A 10% to 20% devaluation of SAR vs USD, and probably a switch to a crawling peg to an FX basket would make sense.
How the second shift in 2 years in Saudi’s Oil strategy (symbolized by the about-face at the Doha April 2016 meeting, and Al-Naimi’s departure) and some aggressive changes in the labor laws, made me completely change my view on the necessity of a SAR depeg. One of the key problem is demographic!
In January 2016, when Oil was at its lows I wrote in an FT comment (see full text at bottom) why a SAR depeg was foolish, unnecessary and highly unlikely (and why oil had just bottomed). I expected at the time a major rebound in Oil prices driven by a likely agreement between Opec and Russia, as had been suggested by Saudi Arabia (SA) since November 2015 (see my tweets in nov15 and jan16). The rational was that the Saudis had triggered a sharp Oil price correction since H2-14 to hurt the high cost producers, but once that was done successfully they wanted prices back to their fiscal breakeven which is about 90$.
The reason why they needed those elevated levels of prices is mostly political. The fear of the consequences of the Arab spring (Mubarak’s downfall and total absence of US support), and the policy the Saudis had adopted since then of huge public spending to quell any social discontent.
Hence abandoning the peg which had been a cornerstone of stability in the country – primarily by allowing inflation to stay low and stable – didn’t make any sense in that perspective. Indeed with the upcoming rebound in Oil prices, the fiscal difficulties were surely temporary – a matter of one or two years. Also as I argued in my FT comment (which by the way is still the IMF official line) a devaluation wouldn’t bring any competitive gains as SA’s main exports are priced in USD from Oil and Oil derivatives (see graph below – from last article 4 ). Also importantly the country’s private sector was relying on an army of foreign workers attracted by petro-dollar wages. So all in all, ending the peg would mean that Saudi nationals would have to work much more in the private sector – a huge societal and growth model change (see graph IMF) – and surely not in line with the policy of fiscal profligacy.
Then came Prince Salman… may he succeed!
As a Frenchman, I have true intellectual difficulties with the very idea of Royalty. BUT, I must recognize that there are sometimes dynasties of true natural born leaders – able to foresee necessary changes, gather society’s forces around them, and drive changes. If Rahul Gandhi surely is not one of them, Prince Salman surely could be. He has the intelligence to understand the challenges, the courage to dream big, and takes the risk associated. Of course there is a high probability of failure. But not moving also is a big risk. And these risks poised by reforms are precisely why I think he has to depeg the SAR because it will strongly increase his odds of success.
How did I realize the depth of the policy change?
First I was long Oil during the April 2016 Doha OPEC meeting (just as I had been short Oil during the Nov14 Opec meeting), and I was literally AMAZED to see that over the week end, the Saudis had shifted their stance and refused the agreement they had been calling for for months. Moreover, this was followed by the departure of Al-Naimi this historic figure of Oil policy. Importantly Al-Naimi was the architect of the policy that consisted in triggering a temporary price collapse to get rid of high cost producers. And he wanted that to be temporary and a return to levels consistent with fiscal breakeven. So his departure clearly suggested that things were changing seriously.
Second, I was stunned by the very aggressive recent labor law changes for foreigners in SA, which clearly suggested that internally something huge in terms not just of growth model but of societal model was going on. Clearly, they seriously want nationals to replace foreigners in the private sector, so attracting foreign labor with wages in USD equivalent is not needed anymore.
So all these points may look like some anecdotal secondary issues, but to me they are the real indicators of policy shifts. (And there are others – like the recent publication of US Treasury holdings by SA). Indeed, the economic case for the depeg is a function of these Oil and Labor policies. In other words once the right growth model and right oil policy are chosen, the positive effects of a depeg become obvious – see the annex 1 on the recently published “Economic Diversification in Oil-Exporting Arab Countries” by the IMF.
Why do they need to change the growth model?
James baker recently said that “These things are semi-revolutionary ideas“, “There does need to be some fundamental change with the way things are done in Saudi Arabia.” “They’ve got this huge workforce that they can’t employ… and of course they’re running some substantial budget deficits now”. The statement from the frontpage of the last Article 4 (yes again), is very clear. One of their main problem is demographic. To stigmatize, until now the model of high oil prices was just fine to hire everyone in the public sector, but now they need to have some real jobs in the private sector.
And that’s precisely the plan announced by the Prince (see long interview in the economist), and in line with the Mc Kinsey big reform plan (which is btw very much in line with what the IMF had been advocating) – see the 150pg online report – which is pretty ambitious to say the least. (Probably they worked too much on unicorns’ biz plans lately). In particular the second graph here shows the central ambitions they have for the private sector! That’s a key point for the rational of the depeg – as explained in the following paragraph. The graph also shows the extent of the population rise, indeed with a 5% annual population growth, they surely have to change the growth model!
Of course, what is still unclear (and clearly not reflected in Oil prices), is what’s their new strategy for Oil prices is. There are many factors of influence here, and primarily the threat that Oil prices could fasten replacement technologies and the end of Oil age – see this formidable article in foreign affairs. Of course, there are also external issues, such as the influence and state of economic development of Iran, but these are well known issues.
But in any case – whatever the new Oil price strategy – for the new economic model to succeed, a depeg would hugely help.
So let’s go into economics issues now – why would they need to depeg?
Of course the most obvious and well known figure that reflects that pressure to depeg is the sharp drop in FX reserves from about 750bn USD in mid 2014 to to about 580bn lately. They are used both to protect the peg and as a substitute to falling fiscal ressources (falling oil prices). But this is just a symptom of the problems actually, so beyond this figure, why would a depeg help?
