The Gravitational Pull of the Lower Bound

The idea of this is not to say the world is ending, or that this is an economic forecast in any way. The point of this note is to offer a different perspective on what is currently weighing on the bond market as the broader context of these under-appreciated technicals seems very important. Also, if these factors are right, and continue to push yields lower, it will end up being very supportive for asset prices, especially in the US.

We are at a critical stage in monetary policy in the US. Three key themes. 

1) When r* is this low, there is an innate bimodal distribution for the funds rate, you are either close to neutral or close to 0. And this is the exact setup the market is facing now, does 50 do the job or does 0 beckon. Did the Fed adjust to a shifting goal post in terms of neutral, or is this part of a "natural" move to 0. We will soon find out and it should create real two way action in Eurodollars going forward.

2) There is considerable research to suggest the ZLB is binding a significant percentage of the time when r* is low. Ben Bernanke has made this point multiple times over the past year, most recently in his keynote speech at the AEA conference in January. Bernanke's point was, assuming r* in the US of 1%, there are Lower for Longer (L4L) policies the Fed can do to add policy space and minimize ZLB episodes. His forecasts show that under a traditional Taylor rule with 2% inflation target and r* of 1%, the lower bound is binding 30% of the time. Even assuming L4L policies, that number is still around 20%. The point is, ZLB episodes are extremely difficult to avoid when r* is this low, that's just the nature of the beast.

3) The other source of this gravitational pull towards 0 is, divergent interest rate levels are innately unsustainable. The Fed wants to react domestic factors in line with their dual mandate of price stability and maximum employment. However, too much of the policy setting is set abroad. As we learned in Jackson Hole this year from the terrific Riders on a Storm paper, around 50% of the of the monetary policy stance comes from global factors. This goes a long way in explaining that despite 50 year lows in unemployment and inflation not far from target, the Fed has now cut 125bps in less than a year.

Conclusion: 

The market and FOMC are entering a critical phase which seems bimodal in an outcome sense. Either, the Fed was able to instill enough accommodation to reduce ZLB risks, as their research suggests, when close to 0 act swiftly, or, the natural forces of this very low r* world are exerting their natural forces and bringing down the funds rate to its lower bound. Said another way, will the Fed be able to adjust for lower r* and tighter financial conditions, as they did in 2019 in response to tariffs. Or, have we reached the point of no return in terms of the immense pull of a binding lower bound.

The Fed is in no mans land between neutral and 0, the power of the zero lower bound pull

One of the things that is most interesting at the moment is the sheer speed at which the market priced Fed rate cuts. There is a cascading feeling to US bond yields at the moment and the reason is deeper than just uncertainty about the current shock.

The problem the Fed has, and why the market has gone so fast in pricing implieds, the Fed is is no mans land. As we have seen in research from places like DE Shaw, when r* is low, there is an innate bimodal distribution to the funds rate.

The sum of it is, you are close to neutral or at zero.

As the shock has evolved the, market has transitioned from pricing natural negative permia of an asymmetric reaction function, to the pressing need for rate cuts to arrest the decline in financial conditions. As the market prices a lower policy rate, the gravity of the lower bound begins to kick in and this vicious rally in bonds begins.

One of the reasons the Fed was relatively aggressive last year in lowering the policy rate was because of the well known research that when you are close to the lower bound, you have to be aggressive to minimize the chances of hitting it. This is why the research topic du jour in the Fed framework review has been about creating policy space in a low r* world. The problem now is, this shock is different than tariffs via the exchange rate channel (limiting USD upside), and the Fed has already played the insurance card. The gravity of the ZLB is, 125bps in rate cuts over the course of the year is no longer insurance. I.e. part of the reason this move in rates has been so swift is, the market has to consider that the "adjustment" period is over and zero beckons. The idea that Fed can continue to recalibrate policy relative to their celestial stars is getting exhausted. That doesn't mean they cant cut 100bps and say job done, but the real message of this move in market pricing is, the Fed is caught in no mans land and "gravity" or the binding ZLB will continue to pull them to zero in the case of shocks.

This chart is Bernanke's estimates for ZLB frequency under a traditional Taylor rule model and 2% inflation target. As we know from his work with Kiley and Roberts last year, that under assumption that r* = 1, the ZLB is binding around 30% of the time. Even with some lower for longer (L4L) policies like QE and forward guidance, the ZLB is still binding around 20% of the time. The point is, especially under more traditional monetary policy settings, it doesn't take much to push the Fed back to zero.




So what do we know so far, 2 things:

1) When r* is low, the bindingness of the ZLB bites and is like gravity pulling interest rates to zero

2) When r* is low, there is innate bimodal distribution, you are either at neutral or zero

Now, this is pretty powerful on its own, but what if r* is even lower. Both the DE Shaw chart and much of Bernanke/Kily/Roberts, have base assumption that r* is 1. What if its 0....

One of the biggest differences between 0 and 1 in terms of the level of real neutral rates is, there is more room for L4L policies to contribute at r*=1 in terms of adding policy space and limiting chances of ZLB episodes. Bernanke said, if the nominal neutral interest rate is between 2-3%, which is what is assumed for the US economy, then L4L (lower for longer) policies can add up to 3% of policy space at the lower bound.

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

So now we have to add a third finding, if the r* is actually closer to 0 than 1, than the Fed even by adopting lower for longer policies, which they will for sure try and do with their strategic review, will still very much struggle in preventing ZLB episodes.

Another factor in pricing the funds rate, so much of r* comes from abroad

One of the more interesting macro themes of the past few year, which continues to prove itself, is that divergence, especially in monetary policy is unsustainable. There have been two key papers from the academic side that encapsulate this message.

1) Something Kristin Forbes has been talking about since Sintra 2018, there is a global Phillips Curve and that has a massive impact on the slope of any local curve. In her latest paper, a couple months ago, "Inflation Dynamics; Dead, Dormant or Determined Abroad?" Dr. Forbes posits that domestic CPI inflation is increasingly determined abroad.

One of the charts from her paper show, that incorporating "global variables" such as commodity prices, world slack, exchange rates, and global value chains, are necessary in forecasting domestic inflation.

