"Every positive value has its price in negative terms…” Pablo Picasso
While August closed with a clear dominance of political and geopolitical factors dominating sentiment and positioning, September has begun with economic factors (and by extension the implications for monetary and fiscal policy) at the forefront. The first half of September saw a clear rotation into more pro-cyclical assets, suggesting that markets were perhaps rethinking - and repricing - the prospects for global growth. There have been a number of factors that have driven sentiment in this regard, such as more positive rhetoric on US-China trade and hopes for a broad fiscal impulse (not least from Europe). However, the main area of global growth outperformance (at least relative to expectations) over the period has been from the US. Thus, last night’s monetary policy update from the Fed was a key focus.
Earlier in the month, there were a broad array of view on the FOMC’s most likely course of action - ranging from unchanged to a 25bp cut to a more aggressive 50bp cut and even in some extreme corners signals of an imminent return to QE. However, a more positive tone to the global trade concerns and continued strength in the US economic data (critically the acceleration of wage prices in the August employment report and the reacceleration of the service sector ISM activity index) had tempered market expectations back towards the middle ground. Notably, over the start of this week, funding stress in the US repo markets nudged any expecting no change back to the centre ground too.
"I keep my cards in my pocket and my cash in my boots” Jackson Rathbone
The funding concerns that have got a lot of airtime this week are technical in nature, and as Powell referred to in the press conference last night, "have no implications for monetary policy or the economy”. Indeed, while there is a potentially troublesome issue of reserve scarcity in the US financial system if it were to persist indefinitely, the current spike in overnight rates is a result of corporate tax payment dates driving a demand for cash (close to quarter-end cash requirements), at a time of an inverted money market curve and heavy bill issuance as a function of bloated budget deficits. There is the risk that if such stresses and thus high cash rates were to persist, that it could turn from a liquidity issue to a solvency issue for the weakest in the markets. However, for now we would suggest that the Fed liquidity provision (in the form of repo auctions) will suffice.
From our perspective however, the most significant factor of the US monetary policy debate outlined last night is the disparity between the market expectations for the future path of rates and that of the Fed itself. The ‘dots’, or rate path expectations from individual members of the Federal Reserve Board, highlight a median expectation of no further cuts (though several project one more 25bp cut). The market is currently pricing around 30bps of rate cuts this year and another 45bps in 2020.
Immediately after the Fed decision to cut rates 25bps, but prior to the press conference, President Trump tweeted his disquiet with the Fed’s balanced approach to meeting its mandated monetary policy objectives (2 percent inflation and full employment), opining that "Jay Powell and the Federal Reserve Fail Again. No "guts”, no sense, no vision! A terrible communicator!”. Ironically, immediately after this tweet, Powell managed to deliver a statement and Q&A session in which the implied monetary stimulus was significantly below the expectations of the market, calm fears of an imminent repo funding disaster against a backdrop of significant global uncertainty, and did so with a modest positive response from the USD, and US yields and minimal reaction from equities and risk assets. From our perspective, such an outcome required clear, careful and effective communication.
"Flight without feathers is not easy” Plautus
In the eurozone, following the package of easing measures from the ECB (a 10bp rate cut, reopening of the Asset Purchase Facility, extended forward guidance - including reinvestment policy and a tiering of reserve remuneration) have thus far had minimal impact on the EUR; a lower EUR is likely the most efficient, though not explicitly targeted stimulus to the eurozone economy at the current juncture. This is likely a function of two linked factors. The pushback from a number of national central bank heads to the extent of the President Draghi’s latest measures suggests either the view that monetary policy is near (or at) its effective lower bound or that there is reduced desire for further easing. Indeed, if we add this to the increased debate around fiscal easing from those member states who have room (Germany, Netherlands,...) then there is a perhaps understandable near term support for the EUR.