The IMF says it very clearly in his article 4 last year (the new one will be out shortly), REER has increased by 14%, while the Terms of Trades has collapsed – see graph and full text right below. So it is precisely the OPPOSITE of the counter cyclical adjustment that would be necessary. As a result all adjustment had to be done through fiscal means and through the highly flexible [poor foreign] labor market. And as I said above, the IMF concludes that a depeg wouldn’t bring any major benefits now because SA only exports Oil and Oil derivatives, so there is no competitiveness gain. Except that this isn’t true if there are major changes if the labor force composition. And at the same time, the Fund strongly encourages the govt to change the growth model, and lately showed it was extremely happy with Prince Salman reforms. Moreover the important paper in Annex 1 clearly shows the general framework for reform of Oil exporting countries, and it states that having a REER at fair value is a key pre-condition for economic diversification.
Here is the full IMF quote – pretty clear I think, given that the plan is to have a far less flexible labor market (nationals), and less reliance on foreign labor (that would revive FX competitiveness).
“33. Supported by the flexibility of the labor market, the exchange rate peg has provided monetary policy credibility and has helped deliver low inflation and inflation volatility.
Nevertheless, with the U.S. dollar appreciation, the REER has appreciated by nearly 14 percent over the past year while the terms of trade has fallen by over 30 percent in 2014–15. A more flexible exchange rate would have benefits for the stability of fiscal revenues in nominal riyal terms and enable a more independent interest rate policy, but given the structure of the economy (heavy reliance on oil exports and limited import competing industries which are anyway reliant on imported inputs, including labor) would have very limited benefits for competitiveness and could increase the volatility of inflation. Moving away from the peg would also remove a credible monetary anchor, and reduce certainty for trade and investment.
34. The authorities and staff agreed that the exchange rate peg remains appropriate for the Saudi economy. Nevertheless, staff suggested that the peg be reviewed periodically (in coordination with other GCC economies) to ensure it remains appropriate given the evolving structure of the Saudi economy due to ongoing labor market reforms and efforts to increase diversification. Meanwhile, reforms that would support a move to a more flexible regime, if this became appropriate in the future, would be desirable in their own right and could proceed (including strengthening liquidity management, improving monetary transmission by developing money and debt markets, and improving data on foreign currency exposures of corporates).”
So the benefits of depeg would be quite obvious:
- Cope with terms of trade shocks,
- Cope with the fiscal revenue shocks (see chart below and Debt Sustainability Analysis where it is clear that the Debt dynamic could become unsunstainable easily),
- Competitiveness for the nascent / projected manufacturing industries,
- Monetary policy independence from the Fed (see IMF paper on the subject in annex 2 on distortions created by the peg with Fed policy), this is particularly relevant ahead of the Fed’s tightening cycle with possible further dollar appreciation,
- Help the switch between national / foreign workers,
- Foreign capital attractiveness.
What’s needed for an independent monetary policy?
Now there is a sequence usually for a depeg to take place without problems (RBA’s Guy Debel had some good advices for China about that recently). In particular, one must make sure that the central bank will be capable of providing liquidity to the domestic financial sector. Banks have to be ready. I think they are. And for that to go smoothly a bond market (ST, LT) has to be developed. That’s precisely what we have been seeing everywhere in the GCC lately – the so-called Sukuk bonds. And we are starting from a situation of almost no debt as shown below.
Also there are regional considerations. SA is a member of the GCC, so it has to coordinate with its neighbors.
But as recently seen with the Egyptian and Nigerian deval (admittedly they were already in quasi crisis), there is no need to prepare that for years. I guess from this point of view the GCC could do it. To me the level of Oil prices is much more important, to avoid a useless and costly run on reserves to defend the old or new peg system.
Time window considerations:
First, let’s state the basic, when it depegs, it has to avoid being pressurized by outflows. So it HAS to occur in period of strength – that is when Oil revenues are high – ie. when Oil prices are high. If it had depegged in January 2016 (whatever the model / basket that is chosen), it would have had to use its reserves aggressively to counter outflows). Also, ideally the idea is to do it before the Fed accelerates its rate hike cycle (because SAMA will have to hike too), hence creating further pressure on the economy at a really bad time, and particularly so if the dollar rises further. In a sense it is a bit similar to the SNB sudden depeg in January 2015 (2 days after swearing that it would fight for the peg forever), just because the ECB QE was coming.
Second, the timing depends on the financial reforms / privatization program. For instance should they do it before or after the Aramco IPO? Should they do it after the bonds issuance? As a general principle, as just discussed it is important for the domestic financial system to be ready to cope with liquidity provision from the central bank (I think they probably ready). Also the attractiveness of FDI is suppose to increase after the FX regime is clarified and is in line with REER. But I must say, in this specific case, things might differ, I would be happy to talk to an EM IPO expert. I would tend to say after the bond issuance (they already started everywhere in the GCC), but before the Aramco IPO which is too far away.
So overall I would say, I have a large position long USD/SAR, and will turn it bigger, when I feel the odds of timing are improving – typically I would say quite likely before Ramadan (June 6), even more likely after Ramadan (after July 6), and otherwise after the Aramco IPO (planned in about a year).
Of course all of these elements don’t guarantee that they will depeg. (After all, and fortunately for macro traders, the world is full of policy errors). But, for sure, there are many factors suggesting that it would help them in achieving the success of their new growth model. It is a logical measure within their plan, so it should happen within 2 years. I would even argue that I don’t see any reason why they should not depeg, the only real question being the sequence (timing). And as I said, there are many elements suggesting that they may be preparing for such a policy shift, which by definition is NEVER pre-announced, and always denied and fought actively to the last minute – otherwise it’s self defeating. Indeed, any official recognition that the peg could go encourages more outflows which are costly to offset in terms of FX reserves. So be ready for more refutal.
If that happens, it would have important implications – SAR of course, GCC, Oil also potentially, so of course implications for Russia, Norway etc.… I have been asked what proxy to use instead of SAR? Well all GCC are in the same boat from my perspective.
