The potential for a USD overshoot

The USD has not reacted well to the early days of a Trump Presidency. Hopes for a pivot to the political centre have receded into the rear view mirror as Trump has started enacting his policy pledges. As controversial as these policies have been, the nature of the implementation process has been an additional source of concern: a lack of planning, coordination and prioritisation has inflated concerns that Trump and his team are not ready for administrative Prime Time. However, to adapt a sporting phrase – when looking at the longer-term impact of Trump on the USD and US assets one has to try and follow the ball rather than just the man. We still believe that Trump’s economic policies have the potential to create a sugar rush period of stronger economic growth in the US and lay the foundation for a USD overshoot. This does not mean that the experiment with Trumponomics is likely to end well. His policies are expected to ultimately exacerbate the slow burning growth and income crisis that laid the foundations for his election victory. Trump rode a populist wave but he is no populist. This feeds into our view that the US interest rate market is reaching levels where investors can look to buy-USTs/ receive IRS. Nonetheless, over the coming months the current correction lower in the USD is likely to provide a compelling buying opportunity, particularly against the currencies of Asia ex-Japan where Trump poses a substantial threat to the region’s already struggling growth model. Meanwhile, his policy platform and his administration’s decision-making process both reinforce our view that the global markets have moved to a new and higher volatility regime.

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Trumponomics – what if President-elect Trump does not pivot economically to the centre?

It has happened. The continued failure of global policy makers to address the compelling economic challenge of our age – the slow burning global growth and income crisis – has spurred the US electorate to embrace the anti-systemic. Much of the world will wait to see if president elect Trump pivots towards the centre in terms of his economic, social and trade policies. As we wait, we can consider what would happen if President Trump was not bluffing, if he enacts his full economic agenda. While this is unlikely, it provides a possible limiting extreme in terms of the potential economic and market impact of a trump Presidency.  

Some implications leap out. A fiscal expansion that could dwarf the Bush tax cuts – a package amounting to a USD5.8trn expansion in Federal debt – would provide a sugar-rush leap to economic growth. The switch to fiscal reflation would enable the Fed to enact it’s desire to tighten policy, and could reverse the multi-year downtrend in the neutral Fed Funds rate. The consequence is highly negative for USTs. Meanwhile, President Trump’s stated desire to weaken the USD could be initially undermined by policies to encourage a repatriation of overseas liquidity and by a policy outlook for much looser fiscal and somewhat tighter monetary policy. Trump’s projectionist leanings could also spark crisis among key emerging markets, with China being particularly vulnerable, as Beijing may be pressured into implementing deflationary policies at a time when its highly levered economy was struggling with a structural slowdown. Into the initial period of “Trumponomics”, US risk assets could defy conventional wisdom and perform well into the expected flurry of activity in Trump’s first 100 days, especially in relation to overseas markets.

However, from a longer- timeframe, optimism in the immediate US economic and market response to untrammelled Trump policies could be fleeting and represent a pyrrhic achievement. Undiluted Trump policies would represent an accelerated withdrawal of the world economy from 40 years of globalisation and liberalisation, which has so supported economic and financial market growth. The significance of this regime shift could not be over-stated. Actual and potential global growth would continue to fall, as would the alarming decline in global productivity growth. This would be an economic story that may not end well. Hence, hope for the policy pivot and if not, enjoy the sugar-rush phase of growth which may not last

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BOE’s need to allow the GBP slump to run its course and break the negative correlation to Gilt yields.

The downside risks to the GBP have grown profound and are increasingly being actualised. We looked for 1.20 as an appropriate target for GBP/USD post-Brexit. However, this is far too conservative in light of the growing signs that hard-Brexit is the central scenario and the recent uncertainty over reflationary policy, amid government criticism of Bank of England and signs of a less ambition fiscal stimulus to come in the November statement. The critical thing for the authorities to do is to allow the GBP slide to take its course. The memories of 1992 highlight how self-defeating it would be to focus policy on an exchange rate in contrary to the needs of the economy. A greater concern is the need to reverse the emerging negative correlation between GBP and Gilt yields. This will require the Bank of England to reiterate how its monetary policy framework is intact and to restore confidence in the durability of monetary easing. The slump in the probability of a November rate cut by the BOE to just 8.4% might provide a “lottery ticket” way of positioning for the BOE to make such a statement. However, the uncertainties over the government’s response to the GBP slump means that positioning for further GBP deprecation may, for now, be a cleaner trade than looking for a renewed downtrend in Gilt yields. Indeed, were the authorities to fail to quell speculation that the GBP could become more of a focus of policy, the surge in Gilt yields and associated risk of capital reflux from foreign investors, may only be beginning.

