A Global Beta Hedge with Alpha: Short Korean Won


In previous posts, I have laid out the late-cycle dynamics which could derail this global bull market, which seems to have been propelled by excess liquidity flowing from China, Japan and Europe.  Markets have bounced hard off recent lows, as the S & P 500 dropped as much as -10%, and tested its 200 day moving average.  There are few signs of weakness in the U.S. or global economy, which has fueled a self-perpetuating cycle of positive sentiment (see ’99 Redux ).  On top of the continued excess liquidity from global central banks, the recent tax cuts passed in the U.S. will provide near term stimulus as the budget deficits, which are already the highest since 2013 at 3.4% of GDP, are set to surge higher.  There has been no persistent inflationary pressures throughout this cycle, allowing central banks to provide liquidity at every sign of weakness, and to keep the spigots on at least partially during the mediocre growth that has prevailed.  With labor markets starting to tighten, and inflationary pressures rising, central banks’ friendly demeanor is unlikely to remain so friendly.


The recent selloff was quite overdue, given a run that had become excessively exuberant.  While possible that we have seen the highs, the strength and breadth of growth makes it just as likely that those highs will be tested (maybe bested!) after a period of consolidation.  The real key will be the action in interest rates and availability of liquidity (see The Only Thing to Fear is…Higher Rates? ).  So far, rates and expectations have remained extremely tame.  Which is why the recent sharp correction should be somewhat concerning to investors.  Rate sensitivity could be higher than in the past, because the duration of this business cycle has hinged on continued central bank liquidity.

A Global Hedge

Historically, the South Korean economy tends to be strongly cyclically linked to the global economy.  That makes the currency, the Won, a pretty efficient hedge against global risk off (the Won dropped -42% in the 2008 crisis).  That cyclicality alone makes it a good hedge, but present fundamentals are what make it stand out.


In a previous post, I introduced a fundamentally based indicator (F-FX) designed to project moves in currencies (see FX Dynamics Part 1: Dollar Weakness ).  Chart 1 shows the Korean Won vs. the U.S. Dollar (KRWUSD) normalized, along with the F-FX indicator. In line with previous charts provided, there is a strong tendency for the currency to move in the direction of the F-FX.  In April 2014, the F-FX registered a -73.  In the next 2 months, the Won  dropped  -11% relative to the dollar over the next 9 months.  Over the next year and a half, the Won depreciated around -20%.


Chart 1



Ideally, it is helpful to combine a fundamental view with some sort of positioning indicator.  Most FX positioning takes place in the forwards market, for which there is no comprehensive positioning measure (although many investment banks track as best they can).  As a proxy, I typically use CFTC futures positioning.  Unfortunately, for the Won, the futures trade so little that the CFTC does not bother to track positioning.  In this case, we need to rely more on economic data.



Economic Data for South Korea is Weakening

Chart 2 shows the Citi Economic Surprise Index. This index is a useful indicator to compare incoming economic data against expectations.  Positive numbers show that, in general, economic data is beating expectations, while negative numbers indicate most data is missing expectations.   The present level of -136 has improved a bit recently after dropping to the worst levels (and at the fastest rate) since 2008.  As shocking as this may be, caveats are in order.  The sharp drop came on the heels of the highest level since 2011.  Key to understanding the surprise index is that it is designed to measure deviations from consensus expectations (forecasts), not levels of growth.  Back in October, 2017,  Korean economic data was significantly better than expectations, leading to an upgrade of future forecasts.  Since then, forecasts have proven too optimistic for Korea on a level equal to 2008.  This does not mean a crisis is on the way – or even necessarily a recession.  However, it does mean that expectations for growth need to be downgraded. And expectations are what drive markets.


Chart 2


Source:  Citigroup and Bloomberg


A look at some recent South Korean economic data is concerning.  The last report of sequential quarterly GDP registered the first negative growth rate (4Q quarterly GDP dropped -0.2%) since 2008.  On a year over year basis, Industrial Production measured a drop of -6% for the month of December, and has been running at a negative rate since September.  Relative to strong global growth, this weakness stands out.


Interest Rate Differentials are Bearish

In previous posts concerning FX (see FX Dynamics Part 1: Dollar Weakness or FX Dynamics Part 2: Yen Strength ) I made no mention of interest rate differentials as driver of currency movement.  Since interest rates do often have a strong relationship with FX, some might find this odd.  My own research finds that correlations between interest rates and FX is quite variable.  Rates may lead, lag or move coincidentally with FX.  The dominant rate (duration) correlation will change as well.  Sometimes 10 year rates seem to drive currency movement.  At other times it may be the 2 year, or overnight rates with the highest correlation.  


None of this is to say that rates cannot provide some clues on FX movement, but they need to have corroboration from other data.  Chart 3 shows the 2 year interest rate differential between Korea and the U.S. (sovereign bonds).  Between the middle of 2014 until early 2016, the chart shows a strong correlation between the KRWUSD and 2 year rate differentials.  As Korean rates fell relative to the U.S., the Won depreciated in line.  Interestingly, in the year prior, a wide differential in favor of the Won had preceded a strong appreciation. Presently, the differential is heading in the opposite direction.  South Korean 2 year rates are now 10 basis points below the U.S.  The highest probability, given all the data, is that the KRWUSD converges toward the rate differential by depreciating over the next several months.


Chart 3


Source:  Bloomberg


Fundamentals for the Won are Negatively Aligned

The South Korean economy is highly cyclical, and typically correlated with global growth.  With exports accounting for 42% of GDP, versus the 28% global average (see World Bank data ), Korea is considered a global bellwether.  That presents an interesting conundrum given recent better global growth.  While South Korea initially participated in that acceleration, the recent divergence into economic weakness could be reason to doubt the resilience of global growth.  Or, it could simply be that the Korean Won is overvalued, and needs to depreciate.  Regardless, that represents an opportunity.


South Korea is a country with a high savings rate, which leads to perpetual current account surpluses.  Yet the current account has deteriorated in the last 12 months.  The Real Effective Exchange Rate, which accounts for inflation differentials versus trading partners over time, is in the 92nd percentile, indicating a significant overvaluation.  Interest rate differentials are not supportive for the Won, and are moving in the wrong direction.  Weakening domestic growth is also evident.  Putting all the pieces together, the Won looks like a good short here.  With recent market weakness, and the usual positive correlation the Won has with risk assets, a short KRWUSD position could also act as a good hedge;  a global beta hedge with positive alpha.

The Only Thing to Fear is…Higher Rates?

“The only thing we have to fear is fear itself.”

Franklin Delano Roosevelt

Purely Technical?

FDR’s first inauguration speech gave us the iconic quote above. Delivered in the midst of the Great Depression (1932),  he was referring to fear about the economy, but as all experienced investors know, the thought can just as easily be applied to financial markets.  Whether it’s an economic or market collapse, there is a truism inherent in the statement.  Panic is a necessary condition for such events. However, it is not sufficient.  Busts do not happen without booms, and market crashes only come after periods of extreme optimism.