Original view in January – as published in FT comments – (forgive typos)
January 28, 2016 4:36 pm
Russia ready to discuss oil output cut with Opec
macrottt Jan 29, 2016
I forecasted this Russian policy shift 2 weeks ago (in communication at least) – when the RUB collapsed (see my blog and twitter account – https://macrottt.wordpress.com/) . Indeed, despite the absence of an imminent russian financial systemic risk, what mattered was the inflationary impact and budget impact (the fund used to fund the budget’s deficit would soon be empty at these levels) which were dramatic . So a Russian reaction was surely going to happen.
Now what really matters is the possibility of an agreement to cut, not the cut itself. Simply because staying short oil then becomes completely crazy given the possibility of a sharp jump to 50$.
So yes, of course Putin as always is negociating with aggressive tactics. He doesn’t want to cut, but he needs a higher price desperately. So we will now have statments and counter statements. Saudis said this, Russia said this, Iran didn’t say this… And a volatile market. But we now all know that they are all in stress and are negociating in secret.
But what matters really is that the fiscal breakeven of Saudi Arabia is about 90$. And it doesnt make sense for them to devalue the SAR as most of their imports and huge foreign workforce (from nepal / india) are paid in USD. And they can’t continue to deplete their FX reserves at this pace. Also the peg has been one of their strongest institution and achieved great results in terms of inflation. It would make much more sense to cut public spending (a thing they can’t do for political reasons). And it is about the same for Russia, the Oil price at 28$ had become a real threat.
Also, even if the production adjustment in Shale is not yet done. It is now clear that the funding of this industry has structurally changed and that many actors will disappear (or merge) in the coming months. Also capex has collapsed. So the strategic goal of the Saudis is achieved. And clearly as I anticpated before the Nov OPEC meeting, they have already said that they were willing to cut – that was a major shift. But nobody cared then. Rightly because Russia didn’t at the time.
So if one wants to stay short in this context, he might be proven right, but given the loss he will make if wrong, that’s definitely not good trading. That’s why the Oil bottoming process has clearly started.
Some good reads / ANNEXES
1/ April 2016 – Economic Diversification in Oil-Exporting Arab Countries – Prepared by Staff of the International Monetary Fund – Annual Meeting of Arab Ministers of Finance
2/ IMF Var study on impact of oil & us Monetary policy shocks
3/ Background / Who’s who in the Saud Dynasty
The coming next weeks are likely to be quite volatile as market participants will reconsider several assumptions.
Most important of all, could the Fed hike in June or July? The answer will be given by Yellen this Friday and on June 6. How she stands in the debate of closure of the output gap (employment being at potential or still having room to progress) will be key. In the last few months she was close to Dudley’s views and he was definitely less dovish last week. The repricing move of Fed’s expectations already started since the publication of the minutes last week, but it is accelerating. Most at risk are Gold positions which have reached an exceptional level. I have been short Gold for a few days, and guess that if the current break of 1245/50 is confirmed we could go as low as 1170. One thing is sure, if I was long Gold, I would definitely get out before the Yellen’s speeches.
(Note – charts from soberlook).
Then there is Oil – will the rally reverse? Admittedly it is not on radar screens yet, but since Al-Naimi’s departure (which baffled me and forced me to close some positions at 1AM a Monday morning), I have had the sense that the Oil rally has mostly been driven by temporary issues (Canadian wildfires, Venezuela closures…). Indeed the departure of this historic figure of Saudi Oil policy shows that the Saudi policy has really changed (and not just on economic reforms), and an agreement on a freeze is now very unlikely. Opec meets on June 2 and we will know. But I suspect – as it has been the case for the last 3 years – that due to the “robotisation” of markets, the oil rally has now overshot the fundamentals on the upside, just when net oil longs are at a record high. And importantly, some shale producers could again become profitable and reopen supplies. If that happens that should be seen in the weekly inventories’ inability to drop, today and tomorrow. Of course if Oil drops, it will impact every asset – Equities, commodity FX producers etc… I am planning to short Oil when possible – maybe after another high. And I am so impressed by the Prince Salman reform program that I am convinced that he will have to depeg the Saudi Riyal and consequently I am also long USD/SAR. (In terms of timing though, I guess that even if the end of Ramadan around July 6 could be a good fit, I also think that they imperatively have to do it when Oil is strong).
Apart from these two key drivers, there are several other interesting questions:
Now that the G7/US has clearly disagreed on JPY intervention, will Japan choose the confrontation? And more importantly, how long will it take for real money investors who bought the “Abe in wonderland” story to completely close exposure on Japan? As I have said on many occasions, Abenomics was supposed to be made of three arrows, and the most important was the third one – structural reforms – the only one really capable of dealing with deflationary features. And the first one – monetary policy – was only a temporary “booster” that would mostly help thanks to the FX devaluation. 3 years later, reforms are not really significant, and G7 patience and sympathy has vanished as clearly confirmed this week end by the rare show of tensions with the US. (The systemic nature of the Chinese devaluation threat has also changed the context). I am short USD/JPY – reaching 105 wouldn’t surprise me, and also trying to build a short Nikkei exposure. But BOJ meeting on June 15 might be a better fit for the unraveling…
Last important point which might challenge markets, China’s policy support started in Q1, clearly has been reversed somewhat lately due to renewed concerns about a credit bubble. But more importantly there seems to be confusion / disagreement at the top in China. This excellent The economist article presents two different theories for the weird policy “smoke signal” given last week. It might be a sign of upcoming policy volatility. I am long USD/SGD, partly due to deflationary concerns in Singapore, partly on dollar strength, partly on China’s possible weakness.
