Macro and Credit - Stalemate

"In life, as in chess, forethought wins." - Charles Buxton, English public servant

Watching with interest the outcome of the US midterm elections in conjunction with a divided congress leading somewhat to a gridlock, as well as the tentative rebound in Emerging Market equities, when it came to selecting our title analogy, we decided to go again for a chess analogy on this very post (see previous chess analogies: "Zugzwang", "The Game of The Century"). "Stalemate" is a situation in the game of chess where a player whose turn it is to move is not in check but has no legal move. The rules of chess provide that when stalemate occurs, the game ends as a draw. During the endgame, stalemate is a resource that can enable the player with the inferior position to draw the game rather than lose. In more complex positions, stalemate is much rarer, usually taking the form of a swindle, a ruse by which a player in a losing position tricks his opponent, and thereby achieves a win or draw instead of the expected loss. A swindle in chess only succeeds if the superior side is inattentive. Stalemate is also a common theme in endgame studies and other chess problems. The outcome of the US midterm elections gridlock could create short term what we would call "Goldigridlock", namely a potential end to the bear steepening experienced during the jittery month of October and some restrain on the US dollar. In conjunction with the return of buybacks following the blackout period of earnings, then, this obviously could be bullish equities wise we think, with high beta pulling ahead until the end of the year. For credit, we are not too sure, given a fall in oil prices with definitely put pressure on the high beta CCC bracket of US High Yield and its well documented exposure to the energy sector but, we ramble again...

In this week's conversation, we would like to look at what the US midterm election stalemate entails of asset prices in general following a very much "red October".

Synopsis:

• Macro and Credit - Goldigridlock for asset prices? 
• Final charts -  The invisible hand is fading...

• Macro and Credit - Goldigridlock for asset prices? 

The month of October was clearly a bloodbath for many asset classes and diversification didn't offer protection. While the velocity in real rates as we pointed out in our previous conversation forced a serious repricing of the Fed "put" at a much lower strike, the fact that it was a blackout period thanks to earnings reporting season and lack of buybacks, being another strong pillar in US equities rally seen in recent years was enough to wreak havoc on global markets on the back of weaker US equities. Looking at the below performance chart from Bank of America Merrill Lynch for the month of October can clearly see that, indeed, “misery loves company”:

- source Bank of America Merrill Lynch

As we pointed out in our final chart in our mid-October conversation "Under the Volcano", 2018 has marked the return of large standard deviations move, typical of late cycle behavior in conjunction with rising dispersion. 

What we also find interesting (H/T Driehaus on Twitter) is that 89% of asset classes tracked by Deutsche Bank have a negative total return YTD in USD terms. This is the highest percentage on record since 1901. Last year just 1% finished without negative total return:

- source Deutsche Bank - Driehaus Twitter feed

2018 is indeed a year where volatility and large standard deviations move have staged a comeback as the US Federal Reserve is trying to exit the stage with its Quantitative Tightening policy (QT) and its continuing hiking process. US Employment and wage growth likely to trigger another hike in December from the Fed. That’s a given. Total nonfarm payroll employment increased by 250,000 in October vs. 190,000 expected. Over the year, average hourly earnings have increased by 83 cents, or 3.1 %. Fed will remain hawkish.

With the "Stalemate" with the latest US midterm elections, what are the implications for asset prices, one might rightly ask?

First thing we would like to look at given the recent bounce from Emerging Market equities with Brazil leading ahead the bounce thanks to the hope brought by the presidential elections is the trajectory for the US dollar and what it means for "high beta". On that subject we read with interest Bank of America Merrill Lynch's take from their Liquid Insight note from the 7th of November entitled "Midterm outcome":

"FX: a split Congress is bearish USD, but downside could prove limited

As we have argued, tonight’s split Congress outcome should result in dollar weakening. We think this could continue for a while yet as the first order effects of US growth deceleration and increasingly-limited monetary policy support cause a reevaluation of long USD exposure. Ultimately, second order effects could limit USD downside; however, we think that markets are likely to focus on first order effects for now.

Initially, we expect a weaker USD predicated on a further softening in US growth leading to reduced monetary policy support. US growth deceleration from the 2Q high water mark should continue as intense political gridlock precludes new stimulus measures, putting the prospect of a Fed move beyond neutral in doubt for now absent convincing evidence of inflationary pressure. Indeed, our US economics team is forecasting a gradual US growth deceleration toward 2% (around potential) by the end of next year, alongside a largely-benign inflation profile. While a Fed move beyond neutral was never in the market (the Fed is still priced to end the cycle at around the long-term median dot of 3%), a move above neutral looks increasingly less likely given the new information set. Thus, interest rate support for USD looks asymmetrically skewed to the downside, and the market’s expectation for Fed hikes next year (currently about +50bp) is at risk of compression, in our view. Positioning is net long USD – particularly in the riskier parts of the FX spectrum (Exhibit 1).

Diminished rationale for USD longs and a potential relief rally in markets post-midterm resolution suggests liquidation flow driving USD lower. Finally, we would expect modestly higher USD risk premium – reflecting a state of political acrimony in DC – to provide an additional headwind to the dollar. That said, because the Senate has remained Republican-controlled, we do not expect a material spike higher in USD risk premium arising from the expectation that House leadership could successfully remove the President through impeachment.

Looking beyond the initial reaction, however, we think that potential second round effects could serve to limit USD downside. Successful resolution of the present state of global trade policy uncertainty has become more challenging, particularly if President Trump’s negotiating position has been weakened as we suspect may well be the case. To be sure, the evolution of global trade policy uncertainty is critical to the global economic cycle. Reduced prospects for a speedy end to this uncertainty, and indeed increased risks of further deterioration, add to downside global growth risk in our view. Although hardly a recession story, US deceleration represents a potential negative impulse to the already-sagging global economy. An increase in risk aversion as markets anticipate a global downturn could thus broadly support the dollar. Finally, on a brighter note, compromise on US economic stimulus later next year is possible due to potentially overlapping interests. Democrats seem to be advocating an increase in infrastructure spending, and the President may well seek to prime the economy in advance of his 2020 reelection bid. If ultimately successful, this should support USD as it could lead to a renewed bout of US cyclical and monetary policy divergence.

