were a bull market in exogenous risk

One of the defining themes of the post GFC period was this long safety short cyclicals theme. Given the low level of rates, the scarring from the GFC/Euro crisis and skew towards deflation, risk premium traded at a very elevated level. The knock on effect of this bull market in risk premium was that anything the market determined was "safe" was given an infinite valuation. The trade was capital protection, not capital appreciation, and that was in the context of an asset shortage on a global level. This sort of pricing was entirely logical. One, given the hysteresis of the GFC, and rising exogenous risk from geo-political events, the structural bias to price deflationary risk made a lot of sense. This was also in the backdrop of rising government surplus' in places like Europe and Asia, a global savings glut and a structural change in terms of Chinese growth levels which the global economy had become highly dependent on via exports.

So the macro backdrop was:

- Economic hysteresis.
- Slower levels of global trade.
- Rising exogenous risk (geo-politics).
- A rising USD.

Which is all to say, it made sense for the market to continuously price a relatively high level of risk premium, as that was certainly what the skew of potential/realized outcomes favored. And all of this culminated in the perfect economic shock, a global pandemic recession.

Risk premia has been quite elevated on a structural level

One of the more interesting findings in a terrific Emmanuel Farhi paper that he presented at the ECB in 2018 was, despite a much lower level in the discount rate, risk premia has been building for a while. Farhi's framing is actually a challenge to the global savings glut thesis, because the level of risk premia has risen despite the fact that MPK (marginal product of capital) has stayed fairly high. In theory, savings should drive everything lower, but the MPK rate has stayed elevated. So there has been a fairly wide wedge between the returns on private capital and risk free rates and elevated levels of risk premia likely have a lot to do with that.

Divide between "safety and "risk" has been a clear trend in markets

This sort of bifurcation between safety and cyclical beta has had a profound effect across global markets. The well known long tech short everything else trade, long USD, flatteners in the bond market etc. At their core, these trades had a lot of overlap, the market continued to ride the skew of "bad" things were just much more likely than "good" things.

If we look at FX, safety (USD, CHF) was a 10y bull market and cyclical (SEK, AUD) beta got crushed for a decade.



What if the post policy backstop world changes these distributions even slightly?

One of the more interesting questions post covid will be, does the calculus regarding risk premium change at structural level and not only at a cyclical one. I.e. the market right now is reducing the level of risk premium on the back of the vaccine results and their high level of efficacy. But the bigger question is what if the post covid global economy is able to exhale just a bit from a decade of relentlessly high levels of risk premium? It is still likely a very low delta but it is possible the skew of the last decade has changed. The reason is that despite some fumbling in terms of US fiscal or NGEU disbursements etc. the global policy focus is intensely on preventing "bad" outcomes. The question going forward is, if the left tail footprint is being structurally lowered, even just a little, that could have a profound effect on risk distributions going forward. The Covid shock brought out all of the market/economy's vulnerabilities at the same time, the fact that so many of them were contained could change the pricing distribution going forward. Will be very interesting to see. 


Happy holidays and all the best in 2021.

jonturek@gmail.com

Can Policy Restart this Circular Flow into Rising Covid Risks?

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

Stabilization to Accommodation, Brainard's Policy Transition

Sections

- Jackson Hole, the Fed’s current duality.

- Can we have a “beautiful” recovery or is fiscal in trouble?

- What if we have the USDJPY question all wrong?

- Lane's EURUSD comments were no faux pas.

Overall: One of the more interesting things going into the September ECB/FOMC meetings and the updated staff macro forecasts is they both have very important questions to answer. The ECB has to answer the EURUSD question, does 1.20 really bother them? The Fed will have to show what they can do to further ease given the SEP will continue to show them coming up short of their dual mandate goals. We know what they will do (won't do) when things get better, what can they do if things get worse? 

The Fed's duality

With the culmination of their strategic review, the Fed showed the interesting duality they find themselves in. On the one hand, it is clear the Fed will not be preemptively hiking rates in this new framework, something we have known since they initiated this review in 2019.

The Fed wants to allow the economy to recover and accentuate that recovery by remaining accommodative for longer than it traditionally has. That is of course dovish. And despite some missteps in the communique with regard to what exactly inflation overshoots will look like, the bigger message should not get lost, they will be allowing inflation overshoots and FAIT is the end of the “bygone” era.

However, this sets up two camps for the Fed going into the post covid recovery.

On the one hand, if this Fed backdrop is accompanied by a continued substantial fiscal response and an inevitable vaccine, it is rocket fuel for risk assets. As we saw in Brainard's July speech, the Fed's degree of monetary accommodation will expand with the recovery. That is when forward guidance is so powerful.

On the other hand, a problem the Fed has right now is especially in regard to this framework, they are fiscal dependent in terms of creating the conditions they desire in an outcome sense. By itself, despite opening up policy space with the balance sheet and forward guidance, the Fed will struggle to generate "good" economic outcomes on their own given the lower bound constraint. As Brainard effectively put it in her July speech, the Fed is very capable in preventing left tail outcomes via their balance sheet, however in terms of "accommodation" that will largely come in a pro-cyclical fashion given the lower bound constraint.

One of the things that Bernanke noted in his January AEA speech, L4L (lower for longer) policies can only do so much if neutral rates are below 2%. And this is where the Fed likely finds themselves.

“if the nominal neutral rate is much lower than 2%, then model simulations imply that new monetary tools while still providing valuable policy space can no longer fully compensate for the effects of the lower bound.”