Changes to the Blog & taking stock on last 2 years of macro trading & development in the macro hedge fund sector
I have gradually stopped publishing on this blog as I was focusing on the finalization of my trading processes. Following this completion and some strong trading performance last year (Romad = 4.9), and in preparation to capital raising discussions, I will now write regularly on market views, drivers and how my risk exposure evolves.
Speak only if you have something original and smart to say…
One thing I hate on the web is the amount of irrelevant things that are published. It is damaging for the authors who sometimes have interesting things to say. So this blog has gradually turned into an arena for my big original strong ideas. For instance in 2 of the last 3 posts I explained:
1/ Why I thought that China would devalue (Nov 2014),
2/ Why I thought that the USD rally would temporarily stop (March 2015),
…These calls were quite originals and successful I must say (I am myself surprised by the accuracy of my timing).
Writing takes an enormous amount of time…
And so instead of using the blog, I have increasingly been using twitter to make quicker shorter comments on my investment cases, significant market moves and more and more comment on my risk exposure. For instance:
3/ In August 2015, after the CNY devaluation that I had been expecting finally took place, I explained in a series of tweets what markets reaction I expected (Nikkei & USD/JPY selloff + EM NJA selloff), and kept a live account of how I traded these great market moves. It was my most profitable month ever! https://twitter.com/DDeddouche/status/630978173929394176
4/ Also, in January 2016, in a series of tweets I explained why an Oil rebound was upcoming.
As an aside… sharing feelings on my macro trading
As I have just talked about this CNY devaluation call, allow me to diverge a bit and give flesh to a few great moments of my trading life. I must say that having the right position when a depeg takes place (I was long USD/CNH on August 9) to me has always been the ultimate intellectual accomplishment in macro trading and provides some great feelings. This is what every (traditional, analytical) macro trader used to dream of, when reading accounts of the Soros positions on GBP in the 1992 ERM crisis. And not just that, trading close to “perfection” the ensuing vertical waves of unwinds in Nikkei and USD/JPY, as panic did spread in August 2015 made me really understood what Paul Tudor once described – “One has to experience both the elation and fear as markets move five and six standard deviations from conventional definitions of value. The only way to learn how to trade during that last, exquisite third of a move is to do it, or, more precisely, live it — a sort of baptism by fire.” Who said that trading has to be boring? Or that macro trading was dead?
[By the way, I am convinced that the Saudis should depeg the Saudi Ryal given their new growth model, and they have to do it while Oil is high. So I am long USD/SAR. But I keep wondering if I have to be just big or huge – as Soros once advised. More on that in a latter post].
… and some thoughts on macro trading strategy and the industry in general
So of course, lately there were lots of articles on the death of macro Hedge Funds. I find that quite ridiculous. But it is true that the industry had to evolve for many different reasons and is being forced to trade differently:
- The first thing to mention is that macro trading – à la Soros or Kovner – is originally about understanding macro-economic developments, understanding policy frameworks and anticipating policy shifts. [As Kovner once said “For example, it is trying to figure out the problems the finance minister of New Zealand faces and how he may try to solve them.”]. And I wonder what percentage of the macro HF sector does really apply that strategy today (or say up until last year). I guess a large part of macro HF had gradually turned into trend followers, Fixed Income funds, or macro algo funds. (Relevant strategies but which are increasingly distant from the business of anticipating macro policies). For instance, some “macro funds” supposedly having a macro strategy had to close when the SNB ended its semi-peg EUR/CHF policy. It was amazing! The internal contradiction of the SNB policy and potential policy failure was something I had written about in 2012, as soon as the SNB started it. It was a risk obvious to anyone with a minimal knowledge of macro policy. You can’t control your monetary policy, have free capital flows and have a peg. It is called the impossible trilemma. It’s macro policy 101! So it seems to me that many macro funds are actually doing something that is not macro trading.
- Importantly and obviously, the economic policy context has changed since 2008. With the experimental nature of policy making since 2008 (QE etc), and much lower growth levels, economies have been very vulnerable to shocks, and consequently policies have been versatile (Fed to taper, then no taper, then taper again, then hike, then no hike, then hike…). So it is a much tougher context than in the old day of 1990 when you could start a long bond position, double, and wait three years to make a fortune. Trends are shorter, reading policy making necessitates a lot of hard work!
- Also importantly, the “quantification” of trading, has been very harmful for some macro actors forcing to be extra selective. Trend followers (CTAs) with High Frequency Traders (trending strategies) are generating almost systematic overshoots in trends (for instance Oil couldn’t rebound before feb 2016), and HFT (squeeze strategies / mean reversion) are constantly “attacking stop points and creating significant costly intra-trend volatility, so it forces you to have larger stops and always be mindful of crowded positions. It seems to me that this has contributed to less and less actors who “think” and understand macro. And actually I wouldn’t be surprised to see market authorities start dealing with these issues. Indeed, I have noticed that changes in macro fundamentals are increasingly long to be priced in (which is good for me as long as I know it and have strong confidence in my cases). Sometimes between the publication of an important pivotal data, and the market awareness of its implications, it can take between 1h or even several days. For instance in case 3/ above, when China devalued on Aug 10, Twitter was full of “macro experts” saying that it was irrelevant, and that this would be forgotten within a week (no I won’t give names in public). And indeed it took one week for the USD/JPY to collapse! Similarly, in case 4/ above, when Russia was finally giving signs that it could agree to a meeting with OPEC, it took several weeks for the market to bottom as the market was so driven by CTAs.
- Finally, for big macro HF, the liquidity in FX markets in particular is not the same, harming particularly the biggest funds (thank you Dodd Frank / Volcker).
These are at least the feelings I have after trying many macro strategies over the last few years. So one now has to be very selective, constantly avoid crowded positions and likely liquidity holes, manage to deal with the new intra-trend volatility generated by algos, and finally be aware of the versatility of the current policy context. So of course that’s a market less suitable for huge funds.