In that vein, the nasty equity market correction we have experienced in the last week should not have come as a surprise.  Over the last year, the S & P 500 has barely had more than a 3% correction, with market volatility setting record lows.  By any technical measure, the market was severely overbought.  A simple check of the daily “Relative Strength Index” (RSI), which is a common “oscillator” type technical indicator, shows the extreme optimism.  The RSI runs between 0 and 100, with readings above 70 considered overbought, and below 30 being oversold.  The daily RSI for the S & P 500 (SPX) was above 70 for almost all of January, and reached 87 on January 26th, which is the highest level since 1971!


Bullish momentum such as this can lead to quick and scary corrections when they break.  The rapidity and severity of this correction (the SPX is down around -10% in 2 weeks) has led to worries that something worse could be in store.  As long as fundamentals are solid, and a recession isn’t set to occur for the next year, a -10% to -15% is usually as bad as it gets.  Both global and U.S. growth are the best we have seen in several years, which is supporting a general consensus that this is no more than a “healthy correction”.  That is likely an accurate depiction, but it is always worth asking the question of how, or why, the downturn may be than just a technical correction.


The Ebbing of Global Liquidity

Most market commentary  is focusing on the long duration of this business cycle, and the abnormal level of interest rates.  As everyone knows, we have had almost a decade of record low interest rates.  Exiting from these extraordinary monetary provisions is bound to cause anxiety in markets, as there is no historical precedent to provide insight.  To some extent, every business cycle suffers from uncertainty as the labor market tightens, inflation picks up, and the central bank is forced to raise rates.


The one thing missing from most market analysis has been an acknowledgement of the continued central bank liquidity that has been persistent over the last three years.  The Federal Reserve has been raising rates (at a glacial pace), but that has more than been offset by Europe, Japan and China.  Europe and Japan unleashed extraordinary measures at the beginning of 2015, with China stepping up in early 2016, as global growth began to falter (see Manna From Heaven ).  I continue to believe that the “coordinated global growth” that many have been touting to support a bullish thesis is, to a great extent, a function of coordinated QE.  If that is the case, removal of that liquidity would be problematic.  In that last decade, we have had no significant removal of global liquidity without economic growth weakening to worrying levels.


Detox is Painful

Chart 1 shows U.S. 5 year Treasury Inflation Protected Notes (TIPs) as a proxy for 5 year real interest rates.  Since inflation actually benefits debtors, tracking real rates gives a better view of how much rising interest rates are actually curbing liquidity. As can be seen, real 5 year interest rates have remained below zero for most of this cycle.  The few times it has risen above zero for any length of time, economic weakness followed.  Certainly, this time may be different.  It is possible enough economic momentum has been created that will allow real rates to rise above the levels that derailed growth previously in this cycle (around +50 basis points for the 5 year).


Chart 1

5 Year Real Interest Rates


Source:  Bloomberg


It is also important to note the trend in real interest rates for the last 20 years.  During the late 1990s, the economy was able to weather 4% real 5 year rates.  In the mid-2000s, that level was around 2.5%. Since the crisis, negative rates have been needed to keep the economy above water.  There may be several reasons for this, but the most relevant issue is the record level of debt.  Chart 2 shows the ratio of total nonfinancial debt to GDP for the United States going back to 1947.  In effect, the chart shows that the ratio of all U.S. nonfinancial debt has roughly doubled since the 1950s to approximately 2.5 times GDP.  Simplistically, that would imply the amount of GDP required to service debt has almost doubled in the last 60 years.  


Chart 2


However, the actual amount of debt service versus GDP depends on the level of interest rates, the distribution of debt among economic sectors, the distribution in terms of risk, and risk premiums.  As a general rule, corporate debt is considered most beneficial to an economy, because investments are geared toward generating long-term profits and growth.  On the other hand, household debt, which is used for consumption, is a more dangerous, because its generation provides no means for its repayment.  Government debt is often considered “risk free” (at least for developed countries), due to the ability of the federal government to tax (and yes, print money!) in order to ensure repayment.  However, government debt shares some of the characteristics of household debt in that it is not necessarily efficient, or self-sustaining.


Chart 3 shows U.S. debt to GDP ratios broken down by the major sectors (corporate, household, federal).  For greater clarity, Chart 3 only goes back to 1980, which was a watershed period for interest rates and debt generation.  The Federal Reserve Chairman in the early 1980s, Paul Volker, “broke the back” of inflation by hiking short-term rates to double-digit levels, and convincingly tightening monetary policy.  Yields on 10 year U.S. Treasuries reached almost 16% in 1980, before embarking on an epic bond bull market that saw yields go to 1.32% in 2016.


The descent of interest rates set off an equally epic trend in debt accumulation, with the most dramatic expansion of debt occurring in the household sector.  The origin of the mortgage bubble can be seen clearly in the move of household debt as a percentage of GDP from 67% in 2000 to a high of 97% in 2008 (red line).  As the crisis developed, mortgage defaults drove a cycle of debt deflation in the household sector that was almost completely offset by expansion of debt by the federal government (green line).  While many have criticized the record peacetime expansion of government debt, it is the primary reason we avoided another Great Depression.  That is, along with the unprecedented purchasing of government debt by the Federal Reserve known as quantitative easing (QE).


Chart 3



The upshot of this exercise is that household debt, while much lower than pre-crisis levels, is only back to where it was in 2002, which was a record at the time.  Chart 4 shows the U.S. Household Debt Service Ratio.  It is the percentage of household disposable income which must be used to pay interest on debt.  As optimistic analysts have highlighted, the ratio is close to a record low.  However,  it should be recognized that this low level is very much a function of record low interest rates.  Any substantial pick up in rates will lead to a rise in household debt service.


Chart 4



Furthermore, the debt service ratio does not measure the credit quality of loans being made.  It is well-known now that the mortgage crisis was worsened by a tendency to lower credit standards in order to keep loan growth going.  With the homeownership rate at 64.2%,  below its long-term average 66.5%, mortgage debt is unlikely to be an issue this cycle.  However, areas such as subprime auto loans (see New U.S. Subprime Boom ) and student loan debt (see Student Loans “Eerily Reminiscent” of Subprime Mortgages ) have been flagged as potential problem areas in the future.  While default rates are rising in these areas, most do not believe they portend the systemic level danger of subprime mortgages circa 2008.  That is a reasonable assessment, but I believe caution is still warranted.  There may not be a systemic crisis on the horizon, but that does not mean a reduction in liquidity (higher rates) will be a smooth ride for this economy.


