USD Soft Patch to Set the Stage for Another Grind Higher in Asset Prices and Interest Rates

  • Bullish USD sentiment clearly became overly reliant on the Trump Administration’s desired agenda of tax cuts, deregulation, and infrastructure.
  • Due to the host of potential political scandals plaguing the Administration, as well as general political dysfunction in the US Congress, expectations of a pro-growth agenda being enacted this year have been significantly muted, though not completely discounted by Assist FX.
  • Assist FX still sees passage of a lighter version of market-friendly reforms in 4Q2017/1Q2018 limping past the finish line in what is becoming a non-consensus call. Sparring blocs within the Republican party will increase cooperation as political viability becomes increasingly threatened for the 2018 midterm elections.
  • In the near term, USD will struggle to stage sustainable rallies as political uncertainty takes its toll.
  • As financial asset prices in equities, real estate, and alternatives continue to inflate further into historically stretched valuation territory, it will place pressure on the Fed to remain on track for gradual rate hikes approximately once per quarter.
  • Long duration USTs will be pressured by lower real yields, lifting rates at the long end of the curve. This will contribute to moderate firming in USD in the medium term 3-6 month outlook.
  • Top risks to this view include a pronounced spillover effect from China’s debt deleveraging efforts resulting in global financial market instability, as well as any number of potential Trump Administration scandals escalating to such severity that the blow-back shifts the political landscape in favor of left leaning populists for 2018 and beyond. While these risks are currently underappreciated by markets, they are not our base case.

China’s Controlled Deleveraging

  • China has decided it is time to pull away the punch bowl for a little while.
  • There is a coordinated series of moves by China’s leadership to slow down the risk buildup posed by excess leverage.
  • The correction in both Chinese bonds and equities has thus far been met primarily with utter disinterest by advanced economy risk markets. Volatility levels are still crawling near historic lows across major asset classes and new all time highs are regularly being surpassed.
  • Still, if there is anything posing an out-sized share of global systemic risk it is China’s massive debt load.
  • Keep an eye on raw commodity prices in China as a leading proxy for  inflationary/deflationary asset price impulses. Iron ore specifically has had difficulties stabilizing as the Q4 2016 run up is moving closer to being fully erased on the way back down.
  • My base case is that China is not yet ready to unravel and this is a healthy process of mild deleveraging. However, it won’t take many more risk off days in China before it begins to spill over into developed markets elsewhere. If this situation does not materialize with increased stabilization by the middle of next week, there will be a tradable risk off wave. Stay tuned.

iron ore 051217

overnight shibor 051117

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This is the Most Important Inflation Chart in the World

china-ppi-feb-2017

The most important inflation chart to focus on right now is that of producer prices in China. It provides a depiction of what is happening with prices at the early stages of production in the largest net exporter nation.

China’s producer prices tend to filter into the rest of the world in the form of exported deflationary or inflationary pressures. After remaining deep in negative territory since early 2012 and registering a long string of consecutive contractions, China PPI has turned positive and is moving sharply higher.

It may only be a temporary spike to 7% that plateaus and then falls off as it did in 2011. According to the models I follow, which directly oppose the more traditional models used by many Keynesian economists, consumer price inflation is an input directly responsible for choking off economic gains. You can’t easily make raw commodities cost less but you can often replace labor with automation at a certain breakeven cost point. Thus, wage gains will struggle to keep up with input-cost led inflation, inflicting harmful economic damage when central banks get behind the curve rather than providing additional stimulus from “running the economy hot.”

In that sense, higher inflation may take care of itself by slowing down growth and threatening to let air out of the massive China credit bubble. Of course, monetary conditions should be tight enough to prevent the type of extreme credit expansion seen in China and elsewhere from happening in the first place. However, we are living in a Keynesian-dominated world of permanent bubble manufacturing after all. But what if the credit bubble doesn’t burst and producer prices keep rising?

If China PPI doesn’t level off very soon and it indeed surpasses 2011 levels, we have ourselves a potential black swan for 2017. Global consumer prices would certainly follow the China PPI trend with or without additional oil price gains (higher oil will only compound the problem). It is too early to know at this stage, but you should be watching the most important inflation chart in the world for further clues as new data is released out of China. We may eventually be headed for an inflationary spike followed by the bursting of the great credit bubble, in which China is at the epicenter.