"This chart shows the resulting “error” between actual inflation and inflation explained using the rolling estimates. It shows the superior performance of the model with the global variables (in red) relative to that with only the domestic variables (in grey) and with the domestic variables plus import prices (dashed black)."

If global factors lead to reduced model error in expected inflation outcomes, then obviously global variables are having a large impact on domestic prices.

2) Arguably the star paper from Jackson Hole this year, "Riders on a Storm", shows that interest rates are increasingly correlated to moves other than Central Bank reaction functions and domestic mandates.

"Taken together, the average monetary policy stance explains only about half of the variation in interest rates. The other half of the time, interest rates move for reasons other than a central banks response to the economic outlook."

Variance decomposition of real short term interest rates (calculations by Jorda and Taylor)

The point is, inflation and neutral interest rates are increasingly a globalized concept, monetary policy does not exist in a vacuum. Another example of this, from their paper is how synchronized policy rates have become.

Stance of monetary policy is highly synchronized (calculations by Jorda and Taylor)

Global factors are pushing the Fed, despite the FOMC being the closest CB to its mandate.

So to update again, now we have 4 strong factors anchoring front end yields lower

1) When r* is low, the bindingness of the ZLB bites and is like gravity pulling interest rates to zero.

2) When r* is low, there is innate bimodal distribution, you are either at neutral or zero.

3) If r* is below 1%, the ability for the Fed to minimize ZLB episodes is further curtailed.

4) Low r* has large global beta, from the nominal neutral level of interest to inflationary forces.

If the Fed ends up at 0, what comes next, steepeners never work but they may have to this time

A good place to look at how the Fed will likely respond in the case of conventional policy space running out, is Governor Brainard.

One of the reasons steepeners have been a brutal trade since the middle of last year is, despite their approach of preemptive policy, the Fed has not really been cutting to get ahead, they have been cutting relative to shifting goal posts. This is why the dollar has remained strong and the curve flat.

However, this time really could be different, especially with 10y note yields sub 1%. If the market is seriously going to entertain the lower bound, then we know two things.

First, it will stay there a while. Brainard's February speech shows this, once you get to 0, you stay.

"Forward guidance that commits to refrain from lifting the policy rate from its lower bound until full employment and 2 percent inflation are achieved is vital to ensure achievement of our dual mandate goals with compressed conventional policy space." 

Second, as the same Brainard speech shows, the Fed will consider some sort of YCC via caps on interest rates in the short to medium term part of the yield curve.

Conclusion: If the market has to entertain the lower bound, there are two key things that should continue to favor steepeners. 1) the very front end will continue to glide towards 0 while the belly of the curve is running out of room to rally if part of the response mechanism is going to be caps on the belly. 2) If the Fed were to do YCC type thing, 2s are anchored to the ELB, tenors outside the cap have to price a normal distribution + the floor of caps. Basically, if the market wants to price 0, the very front end has plenty of room to rally, that case is less compelling in the outer parts of the curve in a very mechanical sense.

Thanks for reading. best place for comments and feedback is by email, jonturek@gmail.com

Imperial Circle Part 2: The Long US Asset/Short Global Growth Feedback Loop

This post will not be based on any specific trade ideas but rather on what appears to be one of the more dominant macro themes out there and one I have been spending a lot of time looking at. Most of the things here are very well known, the world is very long US assets. However, I don't think many people are looking at the interconnectedness of it all, especially as it relates to the real economy. 

The most obvious macro theme is and has been being long S&Ps, USD and bonds. There are many reasons for individually each of these have done well. The question I am interested in is what has them so interconnected, self fulfilling and sufficient in terms of durability.

The basic point is, there are two ways in which the not only do bonds/S&Ps/USD do well on their own, but actually create a positive feedback loop for each-other that has proven to be remarkably durable. The consequences have been massive US asset outperformance and lower global GDP mostly via the dollar. 

This is what is unique about this version of the imperial circle, it leads to divergent outcomes between global growth and US asset prices. The US has been rewarded for being the only place able to absorb this massive global savings glut, mostly from Asia. The knock on has been, money floods the US, USD rises and then hurts global growth. Not only do these coexist but they have become self reinforcing in a way. Anyway, this my attempt at connecting the duality of money flooding US risk markets and the dampening effect the strong dollar has on global growth as they are clearly connected.  

Two interconnected factors, capital flows and economic effects:

1) Capital flows

The $8t Asian saver (Asia IIP) has neither yield nor capacity to deal with the size of domestic savings, so they need to be exported. What has capacity and yield, the US' balance sheet in both corp and UST. So what happens is simple, Asian savings flood the US. However, these pensions/lifers in Asia would rather not take currency risk, and post 2018, FX hedged yields in terms of USTs were actually negative relative to domestic JGBs KTBs etc. 

So two things happen as the US is still the only place that can take this capacity. Asian savings move out the risk curve and takes more naked FX risk. And they did both. We know this in places like Taiwan were lifer assets are 150% of domestic GDP, now over 20% of their book is FX unhedged. 

So when FX basis crushed yield pickup in the US, Asian savings transitioned into IG/take more FX risk. 

(data from IMF GFSR 2019)




This chart is a ratio of Lifer assets relative to size of domestic corp bond market according to the IMF. As I've seen Mark Dow post on twitter, there is a massive global asset shortage, it's very pronounced in Asia and it has forced this money into the US. Pretty much for all of surplus Asia, the size of lifer assets is +10x the size of their domestic IG market, with Japan the extreme at over 20x. 



2) Doom loop in terms of lower global output

There seem to be two key parts to the dollars relation to the global economy. The way this ties into asset shortage part is, demand for US assets has been an important factor in USD strength. 

One, we know USD tends to do well in times of weaker global growth because the US is by far the least levered DM economy to China. DM exports still account for +20% of GDP, in the US that number is closer to 12%. One of the reasons that structurally growth is so low is because global trade is not the engine it once was and DM is just as levered to it. This is why the market is crying out for fiscal, there needs to be a composition shift away from NX to C+I in terms of GDP. Anyway, the point is, the dollar tends to outperform when global GDP is weaker because it is less exposed to global trade.