If neutral rates are too low, L4L can't overcome ELB by itself most of the time.

*the QE options vary by size, B being the smallest, D the biggest.

So, this is how the duality presents itself. The Fed's new framework is incredibly constructive to an economic recovery, but by itself cannot create that recovery given the lower bound constraint. And while L4L policies will help, they cannot overcome ELB by themselves as they likely could in a higher neutral rate world. The Fed will try to answer questions on their easing constraints at the September meeting. This will be an especially powerful moment as it will likely coincide with continued fiscal impasse and an SEP (staff economic projections) that shows the Fed below their dual mandate goals for the duration of the forecast horizon.

All roads lead to the Fed trying to prove themselves again in September. We know how they will act, or not act, when times get better, what will they do if things get worse…. They will have to answer that question, or at least try.

Can the Fed keep getting this chart to bull steepen?



Can we have a “beautiful” recovery?

This is a bit of a play on Mohamed El-Erian’s/Ray Dalio's “beautiful deleveraging” concept from a few years ago. 

One of the more interesting under the radar aspects of this years Symposium was, Kristin Forbes of MIT and ex BoE, as chair of the second day conversations, had one overlapping question for all her panels: what is the hypothetical policy response to a right tail outcome in 2021? Let’s say there is an effective and widely distributed vaccine in Q1 2021, pent up demand is met with the combination of supply shocks and pricing power, how does policy respond? What if fiscal support has changed the calculus for hysteresis in the next cycle? As one could have guessed, there was no answer. Governor Bailey of the BoE basically laughed it off. The reason being, policy makers are assuming a post GFC recovery of low NGDP for their entire forecast horizon. And despite a substantial rally in headline risk assets, the market generally agrees.

The market seems to be entertaining a pretty striking inconsistency. One that I think is captured by the relative divergence between the weakness in the dollar and cyclical beta. The market is seemingly having no problem entertaining an 85 or 80 DXY world, but rates will stay where they are forever, tech will outperform everything and NGDP is still dead. Given all the body of work on how big of a multiplier the $ is on the global economic cycle, surely this can’t be. In fact, as the chart below shows, neutral interest rates and the dollar have had a pretty strong relationship going back to the GFC. The dollar can open up new economic outcomes given its strong multiplier effects such as credit, invoicing etc.

G4 avg r* LW model (inv) v USD REER pre Covid



So far, the market has traded the very positive dynamic that the dollar is a “solved problem”, i.e. its skew is no longer violently higher. However, what if the dollar was to really fall 2017 style in rate of change terms, that's a game changer for the global economy and changes the growth/inflation dynamic going forward. 10y breakevens will not be 1.80 in an 80 DXY world.

The big question now is, will the market transition from removing left tail risk premium to pricing in right tail outcomes in terms of growth and inflation? Was this just a mean reversion in terms of left tails leaving the distribution, deflation, Euro fragmentation risk etc. or, is the market beginning to entertain a new regime of fiscal permanence and a faster global economic recovery? In theory we could define the move in breakevens as simply mean reversion. Take what’s priced in caps/floors on inflation swaps, the composition of the move is in that inflation will *certainly be above 1%, but very little of the move is in the possibility that inflation will be significantly above 2%.

With this in mind, we enter three possible camps for the market and inflation right now:

1) The current camp, deflation is off the table, but this will still be a slow recovery, so ED strip stays flat like the dots. Risk assets get benefit of mean reverting data and zero discount rates forever. In that world, duration acts as a vacuum for equity risk premium and the long tech v everything else trade continues to work despite technical hiccups. 

2) The second potential camp, fiscal inaction leads markets to at least challenge the idea of a fiscal put and successful policy handoff from monetary. As Coeure always warned us, fiscal lacks "agility." Shorter term liquidity concerns turn into longer term solvency ones again and risk premium shoots up. This risk has been largely put down in places like Europe, as Germany has extended their furlough scheme until the end of 2021. However, it’s hard to say in the US it is off the table.

3) The third camp, the new world of fiscal is here. Aggressive fiscal policy leads markets down a much swifter recovery path, and we begin to question what if neutral rates won’t be 0 forever. This is the world where fiscal transitions from an economic backstop to an economic accelerant. This world is becoming easier to imagine. It is perfectly in the realm of possibilities that the US has an effective and widely available vaccine in Q1 2021 into a new democratic mandate that passes a +$3T HEROs bill. 

It is very possible that both tails are underpriced at the moment. The market is fully priced under the assumption that fiscal/monetary will be big enough to to cap any downside risks but not too big to create inflationary pressures. While that is the most likely outcome, it is a very tight distribution for a policy set that we really don't know much about. 

Copper may be evidence of the third camp is gaining steam



Does the market have the USDJPY question wrong?

One of the emerging questions in global macro these days is when does USDJPY breakdown and follow the broad dollar index lower. So far, USDJPY has been in a tight range due to very loose funding markets on the one hand and real money flows capping Yen strength on the other. And Yen is not going to trade on relative real rates. The question is, when does this tight range break and do we get this sort of inverse Abenomics move where USDJPY goes back to the 80s?

It's possible the market is asking the wrong question. The right question may be, what if USDJPY is able to absorb these weak dollar pressures and stay above 100, maybe even in this tight 105 range? Let’s say in a world of reflation, rising asset prices and flat term structures, Japanese policymakers are able to get what they want and effectively pin the Yen. That world is a very interesting world for Japanese stocks which are close to pressing up against multiyear resistance.

