My Thoughts on Currencies
Stephen L Jen (London)
June 13, 2013
Bottom line. Positioning unwind has been behind the messy price action in the
FX markets, and in EM. Indeed, macro has remained confusing since
Bernanke’s JEC testimony on May 22, 2013. I think the Fed’s prospective
policy shifts and the concomitant rise in the US long-bond yield since earlyMay are two of the most important drivers of markets. My understanding is that
the Fed is quite determined to start tapering early – it’s not just talk – and the
markets are not ready for this, I fear. If the Fed does indeed move toward
tapering, I fear that this may be a long and dangerous summer. Of course many
investors presumably are assuming that the Fed will have soothing words in the
next FOMC statement (June 19). I’m less sure that the Fed will remain that
dovish. (1) For EM, it is natural to experience tremors before a big earthquake.
I think we are witnessing the first such pre-quake tremor. If we see stabilisation
in EM, many would presumably interpret what just happened as a bad dream,
and that buying the EM bonds back would be a profitable trade. I think such a
view will prove to be wrong this time: the Fed’s tapering seems for real and
may start as early as later this summer. The world owns too much EM assets
for there not to be a big shock. (2) Right after the collapse in the Nikkei on
May 23, I compared and contrasted that experience with the significant decline
in the stock price of Apple and the collapse in gold prices in mid-April. I
observed the similarities between the three trades – all were supported by
intuitive and compelling arguments that remained persuasive even after the
price corrections, but concluded, erroneously, that the Nikkei would recover
sharply back to the highs before the Upper House Election. My logic was that
‘surely, the Abe Administration had more to lose than me.’ In any case, I’m
losing faith in the USDJPY and Nikkei trades, and suspect that a prospective
recovery in the Nikkei would be rough and protracted, i.e., it will be a much
lower Sharpe ratio trade than prior to May 23. In contrast, the EM trade may be
a fresher theme for H2. (3) In contrast to my expectations, there has not been a
pure across-the-board dollar rally. Instead, it’s been more of a ‘triangular’
story, with the dollar having strengthened materially against the EM currencies
and commodity currencies, but weakened against the likes of EUR, GBP, JPY,
and CHF. EURAUD or KRWJPY are two crosses that summarise well this
triangular relationship. I don’t have a good explanation for why EURUSD is so
much higher, except to think that long-dollar spec positions within G10 had
been extremely high prior to May 23, and positioning liquidation may have
helped support EUR, GBP, and JPY against the dollar. It puzzles me why the
higher 10Y UST yield is having a bigger impact on USDEM than the USD
against the other DM currencies… It almost feels like bond prices are driving
USDEM, while equity prices are driving USDDM. (4) Whether the 10Y UST
yield can continue to march higher will be in part a function of the resilience of
the US economy. What is worth reminding ourselves of is that the 10Y UST
yield was 3.5-4.0% in 2009-11, suggesting substantial upside risks to the
Treasury yield. (5) As a follow-on from point (2) above, the Abe
Administration, the BOJ, and the MoF have evidently shifted their emphasis on
getting the fundamentals – the economy and the policies – right, rather than
resorting to the use of different bazookas to tame the bond, equity, and currency
markets. Governor Kuroda’s insistence on not taking announcing further
actions to not just stabilise the JGB yields but to depress them has unnerved the
markets. Risk takers like myself should not expect PKO (price-keeping
operations) or other extraordinary measures to support the Nikkei or USDJPY.
Instead, the Abe Administration will now focus on getting Arrow 3 right – both
its design and its delivery. I am no longer convinced that the Nikkei can rally
back to the 15,000-16,000 levels in the near-term. The Japan story has become
much more complicated.