Historical parallels suggest gridlock is not always so benign

The consensus among investors is that a gridlock is a benign outcome for markets. We think this may be overly optimistic. In our view, the most relevant historical precedent for the next half year may be the months following the mid-term elections of 2010 that resulted in the same configuration in Washington as the latest elections (with the President’s party controlling the Senate but the other party controlling the House). In 2011, the Republicans, upon regaining control of the House, used the debt ceiling as a lever to demand budget reduction by the Obama administration. The brinksmanship that ensued raised concerns in the market of a possible default by the US government which led to a sharp sell-off in risky assets as well as a major rally in rates (10y Trsy yields falling from 3.7% in March 2011 to 1.8% by September). The USD came under considerable selling pressure during the same period as foreign investors avoided US assets (EUR/USD rose from 1.30 in January to 1.48 by July that year). The market turmoil around the US debt ceiling crisis probably exacerbated the Eurozone sovereign crisis that occurred later that year (which saw the euro surrendering all of its earlier gains).

With the House Democrats having stated their intention to open new investigations against President Trump and with the 2020 presidential election campaign kicking off very soon, we see greater chances of brinksmanship than cooperation. History suggests that brinksmanship could mean lower rates and lower USD." - source Bank of America Merrill Lynch

With growing downside risk for growth with a notable deceleration in Europe and in global trade, there is indeed potential scope for the US yield curve to start flattening again. A conjunction of a flatter yield curve would be positive for the long end of the US yield curve and a falling US dollar would enable Emerging Market equities to continue to rally in the near term we think.

Second point, the recent fall in oil prices is as well putting some pressure on US breakevens as of late, meaning that for now a scary inflation spike has been avoided but, nonetheless, healthcare inflation, namely acyclical inflation is something to monitor closely as indicated by Bank of America Merrill Lynch in their US Economic Viewpoint note from the 5th of November entitled "Inflation in pictures":

"No scary inflation monsters

• Procyclical inflation has moved sideways over the past year, despite the unemployment rate improving by half a percent to 3.7%. The muted inflation response highlights the flattening in the Phillips curve.
• In No fear of an inflation curveball, we evaluated whether there was a kink in the Phillips curve at full employment. We find some, but not strong evidence, and therefore believe a strong cyclically-driven breakout in inflation is unlikely.
• While procyclical inflation has been flat, acyclical inflation has picked up, healthcare in particular. We expect healthcare inflation to continue to accelerate, driven by hospital services.

• In No inflation monsters under the bed, we looked at the disaggregated PCE components and found that there was an increasing share of PCE that has moved into a “low inflation” (0-2%) bucket, and a dwindling share in the “high inflation” (5-10% bucket).
• This shift in inflation dispersion is illustrative of a structural move lower in inflation. A lower trend decreases the probability of an inflation breakout.
• Digging into the components, we found that healthcare services accounts for much of the shift. As healthcare inflation picks up going forward, we may see some reversal of the shift, albeit into the more moderate 2-5% inflation range.

• Another reason to expect only a gradual pickup in inflation is because of inflation expectations, which have drifted lower over the cycle and serve as an anchoring point.
• In particular, University of Michigan 5-10yr inflation expectations have descended to a trend of 2.5%. The central tendency has also consolidated closer to the median, mostly from the 75th percentile. This indicates a greater decline in those expecting high inflation.
• Given core inflation is likely to run above target by next year, inflation expectations could improve, presenting upside to the outlook. But even with some improvement in expectations, inflation upside would likely remain contained." - source Bank of America Merrill Lynch

In our recent conversation we hinted that housing was in earnest starting to turn "South" in the US and that housing affordability was becoming a headwind on top of US consumers using their savings and increasing their use of the credit card to maintain their consumption level. Both auto and housing, which are very cyclical in nature are clearly showing the late stage of the credit cycle in our book.  

One segment where spending rises with age is healthcare (out-of-pocket and government). Healthcare will account for a greater share of spending among Boomers than previous generations. Rising insurance premiums have more than offset out-of-pocket savings on prescription drugs due to Medicare Part D. Housing is also taking up a higher share of senior spending as more households reach age 65 without having paid off their home or are renting, leaving them exposed to future price increases.  This upside risk to healthcare prices and expected further labor market tightening, one could expect core PCE inflation to rise further:

- graph source Macrobond

Sure falling oil prices bring some relief to the US consumers but rising healthcare costs as well as housing costs will not be sufficient to offset the risk of "stagflation". We could see lower growth ahead and even looming recession risk.

As we pointed out in our recent conversation "Ballyhoo", Main Street has had a much better record when it comes to calling a housing market top in the US than Wall Street. If you want a good indicator of the deterioration of the credit cycle, we encourage you to track the University of Michigan Consumer Sentiment Index given the proportion of consumers stating that now is a good time to sell a house has been steadily rising:

- graph source Macrobond

Maybe after all, they are spot on and now is a good time to sell houses in the US? Just a thought. Main Street was 2 years ahead of the 2008 Great Financial Crisis (GFC) as a reminder.

As pointed out by Lisa Abramowicz on her Twitter feed, you need going forward to monitor closely in the months ahead the rise in inventory of new unsold homes:

"The inventory of new unsold homes in the U.S. has reached the highest level since 2011, as measured in months of supply. https://blogs.wsj.com/dailyshot/2018/11/07/the-daily-shot-the-inventory-of-unsold" - source Lisa Abramowicz, Twitter

In a response to Lisa's Tweet, M&G Bond Vigilantes made the following important point on Twitter:

"If you saw the Lisa Abramowicz tweet about inventory of new unsold homes reaching 7 months, you should worry. Historically that level is consistent with GDP growth of zero. This chart is from our 2007 blog."

- graph source M&G Bond Vigilantes - Twitter

Housing has always been a leading indicator in the United States when it comes to forecasting GDP growth.

To illustrate further the rift between Main Street's much more sanguine view of housing than Wall Street we would like to point towards Wells Fargo's take on the weakness in home sales from their Economics Group note from the 7th of November entitled "Home Sales Remain Soft":

"The Softening For-Sale Market Has Been Good for Apartment Owners

The magnitude and speed at which home sales have weakened is surprising, following just a three-quarter of a percentage point rise in mortgage rates. We suspect the problem is a lack of affordable product in the markets where potential home buyers would like to live. This helps explain why sales turned down well ahead of this fall’s rise in mortgage rates. The lack of inventory in desirable markets is a function of how highly concentrated economic growth has been in this cycle. Two industries, technology and energy, have accounted for a disproportionate share of job growth. While job gains have broadened more recently, a larger proportion of the high-paying, creative industry jobs are being added in submarkets closer to the central business district. By contrast, job growth in suburban markets has been slower to recover and wage gains have lagged for many occupations that are at greater risk of automation and outsourcing.

