Big Surprise, No Inflation Ahead
By John R. Taylor, Jr.
“Tapering” is the word of the month, or maybe we should paraphrase Andy Warhol, as this word seems to be having its 15 minutes of fame. I never even conceived of the idea of tapering, much less considered it a significant word in the financial lexicon, but here it is. There must be a publicist out there somewhere who makes up these obscure and oftenabsurd issues that the market hyper- entilates about for a short while before the idea drops out of sight and is only of interest to financial trivia collectors and writers of financial histories. Does it really matter if the Fed cuts back from $85 billion a month of MBS and Treasury securities to $65 billion? Considering that the Treasury has cut back its borrowing needs dramatically over the past 6 months and that the trend is continuing, this level of purchases probably will finance the entire needs of the US government plus support much of the financing needs of the housing market. But, the fear of future “tapering” has the market in a panic. One would think with the sheer magnitude of money sitting in bank vaults earning nothing, that any move higher in rates would be met with a torrent of bids. Government yields have moved sharply higher since the start of May, jumping about 50% in a few weeks – the 5-year went from 0.647% to 1.00%, but even after all this huffing and puffing, the 5-year–5- year spread implies an inflation of slightly over 2% in 10 years, up from 1.1% today, and still easily below the Fed’s target.
Why is everyone so worried about US inflation? It’s a Pavlovian reaction generated from memories dating back to 1945, added to Bernanke’s boast that he could create inflation on demand. But, in fact, “helicopter Ben” is a myth. If the Fed really could put money in the hands of consumers, it could create inflation, but it can’t. The Fed can only give money to the banks and they have to ‘loan’ not ‘give’ the money to consumers. The consumers have to repay what they owe as they are already deep in debt, and they are desperate for higher pay (which is increasingly rare in today’s world), so either they won’t take on the new borrowing themselves or the banks won’t lend it to them. The multipliers between high-powered money and credit growth have collapsed. They can only grow when the banks feel safe in lending – because their balance sheets are strong – and when the borrowers are no longer scared. The Abe plan has had an impact only because the Japanese consumer is flush with money. No helicopter dropped it on them – it took 20 years for them to get that way. And even then, getting inflation above zero is not a sure thing. Neither the Fed in the 1930’s nor the BoJ in recent times has been able to create inflation, and it is extremely unlikely that there is inflation coming now. Deterioration in the Treasury’s balance sheet, the balance of power in Washington, the weight of the entitlement programs, plus negative demographics around the corner assures that the US is more likely to be a 1 + 1 economy, 1% growth and 1% inflation with a need for low interest rates and steep yield curves than one that forces short term rates much above zero. The situation today is not like the one in 1994 nor is it like the one in 1975. Between WWII and the 1980’s labor could push inflation higher, but today labor productivity is often decreasing the cost of production – there is no inflation there. The only asset that has a chance of going up is commodities, but this just takes money out of the consumers’ pockets, and is actually deflationary. Let the “tapering” get out of the system and then buy US
Emerging Downfall
By Robert Savage
The good times do not always roll. Sometimes they crash away. While many in the FX market have been clear about the ongoing trending weakness of the AUD and CAD and NZD in May 2013, the weakness from emerging market currencies has been more problematic – and surprising to many. The logic of trading risk over the last 10 years has rewarded owning both the EM currencies and equities when the FOMC eased or the rest of the developed world needed a kick start form Draghi. Not anymore. The risk of the moment rests with MXN, TRY and THB. They are the most overbought of the Emerging Market currencies, and are likely to suffer as position liquidations are forced at month-end and also due to increases in volatility. Risk management has taken hold of this market hurting commodities, EM and equities. The longer picture is even worse. The Emerging Markets are reflecting the same risks they had back in 2000 and 2008. Correlation of equities to currencies in emerging markets has worked very well since 2004 when China joined the WTO. Since then, the EM world became deeply ingrained with trading of commodities as we all believed that China 8% GDP growth would last for decades. The China demand function pulled up emerging LATAM and African equities and spilled over into the Asian region as capacity was quickly filled at mines and oil fields. But in this pullback in EM and the others, the slowdown in the US isn’t imminent but this seems a story about Europe and other nations. The big picture concern for US investors is finding a home for their assets and finding US growth without the rest of the world.
For emerging markets and commodities, the picture is much less fun. The traditional rolldown of lower US rates isn’t working. The hope rests with Japan growing more than priced in, with the ECB doing something extraordinary like negative deposit rates, or with China enacting another big stimulus plan. The long term cycles say that even then they won’t be enough. All of these events may be on the horizon and yet the charts say weakness ahead. We expect more pain in commodity-linked emerging markets with special focus on BRL, RUB and ZAR. The break of BRL beyond 2.10 opens a risk for 2.20. The COPOM meeting is widely expected to raise rates again by 50bps but unlike other better times, higher rates won’t bring new carry trades. The RUB faces a difficult few days with Oil off over 2% today alone. The 31.90 level will be critical with a risk of 33 in the next month. ZAR has already suffered as labor unrest in the mining sector no longer lifts Platinum or Gold prices. The ZAR is back to levels of the 2008 crisis and risks a run to 11. The next month for EM will be difficult – we see this pressure lasting into July
By John R. Taylor, Jr.