A Shot Across the Bow

Ultimately, it could be argued that recent market volatility is nothing more than a technical correction.  Markets as overbought as U.S. equities were coming into February do not need a fundamental catalyst to trigger a correction.  Most analysts and strategists are touting strong economic fundamentals, and good corporate earnings as reasons to ignore the recent selloff, and stay the course.  Yet, a small minority has been warning of a 1987 style crash for some time, and not surprisingly, those warnings have become more strident with the recent selloff.  Before investors dismiss such warnings, they should be aware that the 1987 crashed occurred amidst considerably stronger economic fundamentals than what we have now.  The danger, as some have been noting, is in a collection of portfolio strategies (e.g. volatility targeting, risk parity) that could lead to self-reinforcing selling in a downturn (see “The Coming Crash Will Be Like 1987…But Worse” ).  Personally, I prefer to avoid hyperbole, but it would be foolish to not factor in such circumstances.


As I write, the market is bouncing hard off the lows of last week.  Having touched the 200 day moving average, which usually provides support in a bull market, the S & P 500 has ripped higher in the past few days.  In all likelihood, the market will consolidate here over the next few weeks, and fear will subside.  But interest rates have barely moved to what should be considered restrictive levels.  With 10 year treasury yields at only 2.85%, we just witnessed some vicious volatility.  Businesses are warning of inflationary pressures rising.  Average hourly earnings just registered a 2.9% YoY rise, the highest of the cycle.  With inflation finally starting to rear its ugly head, the one thing that has kept this cycle going (i.e. endless central bank liquidity) is now in danger of disappearing.  So far, global central banks continue to be very accommodative.  That is unlikely to continue.  When liquidity really starts to get drained is when investors should start to get seriously cautious.  The warning shot has been fired.





FX Dynamics Part 2: Yen Strength

As I began writing this post yesterday, equity markets once again decided to remind us that they can go down as well as up.  Previous posts have noted the rising danger in the fundamental picture via rising inflation, and the potential for higher rates (see ’99 Redux ).  Yesterday’s fireworks should be a wake up call as to how sensitive markets may be to higher rates.  I hope to give an update on that soon, but for now, I want to continue with some thoughts on FX.


The Dollar Moves Everything

Over the past year, the U.S. dollar (DXY index) has had a drop of about -13%.  In a world where Bitcoin is the most talked about market entity, and is moving more than 10% in a day (see Bitcoin’s Greater Fools ), such a move does not grab investors’ attention.  But movements in the U.S. dollar can have profound effects, or at times, may be indicative of important events happening under the hood of the global economy.  As the world’s premier reserve currency, most trade takes place in dollars, commodities are priced in dollars, and more debt is owed in dollars than any other currency.  Therefore, moves of 10% or more in the U.S. dollar are quite meaningful.  A weaker dollar tends to indicate better global liquidity, and often coincides with better performing global risk assets.  For U.S. equity markets, large multi-national American companies get a boost from earnings when the dollar is weaker.


As outlined previously (see FX Dynamics Part 1: Dollar Weakness ), the majority of the dollar weakness has been driven by the Euro.  On the other hand, the Japanese Yen, which is the second largest weighting in the DXY, has only strengthened about +6% since the beginning of last year, versus over +20% for the Euro.  This differential is not a huge surprise in light of the extremely positive environment for risk assets.  The Yen tends to perform best when markets get hairy.  When global markets are buoyant, the Yen may be falling, or have no particular correlation.  But when fear is in the air, and markets are dropping significantly, and persistently, the Yen virtually always rallies.


Yen as Safe Haven

Market correlations vary over time, as fundamental relationships change, and market positioning shifts.  Generally, the inverse relationship between the Yen and global risk assets in major risk-off episodes has endured for well over a decade.  It is possible that the extraordinary monetary stimulus the Bank of Japan (BOJ) may have changed the previous correlation.  However, we have not had a major selloff in global markets since the precipitous drop in August of 2015, which carried over into early 2016.  At that time, the Yen, contrary to previous risk-off periods, remained somewhat steady during the initial sell off on global markets, then appreciated around +20% as heavy short positions were squeezed.  The lag in the move was somewhat abnormal. Normally, in similar episodes, the Yen would have moved simultaneously with a market sell off.  It’s quite likely that market participants initially believed the enormous stimulus provided by the BOJ would continue to keep the Yen weak.


I think it’s important to address the reasons the Yen usually appreciates during global sell offs.  At times, the Yen is described as a “safe haven” currency, which I believe is a bit of a misnomer.  For twenty years, the Japanese economy has been a basket case.  Following the incredible bubble Japan experienced in the late 1980’s, they have experienced decades of deflation.  Much of the deflation is a secular phenomenon driven by a horrible demographic profile.  Japan’s working age population (ages 15 to 64) has been falling since 1993.  Working age population has collapsed from almost 70% to around 59%.  Absent increasing productivity, this leads to a lower trend economic growth rate.  Lower trend growth has made it more difficult to service extremely high debt loads that accumulated during the bubble.  This situation is known as “debt deflation” (see Debt Deflation ).  It was prevalent in the Great Depression, and is the nightmare of every central banker.


Another element of Japan’s economy which exacerbates its debt deflation is that Japan, like most Asian countries, has a high rate of savings.  Higher savings rates, while providing an economic cushion, lower near-term growth.  Decades of weak domestic demand is evident in excess savings, which goes hand in hand with current account surpluses, and has led to Japan owning an enormous amount of foreign assets.  In effect, this is the key to the Yen’s inverse relationship to risk assets during market panics.  During global risk-off episodes, many Japanese investors will sell foreign assets, and repatriate funds back to Japan.  Or, those that do not sell may hedge their currency exposure.  Either way, buying pressure is exerted on the Yen;  which explains why it typically appreciates during global panics.


A Timely Macro Hedge

In my previous post, I introduced a fundamental indicator, the F-FX, which is designed to signal whether a currency is expensive or cheap (see FX Dynamics Part 1: Dollar Weakness ).  Chart 1 shows the Yen (vs. U.S. Dollar) normalized against the F-FX indicator.  Similar to charts of the Euro and DXY shown in the previous post, the two series tend to move inversely.  When the F-FX is relatively high (say +50), the currency is poised for appreciation, while low readings presage depreciation.  Prior to the market turmoil in the last few days, there has not been a period of extraordinary volatility since late summer 2015 through early 2016.  As noted previously, the Yen remained somewhat depressed initially, during that period as traders/investors continued to believe the record liquidity provided by the BOJ would keep the Yen depressed.  However, as the F-FX indicates, the market was leaning very heavily against real economic factors that were exerting bullish pressure on the currency.


Chart 1



Chart 2 shows the technical picture for the Yen in terms of positioning using Yen futures data from the CFTC.  Using net speculators as a percentage of open interest as a positioning proxy, we can see that prior to the strong rally in the Yen in 2016, positioning was quite bearish.  Net speculator positions registered -40% of open interest while the F-FX indicator was at 94.  That combination of bearish positioning and strong fundamentals subsequently led to a Yen rally of almost +20% over the next six months!

