Driver update – 2y & 10y $ correlation break – differentiating tapering & forward guidance

November 19, 2013 Leave a comment

In my last post I signaled the possible market confusion about the Fed’s dovishness. For sake of clarity, I voluntarily skipped an important development going on within the Fed’s policy framework – the switch from a focus on tapering bond purchases to a focus on thresholds of forward guidance.

Ahead of the Fed minutes tomorrow, this switch deserves some explanations for three reasons: 1/ it is probably the main reason why the market got confused about Fed’s dovishness; 2/ the market has started being sensitive to this switch as can be seen in the correlation break between the 2Y USD and the 10Y USD; 3/ the reliance on forward guidance involves some risks for the Fed as controlling indirectly money market expectations is very different from controlling directly the 10Y yields – as the BoE experience has shown recently.

1/ In Fedspeak, tapering is not tightening.

In virtually every newspaper last week you could read that Yellen had been dovish, the main reason being cited was that she said that the output gap was such that accommodative monetary conditions were necessary for a long time. Many concluded that tapering will be pushed back. But the Fed has been clear for a very long time that tapering – the end of bond purchases – would not affect monetary conditions. In other words, in Fedspeak, ending purchases will keep monetary conditions as accommodative as before. That will just stop them from becoming more accommodative. So when Yellen or Dudley yesterday, are saying that the size of the output gap, or low inflation should be met with accommodative conditions, it does not mean at all that tapering is going to be pushed back. That’s a key source of confusion I think.

2/ 2Y – 10Y correlation break indicates that the switch in tools has started.

That being said, when one looks at a chart of 2Y and 10Y USD yields (below), it is clear that the two maturities have been  pricing something different (NB. I voluntarily take 2Y Swaps vs 10Y Govies  to take what I consider to be a more accurate picture of Fed expectations vs Financing conditions in the Bond market). One can notice that since end October, the 2Y has fallen, while the 10Y was rising (red arrows in the upper panel). This is a rare occurrence, as the curve tends to bull flatten (lower yields , with the 10Y going faster down) or bear steepen (higher yields with the 2Y going faster up).


That has occurred because the Fed has two main policy tools – it’s bond purchases (QE) with which it impacts directly the 10Y yields, and the forward guidance and its thresholds (when will rate hikes start) with which it tries to impact the money market curve and also indirectly the long term rates (which are an aggregation of expectations of forward short term rates and a risk premium).

The thing is, because QE is seen as having high risks, tapering needs to take place. But because the Fed doesn’t want long term yields to spiral higher, it might be trying to “compensate” by being dovish in terms of forward guidance. That is why we are seeing a higher 10Y, and simultaneously a lower 2Y.s why the Fed message has seemed so confused. But actually, attempting to differentiate between these two tools is the very reason why forward guidance (see QE4) was created.

The divergence in yields was triggered by the debate on thresholds. At the start of the month, two major papers were published by the Fed research discussing the possibility of lowering the unemployment threshold or adding an inflation threshold, one by English and the other by Wilcox. I must confess I didn’t read them, but from discussions I had, I tend to think that it is more likely that the Fed would add an inflation threshold, rather than move the unemployment threshold (which would tend to be more risky in terms of credibility).

Another factor that has helped the divergence between 2Y and 10Y in that period was the drop in inflation. Inflation has surprised on the downside and even without a formal inflation threshold it has mechanically pushed back expectations about the first rate hikes.

In any case, around this time window, the high frequency correlation between the 2Y and 10Y (10 day, in return) moved from 80% to about 40%, showing clearly how the two Fed tools were affected by a different message. The thing is, since then, the correlation has resumed which can be a good thing as long as market expectations about economic growth remain in line with the Fed’s scenario.

3/ But there are risks in the switch.

First, if you accept that what primarily matters for the economy is the ability to control the level of the 10Y yield and the 30Y MBS, then it is rather obvious that it is a risky move because the “forward guidance” tool is much less accurate. With QE, the Fed was directly buying bonds, while with Forward Guidance it is going to affect the long term yields only indirectly through the money market part of the curve.

