Of farewells, underpants and unfinished themes

Of excitement and regret

It is with decidedly mixed emotions that I report that Event Horizon Research will be tenderly and proverbially, covered in bubble wrap and placed in storage. EHR will no longer provide economic and market analysis, advice and strategy – either in written or verbal form. I would to thank our clients and readers. It has been a wonderfully enjoyable ride.

The reason for shuttering EHR is that I have decided to return to the buy-side. As excited as I am about the position I will accept and the organisation I will be joining, I still feel sadness at closing EHR. On one level, when you pour your energy into building a venture from the ground-up you come to think of your creation as somehow, organic. A second, and much more prosaic reason for my maudlin mood is the realisation that the balance of probabilities suggest that in my new institution, I will no longer have the option of deciding to work in my underpants.

Fig 1. A form of work attire that is unlikely to be maintained

A third source of poignancy is that I will not be able to update the analytical narratives I had been building.

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The BOJ’s SNB moment? JGBs, USD/JPY and potential negative convexity

As the BOJ steps up its rinban operations to defend its yield cap, it is demonstrating the unusual pro-cyclciality of it’s monetary framework: during times of improving growth expectations and rising yeilds the pace of BOJ liquidity creation is biased to increase, and vice versa. The failure of the era of Abenomics to end Japan’s multi-decade experience of deflation argues in favour of the BOJ defending it’s yield cap. As such, with a lag domestic investors could start to allocate more funds to JGBs and there is the potential for the JPY IRS 7fwd 3yr (the pivot point of the curve and our favoured way of expressing bullish views on JPY interest rates) to rally 25-30bp over the coming 3-6 months. However, we cannot recommend such a trade with any degree of conviction. Our bias is to seek trades with a positively convex return profile, but being received JPY interest rates essentially makes investors “short” the potential for a possible BOJ regime shift in policy formation. While we feel this is unlikely, Japan’s long history of policy mis-steps and the experience of the SNB and its decision to break its FX floor, both provide reason for caution. We have greater comfort in expressing a short-JPY FX view, particularly against the USD. While USD/JPY is clearly correlated to the JGB trade, there are some independent dynamics that could argue for the recent correction lower in USD/JPY running its course and reversing.

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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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UK – the emergence of economic policy clarity

Many of the key concerns over the outlook for UK economic policy have been eased over the past week. Concerns over Bank of England independence and of the possibility of monetary policy being focussed on the GBP or imported inflation have all eased. The conditions have been laid for a breaking of the recent negative correlation between GBP weakness and Gilt yields. However, concerns have grown that the government will prove insufficiently ambitious with respect to fiscal expansion, which adds to our concern that the BoE is over-stating the outlook for economic growth into 2017. Further monetary expansion into H1 2017 appears likely. While there are some significant potential pot-holes for the global economy to traverse, most notably the forthcoming US Presidential election, it is time to start looking for opportunities to scale into long-Gilt position by building-up DV01 to the target level into weakness. From a medium-term perspective  Gilt yields have yet to reach their cycle low.

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UK break-even inflation spreads and the cyclicality of the RPI-CPI inflation wedge

In our recently released strategy note (The Gilt sell-off, mounting UK economic risks and an inflation scare that rhymes) we outlined that the upsurge in UK break-even inflation rates to over 3% had over-stated the likely path of UK inflation. Admittedly, the slump in the GBP will drive import prices higher and could see the Bank of England’s (BOE) 2% inflation target overshot by over 1% within 12-18 months. However, the laggardly nature of wage growth and growing downside risks to the economy will mean this poses more of a threat to household disposable incomes and hence private consumption more than it will spark a second round inflation effect. A steep disinflation if not deflation will follow the import price shock.

Chart 1. The UK CPI-RPI wedge is cyclical

uk-inf-wedge

Source: CEIC

One rejoinder to the view that BE spreads have overshot is that the reference rate for UK Linkers is the RPI rather than the CPI. Due to numerous computational and compositional weaknesses, the RPI substantially overstates the level of inflation as determined by the more robust CPI. This “inflation wedge” currently sees the RPI 104bp above the 1.0% Y/Y rise in the CPI and over the past 5 years has averaged 71bp, which has been the medium-term differential. BOE analysis suggests that the wedge could rise to 1.4pp over the long-term. This questions whether UK BE inflation rates have actually overshot since a 3% RPI may be consistent with a CPI of 2% or lower.

This is a viable criticism. However, there is a strong cyclical component to the UK inflation wedge. One of the reasons why the RPI tends to be higher than the CPI is that it includes measures of housing price trends and mortgage payments. Both of these measures tend to move lower into a UK economic downturn. Chart 1 demonstrated how the CPI wedge turned steeply negative in 2008-2009 when the UK economy went into a deep recession, and then reasserted a positive differential as the recovery matured. Given our growing concerns with respect to the UK economic outlook, we would expect the cyclicality of the inflation wedge to narrow the differential between the CPi and the RPI. Hence, we feel confident in believing that UK BE spreads have over-short the likely path of inflation.