“Tapering” is the word of the month, or maybe we should paraphrase Andy Warhol, as this word seems to be having its 15 minutes of fame. I never even conceived of the idea of tapering, much less considered it a significant word in the financial lexicon, but here it is. There must be a publicist out there somewhere who makes up these obscure and oftenabsurd issues that the market hyper- entilates about for a short while before the idea drops out of sight and is only of interest to financial trivia collectors and writers of financial histories. Does it really matter if the Fed cuts back from $85 billion a month of MBS and Treasury securities to $65 billion? Considering that the Treasury has cut back its borrowing needs dramatically over the past 6 months and that the trend is continuing, this level of purchases probably will finance the entire needs of the US government plus support much of the financing needs of the housing market. But, the fear of future “tapering” has the market in a panic. One would think with the sheer magnitude of money sitting in bank vaults earning nothing, that any move higher in rates would be met with a torrent of bids. Government yields have moved sharply higher since the start of May, jumping about 50% in a few weeks – the 5-year went from 0.647% to 1.00%, but even after all this huffing and puffing, the 5-year–5- year spread implies an inflation of slightly over 2% in 10 years, up from 1.1% today, and still easily below the Fed’s target.
Why is everyone so worried about US inflation? It’s a Pavlovian reaction generated from memories dating back to 1945, added to Bernanke’s boast that he could create inflation on demand. But, in fact, “helicopter Ben” is a myth. If the Fed really could put money in the hands of consumers, it could create inflation, but it can’t. The Fed can only give money to the banks and they have to ‘loan’ not ‘give’ the money to consumers. The consumers have to repay what they owe as they are already deep in debt, and they are desperate for higher pay (which is increasingly rare in today’s world), so either they won’t take on the new borrowing themselves or the banks won’t lend it to them. The multipliers between high-powered money and credit growth have collapsed. They can only grow when the banks feel safe in lending – because their balance sheets are strong – and when the borrowers are no longer scared. The Abe plan has had an impact only because the Japanese consumer is flush with money. No helicopter dropped it on them – it took 20 years for them to get that way. And even then, getting inflation above zero is not a sure thing. Neither the Fed in the 1930’s nor the BoJ in recent times has been able to create inflation, and it is extremely unlikely that there is inflation coming now. Deterioration in the Treasury’s balance sheet, the balance of power in Washington, the weight of the entitlement programs, plus negative demographics around the corner assures that the US is more likely to be a 1 + 1 economy, 1% growth and 1% inflation with a need for low interest rates and steep yield curves than one that forces short term rates much above zero. The situation today is not like the one in 1994 nor is it like the one in 1975. Between WWII and the 1980’s labor could push inflation higher, but today labor productivity is often decreasing the cost of production – there is no inflation there. The only asset that has a chance of going up is commodities, but this just takes money out of the consumers’ pockets, and is actually deflationary. Let the “tapering” get out of the system and then buy US
Emerging Downfall
By Robert Savage
The good times do not always roll. Sometimes they crash away. While many in the FX market have been clear about the ongoing trending weakness of the AUD and CAD and NZD in May 2013, the weakness from emerging market currencies has been more problematic – and surprising to many. The logic of trading risk over the last 10 years has rewarded owning both the EM currencies and equities when the FOMC eased or the rest of the developed world needed a kick start form Draghi. Not anymore. The risk of the moment rests with MXN, TRY and THB. They are the most overbought of the Emerging Market currencies, and are likely to suffer as position liquidations are forced at month-end and also due to increases in volatility. Risk management has taken hold of this market hurting commodities, EM and equities. The longer picture is even worse. The Emerging Markets are reflecting the same risks they had back in 2000 and 2008. Correlation of equities to currencies in emerging markets has worked very well since 2004 when China joined the WTO. Since then, the EM world became deeply ingrained with trading of commodities as we all believed that China 8% GDP growth would last for decades. The China demand function pulled up emerging LATAM and African equities and spilled over into the Asian region as capacity was quickly filled at mines and oil fields. But in this pullback in EM and the others, the slowdown in the US isn’t imminent but this seems a story about Europe and other nations. The big picture concern for US investors is finding a home for their assets and finding US growth without the rest of the world.
For emerging markets and commodities, the picture is much less fun. The traditional rolldown of lower US rates isn’t working. The hope rests with Japan growing more than priced in, with the ECB doing something extraordinary like negative deposit rates, or with China enacting another big stimulus plan. The long term cycles say that even then they won’t be enough. All of these events may be on the horizon and yet the charts say weakness ahead. We expect more pain in commodity-linked emerging markets with special focus on BRL, RUB and ZAR. The break of BRL beyond 2.10 opens a risk for 2.20. The COPOM meeting is widely expected to raise rates again by 50bps but unlike other better times, higher rates won’t bring new carry trades. The RUB faces a difficult few days with Oil off over 2% today alone. The 31.90 level will be critical with a risk of 33 in the next month. ZAR has already suffered as labor unrest in the mining sector no longer lifts Platinum or Gold prices. The ZAR is back to levels of the 2008 crisis and risks a run to 11. The next month for EM will be difficult – we see this pressure lasting into July
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