ARE CENTRAL BANKS CAUGHT IN THE FIRST GLOBALIZATION TRAP
- THE GLOBALIZATION TRAP
- ECHO BOOM
- GLOBAL POLICY UNCERTAINTY
- CENTRAL BANKS "NORMALIZATION' GUIDANCE
- THE PROBLEM - CAN'T STOP THE TURNING CREDIT CYCLE
- THE EURODOLLAR SHORTAGE
- WHERE WE ARE HEADED
- WHAT TO WATCH FOR
THE GLOBALIZATION TRAP
In 2014 our annual Thesis was entitled "The Globalization Trap" in which we laid out the premise that we would see continued Central Bank liquidity injections and balance sheet growth which would foster asset appreciation and a "crackup boom" of some form. We felt this part of the cycle would come to an abrupt end when disinflation and real deflation, brought on by excess global over-supply, over-leverage and falling consumer demand would eventually cause collateral impairment to reverse the credit cycle.
This would be the first truly globally synchronized credit cycle. One which the central banks are unprepared for and would not be able to control. Eventually as a result of unsound money the global platform of "fiat currencies" would be found to be unstable and be replaced. Likely during a period of economic crisis.
We also felt a central part of the problem would be as a result of what we referred to as an "Echo Boom". This would be the fall-out from excess borrowing by the Emerging, Developing and Frontier markets in Eurodollars, thereby tying them to the ravages of Financial Repression being imposed by the Currency Cartel (that is the Dollar, Yen, Pound and Euro).
That was the fall of 2013. Where are we now?
GLOBAL POLICY UNCERTAINTY
Setting aside multiple signs of a global and US economic soft patch and sluggish inflation, the Federal Reserve did three things during the June 2017 FOMC Meeting that lessened monetary stimulus, only the first of which was widely expected by markets:
- It raised interest rates by 25 basis points,
- Reiterated its intention to hike four more times between now and the end of next year (including one in the remainder of 2017), and
- Set out a timetable for reducing its $4.5bn balance sheet.
These three actions confirm an evolution in the Fed’s policy stance away from looking for excuses to maintain a highly accommodative monetary policy — a dovish inclination that dominated for much of the aftermath of the 2008 global financial crisis. Rather, the Fed is now signaling its intent on gradually normalizing both its interest rate structure and its balance sheet.
As such, it is now apparently more willing to “look through” weak growth and inflation data. I guess that is what you do when the data doesn't support what you planned or were required to do all along.
On the surface I suspect the Fed is actually attempting, as one of its objectives, to tightening Financial Conditions, which so far it has been totally unable to do.
But the speculation is getting much worse instead of better, it is now obvious to all (including the Fed) and everyone remembers only too well the last two bubbles!
The market however is simply not buying it (as shown by the yield curves reaction) with the confusion leading to heightened investor uncertainty. This yield curve reaction should not happen when the Fed raises rates and its guidance indicates further tightening!
In parallel we have seen the central banks of the other currency cartel members also lay out plans to reduce their current rate of liquidity injections (now totaling approximately $300B/Mo). This all fly's in the face of slowing macro economic data.
This has lead to a massive rise in Global Policy Uncertainty as illustrated here. Political, monetary, geopolitical, fiscal, and economic uncertainty remain entirely un-priced-in by this market...
This is not a good situation as anytime central bank policy has shifted towards tightening, historically it has lead to a financial crisis of some description.
This time what is even more troubling is we have never seen the yield curve flat to such a degree when a central bank began tightening. This is what is causing the anxiety regarding global policy uncertainty
This is good as it gets before the business cycle turns and the yield curve knows it.
CENTRAL BANKS GUIDANCE
If we step back and focus solely on the global picture we see the how significant the recent guidance from The Fed, ECB, BOJ and SNB will have to the rolling three month central bank security purchases.
WHAT IT APPEARS THEY ARE AFTER
What this will do in theory is to potentially lower the real rates of interest.