Nikkei 24k is a huge level if we get there. 3y daily chart. 



This may not be actionable right now, but it is something worth watching. Of course, it is too soon to say that USDJPY won’t follow this dollar move lower and that will pose a challenge to Japanese equities, especially in a relative sense. However, given the asymmetry, it is likely worth asking the question of, let’s say we are in a durable reflation and the BoJ has figured out a way to peg JPY, that is about as constructive as it gets for Japanese equities in zero rate world. All of this is happening at close to very interesting technical levels.

Keep an eye on the ECB this week

It was a bit surprising to hear comments from Phillip Lane last week re the current level of EURUSD. It wasn’t anything drastic, and the blog posts from Schnabel have not been particularly worried re the level of the exchange rate.

“At the moment I am not worrying too much about exchange rate developments.”

However, nothing is by accident with Lane, and he wanted it out there that the EURUSD rate matters and the ECB is watching it.

This sets up two questions:

1) Lets for a second entertain the idea that +1.20 worries the ECB. This is something I am not convinced of as the ECB knows the combination of fiscal and the nature of the shock have changed the pass through dynamics. However, in this hypothetical, they care. What do they do? The street is expecting an upsized PEPP, and that makes sense. In theory, QE is two birds with one stone for the ECB, it decreases fragmentation risk and lowers the XR (exchange rate). The problem is, in practice it won’t weaken XR and I think the ECB is well aware of that. The traditional portfolio balance channel ala 2014 is broken. Upsizing PEPP has a much bigger impact on left tail pricing/accommodating fiscal than it does on the portfolio balance channel, so QE in Europe could actually be XR positive…..

Marginal QE effects have changed since Draghi started PSPP



2) Is Lagarde going to entertain rate cuts? This is something that should be off the table, and it likely won't happen because it EURUSD 1.20 is an overrated risk for EA inflation. However, it would be very interesting if Lagarde makes a nudge at getting negative term premium to go a bit further. I.e. testing that lever and see what it does to EUR. And of course, because of that most recent inflation print, she has every right to do so. The knock on if the ECB starts to push the market a bit on getting serious re DFR cuts would be huge. This would open up the same problems of 2019, where the ECB via pushing the dollar higher ends up being a duration vacuum and broadly negative risk. Also, in a more structural sense, it threatens this new world of ELB + fiscal which has been $ negative. It is a much more positive risk FX environment when the only CB really entertaining cuts is NZD and we push the policy handoff narrative. ECB entertaining cuts would threaten that so it is worth watching even if it’s a small probability. As noted above, the $ is the key outlet for a global recovery and the ECB should not want to get in the way of that.

@jturek18

Macro in a World of Policy Omnipotence

The one trade now in global macro is, can policymakers continue to get whatever outcomes they want.

Sections:

- For the market, skew has mattered more than expectations

- Macro in a world of policy omnipotence

- The last idiosyncratic rates trade, China

- Is the JGB curve ironically the best DM steepener

For the market, skew has mattered more than expectations

One of the things that has seemingly been missed in this market is, the narrative has been focused on outcomes while the market has been pricing skew. I think over the past few months there have been a few examples of this.

- EUCO recovery fund. The narrative at the beginning of the process after the M&M press conference on May 18th, the size is not big enough. What has the market reaction been? the precedent of European fiscal transfers is a far more important development than the actual size of the recovery fund. As we have learned in Europe, it is harder to start something than to make it bigger, ask Mario Draghi.

- In the US, fiscal stimulus was supposed to struggle to cap the revenue drop caused by the unprecedented nature of this crisis. To an extent, it has, but what this narrative missed in a distributional sense is, the policy response to deflationary shocks has changed and the left tail has been clipped. The government sends out money and the central bank does open ended QE. Does this mean future growth is promised, no, but it does change the recession landscape in terms of size and duration.

- The US dollar is another example of this. How was the Fed going to downstream dollars to EM corps and Asian non banks. And then from there, was there really going to be a change in global growth composition that would change the USD "smile" world where US asset outperformance continues in perpetuity. Would previously frugal surplus countries step up with ambitious fiscal plans that would not only plug the covid hole but transcend the current crisis and serve as an economic accelerant going forward. The immediate answer to a lot of these questions was, the most probable outcome is no, but the market traded the skew and thats where we are today.

Going forward, I'm not sure what changes the current risk dynamic. I think a very interesting dynamic has been the fact that a weak dollar has not elicited a response from the long end of the US bond market. This may speak to the asymmetry we see in the current relationship. When the dollar is strong it weighs on global NGDP and thus term premium. When the dollar is weaker, FX basis tightens, and it again makes sense for foreign real money to buy the long end FX hedged to get a yield pickup over its local government bond equivalent. This latter dynamic is like rocket fuel for risk assets, especially EM, as all the stimulative effects of a weaker dollar, trade finance etc. can happen without a commensurate move up in term premium. This is the dream for EM. The question now is, after a pretty substantial move lower in the dollar, does it make sense to have some tactical stuff against core positions that have a risk bias. I think the places to look for this sort of exposure is CBs that have already said they don't want further FX appreciation (ILS, THB, TWD).

