Risk Update – July 2019

As widely anticipated, the Federal Reserve cut the Fed Funds rate by 25bp on July 31st. In the official statement they claimed that they did so “in light of the implications of global developments for the economic outlook as well as muted inflation pressures”. The Fed also announced that they would cease the balance sheet reduction exercise immediately, two months earlier than previously targeted. Hard not to come back to what we quipped last month – “ten years of extraordinary monetary accommodation and all we got was this T-shirt”. By some accounts, we are now in the longest US economic expansion and equity bull market on record. The US has the lowest Unemployment Rate in 50 years. The Fed’s various inflation measures (useless as they are we think) are within margin of errors of historical averages. GDP growth rates are at or above historical averages. Yet, it is deemed unworkable to continue the efforts to “normalize” monetary policy.

Figure 1: US Fed Funds, CPI, Unemployment, UIG
Source: Bloomberg

Inevitably, the 25bp point cut was seemingly not enough to satisfy market desires, and clearly displeasing to President Trump. Much discussion about the Fed losing their independence has ensued. If that were a legit concern, it probably should have been raised prior to the US Govt Debt/GDP blowing through the 100% level, like pretty much every other Central Bank – Central Govt relationship in the world today.

Figure 2: Federal Reserve Assets, US Nominal GDP, US Government Debt/GDP
Source: Bloomberg

The Bretton Woods system came into being in 1944 when the major post-war countries agreed global coordination to maintain currency parities based upon ties to the US Dollar and to Gold. One of the key drivers to the agreement was to prevent competitive currency devaluations. In 1971 US President Nixon delinked the USD from Gold, ushering in the era of one fiat currency as the central reserve currency for the global monetary system. One might say the beginning of the end. Over time, increasingly more unorthodox policies were thrown at the system; the Greenspan/Bernanke Put, ZIRP, QE, Operation Twist, TARP and an endless number of acronyms to describe extreme efforts in Japan, Europe, Switzerland and the UK. In the Emerging Economy world, near endless QE, better known as building FX Reserves, was the tool of choice to maintain one’s chosen “parity”.

At the end of the post-GFC monetary experiment, where are we in terms of efforts to maintain “parity”? Well, Developed Economy central banks are near their post-crisis ZIRP/NIRP policy rate lows. This first grouping is what we might call highly-managed currencies, where monetary policy long ago became explicit currency manipulation.

Figure 3: Central Bank Policy Rates JPY, EUR, CHF
Source: Bloomberg

For good measure, it is worth adding a chart on the respective balance sheets. We would not expect to see these “normalized” any time soon.

Figure 4: Central Bank Assets Fed, ECB, SNB, BOJ
Source: Bloomberg

The second grouping is a sampling of what passes for, in this day and age, free floating currencies. Regardless, we are pretty much at all-time lows in policy rates, at or below zero in the first group, and approaching zero in the second.

Figure 5: Central Bank Policy Rates GBP, AUD, NZD
Source: Bloomberg

As often discussed, the monetary/currency policy of choice for maintaining desired parity in the EM world is QE, or “building FX Reserves”, as the IMF (itself a creature of the Bretton Woods system) prefers to call it.

Figure 6: FX Reserves China, India, Singapore, Korea, Taiwan, Hong Kong
Source: Bloomberg

Point being, post GFC, there has been an awful lot of effort to maintain desired levels of parity. So what now? What if the Fed’s attempt at an end-of-cycle tightening effort is indeed over and they are returning to more accommodation? How on earth does everybody else match them? It sure seems a dilemma. What if the Fed proceeds to cut rates back down towards zero? How do the others match that? Can the system handle another round of QE kicked off by the reserve currency Central Bank? Is it possible that the Fed is kicking off a fairly explicit round of currency devaluation wars? Could this be the nail in the coffin of the Bretton Woods / dollar as the central reserve currency world?

Conveniently, as tends to be the case, the lowest market price for volatility lines up with where you are likely to find the biggest risks. Just as we approach a crossroads for maintaining parity, we find vols across most of all the above currency pairs at historical lows. In general, the same goes for most of their respective interest rate volatility markets.

Figure 7: 1yr Implied Volatility USDJPY, EURUSD, USDCHF
Source: Bloomberg

So again, if hypothetically the Fed carries on and cuts the 225bp back to zero, what can the ECB, BOJ, SNB do to offset that? Can they (or anybody for that matter) win a currency war against the US? How aggressively will the likes of BOE, RBA, RBNZ need to move their yield curves lower?

Figure 8: 1yr Implied Volatility GBP, AUD, NZD
Source: Bloomberg

Is the PBOC likely to start building back up their FX Reserves when it appears the pressure is for flows going out, not in? How will trade and export driven countries like Korea and Singapore respond to another round of import suppression from global trading partners?

Figure 9: 1yr Implied Volatility CNH, IDR, KRW, SGD, PHP
Source: Bloomberg

We have used this image often before to help explain the challenge facing the PBOC. The gist is, they have created a lot more domestic Renminbi than they have stored USD in their FX Reserves. This puts them in a particularly tough position as they have created a lot of fragility around the potential risk of lost confidence in their currency. In a very real sense, they can’t risk competing in the currency devaluation game, and yet they have almost no choice but to do so.

Figure 10: China FX Reserves as % of M2
Source: Bloomberg

The strongly held belief that Central Bank rate cuts are good for stability and asset prices is contradicted by market behaviour after the Fed initiated their rate cutting cycles in December 2000 and September 2007. Maybe that is why the Fed tried to spin the latest cut as not being the beginning of a cycle of cuts.

Figure 11: SPX (log scale) and Fed Funds
Source: Bloomberg

We criticize regularly that portfolios have carried too little risk throughout this cycle, primarily driven by their lack of confidence in increasingly inefficient allocations to defensive/risk mitigation strategies. There will come a time when the pain from foregone compounding gets further compounded when the other side of those ineffective defensive strategies gets laid bare. Everybody that has ever seen us in person has seen the explanation of global imbalances driven by the flawed linkages through the ties to the global reserve currency. An eventual unwind of that structural flaw would be the mother of all market volatility events.

Figure 12: SGD/JPY Cyclical/Seasonal Chart
Source: Bloomberg
Figure 13: Volatility Comet
Source: Convex Strategies, J.P. Morgan

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