"When everyone is thinking the same, no one is thinking." - John Wooden, American basketball player and coach
In this week's conversation we would like to discuss our contrarian stance surrounding "Mack the Knife" aka King Dollar + positive real US interest rates and why we think that eventually "Trumpflation" could morph into "DeflaTrump", meaning a lower dollar thanks to that 30s model we discussed as of late, namely that populism and discontent means we are potentially facing a global trade war with the rise of protectionism.
- Macro and Credit - All the promises we've been given...
- Final chart - The central bank "put" has been weakening
- Macro and Credit - All the promises we've been given...
We might sound a bit philosophical in these early days of 2017 but, we do share Jim Chanos and Steen Jakobsen, that we are going to see some tectonic shifts.
These shifts will have some significant consequences in terms of allocations rest assured. You might be wondering why we have entitled our bullet point this way? Well as goes the lyrics for an Electro House song we like "All the promises we've been given", government and central bankers have been very good at promising:
"All the promises we’ve been given
All the fires that we’ve feedin’
All the lies that we’ve been livin’ in
Wouldn’t it be nice if we
Could leave behind the mess we’re in
Could dig beneath these old troubles return
To find something amazing" - The Presets - Promises
"We quoted Dr Jochen Felsenheimer in our conversation "The Unbearable Lightness of Credit" in August 2012, let us do it again for the purpose of the demonstration:
"The advantage of explicit guarantees is that the market can value them and that the guarantee can be taken up - even in a crisis! For this reason, we can quote the "last man standing" at this point, the president of the German Federal Constitutional Court, Andreas Vosskuhle:"The constitution also applies during the crisis". That is a hard guarantee, both for politicians and for investors!"
We will not discuss the issue of implicit guarantees and explicit guarantees from a credit valuation point of view as we have already approached this subject in our conversation quoted above. The only point you should take into account is that the advantage of explicit guarantees is that markets tend to "function" better under them. Obviously our great poker player "Mario Draghi" at the helm of the ECB has played with his OMT a great hand but based only on "implicit guarantee". That's a big difference." - source Macronomics, November 2013
"As we have pointed out in numerous conversations, just in case some of our readers went through a memory erasure procedure, when it comes to "investor flows" Japan matters and matters a lot. Not only the Government Pension Investment Funds (GPIF) and other pension funds have become very large buyers of foreign bonds and equities, but, Mrs Watanabe is as well a significant "carry" player through Uridashi funds aka the famously known "Double-Deckers". This "Bondzilla" frenzy leading our "NIRP" monster to grow larger by the day is indeed more and more "made in Japan"- source Macronomics July 2016
"Surplus structure keeps yen in check
Japan's Ministry of Finance today released the November international balance of payments and a preliminary portfolio investment report for December. Japan’s current account stood at a ¥1.8tn surplus in November to match the recent trend (Chart 3).
We are seeing a gradual recovery in Japan’s real exports, which seems in line with the positive cyclical trend in global manufacturing. Oil imports have stabilized, but remain low. Outward direct investments exhibit structural strength, but the yen’s significant depreciation since the summer suggests “tactical” large-scale purchases of foreign companies (eg, Softbank buying ARM) are probably behind us for the time being (Chart 4).
The BoJ’s yield curve control has widened the yield gap between foreign and yen rates, which should support Japan’s thick income surplus. Overall, the surplus structure marginally stabilizes the yen’s move especially as Japanese investors first reacted to the US election by selling foreign bonds (Chart 2).
Trump shock led to foreign bond sale
In December, Japanese banks and lifers sold ¥1.48tn of foreign bonds, the biggest sale since June 2015 amid the Bunds tantrum. This is in line with our view given the rise in volatility in the US and the likely loss from the move in rates after the election. Details are yet to be reported, but we would assume this is a continuation of November where most of the sales happened in the US rather than Europe (Table 1).