The other angle is, the dollar itself can hurt global trade and output. This is Hyun Song Shin at the BIS and Gita Gopinath when she was at Harvard. Gita takes the global invoicing angle and Hyun looks at it from a financing perspective. The focus of Hyun's recent paper in October is, a broad appreciation of the dollar dampens international trade by weighing on the operation of credit intensive global value chains (GVCs). 

From Hyun, USD inverse relationship with global trade.



If we combine these two angles of (2), one that the dollar outperforms when global growth is weak due to lower beta, and that the a strong dollar can "impose" global trade weakness via the credit supply channel, a pretty brutal doom loop is formed. The dollar rallies because global growth is weak and then imposes pain on GVCs which makes global growth even weaker and the dollar rallies more etc.

As Mark Carney said at Jackson Hole last year, this is a natural problem with the US share of global GDP shrinking but USDs role is not.

This chasm between US as percentage of global GDP and the role the dollar plays is structurally disinflationary. 

"These dynamics are now increasing the risks of a global liquidity trap. In particular, the IMFS is structurally lowering the global equilibrium interest rate, r*, by: - feeding a global savings glut, as EMEs defensively accumulate reserves of safe US dollar assets against the backdrop of an inadequate and fragmented global financial safety net; - reducing the scale of sustainable cross border flows, and as a result lowering the rate of global potential growth; and - fattening of the left-hand tail and increasing the downside skew of likely economic outcomes." - Mark Carney 

(data from Mark Carney JH speech)

Combining the rush of foreign capital into the US with the strong dollars global effect

Now we add in (1) and the fact that all this excess savings is going to basically to one place, and you have a new sort of imperial circle but one that is slightly different mechanistically than the one Soros diagnosed in the 80s. But, one that is also creating this sort of feedback loop, however this one is connecting the financial economy and the real one in a very divergent manner. 

Soros Imperial Circle: combination of high rates, fiscal and strong dollar all together create this virtuous circle.

Current dollar feedback loop: a strong USD, lower global growth and the global savings glut feed off each other in way that suppress real interest rates and elevates asset prices.

The current regime offers stronger durability

Eventually what broke the imperial circle was excess dollar strength. However, there is something fundamentally different now, the low neutral rate world has been effectively making sure this dynamic of flooding US markets continues. So what happens:

Real money buys US financial assets:

Step 1: credit tightens and stocks go up

Step 2: dollar goes up

Step 3: Even though risk is bid, bonds actually go up in price because they have to price the second derivative, strengthening USD and the negative effect that has on growth.

And step 3 shows how this cycle continues in an immensely durable way. The dollar and the bond market effectively keep each-other in check. And of course, given the low neutral interest rate world and asymmetric monetary policy response function, the Fed can backstop that bond market reaction. Which is what we saw in 2019. The Fed had to cut to stand still in an FX sense given what effect the tariffs were having and the Chinese using the exchange rate as a shock absorber. 

So the dollar goes up, which triggers a stronger and flatter bond market, which keeps the dollar in check and excites asset markets. That is the durability element. 

Conclusion:

The US is in the process of a monster sucking in of capital from the rest of the world. This is very easy to see in the IMF BoP data which basically shows a 1:1 match of big positive NIIP positions equaling out in the US' negative one.Basically the world saves a lot and then invests in US because it has the combination of best growth and maybe more importantly, the most capacity.

Global NIIP v US (ex Taiwan, which is fifth biggest in the world)

(data from IMF)



Then we combine the current dynamic of these two forces: the US sucking in global savings and the dollar reflecting/contributing to lower outcomes in terms of global output. It seems like the one of the biggest macro dualities effecting global markets and is it very durable as the feedback loop is very well reinforced. Savings come to the US, the side effect of that is USD constrains global growth and that reinforces the short GDP trade which is long duration and USD. 

The question now is, what ends this regime, rate differentials haven't mattered yet



In theory, the dollar should have been a compelling short for much the past few months as it set up in such an asymmetric fashion. Either growth around the world was going to pickup or the Fed was going to cut more. Interest rate differentials have topped in the developed world and the dollar will have to price that. Neither have really happened, and DM rate differentials continue to narrow. 

In a low r* world, with most of the developed world at the ELB, in risk-off periods the Fed is the only ones with ammunition. This fear was very prevalent last year, so much so that it forced the ECB to get out ahead of this potential narrative by cutting and more importantly trying to push out the perception of the lower bound in order to keep the EUR capped into Fed cuts. This eventually died out after the September GC meeting. 

Looking at things now however, their fear may have have been misplaced to an extent as narrowing interest rate differentials post facto are having almost zero effect on exchange rate valuations. The question is why. 

The basic idea is, we may have transitioned from measuring the degree of rate differentials to once we establish them, it's about leveraging them out the risk curve. FX has become much more sensitive to capacity in terms of savings absorption than rate differentials in pure isolation, especially in DM. Japanese real money is not going to repatriate because the differential between JGB yields and USTs is narrowing, the problem the GPIF has is not only yield, although mismatch is huge problem for real money, but the other problem is there are not enough assets for them to invest in at home. As the chart above shows, in Japan lifer assets are more than 20x the size of the domestic IG bond market......

The broad dollar recently has been more correlated to relative risk asset performance than yield differentials.

With that in mind, what are the two things that can change this dynamic:

1) US idiosyncratic risk that causes US equities to underperform global peers. 

2) Global growth pickup led by China as the US less levered to Chinese growth than everyone else. 

We can see (2) in the correlation between rising USD and lower global r* via Laubach Williams estimates. 

(data from NY Fed)

The dollar is a both a result of a disinflationary world but also is a culprit in it.

This is a bit confusing but I think it is one of the most important points. I think Taiwan is a very good example of this. Basically, within the current account there is war between the financial side and the goods side. The goods side does poorly in this low NGDP world as agg demand is low. However, the financial side is effectively short these outcome via long USD exposure and a massive duration position in US fixed income. 