Macro in a world of policy omnipotence 

One of the more amazing transitions in markets since March has been the market's outlook towards policy. In the darker days of March, the Fed was "constrained" by the effective lower bound and fiscal was too slow. So the bet was, this shock would overwhelm policy. Fast forward to now, and the market has basically said no shock is too big for policy makers and if that is the case, we just gravitate towards the right side of the risk distribution as the policy put is struck so high.

Where we are now is, the market asks itself what the Fed wants and then puts those trades on. What are those trade:

- The Fed wants a weaker dollar. They turned every world government bond market into USD to prove that.

- The Fed wants IG to trade at new tights. Allowed record IG issuance three months in a row. Liquidity that prevents solvency issues.

- The Fed wants risk assets higher to ensure smooth financial market functioning for the real economy.

- The Fed wants real yields to plummet which effectively allows their easing footprint to expand with improvements in the outlook. Pro cyclical policy.

We are now in the market cycle of, the Fed can do what it wants, so the only thing to figure is what it wants to do.

The next stage of this understanding is in Brainard's speech from last week. The theme of that speech was the transition from "stabilization to accommodation". But I will translate that differently: we got nominal yields where we want them, now the policy focus is on real yields.

A key theme in the speech was this transition of, "stabilization to accommodation." What does that look like. Well, we know from pre covid, at the ZLB, Brainard was in favor of using ycc to reinforce forward guidance. However, "stabilization to accommodation" has further consequences. This theme of transition is right out of the Benoit Coeure playbook. During the stabilization period, what is important, as Coeure put it, is for the central bank to "put its money where its mouth is." QE plays outsized role and has a higher multiplier. Then the transition happens, to accommodation. QE multiplier falls as policy has succeeded in shifting upwards the distribution of risks around the growth outlook. This is when strong odyssean or outcome based forward guidance is most efficacious and asset purchases serve as reinforcement for forward guidance. “As the outlook improves, the signal that asset purchases send regarding the likely date of a first rate hike becomes increasingly important for anchoring the medium to long-term segment of the curve.” This is where the Fed is: they have cutoff the mechanism in which good news is priced into any part of the yield curve and they plan on reinforcing that, whether that is outcome based forward guidance with curve caps or not, I'm not sure it will matter. The market already knows. The Fed’s policy goal is to prevent bad things and accentuate good things.

So the skew for real yields is still towards going further negative. A few things:

- The market has transitioned from thinking policy can't respond to this size of a shock, to where it is now, policy can do anything. Betting on rising real yields is basically a bet policy is outmatched versus the size of the shock. That has been the wrong bet.

- Assuming my previous note about the dollar being a solved problem is in the ballpark, the chances of a runaway dollar clogging up the financial plumbing and constricting trade finance again has been severely reduced.

- The traditional Phillips Curve is dead. Maybe the New Keynesians have it right (marginal cost driven as opposed to slack). In fairness, they did tell us to look through current slack. Future marginal costs matter more than current economic activity. I.e. there is this form of discounting which leads to stickiness. But either way, in a world that policy makers are going to be expected to replace lost incomes, the distribution of potential economic outcomes is changed.

One of the things that weighed so heavily on bonds and breakevens in the prior decade was the asymmetry of deflation. When the economy was doing well, inflation did nothing, so imagine what would happen in a recession. That skew has fundamentally changed in a world where lost income is replaced to a certain extent and recoveries are unencumbered by premature stimulus withdrawals.

I'm not sure what stops this chart unless the market is to reevaluate its views on USD. Real yields and precious metals by extension are a just bet on continued policy omnipotence.

The last idiosyncratic rates trade, China

One of the more interesting and frustrating government bond markets in the world has been China. Yields in China seem to be the only place where the market is taking the "V" seriously. And when it comes to things like TSF (total social financing) and industrial production in China, it has been pretty "V" like. To add to this, China following the NPC let rip a special CGB issuance which the NPC fast tracked. Without a big RRR cut and other liquidity measures from the PBoC which were evidently absent, it zapped all the liquidity from the market and yields backed up a lot and the fixing rate from 1.5% to over 2.2%.

The question now is, are Chinese rates the place to receive and get some counter risk exposure. I have been burned on this trade before, but in terms of asymmetry, it ticks all the boxes. The Chinese "V" in industrial activity is more than priced and TSF numbers have likely made policy makers a bit nervous which could see the Q3 numbers come down. And finally, the PBoC is now adding a lot of liquidity even if it is not cutting rates such as the MLF or OMO. Since last week, the net injection of reverse repos has been over 230b RMB. To me, at a minimum this is policy makers saying, rates have gone far enough. And if that is the case, you get some negative equity correlation with a good risk reward.

A trade I am really interested in is a cross currency steepener with Korea. Basically the idea is, if Chinese industrial activity is again leading the global economy out of covid, then the backend of Korea should begin to reflect that. So if this is a China led reflation, 10y KRW below 1% is probably wrong. On the flip side, in risk off, Chinese 2y above the fixing rate will move a lot. The point of this trade is, you are vol-adjusted received, and in case reflation goes into third gear, you're paid some duration and hoping the front end of China still sticks towards the fixing.



Is the JGB curve ironically the best DM steepener? 

Not so many people spend much time on JGBs anymore, and probably for good reason, it's barely a market at this point. With that said, there seem to be a few interesting parts to the market, especially given the external backdrop.