Chart 2



Present positioning and fundamentals are not as strong as they were at the beginning of 2016.  Nevertheless, they indicate a meaningful bias toward Yen appreciation.  Net specs are -37% of open interest, which is a somewhat crowded position.  Coincidentally, the F-FX is at +37, the mirror image of net specs.  While not an extremely positive reading, it is down from 69 in November. Often, once the trend shifts for both net specs and F-FX, they move to the opposite extremes.  Assuming global markets stabilize in the next few days (or weeks), any Yen appreciation may be somewhat slow.  But given the normal reaction of the Yen to global market panic, a long Yen position could act as an effective macro market hedge.  Whether in the next few days, weeks, or months,  that may come in handy.

FX Dynamics Part 1: Dollar Weakness

Strong Dollar Policy?

This past week in Davos, at the World Economic Forum, the U.S. Treasury Secretary Steve Mnuchin, remarked that the recently weak dollar has been good for the economy.  As the U.S. dollar dropped the most in almost a year, verbal daggers began to fly. Mnuchin was attacked for apparently abandoning the “strong dollar mantra” to which previous Treasury Secretaries adhered.  Commerce Secretary Wilbur Ross, directly refuted the notion that the U.S. is abandoning the “strong dollar policy”.  President Trump, despite comments during the election calling the dollar “overvalued”, stated that good economic fundamentals would cause the dollar to get “stronger and stronger”. Former Treasury Secretary Larry Summers felt compelled to write an op-ed piece in order to call Mnuchin out for his blasphemy (see Mnuchin fails on style and substance ).  Some of the criticism from Summers is well-founded.  Summers advised Mnuchin to say as little as possible about markets, which all politicians, and their appointed officials, would do well to heed. His admonitions about the ill effects of a weak currency, and markets’ tendency to overreact to official statements, are on the money as well.


In reality, this is all nothing but noise.  Statements by the Treasury Secretary, the President, or any other official, that we have an official “strong dollar” policy has no bearing on whether our policies are actually fostering a stronger dollar.  Besides that, most of the fundamentals which drive currencies cannot be directly affected by these officials.  Technically speaking, the value of the dollar falls within the purview of the U.S. Treasury.  It is the agency which intervenes in currency markets, when such intervention takes place.  But the treasury has not intervened since 2000 (see Treasury FX Intervention ), when it purchased Euros (sold U.S. dollars) to stabilize the European single currency after a sharp drop.  Intervention notwithstanding,  virtually nothing in the treasury’s normal operations affects the fundamental drivers which determine the value of the U.S. dollar.


Fundamental Drivers

The theoretical cornerstone for currency analysis has historically relied on the concept of Purchasing Power Parity (see PPP ).  There are two versions of the theory:  absolute; and relative.  Absolute PPP holds that a basket of goods should cost the same no matter in what country it is sold, or currency in which it is priced.  In effect, arbitrage should cause currency cross-rates to converge to levels where arbitrage is no longer possible.  In the real world, to the extent this theory holds, it’s over very long time horizons.  Furthermore, analysis is heavily complicated due to tariffs, quotas, various transaction costs, and the fact that many services cannot be exported. Relative PPP promotes the idea that inflation differentials over time should be reflected in the FX rate.  For example, if country A has an inflation rate 5% higher than country B, country A should see it’s currency depreciate -5% relative to country B.  Within the concept of Relative PPP, we have the Real Effective Exchange Rate, which is a measure of a currency adjusting for inflation over time ( REER ).  While the relative version of PPP seems to hold better than absolute, it still suffers from very long lags.  History not only shows that currencies can deviate substantially (+20% or more) from PPP estimations, but also, a trend from overvaluation to undervaluation (or vice versa) often occurs over a period of a decade or more.


In addition to PPP, various theoretical models have been developed to explain exchange rate dynamics.  Generally, these models focus on estimating some level at which fundamental forces are in balance.  The macroeconomic-balance approach favored by the International Monetary Fund seeks to find a rate that equalizes a normal savings/investment balance in a country  with its current account balance.  Generally speaking, this is a good approach for the long-term.


The current account is the measure of net trade plus net factor income.  The balance of payments (see BOP ) equation in economics requires that the current account be directly offset by the capital account (adjusting for statistical discrepancy).  To simplify, the current account can be thought of as a measurement of income flows, while the capital account measures the investments which create the financial portion income flows (non-trade related). Since it is an accounting identity, it must hold.  For example, a current account surplus (money flows in) must be offset by a capital account deficit (money flows out).  By the same token, a current account deficit requires a capital account surplus.  For anyone seeking to anticipate FX movements, it’s important to realize that the cause/effect relationship can flow in either direction.  Exchange rate movements can be dominated by either the current account (mostly trade flows), or the capital account (investment flows) in any given period. A basic understanding of these forces is a good starting point to developing a method to forecast FX rates.


An Empirical Indicator Approach

Utilizing the theoretical insights outlined above, I have developed an indicator based on 10 different fundamental metrics.  The metrics utilized include several balance of payment data series (scaled by GDP), along with Terms of Trade, International Reserves, and the Real Effective Exchange Rate.  Terms of Trade is defined as the ratio of export prices to import prices.  For ease of measurement, commodity prices are generally used, since those prices are easily observed.   As previously noted, the Real Effective Exchange Rate (REER) is derived from the theory of Relative PPP, and seeks to measure the cumulative changes in the FX rate (nominal rate) against its inflation differentials averaged across a trade-weighted basket of major currencies.  For example, a high REER would mean that a currency has not depreciated in line with a higher rate of inflation relative to other countries.  International reserves is straightforward.  A large amount of foreign currency reserves acts as a buffer against depreciation, since it would allow for  intervention if necessary.


It’s important to note that some countries will always have a tendency to run either a current account surplus or deficit.  While a CA deficit (surplus) would normally be associated with currency weakness (strength), this may not necessarily be the case.  The macroeconomic-balance approach dictates that there needs to be a long-term equilibrium between the current account and a country’s “normal” savings/investment balance.  Some countries, because of demographics, culture, or other reasons, will always run current account surpluses, due to a persistent excess of savings. Others typically run current account deficits caused by a dearth of savings.  Neither of these situations, if in balance, will necessarily prompt exchange rate movement.  Therefore, in constructing my indicator, I rely on levels and rates of change relative to history, rather than directly on the metrics themselves.


Chart 1 shows the U.S. dollar (DXY Index) versus my “Fundamental FX” indicator (F-FX).  The F- FX runs between +100 and -100 (right axis), with more positive numbers being bullish, and negative numbers bearish.  While not perfect (no indicator is), for almost all of the 32 currencies I follow, there is a strong positive correlation between the level of F-FX and currency movement over the next 6 to 12 months.  This time frame bridges the gap between the very long-term nature of many fundamental models and shorter-term approaches, which tend to focus on technical analysis, or attempting to guess the timing of central bank policy changes, and their effect on interest rate differentials.