The rapid growth in higher value-added positions closer in to many major cities has fueled a housing crunch that has sent home values and rents soaring in many rapidly growing markets. The lack of developable lots closer in to the city has fueled growth of in-fill developments and teardowns, which have often removed more affordable homes from the market. The resulting battles over gentrification have also led to some political blowback, which has stymied development in some areas. Growth is also creeping back out toward the suburbs, particularly those that are developing their own urban cores. What has largely been missing, however, has been the push to develop exurban areas, where land has historically been less expensive. Such development has remained elusive, as higher development costs have largely offset any savings in raw land costs.

The same trends impacting home sales are evident in the rental market. Demand remains strong for amenity-rich apartments located near the city center or in the metro area’s second or third largest employment centers. Demand for apartments further out in the suburbs has taken longer to recover but has been doing better more recently, reflecting stronger job growth and an acceleration in wage gains. The suburbs have generally seen less development, so the improvement in demand has pulled vacancy rates lower and pushed rents higher. New suburban development remains elusive, however, and most new projects continue to cluster around pricier submarkets closer to the central business district.

We have further reduced our forecasts for home sales and new home construction following the recent string of weaker housing reports and downward revisions to previous data. We still see new home sales increasing over the forecast period but now look for just 5.6% growth in 2019 and 5.3% growth in 2020.

Much of that increase will come from more affordable homes in the South and West, which will restrain new home price appreciation. With little inventory, new home construction will continue to gradually edge higher. Apartment development is now expected to remain stronger for a little longer. There are a great deal of projects in the pipeline and a large number of proposed projects that have not yet moved forward. Demand for well located projects should remain strong, but vacancy rates will likely rise as job growth moderates in 2019 and 2020."  - source Wells Fargo

We do not share the optimism above relating to new home construction due to affordability issues coming from rising mortgage rates due to the Fed continuing its hiking path, their views being supported by the most recent employment report. Housing affordability has become a headwind, no wonder in some parts of the US prices are starting to cool down as indicated by Bloomberg on the 30th of October in their article entitled "Mortgage Rates Are Pushing U.S. Homes Out of Reach":

"While U.S. home prices have gained almost 60 percent since March 31, 2012, according to the S&P Corelogic Case-Shiller 20-City Composite Index, household income is up a little less than 30 percent in the same period, Bureau of Economic Analysis data shows. The average rate for a 30-year fixed mortgage rose from about 3.85 percent at the start of 2018 to about 4.74 percent now, Bankrate.com reports. Next year, it’s expected to rise further.

A buyer with a $2,500 monthly housing budget has lost almost $30,000 in purchasing power this year, according to Redfin Inc., a national brokerage.

In Orange County, California, more than 30 percent of homes for sale in the metro area would become unaffordable to buyers with a $3,500 monthly budget, Redfin estimates. In San Jose, that number would be almost 40 percent." - source Bloomberg

Housing markets turn slowly then suddenly...Just a thought.

While the US elections stalemate and the return of buybacks should be supportive, US markets for many years have been levitating and defying gravitation provided by the central bank support. This support has been obviously fading during the course of 2018 with QT as per our final charts below.

• Final charts -  The invisible hand is fading...

If October has been murderous for various asset classes thanks to the conjunction of several factors such as the velocity in the rise of real rates, blackout period leading to smaller buybacks, escalating tensions in the trade war narrative between the United States and China as well as Italian worries, our final charts from Bank of America Merrill Lynch coming from their European Credit Strategist note entitled "The hunt for red October" from the 2nd of November clearly shows that the "invisible hand" coming from the central bank is fading:

"The end of the “invisible hand”…

Last month wasn’t unique, though. We think it reflects a bigger picture theme…namely that assets are now struggling to produce meaningfully positive returns in an era of less central bank liquidity. The “invisible hand” that once propped-up market prices is now significantly smaller.

Chart 1 shows that there are precious few assets that remain above water this year. In fixed-income land, US leveraged loans have produced total returns of around 4%.

In Europe, many government debt markets – with the exception of Italy – are up for the year, albeit only by a modicum. But note that the biggest loser of all during the QE era, namely cash, has turned into one of the best performing assets of 2018 (1.5% total returns).

…the start of abnormal markets?

This spectrum of returns, however, is also far from normal. Chart 2 shows the historical percentage of assets with positive vs. negative returns on a yearly basis (our sample contains over 300 equity, fixed-income, commodity and FX indices). 

This year, we find that only 23% of assets have produced positive total returns. As can be seen, historically this is a very low number. In fact, such a number is usually only observed in periods of financial crises (2008), debt crises (2011), or just plain old recessions. And yet despite the shocks and bumps lately, the global economy is still humming along fairly nicely in 2018.

In our view, after such a big drawdown last month, markets are likely prepped for a rebound in November. Yet, we caution that bounces in risk sentiment could still be shallow ones. After all, with so many assets trending lower this year, long-only investors are finding that there are much fewer ways to help them diversify and protect their portfolios." - source Bank of America Merrill Lynch

One could argue that, no matter what "stalemate" we have reached in the United States midterm elections, the "fall" in the fall is surely indicative that at some point winter is coming. Could housing woes be seen as leaves already falling? We wonder...

“How did you go bankrupt?" 

Two ways. Gradually, then suddenly.” - Ernest Hemingway, The Sun Also Rises

Stay tuned!

Macro and Credit - Mercantilism

"What generates war is the economic philosophy of nationalism: embargoes, trade and foreign exchange controls, monetary devaluation, etc. The philosophy of protectionism is a philosophy of war." - Ludwig von Mises

Looking at the strong yet short bounce in equities following market jitters on Italian wobbles (while enjoying some much needed R&R hence our lack of recent posting), indicative of our "white noise" previous analogy, given the acceleration in the trade war rhetoric in the G7, soon to be G6 by the look of it, when it came to selecting our title analogy we decided to go for the simple one of "Mercantilism". "Mercantilism" is a national economic policy designed to maximize the trade of a nation and, historically, to maximize the accumulation of gold and silver (as well as crops). Mercantilism was dominant in modernized parts of Europe from the 16th to the 18th centuries before falling into decline, although we would argue that it is still practiced in the economies of industrializing countries in the form of individual rights. High tariffs, especially on manufactured goods, are an almost universal feature of mercantilist policy. Even if mercantilism and protectionism are applied through the same economic measures, they have opposite aims. Mercantilism is an offensive policy aimed at accumulating the largest trade surplus (China, Germany). Conversely, protectionism is a defensive policy aimed at reducing the trade deficit and restoring a trade balance in equilibrium to protect the economy (United States). Mercantilism is the economic version of warfare using economics as a tool for warfare by other means backed up by the state apparatus, that simple. In our previous conversation we reminded ourselves our thought from October 2016, namely that we were drifting towards the inevitable longer-term violent social wake-up calls: populist parties access to power, rise of protectionism, the 30’s model. Back in January this year, in our conversation "The Twain-Laird Duel" we looked at the recent rise in the trade war rhetoric and we argued the following:

"Although Barclays continue to believe the US administration will want to avoid deterioration into a trade war, this is akin for us of being "long hope / short faith". For those lucky enough to be on Dylan Grice's distribution list (ex Société Générale Strategist sidekick of Albert Edwards) now with Calibrium, back in spring 2017 in his Popular Delusions note, he mused around the innate fragility of trust and cooperation and how cooperation and non-cooperation naturally oscillate over time. One could indeed argue that "Globalization" has indeed been (as also illustrated by Barclays) an example of a long cooperative cycle. Global trade is illustrative of this. The rise of populism is putting pressure on "globalization" and therefore global trade. The build-up of geopolitical tensions with renewed sanctions taken against Russia by the United States as an example is also a sign of some sort of reversal of the "peaceful" trend initiated during the Reagan administration that put an end to the nuclear race between the former Soviet Union and the United States. Times are changing..." - source Macronomics, January 2018

Hence our "Mercantilism" analogy or basically the reality is that we are fast moving from a cooperative world to a non-cooperative world à la 1930s. It isn't only tensions rising between China and the United States, or United States with Europe, there is as well growing tensions between European country and internal tensions rising even in Germany putting Merkel's feeble coalition at risk thanks to political tensions surrounding immigration issues. We would like to repeat what we we wrote in June 2012 in our conversation "Eastern Promises":

"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed (which we reminder ourselves in "The Daughters of Danaus")."  

Remember, it is still a game of survival of the fittest after all:

Euro Breakup Precedent Seen When 15 State-Ruble Zone Fell Apart - by Catherine Hickley, Bloomberg:

"While differences between the Soviet Union and the EU are greater than their similarities, there are parallels that may prove helpful in assessing the debt crisis, historians say. Both were postwar constructs set up in response to a collective trauma; in both cases, the founding generation was dying out as crisis hit and disintegration loomed." - source Bloomberg.

Also in June 2012, in our conversation "The Unbearable Lightness of Credit" we argued the following:

"We do see similarities in the current European "complacent" situation with the Brezhnev Doctrine, first and most clearly outlined by S. Kovalev in a September 26, 1968 Pravda article, entitled "Sovereignty and the International Obligations of Socialist Countries".

This doctrine was announced to retroactively justify the Soviet invasion of Czechoslovakia in August 1968 that ended the Prague Spring, along with earlier Soviet military interventions, such as the invasion of Hungary in 1956. "In practice, the policy meant that limited independence of communist parties was allowed. However, no country would be allowed to leave the Warsaw Pact, disturb a nation's communist party's monopoly on power, or in any way compromise the cohesiveness of the Eastern bloc. Implicit in this doctrine was that the leadership of the Soviet Union reserved, for itself, the right to define "socialism" and "capitalism"." - source Wikipedia.

The Brezhnev Doctrine is interesting in the sense it was the application of the principal of "limited sovereignty". No country would be allowed to break-up the Soviet Union until, the "Sinatra Doctrine" came up with Mikhail Gorbachev.

"The "Sinatra Doctrine" was the name that the Soviet government of Mikhail Gorbachev used jokingly to describe its policy of allowing neighboring Warsaw Pact nations to determine their own internal affairs. The name alluded to the Frank Sinatra song "My Way"—the Soviet Union was allowing these nations to go their own way" - source Wikipedia

"The phrase was coined on 25 October 1989 by Foreign Ministry spokesman Gennadi Gerasimov. He appeared on the popular U.S. television program Good Morning America to discuss a speech made two days earlier by Soviet Foreign Minister Eduard Shevardnadze. The latter had said that the Soviets recognized the freedom of choice of all countries, specifically including the other Warsaw Pact states. Gerasimov told the interviewer that, "We now have the Frank Sinatra doctrine. He has a song, I Did It My Way. So every country decides on its own which road to take." When asked whether this would include Moscow accepting the rejection of communist parties in the Soviet bloc. He replied: "That's for sure… political structures must be decided by the people who live there." - source Wikipedia 

Could Europe allow for the adoption of the "Sinatra Doctrine"? We wonder, but nonetheless, before we enter into the nitty gritty of our long overdue new conversation, we thought it would be interesting to remind ourselves of the above given our take for Europe from our November conversation "Chekhov's gun" is still as follows:

"Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…)." - source Macronomics, November 2014

In this week's conversation, we would like to look at the continuous adverse effects of moving from QE to QT, and the impact is having on Emerging Markets with rising tensions as well on the trade war front. 

Synopsis:

• Macro and Credit - The receding QE tide thanks to QT will expose those who have been swimming naked...
• Final charts - Capital Flows? This time it's really different.

• Macro and Credit - The receding QE tide thanks to QT will expose those who have been swimming naked...

While the short-vol pigs house of straw was the first casualty to go in the change in the sea of liquidity provided by our "Generous Gamblers" aka our dear central bankers, Emerging Markets have been of course next in the line in the change of the narrative with the return of  "Mack the Knife" aka rising US dollar and positive US real rates. We wrote in our last missive that investors were moving back into assessing the "return of capital" rather than the "return on capital". This is creating rising dispersion thanks to investors being more "issuer credit profile" sensitive with the return as well of US cash in the allocation tool box. The rise in dispersion should continue to make active management benefit from this trend after years of being in the shadow of passive management and consequent fund inflows into ETFs.

With the receding tide of cheap liquidity, there is no doubt an intensification in the competition for capital. When it comes to credit, we have recommended to start moving up the quality spectrum and tone down the high beta game, basically meaning being more defensive that is as the game is changing.

Sure some pundits when it comes to Emerging Markets would like to point out to "fundamentals". Yes they do indeed matter particularly when looking at current accounts, but in the end, if there is spillover and contagion from the "usual suspects" with Argentina, Turkey and now Brazil, then what will matter much more is "liquidity". Right now liquidity is being drained by central banks, this will ensure financial conditions tighten. As many have pointed out, including ourselves, the Fed will hike until something breaks, and in the end, what drives the credit cycle is simply the Fed. On the matter of liquidity, which we think is paramount, we read with interest Morgan Stanley's take from their FX Pulse note from the 14th of June entitled "Liquidity Breaks Correlation":

 "Global liquidity… 

The pool of global liquidity appears to be starting to shrink. Several factors are at play here. First, the Fed's balance sheet reduction is increasing pace while the ECB and BoJ are reducing their asset purchases (Exhibit 8).