Tapering by the Fed. Much has been written on this. I have these thoughts to
add to the discussion. (1) A critical part of the discussion is the potential for an
economic decoupling between the US – an oasis of growth – and the rest of the
world. If the world were to remain fully coupled, then the Fed wouldn’t be
talking about tapering and even if it were to taper, the impact on the rest of the
world would not be so scary. But if the US can grow without lifting up the rest
of the world, then the Fed will be taking down liquidity just when the rest of the
world needs more liquidity. Europe and China have their domestic reasons to
slow, in contrast to much of the past decade. The US, in contrast, was FIFO
(first one into the Crisis and the first one out). This is not just a point about the
cyclical asychronism across countries, but that key structural problems were
exposed in Europe and China that will take time to address. In contrast, the US
let the housing market adjust fast, the banks to de-lever fast, and the households
to also de-lever fast. The end result is an economy that is flexible and ‘clean’
enough to drift back toward its potential. (2) For the Fed, there is a lingering
gap between the economic reality and what the Fed expects to see. The Fed
does not have a great track record in forecasting the economy. For example, the
FOMC’s June 2009 forecasts had growth in 2009 projected to be -1.0 to -1.5%.
The actual outturn was -3.1%. Similarly, in the 2010 projection, growth was
expected to be 3.0-3.5%; the actual figure was 2.4%. In the 2011 projection,
growth was expected to be 2.7-2.9%; the actual figure was 1.8%. Every press
conference meeting, the Fed forecasts growth over the three-year horizon. In
the out-years (i.e., the two years beyond the current year), the FOMC’s forecasts
have been even bigger misses than the current year projections. Could the
FOMC finally be right with their optimistic economic forecasts this time?
(Their latest projection of GDP to fall between 2.9% and 3.4% for 2013 seems
more realistic than past forecasts). I don’t know and it does not matter for our
discussion as long as the Fed is convinced the economy will recover in H2 and
reach escape velocity by 2014. (3) I have proposed a thought previously to
‘square the circle’ here on why the Fed seems so keen to start tapering even
with the economic data being so mixed. The policy on the FFR was always
meant to deal directly with the real economy. Therefore, the ‘threshold’ on the
unemployment rate reaching 6.5% and the condition on inflation were explicitly
announced to provide guidance on the FFR. On the other hand, QE was always
meant to distort asset prices (financial repression) to stimulate the real economy
indirectly through a positive wealth effect. Thus, the Fed could very well have
become worried about the risks of inflated asset prices, and are contemplating
tapering in the hope that there would be a smooth transition in asset prices from
being driven by central bank liquidity to being driven by the improving
economic fundamentals. This interpretation in turn suggests that the Fed may
not be unhappy with the increased volatility and price correction in some
markets, as that would signal the removal of some market frothiness. As long
as the corresponding equity and credit market correction does not undermine the
real economy, tapering will continue. (4) I have long argued that the benefits of
QE are front-loaded and easier to quantify, while the costs of QE are backloaded and difficult to quantify. Well, we may have crossed the inflection point
where the costs and risks (bubbles and other balance sheet risks) outweigh the
benefits (higher bond and equity prices). This is the cost-benefit tradeoff for the
US. However, the cost-benefit tradeoff is different for EM. When in 2009-10
the EM economies did not need extra monetary liquidity, the Fed conducted
QE1 and QE2 anyway, dismissing complaints from EM. Now that the EM
economies are decelerating, the Fed is retracting on QE, dismissing the worries
from EM. Thus, the Fed’s tapering would reduce the risks and the negative side
effects for the US, but increase the risks and the side effects for much of the rest
of the world, especially EM. Of course, the Fed only cares about the US: it
didn’t stop tightening in the 1980s because of the LatAm Crisis. (5) There
seems to be a lot of upside risks to the 10Y UST yield. The 10Y UST yield has
indeed risen in the past month, but it is not substantially higher than the highs
seen in the previous quarters: at 2.20%, it is a bit higher than the 2.1% or so
seen in Q1 2013, but is significantly lower than 3.5-4.0% seen in 2009-2011.
The reason why such a relatively modest rise in interest rates is having such a
big impact on the markets is that a much larger ‘stock of financial assets,’
including private sector and public sector debt in and outside the US, have been
contracted or created while interest rates were below 2.0%. The volatility seen
in EM in recent weeks reflects not just a rise in the US and the local interest
rates, but the fact that so much capital inflows to buy the local bonds are now
affected by a modest (relative to the historical ranges of yields) rise in yields.