As can be seen from Chart 1, entering into 2017, the U.S. dollar F-FX indicator was below -50 on its way to -82 in March.  This negative trend was led by weakening trade deficits, but more substantially, a real exchange rate in the 98th percentile for the last 10 years.  Subsequently, the DXY fell -11% (102 to 91) from March to September.  This happened despite the fact that the U.S. was the only major country where the central bank was tightening monetary policy.


Chart 1

U.S. Dollar (DXY) vs. F-FX IndicatorDXYffx


Certainly, shifts in monetary policy are a common catalyst for FX inflection points.  In this era of unprecedented monetary policy, timing and anticipating moves may be more difficult than in the past.  However, an understanding of the fundamental catalysts to currency moves can often presage central bank policy shifts.  Chart 2 shows the Euro vs. its own F-FX indicator.  It illustrates the same inverse relationship as seen in the DXY in real-time (with a positive correlation between F-FX and 6 to 12 forward moves in the currency).  The reader may also notice that both the Euro and its F-FX show a strong inverse relationship to the DXY and its fundamental metric (the 2 charts are almost mirror images).  This isn’t surprising given that the Euro makes up about 57% of the DXY index.  The inverse relationship between the two fundamental indicators acts as further confirmation of the efficacy of the indicator.




Chart 2

Euro vs. F-FX Indicator


An interesting element illustrated in Chart 2 is the price action of the Euro from late 2015 through 2016.  The European Central Bank (ECB) embarked on a massive Quantitative Easing (QE) program, along with negative interest rates, in an unprecedented move to stimulate the European economy.  The F-FX indicator showed modestly negative fundamentals prior to this, but the massive depreciation in the Euro shifted fundamentals sharply positive by the time the Euro had dropped around -20% to around the 1.10 level.  By that time, market sentiment had moved to an uber bearish zone.  It seemed to many that the Euro was definitely going to 1.00 or lower.  And yet, despite what could be the most aggressive monetary policy in history, which would usually be bearish for the currency, the Euro could not go lower than about 1.03.  At that level, real economic forces, such as a +3% current account surplus (as a percentage of GDP), were completely nullifying speculative flows (a current account surplus requires an equal outflow of capital absent currency intervention).


As I have noted in previous posts, combining fundamental analysis with positioning can help investors anticipate significant market inflection points (see ’99 Redux ).  Chart 3 shows the Euro vs. CME Net Speculators positions as a percentage of open interest.  It’s pretty obvious from the chart, that large net long spec positions typically precede depreciation, while large net short positioning indicates higher potential for a rally.  When periods of extreme positioning coincide with fundamentals applying pressure in the opposite direction, powerful FX moves usually ensue.


Chart 3

Euro vs. Futures Net Speculators as a Percentage of Open Interest


Source:  CFTC and Bloomberg


Prior to the strong move higher in the Euro last year, the percentage of net specs in Euro futures was hovering around -30% of open interest.  As the global economy accelerated in late 2016, with Eurozone growth improving to the highest level since 2010 over the last year, the table was set for rapid Euro appreciation, as shorts got squeezed, and capital flowed into Euro-denominated assets.  The Euro is now up about +21% since the beginning of last year.  Interestingly, based on the F-FX indicator (+10 for the Eurozone), that huge move has only gotten the Euro close to a neutral reading.  And the ECB has yet to begin normalizing policy.  Although, the case could be made that much of the move in the Euro was in anticipation of that normalization, actual tightening of monetary policy by the ECB could still power the Euro higher from here, taking it to an overvalued level.


Ignore the Noise

Talk about a “strong dollar” policy, or any other such political noise, certainly has the potential to move FX markets.  But investors are better served by keeping their eyes on fundamentals and positioning.  The U.S. dollar (DXY index) has dropped almost -15% since the beginning of last year.  Currency fundamentals and FX positioning did a good job of signaling this move.  In all likelihood, most of the dollar depreciation is probably behind us in the short-run, as the dollar is heavily oversold .  So far, dollar depreciation has been dominated by the Euro.  The next biggest weightings in the DXY are the Japanese Yen (13.6%) and the British Pound (11.9%).  The pound has had a similar appreciation to the Euro (relative to the U.S. dollar), but the Yen has lagged.  This last year’s dollar weakness has occurred in a strong risk-on environment.  My next piece will focus on FX dynamics in a risk-off environment.  Historically, in such an environment, the Yen is king.








Needless D.C. Drama

Cycle of Dysfunction

Polls measuring approval for congress have been running in the mid-teens in the last few years.  Only about one out of every six people think congress is doing a good job, which is a pretty pitiful statistic. Based on readily available information, one must wonder if those who believe congress is performing well actually have televisions, or read newspapers.  Case in point, as I write, congress is continuing its tradition of failing to pass a budget to fund the federal government, having shut down the government over the weekend, only to pass a continuing resolution (CR), to reopen on Monday.


On this past Friday, a failure to pass yet another CR, caused the U.S. government to shutdown for the fourth time since 1995.  Both Republicans and Democrats, as is always the case, pointed fingers of blame to the other side.  We can debate the specific reason for this shutdown (Democrats wanted a deal to protect DACA recipients from deportation), and whether that is a good reason, but that is not where I wish to focus.  Shutting down the government is a very unique American event that need never occur.  Many countries of lesser stature have weathered civil wars, coups, and all manner of chaos, without shuttering the government, and failing to pay employees.  Rather than dwell on the specifics of the partisan bickering, which are endless, maybe we should look for simpler solutions.


There are two similar, but unrelated, issues that often get confused:  government shutdowns due to the inability of congress to pass a budget; and breaching of the statutory debt limit.  The failure of congress to pass a budget for a new fiscal year (which runs from Oct. 1 to Sept. 30 of the following year) means that the government cannot legally spend money.  By law, it must be “appropriated” first.  When this happens, congress will usually pass a CR, in order to keep the government running.  If not, there is a shutdown of government operations considered “discretionary”, while “mandatory spending” continues (which primarily consists of transfer payments such as Social Security).   The debt ceiling issue refers to an absolute dollar limit on the amount that the federal government can borrow.  Periodically, when the debt limit is about to be breached, it either has to be raised, or serious problems may ensue (e.g. U.S. debt default and global financial turmoil).  Fortunately, in most cases, the ceiling is raised on a bipartisan basis, with no issues.  However, it doesn’t always go smoothly.  With projections that the debt ceiling will be reached again in March, and partisan polarization on full display with the budget impasse, we could be in for more fireworks in coming months.


The Debt Ceiling is Arbitrary

Since 1962, congress has voted to raise the debt ceiling 74 times, for an average of 1.32 times per year (see History of the U.S. Debt Ceiling ) This factoid should lead to an obvious question:  why do we have a debt ceiling at all?  If it is simply going to be raised once or twice a year, then what is the point?  Conventional reasoning that it provides a check on government debt is belied by the both the ease with which it is raised (under normal circumstances), and our debt levels relative to other countries.