On net, global central bank liquidity is likely to turn negative over time when compared to GDP growth. Second, the global economic expansion suggests that capital will increasingly be allocated to 'real' economic uses as opposed to financial assets. A closed output gap suggests rising capital demand as spare capacity is eroded, and investment into new capacity requires financing.

Third, the flattening of the US yield curve has reduced the incentive of local financial institutions to transform short-term liabilities into long-term assets (maturity transformation). If banks are less willing to generate liquidity through the maturity transformation process, another buyer will have to step in to make up for the shortfall. Japanese banks liquidating their FX-denominated assets is evidence that demand for US assets is falling outside the US as well, meaning tighter liquidity conditions as demand for financial assets declines (Exhibit 9).

...volatility... 

Tighter liquidity conditions suggest higher volatility as the risk-absorbing capacity of markets declines. When liquidity is ample, all boats tend to get lifted. The reverse effect may be more selective, though. EM volatility has risen sharply, but DM volatility, with the exception of some credit markets, has been relatively muted (Exhibit 10).

Indeed, US equity markets are trading near historical highs, while the 10-year Treasury yield fell back from the recent 3.12% cycle high. It seems the liquidity pool is both shrinking and becoming more concentrated, too. One explanation for the differential in volatility is that we have simply seen a rotation – out of EM and into DM – which explains why DM volatility has been relatively muted compared to EM. This too suggests that a positive outlook for US shares may no longer imply that EM assets will perform well too if they increasingly attract funds at EM assets' expense.

The feedback loop: It is likely that recent market thinking and positioning have been, at least in part, impacted by RBI Governor Patel's recent op-ed where he suggested that the Fed's balance sheet reduction, coupled with rising US public deficits and private debt levels, is leading to an absorption of offshore USD liquidity. Many EM economies experienced recessions following the US taper tantrum in 2013, which in turn resulted in balance sheet consolidation and reduced foreign funding needs. Still, EM countries require capital inflows to keep the economic expansions in place, particularly in the current environment of closed output gaps where spare capacity is increasingly scarce.

Indeed, 2017 saw record inflows into EMs, but this has turned into outflows, tightening local financial conditions and thus their economic outlooks. If not addressed, this issue could create bearish economic feedback loops where liquidity outflows worsen the growth outlook, resulting in more outflows, and leading to even more weakness.

Thus, it may be argued that the US fiscal expansion, implemented at a time when the US output gap was closed and global funding costs were at the lows (and are now rising), may actually reduce the length of the global economic cycle, sowing the seeds for financial asset volatility and investors increasingly seeking safety. Our bearish risk outlook projected for 2H18 has gained traction, we think.

The FX message: Currencies not requiring capital imports and running net foreign asset positions should perform best in this scenario, explaining our bullish JPY call. EUR and Nordic currencies offer value too in this regard. As long as markets only de-correlate but do not fall collectively, CHF should weaken, though. As noted above, the relatively low risk of its asset position suggests that it is not much exposed to waning risk sentiment; otherwise, its income balance would be far higher. Thus, CHF may benefit less than the other surplus currencies should risk sell off. CHFJPY shorts may begin to look attractive again." - source Morgan Stanley

While we got out of EM equities back in January this year following impressive performance in 2017, we continue to believe that US equities will fare much better relative to EM in 2018, contrary to what played out in 2017. Fund flows related wise, in similar to US High Yield, where there is a large contingent of retail punters, Emerging Markets are starting orderly retreat from the asset class at a rapid pace. This is confirmed by Bank of America Merrill Lynch GEMs Flow Talk note from the 14th of June entitled "EXD & LDM outflows continue… 8th straight week down; big blow for EXD":

"EPFR fund flows down: EM debt 8th consec week down

• EXD, LDM and EM Equity were all down, while blended funds were slightly up.
• 8 negative weeks in a row for overall EM debt, outpacing the large negative trend recorded at the end of 2016 (six consecutive weeks down) but still not as bad as the one registered since Oct 15 – Feb 16 (18 consecutive weeks down).

• EPFR aggregate EM debt flows were down -0.3% total.

-0.1% for Local Debt (LDM), -0.5% for External Debt (EXD),
+0.1% blended funds and -0.1% EM equity.

• ETF flows were down in LDM but positive in EXD (-0.2% and +0.2%).

EXD outflows are from retail and mild vs 2013

EXD funds now have a small negative total YTD outflow after this week. They are still quite small compared to the large wave of outflows in 2013, at a time when retail investors were a larger part of the EM market (Chart 1).

We do not think they returned.
The outflows reported by EPFR have been almost entirely from small retail accounts who are less than 5% of the EXD market ($66bn AUM of the $2.4tn EXD outstanding). The remaining funds monitored by EPFR are another 5% of the EXD mutual funds in the US, SICAVs in Europe and ETFs. (Table 5).

The rest, who do not report weekly, include mainly large privately managed accounts, pension funds, sovereign wealth funds, insurance companies and banks and who are the mainstay of the EM buyer base. Our institutional managers do not report these sorts of institutional outflows at this time, and we believe there are still EM mandates expected." - source Bank of America Merrill Lynch

In a competitive system for capital allocation, with the receding QE tide thanks to QT, we are much more concerned about the "corporate sector" due to dollar funding and leverage in some instances. We have also voiced our concern in our October 2014 conversation "Sympathy for the Devil" in relation to the particular vulnerability of LATAM and the large part of Brazil High Yield risk representing $30 billion of EM dollar denominated debt issued out of $116 billion with the top sector being energy with $27.7 billion of exposure so watch what oil prices do going forward, not only what the US dollar does. It is not a surprise to see LATAM High Yield down 3.8% YTD compared to Asia High Yield only down 3.3% YTD. Overall in both EM and DM, credit has suffered more than equities when US High Yield has been much more stable relative to EM as well.

One might ask itself that if indeed the short-vol yield pigs house was made of straw, then maybe the EM yield pigs house is made up of wood and the next step could be a full blown EM crisis on our hands. Bank of America Merrill Lynch made some interesting points in their Credit Market Strategist note from the 8th of June entitled "When the tides goes out":

"EM crisis?