Going back at least a year, in the very front end (tbills) and the very long end, there has been a lot of interesting things going in JGBs, even if YCC has crushed everything in between

- In the long end, the BoJ has not been shy about encouraging steepness in the name of financial stability. This has been clear in FSR's (financial system report) and Rinban schedules of long end purchases. The BoJ is firmly aware that too flat of a curve is a problem for its bank/saving heavy economy. Throw on covid and budget blowout after at least two supplementary budgets, it makes sense the curve has steepened quite a lot, especially in the back end.



- In the short end, something else has been going on over the past couple years ago and it explains why foreign ownership of JGBs has soared. Basically, as Japan was one of the biggest users in the FX swap market in terms of funding/hedging USD, its cross currency basis swap spread traded very negative. Because of this dynamic, money would come into the FX swap market to take advantage of this very negative spread. What happens is, money comes in to take the other side of Japanese lifer/pension money looking for USD, usually at 3m point. Lifers would swap Yen for USD, to either US banks or reserve managers sitting on USD. Now, with all that Yen, these players would then buy Japanese tbills, which because of the negative xccy created a massive yield pickup over equivalent treasuries or bunds. However, given where FX basis trades now, the Japanese carry trade is a bit less compelling.



This dynamic could set Japan up to actually be the most asymmetric steepener out there. What we have seen so far is, as it relates to DM curves is, anything with carry and rolldown gets taken in, which explains the foreign bid in ACGBs. However, the background of that is, if FX basis is normalized, Japan can go back to getting foreign hedged yield pickup abroad, which will weigh on the long end in JGBs. Basically the point of this is, 2s30s Japan is being encouraged to steepen by both policy makers and dynamics within the financial plumbing. It can't go forever, but Japan may ironically be the place to steepen.

Japan more so than anyone else explicitly wants steepness in the curve and some of the technical backdrops may go to reinforce that bias. Of course there will be cuteness with overseas buying of JGBs on asset swap to take advantage, but the bias of the long end of the curve is to steepen and Kuroda wants the same thing.

@jturek18, jonturek@gmail.com

What if the Dollar is a "Solved" Problem

Sections: 

- Markets in two times frames

- Is the dollar a solved problem

- Relative FX vols, change in regime

- A lot is happening in China, what if CNH strengthens

Markets in two time frames

One of the things that is very interesting to me at the moment is, the current macro risk setup seems to be occurring over two different time horizons. Yes, markets are bid again, but really spoos have been stuck in the 3100-3120 area for the past week now.

In the near term, the macro setup seems to have a few headwinds. Reintroduction of mitigation measures in Beijing, rising positive test rates across the south/west in the US, rising possibilities of W's across many high frequency indicators and pending fiscal cliffs most notably in the US.

However, over the longer term, there are some very bullish things happening. One, the dollar is appearing to look like a solved problem (will further explain this below), at a minimum, the Fed has nipped the $ feedback loop in the butt. Second, the European recovery fund is not perfect but it is a paradigm shift in terms of fiscal transfers and expands fiscal scope for the periphery. Third, it seems like there will be a vaccine, and with the discount rate at 0, the waiting game is doable. And lastly, maybe most importantly, the global economy's fiscal posture looks like it could outlast covid, which either changes the distribution in terms of pricing demand shocks, or best case, leads to a bit of a demand side revolution where governments transition from economic cushions to economic accelerants. Either way, the skew is positive.

With that said, the path there will be messy and likely will entail multiple retests. In terms of equities, one of those levels that has been of great interest to me recently has been 2950 area in S&Ps. That is where, the rally shifted from tech led to cyclicals led. Now, as the rise in new cases accelerates and some of the promising high frequency data appears to be showing signs of rolling over, tech has reestablished itself as the leader of this rally. If we stay in this current environment, especially with a fairly nasty quarterly rebal on the horizon at month end, S&Ps should be biased lower over the next few weeks. After that, the debate in price action returns to, how long will this fiscal impulse be with us. If it is temporary, tech by itself can keep the major averages fairly elevated, likely above 2850 in S&Ps. However if this fiscal impulse will transcend covid, multiples look a lot less scary and equity risk premia will continue to be taken in. To me, the balance of risks is, going into potentially slowing high frequency data and fiscal cliffs (end of July), the market will have a tough time absorbing quarter end, however, once the fiscal impulse globally is clearer and sustainable, the market will have little trouble discounting a turbulent fall in terms of the virus.

Is the dollar a solved problem? 

I want to preface this section by saying, this is not an all clear on selling the dollar. However, there is something very interesting about the dollar backdrop that could have massive global economic implications. The question for the dollar has shifted. Given the Fed backdrop and potential for sustained synchronized global fiscal expansion, the question is not what if the dollar has an ugly break higher, the question now is, what is the catalyst that turns the dollar into 2017 mode and trend weaker.

Dollar liquidity has gotten a bit interesting again. Bill supply, huge TGA cash balance, first swap line maturities, slowing swap line operations etc. The thing is, the counter measures are already in place. Between the CB program at OIS+25bps and the repo program, stress should be under control, as the combination of these programs should keep the market liquid and balanced.

In March, before the Fed expanded its CB swap program, I did a post on why the Fed might be challenged this time around in terms of arresting USD strength. The main reason was, this time around, the dollar crisis was not really on the sovereign or banking side, it was in Asia non bank financials and EM corporates.

So the question was, could the Fed properly downstream dollars to these actors. The answer has been, yes they can.