Only seven countries in the world have debt limits. Out of those, the only developed countries are the U.S. and Denmark (see Countries with Debt Limits ).  Denmark has never been anywhere close to breaching its limit.  Therefore, the U.S., like our budget shutdowns, is alone among developed countries in having to deal with a ceiling on our debt.


There are a couple of elements involved here worth noting.  The first is the fact that the ceiling is a specific dollar amount, that does not automatically increase through time.  This makes the limit completely arbitrary.  Any limitation on government debt should be based on the country’s ability to repay.  Because of both natural real economic growth (driven by growth in productivity and population), and inflation, the economy is constantly growing over time (measured as nominal Gross Domestic Product).  Since government debt will typically grow in line with the economy, a debt ceiling will always eventually be reached.  Therefore, unless there is a specific goal to reduce the debt as a percentage of GDP, the debt ceiling serves no purpose.


Furthermore, evidence shows that a debt ceiling does nothing to actually limit debt.  If it had any effect, the U.S. should be running lower debt levels as a percentage of GDP relative to other developed countries. But that is not the case (see List of Countries by Debt ).  Based on International Monetary Fund data, only 9 countries have “net government debt as a percentage of GDP” higher than the U.S., which is currently at 87.8%.  Among those where the data are available, 85 countries have lower debt.  Once again, to stress the relevance of these data, only 1 developed country in that group (Denmark) has a statutory debt limit.

A Couple of Easy Solutions

Every American, as they witness these recurring episodes of drama surrounding U.S. Federal Government finances, should be appalled.  Partisan bickering is often completely divorced from any ideological principles. That is, allegiance to party lacks a philosophical underpinning.  Other times, a small minority in one party dictates the course of events against what the majority of legislators (or Americans) would support.  In actuality, none of this is new.  Democracy has always been a messy business, and politics has always been dirty, but today’s political arena seems to have decayed beyond anything we have seen in modern times.


While calls for bipartisanship may seem futile, with a small amount of cooperation, events such as government shutdowns, and debt ceiling fights, could become a thing of the past.  We already have a mechanism for continuing government functions in absence of a budget being passed: the CR.  Continuing resolutions could be a logical framework for preventing government shutdowns.  Amending previous budget legislation to provide for an automatic CR in the event of a failure of congress to pass a budget could make government shutdowns a thing of the past.  Government would continue to run with appropriations based on the previous year’s budget.  This should not be too controversial.  Apparently, it has been proposed before, but for some reason, lacked support (see Legislation for Automatic CR )


Concerning the debt ceiling, there has already been some movement in the direction I would propose.  In September of last year, President Trump met with Chuck Schumer and Nancy Pelosi, Democratic leaders of the Senate and House respectively.  In that meeting, there was a “gentleman’s agreement” (according to anonymous sources) to discuss a repeal of the debt ceiling (see Trump, Schumer agree to pursue plan to repeal the debt ceiling ).  As far as I know, this is the first time such a proposal has been made at the leadership level.  However, Republicans in congress have balked at the notion of repeal, with the usual arguments about removing budget discipline.  As I have already noted, there is no evidence that a debt ceiling has any positive effect on the nation’s debt level.


Addicted to Brinkmanship

Politicians almost universally express distaste for shutdowns, and yet, they continue to happen.  The reason why is pretty straightforward.  Many politicians see these events as opportunities to force policies that otherwise may fall by the wayside.  More importantly, as disgusted as the voting public is by such incidents, legislators do not seem to be hurt at the polls (see Why Can’t We Avoid Government Shutdowns? ).


Despite the fact that almost everyone believes this is a horrible way for our nation’s legislators to conduct business, it persists. It persists in a large part due to the extreme partisan polarization in the country.  There are many reasons for this.  In the broadest sense, the statement that there are “Two Americas” is generally correct.  Certainly, there is a broad spectrum of cultural predilections (defined by socioeconomic circumstances, racial and religious views) represented around the country. But regardless, rural areas tend to lean strongly Republican, and urban areas toward Democrats, creating a sharp political divide down the middle.  Strengthening this divide is the modern media structure, which allows individuals to choose news sources that cater to their world-view; reinforcing those views.  Social media, particularly Facebook, works in tandem with classic media in the same way by promoting news stories similar to ones the user normally reads.  The end effect is that views opposed to predetermined beliefs have virtually no chance of being heard, much less considered.


While the media solidifies existing beliefs, cementing natural divisions, gerrymandering helps hardcode that divide into the U.S. House of Representatives.  Gerrymandering is the act of the party in power drawing congressional districts in a way that favors their own party.  Since congressional districts are usually drawn by state legislatures, states that lean toward a particular party tend to magnify their ideological slant in the U.S. Congress.  Both parties through the years have utilized the strategy. But, for the first time, earlier this month in North Carolina, we have seen a federal court strike down an election map as unconstitutional (see Has the Tide Turned Against Partisan Gerrymandering? ).  We should all hope, for the sake of moving toward a fairer, and more transparent political system, that this trend holds.


Given the above-mentioned conditions, it’s easy to see why a significant number of congressional districts are slam dunks for a particular party.  Since the most heavily partisan voters are more likely to vote in party primaries, and the most fervent party supporters are more likely to skew strongly to the right (Republican) or left (Democrat), a larger portion of legislators than is representative of the population hold extreme views.  For such legislators, taking uncompromising positions is a point of pride, as well as, a necessity to get reelected.  Shutting down the government, even if it doesn’t accomplish the stated goal, allows a politician to congeal support from the hardline partisan voters who are most likely to show up at the polls.



Gallop polls show that Independent voters are almost as large as registered Republicans and Democrats combined (see Party Affiliation ).   Despite today’s more pronounced delineation among voters along party lines, most of the moderates in both parties are open to pragmatic compromise.  If you add moderate Republicans and Democrats to Independents, you easily have over half of the voting populace.  This group is what I would call the “Real Silent Majority”.  I believe this is the group that is most disturbed by continuing legislative dysfunction, as those on the extreme left and right aggressively promote an agenda outside the mainstream.


The existence of a debt ceiling, and the necessity to pass an annual budget do nothing for our country besides offering opportunities for brinkmanship.  Rather than allowing certain politicians to exploit these tense situations, our leaders should simply remove the temptation by enacting some simple legislative changes.  Such changes are long overdue.  If those changes fail to come about, those of us in the “Real Silent Majority”, the political middle, should all contact our representatives.





’99 Redux

Perception Trumps Reality

I awoke on Tuesday this week to Bloomberg’s “Daybreak” app proclaiming that Dow futures were poised to open above 26,000 for the first time.  They expanded on that by stating that this was the fastest 1000 point rise in history!  Immediately, I flashed back to 1999, when I was a young, green buck on the trading floor, and CNBC had made a similar claim that the Dow Industrials Index had just completed its fastest 1000 point rise from 10,000 to 11,000.  CNBC then went on to tell the audience that the slowest rise occurred on the move to the 1000 level.  Yeah, they really did that.  So, in incidents separated by 20 years, two of the most watched financial news outlets have reflected a lack of understanding of basic math (i.e. how percentages work).  Or, maybe they are just catering to the average investor, which they assume lacks such knowledge.  Either way, it is somewhat depressing for investment professionals attempting to perform any robust analysis.  In the short-term, it is often meaningless, as many market participants react to noise.


