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
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One positive side effect of the UK vote for Brexit appears to be a policy shift away from austerity towards an embrace of reflationary fiscal policy. This has the potential to meaningfully change the UK’s economic growth outlook. Moreover, the expected UK policy shift is part of an evolving global theme whereby more policy-makers are starting to address one of the key factors behind the slow-burning global growth crisis – a lack of policy coordination between reflationary levers. The US presidential candidates each propose a more activist fiscal policy, Canada’s government is enacting its election pledge of fiscal stimulus, while Japan may soon combine fresh fiscal stimulus with QQE3 and potentially the “Hail Mary” opinion of Helicopter money. These are encouraging signs, and may offer some hope that the world economy may not reach the deflationary end-state that appears to be it’s current destination. However, optimism needs to be tempered. Any fiscal easing in the UK will be aimed at avoiding recession rather than accelerating recovery, and may fall far short of the 2% of GDP we feel is required over the next 12 months. The UK policy change reduces severe left-tail risk with respect to the GBP rather than comprising a bullish scenario: GBP/USD is still expected to move below 1.20. Globally, with a few exceptions, progress towards sufficiently aggressive and broad-based policy reflation remains patchy, and geographic coordination remains poor as policy-makers still address multi-lateral problems with bi-lateral solutions. Nonetheless, that more policy-makers are embracing more economically optimal policy options can only be a positive trend for global growth. In terms of Japan, which is closer to the point of radical policy coordination and where policy mis-steps of the past 12 months require bold action from the government and Bank of Japan, we see value in owning deep out of the money upside in USD/JPY while CAD/JPY could be an interesting play on relative policy dynamics. Meanwhile, stay receved JPY IRS.
The BOJ’s soon to be majority ownership of the JGB market blurs the line between QQE and helicopter money
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Within a slowing global economy that is replete with potential event shocks, the Eurozone stands apart from other major economies in terms of its lack of policy flexibility. Monetary policy has to remain the dominant source of reflation, with the diminishing multiplier effect this entails, while fiscal policy remains overly tight and regulatory policy comprises a notable tightening of monetary conditions. To make matters worse, Germany comprises a “deflation engine” at the heart of the Eurozone. This is an unstable equilibrium with respect to the medium-term durability of the Euro. More immediately a lack of policy flexibility comes at a time when some key inflation measures in Europe are flashing deflation warnings while concerns are building with respect to the banking sector solvency of some Eurozone countries, most notably Italy. The negative interest rate and QE policies of the ECB complicate translating these risks into investment themes given that they seek to suppress credit and risk premium in financial asset. However, the current structural and cyclical forces in Europe reinforce the value in core bond markets despite the ticker-shock of low/ negative yields: Bunds, for instance, should continue to trade more as collateral instruments with an embedded FX option rather than yield products. There is also value emerging in trades that fade the ECB action with respect to select non-core sovereign bond markets, with the proviso that trades need to be structured appropriately: a BTP curve steepener, or short BTPs and long Bunds or USTs in the 10-yr area offer value. Meanwhile, Eurostoxx are expected to persist their marked under-performance of US equities while high yield and financial credit spreads appear increasingly vulnerable, particularly as they lie outside the ambit of ECB QE. Finally, an increasingly structural outflow of capital is expected to establish a medium-term trend of EUR weakness.
EUR 5fwd 5yr inflation swap: warning lights and wailing klaxons regarding the prospect for price stability.
In the post-Brexit political turmoil that has engulfed the UK, the Bank of England is providing some required adult supervision. It’s early diagnosis of the economic impact of the Brexit vote allied to it’s policy response – talk of monetary easing, and the Financial Policy Committee’s easing of financial conditions via the regulatory channel – are necessary and welcome. However, a theme of the post-crisis global economy is that monetary policy should not bear the brunt of reflationary policies due to diminished money multipliers. Fiscal policy needs to be more active. Unfortunately, the government’s talk of corporate tax cuts will do little to address the looming problem of insufficient aggregate demand and of the risk that UK consumers copy their US counter-parts and increase their savings rates. A policy response that is uncoordinated across reflationary levers implies continued downside for the GBP, which we expect to depreciate to below 1.20 vs. the USD. Meanwhile GBP interest rate markets have continued reason for strength. We continue to see the 10yr Gilt yield moving flat to a lowered (0.25%) policy rate, and over the coming months see receiving the GBP IRS 10fwd 10yr becoming a higher beta play on the GBP yield curve.
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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There is a comfortable consensus with respect to the US economy: the labour market has recovered and rising wage inflation could risk the Fed’s inflation mandate were it not to continue to tighten policy. This may prove to be a dangerous assumption. There are many reasons to believe that the headline US unemployment rate remains a poor guide to wage inflation. In addition, there are numerous additional factors that are restraining wage growth in the US and indeed across many countries in the G10. A comparison to the UK is instructive. The UK labour market recovery has been far stronger and broader than that of the US and yet wage growth is less than half the pre-crisis and long-term trend. Something is afoot in the G10 and is being overlooked by the consensus. Analysing the UK experience shows that many of the factors restraining wage growth are applicable to the US. Were these factors to continue to restrain wage growth, the Fed’s tightening cycle could increasingly resemble to a policy error. Continue reading
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
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
China’s investment-driven growth model is unsustainable in a post-crisis world of low global growth. Weak external demand magnifies the adverse side effects of this growth path – inefficient use of capital, excess industrial capacity, deflationary pressures, high corporate leverage. When these problems are allied to demographic challenges, China appears to be one of the world’s leading economies for which the secular stagnation argument could most readily apply. China’s slowdown is a challenge for the world economy given that China has accounted for nearly a third of global GDP growth since 2007. The challenge for China’s policy-makers is to address the non-linear risks implicit in a highly leveraged and deflationary economy shifting to a lower growth path. Monetary policy will need to remain exceptionally loose. Given this backdrop, there are growing downside risks to the CNY. Already Chinese institutions are increasing their holdings of overseas assets and the scale of China’s domestic liquidity is such that only a marginal increase in demand for foreign assets can swamp the balance of payments: China’s M2 approximates the combined M2 of the US, Germany and Japan. The CNY forward curve would appear to under-price the likely depreciation of the CNY over the next 12 months. Continue reading
Japan’s economy is exhibiting the same critical trends that were seen during its long expansion in the 2000s. The expected consequence is an income-lite growth path that challenges the BOJ achieving its 2% inflation target. More policy stimulus is needed, and QQE3 (and beyond) is likely to be forthcoming. Fears that shortages of JGBs will preclude further stimulus and require a BOJ taper into 2016 are misplaced: there are potentially over JPY200trn of JGBs that the BOJ can buy. More QQE will help restore the trend of a weak-JPY and support the Nikkei while investors should expect fresh record lows in JGB yields. The current move in USD/JPY below 120 is an opportunity to scale into USD-longs while for those that can overcome the ticker-shock of low yields, the “old faithful” point of the JPY interest rate market – the JPY IRS 7fwd 3yr – is looking appealing. Continue reading