Which brings me back to me and this blog…
So last year, mostly by anticipating well 4 major trends (Oil collapse, CNY and NJA FX weakness, Gold drop and consequences of CNY devaluation on Japanese assets) I have manage to have a strong performance – getting a ROMAD of 4.9 and Sharpe ratio of 2.1 (that means that my Return was 4.9 times my Max Drawdown). So again making money out of a macro strategy is still possible, and actually it seems to me that focusing on policy expertise gives an increasingly great edge in a market driven by computers, as long as you have the right trading “parameters”.
As a consequence, my goal with this blog, is now to write much more regularly to reflect generally the building blocks leading to my risk exposure (so of course the views will likely be less original). I will cover my market views, my macro investment cases, the market drivers and my positions. Note that I will not keep track of my positions on the blog – as it is a trading book which can change very quickly (and it is private😉 ) -instead I will try to give updates of the biggest positions via twitter.
1.5 year later, the market is still un-prepared for the clash of G7 FX
To finish with a quick market comment, it is funny to see that the market and policy makers are focusing this week-end with the G20 meeting, on the subject of the post I wrote 1.5 years ago. https://macrottt.wordpress.com/2014/11/21/why-jpy-shorts-should-keep-an-eye-on-the-6-13-usdcnh-level/ . The problem is simple, given the huge systemic risk posed by China’s possible devaluation (they used a large part of their FX reserves to avoid a too large devaluation, but surely won’t do it again in case of renewed massive outflows), SO there is no way that the G7 (and the US in particular) can again “authorize” Japan to devalue its currency again (Abenomics has essentially been a massive FX devaluation and apart from that nothing serious in terms of structural reforms has been implemented). So if the market realizes that Abenomics is over, the Nikkei and USD/JPY could selloff much more. If instead Japan chooses to clash with the US (and China), then we will have rising odds of seeing a much more destabilizing 20% CNY devaluation or trade tensions (see Steel tariffs) – and that is a systemic issue.
Mind the gap this week end!
Identifying possible macro surprises is usually a great source of outperformance in yearly results. Just to take one example, how many investors were hit by the taper tantrum and the Bernanke speech in mid-2013, despite the numerous early warnings (see my post in March 2013…)?
So now, as often in Q1, investors have two huge convictions for the year. One is that the USD is up thanks to upcoming Fed hikes. Portfolios are fully loaded with dollars. The other is that ECB QE (and the EUR drop) is giving European equities a major boost. I must admit I am sympathetic to the second theme in the medium term (even though the likely FN success in March French elections is likely to be a big surprise, and I am very worried by the impact of Fed hikes on equities…).
But, as often, there is one thing that could prove problematic in this beautiful scenario… and could suddenly squeeze FX positions, and the associated equity themes (long German exporters). It is the USD rally.
I won’t pretend that I know, or have quantified the deflationary impact of the USD rally. But I have not either seen anything convincing on that issue from the Fed. To say the least the small paragraph in last week’s MPR was disappointing. So my guess is that nobody knows for sure. And there are two data that I find weird enough: 1/ The ISM new orders index have collapsed below 50 at 48.5. So, yes it might be due to cold weather, to weak global demand, and to the strikes in the West Coast ports. But it is also surely due to some extent to the USD rally. 2/ The core PCE inflation is steady on a yearly basis, but on a 3m basis it is at a low since 2008. Whether this two data rebound in the coming months will be key for the Fed scenario. Moreover, from previous works I know that there is usually a link often lagged (as the theory also suggests) between a currency, and inflation. (See two non-updated charts out of an old spreadsheet).
All that to say that if US manufacturing is more affected than initially though by the strong USD, and more importantly if the disinflationary impact of the strong USD proves stronger than expected, then the Fed plans about its first hike will have to change – OR – the Fed will have to talk the USD down.
US Treasury secretary Lew, at the last G20 in February was quite clear on the fact that weaker EUR and JPY were ok as long as they enabled structural reforms – that had been asked for more than a year already. And who sees any structural reforms in Europe? And where is the 3rd arrow of Abenomics? I am not aware of anything convincing on these grounds. And now, as I suggested in my last post, the Yuan is getting weaker too.
There are recent precedents, when the Fed had to intervene in the currency debate. In particular, I find quite compelling to highlight a 2009 Bernanke speech on the links between the weak dollar, inflation, and commodity prices (see below some parts of the speech and some comments I wrote at the time). This is a speech which incidentally occurred 10 days before a major reversal of the EUR/USD (see below).
It is astonishing how we are now exactly in the opposite situation to what happened in 2009. Admittedly, at the time Europe wanted a weaker currency too, so there was a shared interest. In any case, by reading this speech, it becomes rather clear that a well-chosen tactical statement on the dollar can be enough to stop a powerful FX (over-crowded) trend in a matter of days.
Bottom line: watch core pce, imported inflation, and new export orders… if they don’t rebound soon, start listening to Fed regional governors for signs of an fx policy debate… if they come-up sell your dollars, and also maybe your European stocks…
Again, so far, it is just a risk scenario… but the main point is that I see a possible conflict between the impact of the strong USD, and early rate hikes. More generally, I tend to think that for a sustained USD rally to last, we would need to have a confirmation that the Fed has started a multi-year cycle of hikes. And that seems quite premature to be fully priced in, and will be so as long as we don’t see inflation bottoming, as Yellen clearly explained last week.
