Deciphering the Investment Climate

The US dollar's strong advance ended a month ago.  Weak economic data encouraged investors to push out their expectations of the Fed's first rate hike. Some are even shifting it out of 2015 entirely.

At the same time, economic conditions and lending improved in the eurozone. The stabilization, and then recovery in the price of oil, has helped ease, on the margins, deflationary forces.

The persistent and sharp dollar gains also stretched speculative positioning, judging from the futures market.  A period of consolidation or retracement comes after an extended trend like night follows day. Within the ranges, the dollar has moved from the higher end toward the middle or even lower end.   Portfolio adjustments for a strong dollar environment left many investors under-weight emerging market exposure and had to adjust accordingly.

The Canadian dollar is the only major currency against which the US dollar appears to have broken out of its range.  The recovery in oil prices helps, but investor expectations of the trajectory of monetary policy have also moved in a more supportive direction. The Bank of Canada's surprise January rate cut was offered as an insurance.

Similarly, many  investors were disappointed when the Reserve Bank of Australia did not cut rates earlier this month. This served to increase the perceived likelihood of a move in May. However, the recent string of data, including the employment report have seen expectations scale back. This change in expectations appears to have helped the Australian dollar recovery from multi-year lows.

We caution against getting to bearish the US dollar.  It is true that the first quarter has disappointed expectations.  Again.  The economic performance in the first quarters (average 0.6% past five years) is not representative of the other quarters (average 2.8% past five years).   The Fed recognizes this and anticipates stronger growth.  The Federal Reserve has a tightening bias.  It is looking for an opportunity to raise the Fed funds target.  That opportunity is understood in terms of data.

The Fed's statements indicate that the bar to lift-off is "reasonable confidence" that the mandates will be achieved.  Some officials explain this in terms how monetary policy acts with lags. The Fed has to be forward looking.  The economic performance in Q1 and a smidgen of April data can not reasonably impact the Fed's decision in September.   The Fed warned that the dollar's strength and the decline in oil prices were transitory headwinds, and they are proving to be so.

The decline in oil prices, interest rates, and the euro was widely understood to give the regional economy better traction.  And so it has.  This week's flash PMI reading is expected to confirm that Q2 has begun with reasonably good momentum.  The key determinants of the investment climate EMU are not economic growth per se.

It is the ECB's monetary policy.  It is that the Greek tragedy continues to fester. Life goes on while the finance ministers discuss as creditors acceptable reforms, and this has seen a marked deterioration in the Greek economic and financial conditions.   Moreover, as the risks of Grexit increase, peripheral sovereign bonds have been pulled lower alongside Greek bonds, rather than be lifted by Germany bunds, where the 10-year yield is below 10 bp. Contagion is a dynamic process.  

There is a Eurogroup meeting of finance ministers at the end of next week.  Officials already signaled that the negotiations have yet to reach a point that would allow granting another tranche of aid.  Keynes objected to the onerous demands that the victors were imposing on Germany not on moral grounds, but for good, solid, pragmatic reasons.   One need not be sympathetic to the Syriza government to appreciate the parallels.

The ECB's asset purchase program is very new.  Around 8% of its purchases have been made.  One of the key talking points involves a potential shortage of German bonds, used for investment purchases as well as collateral.  In terms of net new issuance, recall that the grand coalition in German agreed not only to run a balanced budget this year but pay down some debt as well.

These considerations appear creating some dislocations and making the ECB's -20 bp deposit rate not the floor.  The ECB may have to ease its own rules and prices for its securities lending program if it wants to re-establish control over short-term interest rates.

On one hand, Draghi appears to appreciate the irony.  There is a shortage of bonds during a debt crisis.  Ha.

On the other hand, one of the channels through which a central bank's bond purchases are supposed to work is through the portfolio channel.  In buying its sovereign bonds, the central bank displaces other bond buyers who are forced to buy other riskier assets by definition.    It is supposed to create a scarcity in this sense.  Prices rise to distribute the scarce resource.

Moreover, the shortage is specific not generalized.  There is a shortage of German bunds relative to demand, and use as collateral, exacerbated by the fiscal consolidation to which the government is committed.  This is what has been, at least until very recently, one of the critical forces dragging down other sovereign bond yields.