Second, if for some supply / demand reasons, bond holders don’t want to buy more bonds (I think of EM central banks in particular – China and Japan), bonds will selloff whatever happens to the 2Y. The advantage with QE was that the Fed could directly affect the supply / demand balance and prevent a selloff, something that can’t be done with forward guidance. In that sense, forward guidance can work (in terms of impact on the 10Y) only in a context of stability of the bond market’s suppy / demand.

Third, the BoE’s experience with forward guidance has been a complete fiasco so far. In the sense that the rate market has reacted in “black or white” to economic news, by that I mean that the 2Y and 10Y GBP didn’t suggest any differentiation between end of QE and start of rate hikes. All good data were pushing both yields higher (see chart). And the correlation between the two yields is at a high.


That makes sense in a way because at the end of the day forward guidance is data dependent, so what really matters are market expectations about the economy. The thresholds are a framework, but the actual Policy moves will depend on your economic forecasts! Worse in terms of precedent, the market was proven right in its economic forecasts and it is the BoE which last week modified its expectations of first rate hikes and moved them forward by 18 months! (ok admittedly the Fed has a better forecasting track record…).



Recently the Fed has had two messages for two different tools – QE and forward guidance. That might have been a source of confusion for some investors.

At the same time, the correlation break between the 2Y and the 10Y might prove transitory as it was driven  by temporary factors: 1/ the current debate on integrating an inflation threshold or lowering the current unemployment threshold, and 2/ a downside surprise on inflation. Once these factors are over (priced in), better data might tend to push all yields higher once again just like in the UK, because in the end what matters are data and economic forecasts. If so, relying on forward guidance would mean more difficulty for the Fed to control the 10Y yield, putting the valuation of many financial assets at risks.

Tomorrow’s minutes are likely to be very instructive, watch the reaction of the 2Y-10Y!

Categories: Driver update Tags: ,

Global View – Transition Time… on Timing Fed’s Tapering

November 15, 2013 Leave a comment

Market’s misunderstanding about the Fed’s message has been a great trading edge over the last 5 months. With the market’s reaction to Yellen’s confirmation hearing, I wonder whether a new confusion – and trading opportunity – is not appearing. Indeed I see absolutely nothing new in terms of tapering odds and timing in her testimony, it is just pure policy continuity.

First, I want to apologize to my regular readers for not writing for quite a while… I am the happy father of a second child so sleepless nights have had a direct impact on my propensity to write. As I kept following markets astutely in that period, I will write a few stuffs in the coming weeks to catch up on what I think are the biggest developments. But for now, let’s discuss the global view and the biggest factor affecting it – the Fed’s tapering…

Coming back on the history of tapering:

In March already the debate about the timing of QE’s end started. At the time I wrotethe debate about the timing of QE ends should last. If that is the case, 10YUSD could rise further and break the 2% threshold for good, then it would affect all valuation metrics, in particular, it could have consequences for corporate bonds, EM bonds currencies and equities and DM equities”.

In May, Bernanke confirmed that the “exit” was coming, but the market thought –wrongly – that it was a communication mistake from the Fed. I thought at the time that “importantly, and contrary to many, I don’t think the Fed is surprised or scared by the market moves. I think it had exactly the reaction it hoped for. Delaying it too much would have been a mistake.”

Then, finally starting in July, Bernanke clearly suggested that the relative stability of the 10Y yield was a key pre-condition for tapering to take place, but again as I wrote at the time, nobody noticed. I noted that the Fed’s core assumption was that “thanks to the forward guidance and clear indication that there will not be any faster rate hikes, then 10Y yields should stay where they were initially”. [Admittedly, following discussions with my ex-colleague Olivier K, I oversimplified here; and should have written that the Fed expected only a limited rise – rather than no rise at all]. What is even more astounding is that I wrote that “Bernanke replied frankly as usual, and he said that indeed he and other members of the FOMC now had doubts about that core assumption, notably following the recent rise in yields (that was last month). Yes, it is amazing. And amusingly that went totally unnoticed and unreported (to my knowledge).”.