What would happen if 2017 reappeared and a Chinese led demand spurred a reflationary episode that pushes up global GDP and global trade and inflation. One would think in that world, USDTWD would be a sell as Taiwan being a a key supply chain would be a large beneficiary of this pickup in global trade volumes. However, and even in the context of a good risk environment, that could pose a problem to the Taiwanese economy. The lifers have a huge effective long USD exposure via over 20% of their foreign asset position FX unhedged. Brad Setser has done amazing work on this and he shows that if USDTWD were to drop 10%, the lifers would incur over 12.3b USD of losses and they would need to rollover the hedged part of their book even as they were taking losses on the unhedged part, that reduces their capital.

Taiwan is of course an extreme example of this, especially in terms of unhedged risk as the CBC has used intervention to protect the lifers. However, it is just an extreme example of a prevalent trend, Asian savings is short their own real economy. Surplus economies in Asia still get +50% of GDP from exports.  

In its current form, the second derivative of this trade is in a sense hurting their domestic economies via the dollar. 

Short NGDP = long US assets. This chart is US NIIP v SPX/RoW equities ex US. 

To conclude, to me there are few takeaways from this:

1) The world has a short global growth position on via the US on the financial side, while on the output side is still highly levered to it via high export dependency. 

2) There is a massive global asset shortage that is forcing the most money into the place with the most capacity. It is also rewarding it via the currency. 

3) This phenomena is creating a self fulfilling loop in which US equities, the dollar and the bond market reinforce each-others strength. 

Money comes into the US to buy financial assets => hedging costs become prohibitive so more is unhedged => USD stays strong as their immense demand for it from the massive global savings pool => because of USD strength and the effect that has on the global economy, the bond market stays bid and flat => low and flat curves force money further out the risk curve and this circle starts again. 

Vale for now: Neutral Rates, "Symmetric", and EURGBP

I think there are a few interesting things happening that could make the summer quite exciting.

1) Talk of higher neutral rates is deafening. Dudley is entertaining a 3% r* in the US, even in Europe despite this slowdown in economic momentum, Coeure gave a fantastic speech (no surprise there) on the possibility of a reverse hysteresis type phenomena. Given this context, there are some interesting trades in the ER complex and EUR rates. In general, the market is clearing out short vol positions one by one. First US equity vol, then EM via USD, and next will be vol in EUR rates.

2) As I have been writing to a few people recently, there is an interesting dynamic going on between the ECB and Fed. Basically, given the Fed's desire to get to neutral in the face of this fiscal juice over the course of this year AND next, and an ECB still crushing global term premia, we are in the midst of a persistent flattening of the US yield curve. I wanted to suggest that as front month ECB implieds begin to steepen again after this softening of inflation, you could actually begin to see the US curve steepen. I had thought this could create a favorable dynamic for being short EURUSD or long USDCHF. The thought was, either the ECB continues this dove loop with its continental peers (Rix, NBP, etc) or they actually end up giving the Fed more scope to hike by beginning the process of allowing the forwards in the curve to start removing at least some of this term premia crush. Effectively, a term premia transfer from the steeper EUR curve into the US', especially as the ECB can ill afford the end of the Feds hiking cycle. The trade has worked, however, neither really has happened. Yes, the ECB still seems like the key central bank player in terms of dominos, but I believe this "either or" to quote Kierkegaard, can be expressed differently. Long EURGBP.

3) The reaction post the Fed's May policy statement was all about the usage of "symmetric." My first interpretation was, so what, Evans has been talking about this forever and even a likely 4 dots guy, Williams, has been talking about it in the context of his desire for price level targeting. So what's the big deal? I am now beginning to think the market reaction was actually more interesting then the usage of the word itself. Using it twice was purposeful, the Fed knows inflation will likely run above target in the coming months as one offs continue to drop out. Given where the yield curve is, and the desire of the board to have a balanced hiking cycle over the next couple years as fiscal keeps us decently above potential this year and next, this seems like an explicit attempt at steepening the curve. The problem is, the curve didn't steepen, in fact, we are back at the lows...... So what does this mean? The Fed showed their hand, and risk in equities and credit have ripped, which means it could be time for some bottom picking in EMFX.

Trades: Long ERZ9ERZ0, EURGBP, vol in bunds. Also, a no touch in USDMXN

Reverse hysteresis and forward guidance, steeper reds/greens and vol in rates

There are two key elements to this trade, first is the role of FX, second is this possibility of a reverse hysteresis in the face of a loss in near term economic momentum. The two are obviously interconnected so well look at it in one shot. Since the beginning of the year there has been a well documented loss in economic momentum in the Euro-Area. In my opinion there are a few key contributors to this. First, China clearly slowed, surveys, M1 and the LK index all point to a weaker first quarter. The balance of how much more softening regulators will allow, maybe not so much given the RRR cut, and the seasonal contributors related to the new year, is likely key. With that said, given EUR economic beta to the Chinese machine, a softer Q1 in places like Germany makes a lot of sense. External demand is still the key marginal driver of growth, China slowed and the EZ felt it. The other element is domestic factors. However, the ECB has been quick to come out talk about the temporary nature of the slowdown. Especially in inflation, we have seen people like Praet suggest it was temporary factors related to, the cold winter, timing of Easter, labor strikes and even the early innings of capacity constraints in the capital goods sector.

In my opinion this is where the opportunity lies, especially given the current backdrop. Praet's super core measure is running higher than current HICP readings. This means, stickier factors do seem to corroborate the ECB's stance that there are little signs of a material softening in domestic demand. Brent has ripped to almost 80 bucks, EURUSD is basically back at ECB staff macro estimates, and China is trying to re-up liquidity; all at a time that stickier components of inflation are largely behaving as expected. This could be why the market hasn't really budged on aggregate ECB hikes and has just pushed them further out the curve. Looking at Z9Z0 in Euribor is very interesting in this light, especially if FX signaling is such an important variable. ERZ9ERZ0 basically can't trade materially lower on further economic weakness and has a lot of upside to a mean reversion in CESI and the chances of a higher neutral rate (which I will get to). If the data will continue deteriorate as external demand does not pickup, EURUSD will continue on its path to 1.15 at a time oil has absolutely ripped, this means reds/greens have to take into account expected value of rising inflation. Or, this loss in momentum really is just "temporary", which seems to be the ECB's version of "transitory." This is what EUR duration also has to take into account, which makes me think Sintra type fireworks are coming to bunds and buxl as vol has gone to ridiculously low levels. If further econ n/t weakness is priced in FX, duration has to discount an increase in inflation expectations given oil and EUR moving at once. The asymmetry in shorting EUR FI looks pretty decent. This is all at a time scarcity may force a July decision the ECB may ideally want to avoid. Then there is the increased chances of reverse hysteresis kicking in and the limits of forward guidance which we can now get into.