For institutional investors, it is not news that many in the financial media, along with most average investors, are financially (and mathematically) illiterate.  Much of the time, it is of no real consequence.  Occasionally though, when markets become particularly ebullient, investors’ credulity becomes paramount. John Maynard Keynes famously remarked on the persistence of irrationality in the markets.  But I must disagree with his assessment.  It’s not that investors are necessarily irrational, it’s just that they don’t know any better.  On a recent trip to my home state of South Carolina, I conversed with an octogenarian uncle about the markets.  As I attempted to explain that much of the recent upswing in the global economy, and the markets, has been driven by massive new injections of quantitative easing by Europe, Japan and China, with the GOP tax cut as kicker, I was met with this simple logic:  “But my investment account is going higher, and I see that as a good thing.”  Well, who can argue with that!  Honestly, I cannot call it irrational.  It is inherently rational.  Investors’ “reptilian brains” guide them toward such lines of thinking.  And for now, it is working.  Unfortunately, history tells us that when the retail investor is in this frame of mind, it’s time to get cautious.


While novice investors simply sense an immediate betterment in economic conditions, and feel compelled to buy in, those of us tasked with providing professional analysis seek to parse the data understand the reasons why.   Don’t get me wrong, as a trader, I often simply bought into momentum without spending an excessive amount of time “thinking”.  Certainly, I would have never survived Wall Street in the late ’90’s otherwise.  But for me, determining the why was always a primary motivation.  If you don’t understand the reasons markets are moving, anticipating the next chain of events is impossible.


Prior to coming to New York in 1998, I was listening to a recruiter for a job as an investment advisor at a major investment firm.  The speaker described a fellow advisor in the following terms:  “Her clients love her!  She probably pulls down $1 million a year.  And honestly, I don’t think she even knows what a mutual fund is.”  I wonder if her clients still loved her in 2002?  Or 2008?  The point being, it’s easy to promote passive investing, which is in vogue now, when markets are marching higher.  Professionals concerned about the drive toward passive investing should keep this in mind.  Worries about passive investing are likely a contrarian signal (albeit early).


Just Follow the Money

Countless market prognosticators have been made to look foolish over the last year for being overly bearish.  Underinvested fund managers are feeling heat as well.  Initially, market valuations have been touted as the primary reason for caution.  More recently, excessive exuberance indicated by relentlessly bullish price action has been the primary call for worry.  Central banks have pulled skeptical investors kicking and screaming into the market over the last several years.  Our recent experience could be described as a “Perverted Goldilocks” situation where economic weakness leads to more QE, which drives markets higher.  Economic strength then leads to central banks curtailing liquidity, which causes economic and market weakness, but not too much, because overall liquidity still remains fairly abundent.  Yet, the weakness is enough to once again bring the central banks back to injecting liquidity.  Round and round we go.


Markets definitely seem to think this time is different from periods of strength experienced in recent years.  It could be that a global synchronization of growth is adding to optimism by providing a stronger sense of fundamental solidity.  Regardless, I continue to believe that the primary impetus to the past year’s strength has been unabating global monetary stimulus (see Manna From Heaven ).  Additionally, the GOP tax plan, which U.S. investors clung to for hope through weaker economic data early last year, came through with a bang right before Christmas.  I have already addressed the dubious nature of the economic impact from the tax plan (see Candy and Liquor for X-mas ), but much of that is a long-term story.  In the short-run, a massive tax cut for corporations incrementally increases profits (+10% has been the general consensus).  Given high equity valuations, it is reasonable to believe that the market has “priced in” the tax cuts already.  But I believe that sort of fundamental view is irrelevant under present circumstances.


A short-term jolt to the economy through deficit spending, as well as, a sharp increase in inflow to corporate coffers is having the immediate effect of juicing market momentum.  The man on the street is seeing his 401K appreciating, and will get $1000 (on average)  extra in his paycheck over the next year.  To quote my uncle, “I see that as a good thing”.  Never mind whether we have the fundamental backdrop for sustainable strong growth.  Who cares if equities are expensive relative to history.  Does it matter for now if increases in bonuses by large corporations are a one-off, done only for PR purposes?  “Average Joe” is feeling good, and looking to dance.  Right now, that’s all that matters.


Blow Off Time

Wall Street is replete with trading indicators.  On a standalone basis, many are typically useless.  However, my experience has been that technical indicators, properly constructed, can be quite powerful if employed in conjunction with an understanding of the fundamentals.  By properly constructed, I mean an indicator should not be a product of statistical overfitting (i.e. the indicator only works on the specific data used to create it).  A classic example of such an indicator is the “Hindenburg Omen” ( Hindenburg Omen ), which sought to predict crashes.  My guess is that almost any indicator designed to predict crashes will eventually fail for this reason, because crashes are quite rare.  Furthermore, in our age of extraordinary monetary intervention, bearish indicator signals are much more likely to fail.


With the above caveat in mind, Chart 1 shows the spread between “AAII Bulls” and “AAII Bears”, which is constructed using a survey from The American Association of Individual Investors ( AAII ).  While this indicator can at times do a pretty good job of calling short-term equity market turns, it is shown here mostly for illustrative purposes.  As the chart illustrates, individual investors recently became the most bullish they have been since late 2010.  That is a pretty shocking detail.  Also, it’s likely not a coincidence that the 2010 reading came 2 months after the Fed implemented QE2.


Chart 1


While such a spike in the Bull/Bear spread usually presages at least a minor market correction (worse than -5%) within the next couple of months, it is probaly unwise to be too negative given other factors.  For instance, Chart 2 adds nuance by showing “AAII Neutral Investors”, along with a 52 week moving average (red line).  Notice that for the past several years,  the 52 week moving average has remained above the highs of the previous cycle, showing extraordinary uncertainty.  However, recently there has been a sharp drop in Neutrals to around 24%, which has been a floor for the past few years, as uncertainty has remained stubbornly high.  A further move down in neutral investors, along with an increase of the Bull/Bear spread would provide a pretty good contrarian signal, as it would show investors were moving “all in”.  But we’re not there yet.


Chart 2


Ultimately, the purpose of looking at sentiment surveys is to attempt to discern what I believe is the most important part of predicting market turns:  positioning.  Economic and corporate fundamentals provide the baseline levels for what equity market returns are likely to be, but it’s the fundamentals relative to positioning that determines market direction, and the rapidity of moves.  Sadly, it is virtually impossible to get a full picture of overall investor positioning.  Ideally, what we would like is a comprehensive view of the allocation among all asset classes for all investors.  Instead, we must rely on various surveys to provide us with a rather murky view.  At best, it’s like trying to discern the picture from a jigsaw puzzle with half or more of the pieces missing.