Other markets benefiting from QE include EM. With a rising dollar the greatest rollover risk is now for countries that have relied on external dollar denominated financing and are running deficits. Hence, this year’s worst performing countries in terms of currency depreciation and sovereign CDS include Venezuela, Argentina, Turkey and Brazil (Figure 1).

In terms of spillover risk to US credit, we would de-emphasize the EM story and focus on Italy and the European sovereign situation, which has much more cross-exposures to the US and systemic risk to the global financial system. Of course, the Italian story is also partially an outcome of QE that allowed cheap deficit financing, and made worse with the coincident timing of ECBs coming final taper (Figure 2).

Another important contributing factor has been a fixed exchange rate (euro member), which used to be how EM countries got into trouble via large current account deficits." - source Bank of America Merrill Lynch

Sure fundamentals matter, but given the receding tide in liquidity thanks to central banks turning slowly turning off the tap, more and more liquidity will matter. There is as well the L word for leverage and on that point we are worried about US corporate leverage which has been creeping up in recent years on the back of a buyback binge. To illustrate this we would point out towards another point made in Bank of America Merrill Lynch note about the state of credit fundamentals:

"Final update on 1Q credit fundamentals

Based on almost final data for 1Q (covering 97% of companies), gross leverage for US public non-financial high grade issuers increased to 3.04x in 1Q from 2.98x in 4Q, while net leverage rose to 2.67x from 2.54x. Both gross and net leverage are now the highest on record (Figure 36).

For our “core” issuers excluding Energy, Metals and Utilities gross leverage was 2.39x, up from 2.34x in 4Q but below 2.40x in 3Q-17. Net leverage increased to 1.79x from 1.59 in 4Q (Figure 37).

The coverage ratio fell to 8.23 in 1Q from 8.44 in 4Q for the full universe of issuers (Figure 38), and was a bit lower at 10.79 in 1Q compared to 10.91in 4Q for the core set of issuers (Figure 39).

- source Bank of America Merrill Lynch

It's not only the leverage which is higher in US Investment Grade credit, quality as well has been worsening in a market where secondary trading is much weaker than before thanks to low inventories on US banks balance sheet and less appetite in providing "risk" in a context where "passive" management through ETFs has exploded in terms of inflows. It isn't a good recipe for when things will start heating up, but, we are not there yet in this credit cycle. Dispersion is rising still between issuers as the competition to attract capital is ratcheting up thanks to central banks turning the liquidity spigot gradually until it hurts.

If L is for "Leverage" when looking at US credit, L is as well the word for "Liquidity". Liquidity, as many veterans from the Great Financial Crisis (GFC) know is a coward. For EM it is already the case as pointed out in another note from Bank of America Merrill Lynch, in their Emerging Markets Weekly from the 14th of June entitled "It is the "L" word...Liquidity":

"It is the "L" word...Liquidity

• Near-term liquidity in EM is a big problem. Several factors are having an adverse impact, but some of that is improving.
• EM EXD technicals are better now, long-term fundamentals are good, spreads have risen far more in EM than in HY and institutional mandates have not ceased, but risks are high.

Dealer liquidity has fallen sharply while the market doubled in 6 years. Compared to last year or even to January 2018, dealers are less able to position the size clients need for three main reasons. First, there are fewer dealers than previously. Several major dealers have substantially reduced the size of their EM business and some have retreated from EM altogether. Second, the higher the volatility, the smaller the size of dealer trading books, making it extremely difficult for the Street to buy large positions. Third, over the last five years, EM-dedicated managers have become so large that the trade sizes that can be done in these illiquid markets are inconsequential to performance of a large fund compared to the market impact for trying.

It is a tale of two markets ‒ before and after April 16 Before April 16, EM debt was a different market, outperforming every other debt asset class, with continued EM inflows (2%) while there were outflows from US (-4%) and non-US HY (-7%). Unlike 2013, EM inflows persisted, even during the first 75bp of the US rate rise from Sept 2017 to April 16, 2018. Since then institutional flows are somewhat offsetting the small retail outflows and EXD ETF inflows have been fairly stable. EM issuance was up 8% through April 16, while that for US IG and HY was lower by 7% and 25%, respectively (EM supply? Relax. It is not as bad as you fear). 

2017 to early 2018 large growth

EM economies are still booming and new markets have opened with new demand. First, GCC sovereign issuance and frontier markets have grown rapidly, offering investment opportunities for high credit quality crossover buyers, as well as higher yielding and promising credit stories offering diversification. In addition, China has become more than one-third of EM corporate issuance and as much as 90% of that is placed in Asia, much in China itself. Fundamentally, most of those markets have not changed in the last 2 months." - source Bank of America Merrill Lynch

Yes, in illiquid markets, size matters. No matter what some sell-side pundits would like to spin, liquidity trumps fundamentals. It is your ability to trade that matters.

Having learned quite a few things from reading over the years the research from the wise Charles Gave of Gavekal research for whom we have great respect, at this juncture from QE to QT we think we needed to reminded ourselves his wise words:

"if there is more money than fools then market rise, and if there are more fools than money markets fall"

Last year rush for Argentina 100 year bond was indeed a case of more money than fools for EM. As the tide slowly recedes and we turn from QE to QT, we will over the course of the next quarters gradually discover who has been swimming naked, given capital will flow more discerningly we think. QE was a period where money thanks to NIRP and ZIRP was chasing anything with a yield without distinction. Now with rising dispersion, there will be truly more "credit analysis" done at the issuer level. Times are changing as pointed out by Bank of America Merrill Lynch in their Credit Market Strategist note from the 15th of June entitled "On the road from QE to QT, redux":

"On the road from QE to QT, redux

We have used this title before (see: Credit Market Strategist: On the road from QE to QT 29 March 2018) and this week’s central bank meetings - Fed, ECB and BOJ - motivate us to recycle it. Quantitative easing (QE) was mostly characterized as an environment with too much money chasing too few bonds, lower interest rates, tighter credit spreads and volatility was suppressed. There is no doubt that quantitative tightening (QT) at times will lead to the opposite - i.e. higher interest rates, wider credit spreads and very volatile market conditions (Figure 1).

However, we are currently in this intermediate phase - i.e. on the road from QE to QT - where things remain orderly although technicals of the high grade credit market have weakened notably this year due to less demand (Figure 2).

Hence, we have seen higher interest rates, wider credit spreads (Figure 3) and more volatility (Figure 4).

Domestic QT+ foreign QE/NIRP=OK

The reason we are not yet experiencing the full effect of QT is that foreign central banks - the ECB and BOJ in particular - are still providing tremendous monetary policy accommodation via QE and negative interest rates (Figure 5).