The reverse hysteresis aspect is quite interesting and will play a key role in my FX idea below. Coeure in his speech last month noted that weighing hysteresis on general potential models has proved to be very tricky to flat out wrong in the post crisis world. What we are seeing more and more of is, potential just seems to move with cyclical fluctuations of aggregate demand. This means, in the post crisis world, we are too often confusing "scratches for scars." The ramifications of this for policy is quite interesting. Coeure of course only addresses it within context of current ECB stance, however, it does open door for some interesting hypotheticals especially in the current backdrop. What could happen is, as growth picks up again and inflation gets back closer to target, the market will have to take this idea much more seriously and likely add a lot more ECB hiking scope; maybe r* is more positive than we currently think......  The added part is, Draghi was asked about this in his most recent presser, and instead of entertaining a temporary overshoot in inflation, he opted for the higher neutral rate answer. If he wanted, that could of been an clever way to further the EUR sell-off and he didn't take it. All of this makes it hard for me to be EUR bearish, in fact, quite bullish in some crosses in spite of the steep fwd curve.

On forward guidance. The BIS did an interesting paper recently on forward guidance and the signal value of markets. Going through the references I saw a Coeure speech from last year that I slightly recalled. Given his recent stance and the worries he has re overextending the current forward guidance framework, it was interesting to go back. In that speech, he quotes an interesting Stein paper from 2015, on the time consistency problem with gradualism. The context of this for the ECB is of course on the current forward guidance stance acting as an anchor on rates vol. Constancio has explicitly said the biggest thing that scares him is a rates tantrum. The problem, as Stein notes is, a policy with the primary goal of controlling rates vol won't work over the long term, especially as their assessment of the progress of inflation evolves. Stein coins this as a problem with gradualist equilibria. Coeure is worried about the role it will play in a reaction function sense as the economic assessment evolves. Over the next few months, the ECB could not only be facing scarcity in PSPP, but also reaching the effective time limit in its goal to keep rates vol completely non existent through its current forward guidance framework. What's worth noting is, these things could very well end up happening at the same time.

EUR rates have to deal with inflation that can really only go one way from here at a time both the APP and current forward guidance framework seem to be closing in on their respective limits......
Summer fireworks are coming.

This all should mean EURGBP goes higher



Part of my issue in the last post was my lack of respect for geo-political events, especially in Russia and the Korean Peninsula. Given the fairly poor political dynamic in the Euro Area, it seemed like a good idea to use a cross who's political economy is just as shitty. Brexit is a soap opera that continues to weigh on UK sentiment, especially on the investment side, and the possibilities of an election being called this year are likely real. Of course, politics is not the reason why I like this long. If you recall, from last post, my -USTs+Gilts idea, it is quite similar. I am playing the chance that the respective equilibrium neutral rate is going in the opposite directions for these two economies. What seems to have happened is, sterling got two key things that have now changed. First, the BoE was able to establish a bid by convincing the market of a steeper SONIA curve through forward guidance. Watching short sterling implieds go from 90% to no May hike, puts a big dent in Carney's ability to  establish meaningful scope over the forecast period. The other element was the general tide of liquidity emanating from the Chinese fiscal expansion that fed the world in 2017. Now, survey sentiment is dropping rapidly, capacity is tight, inflation is falling faster than the BoE originally thought in November and Brexit refuses to leave the headlines. A cyclical change in expected potential does not look likely in the UK.

The other element of this trade, and what makes it in my opinion quite asymmetric, is the ECB-Fed dynamic I was talking about in the beginning. Basically, we are in a place where the ECB seems to be in control of how much Fed scope we can have given the effect of QE on term premia. What seems to have happened is, the loss in Euro-Area economic momentum pushed off ECB implieds further out the curve. In turn, we got a higher probability of a APP extension into next year. This creates a tricky dynamic for the Fed which is de facto relying on the ECB to get on with it to help get term premia off this crazy low level. So ECB implieds in whites go to zero, US yield curve forwards cant price any let off, and the relentless flattening continues as the Fed goes with the dots. So the question is, is this situation becoming quite binary and if so, how does EURGBP win either way.

The most likely situation to me is, contrary to current market pricing and sentiment, over the next few months, the ECB hiking cycle could actually be priced earlier than current the EONIA curve suggests with APP going through a more serious wind down. If that is the case, Euro should explode against sterling as the market dynamic of last summer looks set to return; doubting the BoE and a further deterioration in the political economy. However, lets say the other possibility, which is quite high in a probabilistic sense, occurs. The ECB has no let off as inflation remains subdued, the Fed keeps going and US 2s10s is 0 by year end. In that case, the market has to price the end of the Fed hiking cycle at a minimum and at max price a recession a lot more seriously as this will likely coincide with global growth that looks more like Q1 given that the ECB couldn't move. The UK economy, which is already at/near potential, likely is the first to go into recession and BoE has to cut, all while DFR is still stuck at -40bps, the ELB, and FX has to price it....... The other element of course is relative neutral rates as discussed above. In my estimation it seems likely that low potential in the UK is here to stay for now and the Euro Area economy may actually have a steeper hiking scope than is currently priced or expected. Given the asymmetry in my view, a 1y parity one touch, which currently trades for 13.5, makes a lot of sense. Given how steep EUR fwd curves, stuff in exotics is not that exciting, which may mean riding spot is the best option. However, I think given the power of these dynamics, this thing could really begin to move.