November 17, 2009 – On the Fed, the USD & commodity inflation
Bernanke’s speech yesterday was significant for the dollar. The important point in that speech is that it validates the idea that a lower USD can have an inflationary impact through higher commodity prices. That idea had been the subject of a long debate at the Fed last year in H1-08, before Oil peaked. Bernanke had been reluctant in embracing that view. But his statements yesterday hint to a clear change:
1/ “Commodities prices have risen lately, likely reflecting the pickup in global economic activity, especially in resource-intensive emerging market economies, and the recent depreciation of the dollar.” That means that a weak dollar is now considered by the Fed as one of the sources of rising commodity prices… A validation of the idea debated last year.
2/ “We are attentive to the implications of changes in the value of the dollar and will continue to formulate policy to guard against risks to our dual mandate to foster both maximum employment and price stability”. The dollar value is monitored in the context of its inflationary impact (amongst other of course), not only in terms of imported inflation but also through its impact on commodity prices.
The implications are that, should the dollar drop significantly more in the medium term (between 1.55 and 1.60 against EUR), its inflationary impact through commodity prices (“negative feedback loop”) will now be finely monitored. And the corollary is that this factor could be one of the reasons for a Fed/Treasury intervention, to stabilize / put a floor to the USD’s value. (Note that threats to global financial stability is also an important factor underlined by Bernanke).
Here are the two key parts of the speech:
“The outlook for inflation is also subject to a number of crosscurrents. Many factors affect inflation, including slack in resource utilization, inflation expectations, exchange rates, and the prices of oil and other commodities. Although resource slack cannot be measured precisely, it certainly is high, and it is showing through to underlying wage and price trends. Longer-run inflation expectations are stable, having responded relatively little either to downward or upward pressures on inflation; expectations can be early warnings of actual inflation, however, and must be monitored carefully. Commodities prices have risen lately, likely reflecting the pickup in global economic activity, especially in resource-intensive emerging market economies, and the recent depreciation of the dollar. On net, notwithstanding significant crosscurrents, inflation seems likely to remain subdued for some time.
The foreign exchange value of the dollar has moved over a wide range during the past year or so. When financial stresses were most pronounced, a flight to the deepest and most liquid capital markets resulted in a marked increase in the dollar. More recently, as financial market functioning has improved and global economic activity has stabilized, these safe haven flows have abated, and the dollar has accordingly retraced its gains. The Federal Reserve will continue to monitor these developments closely. We are attentive to the implications of changes in the value of the dollar and will continue to formulate policy to guard against risks to our dual mandate to foster both maximum employment and price stability. Our commitment to our dual objectives, together with the underlying strengths of the U.S. economy, will help ensure that the dollar is strong and a source of global financial stability.”
We live in fascinating times – largely thanks to the QE revolution.
When two of the most important data seen in the last two years are screaming that the Fed is going to start hiking soon, and you see LT and ST rates going DOWN, because that is pushing equities DOWN… you know there is a big problem going on. That is particularly true when the Fed is telling you that the Conundrum 2 is becoming one of their big worry…
The Fed has been saying for months that it expected wage inflation to appear, to start the hiking cycle. Last month we had the rise in the ECI… nobody cared. Last Friday we had the rise in average earnings… US equities started falling. Interestingly according to the financial press – and confirmed by market internals it was mostly due to the energy sector finally going down. The Greece Damocles threat didn’t help either.
Now we have the inflation expectations of the Michigan survey – one of the best inflation survey available – showing that despite collapsing gaz prices, inflation expectations are going UP. If the Fed isn’t happy with that… what does it need?
And… finally… we are seeing some reactions from equities. As I discussed at length in a recent post – most believe wrongly – based on historical (and inappropriate) basis that the start of a rate hike cycle is bullish equities. True historically, except that this time the Fed has been deliberately using equities for 5 years to help in the deleveraging process. And that the process is over, they said explicitly many times that now they didn’t care anymore about equity valuations.
Worse, Dudley had a great speech last week explaining that what would matter in the speed and size of the normalization process was not the ST rates but how financial conditions would respond– and LT yields in particular. And he implied that the “Alan Greenspan conundrum scenario” was one of the big current worries at the Fed (inability of 10Y yields to rise in 2003/2007 despite a full cycle of ST hikes). He implied that the least the 10Y would react the more hikes were likely… (my take). [Find the full quote below…]
So of course the equity market reaction and the break in correlations that we are seeing might be due solely to end of week / end of year profit taking or may be just oil related. Maybe the last trend of the year will be a big squeeze (of USD longs, and equities)… maybe not. Maybe it will be next year. Who knows?
But in any case, we now know that 1/ we now have the data that the Fed has hoped to see for 3 years, 2/ we have an equity response that is highly worrying because it goes against the dominant assumption that equities will rise on the start of the rate hike cycle (as it historically does), 3/ finally, and quite worryingly we have a Fed that is worried about a conundrum 2 scenario that would necessitate more or faster tightening.
So staying too long in crowded markets might definitely be a bad idea. Tactically, on the contrary going for the squeeze makes a lot of sense. It actually reminds me of the taper tantrum in Q2 2013.
With respect to “how fast” the normalization process will proceed, that depends on two factors—how the economy evolves, and how financial market conditions respond to movements in the federal funds rate target. Financial market conditions mainly include, but are not necessarily limited to, the level of short- and long-term interest rates, credit spreads and availability, equity prices and the foreign exchange value of the dollar. When the FOMC adjusts its short-term federal funds rate target, this does not directly influence the economy since little economic activity is linked to the federal funds rate. Instead, monetary policy affects the economy as the current change in short-term interest rates and expectations about future monetary policy changes influence financial market conditions more broadly.
Developments in financial market conditions are thus an important element in the transmission mechanism of monetary policy to the economy. Changes in financial market conditions influence economic growth through a number of channels. For example, a stronger equity market raises household wealth and lowers the desired personal saving rate—lifting consumer spending. A stronger equity market also reduces the cost of capital for business, which may help encourage greater investment spending. Lower long-term interest rates push down business financing costs, which also supports investment spending. At the same time, lower mortgage rates support housing demand and reduce household interest outlays. A weaker dollar supports growth by making imports more expensive and by increasing export competitiveness. The combined effect is to increase net exports.