Thus, if US yields rose too much due to QT and rate hikes there would be large foreign inflows. Hence, US yields would not increase too much and fixed income volatility remains moderate. While this week the ECB announced the end to QE, they came out dovish by promising continued negative interest rates (NIRP) for a long period of time (Figure 6).

NIRP in the Eurozone works much like QE, as explained below, as it encourages companies and individuals to take risk way out the maturity curve or down in quality.

How does the ECB influence the back end of the curve? It is very simple: with negative interest rates, European investors are forced to either take a lot of interest risk or credit risk to earn even a small positive yield of 0.50% for example (Figure 9).

That asserts bull flattening pressure on both rates and quality curves.

We have not seen this movie before

While QT in itself is a rare occurrence we have never been in an environment of QT with a backdrop of major foreign QE/NIRP. Given the clear failure of the ECB and BOJ to meet their policy goals of near 2% inflation (Figure 8) the road from QE to QT may be very long - certainly years.

However, while we consider high grade credit spreads this year range bound - and in fact presently are at the wide end of the range due to supply pressures that will ease and Italian risks we will increasingly decouple from (although they remain severe a bit further out) - we continue to believe that the end to ECB QE means moderately wider spreads next year and in 2020. This is because the ECB presently buys about $400bn of bonds annually, which pushes investors into the US market. Without that we get less inflow from Europe and technicals deteriorate further. Partially offsetting this will be less supply as the relative after-tax cost of debt has risen due to higher interest rates and a lower corporate rate." - source Bank of America Merrill Lynch.

The escape route is somewhat less tricky for the Fed than for the ECB. It remains to be seen if Mario Draghi will rock the boat before the end of his term in 2019. We do not think he will. The Bank of Japan remains so far committed to QE, so there is still some time on the gradual tightening spigot we think.

Returning to our core subject of "mercantilism" and trade wars, it is looking more and more likely that in similar fashion to the 1930s, we risk seeing tit for tat reactions from China to additional US sanctions. Obviously equities market are reacting to this. Emerging Markets were the big beneficiaries of globalization and cooperation. Following NIRP and ZIRP implementation by DM central banks, EM have benefited from the high beta chase and massive inflows into funds. With the QE tide receding thanks to QT and with the escalation of trade war fears, obviously EM are coming under much pressure, hence our reverse macro osmosis theory we have been discussing various times playing out. On the subject of disruption from trade wars, we read with interest Barclays take from their Thinking Macro note from the 1st of June entitled "Trade war in perspective":

"US trade protectionism: Where do we stand?

This year, the US has implemented a number of protectionist trade actions. In March, President Trump announced a 25% tariff on steel (10% on aluminium) imports. The US Trade Representative (USTR) then proposed a 25% intellectual property (IP) related tariff on 1,333 Chinese goods. President Trump then asked the USTR if it was possible to impose tariffs on a further $100bn of Chinese goods. Import tariffs in the automotive sector are also being considered. Some progress has been made in trade negotiations with China (see China: Tariffs on hold, long negotiations continue, 12 May 2018). But escalation risks remain, since the steel tariff exemption will expire on 1 June and the White House said it will impose a $50bn IP tariff on Chinese products, with the list published by 15 June 2018.

We use a VAR model to quantify the potential impact of US tariffs on global growth and CPI inflation. The first year estimates are subject to high model and parameter uncertainty. We thus use second year estimates. These show that a 1% unilateral rise in US tariffs as share of US imports may reduce global growth by 0.3pp and increase inflation by 0.4pp. That said, the impact of the steel tariff, even without exemptions, would only lead to a 0.1pp decline in global growth and a rise of 0.1pp in CPI inflation, as steel is only 0.33% of US imports.

Large economic effects larger require big tariffs. If the proposed 25% tariff of $100bn of Chinese goods is added to the steel tariff, together with tit-for-tat retaliation, our model shows that such a scenario would raise CPI inflation by 1.1pp and cut growth by 0.9pp.
Our model suggests that the adverse effects of US trade tariffs on emerging markets are likely to be much larger and more persistent. This is intuitive, as these economies have been the largest beneficiaries of the most recent globalisation wave. According to our model, a 1% rise in US tariffs leads to a 1.1pp reduction in EM growth in the first year, versus 0.5pp for DM. For CPI inflation, the numbers are +1.1pp for EM versus +0.2pp for DM.

However, there are a number of mitigating factors. In the first age of globalisation, US tariff policy was very active, but large retaliations were rare. Similarly, their 70% success rate incentivises the US and EU to keep the WTO for resolving trade disputes. In addition, President Trump’s drive for deregulation, by removing entry barriers, could encourage more services trade, which may mitigate the negative effect of higher tariffs on goods. That said, any rise in services trade flows is unlikely to fully offset the impact of higher tariffs on EM countries, given the size and persistence of the effects estimated in this paper.

The impact is larger for emerging, than developed, markets

Emerging markets have likely benefitted the most from the trade hyper-globalisation of the 1990s. The abundant and competitively priced labour supply in these countries, together with free trade, led to large FDI inflows, allowing these countries to export their way up the development ladder. Intuitively, this suggests that these countries should also be more vulnerable to a rise in protectionism. In this section, we split our global real GDP growth and inflation variables into corresponding variables for emerging and developed markets, to econometrically examine if EM economies react differently to DM economies.

Figure 8 and Figure 9 shows the results for EM and DM economies, respectively. This breakdown produces several interesting results. First, EM GDP growth is likely to shrink by roughly twice as much as DM. Second, the DM GDP effect is short-lived and not statistically significant after one year, but is much more persistent in EM. Finally, the impact on EM CPI inflation is approximately five times as large as in DM. This could be due to higher USD denomination of financing flows and trade transactions, as well as different monetary policy reactions to external shocks in EM than DM.

Not surprisingly, the effect of the current US steel tariffs is much larger for EM economies (Figure 10.) than DM economies (Figure 11).

We compare first year estimates, because of a lack of statistical significance for the DM GDP response after the first year. With the steel tariff alone, our model suggests that EM (DM) GDP growth could fall by 0.3pp (0.1pp) and inflation rise by 0.3pp (0.1pp). With steel tariff retaliation, EM growth could fall by -0.7pp, with inflation rising by 0.7pp, which are sizable effects. If the US unilaterally implements IP-related tariffs on $50bn of goods from China, then EM (DM) growth could fall by 0.9pp (0.4pp) and inflation rise by 0.8pp (0.15pp). In the case of tit-for-tat retaliation, EM (DM) real GDP growth falls by 1.7pp (0.7pp) and inflation rises by 1.7pp (0.3pp). Overall, DM would only really feel any effects from tariffs in this very last scenario, while the impact for EMs is already sizable if the current steel tariffs are retaliated against.