Back to the Fed

As said above, the Fed's communiqué from the May statement seemingly failed. The combination of adding emphasis to "symmetric" and having hawks like Mester come out and say gradualism should be the approach even in the face of overshoots in inflation from target suggests, the Fed is making a conscious effort to get the curve steeper. Fiscal is going to juice this year and next, and they want a balanced hiking cycle to keep it in check. However given current curvature, its hard for implieds to price much in scope given the fact the Fed wont move at inversion. Now, the Fed is really showing the market they're paying attention to the curve and seemingly cannot control it. This means, the market now knows the Fed will struggle to add scope to implieds even in the face of higher neutral rates and this massive fiscal boost. This effectively means a forced elongated stay at "policy is still accommodative" in a relative sense; risk assets have taken note of this as spoos have broken out. Given my opinion from last time is unchanged re the effect of fiscal and trade serving as the reverse QE, I am not bearish USD as the scope may exist, but it does mean I struggle to see how a swift 2014 type move could happen. If that is the case, some of the punishment in EM looks a bit overdone. Dollar Mex 6M 20 no touches trade for 25. The Fed will struggle to establish hiking scope until the ECB moves, this gives us time in the n/t for a swift move lower in USDMXN. This is the shortest time horizon trade, but the move could be quite swift. Expiration does encapsulate the July 1st elex, however given AMLO's 20pt lead in the polls, it looks like politics may only be tailwind. The other element is, NAFTA. Does Trump really want a two front negotiation while he deals with China, I doubt it. EM liquidity will begin normalize as public external balance sheets are not nearly as bad as '14. And given the above factors, MXN looks like it should be one of first beneficiary.

End on a longer term story, rebalancing in China 



What has really interested me over the past few weeks has been the relative strength of Asia FX given this broader rally in USD. Part of it is political given the promise of denuclearization of the peninsula, but there seems to be more. Another striking economic development this year was seeing China's current account go into deficit. Of course a lot of it was on more temporary factors such as, tourism related spending and a decent swing in the goods account. However, this move in the external account does seem to jive well with China's broader goal in getting consumption as a much higher percentage of GDP. In the face of this rather large move in the current account, a big compression in the front end spreads v US rates, USDCNH has not done all that much since the end of March.

Now we can look at this from the broader structural setup of the global economy. China in its quest to become a more consumer centric economy, at a time the US is trying to get manufacturing as a higher percentage of its output. The facilitator of this is a relative rebalancing in the exchange rate. To go along with this, China wants to issue for BRI in yuan. So someone has to finance this deficit through the capital account and contribute to the sprawling belt and road initiative; GPIF can do those things. It is very interesting that over the past year, in terms of JPY/Nikkei correlation, CNHJPY has better r^2 than USDJPY.

This relative rebalancing of output composition of the worlds two largest economies has wide ranging ramifications. First thing that comes to mind is term premia, as the recycling of Asia trade surplus' is slowed. This is why having a short yen element makes a lot of sense in this structure. So the way to play this longer developing story, which seems to have already begun, in a highly convex way is maybe through a 2y 20 one touch in CNHJPY. Fwd curve is very giving for betting on CNH strength, especially against yen. Which means, this relative economic rebalancing which will likely occur most through the exchange rate, you can own at 15:1 payout.

This will likely be my last post for a while, thanks for reading and for all of the engagement.

jonturek@gmail.com

Macro Is Back: Oil, USD/Asia FX, LOIS and TY/Gilts

Hope all is well. Markets have had a very interesting start to the year. Positioning has started the year kind of lopsided, despite sound reasoning. I don't think it is too contentious to say that given that fact there will be a pain trade in the next three months. I don't claim to know what it is, but to me, the cheapest way of expressing it is in a few USD crosses. Is USDJPY still going below 100, most likely and I continue to like that short from previous posts. The problem I am now grappling with is, what is going on in China? LK index shows GDP has come in, Asian trade data for Q1 has reflected that and housing prices look set to continue to fall. Yet, CNH remains pretty strong and imagine if we get a hedge bid from exporters, policy is accommodative and iron ore is near its highs as continued capacity cuts have been a big boost. So ya, I have no idea whats going on, but other than short USDJPY, you can balance out a book that I think over the next 3-6 months is decently convex in terms of narrative and fundamentals. Given this confusion, it makes sense to have "confusing" trade ideas. I think given near term potential for an acceleration in Chinese industrial sector deleveraging while we continue to see manufacturing upside in the US economy, I want to be long USD/Asian FX, short CHFJPY and synthetically long crude upside by being short USDRUB. USD is either dead, or we are due for a further technical bounce and Asia FX is the best r/r way of playing it as CBs there have effectively said this is as much strength that we are willing to tolerate. I have no idea if the USD is set for a reversal bid, but I do know USD/Asia vol is cheap given the current geo-political and economic backdrop. The same can be said for oil. I don't know if crude will trade choppy or not, but to me, given the current move in the US manufacturing sector, the right tail is being underestimated and RUB seems like a good expression, given their domestic cyclical uptick and very cheap ccy given improvements in terms of trade. Then finally, in all of my strangeness we get from the current widening in LOIS to being long TY/Gilts wideners. 

Hope you enjoy, and I look forward to all of the feedback. 

Oil upside in being short USDRUB

While the extended long positioning in crude is something to worry about, I still think the shadow of shale has blinded everybody's (IEA, EIA) vision about supply/demand dynamics. US has gotten to over 10mbd, its true, but the structure of the oil curve is sorta saying so what. The other 90% of global production is not keeping up with this pretty robust move in demand. Demand estimates seem soft if the US cycle has one last hoorah in it thanks the current policy stance. US makes up a fifth of global consumption and demand is at the highest its been since 2011. Despite this, the assumption is the right tail in oil is unreasonable given shale growth, effectively capping prices. But what if it disappoints, and pretty much every supply/demand dynamic is suggesting higher prices. Basically what I am thinking is, understated US demand and continued reduction in inventories may mean another big leg higher in crude, as we usually see at this stage of the economic cycle. What if oil trades to 80 bucks a barrel as IEA and EIA estimates of crude surplus' are off. As I said, the longs are overextended in crude and I am not playing for a few bucks of upside, especially into refinery maintenance season. A cheap way to play the right tail in crude is RUB. FX forwards continue to price a disaster and persistent weakness but to me, its a decent late cycle story. The combination of the return in domestic purchasing power as CBR easing cycle leads to pick up in private sector lending, means economic velocity should continue to trend higher. And, the CBR still has a lot to do with RUONIA up here given how low inflation is. An easing cycle in the middle of a broader cyclically led commodity rally should be RUB positive, and given the flexibility from cheap RUB (REER in mid 80s), they can win in price or volume, as we've seen in Wheat in the past 16 months. A 9M 48.50 USDRUB one touch trades for around 2.5. Which means you can effectively be long the right tail in crude at a 40:1 payout. 