Recent swings in tapering expectations:

All that to say, that when after the summer, you could see the chart below, it was the single most important piece of data you could see. And there was zero doubt that the Fed would be much more dovish than what the market expected. Despite that, the market was very very surprised on September 18, showing how far the misunderstanding had run.


The chart clearly showed that the sharp unwanted rise in 30Y mortgage rates had triggered a collapse in refinancing, which would surely impact the most important pillar of the US economic recovery – that is the housing market. At that time there was a clear trading edge for investors as Fed’s dovishness / later tapering was highly likely. And indeed the Fed’s delayed tapering has been the key driver of the equity rally.

I must say that the most striking comment came from a Fed watcher I respect a lot at Pimco who wrote that he was surprised that the Fed had talked about “tightening of financial conditions” in the Sept communique, when stocks were at some record highs! Didn’t he realize that the 10Y yields and Mortgage yields were the two most important tools for the Fed?

Yellen’s confirmation hearing:

That brings me to another trading edge. I realized at the end of Bernanke’s conference on September 18 (when tapering was supposed to be announced – in other words, at the most important policy event of the last five years) that there were only 5000 people still logged onto the Fed web site to listen to his answers. When you compare that with the number of Bloomberg terminals (310 000?) you can easily understand how most investors don’t know much about the thought process of the most important policy maker on the planet. Most just take for granted what their average reporter / analyst has understood or heard from someone else.

And finally that brings me to Yellen’s speech. When you look at the market’s reaction to yesterday’s hearing, it is as if there were some new information, or even a policy turn. But Yellen has been key in the framing of most of what Bernanke has been doing for years now. I see nothing but continuity in her speech and in her answers. Why would anything she said yesterday indicate that tapering is going to be delayed further?  For instance she is the main architect of the “forward guidance” as I exposed already last year. She also already gave her view – which is the Fed’s official view – on “search for yield behaviors” a long time ago. If anything, the only thing that I find interesting is a confirmation of the doubts that Bernanke signaled about the Fed’s core assumption (see above – the stock or flow debate). Indeed, according to the FT she confirmed that the recent rise in rates had caused the Fed to “ask ourselves whether or not that could potentially derail what we were trying to achieve”.

More important, it is sure that Bernanke and Yellen have been preparing for the transition for at least several months. Yellen certainly had an important role both in the decision to push back the tapering (as financial conditions had tightened too much), but also in the wording of the latest Fed communique which intentionally withdrew the reference to tighter financial conditions, signaling that Tapering could finally occur before year end – despite the fiscal cliff fight.

Where does this leaves us?

That leaves us simply where we were after the latest FOMC. Like the Fed we need to watch the data to have a view on Tapering’s timing. And data have not sent a clear and consistent message, so we are in transition…

On one side we have the latest Non-Farm Payrolls which have been very good, we have the last FOMC communique that got rid of the “financial condition” mention, and we have spreading global growth. On the other side, we have US cyclical data that have been marginally disappointing (ISM new orders down to 56.1 in Oct from a top of 60.5 in Aug; GDP growth showing weakening consumption and excessive inventory buildup, Conference Board Consumer confidence down to 71.2 from 79.7), and concerns on housing (pending home sales slowing down to 3 years low at +1.1% y/y from +2.9%y/y). Plus the effects of the Debt ceiling fight unclear (from a statistical and growth point of view).

The slight breakdown in price action between the Bond market and equities (in blue below) might be a confirmation of that transition thesis. Don’t get me wrong, if DATA end up supporting a tapering delay then I reckon that it would legitimate (from a macro standpoint) a continuation of the equity rally. And that would likely be signaled by a Tnote rally, to new highs, maybe 130 / 131 are the obvious targets. But for that we need first to see more evidence from the data.