Market Impacts of Economic Populism and Elevated Debt Levels

The politics of trade protectionism, nationalism, and anti-immigration are the match which will ignite dormant inflationary gasses bubbling underneath the surface after years of short-sighted monetary policy experiments.

Governments have failed for several years to enact meaningful structural reforms that would set economies on a more sustainable path. This is just now beginning to lead to the realization of painful, inflationary solutions. Losses in real wealth and spending power for many advanced economy citizens in the name of “economic competitiveness” and “growing out of debt” are under way. Central banks are somewhat subtly engineering an inflation overshoot as it is implicitly understood that government gridlock, corruption, and incompetence are preventing wiser legislative solutions from coming to fruition. Central banks have been “the only game in town,” as coined by Allianz chief economic advisor, Mohamed El-Erian. In other words, growing out of debt with real growth, innovation, and productivity gains is much less likely at this point than inflating out of it with falling real wages, lower standards of living, and stagflation.

Real average hourly earnings in the US fell by 0.5% in January versus the prior month; nominal wages rose by 0.1% while the BLS CPI-U Consumer Price Index increased by 0.6%. Even excluding energy, nearly any measure of consumer prices leads to a trend of deteriorating real incomes and saving rates going forward. Bank of England Governor Mark Carney has warned of accelerated losses in purchasing power on the way for the United Kingdom.

While the UK’s 20.5% year-over-year manufacturing input price inflation in January was largely inspired by pound sterling depreciation after voting to leave the European Union, the reflation trend is a global phenomenon. Germany, Norway, Sweden, and countless emerging markets including Mexico, China, Chile, Turkey, and Egypt, are experiencing a pace of wholesale (PPI) price increases faster than has been witnessed since at least 2011. PPI increases of this magnitude are generally a leading indicator for CPI to follow suit, though wholesale businesses will absorb a portion of the input cost increases through margin contraction.

I have been warning about building inflation risks for the past couple of years. Contrary to what new Keynesian economic advocates will have you believe with their gravity and logic defying models, there exists a simple mathematical problem of too much debt and not enough productivity to legitimately grow out of it in developed nations with aging demographics.

Prominent demand-side economists such as Larry Summers have been advocating currency debasement, money printing, debt-fueled fiscal stimulus, and interest rate repression continually since the financial crisis. Paul Krugman famously called on then-Fed Chair Alan Greenspan to create a housing bubble in 2002 to replace the .com bubble bust. This cyclical mentality of monetary bubble manufacturing has been blind to the secular economic rot festering underneath those same policies. It has also had unfettered control of the levers within the world’s most powerful central banks for the past 20 years. Financial history books will eventually hold these highly flawed policies and their proponents accountable for doing little other than fueling the next great bubble—the credit bubble. Or, as I alternatively call it, the global QE bubble.

Keynesian economists calling for debt-financed spending, ultra-easy monetary policy, and demand-pull inflation during a period of economic stagnation is nothing new. It isn’t only the usual suspects, however, singing the inflationary gospel now. That is why we are at such a significant inflection point. The populist right is winning political momentum and its policy prescriptions are astoundingly inflationary—border taxes, import tariffs, currency debasement, immigration restrictions limiting the labor market supply, etc.

Economic populism is credited with giving birth to the new political paradigm. Its recent “scalp prizes” were supporters of the UK staying in the European Union and the entire US political establishment. Lines between the traditional political left and right have become blurred in the developed world. Right wing populist candidates are closely vying for power in the least likely places on earth one would expect—the Netherlands (Geert Wilders) and France (Marine Le Pen).

Established politicians and their party infrastructures are more at odds with each other than they have been in decades. Yet, grass roots supporters of what are typically opposing parties have converged as strange bedfellows in supporting several key areas of common ground: reforming global trade rules with the intention of better protecting their own domestic workers, reducing cronyism within big government and big business, decriminalizing marijuana, and protecting civil liberties from government overreach, to name a few.

US President Donald Trump has lashed out concerning a too-strong dollar and flirted with altering a decades-long US strong dollar policy. France Presidential Candidate Marine Le Pen wants to leave the euro currency bloc, take control of the central bank, kick out the immigrants, and print money to fund social spending; and this is coming from someone widely considered to be of the political right wing. What could possibly go wrong? This has not gone unnoticed in the FX market or the French bond market. I’m afraid we haven’t seen anything yet, however.