However, we remain of the view that the downside economic risks to the eurozone have not been negated and that the desire for significant fiscal stimulus - particularly from Germany where there is the most space - remains very low. Against this backdrop and our maintained view that the manufacturing recovery in China will be intentionally shallow (as China increasingly focuses on the quality, not quantity of economic growth), it is likely that the growth and yield premium of the US over the eurozone widens rather than narrows. From our perspective, this ultimately continues to favour a weaker EUR.
Lastly, GBP has been relatively well supported over recent days / weeks, despite the well publicised disparity between the views of the government and of Parliament. We retain a positive bias for GBP, and despite the increasing rhetoric from the press and the EU, we are increasingly convinced that there is a clear (or at least clearer) plan behind the scenes. If we are right and there is the prospect for a solution to the backstop issue and thus the passage of a withdrawal agreement, then GBP is significantly undervalued.
It just isn’t cricket: [Idiom: It isn't fair, sportsmanlike, or legitimate]
When Ben Stokes stood at the opposite end of the wicket to Jack Leach at the weekend, England required 73 runs with no remaining wickets, to retain any hope of regaining the ashes. Few, if any, gave him an appreciable chance of success. With the opposition conspiring to unnerve and remove England’s sole remaining batsman (with no disrespect intended to Leach), Stokes’s response shocked the Australian bowling onslaught. Stokes’s strategy of taking the game to the Aussies by quickly and confidently attacking both pace and spin from the opposition.
I have no idea whether Boris Johnson is a cricket fan or whether this immense innings from Ben Stokes was in any way an inspiration, but the analogy between this batting display and the bold confrontational approach that PM Johnson appears to have invoked. There is no doubt that there is a long way to go if Johnson is to be successful in bringing a renewed withdrawal agreement to the House of Commons before the October 31st deadline. He may need to hope that the (united?) opposition drop the ball in the closing stages - instead of getting the run-out or dismissal some are becoming hysterical about.
As Harold Wilson once said: "a week is a long time in politics”. That may never be more true than the week ahead for Parliament. Ironically, if the PM does survive long enough for parliament to be prorogued for a few weeks, then he may well have the best chance yet to negotiate something that Parliament can get behind. For many, anything else simply isn’t cricket!
September is set up to be a very interesting month - at least for the neutral supporter. Watch this space.
"At first I did adore a twinkling star But now I worship a celestial sun” William Shakespeare, The Two Gentlemen of Verona
In Italy, political strategy is also being tested at the highest level. A couple of weeks ago, deputy PM, and leader of the Lega party called a confidence vote in the Prime Minister that he himself had put in place only months before, Guiseppe Conte. With polls suggesting a further surge in support for the Lega (35 %) and diminished support for the 5star coalition partners, it seems likely that Salvini was expecting the confidence vote to result in fresh elections that would see the Lega as the dominant coalition partner (but not in alliance with 5star) and perhaps even Salvini installed as the PM.
The current dynamic suggests that this was a strategic miscalculation by Salvini as the PD party and 5star attempt to form a new coalition government, united behind Guiseppe Conte. However, this is far from a done deal. President Materella has given the parties a week to formalise its alliance for government and even if they are successful at this stage it is unlikely that 5star, "a party that has long defined itself by revulsion for the PD party and the insider elitism it stands for” (- Ambrose Evans-Pritchard) will boost their ratings under such an arrangement. Salvini will be waiting - perhaps increasingly strongly - in the wings.
"I see the glass half full… but of poison” Woody Allen
Lastly, it is impossible to discuss global geopolitics without mentioning Donald Trump. Opinion, on the tactics of President Trump and his administration are likely as polarised as those in the UK over PM Johnson, or in Italy over Mssrs Di Maio and Salvini. The start of August saw a further deterioration in progress towards a US-China trade deal and a further escalation in tariffs. However, we continue to believe that the ultimate dynamic reached will be one of lower global tariffs (not higher) and a more open and free China (not a more closed US and global economy).
Against this backdrop we continue to favour the USD on continued economic and yield differentials - even if the global rush for positive yielding safe haven assets has had the net effect of dramatically lowering US yields. We remain glass half full on the US, the UK and the ultimate global economic trajectory.