Given our core view in the US remains bearish duration while the BoJ’s monetary policy helps keep JGB yields relatively low, this likely leads to some repatriation of Japanese money to the JGB market, which explains the rise in JGB purchases at both banks and lifers in November.
Pensions rebalance into bonds, out of equity
In Oct-Dec, trust accounts–represented by pension accounts–sold domestic and foreign equities and bought JGB and foreign bonds (JGB data up to November) (Chart 6).
In our view, the GPIF portfolio is close enough to its target that large moves in financial markets would lead to rebalancing activities where appreciating assets are sold and depreciating assets are bought, reducing market volatility at margin.
Flows may keep USD/JPY basis from widening for now
Meanwhile, foreign investors net-sold ¥123bn of JGBs in December. This most likely resulted from quarterly redemption of JGBs as a data from the JSDA, which excludes redemptions, shows foreign investors were net purchasers for a 29th straight month in November. We argued that tightening in USD/JPY basis spread is unlikely to become a trend, but a combination of cautious Japanese investors in foreign bond investment (and some repatriation into JGBs) and demand from foreign investors for JGBs will keep the USDJPY basis off the high seen in November for a while." - source Bank of America Merrill Lynch
"King Kong Dollar
The most prominent theme in our 2017 FX blueprint is that a Trump presidency changes everything. The US economy is the 800-pound gorilla in the room – policy shifts are too important to not matter for global FX. Our overall assessment is that Trump will be highly supportive of the dollar. Whether this mostly happens against the low-yielding EUR and JPY or EM FX will depend on the policy mix that is delivered: greater emphasis on growth and the euro and yen will suffer most; greater trade protectionism and EM, particularly Asia, will bear the burden. Either way, the broad trade-weighted dollar should strengthen, with a Trump administration coming at a convenient time for our medium-term bullish view. First, the greenback has finally entered the ranks of a G10 FX top-3 high-yielder, an important driver of dollar appreciation in the past. Second, a rally that is front-loaded to the beginning of a Trump presidency fits in nicely with the mature stage of a typical 7-10 year dollar up-cycle.
It is tempting to only talk about President-elect Trump, but currency drivers run beyond the US. From Brexit to European elections and China’s ongoing battle with outflows, politics and de-globalization stand out as the broader FX drivers of 2017. In most instances, particularly in Europe, idiosyncratic stories provide further support to a bullish dollar view. In other cases, local drivers allow for useful diversification against dollar longs, with ZAR, RUB and IDR standing out in particular. 2017 promises to be another exciting year for FX.
Looking for the dollar catalysts
We see Trump’s Fed appointments and corporate tax reform as the most important drivers of the dollar in 2017. Four out of seven board nominations are due this year, including Yellen’s replacement. These are likely to lean hawkish and entirely reshape the Fed. Corporate tax reform may well mean lower rates, but far more important would be an imposition of a “border tax” –potentially the biggest shift in global trade since Bretton Woods and leading to a big US competitiveness gain. Beyond America’s shores, idiosyncratic drivers point to a stronger dollar against both the JPY and EUR. In the Eurozone, negative surprises in either the French or potential Italian election open up existential risks. Even if all goes well, the beginning of ECB taper could accelerate record portfolio outflows: wider spreads (and redenomination risk) and more volatility in bunds should further lower demand for European assets. Japan stands out for the opposite reasons: political stability will allow the BoJ to continue targeting JGB yields unhindered, further increasing policy divergence with the US. We expect EUR/USD to break parity and USD/JPY to approach its all time-highs this year.
It’s all about Trump’s tax policy
While most attention is focused on US fiscal stimulus, we think corporate tax reform stands out as the biggest positive driver of the dollar in 2017. Lower tax rates, border adjustments and a tax holiday on unrepatriated earnings all matter. Border adjustments would impose a 15-20% tax on all US imports while exempting export income from taxation. The policy would amount to a 15% backdoor competitiveness gain for the US economy. A mechanical application of trade elasticities would imply that the US basic balance would go back to the highs seen at the start of the
century (chart 1).