These inflationary macro trends will continue to surprise many, even if Le Pen is not victorious in the France elections this year. The easy monetary policy leanings of the establishment-left and nationalistic fiscal policies of the populist-right are in alignment. They are both clamoring for a wave of higher consumer prices to erroneously “fix” structural problems of high debt and low labor productivity. It is completely illogical and will only have the opposite effect, but that is beside the point.

I sensed a stronger populist undertone than given credit by the press before the UK referendum to leave the EU and before the US presidential election. My base case doesn’t currently have Marine Le Pen winning the France presidency this year, but there is little room for error in the upcoming election season in Europe. Economic populism is here to stay due to the alignment of interests between grass roots supporters of opposing parties against political elites in general.

Punishing the globalist-minded political elites who have presided over declines in living standards for middle and working class Average Joes throughout the developed world is no longer exclusive property of the hard left. The populist right wants to make its dent in the elites’ armor as well. The result of anti-elite political sentiment will have profound impacts on financial markets for the next several years and some of these impacts are relatively predictable.

Behind the tire marks of the new anti-elite political paradigm exists a trail of how we got here. Gross mismanagement of government budgets globally and the inability of labor to share in the economic gains created during the previous period of high productivity have contributed to a deep structural hole that might prove too deep to escape with a “healthy” type of growth. This is especially the case given the drop off in productivity in recent years and aging demographics. It has also created outrage amongst the masses who feel duped for trying to play by the same rules the elite class gamed in order to gain even more wealth; ie, the carried interest deduction allowing billionaire money managers to pay lower tax rates than electricians.

The current hot topic of “low productivity” is often lazily discussed as if it is the reason real wages have been stagnant (or falling) for decades. Low productivity is more of a post-Great Financial Crisis phenomenon probably caused by a misalignment of corporate incentives. With Zero Interest Rate Policy (ZIRP) and central bank quantitative easing (QE) flooding the capital markets with fresh cash, why invest in new equipment to improve worker productivity when you can simply borrow for a negligible cost and use the cash to immediately fund common stock buybacks, dividends, and M&A? Excessively easy monetary policy distorted market dynamics and reduced incentives to increase productivity. Additionally, governments used the temporary benefits of monetary stimulus as cover to avoid taking more unpopular measures to improve their structural situations.

A decade of global central bank activism paired with several dysfunctional governments did not permanently address very many structural issues. What it did is limit the immediate severity of the 2008/2009 financial crisis, inflate asset prices to bubble territory, boost employment mainly for lower paying service sector jobs, and change the composition of the next recession to an inflationary debt reset rather than a deflationary bankruptcy-based debt reset, thus destroying responsible savers to the benefit of debtors.

What kind of a market environment will persist in a political climate of economic populism combined with excessive global debt? Real wages will take a beating initially, as will fixed income markets. Equity indices will be tugged higher on the illusion of inflated corporate earnings and then yanked lower after resulting interest rate spikes. FX rates will have multiple “Brexit-esque” caliber events, causing pockets of illiquidity and displacements in rates. A targeted Chinese yuan devaluation of 15% or more within 1-2 years is likely as one prime example. Any implementation of border taxes or tariffs designed to protect domestic workers will likely be met with retaliatory actions that will greatly harm those same workers, unless the new trade rules are negotiated and agreed upon by both sides. Bilateral trade deal negotiations and politics could be the chief drivers of global markets for the next five years in the same way monetary policy divergences drove markets in the past five years.

The best case scenario is governments use a period of unsustainable increases in budgets and financing costs over the coming years as political cover to get leaner, more efficient, and more responsive to the needs of their citizens (hopefully this doesn’t cause readers to erupt into spontaneous laughter). In a glass-half-full world, wages will eventually catch up to price increases. Those who are unemployed, retired, renting their primary residence, net savers, or whose incomes are not closely tied to actual inflation will feel like they were on the wrong side of a crash. It probably won’t be a traditional nominal price crash so much as a crash in real terms; however, there could be flashes of both.

Ultimately, the same forces that have always been responsible for real wage increases and higher standards of living still hold true: high productivity, broadly enjoyed technological innovations that lower costs without displacing too many workers, and a peacetime dividend enjoyed during times of no major war conflicts. Does it seem like we are headed toward this scenario?