If the linkage from the federal funds rate to financial market conditions were stable over time, there would be no need to focus on financial market conditions. In a world in which the linkage was solid and unchanging, adjustments to the short-term interest rate and communication about future policy would have a predictable and reliable effect on financial market conditions. Central bankers, then, could keep their focus narrowly on their policy rate.
However, as has been very clear, especially in recent years, this linkage is not stable. Thus, how much one pushes on the short-term interest rate lever depends, in part, on how financial market conditions respond to such adjustments. Imagine driving a car where the connection between the gas pedal and the engine speed was variable and uncertain. The driver would have to constantly monitor and adjust the pressure on the gas pedal to achieve the desired speed. Similarly, we will have to monitor and adjust short-term interest rates to achieve financial market conditions consistent with achieving our labor market and inflation objectives. All else equal, less responsiveness implies larger interest rate adjustments and vice versa.
Quickly, let me give two examples that illustrate how variable this linkage can be. First, during the 2004-07 period, the FOMC tightened monetary policy nearly continuously, raising the federal funds rate from 1 percent to 5.25 percent in 17 steps. However, during this period, 10-year Treasury note yields did not rise much, credit spreads generally narrowed and U.S. equity price indices moved higher. Moreover, the availability of mortgage credit eased, rather than tightened. As a result, financial market conditions did not tighten.
As a result, financial conditions remained quite loose, despite the large increase in the federal funds rate. With the benefit of hindsight, it seems that either monetary policy should have been tightened more aggressively or macroprudential measures should have been implemented in order to tighten credit conditions in the overheated housing sector.
Economics 101 – What should a central bank (the Chinese PBOC) do when:
1/ its currency has appreciated by 30% in REER terms over the last 5 years,
2/ it has a semi-peg with a currency (USD) whose central bank is about to embark on a rate hike cycle,
3/ the government has been implementing ambitious and far reaching structural reforms to the point that the two main engines of growth are slowing fast, and only external demand is helping somewhat,
4/ inflation is collapsing because of an oil shock and a sharp drop in food inflation, and also because of excess capacities,
5/ one of his major trade partner and competitor (Japan) has just devalued its currency by 40% (without one inch of structural reforms) and all regional currencies are starting to react to that,
6/ its economy is slowing down fast but its policy makers don’t want to send the wrong message with rate cuts because it is dealing with a credit bubble (see the economist’s article this week),
7/ it has just chaired a major regional event where it showed its power and generosity… (and therefore, the calendar is now appropriate to refocus on its domestic agenda)…?
My guess is that a weaker Chinese currency would help…
Given the above, a subsidiary question is what should an investor do when :
1/ You can’t find a bank who doesn’t expect the USDJPY to reach 140 and the CNY to continue to rise indefinitely,
2/ the US treasury secretary just complained about BOJ QQE2, when not accompanied by structural reforms,…?
Well I would say that buying the USD/CNH doesn’t seem too risky to say the least (given the possible reward), AND that for JPY shorts and nikkei investors, I would watch the 6.1350 level of USD/CNH quite finely… because if it breaks it should be a sign of temporary FX policy shift in China… and that would change the context for Japan…
For readers who don’t remember well the asian crisis, here is an interesting text from the NY Fed WP. We are in a different situation today of course (NJA ccy are not pegged and have large reserves), but it is interesting to see how history sometimes rhymes…
What was the role of Japan, the leading regional economy, in the crisis? At the beginning of 1996 it appeared that the economy was recovering after five years of near zero growth, but with the increase in the consumption tax in April 1997 Japan fell into another economic recession: the level of activity actually declined in the second and third quarters. Clearly, the economic weakness in Japan contributed to the crisis in terms of a reduced demand for imports from the region. As Japanese authorities kept monetary policy loose and interest rates extremely low, the continued depreciation of the yen relative to the US dollar since the middle of the 1995 exacerbated the exchange rate tensions in the region, and in 1997 caused a steep real appreciation of the Asian currencies that were pegged to the dollar. The crisis finally exploded in the summer, when the dollar went through what seemed an unstoppable rise and the yen continued its decline.
The intellectual and political split in the French socialist’s party could be a major turning point for the buildup of a more fiscally integrated Europe, and would then significantly reduce the Euro’s structural weaknesses. Indeed, to me, the lack of intellectual reform within the French socialist party has been one of the main impediments to an adaptation of the very costly and inefficient French welfare state and thus to any fiscal integration / alignment with Germany.
NB – This is a post about the long term drivers of the Euro. In the short term the ECB is the key driver and my guess is that it will do its best to talk the EUR down to 1.20 simply because it is its best available tool (after a possible rebound as Draghi might disappoint very ambitious markets expectations at September’s meeting).
To introduce what we are talking about, I’ll remind Milton Friedman prophetic statements made in 2000 (I don’t want to elaborate on those structural issues which are well known): “I think that the euro is one of the few really new things we’ve had in the world in recent years. Never in history, to my knowledge, has there been a similar case in which you have a single central bank controlling politically independent countries. […] I think the euro is in its honeymoon phase. I hope it succeeds, but I have very low expectations for it. I think that differences are going to accumulate among the various countries and that non-synchronous shocks are going to affect them. On purely theoretical grounds, it’s hard to believe that it’s going to be a stable system for a long time. On the other hand, new things happen and new developments arise. […] You know, the various countries in the euro are not a natural currency trading group. They are not a currency area. There is very little mobility of people among the countries. They have extensive controls and regulations and rules, and so they need some kind of an adjustment mechanism to adjust to asynchronous shocks—and the floating exchange rate gave them one. They have no mechanism now. […] So the verdict isn’t in on the euro. It’s only a year old. Give it time to develop its troubles.”