 

The Gilt sell-off, mounting UK economic risks and an inflation scare that rhymes

The continued negative correlation between GBP weakness and Gilt yields is a threat to the UK economy as it at least in part negates the expansionary effect of BOE monetary easing and indeed of GBP weakness. It may also lessen the ambition of the UK government to initiate a much-needed fiscal stimulus. This is concerning since the UK economy is particularly ill equipped to withstand the Brexit shock. Households – the core driver of the post-GFC economic recovery – face the shock with a weakened balance sheet: nominal wage growth remains weak, and rising inflation will squeeze disposable incomes; households have rapidly increased leverage in recent years; flow of funds data shows UK households to be dis-saving at a rate last seen on the eve of the GFC.

 In terms of the drivers of Gilt weakness, the variable we are least worried about is the concern over inflation. While higher import process will see the CPI exceed the BOE’s 2% inflation target, insufficient wage growth will mean this poses more of a threat to growth than to medium-term inflation. This is a story of FX and commodity price shock to headline inflation that we have seen play-out many times in G10 economies over the past decade. Now is no different. BE inflation spreads have already widened to the point where they significantly over-state the likely path of inflation. Similarly, concerns about the impact of a foreign investor flight from Gilts may prove over-stated. However, while we have maintained our bullish medium-term forecasts for Gilts, any near-term appetite to fade the rise in nominal yields is tempered by an understanding of how it may take some time for the market to recognise that the current inflation scare is over-stated and also by the emerging signs that the government may persist in its recent criticism of the BOE’s loose monetary policy. The latter poses a particular threat to the Gilt market, and ultimately the GBP and UK economy, if it reinforces the increasingly common – and persistently incorrect – viewpoint that the UK requires tighter monetary policy.

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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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The falling neutral Fed Funds rate – a yield curve anchor and insulation against a Fed policy error

The Fed’s search for a reason to raise interest rates risks creating a policy error. There is no compelling reason for the Fed to hike, or to forego its battle-tested strategy of trying to manage asymmetric economic risks. Moreover, one consequence of a steady downtrend in the Fed’s neutral policy rate is that monetary tightening will bite far sooner than in previous cycles: a 25bp hike could be equivalent to a ~75bp hike pre-GFC. The market appears right to be sceptical about the Fed’s “targeted” rate hike trajectory. However, a lower neutral policy rate would provide resilience to the US yield curve in the event of a Fed hike since this trend is compressing the “equilibrium” term structure of yields. Indeed, this lower term structure helped limit the scale of the summer sell-off in US interest rates, a move we expect to continue to be retraced. We see value in positioning for lower 10yr US yields in both spot and forward space. One risk for the Fed is that while it agonises over how to appropriately conduct monetary policy in a world of a lowered neutral policy rate, by hiking prematurely it could exacerbate its dilemma by helping to maintain this very downtrend in the neutral rate.

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The Bank of Japan’s new policy framework and Jar Jar Binks

The Bank of Japan delivered a new monetary regime following today’s policy meeting. Unfortunately, the switch to a yield and yield curve targeting framework will lessen the authorities’ ability to achieve their growth and inflation targets. The new regime is internally inconsistent, lacks a theoretical anchor and may compel an early tapering of QE. The new policy regime may provide a support to investors looking to buy-JGBs and receive JPY IRS in the 10-yr area of the curve as the BOJ tries to limit sell-offs and create a path to stable roll and carry returns. (The “old faithful” JPY IRS 7fwd 3yr is a “receive” into today’s policy decision.) However, in so doing the BOJ will slow the flow of liquidity into risk assets by allowing Japanese financial institutions to maintain their deflation-focussed portfolio mix. The new regime will also make it more difficult for the BOJ to prevent continued downside moves in USD/JPY over the coming months.

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The weak CNY and the potential for a trend acceleration

One of our core medium-term investment themes has been for the emergence of a cyclically and secularly weak CNY, and we continue to hold to this view. The Chinese authorities’ current embrace of a weak-CNY is expected to persist, with the pace of CNY depreciation continuing to out-strip that priced into the FX forward curve. We also continue to favour positioning for CNY weakness via the NDF curve rather than the CNH offshore forward market, and accept paying wider forward points in return for reduced fixing risk. The method that the authorities have deployed to weaken the CNY has allowed the sizable depreciation seen over the past few quarters to go somewhat below the market’s radar screen. Nonetheless, continued CNY weakness may increasingly influence the performance of currencies and markets in Asia ex-Japan. The current liquidity driven rally in emerging markets may therefore provide attractive opportunities to short Asian currencies such as KRW and SGD, and also initiate some interest rate trades such as recieving KRW IRS and implementing SGD IRS curve flatteners. An additional appeal of a long-USD/CNY position is that the position contains an embedded long convexity component. There are growing non-linear economic risks associated with China’s economic slowdown given the combination of surplus industrial capacity, an increasingly inefficient allocation of capital and exceptionally high corporate leverage. These risk will increasingly require ultra-accomodative monetary settings to help limit the rise of credit risk and NPLs, and such a policy is consistent with a faster pace of CNY weakness. The unprecedented recent stability of the CNY IRS curve reflects the current policy stasis: PBoC is trying to strike a balance between supporting economic growth with low rates and limiting the rise in USD-demand; ultimately, as growth continues to slow the need for lower interest rates will prevail and the CNY IRS 2s5s spread is likely to steepen sharply as the fixing rate is allowed to decline.

The USD/CNY NDF curve continues to under-price the depreciation potential for the CNY

CNY1

Source: Bloomberg

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