To conclude, Yellen was probably very much involved in the last FOMC’s communique where the “tighter financial condition” mention was deliberately suppressed. So again, like the Fed, we are left watching DATA to decide on the timing of tapering. And data have not sent a clear and consistent message in the last few weeks. That means that there is no particular trading edge currently (from a macro / policy standpoint) in staying in the market’s current trends.

Of course one might argue that the traditional year-end trend is currently gathering momentum so this is not a time to get out. That’s a possibility, but one should be aware that the rally has lost one of its key macro drivers (contrary to the last two months), and consequently if data fail to disappoint, another “alleged surprise” by the Fed might end the party all of a sudden at the worst possible time in the year. A risk reward tactic suggests waiting for a clearer turn in data. In the meantime we and the Fed are in transition.

Driver update – Bernanke – The right debate is about the Flow or Stock of bond purchases

July 10, 2013 1 comment

For some reason, just like last month, the market seems to be focused on the wrong questions. It completely misses the key monetary policy debate about how QE works – is it the stock of bond purchases or the flow of bond purchases that matters for monetary policy conditions? This is the key of the Fed’s exit. After his last speech, Bernanke himself recognized that he had doubts about the Fed’s core assumption. A few quick thoughts on that issue ahead of Bernanke speech today and next week’s semi-annual monetary policy meeting before Congress.

The market is focused on the timing and extent of Fed tapering. Will it take place? When? How much? Bernanke has been relatively clear on these questions. It is going to happen soon, unless financial conditions deteriorate significantly (read equities drop, or 10Y yields rise too sharply). So why wonder? Particularly now that US equities have decided not to fight the Fed and have actually given the Fed its vote of confidence (=> stronger growth, and no rate hikes is bull for equities… for now at least).

So for the market the more important question is one that has been THE core assumption of the Fed’s QE program, and has actually been a key reason for the adoption of forward guidance. The question is whether QE is working on monetary conditions, through the total stock of bond purchased by the Fed – as is the Fed’s core assumption, or whether it is the flow of bond purchases that matter?

If it is the stock that matters, as the Fed believes, then stopping the purchases should keep the monetary conditions unchanged – very accommodative. The only change is that there would be no faster accommodation. But in no way would there be a tightening of monetary conditions. In this case, thanks to the forward guidance and clear indication that there will not be any faster rate hikes, then 10Y yields should stay where they were initially.

If it is the flow of purchases that matters, then tapering would mean a tightening of monetary conditions… And the Fed’s Exit would be much more complicated… (In a way in that case, the risk is that it could be condemned to buy bonds for much longer, with the risks of bubbles that it carries)

What is interesting is that after his speech last month, an FT journalist (Harding if I remember well) asked precisely that question to Bernanke. And Bernanke replied frankly as usual, and he said that indeed he and other members of the FOMC now had doubts about that core assumption, notably following the recent rise in yields (that was last month). Yes, it is amazing. And amusingly that went totally unnoticed and unreported (to my knowledge).

Any precisions from Bernanke about the “doubts” he has on the Fed’s core assumption (the stock effect) would be greatly appreciated, but I doubt there will be some at this stage as that would bring a lot of volatility. In the longer term this question will certainly have to be treated. And I must say that I tend to think that it is the marginal change of monetary conditions that matters, so would tend to vote for the “flow assumption”.



I think Bernanke is very likely to stay within the framework of his main assumption (it is the stock of bonds that matters) and will not speak about these “doubts” (be ready for a big move if he does).

Instead he will strongly emphasize the dichotomy between QE tapering on one side, and on the other side, forward guidance and the next rate hike cycle. In other words, the message is likely to be - in this perfect framework, tapering doesn’t tighten monetary conditions so 10Y yields should have barely moved as the timing of rate hikes hasn’t changed (as forward guidance indicates).

