Category: Countries & Regions

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Trade Wars: Playing hardball with China

Remember North Korea and the imminent nuclear war? With leaders trading insults on Twitter and bragging: “My nuclear button is bigger than yours.” It may resemble a WWF arena more than international diplomacy but that is how Donald Trump conducts foreign affairs.

The current Twitter war over trade tariffs is no different. Threat and counter-threat of wider and deeper trade tariffs are likely to bounce back-and-forth over the next few weeks. Xi Jinping thinks he has the upper hand because he doesn’t face criticism from a hostile media at home. Nor does he need to front up to a hostile domestic opposition. They’re all safely tucked away in jail. His stock market has already crashed, so there is not too much to worry about on that front either.

Shanghai Composite Index

Xi will do his best to undermine Trump’s shaky support. Targeting Trump’s electoral base with tariffs on soy bean imports (farming states) and steel tubing (Texas) in order to undermine his support. Targeting technology companies like Boeing and Apple, where China is a large slice of their global market, is also likely to elicit strenuous lobbying in Washington. As are well-timed tweets aimed at undermining stock support levels, threatening a major stock market rout.

Dow Jones Industrial Average

Trump probably recognizes that China can withstand more pain, but figures that he has the capacity to inflict more pain. The US has a large trade deficit with China.

Twitter: US-China trade deficit

And exports comprise a larger percentage of China’s GDP.

In 2010, Paul Krugman wrote:

Some still argue that we must reason gently with China, not confront it. But we’ve been reasoning with China for years, as its surplus ballooned, and gotten nowhere: on Sunday Wen Jiabao, the Chinese prime minister, declared — absurdly — that his nation’s currency is not undervalued. (The Peterson Institute for International Economics estimates that the renminbi is undervalued by between 20 and 40 percent.) And Mr. Wen accused other nations of doing what China actually does, seeking to weaken their currencies “just for the purposes of increasing their own exports.”

But if sweet reason won’t work, what’s the alternative? In 1971 the United States dealt with a similar but much less severe problem of foreign undervaluation by imposing a temporary 10 percent surcharge on imports, which was removed a few months later after Germany, Japan and other nations raised the dollar value of their currencies. At this point, it’s hard to see China changing its policies unless faced with the threat of similar action — except that this time the surcharge would have to be much larger, say 25 percent.

I don’t propose this turn to policy hardball lightly. But Chinese currency policy is adding materially to the world’s economic problems at a time when those problems are already very severe. It’s time to take a stand.

Krugman (no surprise) now seems more opposed to trade tariffs but observes:

….I think it’s worth noting that even if we are headed for a full-scale trade war, conventional estimates of the costs of such a war don’t come anywhere near to 10 percent of GDP, or even 6 percent. In fact, it’s one of the dirty little secrets of international economics that standard estimates of the cost of protectionism, while not trivial, aren’t usually earthshaking either.

I believe that Krugman’s original 2010 argument is still valid and that Trump is right in confronting China. The gap between imports and exports of goods is widening, especially since 2014, not shrinking.

Exports and Imports: Value of Goods for China

But let’s hope that Trump has done his homework. At this stage this is just a Twitter war rather than a trade war, intended to soften up your opponent rather than inflict real damage. But for Trump to succeed he must demonstrate that the US is prepared to endure the pain of a lengthy trade war if needed.

Men naturally despise those who court them, but respect those who do not give way to them.

~ Thucydides (circa 400 BC)

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“Headwinds have turned into tailwinds”

“While many factors shape the economic outlook, some of the headwinds the U.S. economy faced in previous years have turned into tailwinds. Fiscal policy has become more stimulative and foreign demand for U.S. exports is on a firmer trajectory.”
~ New Fed Chair Jerome Powell in his first testimony before Congress

Two very important sentences for investors. Expect further rate hikes but at a moderate pace.

Bond yields have climbed in anticipation of higher inflation. Breakout above 3.0 percent would warn of a bond bear market, after the bull market of the last 3 decades, with rising yields.

10-Year Treasury Yields

The five-year breakeven rate (Treasury yield minus the equivalent yield on inflation indexed TIPS) has been climbing since 2016.

Fed Excess Reserves

But core CPI (CPI less Food & Energy) remains subdued.

And average hourly wage rates, reflecting underlying inflationary pressures, continue to grow at a modest 2.5 percent a year.