The bottom line is that fiscal transfers of some sort, and ideally fiscal integration, are key to the Euro’s long term survival. Actually Draghi confirmed this view in his conclusion (that looked a lot like a warning to European governments) at Jackson Hole – “We should not forget that the stakes for our monetary union are high. It is not unusual to have regional disparities in unemployment within countries, but the euro area is not a formal political union and hence does not have permanent mechanisms to share risk, namely through fiscal transfers. Cross-country migration flows are relatively small and are unlikely to ever become a key driver of labour market adjustment after large shocks.”
The BIG problem until now was that it is politically difficult if not suicidal (for Germany) to fiscally integrate two countries that have so different welfare systems. In particular on the labor market, when one looks at the rules adopted in Germany with the Hartz IV reforms ten years ago and compare them to the unemployment rules in France, the difference is striking. The chart below from the IMF art 4, shows that France unemployment system is amongst the most generous in Europe for activation and in terms of amounts.
To give some more lively illustration, in France as long as you work 5 months, you can have 5 months of benefits, where you earn about 80% of your net salary. You can get benefits of up to 2 years. Until recently you could have the benefits even if you had resigned. You can still get the benefits if you decide to “abandon” your job (you just don’t show up). That’s great… but costly. Moreover, you don’t need to show up to get the benefits (only once a year), and actually just have to confirm through internet that you are still looking for a job. That’ why when backpacking around the world, you can meet many young French people who quite rationally work 6 months, then go on the dole for 6 months and travel (at least that was the case 12 years ago when I was travelling through Asia – I am getting older). Qui est fou? Of course contrary to Germany the income of your wife/husband, or your total wealth isn’t taken into account.
Or let’s talk about social housing (the famous HLM)… Paris city has been buying some of the nicest buildings to turn them into social housing where rents are about 10% of the market price. Look at this brand new complex (image below) just 150m from the Arc de Triomphe – avenue de Friedland – that is one of the great achievements of the Mayor, or La samaritaine of the nicest building in Paris. It is socialist Utopia! Free money for everyone – thanks Germany… And the best thing with Social Housing in France is that it is for life! If you get a 150sq m flat because you have 4 children, and 20 years later your kids leave elsewhere, you can be forced to leave only if you voluntarily declare that your situation has changed (same if you inherit). You bet that few are voluntarily asking to be relocated to a smaller place.
You have to live in France to believe it! Honestly no one in France can blame a German for not accepting to “subsidize” the generous French system.
So the bigger question is why do we have this situation in France, where the Socialist party has failed to reform intellectually contrary to the German SPD in 2004 or the new labor in the UK? Simply because France has benefited from the low German yields, from Draghi’s “whatever it takes” speech, and mostly because the Socialists were the main opposition party until 2012. So of course they didn’t have any incentive – in a period of crisis, and being in the opposition – to reform internally and open a debate about rules of good management and smart changes – but highly unpopular – to be made to the French welfare state. (I remember that already in 1996 Dominique Strauss Khan in his economic classes at the University was teaching that the French Pension system was doomed… Since then, nothing has changed, and I never heard a Socialist policy maker acknowledge the problem). Of course, as I explained in an earlier post – the general lack of understanding about economics in France also helped greatly. It helps many politicians like Arnaud de Montbourg or Marine le Pen propose economic policies completely ridiculous and outdated. And journalists never challenge policy makers on their economic policies (let’s not talk about the scandalous proximity between journalists and the political class). Even last Sunday in the great interview of E. Valls on France 2 TV, he talked about the Hartz IV reforms, but the journalist didn’t even think about asking him if that was something necessary / possible in France. The economic / cost debate has simply been inexistent for too long.
But, after two years in power, the Socialists had to choose because of the political and economic crises. Robert Feldman at MSDW had a model for Japan called CRIC, – crisis, response, improvement, complacency. It works a bit the same in France. At least a crisis is always a pre-condition to go through reforms. It reminds me in a sense of the “tournant de la rigueur” by Francois Mitterand in 1983. After putting the socialist official program in place, and the economic collapse that followed, he made a 180° policy turn. Over the last two years, France has had a major political crisis (with the Front National results), and is also dangerously close from a permanent economic crisis. The efforts made on the fiscal side have exclusively been made on the tax sides, and no spending cuts at all have been made. But Francois Hollande once called a Master of Ambiguity is now forced to make a choice (or rather let his intimate conviction be known).
The key question is to what extent a new true / honest / high level economic debate is going to appear within the Socialist party, and how it is going to “educate” french voters. De Montbourg is surely going to continue to criticize the government, and so they will have to reply. Of course it remains a socialist government and it would be highly surprising to see the equivalent of Hartz IV in France. But for sure the level of understanding of economic issues is going to improve greatly. THE DEBATE MIGHT FINALLY START. The idea within the French left that public money is free and without limit is going to be challenged. Some necessary reforms of the welfare state are going to be discussed (if it is to be saved) and benefit costs are finally going to be a parameter.
The whole process might end up with a new socialist party intellectually reformed, closer to the European social democrats. And that is a pre-condition for more fiscal integration at the European level. At least that’s a possible scenario, and the interview made in Le Point by the new economic minister Macron – who even dares proposing a reform of the 35 hours rule – is encouraging.
A final point, I have an immense respect for Krugman, Wolf etc… And I agree with them that austerity is a crazy policy in the midst of a demand crisis. And Germany (not France) should definitely have a stimulative policy. But I think one has to consider the problem from a political standpoint in Germany, not just from an economic one… That is unless you offer to the German taxpayers access to the HLM on avenue de Friedland…
Again, that’ a structural issue, not a market call to buy the EURO now…