August was about the fracture and dislocation, of politics, alliances and even economics. Perhaps September will be about progress.
"The slow motion replay doesn’t show how fast that ball was really travelling” Richie Benaud
Last week we discussed the regime shift in baseline volatility of financial markets in August as the confluence of macroeconomic and geopolitical factors, intensified. Headlines and sentiment continue to focus on the renewed trade tensions between the US and China, and the credit and risk implications of the rejection of fiscal prudence in Argentina. However, beyond the heightened volatility, we remain focussed on one core dynamic in financial markets: the progression of interest rates and monetary accommodation, and the implications for rate and yield differentials.
"Like a golfer who can’t putt, has no touch” Trump on Powell
Central to the current debate is the Fed. If you listen to the commentary of President Trump, you would be forgiven for thinking that the Fed are significantly behind the curve. Indeed, if you look at the pricing and slope of the US yield curve, you could equally be convinced that the only possible path for US interest rates is to continue lower into the foreseeable future. However, "the objectives of the FOMC, as mandated by the Congress in the Federal Reserve Act, are promoting (1) maximum employment, which means all Americans that want to work are gainfully employed, and (2) stable prices for the goods and services we all purchase” - [FederalReserve.gov]. With the unemployment rate currently below the level viewed as the equilibrium or maximum unemployment level, inflation at or around the level consistent with medium term price stability and GDP rising at above equilibrium or potential growth levels, it is difficult to argue that the Fed needs to cut interest rates by 100bps over the next year, as implied by the markets... and implored by the President.
Indeed, yesterday the CBO (Congressional Budget Office) maintained its growth projections for this year (2.3%) and, more substantially, for next year (from 1.7% to 2.1%).
Last night, the Fed released the minutes from the FOMC meeting on the 30th, 31st July, where the minutes referenced the phrase - that Chair Powell used in the press conference - that "Fed officials viewed the July rate cut as a mid-cycle adjustment”. Implying that the cut (and likely another in September) is a process of adjustment, rather than the beginning of a rate cutting cycle. Indeed, "several Fed officials favoured keeping rates unchanged in July”.
While we maintain a view that is far less dovish than the market (and thus bullish on the USD), there are some obvious caveats. Firstly, the timing of the July meeting - ahead of the escalation of trade tensions between the US and China (Trump raised the tariff threat and labelled China a currency manipulator in early August) and the surprise primary win for the fiscally profligate opposition candidate in Argentina. Secondly, the current market pricing of the US yield curve is now so extreme that it likely presents something of a stability risk were the Fed to choose not to err on the side of caution. We are much less convinced in the predictive power of the shape of the US yield curve (i.e 2s10s inversion equals impending recession) due to post GFC financial repression and the fact that the safe haven bid from the rest of the world is exaggerated by the fact that almost all of the positive yielding investment grade debt is in the US (which also has a strong economy and firm rule of law).
We remain unconvinced that the US should be cutting rates beyond September, unless the world (and the US) deteriorates further, but the case for buying USD remains strong.
"They came to see me bat, not you bowl” WG Grace, putting the bails back on his stumps after being bowled first ball
Today signals the start of the annual central bankers gathering at Jackson Hole, Wyoming. The risk to our views is that the Fed buckle to pressure from the President or (more convincingly) the markets, and offer a further dovish pivot (this time last year, the Fed were expected to raise rates three times in 2019; todays pricing would take the rate movement to more than three cuts). However, while there is no Mario Draghi at this year’s conference, our focus remains on the ECB. Chief Economist, Philip Lane, is the most likely to deliver a dovish narrative, which is likely to include rate cuts and QE among further targeted measures as the China slowdown continues to undermine the growth path of the eurozone.