In addition to these developments on the Atlantic axis, there are two developments on the Pacific axis to note.  First, one of the hurdles to the Trans-Pacific Partnership (TPP) has been securing fast-track (Trade Promotion Authority) for President Obama.  All major trade agreements have given the President such authority that allows for a yes/no vote rather than be saddled with a line-by-line critique and countless amendments.

While passage in the Senate is largely taken for granted, though there may be an attempt to amend the agreement that was struck, the real challenge may lie in the House of Representatives.  This would be a signature program of the Obama's second term, but it is not clear that as a lame duck, he has the influence to secure the vote.   Hillary Clinton's views and enthusiasm is seen as an important for the political dynamics, but it is hard to imagine her challenging the President on this issue.  During this stage of the process, she wants to secure, as much as she can Obama's base.  Later, when facing off with Republicans, she will find ways to distance herself.

The vote is expected in the week ahead.  A defeat would likely mean that that issue is dead until at least until after 2016.  It would also likely undermine efforts to finalize the broad pact with Europe (Transatlantic Trade and Investment Partnership--TTIP).   It would lower expectations for any important legislation in the remainder of the Obama Administration and leave his Pivot to Asia in disarray.

Japan's Abe has also put much stock into the TPP.  If the legislation is not approved, Abe's reform efforts would be set back.  The fallout may impact the second leg of the local elections a week from now.  It would add to the sense that Abenomics is falling well shy of what was hoped.   Europe has been able to achieve lower rates that Japan despite a less aggressive monetary stance.  Inflation pressures have receded.  The economy was lackluster after contracting from April-September last year. The courts have blocked the re-opening of a few nuclear plants.

The second development is China's policy initiative announced after local markets had closed last week. Essentially it did four things.  First, Chinese fund managers have been granted permission to lend stocks (securities lending).  Second, the number of stocks than be shorted increased will increase from 900 to 1100.  Third, officials moved to curb brokers extending margin for umbrella trusts, which already allow greater leverage   All three measures point in the same direction--lower stock prices--and sure enough the futures markets sold off with the cash markets closed.  

However, the fourth measure, announced early Sunday, may push in the opposite direction. The PBOC announced a 100 bp cut in the required reserves of all banks.  This is the second cut in two months and was twice as large as the previous adjustment.  It can be expected to free up around a trillion yuan of liquidity.  Officials appear concerned about the growth prospects, even though Q1 GDP was reported at the 7% target.  In addition, the capital outflows drain liquidity from the banking system.  The required reserves of rural banks was cut an additional 100 bp, and the Agricultural Bank of China was given an additional 200 bp cut in the reserve requirement.  

China's equity markets completed a seven week advance that has lifted the indices to seven year highs.  Measures of valuation are stretched.  Margin use is at a record. The anticipation of additional stimulus measures from the government and central bank, and the government's guidance toward exchange-traded products from the shadow banking system has encouraged a move into equities. Officials have cautioned against "irrational exuberance."

Now is the time to deepen the ability to hedge stock exposure.  Two new stock index futures were launched earlier this month that offer portfolio insurance capabilities. Increasing the ability to lend equities (portfolio managers accrues interest income) is a complementary development.   Even as the China's growth moderates, it is continuing ease restrictions in its capital markets.  Next month it is anticipated to launch a deposit insurance program that is pre-condition of some of the necessary banking reform.

China would be the largest beneficiary of a failure to launch the Trans-Pacific Partnership. The US unwillingness to pay its agreed upon quota to the IMF is blocking reform, and encouraging the rise of parallel institutions.  At the same time, part of the apparent increase in the use of the yuan, a consideration for the inclusion in the SDR, was due to the yuan's appreciating trend.  Now that it is not appreciating, its internationalization has slowed.

The appropriate value of the yuan itself has become a bone of contention between the US, which concludes the yuan is significantly under-valued, and the IMF.  The deputy director of the IMF's Asia Pacific Office was quoted from at a briefing in Washington before the weekend saying "We are now reaching a point where" the yuan is close to "no longer being under-valued".   As the real trade weighted yuan exchange rate has appreciated, the IMF has adjusted its assessment over time.  The gap between the US and the IMF has gradually widened but ahead of the real debate on including the yuan in the SDR that different valuations take on greater significance.