1) In the face of very lengthy and credit intensive supply chains, trade finance has become very important part of the global trade process for global value chains (Bruno, Shin). The fear was, as eloquently put by Agustin Carstens from the BIS, central banks do not have direct levers to address NFC's financial stress as they have for banks, making support measures more difficult. These GVC's are all over the world, and even for the ones in countries with swap line access, getting the dollars downstream is technically difficult, especially in a stress episode. So the question was, given the links between trade finance and the broad dollar (Shin), could the Fed prevent a spiral.



2) In terms of the maturity transformation trade, it was no longer European banks doing RMBS, it was Japanese life insurer's funding in the front to buy US credit duration. So not only did the non bank sector become a bigger player in the FX swap market, it ended up dwarfing anyone else, especially banks, which in Japan do a lot of funding in USD. 

So the Fed had a real job on their hands, would they be able to effectively downstream USD throughout the global financial system, and into what was a much more complicated backdrop than 2008/9, as many of these players didn't have direct access to swap lines.



Now where are we. Well, with regard to pretty much every concern listed above, the counter measures are already in place.

If March dollars need to be rolled, they can at Fed price. If the trend continues, and there is less need to roll those dollars as a lot of the late March take up was preemptive, then some money could come out of the FX swap market; or if bill supply nudges unsecured, then repo take-up rises and the fire is put out. Basically, between swap line and repo operations, the Fed has capped problems in the FX swap market, which in sharp dollar moves has been the fulcrum place where stress shows up. So if the FX swap market is not going to be under stress as the Fed has basically created the best wack-a-mole player of all time by effectively turning most large gov't bond markets into dollars (Pozsar), the dollar shortage is gone. And, if Fed policy is to try and run a hot economy, pulling the swap lines early or hiking the rate to OIS+50, wouldn't be in line with the rest of their policy bias. The Fed won't be keen to have the dollar feedback loop or relative demand for US assets upend any signs of an economic recovery.

The next aspect of the positive dollar narrative has been, it's the other side of important currencies that have negative skew, namely, CNH and EUR. The market has been obsessed about risks such as, Chinese devaluations and European fragmentation. However, if we look at both of these risks relative to March, a lot has changed. Europe's attempt at fiscal transfers may not be perfect in terms of size or composition, but it is a game changer in terms of precedent. Grants via the Commission innately expanded fiscal scope for the periphery and as we have seen with APP, it's easier to make it larger than it is to start it...... Is Europe fixed, no, should EURUSD trade below 1.08, where it was when fragmentation risk was very real, also no. China is bit more complicated, but the policy backdrop is not for CNH weakness. Interest rate differentials aside, the risk of tit for tat tariff/CNH depreciation is over. Could the White House turn on the heat going into the election, possibly but there is very little sign of that. Now the question is, would China want a weaker exchange rate in absence of US trade pressure. That also seems very unlikely. China has prioritized financial opening up and as China has learned, the policy response to excess savings is not a weaker exchange rate.

To conclude: none of these things necessarily mean the dollar is about to weaken in a significant way. What it does suggest, the scope for another sharp and aggressive rise in the dollar is very unlikely.  Between the Fed playing wack-a-mole with CB swaps and repo in the FX swap market, Europe is not falling apart and China is not pursuing a weaker currency, the dollar seems like a solved problem. Now, this does not mean some of these recent moves in EM can't get vicious again, they can. Latam FX especially looks vulnerable with covid fears back in the fold, murky politics and very little defense in terms of carry. The bigger question now is, what is the catalyst for the dollar to have a sustainable move lower. The answer is, as it usually is, global growth and that will in all likelihood be a function of the global fiscal impulse post covid. What is interesting about this though, if the dollar is a "solved" problem, then the left tail in betting on some of these outcomes is significantly reduced. The problem of the last decade has been, betting against US economic outperformance has been a losing one, however in this dollar backdrop it becomes interesting again even if its not the right bet for the next few weeks. The skew for USD has changed, and if that is true, that is a massive macro development.

If the dollar is biased lower, breakevens should be biased higher.



Paradigm shift in relative FX vols?

For the past few years, it has made sense that EURUSD vol has traded inside of USDJPY vol. However, I wonder if that is beginning to change and Euro vol begins to trade outside of Yen vol. The US election makes this a bit murky I guess, but we should regime shift with Euro trading higher vol than Yen. Yen is stuck between cheap dollar funding and GPIF flows. EUR is actually in a make or break moment that it seems like they may just make. With that said, it is very reasonable to see outsized Euro moves given the backdrop of this inflection point. However, where is Yen going given how stable the FX swap market will be and the Fed put is in the market they care most about, investment grade credit.

Overall, it is much easier to imagine an outsized move in Euro over the next year than it is in Yen, given it will likely just be an oscillation between moving hedge ratios to make sure USDJPY stays in the 105-108 area.




A lot is happening in China, what if CNH strengthens

There seem to be a few independent things going on in China that are all quite interesting.

1) The reemergence of mitigation steps in Beijing caught the market a bit offside. Just as a lot of high frequency data was suggesting some level of normalcy was returning to the capital, electricity production in the first ten days of June was the highest it has been since start of the year. Now, the ERL (emergency response level) is back at level 3 and the risks of a "W" have risen. While the number of cases are still low, and track/trace should keep spread under control, this seems like a big blow to a broader resumption in consumption activity, which was already severely lagging the industrial side of the economy.