Private Sector Average Hourly Wage Rate Growth

Real GDP is likely to maintain its similarly modest growth.

Real GDP and Estimates

While the Fed is sitting on a powder keg of more than $2 trillion of commercial bank excess reserves, no one is playing with matches. Yet.

Federal Reserve Bank: Excess Reserves of Depositary Institutions

Those excess reserves on deposit at the Fed have the potential to fuel a massive bubble in stocks or real estate. But investors remain wary after their experience in 2008.

We should be careful to get out of an experience only the wisdom that is in it — and stop there; lest we be like the cat that sits down on a hot stove-lid. She will never sit down on a hot stove-lid again — and that is well; but also she will never sit down on a cold one anymore.

~ Samuel Clemens

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Market Volatility and the S&P 500

It was clear from investment managers’ comments at the start of the year — even Jeremy Grantham’s meltup — that most expected a rally followed by an adjustment later in the year or early next year.

Valuations are high and the focus has started to swing away from making further gains and towards protecting existing profits. The size of this week’s candles reflect the extent of the panic as gains patiently accumulated over several months evaporated in a matter of days.

S&P 500

Volatility spiked, with the VIX jumping from record lows to above the red line at 30.

S&P 500 Volatility (VIX)

VIX reflects the short-term, emotional reaction to events in the market but tends to be unreliable as an indicator of long-term sentiment. I prefer my own Volatility indicator which highlights the gradual change in market outlook. The chart below shows how Volatility rose gradually from mid-2007, exceeding 2% by early 2008 then settled in an elevated range above 1% until the collapse of Lehman Bros sparked panic.

S&P 500 in 2008

The emerging market crisis of 1998 shows a similar pattern. An elevated range in 1997 as the currency crisis grew was followed by a brief spike above 2% before another long, elevated range and then another larger spike with the Russian default.

S&P 500 in 1998

The key is not to wait for Volatility to spike above 2%. By then it is normally too late. An alternative strategy would be to scale back positions when the market remains in an elevated range, between 1% and 2%, over several months. Many traders would argue that this is too early. But the signal does indicate elevated market risk and I am reasonably certain that investors with large positions would prefer to exit too early rather than too late.

So where are we now?

Volatility on the S&P 500 spiked up after an extended period below 1%. If Volatility retreats below 1% then the extended period of low market risk is likely to continue. If not, it will warn that market risk is elevated. Should that continue for more than a few weeks I would consider it time to start scaling back positions.

S&P 500 in 2018

Only if we see a further spike above 2% would I act with any urgency.

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Black Monday, October 1987

Cross-posted from Goldstocksforex.com:

What caused the Black Monday crash of 1987? Analysts are often unable to identify a single trigger or cause.

Sniper points to a sharp run-up in short-term interest rates in the 3 months prior to the crash.

3 Month Treasury Bill Rates

Valuations were also at extreme readings, with PEmax (price-earnings based on the highest earnings to-date) near 20, close to its Black Friday high from the crash of 1929.

S&P 500 PEmax 1919 - 1989

Often overlooked is the fact that the S&P 500 was testing resistance at its previous highs between 700 and 750 from the 1960s and 70s (chart from macrotrends).

S&P 500 1960 - 1990

A combination of these three factors may have been sufficient to tip the market into a dramatic reversal.

Are we facing a similar threat today?

Short-term rates are rising but at 40 basis points over the last 4 months, compared to 170 bp in 1987, there is not much cause for concern.

13-week T-Bill rates

PEmax, however, is now at a precipitous 26.8, second only to the Dotcom bubble of 1999/2000 and way above its October 1987 reading.

S&P 500 PEmax 1980 - 2017

While the index is in blue sky territory, with no resistance in sight, there is an important psychological barrier ahead at 3000.

S&P 500

Conclusion: This does not look like a repetition of 1987. But investors who ignore the extreme valuation warning may be surprised at how fast the market can reverse (as in 1987) from such extremes.

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How QE reversal will impact on financial markets

The Federal Reserve last year announced plans to shrink its balance sheet which had grown to $4.5 trillion under the quantitative easing (QE) program.

According to its June 2017 Normalization Plan, the Fed will scale back reinvestment at the rate of $10 billion per month and step this up every 3 months by a further $10 billion per month until it reaches a total of $50 billion per month in 2019. That means that $100 billion will be withheld in the first year and $200 billion each year thereafter.