From a UK perspective, the discussions between Johnson and Macron today, Johnson and Tusk tomorrow and the G7 over the weekend are important. However, the rhetoric from Merkel yesterday is likely most telling - Mr Johnson has a short window to deliver a plan to Brussels on avoiding the backstop, whilst himself avoiding having the rug pulled from under him by the UK parliament. Indeed as the 3rd Ashes test gets under way today, Johnson may well need the strategy of Joe Root, the pace of Jofra Archer and the agility and composure of (sadly missing today) Steve Smith.
Argy-Bargy: [noun informal British] - "noisy quarrelling or wrangling”
There is no doubt that August witnessed a regime shift in volatility in financial markets - despite the fact that the month began in the middle of a week. The transition from July to August was marked by a hawkish cut from the Fed and the escalation of tensions between the US and China, culminating in the threat of further US tariffs on Chinese exports, and subsequently a relaxation of the yuan through the psychologically significant 7.00 level. Then, just as financial markets were beginning to regain some composure from the trade related volatility, EM credit markets were thrown into uncertainty as the presidential primaries in Argentina resulted in an unexpectedly emphatic rejection of the fiscally responsible incumbent.
In many respects, however, the Argentina story is a side-show. While it has caused some localised losses and even some contagion across the LatAm and EM credit space, it was likely in the US Treasury market where the most significant implications lie. The Argentina story, along with the recent deterioration in Sino-US trade progress (and , it seems, some goodwill) has driven significant flows into the global safe haven asset - US Treasuries. This is not to mention the heightened Middle East Tensions, Japan-S. Korea trade dispute, N. Korea missile test resumption, Brexit and the situation in Hong Kong that all exacerbate the demand for safe haven assets.
"It is playing safe that we create a world of utmost insecurity” Dag Hammarskjold
As global investors scramble to place their money in the perceived safe haven of US Treasury bonds, US yields are dragged lower. Against the current backdrop, the demand for longer dated US bonds has outstripped that for shorter dated securities, and thus the US yield curve (notably between the 2 year benchmark and the 10 year benchmark) has inverted. Herein lies a circularity for financial markets. Every 2s10s inversion since 1956 (according to DB) has seen a recession follow. Thus, the logic in this instance is that the threat of a default in Argentina, alongside the imposition of tariffs on Chinese exports to the US, will send the US economy - until this point running at above potential rates of growth, with employment below the level considered ‘full employment’, with equity markets near record highs (even after the horrible day yesterday, where the Dow Jones -3.05%) - into recession. Former Chair of the Federal Reserve Janet Yellen proclaimed that "the yield curve may be a less reliable signal at the moment”. We would likely agree with this sentiment.
Historical analysis suggests that the median length of time between the point of inversion and recession is 17 months. That puts our best estimate of the impending US recession in 2021 - there are a great deal of global events to take place between now and then. Some would argue that the mere fact that the US curve is inverted (irrespective of the reasons) will drive wider credit spreads, slower business investment, faltering productivity and/or hiring and ultimately a recession. We are not suggesting that the markets are wrong in being cautious about the global economic and political backdrop, nor are we suggesting that there will not be a negative cyclical deterioration for the US at some point, but simply that at current levels, the world’s safe haven asset may not be all that safe in price terms (not in any sense in terms of the credit risk of the US).
"Patience is not simply the ability to wait - its how we behave while waiting” Joyce Meyer
In the UK, the underlying economic data has continued to beat expectations. This week has seen UK headline inflation rebound above the 2% target (on strong pricing power in computer games no less), wages rise at their fastest pace in over a decade (real wages still accelerating), and retail sales beat expectations for a second consecutive month in July. However, all of the UK headlines remain focussed on the political backdrop.
We remain of the view that the Johnson administration will continue to push a hard line until Parliament returns, on the 3rd September. The critical point for this strategy is likely the G7 meeting in France (24th/25th August), where there will undoubtedly be a meeting on the sidelines between Johnson and Juncker (and possibly also with Merkel and Macron).
The near term picture remains unclear for the UK and for GBP. However, a resilient consumer, very promising signs of an accelerated trade deal with the US and still the prospect of a compromise between the UK and the EU suggests that the upside potential for the GBP in terms of sentiment change and the correction of its significant current undervaluation remains substantial.