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Gilts, the GBP, Brexit and the grudging longs

If global investors are nervous about buying bonds at record low yield levels, spare a thought for strategic investors in Gilts. Not only are yields at record lows, but Gilt investors are noted for their pessimism towards the asset and a forthcoming binary risk – the Brexit vote – is finely balanced between being a left- and right-tail event. One comfort, however, is that many of the concerns about Gilts suffering from a “sell-UK” phenomena if Brexit becomes actualised are based on a common misconception about the role that foreign capital reflux plays in developed countries with floating currencies. While our bias is for a Remain victory and a removal of the Brexit risk premium from Gilts and the GBP, our conviction is low. Moreover, the weak global economy could limit the scale and longevity of a correction higher in Gilt yields in the event of a Remain win.

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Avoiding the “Big Crunch” – policies to prevent a deflationary world

The policymaker response to the slow burning growth crisis of the global economy remains uncoordinated across geographies and reflationary levers. It is a path that leads to mounting non-linear risks for global markets and growth. The global economy needs a more effective and coordinated policy response, one that can raise aggregate demand but also prevent some of the increasingly persistent, cyclical restraints to economic growth becoming structural. While there are growing signs that some key countries may switch to more effective reflationary policies, in all too many cases the political barrier to appropriate policy remains high, and may first require a period of pronounced market and economic dislocation which could mean a pyrrhic victory for investor portfolios positioned for a switch to reflation. However, short-of a sufficiently bold policy reflation, there are a number of policies which could meaningfully improve cyclical and secular global growth and which may face a lower political barrier to implementation. Some of these are already emerging onto the global policy agenda, and have the potential to provide a much needed upside risk to growth and market performance.

US worker productivity – An example of how insufficient and misdirected reflationary policies can lad to a cyclical restraint to growth becoming a structural one

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The Saudi Arabian currency peg and the price of convexity

It has rarely been timelier for investors to embed a convex strategy within their portfolios, whether this be positioning for or hedging against out-sized, non-linear moves and trend changes within markets. The list of potential shocks grows ever longer and includes issues such as: a world economy struggling to sustain acceptable growth rates; the growing awareness of the downside risks to inflation in major economies; many policy-makers implementing ever more unorthodox monetary policies; the growing fear that the Fed has repeated the past policy errors of the BOJ and ECB in tightening monetary policy too soon. An additional risk factor, which will likely grow in importance, is the credit risk and secondary market implications of the collapse in commodity prices. Of particular focus for this note is the tension between the Saudi Arabian currency peg and the changed dynamics in the oil market where, firstly, the price of crude has become increasingly exogenous to OPEC members and, secondly, where Saudi Arabia appears to have changed supply policy in favour of preserving market share rather than the price of oil. For all the focus on Saudi Arabia’s current austerity programme designed to respond to the slide in oil prices, it is difficult to see fiscal policy being sufficient to remove the increased FX risk premium attached to the SAR-peg. Continue reading

Trading emerging market yield curves during currency shocks: a tale of two curves

We live in exceptional times, with many financial market prices and central bank policy settings at hitherto undreamed of levels. For many policy-makers trying to navigate their way through a persistently sluggish global economy, the conduct of monetary policy is complicated by their choice of prevailing exchange rate regime. Some significant trading opportunities can emerge from yield curve gyrations that are driven by FX policy, particularly during times of crisis, with Singapore and Korea providing two contrasting examples. These opportunities may be magnified by the prevailing strong-USD climate. The FX and yield curve relationship is also worth considering in the context of the perennial criticisms that are levelled at the crisis response policies proposed by the “Washington Consensus”, policies which so often attract complaints of a asymmetry between the options offered to developed and emerging market economies. Continue reading