How will this impact on financial markets? Here are a few clues.

First, from the Nikkei Asian Review on January 11:

The yield on the benchmark 10-year U.S. Treasury note shot to a 10-month high of 2.59% in London, before retreating later in the day and ending roughly unchanged in New York. Yields rise when bonds are sold.

The selling was sparked by reports that China may halt or slow down its purchases of U.S. Treasury holdings. China has the world’s largest foreign exchange reserves — holding $3.1 trillion, about 40% of which is in U.S. government notes, according to Brad Setser, senior fellow at the Council on Foreign Relations.

Chinese officials, as expected, denied the reports. But they would have to be pondering what to do with more than a trillion dollars of US Treasuries during a bond bear market.

Treasury yields are rising, with the 10-year yield breaking through resistance at 2.60%, signaling a primary up-trend.

On the quarterly chart, 10-year yields have broken clear of the long-term trend channel drawn at 2 standard deviations, warning of reversal of the three-decade-long secular trend. But final confirmation will only come from a breakout above 3.0%, completing a large double-bottom.

Withdrawal or a slow-down of US Treasury purchases by foreign buyers (let’s not call them investors – they have other motives) would cause the Dollar to weaken. The Dollar Index recently broke support at 91, signaling another primary decline.

The falling Dollar has created a bull market for gold which is likely to continue while interest rates are low.

US equities are likely to benefit from the falling Dollar. Domestic manufacturers can compete more effectively in both local and export markets, while the weaker Dollar will boost offshore earnings of multinationals.

The S&P 500 is headed for a test of its long-term target at 3000*.

Target: 1500 x 2 = 3000

Emerging market borrowers may also benefit from lower domestic servicing costs on Dollar-denominated loans.

Bridgewater CEO Ray Dalio at Davos:

We are in this Goldilocks period right now. Inflation isn’t a problem. Growth is good, everything is pretty good with a big jolt of stimulation coming from changes in tax laws…

If there is a downside, it is likely to be higher US inflation as employment surges and commodity prices rise. Which would force the Fed to raise interest rates faster than the market expects.

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Leading Index gives early warning

One of the better composite indicators in the US, the Leading Index from the Philadelphia Fed, points to a slow-down in the US economy. A dip below 1.0% is often early, as in July 2000 and May 2006, but serves as a reliable warning of an economic slow-down.

Leading Index for the United States

The Leading Index predicts the six-month growth rate of the Philadelphia Fed Coincident Index. In addition to the Coincident Index, it includes variables that lead the economy: housing permits (1 to 4 units), initial unemployment insurance claims, delivery times from the ISM manufacturing survey, and the interest rate spread between the 10-year Treasury bond and the 3-month Treasury bill.

The Coincident Index combines four indicators: nonfarm payroll employment, the unemployment rate, average hours worked in manufacturing and wages and salaries.

Coincident Index for the United States

The Leading Index signal does seem early. Low corporate bond spreads and VIX near record lows continue to indicate low market risk, typical of a bull market.

Corporate Bond Spreads and VIX

Monetary policy remains accomodative, with money stock growing at close to 5% p.a. (MZM = cash in circulation, travelers checks, money market funds and deposits with zero maturity).

MZM and Yield Differential

The yield curve has flattened, with the spread between 10-year and 3-month Treasuries falling to 1.0% on the above graph. That is what one would expect when the Fed hikes interest rates in a low inflation environment: short-term rates will rise faster than long-term rates. But a negative yield curve, where short-term rates are higher than long-term rates, is a reliable predictor of recessions in the US economy. Each time the yield differential on the above graph crossed below zero in the last 50 years, a recession has followed within 12 months.

Underlying inflation remains low, with average hourly earnings growth below 2.5% p.a., and the Fed should be careful about single-mindedly raising interest rates without considering the yield curve.

Annual Growth in Average Hourly Earnings

The bull market continues but investors need to keep a weather eye on interest rates and the yield curve.

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Should we Worry that Velocity of Money is plunging?

Some writers have attributed slow GDP growth in the US to the plunging velocity of money.

In layman’s terms, the velocity of money is the ratio between your bank balance and the amount you spend. For the economy as a whole, it is measured as the ratio of GDP (or national income) against the total stock of money (or money supply).