If he chooses to communicate that way, it could bring quite a lot of relief to the bond markets (only in the short term), so for once tactically catching a falling knife (Tnote) could make sense here…

Macro Driver – Expect more policy surprises from China…

July 5, 2013 Leave a comment

What’s the difference between Aung San Suu Kui, the Dalai Lama and Mr Bolton? There is none… at least from the perspective of what determined their recent fortune (or misfortune). It was entirely linked to the fact that China leaders have realized that Chinese models were not working anymore and had to change. This is highly significant. Be prepared for more policy surprises.

(Mr Bolton completely failed to understand that dynamic in its investments, while Aung San Suu Kui and the Dalai Lama after lives of political fight might finally – hopefully – see their efforts rewarded…).


Lee Kuan Yew in his recent interview with the Time struck me with one sentence: “One thing is sure: the present system [in China] will not remain unchanged for the next 50 years. To achieve the modernization of China, her communist leaders are prepared to try every method, except for democracy with one person and one vote in a multiparty system”.

That’s a bold statement that shows how many changes there might be in China in the coming years. It actually reminded me of that famous quote in the movie “the Leopard” when the Prince’s nephew says about the evolution of the political power during Garibaldi’s revolution: “If we want things to stay as they are, things will have to change”. It exactly seems to be what Xi Jinping and other princelings have in mind…


A.      Recognizing failure and adopting new policies…

For two years since the democratic transition in Myanmar, I have been wondering what made the generals suddenly decide to quit China’s system of influence and open the country to the west which necessarily implied making risky political reforms? After all, why would a terrible military dictatorship which had killed lots of its citizens, decide all of a sudden, in a top-down decision to turn into a democracy? Isn’t it amazing? It is almost without precedent!!! Of course there was an economic collapse, but that was nothing new. There was also a change at the top… but that couldn’t be so critical. I have learnt the decisive factor recently, it was actually due to the Chinese authorities mismanagement of the relationship.

Tibet’s sacrosanct policy hasn’t changed since 1949, until the last few weeks… another amazing shift! The Chinese authorities are starting to recognize that their policy has failed, and they are adapting. Apparently some negotiations with the Dalai Lama are even being considered.

Another significant shift in foreign policy was the decision for the first time ever to send combat troops abroad in a UN mission (in Mali). Whatever the reasons, it confirms that some sacred principles (in that case, non-intervention and use of military force) are being reconsidered.

These changes are important because they show that in every domain, not just the economic ones, the new Chinese leadership has a urge of recognizing what doesn’t work, and to adopt policy alternatives. There is no taboo, they can tackle anything, they are flexible and pragmatic (as Lee Kuan Yew suggested). It is true of foreign policy, of internal policy (Tibet) of social rules (Hukou, land ownership or laojiao), and most importantly of economic policy (urbanization, internal rebalancing to consumers, service sector development …). That’s not good at all for short term growth, but very good in the longer term.


B.      Political threats

It is usually thought that things are socially under control in China as long as employment is abundant. That’s why the high rate of growth was so important for the authorities until recently. But even with the current policy shift to domestic growth, the service sector which is very labor intensive should continue to provide employment opportunities for the masses. So why would the authorities feel worried? There are actually numerous social and political risks:

For instance, the economist was recently quoting Wang Shi, the boss of China’s biggest property developer, “the plunge in [real estate] prices that would result from a pricking of the bubble, could lead to popular protests on the scale of the recent Arab uprisings”.

Similarly, the political threat posed by the frustration of the Hukou system remains obvious as the recent events in Beijing demonstrated. The Weibo / social media communication revolution is a clear threat for all authoritative regimes (ability to inform, mobilize), and the costly attempts by China to continue to control it is a proof of the threat it represents.

Likewise, in Tibet the 100 cases of self-immolation since 2011 shows the level of despair, and how badly things could go wrong after the Dalai Lama death (his policy has always been nonviolent resistance).

So, indeed there are risks of social unrest / political resistance, that is why things have to change…


C.      The problem inherent to the current dirigist system

Over-capacity / Credit bubble / SOEs…

There were recently two exceptional articles on Chinese over-capacity problems. In the FT, the focus was on industrial sectors in general. In particular it shows how local government subsidies play a key role. The economist focused more on wasted direct public investments such as high-speed rail networks and metro lines.