(6) However, as pointed out by Chairman Bernanke in a recent speech ‘Long
Term Interest Rates’ (March 1, 2013), the Fed’s suppression of the risk
premium is only one of several determinants of the long-term yields. If the US
economic recovery proves to be more fragile than the Fed appears to think now,
even if the Fed starts to taper soon, it may have to reverse its policies later, just
as the BOJ was forced to reverse the ending of ZIRP in 2000. This could lead
to another turn down in the long term yields in the US. My point here is that
there is still considerable amount of uncertainty in the outlook for both the
Fed’s polies as well as the economy. (7) It is important that John Williams of
the SF Fed – a known dove at the Fed – has endorsed early tapering. President
Williams represents a district with several states that had distressed property
markets (Arizona, Nevada, and California). His endorsement of early tapering
may suggest that, in his opinion, the property markets are robust enough to
withstand a rise in the mortgage rate. (8) I just wonder if the recent working
paper by the Chicago Fed suggesting that the trend growth rate in the labour
force is only 80,000 is one intellectual building bloc needed to support tapering
(see details below). Compared to 80,000, the average so far this year of 189.2K
and the average of 180K in H2 2012 look great. (9) Finally, Hilsenrath wrote in
the WSJ last Saturday that the Fed could explicitly mention the possibility of
tapering in the coming months at their upcoming FOMC meeting on June 1819. It’s as if the ‘default’ is to taper before year-end, i.e., unless there are
compelling reasons for the Fed not to do so, they will start tapering. This is
different from H1 where the proposition was the opposite. After the June
meeting, the next meetings are scheduled for July 30-31, September 17-18,
October 29-30, December 17-18. Of course there is also the KC Fed Jackson
Hole Conference in August (BB will be absent).
The abstract of the Chicago Fed paper on the trend employment growth
rate. This Chicago Fed Letter (‘Estimating the Trend in Employment Growth’)
could lend the needed intellectual justification for an early tapering. I replicate
the abstract of the paper and some quotes here, in case you are interested in the
paper but don’t want to read the whole thing. ‘For the unemployment rate to
decline, the U.S. economy needs to generate above-trend job growth. We
currently estimate trend employment growth to be around 80,000 jobs per
month, and we expect it to decline over the remainder of the decade, due largely
to changing labor force demographics and slower population growth.’
According to our analysis, job growth of more than about 80,000 jobs per
month would put downward pressure on the unemployment rate, down
significantly from 150,000 to 200,000 during the 1980s and 1990s. We expect
this trend to fall to around 35,000 jobs per month from 2016 through the
remainder of the decade. These estimates rely on several assumptions, notably
about future labor force participation and immigration… Payroll employment
was about 6 million jobs, or 4%, below trend in 2012. Closing this gap by 2016,
for instance, would require payroll employment growth of about 195,000 per
month on average over the next four years. We forecast that trend will continue
to decline by roughly 0.3 percentage points per year through at least 2020. The
natural rate of unemployment declined from almost 6% in the late 1980s to 5%
by the turn of the century (figure 2, panel A). We estimate that it rose sharply
during the 2007–09 recession to 6.25% before declining gradually since 2010.
We project that this decline will continue at a measured pace until the natural
rate reaches 5.25% in 2014. The key uncertainty with regard to population
growth is immigration. Immigration fell significantly in response to the
recession and has yet to recover. If we take the most optimistic assumptions into
account, trend payroll employment growth could average a bit more than
120,000 jobs per month over the second half of the decade, roughly where it
stood in 2012. Likewise, the most pessimistic assumptions would result in little
or no growth in trend employment growth, on average, over the same period.
We view 20,000–50,000 jobs per month, on average, to be a reasonable range
and about 35,000 per month to be a plausible baseline.’
An impending EM currency crisis. We issued a note earlier this week titled,
‘The Fed and the Pre-Quake Tremors of EM Currencies.’ We expect to
experience tremors before a big earthquake. While some may think that the EM
markets are starting to stabilise and that maybe there won’t be a crisis after all, I
continue to believe that we have only seen the beginning. When the Fed starts
to taper and if the tapering process is maintained for a number of months, the
risk of a ‘sudden stop’ will escalate. EM currencies are in grave danger, in my
opinion. (1) The USTs will likely be quite volatile. The main reason is the gap
between the run of the actual economic data (unimpressive but not weak, either)
and the hawkish rhetoric of more and more FOMC members. There will likely
be talks of the Fed repeating the policy error that the BOJ made in July 2006 in
pre-maturely ending ZIRP only to readopt it in December 2007, when the
economy faltered. US Treasuries may vacillate before the Fed makes an actual
decision, and this may drive the EM assets. (2) Several EM central banks have
begun intervening in the currency markets to temper the strength of the dollar. I
would say that, in every currency crisis, central banks have tried to do the same
and have failed. In light of the size of the cumulative capital flows into EM in
recent years, I do not believe central bank interventions will be consequential.