When the economy is hot, consumers have a higher propensity to spend — or invest in the latest hot stock — and the ratio normally rises. When the economy cools, the ratio falls.

If the ratio was fixed, the job of central bankers would be simple: print more money and GDP would rise.

M1 Money Supply and GDP Growth

Unfortunately that is not the case. GDP growth has remained slow, post-2007, despite a sharp boost in the money supply.

M1 is a narrow definition of money: cash in circulation plus travelers checks, demand deposits (at call) and check account balances.

The ratio of GDP to M1 money (or M1 Velocity) has almost halved, from a 2007 high of 10.7 to a current low of 5.5.

M1 Money Supply and GDP Growth

Does this mean that consumers are feverishly stuffing cash into mattresses as the economy goes into a death-dive or is there a more rational explanation?

Examine the above chart more closely and you will see a clear relationship until 1980 between the velocity of money and interest rates (in this case the Fed funds rate). When interest rates rise, the velocity of money rises. So when interest rates fall, as they have post-2007, to near zero, the velocity of money should fall. As it has done.

The anomaly is not the current fall in the velocity of money but the rise in velocity of money between 1990 and 2000, when interest rates were falling. There are two explanations that I can think of. One is the digital revolution, with the advent of online bank accounts and automated clearing of business checking accounts which enabled depositors to minimize balances in non-interest bearing accounts. Second, is the rapid growth of money market funds which fall outside the ambit of M1 and M2.

Velocity of money measured as GDP/MZM gives a clearer picture, with velocity rising when rates rise and falling when rates fall. MZM is M1 plus all savings deposits and money market funds that are redeemable (at par) on demand.

M1 Money Supply and GDP Growth

We should expect to see the velocity of money recover as interest rates rise. If that doesn’t happen, then it will be time to worry.

Strange as it may seem, we could witness something really unusual: if higher interest rates stimulate GDP.

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Fed flunks econ 101?

Caroline Baum’s opinion on the Fed’s approach to inflation:

For all the sturm und drang about the Fed debasing the dollar and sowing the seeds of the next great inflation, the public’s demand for money has increased. The increased desire to hold cash and checkable deposits has risen to meet the increased supply. Velocity, or the rate at which money turns over, has plummeted.

The Fed has two choices. It can adopt the Dr. Strangelove approach and learn to stop worrying and live with low inflation and low unemployment. Or it can do something about it, which runs counter to its stated intention to raise the funds rate and reduce the size of its balance sheet.

Option #1 involves learning to live with a low, stable inflation rate about 0.5 percentage point below the Fed’s explicit 2% target.

Not only has the Fed has achieved price stability in objective terms, but it has also fulfilled former Fed Chairman Alan Greenspan’s subjective definition of price stability: a rate of inflation low enough that it is not a factor in business or household decision-making.

Option #2 means taking some additional actions to increase the money supply by lowering interest rates or resuming bond purchases. The Fed is taking the opposite approach. It began its balance sheet normalization this month, allowing $10 billion of securities to mature each month and gradually increasing the amount every quarter. And it has guided markets to expect another 25-basis-point rate increase in December….

The Fed faces a delicate balancing act. Unemployment is low but capacity utilization is also low, indicating an absence of inflationary pressure.

Capacity Utilization

Janet Yellen understandably wants to normalize interest rates ahead of the next recession but she can afford to take her time. The economy is unlikely to tip into recession unless the Fed hikes rates too quickly, causing a monetary contraction.

I believe the Fed chair is relying on the outflow from more than $2 trillion of excess reserves held by banks on deposit with the Fed to offset the contractionary effect of any rate hikes.

Capacity Utilization

If pushed, the Fed could lower the interest rate paid on excess reserves in order to encourage banks to withdraw excess deposits. But so far this hasn’t been necessary. The attraction of higher interest rates in financial markets has been sufficient to encourage a steady outflow from excess reserves, keeping the monetary base (net of reserves) growing at a steady clip of close to 7.5% p.a. despite rate hikes so far.

Capacity Utilization

Makes you wonder why Donald Trump would even consider replacing the Fed chair when she is doing a great job of managing the recovery.

Source: Fed flunks econ 101: understanding inflation – MarketWatch

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Australia: Employment data points to recovery

Total hours worked grew at an annual rate of 2.7 percent in September, suggesting an up-turn in GDP growth after the 2011 to 2015 slump.

Australia: Hours Worked and GDP

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