In both cases, what is striking is how local authorities’ ambitions, are always the source of this over-capacity build up. The FT illustrates well this point with this quote from a research consultancy: “Officials who climb the [Communist] party ladder fastest are usually those who oversee the most flashy investment projects and the fastest growth”.

Local Governments’ incentives are the main problem

The fundamental problem at the core of most unbalances in China is inherent to the one party system. Why is there overcapacity everywhere in China? Why is there excess credit? Why are there too powerful SOEs? Well it is always because local governments have a fundamental incentive of maximizing growth whatever the costs, because it is that way that local officials will progress in the communist party hierarchy.

Xi Jinping said this week end that “We should never judge a cadre simply by the growth of gross domestic product”. That is great, it means he is aware of the problem. But it would be better if we knew how officials are now going to be promoted. The incentive system has to be clear for local officials. And it is not easy to find an alternative in a dirigist one party state… If officials are not elected, how should they be judged if it is not on GDP growth? That’s why they won’t easily get rid of this fundamental problem. They will have to be very creative. It is actually one key to watch – what promotion system – what performance guidelines – they put in place within the communist party?


D.      Several policy solutions: urbanization, Hukou, land ownership, local government financing.

The main economic and social policies available to improve things are now well known. The conference on urbanization headed by prime minister Li Keqiang is surely going to be a key policy moment. Urbanization is the chosen path, but that implies as well reform of the Hukou system – so that migrants have the same rights (and coverage) than locals, a reform of land ownership, and importantly as well a reform of local government financing (so that they stop selling collective land to real estate developers as their sole source of financing). That’s why developing a bond market, that will allow them to get financing is so important.



Reform or burst in a few years… it is a no brainer for the new leadership. This leadership is just starting its 10 years period in power. It is going to take its time, as the challenge is formidable. It wants things to stay as they are (the party to remain in power), so things are going to change (reforms).

There are powerful interests against these reforms (princelings, SOEs, local governments authorities, locals against migrants rights…), but the recent courageous changes in long standing policies (Tibet, Mali, Shibor spike) suggests that the leadership is willing to confront them.

The big reforms that are necessary to save China from a bubble burst are going to take place. There might be fears in the process as many investors are caught by surprise and the process is not very transparent (as was clear with Shibor rates last week). But the new leadership appears surprisingly aware of the problems and of how to tackle them, and more importantly seems to have a huge willingness to sort things out.

The market is likely still underestimating the extent of the policy changes to occur in the coming years. Expect continued policy volatility, negative growth surprises from China in the short term, but very encouraging prospects in the longer term.

Global View – Thoughts on Capitulation, Contagion and Dollar shortage

June 25, 2013 Leave a comment

Is it already over? Have we reached the capitulation point? That’s really the key question that everyone has in mind in terms of short term outlook, particularly people who were short (as I have advised :-)  ), so here are a few indicators I am looking at.

The initial panic reaction when fear was most intense lasted about three days, before seeing the first rebound since yesterday evening. That’s a decent move, and I think it could last a bit further after a one day conso. That would be a good point to take profit. There are two things that could easily stop the move, 1/ some reinsuring words from the Fed (we had maybe some preliminary attempts at doing so yesterday with Fisher, Kocherlakota and Dudley all sounding upset by the markets’ reaction), or 2/ a reversal in the bond market. But I don’t see these as very likely in the coming week (the Fed would lose in credibility, while bonds broke some major levels and there is significant US issuance this week).

So the key in the short term is going to be how long forced liquidation continue. Some big names have apparently made large losses, and are probably not alone given the verticality of the recent moves. The redemptions at credit ETFs also generated a rare mismatch (sometimes quite large) between ETF prices and the underlying credit bonds… Leverage is a key reason for forced selling, and leverage was high, so that could go on a bit. Interestingly, some indicators of financial stress are worsening, look at the OIS/Libor USD spread below…  it rose back to some levels not seen for a while. The banks are rightly more cautious in their short term lending… a counterparty closure can happen so quickly. It is something important to monitor.