"Your problems never cease, they just change” Phil Jackson
An uncharacteristically long period has passed since our last post. Yet while the levels, dynamics and even participants may have changed, the dominant issues in the global macroeconomic backdrop remain. Arguably the biggest driver of global market sentiment continues to be the Sino-US trade spat and the extrapolated implications for global growth and interest rates. The conclusion of the G-20 at the end of June led to a month of agreed, if temporary, truce between the US and China. Over recent days, the seemingly timely progress towards a trade deal, has ceased.
Last week, the US trade delegation visited Shanghai for a fresh round of talks. However, reports following the discussions - which reportedly only lasted 4 hours - suggested that China may be attempting to draw out the discussions in order to gauge Trump’s reelection prospects. The result, perhaps unsurprisingly, was a further tariff threat from the Trump Administration - a 10% levy on up to USD 300 billion of Chinese goods - to take effect on September 1st if there is no progress in the meantime. The Chinese response, it seems, was to facilitate a move in the CNY above the psychologically significant 7.00 level to the USD a move that further unnerved financial markets, driving a sharp fall in equities, EM and other risk assets.
This trade tension escalation has also exacerbated the focus and extent of expectations of US (and by extension, global central bank) rate cuts. In our last post, we expressed the view that markets had priced too much of a monetary response from the Fed in relation to the current state of the US economy. With growth above trend, inflation on all but the PCE measure at target, domestic equity markets near record highs (even after the significant falls of the start of August), we continue to believe this to be the case. However, the Fed have clarified further their intention to cut preemptively as an insurance measure against potential negative global growth risks. If we combine this with sharply revised monetary accommodation from much of the rest of the world, then we maintain the view that the USD should continue to outperform as a function of continued growth and yield premia - exacerbated by monetary settings likely to be looser than the level required by the strong domestic economy.
The combination of our first two arguments also have significant connotations for global markets. We have stated a number of times in previous posts that there are two linked but distinct dynamics related to the backdrop for the global export economy and industrial cycle at the current juncture. The first is the trade dispute; the second is the likely L-shaped trajectory of the Chinese economy, as monetary and fiscal stimulus take a more targeted, less asset inflation-inducing approach. If we add the further global dovish monetary pivot - where the ECB are now expected to cut the deposit rate further into negative territory (and even restart asset purchases under its QE programmes), then we continue to expect the EUR to underperform - perhaps significantly over coming months.
King of the World?
And of course there is Brexit. In the UK, while the issues remain the same, the personnel change has put a new perspective and a new dynamic on the discussions. Having finally been named as the new PM in what was likely a needlessly drawn out process given the urgency of the situation, Boris Johnson has framed the process very differently to his predecessor.
From an FX perspective, markets are acutely focussed on the October 31st / November 1st transition; however, we are of the view that it should be the last week in August / first week in September. The last week of August is significant not just because if signifies the end of the partial ‘grace period’ for Johnson where his actions and demands are not directly rebuffed or undermined by the increasingly ‘creative’ (obtrusive) sitting Parliament, but also because it contains a G7 meeting where the PM will almost certainly have sideline meetings with Merkel, Macron and likely even Juncker. The first week of September is significant as Parliament returns on the 3rd and it is expected that a vote of no-confidence in the PM will follow shortly after.
The Conservative Party under Johnson are currently enjoying a bounce, if polls are to be believed, as the hard line ‘no matter what’ approach to the October deadline appear to be winning votes back from the Brexit Party (the liberal / centrist domestic measures - such as 20,000 police hires and GBP 1.8B NHS cash - may, at the margin, have also contributed to this). This is important in the context of a no-confidence vote as there is no convincing sign that the Labour Party is regaining pledges lost to the Liberal Democrats. Ironically, If Labour (it is conventionally the opposition Party that call such a vote) call a no-confidence vote that ends up in a General Election, the biggest losers at the current juncture could well be the Labour Party. Furthermore, recent rhetoric from the PM’s chief strategist Dominic Cummings, backed up by constitutional experts muddies the water further as it suggests that the PM would not be legally required to step down as PM even if he lost a no-confidence vote - and even under such circumstances could delay any resultant general election vote until after the UK had left the EU on the 31st October.
