A fragile world economy that faces an ever more daunting battle to combat deflation and where there is a growing concern that traditional reflationary policy levers are reaching their effective limits, could have done without another event shock. And yet that is exactly what it has received as the UK voted for Brexit. To make it worse, the subsequent political unravelling in the UK had created the impression that the country is rudderless as it seeks to navigate through the dangerous path the electorate has chosen. The PM has resigned and remains as a care-taker, the main opposition party is in turmoil with a leader at best luke-warm to Europe and whose consistently weak performance has sparked internecine warfare in the party, while it has become clear that the Brexit leaders do not have a plan of implementation or are even aware of the full implications of Brexit. The market turmoil appears fully justified. That said, for international markets the Brexit impact is likely to be more akin to the December-February market rout – painful, deep but finite. Brexit is not the trigger point to ”The Big One”, the financial crisis we fear is coming. However, for the UK – unless reason prevails and Article 50 is not triggered – the outlook is bleak. GBP has enormous downside potential, while Gilts may become Bund-like in that they are viewed as collateral rather than yield instruments. 10-yr Gilts could trade flat to a lowered policy rate.
Category Archives: Event Risks and Left Tail Events
The danger of the Fed’s presumed US exceptionalism: real yields, “illusory alpha”, declining neutral rates and the need for core “received” positions.
The US interest rate market is maintaining longer-term path to lower trading ranges in terms of yields. This is under-pinned by a lower “neutral” real Fed Funds rate. It also reflects an underlying weakness in the US economy, which reduces the resilience of the expansion to domestic and external shocks and which also questions the Fed’s presumed exceptionalism – it’s view that it can tighten policy while the rest of the world is looking to ease. Indeed, despite yet another ratcheting lower of it’s presumed path of policy tightening at its June FOMC meeting, the Fed still appears overly optimistic on the path of rate hikes. Once the Brexit-related gyrations in global risk premia have passed, the underlying trend of lower yields in term-US interest rates is expected to continue. Investors will continue to be rewarded for retaining core “received” positions. Meanwhile, one trend which is supporting the declining trend in UST and US IRS yields – falling real yields – is also serving to preclude a source of “illusory” alpha which benefitted the asset management industry pre-crisis, and which is now supporting the rise of lower cost passive investment strategies.
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.
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
The full note is available for purchase directly from Event Horizon Research. To purchase the report please e-mail admin@eventhorizon-research.
The income-lite recovery trend – does the UK labour market recovery portend continued weak US wage growth?
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
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
China – The non-linear growth and FX risks of the structural slowdown
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
Is the US economy really ready for a rate hike?
When assessing the outlook for The Fed’s monetary policy the clear consensus view is that the US economy is “good to go” for a hike, and that weakness in overseas economies is providing the key restraint to lift-off. This viewpoint could under-estimate the scale of the policy error were the Fed to hike rates over the coming months. Quite simply, the US economy continues to face structural headwinds that are restraining growth and inflation and which argue against policy tightening. These structural headwinds hold the potential to restrain household income growth and consumer demand and give a “data dependent” Fed, quite literally, a reason for pause. There is a strong potential for the Fed to keep rates unchanged in 2015 and 2016. In fact, the structural headwinds in the US increase the economy’s vulnerability to external shocks, meaning that a renewed policy easing is not beyond the pale. Rather than an overshoot, the current rally in US interest rate markets may have further to go over the coming months. Continue reading