2) Liquidity in China has been thin to say the least. Following on what appeared to be signs of liquidity marginally improving, MoF brought down the house with massive SCGB issuance that just zapped liquidity from the system. This has jammed the fixing in rates higher and led to a severe sell off in CGBs and NDIRS. The question now is, into surely another RRR cut, and efforts to get liquidity into the system, is the move fade-able. This question is especially prevalent if current activity indicators are going to turn lower in the near term on the back of mitigation measures in Beijing.

3) Chinese foreign policy has been busy. In the span of one week we have seen, alleged Australia cyber attack, clashes on Sino/Indian border in the Himalayas, airspace intrusions in Taiwan, flair ups in the DMZ and of course HK national security law. And in the backdrop of all of this, a meeting with the US in Hawaii. Is China taking advantage of something or are they trying to divert attention from something more meaningful. This space seems worth watching.

4) Chinese tech stocks are flying and back to crushing industrial beta. Chinese tech is even outperforming US tech since the beginning of June.

To be honest, I have not been able to put all of these things together. With that said, to me, USDCNH is getting very interesting. The most interesting part of this chart is the "what if." We know what a world of USDCNH between 7 and 7.10 looks like, but one where USDCNH breaks this trend line is a fundamentally different world and it is one that is increasingly worth entertaining.




All the best and stay safe. jonturek@gmail, @jturek18.

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.

The Global Savings Glut, a Modern Policy Failure

Back in February I put out a piece called the "Imperial Circle part 2, the feedback loop between rising US asset prices and slowing global growth". From this angle, I wanted to look at other imbalances either financially or economically and have found a lot of them come from this original savings glut that Bernanke highlighted back in 2003. However, while a lot of these factors are structural, many of them are a function of a policy choice, which is worth remembering as this crisis will likely trigger policy changes. However, without changes, these forces are immense and will continue to exert themselves over markets and the global economy. The goal of this note is to combine a lot of macro themes under the umbrella of a meta theme, there is too much global savings.

One of the reasons the long US short RoW trade has dominated is, many DM countries have the trade on, either implicitly or explicitly, or both! Going forward, the question is, is the virus enough of a force to change these dynamics. I think it is, but it will take time. The French+German proposal today could be the start of that change.

Sections:

- How did we get here. Globalization ended in 2011 and no one adjusted. Export based policy and high savings rates reinforced each other even as globalization forces weakened starting in 2011. The dollar was both rewarded as the place that could accommodate this excess savings but also reinforced the dynamic by inflicting pain on export based economies.

- Too many savers post GFC. Everyone wanted to save, governments pulled back, households were in balance sheet recession (Koo) and corporates had very few attractive investment options. If everyone is saving, someone must be dissaving in a big way. The US did and was rewarded for it. We are operating in a world where there is a massive excess of capital vs. productive places to put it. Which is why valuations on high quality assets able to absorb this savings is so high.

- This dynamic neutered monetary policy. Via slower global growth and an immense demand for safe assets, the neutral level of interest was crushed. In that world, monetary policy is not really easing but just keeping pace. If policy can't get inside r*, its adjusting, not easing.

How did we get here

Going back pre 2008. China wanted to be the world's manufacturer but it didn't want to take the exchange rate adjustment that came with it. And if China didn't want to accept a higher exchange rate, the countries that were selling to them, surplus Asia and Europe, weren't going to be keen to have one either. So there is a gap between purchasing power and money coming, that imbalance is worked out via higher savings rate and a continued rise in the current account balance.

So as trade grows, and countries fight against exchange rate adjustments, rising incomes don't get spent because they are effectively constrained by an artificially weak exchange rate. The world then had a choice, rebalance surpluses into buying more US goods via a fair exchange rate regime or just send into the US via demand for financial assets. They chose the latter.

This is one of the reasons the status quo has persisted. US manufacturing never got a chance because it's constrained via a strong FX and it is why there was never a meaningful pickup in consumption as a percentage of growth in the surplus world. Relative exchange rate regimes reinforced this dynamic of, surplus world doesn't spend and the US doesn't save.

The negative dollar spillover

The dollar problem from this became more obvious as Chinese demand began to structurally fall as the credit impulse weakened. Much of the global economy had a fairly simple model, export to china and recycle surplus' into USD. Exchange rates stay tame and the money is better in USTs/US IG/ Tech sector etc. than anywhere else.

However, the financial side of the economy began to inflict pain on the real side. Money comes into the US, the dollar goes up, and that slows global trade. But it also set up a more troublesome effective doom loop. The dollar would rise, inflict pain on global trade, and then rise even more because the US is a relatively closed economy and less exposed to global trade. And what has been the only way out of this doom loop as post GFC global trade has been relatively weak, Chinese credit expansions.

It is not a coincidence that the only time we have seen real sustained USD weakness since the GFC is post China stimulus episodes (arrows meant to mark three most significant Chinese credit expansions).

Globalization died in 2011, no one adjusted

One of my favorite charts is from Hyun Song Shin at the BIS, ratio of world goods exports to world GDP. It shows a pretty remarkable fact, globalization was dying before Brexit, the Trump election and the trade war.

Despite this post crisis shift, growth composition for many advanced economies has been incredibly sticky with exports still making up over 30% of GDP in much of Asia and Europe.



These two charts are structurally disinflationary. World GDP has changed, but advanced country growth composition has not. And the problem is, from a policy perspective, the response has been to chase after lost external demand instead of reforms that rebalance the composition of domestic growth more towards consumption.