The return of US protectionism can be disruptive

In this section, we review the main lessons from our econometric exploration of US tariffs. Modelling the impact of US tariffs on short-term global growth and inflation is challenging. Academic work has focused on the long-term effect, and uncertainty about the impact in the first year after the tariff announcement is large. Our estimates are based on a gradual tariff reduction, while the current situation is a rapid tariff rise. The estimates presented in this paper should therefore be interpreted accordingly. However, they nevertheless provide a first econometric view on how President Trump’s tariffs might affect the world economy.

Our results suggest that US tariffs act like a negative supply shock to the world economy, lowering global growth and raising inflation. However, only large tariffs produce large effects: the current US Steel tariff is only 0.33% of US imports and would reduce global growth only by 0.1pp, while raising global inflation by 0.1pp. It is only when $50bn of IP-tariffs are added and retaliated tit-for-tat that growth falls 0.6pp, while inflation rises 0.7pp.

The impact on emerging markets is much greater than on developed markets. The EM GDP growth impact is twice as large as on DM and significantly more persistent. The EM CPI inflation response is approximately five times as large as in DM. While there are a number of mitigating factors that are not accounted for, the analysis suggests that EM economies will be affected to a much greater extent than developed markets.

Overall, US protectionism could be disruptive, especially if tariffs are large and are retaliated. Emerging markets will likely be more affected than developed markets." - source Barclays

So there you go, if you think EM woes are overdone because of "fundamentals" then again you would be wrong if trade war escalates this could lead to a stagflationary outcome. Then of course, there is as well the trajectory of the US dollar and oil prices to factor in. From a liquidity perspective, we think the second part of the year will be challenging as the central banks turn off the liquidity spigot. You should continue to be overweight DM over EM on a relative basis overall. Then again, there are as well different stories and different issuer profiles. In a rising dispersion credit world, you need to go back to "credit analysis" and this is why active management should be favored right now over passive management. It is time to become more "discerning".

For our final charts, given the increasing competitive nature of capital allocation when liquidity is being withdrawn, we would like to highlight how this cycle is unique.

• Final charts - Capital Flows? This time it's really different.

When it comes to the acceleration of flows out of Emerging Markets and growing pressure on their respective currencies, it is, we think a clear illustration of our "macro theory" of reverse osmosis playing as we have argued in our conversation "Osmotic pressure" back in August 2013:

"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013

The mechanical resonance of bond volatility in the bond market in 2013 (which accelerated again in 2015 and in 2018) started the biological process of the buildup in the "Osmotic pressure" we discussed at the time:

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.

Capital flows react to real interest rates dynamic. Following years of financial repression in this cycle, the reaction and velocity of the moves we are seeing are therefore much larger from a standard deviation point of view. Our final charts come from Wells Fargo Economics Group note from the 13th of June entitled "Capital Flows Part III: This Time Is Different" and highlights the unique nature of the current economic cycle which ultimately affects capital flows as per our reverse osmosis theory stated above:

"The relationship between interest rate expectations and exchange rates has become harder to quantify, largely due to the unique nature of the current economic cycle. This changing dynamic ultimately affects capital flows.

What About Expectations?

As we have discussed in two previous reports,* capital flows respond to relative interest rate and exchange rate dynamics across borders. We now turn to the effect of expectations on our three variables. Expectations have played an increasingly important role in market participants’ reactions to global events. For example, recent Italian political developments led the euro to decline against the dollar, while Italian bond yields rose more than 100 bps (below chart).

While it is too soon to determine any effect these political tensions could have on capital flows, it is clear that expectations play a role in short-term exchange rate and interest rate dynamics. In the long run, these dynamics affect capital flows.

Expectations of central bank actions have also caused unpredictable swings in foreign exchange rates and interest rates. As previously discussed, our currency strategy team has found additional rate hikes from the Fed to be less supportive of the dollar, while at this stage, tightening on the part of foreign central banks has been more supportive of foreign currencies. Throughout much of 2017, short-term rate expectations moved in favor of the U.S. dollar, but the dollar declined (below chart).

This is likely due in part to the FOMC being further along its tightening path relative to other major central banks, and market participants having already priced in future rate hikes to a large extent. Market-implied probabilities of a rate hike are nearly 100 percent for today’s FOMC decision. Market participants likely see the FOMC as only having so many rate hikes left before reaching its terminal rate, and this means the potential for rate hike “surprises” is much lower.

In turn, the effect of interest rate expectations on exchange rates has been harder to quantify. As the Fed began to tighten policy in 2015-2016, one could theoretically identify a more direct relationship between the probability of a Fed rate hike and its effect on the dollar. However, as global central banks have engaged in unconventional monetary policy measures, the focus has turned toward perceived policy stances through actions such as quantitative easing, rather than a pure reaction to actual rate hikes.

Reviewing Past Cycles: All Else Is Not Equal for Capital Flows

The evolving relationship between interest rate expectations and exchange rates confirms why this cycle is unique. We have found that country-specific characteristics lead to volatility in capital flows, and similarly influence expectations. In the U.S. for example, prior cycles may have had a rising rate environment, but lacked a fiscal stimulus. This difference is compounded by unconventional global monetary policy and a deteriorating fiscal outlook during one of the longest economic expansions in recent history (below chart).

These differences influence investors’ relative allocation of capital, and decision makers would do well to pay attention to the unique outcomes that stem from differing market expectations."  -source Wells Fargo

More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike as discussed in our "Mack the Knife" July 2015 musing to repeat ourselves. Why did past Mercantilism failed and will fail again? Just read again Adam Smith's 1776 "The Wealth of Nations" in 1776. In his book Adam Smith's argued that the wealth of a nation consisted not in the amount of gold or silver stashed in its treasuries, but in the productivity of its workforce. He showed that trade can be mutually beneficial, an argument also made later by David Ricardo. In January 2017 in our conversation "The Ultimatum game" we argued:

"The United States needs to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that matters in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again." - source Macronomics, January 2017 

Once again it isn't the quantity of job that matters, it's the quality of jobs. No matter how the Trump administration would like to play it, but productivity matters more than trade deficits but we ramble again...

"It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country." - Adam Smith

Stay tuned !