Feb 28. International Linkages

Themes:

• G20…ineffectual
• Brainard…respectful of the markets and internat’l linkages
• Core PCE was 1.7…inflation coming back?
• Technicals don’t yet confirm an equity mkt bottom

Let’s start with a couple of snippets from the G20: (Rtrs) “Downside risks and vulnerabilities have risen,” [the communique] said, citing a backdrop of volatile capital flows, a drop in commodity prices, the “shock” of a potential British exit from the European Union and increasing refugee flows.

Again from Reuters, “The world’s top economies declared on Saturday that they need to look beyond ultra-low interest rates and printing money to shake the global economy out of its torpor, while renewing their focus on structural reform to spark activity.” But, they “…were unable to agree on a joint push for new stimulus measures.” A Bloomberg article said the G20 is worried about competitive devaluations, notably Japan.

Quick summary: Identify problems and do nothing about them. Talk about the need to avoid competitive devaluations, but tacitly accept negative rates which have currency depreciation as a goal.

Regarding Japan, there’s this note from The Guardian: “Japan’s population has fallen by nearly one million…the first decline since official census records began in the 1920’s. The country lost 947,345 people – more than the population of San Francisco – between 2010 and 2015.”

What else can Japan do besides devalue? It’s the developed economy conundrum, aging populations and heavy debt. It was Japan’s huge QE program which started in 2012 that had the desired effect of weakening the yen, followed by the mid-2013 US taper tantrum, and then the actual taper, which put increasing pressure on China’s peg and led to the August devaluation.

In a thoughtful and nuanced speech Friday, Lael Brainard touched upon policy divergences across the globe, and suggested they might be suppressed in current circumstances. “Such limits [on policy divergence] might reflect common forces buffeting economies around the world or the powerful transmission of shocks across borders through exchange rate and other financial channels that may have the effect of front-running monetary policy adjustments in the vicinity of the zero lower bound.”

A couple of other excerpts…

…if core inflation remains below target in all major advanced economies and inflation expectations remain under pressure in many, I might expect policy divergence to remain more limited than previously predicted.

The global economy is also experiencing a downshift in emerging market growth momentum led by China, which may prove somewhat persistent. … China’s investment has slowed sharply recently after accounting for nearly one-third of global investment over the past three years and about one-half of global consumption in certain metals such as iron ore, aluminum, copper, and nickel. Commodity exporters and close trading partners in Asia will be most affected, but the changes in the composition and rate of growth in a country that has accounted for about one-third of the growth in world output and trade will likely ripple through the global economy much more generally.

In this regard, although China’s direct imports from the United States are modest, uncertainty about changes to its exchange rate system and financial imbalances, together with changes in the composition of its growth, have had broader global spillovers that may pose risks to the U.S. outlook.

In some circumstances, however, cooperation can be quite helpful. If, for example, economies face a common challenge, coordination can communicate to markets that policymakers recognize the challenge and will work to address it.

Unlike Mester, Brainard recognizes the spillover risks of China’s slowdown, essentially concluding that the market has front-run policy makers, though saying that cooperation is important. While I have always thought of the Fed as having only three important players, Yellen, Fischer, and Dudley, I now have to round out the field with Brainard.

How have the markets been front-running? First, as noted last week, the curve is flattening to lows not seen since 2007, with 2/10 closing Friday just under 97 bps and red/gold euro$ pack spread at just 76 bps. Core PCE was higher than expected Friday at 1.7 yoy, much closer to the Fed’s goal but likely heavily influenced by medical care services, just as CPI was.  However, Eurodollar calendar spreads suggest extremely limited odds for rates hikes, with NO one-year calendar exceeding 27 bps. German gov’t yields are at new lows, with the ten year bund below 15 (nearing last year’s low of 7 bps).

In terms of financial market risks, there are many cross-currents. For example, the gold/silver ratio is just above 83, at a level previously associated with stress, like 2008 and 2002. However, VIX has come down and is now below 20 (19.81). A rolling spread of the 2^nd to 4^th VIX future is another stress indicator. Throughout much of January and the middle of February, the second contract traded at a premium to the fourth, reflecting market turmoil, but in the latter half of the month the curve has again gone contango, with nearer contracts trading at a discount. Similarly treasury vol has come well off the highs, with TYM implied now running 5.5.

The bounce in many markets in late Jan/ early February set important technical resistance levels. This week, the S&P 500 exceeded that high, but had a soft close Friday. Nasdaq futures also took out the early Feb high, but the cash index didn’t, and again, Friday’s close was weak. Russell 2000, HYG, JNK, EEM are all testing this same area but without solid closes above, it’s premature to consider a bottom formation. As can be seen on the attached chart, the WSJ major internat’l bank index is sorely lagging the SPX. By the way, even with the recent rally in crude, it remains well below the late Jan high, and NatGas has of course, imploded to new lows as I look out at the bright morning sunshine and mid-50 degree weather in Chicago in February.

This week brings Friday’s employment report, along with ISM data. Consensus for the wage component of Friday’s report is +0.2%, after the strong +0.5 gain last time.

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	2/19/2016	2/26/2016	chg
UST 2Y	75.5	79.7	4.2
UST 5Y	122.3	124.0	1.7
UST 10Y	174.8	176.4	1.6
UST 30Y	260.7	263.5	2.8
GERM 2Y	-53.2	-54.7	-1.5
GERM 10Y	20.2	14.7	-5.5
EURO$ M6/M7	18.0	15.5	-2.5
EURO$ M7/M8	25.0	23.5	-1.5
EUR	111.31	109.33	-1.98
CRUDE (1st cont)	31.75	32.78	1.03
SPX	1917.78	1948.05	30.27
VIX	20.53	19.81	-0.72

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• ABOUT:
  Former member of the CME specializing in interest rate options and yield curve strategies.

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