No more high speed collisions, only minor fender benders

Summary

• The market contemplates the threshold hold for a US rate cut.

• US Dollar liquidity is running dry.

• Australia, Canada, and Sweden all joined the bevy of doves.

• Oil price volatility rose on the news that the US would end Iranian oil waivers.

Equities and bonds both rallied this week, curves were steeper, as concerns mounted that the bar for Fed rate cuts is unclear.  A Wall Street Journal (WSJ) article last Monday suggested that the threshold for rate cuts may be lower than originally expected by market participants (article here). Unlike the Bank of Canada, the US has a dual mandate, meaning that the Fed must target inflation (price growth) and the unemployment rate (labor market). A higher unemployment rate would require a lower interest rate, while a higher inflation rate would need a higher interest rate. A dual mandate is challenging because the labour and inflation market can send mixed signals on the health of the economy. For example, today the unemployment rate is approaching all-time lows and inflation remains below the target of 2 percent. The market is struggling to understand how much weight the Fed puts on each mandate. Recent communications from the Fed suggest that the neutral rate of unemployment (the equilibrium rate that brings inflation to the Fed’s target of 2 percent) is lower than initially estimated. However, that is just an estimate and it is subject to model uncertainty, making market participants think that inflation carry’s much more weight in deciding interest rates. This confusion will likely be cleared up at the Fed’s meeting on Wednesday this week. The above uncertainty did result in broadly lower yields, led by front end rates, which are more sensitive to Fed policy. In terms of US equities, markets were supported by companies that continued to beat earnings expectations. The collapse in cross-asset volatility has also caused risk-parity funds (funds that set a target portfolio volatility and adjust asset allocations accordingly) to allocate more weight to equities relative to bonds. Meanwhile, US GDP numbers came out last week and although the headline number was strong, a staggering 3.2 percent, the underlying trends in consumption and business investment are concerning for growth going forward. The chart below shows the break out of GDP by sector. 

The US dollar index broke through recent resistance levels and has reached the highest level since early 2017. The greenback’s strength this year was, for the most part, tied to the currency being the cleanest dirty shirt out of the other currencies. Although the Fed shifted to a dovish tone, the rest of the world continues to be far worse off. While that narrative continues to hold, a larger factor is behind this rapid increase, a shortage of US dollars. Back in March, the Fed announced that it would reduce the number of assets it was running off of its balance sheet starting later this year. Although positive news for markets, the reality is that the Fed has continued to unwind its balance sheet at the rate it was last year (50 billion per month), and this is finally starting to impact liquidity. Evidence of this can be found in US money markets, which have been experiencing upward pressure on their overnight lending rates for the past few weeks. As the Fed reduces the size of its balance sheet, by allowing treasury bonds and Mortgage back securities to mature on the asset side, commercial bank reserves begin to fall on the liability size (See figure below).

Currency in circulation remains fairly constant, but commercial bank reserves have now fallen to the lowest levels since 2012.

Amongst all of this, hedging costs against the USD have gone through the roof, wiping out any of the nickels and dimes investors could have picked up while hedging their foreign exchange exposure. There is a great Bloomberg article (here) showing the hedging costs for Japanese and European investors going into 10-year US treasuries. A US 10-year treasury is yielding roughly 2.5 percent unhedged, meanwhile, the same bond hedged against the Yen and the Euro is yielding -0.4 and -0.6 respectively. This means that investors are either better investing in their own markets or just going in unhedged (it is more likely they are going in unhedged).

The Reserve Bank of Australia (RBA), Bank of Canada (BoC), and Riks Bank (Sweden) were all added to the list of policymakers that dropped their tightening bias’ this week. The Aussie swap market is now pricing in 2 full rate cuts by the end of the year, following a dismal inflation print last Wednesday. About 12 hours later, the BoC dropped its reference to “further rate hikes” while keeping policy rates unchanged. The BoC revised the neutral rate of interest lower along with potential growth estimates, keeping in line with the narrative of “no más” tightening. The Riks Bank, now known as the Krona killing machine, hiked rates earlier this year with the market poised for a hike later this year (September). After the dovish remarks, the Bank is now expected to hike only into the first half of 2020. I think this week solidified that the normalization push is over (at least for the time being) … are we all going to go the way of the BoJ (Bank of Japan)? 

Good news continues to be bad news in China as equities clocked their worst week since October of last year. China may have saved itself, as the most recent data show that the world’s second-largest economy is indeed stabilizing, although you wouldn’t get that impression from the reaction we got in equities last week. After spending the last 4 months running like they stole something, Chinese equities clocked a nearly 5 percent loss on the week. This was the worst week relative to US equities for China since 2016, and hammers home that point that a stabilizing Chinese economy raises the spectre of reduced stimulus and less liquidity. The signs of stabilization along with the increased likelihood of a trade deal has caused a shift in the mind of policymakers from monetary stimulus to bubble control mode, which is undoubtedly bad news for equities. 

Oil prices buckled the last few sessions after gaining nearly 5 percent on the back of Iranian waivers. Oil prices have posted over a 40 percent gain since the start of the year, with much of the rise being attributed to increasing outages from Venezuela, OPEC production cuts, and rising tensions in Libya. This week another catalyst was thrown into the mix. The US announced that it will end all waivers that allowed certain countries to import oil from Iran without penalty on May 2nd. The goal of this policy is to reduce Iranian oil exports to essentially zero, reducing the level of supply in the global market, putting upward pressure on prices. Although prices rose initially, the decline over the last few days was tied to a rapid unwind of momentum trading hedge funds which flipped from 100% long to roughly 25% long (according to Nomura estimates). I’d like to close with a quick thought on monetary policy, inspired by Aleksander Kocic at Deutsche Bank. Post financial crisis, monetary policy has always to managed step in and help alleviate any pressure in markets by pumping the system with more liquidity. Regulation has stepped up to help prevent future crisis' but at the cost of reducing overall potential growth. Capital requirements have reduced the overall capital available to be deployed, reducing potential growth rates, forcing central banks to keep policy rates lower for longer. Couple that with extremely cautious central banks (willing to create a large safety net at the first sign of trouble) and you get a world where we see no more high-speed collisions, only minor fender benders. Markets are basically stuck in a parking lot, where volatility is systematically suppressed by monetary policy, and growth permanently stagnated by ineffective fiscal policy.  Tiago Figueiredo