What Happened in February? Is It the Start of Something New? And Where Will It All End?

  • Markets reacted strongly to what was possibly a fluke in the data in February. The sharp rise in volatility exaggerated the true significance of the sell-off.
  • As the dust settles it becomes ever clearer that the “correction” was none at all. Even at its most extreme it was in line with traditional annual drawdowns.
  • Yet, anyone betting on an extended expansion will ultimately worry about rising price pressures and a rear-guard fight by the Fed to raise rates. But the bigger worry is a rise in long term rates, which are under assault by the Trump administration’s fiscal expansion and the Fed’s balance sheet reduction.
  • In addition, asset prices have become more stretched, investor confidence has continued to wane and volatility is on the rise, making it more expensive for investors to insure against down-moves in the stock market. In this context, a strong economy offers only scant comfort.
  • This could be the year when investors will start interpreting good news for the economy as bad news for the market.

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Another Year of MOTS and FOMO?

(first published January 14)

  • 2017 was a stellar year for asset markets: simply being long risk was sufficient to achieve strong returns. For 2018, market participants are optimistic on the back of expectations of above-trend global growth and broadly ac-commodative monetary conditions. Indeed, the new year started with a bang.
  • Yet, challenges abound: market and liquidity risks have become elevated and medium term vulnerabilities weigh heavily. The key risks include 1) the outlook for US and DM economic policy, 2) the so-called ‘volatility paradox’ and 3) local EM election risk.
  • The greatest risk to asset markets stems not from short term rates (Fed hiking) but both to and from long term rates. The risk of a significantly accelerating US economy is limited, while Fed balance sheet operations and the unfunded fiscal expansion (possibly amplified by spending increases) will pressure long term yields upwards and disrupt the rosy outlook for risk assets.
  • A reversal of long-term yields will not just weigh on rates markets, but in particular on stretched equity markets whose relative attractiveness is on the wane. Given the combination of low volatility and high leverage, the adjustment to changing conditions risks being sharp.

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Why the Fed Balance Sheet Reduction Won’t Affect the Economy – And Why It Will

  • Quantitative Tightening, as envisaged by the Fed, implies an equivalent, and ultimately sizeable, reduction of bank reserves on the liability side of the Fed’s balance sheet. 
  • However, changes in monetary aggregates have little impact on the real economy or inflation. As a result, the money multiplier is simply likely to rise, as will the velocity of money.
  • The most important effect of QT will be through long-term rates. Maturing UST’s will be replaced by new issues to the market. Once they reach their target pace, roll-offs will be equivalent to a full 60% of current net issuance.
  • The effect will be moderate at first, but could be amplified by the knock-on effects on other asset prices, simultaneous policy changes by other central banks or a widening US federal deficit.

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Central Banks: Stopping the Addiction

  • As global economies recover, central banks are shifting towards ‘normalising’ their bloated balance sheets. Given the scale of the previous build-up, many investors fear that this could be hugely disruptive to markets.
  • Yet, this is unlikely. The Fed’s balance sheet is unlikely to return to its pre-crisis size and the path towards its steady-state size is likely to be a gradual one. The move is well anticipated by market participants and the Fed can use both rates and its balance sheet size to calibrate overall monetary conditions.
  • What is more, normalisation will (only) take place against a backdrop of economic recovery and the Fed will deliberately choose to remain “behind the curve” (i.e. tolerate an overshoot of the inflation target).
  • On a positive note, the release of collateral into the market is set to expand private sector balance sheets and lubricate the financial system.

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The BoJ’s New Monetary Experiment: Riddled with Inconsistencies

  • Adding to its already wide-ranging arsenal of of monetary policy tools, the BoJ last week introduced yet another feature: “QQE with yield curve control”. In addition to the short term rate, the new regime aims to peg the long term interest rate (10yr) as well.
  • However, targeting interest rates is inconsistent with controlling the quantity of money. What is more, the policy may require asset sales and thus run counter the original policy objective.
  • It reveals a sensitivity to banking sector concerns which conflicts with the BoJ’s official price targets. While it may allow the BoJ to delve deeper into negative rates on the short end, the move also undermines the process of asset price reflation.

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Is It Time to Buy Emerging Markets?

  • The dismal performance of emerging market equities during the past three years (a total of -20%) suggests that a rebound may lie around the corner.
  • Yet, country-specific factors aside, three key global factors argue otherwise: 1) insufficiently attractive EM valuations, 2) the structural deterioration in EM balance sheets and the resulting vulnerability to 3) tightening global monetary conditions.
  • The latter in particular far surpasses the small 25bps hike the Fed delivered in December 2015. The end of QE3 is estimated to be equivalent to a 300bps tightening, while the sharp decline in foreign holdings of US Treasury securities further adds to a vicious cycle of tightening monetary conditions.
  • In the short term, rising commodity prices provide non-trivial support to EM assets, but the persistent structural economic weakness and the risk of a shock to market expectations of Fed hikes implies that investors should fade rallies, rather than buy into them.

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Third Time Unlucky or The New Sino-American Symbiosis

  • The global economy is facing its third deflationary shock in succession.
  • After the US economy and the Eurozone, China is the epicenter of the latest crisis.
  • The erstwhile Sino-American Symbiosis resurfaces in a new, more nefarious form. The causation runs from reserve declines, to global monetary tightening. to slowing credit expansion and private consumption. This process is only just beginning.

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