(3) Some have argued that a good portion of the recent investments in EM are
‘structural’, that it is ‘sticky money’ that is there to stay. I don’t doubt that, but
even if SWFs and pension funds don’t sell the underlying assets (equities or
bonds), they would be tempted to hedge out the currency risks. Over the years,
as the proportion of the local bonds and equities owned by foreigners rose, the
corresponding propensity to hedge against currency depreciation should also
increase, even if there is no outright repatriation of capital. (4) I repeat a point I
have made about differentiation. People tell me that it is critical to differentiate
between different EM currencies in a sell off. I think the past experiences
suggest otherwise, especially the main motivation factor is a ‘pull factor’, i.e., a
tighter Fed that ‘pulls’ capital out of EM back into the US. Further, many of the
recent investors in EM did not exercise sufficient discretion in differentiating
between the different EM economies when they invested, why should they
differentiate when they pull out? Much of the allocation decision was based on
GDP or worse yet, expected GDP. (5) One important thought put to me by a
very senior PM is that, since the multinational corporations in the US and other
developed markets derive the bulk of their profits from EM, a faltering EM
(capital outflows would lead to a tightening in the financial conditions in EM
just when they need monetary easing) would undermine the earnings outlook of
DM companies. This scenario is consistent with that proposed by Byron Wien
of Blackstone at the start of the year, that decelerating profits growth may
undermine US equities this year.
The BOJ: lessons for the world. The Fed, the ECB, and the BOJ offer great
benchmarks in thinking about monetary ‘bazookas.’ The inability of the BOJ to
control the JGB market is extraordinary and probably came as a surprise to the
BOJ and the ECB. The world has been watching the developments in Japan to
see if their approach would work, and whether their experience would lend
lessons for other countries. (1) One lesson is about the power of the bazooka.
There is this argument that Governor Kuroda may have overdone it on April 4.
An overly powerful bazooka with an unwavering aim of achieving 2% inflation
in two years may have become a source of volatility for the JGB markets, for
the familiar reasons: if the BOJ is to be successful, the 10Y JGB yield ought
not to be below 0.5%. In a sense, there is a ‘Laffer Curve’ for QE: while the
effectiveness of QE initially rises with the firepower of the bazooka, beyond a
certain point, increased firepower could actually be counter-productive. I just
wonder if the JGB volatility was something that the ECB thought about when
they decided not to introduce negative deposit rates. (2) Japanese policy makers
have also surprised investors (including myself) in not having done more to
support the Nikkei and USDJPY: no verbal or actual interventions. My sense is
that Tokyo will focus on getting the Third Arrow right, and get the real
economy going, rather than taking discrete actions to support asset prices. One
consideration is the G7/G20 commitment to not to intervene. But I suspect that
it is a genuine strategy to get the economic and policy fundamentals right, and
have the asset prices reflect these fundamentals. A senior Japanese policy
makers used the following terms, which I think are great. He said that Arrows 1
& 2 are like ‘Western medicine’ that is administered to yield mechanical effects
on the economy. Arrow 3, however, is like ‘Chinese medicine’ that is aimed to
alter the internal workings of the economy so as to allow the intrinsic strength
of the economy to come through. The key to success, therefore, is a mix of
‘Western and Chinese medicine.’ That process will take time, and Tokyo may
not expect the markets to react immediately and a high Nikkei, while helpful,
may not be necessary in helping the LDP win the Upper House Elections. In
any case, Tokyo’s strategy seems to be to let the recovering real economy (Q1
GDP growth of 4.1% makes Japan the fastest-growing developed country; April
nominal wage growth turned positive) do the talking. This is a very sensible
approach, … just not exactly the typical Japanese approach… (3) The failure of
the BOJ to stabilise the JGB markets also raises an unpleasant thought: could it
no longer be safe to ‘bet with the central banks?’ In the last three years, it did
not pay off for investors to analyse data. The key call was to side with the Fed
and the ECB. If one did not go against the central banks, he/she should have
done well. Japan’s apparent ‘failure’ is notable, and suggests the possibility that
the Fed and the ECB may from now on not get what they want.