A tax holiday and shift to a territorial system of taxation would allow more than $1 trillion of dollar liquidity and $200bn of annual future earnings to be brought back to the US. Most of this cash is already in USD: but the withdrawal of offshore liquidity will maintain widening pressure on cross-currency basis pushing offshore dollar yields higher. Corporates are likely to use the liquidity for buybacks and dividend hikes which together with corporate tax cuts would encourage equity inflows and further support the dollar. With foreigners not having invested in US equities for the last five years, there is plenty of potential for foreign buying of the S&P (chart 2).
- source Deutsche Bank
"Ramifications and Investment Advice
Although it remains unclear which approach the Trump trade team will take, much less what they will accomplish, we are quite certain they will make waves. The U.S. equity markets have been bullish on the outlook for the new administration given its business friendly posture toward tax and regulatory reform, but they have turned a blind eye toward possible negative side effects of any of his plans. Global trade and supply chain interdependencies have been a tailwind for corporate earnings for decades. Abrupt changes in those dynamics represent a meaningful shift in the trajectory of global growth, and the equity markets will eventually be required to deal with the uncertainties that will accompany those changes.
If actions are taken to impose tariffs, VATs, border adjustments or renege on trade deals, the consequences to various asset classes could be severe. Of further importance, the U.S. dollar is the world’s reserve currency and accounts for the majority of global trade. If global trade is hampered, marginal demand for dollars would likely decrease as would the value of the dollar versus other currencies.
From an investment standpoint, this would have many effects. First, commodities priced in dollars would likely benefit, especially precious metals. Secondly, without the need to hold as many U.S. dollars in reserve, foreign nations might sell their Treasury securities holdings. Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.
Investors should anticipate that, whatever actions are taken by the new administration, America’s trade partners will likely take similar actions in order to protect their own interests. If this is the case, the prices of goods and materials will likely rise along with tensions in global trade markets. Retaliation raises the specter of heightened inflationary pressures, which could force the Federal Reserve to raise interest rates at a faster pace than expected. The possibility of inflation coupled with higher interest rates and weak economic growth would lead to an economic state called stagflation.
Other than precious metals and possibly some companies operating largely within the United States, it is hard to envision many other domestic or global assets that benefit from a trade war." - source 720 Global, Michael Lebowitz, Hoover's folly, 11th of January 2016
"Whereas investors have been anticipating a lot in terms of US fiscal stimulus from the new Trump administration hence the rise in inflationary expectations and the relapse in financial "Dystopia", which led to the recent "Euphoria" in equities, the biggest unknown remains trade and the posture the new US administration will take. If indeed it raises uncertainty on an already fragile global growth, it could end up being supportive of gold prices again." - source Macronomics, November 2016
"Weak dollar policy is a natural extension of protectionist policies
Clearly, the one area of trade policy that has been so far little discussed is FX policy. In a detailed interview on 30 November 2016, soon-to-be Treasury Secretary Steve Mnuchin evaded a pointed question on whether he supports a strong dollar. Instead, he responded:
“I think we’re really going to be focused on economic growth and creating jobs and that’s really going to be the priority.” (CNBC, 30 November 2016).
FX policy cannot be ignored in trade policy. A weak currency can be effective in giving domestic industries an advantage over foreign industries. Indeed, this has generally been the policy of emerging Asia economies from China to Thailand. Their substantial growth in FX reserves since the Asia crisis in 1997 is testament to a concerted policy to curb strength in their currencies. For Donald Trump, at a fundamental level, any appreciation of the dollar would offset some if not all of any import tariffs introduced.
As for the practicalities of introducing a weak dollar policy, the Plaza Accord of 1985 under a Republican administration is the last such example. However, it was coordinated with key trade partners and monetary policy was moving in a supportive direction. Replicating such an Accord would be a gargantuan task. The other precedent of sorts is the Nixon shock – again under a Republican administration. This was a unilateral move and involved both a currency devaluation and the imposition of import tariffs.