In terms of longer term outlook, as I have been saying in my two last posts, what matters is that investors’ assumptions are being adjusted. And in that respect, the Fed’s move was a major inflection point. It is amazing to see how the Fed’s impact on global liquidity is instantly spreading. For instance, as an illustration, I just heard a story of a large European airport issuing a 7yr bond. Last Wednesday it was supposed to be issued at Swap+70bp, then on Friday the talk was +100bp, on Monday it was +125bp, and finally the final price decided today is Swap +170bp. The 7Yr EUR swap has risen by 25bp in one week. So the airport is going to pay +125bp more just because of the Fed, to be clear, that is 3.38% instead of 2.12%… not a marginal change!

Of course, valuations are going to be affected as well. The risk premium concept is based on the 10Yr, so the 100bp rise is affecting all asset classes… Equities, EM… The volatility has also risen, which will affect also valuation and risk exposure. Maybe more important Policy uncertainty has significantly changed. Many investors believed in QE infinity, now even if they’re not seeing rate hikes, at least there is a major uncertainty about what the Fed will do. That’s a big change. That means that macro and fundamentals are going to become more important drivers once things normalize.

More interesting as a sign of global contagion, we are seeing some signs that could suggest that reduced USD liquidity is already being felt. (I will write shortly about the “impossible trinity” to explain how USD liquidity has been leaking into EM Asia during QE because of Asian FX policies). Look at the 2Y cross currency basis swaps in USD vs JPY, or in USD vs KRW. Clearly someone needs dollars in Asia… Maybe it’s due to a domestic factor that I am not aware of, so I stay cautious, but maybe it is due to the Fed’s policy shift… In any case it clearly suggests that there is an increased willingness to pay a large spread to get USD funding. Is it the start of a dollar shortage because of shifting Fed Policy ? (That would hit particularly badly EM Asia). Clearly Temasek (Singapore’s SWF) is very worried about that.



Capitulation is usually signaled by sharp vertical down-moves, with new lows, in high volumes. Last Thursday on the S&P could qualify but that was not the lows, and there were Option expiries which blurred the picture. Star equity performers (JPM and Home Depot for instance) are rebounding nicely which is encouraging. Some for some EM currencies that initially got hit, they have stabilized (USD/TWD or USD/MXN). So overall in terms of market internals the signals are not too conclusive to slightly bullish.

Conclusion: Indicators of contagion (Cross currency basis swaps) and of financial stress (OIS/BOR spreads) are more relevant to me in the current context. USD scarcity, but also reluctance to lend because of fear of a financial accident would be major accelerators of the down move. That’s not what I am expecting so far, but things that bear watching particularly for the summer. Tactically in the short term, I would advise to wait a bit more before taking profits, and reassessing the situation ahead of the key data at the start of July (ISM, NFP). Tapering expectations are going to be highly data dépendent…

Global view– How Current Accounts can help set-up a bearish (EM) play

June 19, 2013 Leave a comment

Finally it is FOMC’s day, the market is soon going to resume moving – up or down… I have already given my preferred play last week – the bearish scenario, mostly based on the trending potential of squeezed assets. But Current Accounts are also worth having a look at to help in trade selection, or simply to realize how much the EM and Commodity miracles have changed in the last two years.

The press has well covered the current squeeze in credit markets (here and here). Retail investors are over-loaded with credit and bond ETFs, while banks have sharply reduced their market making / risk taking capacities… so that there is little liquidity left, particularly in times of rush to the exits. Exactly the kind of situation we should be looking for, so shorting US credit markets would be a good bearish vehicle if Bernanke fails to reinsure markets.