Long USDKRW and USDTWD

My thoughts on USD are two fold as of now. First, The market has spent a lot of time focusing on the current account side of the currency, and not enough on monpol side. While we're all worried about twin deficits, the calendar '19 box in EDER is almost back to zero. To me, this means its time to look at structures in long USD/Asia. The combination of a technical bounce in USD and the possibility of worsening Chinese data means vol is too cheap. The reason I like USDKRW or USDTWD is the innate asymmetry, as the respective central banks have basically told you they will not really allow any further upside, we saw the BoK in there at 1050. The combination of a near term soft patch in Asia macro along with the current trade rhetoric from the White House, puts these mercantilist economies at risk. Recent JPY strength v ADXY ccy's is usually a decent indicator of pending ADXY weakness. Upside is pretty cheap and downside is well defined by CB intervention, like we saw with BoK at 1050 and following steepness in front end rates as 3s5s jumped to over 30bps. These crosses can bore you to death, but if it is at all possible for the  USD to get a meaningful reversal bid, it will manifest here.

USDTWD 6M Vol



There are a confluence of potential issues which make USD/Asia vol too cheap given problems mercantilists will face in the near term. First, of course is the potential for the further deleveraging in Chinese industrial economy, now that XI has been able to secure power for life. Recent PMI's were soft but the Chinese New Year probably had a hand in that. Second is, the recent White House rhetoric re trade, Korea and Taiwan fit the "cheater" bill, especially as Navarro and Lighthizer take on bigger roles. These econs are effectively just beta to the global business cycle as around 50% of their GDP is from exports. If the market is going to price trade war escalation, a good way to capture the short globalization theme is in being long USDKRW or USDTWD. Third, a Fed that hikes 4x this year while BoK sits on its hands, actually creating real carry. By being long USD/Asia you can be short globalization and long US economic outperformance v RoW, something that looks quite likely in the n/t, with effectively an implicit beta to broader long gamma. In these crosses you're long all of these potential near term narratives at a very well defined risk reward level. 

Short CHFJPY is Similar 

In a derivative sense, this is a similar structure to the ones above. The Euro Area economy lags the Asian business cycle and CHFJPY lags ECB implieds. Given the current commitment to forward guidance and the number one policy risk being a taper tantrum, according to Constancio, the EuroSwissy curve despite its recent compression, is likely still too steep. The point is, I can fade Euro Area STIRs, which have come in a lot, in this cross and get more JPY exposure all at once. I've made the case for JPY in the last three posts, specifically from a flows perspective, and the policy side changes are only beginning. Recent BoJ moves to me is Kuroda saying, we will do this on my terms, but at 1% inflation and an economy that is reliant on FI income flows, the current YCC range is too low. And if Draghi continues to whack ECB implieds following in the footsteps of his friends at the Riksbank (don't fight Ingves), and the BoJ moves closer to hiking YCC, a 3M 108 digi for 10 is a decent play. Basically, European CBs are in a dove loop where everyone waits for the ECB but Draghi and Constancio watch the Rix and CEE CBs whack hawkish pricing despite inflation being at/above target, and EZ core is still very low. Yes the recent Coeure paper, which was a tour de force, suggests given stock v flow, the GC should be less afraid of ending purchases and forward guidance will keep rates well anchored. With that said, given how low core HICP is, Draghi will likely punt that risk as BE's fall. Basically, being short this cross is long the BoJ making a significant move before the ECB. We know the ECB will have to make a language shift soon, but until we see a meaningful move in the Praet's super core measure, ERH0 thinking we will get positive EONIA before Draghi hands it over, still seems a bit aggressive. The chart looks bad and the JPY move is not done yet. Remember, the BoJ is still in a place where either the global economy continues to chug along and inflation forces them to move, or the Asian biz cycle is led lower by slower industrial activity in China and JPY lags a rally in rates. The BoJ has a massive effective short gamma position and the market is moving away from that, as the GOAT (PTJ) recently said, the last few years were a 5 standard deviation event. I don't mind betting the BoJ will be on the wrong side of the new paradigm markets are entering. 