However, the better reference points may actually be emerging markets. They have pursued weak currency policies without coordination and often at odds with domestic monetary policy. Admittedly, the presence of capital controls makes it easier to separate FX and monetary policy (thereby overcoming the so-called Triffin dilemma).
The success of their policies has often hinged on the scale of their interventions whether through direct currency intervention or sovereign wealth fund purchases of foreign assets. One study featuring 133 countries over the past 30 years found that such state-directed outflows were a significant positive driver of the current account (i.e. pushed it into surplus)9. An IMF study featuring 52 countries (13 advanced and 39 emerging) from 1996 to 2013 found that currency intervention had a larger and more significant impact on exchange rates than interest rate differentials10.
It should be noted that Japan, which has been the most active G7 intervener in currency markets, has typically engaged in sterilised intervention. That is, intervention that would not affect domestic money supply (and so not impact monetary policy). Studies have shown that Japanese intervention has at times been successful even though it was sterilised. Moreover, one study by former Deputy Vice Minister of Finance for International Affairs, Taktatoshi Ito, showed that FX intervention over the 1990s, which was predominantly uncoordinated with other countries, resulted in a profit of JPY9 trillion ($75 billion). This showed that the MoF was buying USD/JPY at the lows and selling at the highs11. Therefore, there could be nothing to stop the US engaging in FX intervention to weaken the dollar. " - source NomuraIt appears that from a "Mack the Knife" perspective, it will be rather binary, either we are right and the consensus is wrong thanks to the Woozle effect, or we are wrong and then there is much more acute pain coming for Emerging Markets, should the US dollar continue its stratospheric run. From a contrarian perspective we are willing to play on the outlier.
What appears to be clear to us is that the Woozle effect from a central banking perspective has been fading as shown below in our final chart.
- Final chart - The central bank "put" has been weakening
"Yielding to populism
We expect to return frequently to the theme of “populism” as 2017’s big narrative. For credit investors, populism doesn’t have to be all bad news. As our US credit strategy colleagues have highlighted, potential Republican tax reform could be very beneficial for some parts of the US market. In Europe, though, we worry that populism will manifest itself in two bearish ways this year: a weaker ECB “put” (read: weaker credit technicals), and rising political risk, which we believe is not reflected in European spreads.
Thus, while Euro corporate bonds have nudged tighter in the first week of 2017, with reach for yield behaviour still evident, we think Euro spreads stand to end the year wider. We look for the Euro high-grade market to finish the year 15bp-20bp wider than today’s levels, and for high-yield spreads to end 50bp wider (applying some tweaking to our Nov ’16 forecasts given the big high-yield tightening in December).
Draghi’s populist moment
In our view, Dec 8th 2016 should be seen as a game changing moment for Euro credit markets. We think the ECB yielded to another form of “populism” – namely pressure from a hawkish governing council to step away from the negative yield era, given undesirable side effects. So from April this year, ECB monthly QE buying will decline from €80bn to €60bn.
But we think that Draghi’s actions highlight a bigger story: namely that the central bank “put” (or influence on the market) is already showing signs of weakening. Chart 1 shows cumulative central bank asset purchases including EM FX reserves (which we think should be viewed as another form of QE buying). Note the peak in September last year, due to declining EM FX reserves (such as China).
But in 2017, we know that the ECB is set to tone down its asset buying, and we also expect the BoE to stop buying gilts and corporate bonds once their respective targets have been reached (which we estimate to be in February ’17 and April ‘17, respectively). A weakening influence of central banks therefore means a weakening of the very strong technicals that have been asserting themselves on European fixed-income markets."
"Every swindle is driven by a desire for easy money; it's the one thing the swindler and the swindled have in common." - Mitchell Zuckoff, American journalistStay tuned!