There are broad structural changes taking place in global markets that are draining liquidity. In recent years, an abundance of cheap capital that flooded into US Treasuries from FX reserves and global quantitative easing (QE) supressed bond yields and crushed term premiums. This was further compounded by a shrinking US fiscal deficit and led to a huge search- for-yield trade in global markets.
Fast forward to today and the picture is starkly different. FX reserves are no longer growing as exporters seek to defend their currencies against a strong US dollar. QE is moving into reverse. The price-insensitive buyers of government bonds have been replaced by private-sector savers who are more discerning with their capital and less tolerant of negative real yields, raising the cost of capital for everyone.
China’s current account is also a massive game changer. For years China has recycled its current account surplus into US Treasuries, but China is now heading towards a current account deficit. To plug this deficit and take pressure off highly leveraged domestic banks, China is seeking foreign capital. Going from an exporter to an importer of capital reduces liquidity, increases volatility and raises the cost of capital.
Fed’s wrong turn
It was against this capital drainage backdrop that Fed Chairman Jerome Powell talked in December about further hikes and leaving the Fed balance sheet on autopilot. Markets started to crack as the sheer demands of the US deficit crowded out the delicate corporate debt markets, as growth started to falter.
The Fed messed up. It was caught in a conundrum last year, as no matter how hard it tried the rate hikes did not tighten domestic financial conditions. The reason for this was the US remained the bright spot for flows in the global economy, countering the tightening efforts. By the fourth quarter, as the global economy nosedived, that all changed as US data turned lower. With US corporates highly levered, the tightening was aggressive and swift. The Fed panicked as the economy could easily have tipped into recession.
In early January the Fed recognised its mistakes:
- It can’t show inflexibility on the balance sheet when global growth is weakening and the US credit markets are so fragile.
- The transmission mechanism from the Fed to Main Street is increasingly via asset markets rather than banks, due to regulation and risk tolerance.
- With corporates borrowing at short maturities, the transmission mechanism is The neutral level of real rates is probably lower than the Fed believed.
- Monetary policy divergence is a killer for global growth and leads to a vicious cycle as dollar strength feeds on itself. By taking its foot off the gas the Fed allows other countries, notably China, to run less restrictive policy.
With inflation expectations way off their peak and the dollar still strong, the Fed has doubled down on its newfound dovishness – and rightly so.
Recent comments from Fed officials have been firmly on the dovish side as it takes a deep dive into the suitability of its current policy framework, with the conclusions to be announced in June.
Comfortable in risk
Until we see inflation shooting high we’re comfortable in risk assets such as emerging markets rates and FX.
Adding to the positive vibes in markets is the US re-election cycle. No president wants a flagging economy into an election so President Trump has taken personal responsibility for the US-China trade talks, increasing the chances of a positive outcome.
What does all this mean for portfolios? We prefer short positions in core duration and long in European periphery, emerging markets and inflation-linked assets. We are short the US dollar as economic and monetary policy reconverges with the rest of the world. As data surprises in Europe, Japan and China, we expect the dollar strength to reverse quickly.