The other asset class where investors are over-exposed is EM markets. When considering things globally, having a look at current accounts is always very instructive, and here one can see quickly that things have changed significantly over the last one or two years. For readers not used to this concept, a current account has to be understood in two ways (I am simplifying of course). One, it tells you whether a country is benefiting or contributing to the Rest of the World’s (RoW) demand. For instance, the US with its deficit has been helping the rest of the World’s GDP grow, thanks to its very strong domestic demand. While, on the contrary Germany has been benefiting from the RoW demand. Second, it tells you whether a country needs capital from the RoW or whether it exports some. Japan and China for instance have been exporting capital for years. That’s important because a country with a large CA deficit is very vulnerable in times of reduced market confidence and outflows (as we could see in coming semesters).


First let’s have a global look. Global imbalances are back, the horizontal conic shape is back, showing an ever more imbalanced world – that’s too bad because that situation strongly contributed to the 2007 crisis because of excess global savings. On the deficit side there is still the US, and on the surplus side China, Germany and Japan and the Oil exporters. Not such a surprising situation when Europe is in recession and China is going through its structural rebalancing. Again, most hopes go to the US consumer.

Let’s go into more details, which is relevant for a local / RV analysis. There are important shifts going on. Look at Brazil and India… two of the star BRIC group. Brazil shifted from a minor CA surplus to a big deficit. That’s what happens when you try to boost consumption, while your China centered commodity exports fall. Same for India, from a flat CA, it is moving quickly into increasing deficits. Growth collapse because of bad policies (see my last post) and budget issues are likely central in that move. Also interesting, the G10 commodity exporters – Australia and Canada – they have shifted from flat current accounts to fast increasing deficits… again like for Brazil, it is a case of strong domestic demand and falling exports.


Now let’s have a look at the shifts in more details, in this second graph. Let’s start with the BRICS. India and Brazil are now well into negative territories, at about -5% and -2.5 % of GDP. And Russia also saw a sharp drop of its surplus. Where is the BRIC’s miracle? We saw above the G10 commodity exporters Australia and Canada – not nice either, between -5% and -3.5%… not exactly what is supposed to happen within a booming commodity exporter, whose currencies have been heavily accumulated by SWF, CBs and Wealth Managers. Admittedly, BRL, INR, and AUD have already well corrected, but the CA shifts are impressive. It could definitely push these currencies much lower.

Let’s have a look at a third group now from EM Asia – Honk Kong, Thailand, and Indonesia. Like China, their CA surpluses have sharply dropped. I have not yet checked in details at the reasons for these drops, but I am pretty sure that the consumption boom in Thailand, and the rebalancing to domestic consumption models in countries like Hong Kong and Singapore are important factors. For Thailand which remains an export led economy it is quite worrying. The worst is Indonesia, once a booming export economy that had the chance of being also a commodity exporter. It’s CA has shifted from a surplus to a large deficit.

Actually, in the case of Indonesia the CA deficit is now as large as during the 1998 Asian crisis (see the chart below), that’s amazing. In the case of India it is even worse. And everywhere the downtrends of deterioration over the last 2 years are surprisingly sharp… the world we had in mind one year ago has really changed with the shift in China’s growth model. (I have voluntarily hidden the years after 2012, because the IMF tends to consider that CA will adjust to balance, and hence the current trends are less clear).


Without considering an Asian Crisis scenario (EM sovereign debt are now mostly in local currencies rather than dollars, EM FX reserves are overall very high, EM debt are much longer term than in the past), some investors are nonetheless rightly worried about EM vulnerabilities in the context of peaking QE. EM Corporate debts for instance have increased significantly and have remained in dollar. Global investors’ massive exposure to EM also matter, particularly if it is trough ETF (just like in the case of Credit). The JPY drop is a worsening factor as it is affecting all of EM asia’s competitiveness – just like before the 1998’s crisis. So CA deficits are a key discriminating factor.

To conclude: 1/ The world has changed with China’s policy shift. The commodity markets have priced it in H1 2013, but the EM markets have probably just started the process. 2/ From a trading perspective, for those that envision to trade the bearish case, the CA factor suggests that the most vulnerable currencies are AUD, BRL, INR, IDR, CAD and THB, against USD of course.


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