CENTRAL BANKS EXPECT GLOBAL SPREADS TO WIDEN AS A CONSEQUENCE
This will also potentially widen the credit spreads. This will put pressure on the large Chinese commodity players which we will come back to a little later.
....but is there even more going on here when we consider the detail of the Global Credit Impulse.
The surge in global credit in the post financial crisis era came from a surge in credit from China. This second derivative rate of change has rolled over as the chart on the right clearly illustrates.
A combination of the shift in the Currency Cartel's Monetary Tightening Policies which we elaborated on, along with China's rate of change is a little alarming -- to say the least!
We live in a Global Economy more than we fully appreciate. Courtesy of fungible money and equivalent, the effects of a credit impulse in one area promptly diffuse around the globe, as "Credit created in one place often drives prices elsewhere." This is the new reality of Globalization which Central Banks are just learning to deal with. Remembering there are two crowds. The BRICS lead by China and Russia and the Developed economies lead by the Currency Cartel.
James Rickards, someone who I have a lot of confidence in, believes the actions of the central banks' of the currency cartel are attempting to prepare for a global slowdown and potential US recession. I personally believe it is too late. Central Banks never lead the markets - they react to them.
When you consider China in this equation, who is not a real member of of the Fiat currency global (that is it still believes in gold and in fact continues to buy it aggressively (as does Russia and the other BRICS) then it could be simply a matter that they know a recession is inevitable and are attempting to prepare as best they can after manipulating the markets for nearly a decade since the financial crisis.
I think it is too late and in fact these actions are likely to assure that is what will occur - maybe sooner than they believe likely.
Some may suggest there are more sinister geo-political priorities at work that would allow us to make sense out of the global policy uncertainty. I will leave that for another discussion.
THE PROBLEM - CAN'T STOP TURNING CREDIT CYCLE
Let's step back for a moment and consider the impact the size of the global debt is currently having on all countries. I have shown this chart in prior monthly reports so I will simply highlight what is important here.
- The central banks of the EU, England and Japan are fundamentally currently making up for the short fall in economic growth required to support the global debt burden,
- Debt continues to grow while GDP growth is failing to grow. This trend suggests that we can see Central Banks being forced to increase the level of support going forward - not shrink it via the guidance they are currently giving us,
- Inflation is failing to materialize which would lessen the burden of existing debt.
The recent US Federal Reserve's QT (Quantitative Tightening) announcement amounted to a pace so slow that they'll still have boatloads of bonds on board when the next recession strikes. The guess is they'll be buying again long before they finish normalizing the balance sheet (whatever that really means). Looking at the Fed's disclosed projections, which anticipate the Fed to continue normalizing until 2020, or well past the point the next recession is expected, skepticism is certainly warranted.
The market reaction has the level of rates two years down the road almost exactly where it was before the Fed hiked, and risk assets around the world are rallying again as the ‘carry party' resumes.
When the US completed "TAPER" and QE3 ended, world stock returns ex-US stocks exhibited significantly different performance.
Since then you can see from the "pink" line the growth in the US balance sheet has been flat while that of the BOJ and ECB has risen dramatically and as such all three balance sheets now approximate $4.5T.
On a aggregate basis this is shown here and we see the slopes of the red highlight lines for for the BOJ and ECB rising significantly at that point as they stepped into the "lurch" on a global basis.
The other central banks stepped up to nearly $200B/Mo. The US market subsequently shot up on the Trump victory and expectations of tax reform, stimulus spending and regulatory reduction.
We now see that the World stocks have been outperforming US stocks on a relative basis to reflect the increase in the G3 (non US) balance sheets
THE EURODOLLAR SHORTAGE
What we need to consider is that during these central bank normalization announcements, we have witnessed over the last five weeks, $1.3 trillion of rate-hike bets being unwound - the most ever.
The derivative market is signaling there is more pain to come as expectations now for lower rates are everywhere. Another $1.9 trillion of rate-hike bets are highly likely to be unwound. This flies in the face of the Fed's supposed tightening.
Part of what is being said here is in fact about the Eurodollar.