Perhaps ironically, after the recent conscious ebb towards no-deal, it is likely that it would only take a minor concession from the EU (though likely around the backstop) to facilitate a Withdrawal Bill’s (WAB) passage through Parliament - particularly if Johnson (and more likely Cummings) can more successfully frame the positive aspects of the WAB and the upside potential that awaits on the other side. While the near term remains fractious for GBP, we are increasingly of the view that the balance of risks beyond the very near term are shifting further towards the upside.
"You can cut the tension with a cricket stump” Murray Walker
Last time we wrote, on the eve of the June FOMC meeting, we discussed our view that the markets were increasingly failing to differentiate between the current US/China trade tension and the slowing in the global industrial cycle or export dynamic - instead choosing to view this as one issue. Furthermore, we went on to highlight our long held view that there will be a rational compromise between the US and China and ultimately a trade resolution that brings lower, not higher global trade tariffs. Despite the rising uncertainties into the G20 meeting at the end of the month - exacerbated by the increased tensions in the Middle East - the meeting between Trump and Xi appears to have put discussions back on track, halted the extension of tariffs and reduced the threat of a more damaging trade war.
However, while the progress at the G-20 was a positive step for global trade and geopolitics, it did nothing (outside of a modest and short lived dip) to arrest the safe haven flow of funds into Treasuries and thus the continued slide of US yields.
It is not just on the issue of trade where there have been significant developments since the last time we posted. The other notable trend of recent weeks has been the further dovish pivot of the Fed and the ECB.
"My Man could have hit that with her broom handle” Geoffrey Boycott
At the June ECB meeting the ECB delivered a series of measures (a six month extension to the forward guidance on rates, a six month extension to the reinvestment of expiring assets under QE and a new, generous TLTRO offering) and highlighted the increased downside risks to the (global and) eurozone economy. However, the initial reaction of the market was one of disappointment. In fact, even when, during the Q&A session of the press conference Draghi (almost certainly intentionally) revealed that the Governing Council had discussed both cutting interest rates further and restarting the QE programme, markets remained underwhelmed and the EUR appreciated modestly.
Next up was Powell and the June FOMC. Despite the fact that the underlying economic momentum and inflation dynamic remains considerably more robust than that of the eurozone, markets have extrapolated fragilities of the global dynamic into explicit expectations of US rate cuts. Current pricing suggests more than 100bps of cuts by the end of 2020. Furthermore, despite the fact that the dovishness of Powell’s speech was veiled and lawyerly, markets were quick to jump on the moderation of the Fed forecasts (the ‘dots’) and US 10 year yields fell below 2.0% for the first time since 2016.
From the perspective of their explicit mandate, the ECB do not target the FX rate. However, it is also clear that the level of the EUR has implications for the relatively open economic area of the eurozone, both for export competitiveness and for the implications for inflation. Furthermore, with monetary policy setting at such extreme levels of accommodation, inflation starting to wane, and a heightened sensitivity to global trade, it is likely that the currency is high up on the ECB’s list of monitored factors. A couple of days after the Dovish Fed (and a further, if modest, rise in the EUR), Mario Draghi was more explicitly and committedly dovish.
From our perspective, even after the central bank ping pong, we see the market as pricing far too much from the Fed, and underestimates the ability of the ECB to act.
In the UK, financial markets have been relatively sidelined as the Conservative leadership process evolves. GBP has been kept on the back foot by the commitment of both candidates to retain the threat, if not the intention of a so called no-deal Brexit. With the announcement of the winner, and thus new PM, not coming until the 24th - just one day before the Summer recess - it is unlikely that GBP is promoted to the forefront of market activity at any time soon. In the meantime, while the sun is out, perhaps we should concentrate on the Cricket.