If we look at European policy making from post Euro crisis on, that is basically what happened. External demand started falling, and the reaction was, we'll try adjusting the currency to rebalance. This is how Europe got to negative interest rates while running primary surpluses. The reaction was to chase demand that wasn't coming back instead of investing domestically. That is basically what nirp is, another way of weakening the currency at the expense of domestic demand (local credit channel). Nirp ends up being a sort of tradeoff between the external and domestic sectors of the economy. The world doubled down on trying to save imported demand instead of figuring out how to grow internally.


Massive savings rates, a policy failure

As the world economy was doubling down on an economic model that was clearly structurally broken, savings rates continue to move higher as investment doesn't seem that compelling in weak NGDP world. The world economy shifted and Asia+Europe didn't get the message, so the imbalance between savings and investment grows even wider. And to add onto this, governments were running fiscal surpluses....



So what do we have now. A balance sheet recession with both the private and public sector trying to save. So savings rates in places like East Asia hit 40% of regional GDP. The gov't wants to run a primary surplus, households and business are either repairing balance sheets or are not seeing attractive investment options because NGDP is low. So where does all this money go..... Financial markets have to absorb it. One problem is, the amount of savings in Asia and Europe was far bigger than the size of their domestic asset markets.

While governments weren't spending, monetary policy was doing QE, removing the few government bonds from the market. And, on average, Asia + Europe lifer insurer assets are over 12x the size of their respective domestic IG bond markets according to the IMF's October 2019 GFSR. So there is no risk free assets and not nearly enough investment grade bonds. So where does the money go if there's no place for it at home, to whomever who can absorb it, which has always been the US.

As Bernanke said in 2007, you want to explain Greenspans "conundrum" here it is. The world saves and funnels it into the US. Term premia never had a chance......




The Japan example

The Japanese financial economy was given a tricky hand. The BoJ owns over 50% of the JGB market. And other than a post Abenomics three arrow blip, bank lending never really went anywhere. So we had this immense transfer of JGB holdings from financial sector to the BoJ. Combine the financial world with massive non bank sector (Lifers etc.) and you get a +3 trillion dollar positive NIIP position. Japanese demand for foreign assets grows every year and it is perfectly logical. Lifer assets are almost 25x the size of their domestic IG bond market and the BoJ owns half the JGBs, what else was there to do.



Another example of this, but with very different characteristics has been Taiwan (5th biggest NIIP in the world). In Taiwan, life insurance asset are over 150% GDP. Creating this imbalance has been a central bank that has repressed the exchange rate to defend the tradeable goods sector and now almost more importantly the non bank financial sector which has built up a very large implicit and explicit FX position. These three Asian economies are sending over 1.4 trillion USD into US credit markets.




The savings glut killed monetary policy

This global savings imbalance has created a big problem for monetary policy.

1) It is a position that is effectively short NGDP. If both private and public sector has a savings impulse, both growth and inflation fall. As the world is highly integrated, those conditions are exported. If r* is falling in Asia and Europe, it will be falling in the US as well.

2) So there are two ways excess savings relate to the neutral level of interest. First, it leads to lower growth as money cannot find productive places to invest or spend. Second, a key part of the calculation for the r* is a the demand for safe assets. So growth is slow and savings leads to a heightened demand for safe assets, interest rates around the world fall.

3) This has contributed to a smaller monetary policy impetus. One, it has driven policy rates around the world to the lower bound. But two, it has never really given policy a chance. We know that rate of accommodation (excluding LSAPs/forward guidance) of monetary policy is the stance of policy relative to the neutral level of interest, which of course is unknowable in real time. However, if global savings via slower global growth and an immense demand for safe assets is crushing the neutral level of interest, then monetary policy is not really easing but just keeping pace. If policy can't get inside r*, it's not really easing, it's adjusting. Said another way, savings have forced CBs to cut in order to not be tightening.

r* has become more and more a global phenomena. Data is from Jorda and Taylor, "Riders on a Storm" paper from last years Jackson Hole.



EM has had an uneven relationship with this savings backdrop

The spillover of this global savings backdrop and DM central banks at the lower bound is, the carry trade. In EM, the carry trade was executed in two stages. First, EM's issued in FX denom (Eichengreen original sin), that didn't work. The way EMs fixed this is by issuing a lot more in local currency and given how low DM yields are, INDOgbs or SAGBs, became very attractive. The problem now is original sin redux (Carstens&Shin). It is difficult for these markets to handle this sort of inflow and countries like South Africa, Indonesia, Mexico, end up with around 40% of the local government bonds in the hands of non resident portfolio flows.



So while yes, it is an advantage that low DM rates have forced capital into parts of the world that need it to further their development, it has come at the cost of volatility. These swings in capital flows since the GFC have become the new normal. EM has way bigger issues than capital flows, but these massive oscillations may have ended up doing more harm than good. This is of course nothing new for EM but this backdrop has helped foster a new vulnerability.




Overall: These all seem to be separate macroeconomic imbalances. Slowing global trade, high savings, low r*, EM flows. However, the umbrella in which they all seem to fit under is the world outlined above, a world that saves too much. And what is interesting from both a trading and a macroeconomic point of view, a lot of this was just a policy choice.

Getting out of the pandemic, there are two outcomes for the private sector. One, a liquidity crisis turning into a solvency crisis, or they are saved and develop a massive savings impulse after this ends. This is why all these plans for fiscal involve some sort of debt forgiveness or socializing necessary costs. Policy will be pushed, whether it knows it or not, to "free" private sector balance sheets.