I have talked about this many times that we are experiencing a EuroDollar shortage. This is hurting global credit creation. A combination of slowing global trade and lack of US dollar trade deficit growth are significantly crimping the global economy. This along with a strong dollar which interest must be paid in on EuroDollar denominated loans has become a monumental problem.
Previously this has been averted by the issue by the Federal Reserve of large scale dollar liquidity swaps. For some reason they have not been carried out.
When you add yield to the consideration , as Bloomberg's Tanvir Sandhu notes, rates, skews, and inflation cross-currents suggest lower yields to come this summer...
USD short-dated skews on 10-year tenor remain deeply negative, with receivers trading at a premium to payers.
As the chart below shows, the spread between USD 3m10y 25bp OTM payer vol and 25bp OTM receiver vol is still negative signaling expectations of lower rates...
Gamma implied vols remain near all-time lows and lack any expectation of a significant move.
Critically important the flatness of the Eurodollar curve has been increasingly pricing in the end of the business cycle...
U.S. 2y1m - a proxy for the Fed’s terminal rate - has crumbled to 1.75% along with break-even rates, having required fiscal-policy expectations to play out to push neutral real rates (r*) away from zero or the term premium to move higher; it has been an unhealthy decline in rates with real rates higher and inflation expectations lower.
Upside for U.S. rates is limited over the summer and is unlikely to see a meaningful sell-off without concrete progress on fiscal reform.
U.S. 10-year yield has broken below the July 2016 trend-line and 38.2% retracement from the low in the 2.13-2.15% area; a move to 100-DMA at 2.36% is optimistic, which has acted as a pivot in recent months.
Downside risk seeing extension to 1.96% over summer, in line with lower terminal rates...around 1.75%. This is suggesting a US and possible global recession is increasingly becoming a worry.
WHERE WE ARE HEADED
It is my opinion the powers to be are worried about the stability of the approximate $700B Interest and Currency Swap market. A market that trades OTC, is unregulated and almost completely opaque. It is the area we have have been warning about and many subscribers will remember seeing since we put this grid together on the eve of the 2008 financial crisis.
WHAT TO WATCH FOR
I advise subscribers to pay particular attention to developments in the Eurodollar area and central bank SWAP announcements.
My feeling is something is seriously broken somewhere in the global financial community and things are being temporarily held together but at any moment are ready to rupture.
My sense is that the disruptive impulse stems from Chinese credit growth and an over leveraged commodity complex. China's tightening financial conditions (higher short-term rates) have crushed not just the yield curve, but global commodities.
In their latest Global Macro Outlook note, the Australian bank "Macquarie" warns that the global economy's recent "coordinated" growth has peaked, which will have implications for all asset classes. They say:
"the supporting factors for wider commodity markets are now being steadily eroded and hopes for accelerating global growth and accompanying healthy reflation are fading. The industrial recovery cycle has matured, and is providing less global impetus."
Once again we go to the credit impulse and the (re)flation cycle, which has in recent years originated almost exclusively in China.
Macquarie's conclusion for those particularly interested in Hard Assets:
- Over the coming months, commodities as a whole look set to face slightly more headwinds than tailwinds.
- We would avoid those most exposed to Chinese construction, given it is currently so strong that the next move is likely to be lower. This means further pressure on iron ore, metallurgical coal and manganese.
- In contrast, we expect upside to gold and silver over the coming months as the market refocuses from healthy reflation to deflation potential. We also believe the wider market has become too sanguine to weather risks in agricultural markets, where we feel risk/reward is skewed to the upside.
- We would also consider optionality around those commodities where the Chinese government is set to curtail capacity. Aluminium has been widely discussed in this regard, but we would also look at stainless steel, nitrogen and alumina as those with potential to be next on the supply side reform agenda.
- On a longer-term view, we like exposure to copper, silver, gold, chrome and, eventually, oil. We also believe that uranium and potash are at the start of a long crawl off the canvas after a tough couple of years.
One last point to consider -- the last two times the US yield curve was this 'flat' (Mar 01, Dec 07), the US economy officially entered a recession.