End on LOIS, r*, Cash, and why the UST/Gilt Widening will Continue

My mentor told me that if I am going to write again soon, which I am grateful so many of you have reached out asking to me do so, that I should talk about the recent move in LOIS. I am not an expert on the intricacies of the LIBOR market, as will become clear, or the potential shift away from it. However, what has interested me is the fact despite a real tightening in USD funding, the dollar hasn't really budged even in cross currency basis swaps. So what has this move LOIS done other than juice ED$ shorts, as JPM estimates almost 50% of your pnl in short whites comes from this widening in basis. I hear, a popular narrative on the sellside is that the culprit is treasury bill issuance. This makes a lot of sense to me as public supply, especially as it has been in bills, crowds out private debt such as commercial paper (CP) and asset backed (ABCP). Fortunately, the academic literature on front end supply and the demand for safe assets is quite extensive. Much of this of course the case because of Jeremy Stein, and his quasi attempts at least in the literature to have the Fed's balance sheet replace bank debt for STSI (short term safe instruments) for the sake of financial stability, think of his Jackson Hole 2016 speech. "In particular, if the relationship between public and private short-term debt issuance is causal and robust, greater provision of public STSI by a central bank may result in smaller issuance of private STSI and lower levels of associated liquidity and maturity transformation, potentially improving financial stability"(Stein 2016, not JH speech). The merits of this argument I will not get into, but I think his work and subsequent papers on this topic have a lot of practical manifestations with whats going on today. As government budget deficits have come in and net issuance in the developed world has gone negative thanks to QE, the worry was that there was an insufficient amount of short term government debt in funding markets creating a "safety premia", which the ECB talked about in March of last year in a working paper (Golec Perotti 2017). Basically the combination of the ELB and the reduction in net bill supply led the market to substitute it with ABCP issuance as money demand is quite high; a substitute which has always scared central bankers. However, in the US, this is now reversing as the government issuance at the front end is increasing leading to much higher yields in tbills which will crowd out ABCP issuance to satiate this "money demand", even lower it. Adi Sunderam from Harvard has a great paper on this topic where effectively qualifies this "money demand" as a negative correlation to the tbill-OIS spread (Sunderam 2014). Effectively, increased tbill issuance means higher tbill-OIS spread and lower money demanded. This means the need for private sector debt substitutes logically falls. We also know from Stein's original paper that the lag of private sector issuance following an increase of tbill supply is usually in weeks not months. We also know, elasticity in bills to supply is the highest relative to other parts of the UST curve. Which is why it makes sense this blowout in basis and hints of slowing CP outstanding has happened so quickly. It is also important to remember that this is happening as reinvestment is slowing, reserves coming out. 

(January 2001 to July 2007, Sunderam 2014)

The question is, is this jam in LOIS just the market adjusting to this changing reality or is there real interbank lending stress. To me it looks like the former as there has been limited spillovers in XCCY and TED spreads. With that said, by boosting the US economy with this fiscal impulse at full employment, paradoxically, the broader fiscal policy has likely tightened financial conditions "forwards", so to speak, (I really make up nonsense sometimes). But really: first, the delta change in the short term funding space is becoming significant, the optionality of cash relative to asset valuations is probably the highest its been since the GFC, and third, fiscal may have mechanically raised r*. I know the latter will be quite contentious but to me, it seems possible even if the fiscal multiplier on output is low.

USD 5y1y - EUR 5y1y

Lets use the Bullard assumption from his presentation two weeks ago on how low r* is. He econometrically decomposes it as simply: labor productivity + labor force growth + desire for safe assets (negative number). So what is the case that recent fiscal measures have actually mechanically even if not explicitly (higher potential) raised r* via the third input. This is quite hypothetical and is backed by little empirical work, but is an interesting thought experiment even as the Laubach Williams model suggests r* has not really budged. 

The HQLA shortage has been well documented and is a side effect of Basel III and the actual shortage of government paper thanks to global QE. Basically a historic structural bid for gov't paper has been met by lower net issuance. The question is, to what extent does this new fiscal paradigm change that picture, if at all. Well, its likely through three channels. First, STSI demand, or the reduction in safety premia should occur thanks to over a quarter trillion of front issuance, just last week. From repatriation holiday effects, US companies needing to hold foreign earnings in money equivalents such as bills, can be lessened. Third, if trade wars escalate and the reserve status of USTs is further challenged, that removes, or at a minimum lessens, a key source of structural demand as surplus nations recycled in USDs. The point is, all of these fiscal knock ons suggest the possibility that third input in Bullard's r* deconstruction may be slightly less negative. Then there is the Fed's balance sheet part of the equation. In the beginning of 2017, the board did a model of how SOMA changes would effect term premia out until 2025, when the balance sheet is only expected to account for 15% of GDP. For the first few years, the balance sheet runoff was expected to account for a 40bps increase in term premia. Interestingly, Brainard speech from September of last year said, the rule of thumb is that the increase in term premia will lower the short neutral real interest rate. This is why Bullard famously last year suggested doing balance sheet instead of hikes. Anyway, what the Fed model did not anticipate is how this massive front end loaded supply of government paper would possibly outdo the effects of QT on term premia..... 

In sum of all; the US economy is running hot relative to potential, or r* is slightly rising. Either way, that means hikes are coming....... Kaplan used language recently which shouldn't be lost on the market, he said the Fed should get started on tightening policy. Having some long USD exposure (despite it being a POS) and short USTs makes some sense, as I will explain why I like USTs to continue to underperform Gilts. Being short ED$ is functionally a LIBOR call at this point. Ya I think the Fed could hike 5x by March '19, but will basis narrowing eventually crush me? I like the risk reward in playing Fed hikes better in having some USD exposure in asymmetric crosses and in being short TY/Gilts.

TY/Gilt widener

The best expression of this trade may in fact be in relative curve trades like in 2s5s, but I will keep it simple. Simply this is an economic divergence trade that will be enhanced by a BoE that looks poised to overstep. Firstly, I think that as the broader spillovers from China's recent credit expansion recede, we will begin to see which economies were swimming with the tide and which the tide was just carrying. Second, the BoE policy path screams for a flatter curve, especially if the right tail in oil plays, and non core price pressures remain elevated. So whats the BoE's play as we know the case for lower TY, everyone has that trade on. The UK economy looks like its chugging along, and since Carney took potential down so low, it is possible spare capacity has been taken out. So even as sterling effects from Brexit will drop out, in theory, core domestic pressures will slightly offset. As I've said in the past, Carney is not scared to move and since the summer, has been very committed to bringing inflation to target. However, what he really wants to do, and is doing with his forward guidance of combining "limited extent" while also suggesting that hikes could be earlier than is currently being discounted in OIS is, he is effectively hiking in spot and easing in the forwards. Which is quite elegant really. The problem is, PMIs are slipping, investment still sucks and city house prices are beginning to fall. Hiking twice this year will remove a healthy chunk of future growth potential which should be long end positive. Carney is thinking, lets juice sterling while we can and naturally ease (limited extent) once Brexit headwinds are more potent in the future (lower potential). It's not dumb, he was dealt a brutal card, but capacity constraints are duration +ve and the UK economy looks to have its fair share of them, especially if Brexit talks and the domestic political economy continue to deteriorate. 

Thanks for reading, thats all I got for now, email is still best way to reach out, jonturek@gmail.com