Troubles brewing in China. The recent rally in the SHIBOR suggests sharply
tightening credit conditions in China. The roll-over needs of the Chinese SOEs
are massive, I hear. The large credit creation in China in the past year has not
contributed to incremental output growth. The main reason is that many of
these loans were used to finance infrastructure projects that are not yielding the
necessary returns. The Li Administration now faces the challenges of (i)
whether or not to re-stimulate the economy if it slows further, and (ii) how to
deal with the impending NPL shock to the banking system. The PBOC reintroduced the CNY appreciation trend earlier this year in order to funnel some
foreign liquidity into the Chinese banking system. But this is supposed to be a
short-term fix and not a long-term solution. Further, if the Fed tapers and
Europe remains weak, capital inflows may stop just when exports weaken
further. Not good…
The Atomisation of Society. I read an op-ed by David Brooks (‘The Solitary
Leaker’) in the IHT on the NSA whistle blower Snowden. While the subject of
government surveillance is controversial, I do find Mr Brooks’ observations
about ‘the atomisation of society’ interesting: ‘ Though thoughtful, morally
engaged and deeply committed to his beliefs, he (Snowden) appears to be a
product of one of the more unfortunate trends of the age: the atomization of
society, the loosening of social bonds, the apparently growing share of young
men in their 20s who are living technological existences in the fuzzy land
between their childhood institutions and adult family commitments. If you live a
life unshaped by the mediating institutions of civil society, perhaps it makes
sense to see the world a certain way: Life is not embedded in a series of gently
gradated authoritative structures: family, neighborhood, religious group, state,
nation and world. Instead, it’s just the solitary naked individual and the
gigantic and menacing state… For society to function well, there have to be
basic levels of trust and cooperation, a respect for institutions and deference to
common procedures.’ As the economies grow and our standard of living
improves, there nevertheless seem to be some things that have gone wrong
alone the way. Income inequality is serious, and so is the declining social
mobility in the US and elsewhere. Pollution and corruption remain problems in
many EM economies. It just feels like, as we have collectively become
materially better off, there are more conflicts between the different classes,
between different countries, and between different cultures. There are problems
I can’t even put my finger on, let alone contemplating possible solutions.
Beyond the economic and financial problems we think about day-in and dayout, there seem to be other deeper problems with our societies… Just a
thought…
DISCLAIMER
This research note is provided by SLJ Macro Partners LLP, a Limited Liability Partnership with Company Number: OC362504,
registered in England with Registered Office Address 7 Clifford Street, London W1S 2WE.
SLJ Macro Partners LLP is not authorised to conduct investment business in the UK nor is it exempt from seeking such
authorisation. SLJ Macro Partners LLP is in the process of applying to the Financial Services Authority to become a
regulated firm in the UK. As such, you are accepting receipt of this note on a pre-marketing only basis. This note should not
be used to form the basis of any investment decisions.
The content of this note is provided for information purposes only. It does not constitute or form part of any offer to issue
or sell, or any solicitation of any offer to subscribe or purchase, shares, units or other interests in investments referred to
herein.
This note is provided in accordance with s.54(1) of The Financial Services and Markets Act 2000 (Regulated Activities) Order
2001, which provides: “There is excluded from article 53 the giving of advice in writing or other legible form if the advice is
contained in a newspaper, journal, magazine, or other periodical publication, or is given by way of a service comprising
regularly updated news or information, if the principal purpose of the publication or service, taken as a whole and
including any advertisements or other promotional material contained in it, is neither—
(a) that of giving advice of a kind mentioned in article 53; nor
(b) that of leading or enabling persons to buy, sell, subscribe for or underwrite securities or contractually based
investments.”
SLJ Macro Partners LLP has taken all reasonable care to ensure that the information contained in this document is accurate
at the time of publication. However no representation or warranty, express or implied, is made as to the accuracy,
reliability or completeness of such information.