Remember this: when someone tells you the surest path to economic prosperity involves devaluing your savings, lowering your real wages, and paying down old debt with new debt—run away and call the police—someone is trying to rob you.

Do Words Trump the Data? Probably Not Yet

“Our companies can’t compete with them now because our currency is too strong. And it’s killing us,” Trump told The Journal, referring to competition from China.

The Trump Administration wants to make America great again by transforming it into a manufacturing powerhouse like it was in the Post War glory days. Buy America, hire America. That’s not so bad really. Most Americans are generally on board with this patriotic slogan as long as its implications stop there. But then Mr. Trump takes things a step further with nonsense about the “strong dollar killing us.” By “us,” he means the 13% of the US economy reliant upon goods exports (as opposed to the other 87% more reliant upon domestic services and consumption). Mr. Trump surely isn’t referring to the more than 97% of Americans whose incomes are gained in dollars and whose spending power declines when the dollar’s does.

It is true that, in the near term, sharp increases in the dollar’s value can cause financial instability as foreign debtors struggle to pay back loans denominated in a strengthening currency relative to their own. It also causes the perception of lower US multinational corporate earnings as a portion of overseas earnings in relatively weaker currencies get converted back into stronger dollars at a lower nominal value on the income statement. This is as much a perception as anything because the same relatively stronger dollars that make foreign earnings look lower also have more purchasing power to lower future costs in those same regions.

In the medium to long term, there is absolutely no doubt that a strong domestic currency is in the interest of not just the citizens sharing it, but real GDP as well. Inflation tends to be lower, real incomes tend to be higher, and overall well-being tends to be notably higher in countries with strong currencies and low inflation. This fact has also been the stance of the United States Treasury for several decades. Is Mr. Trump challenging this stance or is he simply using fighting words to get in front of China (or others potentially) before it might need to devalue the yuan? Does he want to be able to say “told you so” if and when the yuan gets devalued with the intention of gaining enough political capital to impose tariffs against China? Who knows. It isn’t heartening that Mr. Trump doesn’t seem to understand how China is actually burning through currency reserves to prop up the value of its currency rather than hold it down as he alleges.

It comes down to this: will market sentiment return to favoring the dollar when US economic data surpasses expectations or have Trump Administration words materially damaged the perception of the long standing King Dollar policy in a way that it outweighs the data? Assist FX sees a continuation of data dependent sentiment for the dollar unless the Trump Administration makes an official move to target “currency manipulation” of trading partners using an executive order or proposed legislation. Markets are hyper-sensitive to Trump Administration commentary right now given all of the actions taken already in the first couple of weeks of its existence but the data will eventually move back into the driver’s seat.

Watch Out for These Two Macro Risks

If you must limit yourself to only two macro risks worthy of flaring up your insomnia they are these:

1.) Trade war contagion – Globalization and open borders are going out of style in mainstream developed market politics. Fast. In theory, trade reform can be targeted to narrow trade deficits, increase wages for the middle class, and make every developed country great again. In reality, there are tremendous risks of unintended consequences shaking the foundation of modern global economies. Modern economies function with tightly intertwined international supply chains. What would happen if every US import from Mexico, China, or even Germany rose in price by 15-20% at the stroke of a legislative pen? Would it really stop there? Would it not spark a wave of race-to-the-bottom retaliations, currency devaluations, and nasty inflation eroding real incomes across the board?  This is the top known economic and market risk as 2017 swings into gear. Pay attention to statements of pre-retaliation by public officials in trade-dominated economies.

2.) China’s currency reserves burn rate – China is burning through reserves at an alarming rate to prop up the yuan rather than suppressing it for competitive purposes as commonly alluded to by US President Trump. It has depleted more than 25% of its currency reserves in the past 1 1/2 years. It may only have another 6-18 months left before it is forced into a massive yuan devaluation of at least 15% to stop the bleeding. This would increase pressure on other Asian economies to also devalue their currencies, inflict trauma on US exporters and multinationals, compound default risk for dollar-denominated debtors, and destabilize financial markets. Imagine the turbulence seen in August of 2015 multiplied by at least 10; then tack on second-round effect multipliers. It is certainly worthy of being on the top macro risk short list.

Honorable mention goes to political election risk in the Eurozone this year. This will be a topic covered in more detail on this site in the future.