The AAII survey provides a decent picture for individual investors, but it’s a pretty crude device.  For measuring sentiment among institutional investors, one of the best resources is the Bank of America Merrill Lynch Fund Manager Survey ( BAML FMS ).  It provides a pretty comprehensive view of major asset classes, with much more detail than can be found in any survey for individual investors.  The most recent survey shows that the professional herd has shifted sharply from rather cautious views in recent years.  Cash levels sit at 5 year lows of 4.4%.  A majority of fund managers (55%) are now overweight equities.  Hedge funds now have their highest net long position (49%) since 2006.  And most fund managers now see the bull market extending into 2019.


Approaching Cyclical Conclusion

Some market commentators have been saying for the past few years that we could not see an end to the bull market, because bear markets never begin without a wave of substantial, and broad-based, bullish sentiment.  Generally speaking this is true, but I think it conflates a couple of things; typically, with rare exceptions (1987 for instance), bear markets come about in concert with recessions.  That is, the market cycle is primarily driven by the business cycle.  Despite two global mid-cycle slowdowns (2012 and 2015-16), we have avoided recession, as central banks world-wide have repeatedly flooded the world with liquidity.  To a great extent, the persistent economic weakness throughout this cycle has prolonged the expansion by preventing the economy from getting to the “blow off” stage.  Without a tight labor market, and pressure on resource prices driving inflation, central banks have been free to provide virtually endless liquidity.  We are likely now entering a period when these conditions no longer hold.


As the U.S. economy begins to exhibit late-stage dynamics, with tightening labor markets and rising inflation expectations, market sentiment is approaching worrying levels.  I must stress that we are not in the danger zone yet, assuming no deterioration in growth!  Professional investors still have excess cash they can deploy.  Individual investors do not look to be “all in” quite yet.  Although, positioning seems to be moving rapidly in that direction.  The relentless bullish action, with virtually no meaningful pullbacks, increases the risk of a sharp downturn when the cycle shifts.


In the meantime, investors should keep a keen eye on inflation and interest rates.  As has been the case for several years, the one thing that could upset the market apple cart quicker than anything would be a quick rise in interest rates.  Such a move is not likely to happen unless central banks pivot to a much more hawkish outlook, or at least, inflation surprises on the upside, leading investors to extrapolate more hawkish policy.  If that happens in the wake of another leg higher in the market, as both individuals and professionals move the last of their chips into the pot, things will get ugly.



Manna From Heaven

Synchronized Serendipity

Much fanfare has been made of the synchronized global expansion that began in the third quarter of last year.  Repeatedly, since the crisis, both official (central banks) and private economic forecasters have been embarrassed by economic growth and inflation missing projections.  Therefore, this past year has been unexpected surprise, as growth beat expectations in most countries around the world.  Average forecasts for 2017 Global GDP (according to Bloomberg) at the beginning of last year began at 3.2% on a year over year basis.  Instead, full year global growth came in at 3.6%, and average forecasts for next year expect an acceleration to 3.7%.   A few bold economists from major banks (Goldman Sachs and Barclays) are predicting 4% growth or better.  Assuming this year’s forecasts turn out to be accurate, we will have experienced the best two-year growth span the world has seen since the immediate recovery following the crisis.


Before we break out the champagne, there is nothing particularly extraordinary about these levels of global GDP growth (3.6-3.7% YoY).  This is pretty much in line with average levels going back to 1980.  However, if we reach the 4% rate as some anticipate, it would certainly be cause for some celebration.  For the U.S., in particular, along with expectations throughout last year for a record corporate tax cut (see Candy and Liquor for X-mas ), it has been a potent elixir fueling business confidence and stock market gains.


While there is considerable variation in the individual country drivers of growth, as I see it, the common theme is undeniable.  Interestingly, there has been no lack of coverage of the amount of global monetary stimulus over the last few years, but there seems to be a complacency about the prospect that stimulus will be curtailed.  Repeatedly in this cycle, any withdrawal of stimulus has led to a relapse in growth.  Nevertheless, this notion is not on most investors’ minds right now.  At least, not yet.


Our Daily Bread

Man ate of the bread of the angels;
    he sent them food in abundance.

Psalm 78: 25


Global central banker angels have been quite kind to investors in recent years. The slightest hunger for increased liquidity has been granted expeditiously.  In this environment, investment professionals have spent an inordinate amount of time examining the largesse, often focusing on meaningless minutia.  Monetary policy is known to have long and variable lags between initiation and effectiveness, which augments the difficulty of analysis.  In the post-crisis world, monetary complexity has risen by several orders of magnitude, as central banks have attacked secular stagnation with a number of extraordinary measures.


It’s easy to get lost in the weeds when considering the various machinations of individual central banks.  Putting aside the mind-numbing alphabet soup of the various credit facilities, and focusing on the big picture of balance sheet expansion, a rather simple story becomes apparent.  Virtually every attempt to “normalize” monetary policy, which typically only involved a respite in central bank purchases of securities, has led to a weakening in economic conditions.


Now one might say, “Wait a minute.  The Fed stopped QE at the end of 2014, and has been raising rates since the end of 2015.”  True, but rate hikes have been at a glacial pace, and until recently, the Fed has been reinvesting maturing securities, keeping its balance sheet stable.  In addition, both the European Central Bank (ECB), and the Bank of Japan (BOJ) have been conducting extreme QE since early 2015.  Europe has augmented that with negative interest rates.  China, after drawing down its balance sheet around -10% in the latter half of 2015, has since expanded past the early 2015 high point.  In aggregate, what we have is an oscillating trend upward in the major global central bank balance sheets.  Chart 1 shows the “Big 4” (U.S., Eurozone, Japan and China) central bank balance sheets aggregated (in U.S. dollars), along with the MSCI ACWI Equity Index (includes Developed and Emerging markets).


Chart 1

“Big 4” Central Bank Balance Sheets (Millions of US$) with MSCI ACWI Index


Data Source:  Bloomberg


The strong correlation between balance sheet expansion and equity markets is unmistakable, yet, it’s not a revelation.  Many were pointing out the strong relationship between the Fed’s balance sheet and the S & P 500 during the implementation of “QE2” and “QE Infinity” between late 2010 through 2014.  Back then, with the Fed being the most important central bank globally, and actively conducting QE, there was more focus on the connection.  However, with the onus of liquidity provision being met by a combination of Europe, Japan and China, many seem to be missing the continued importance.  Complicating the analysis is the fact that, unlike the Fed, other central banks have gone through several periods of balance sheet contraction.  Therefore, given the fungibility of global liquidity, aggregating the balance sheets of the largest central banks enhances clarity.


Returning to Chart 1, one can see the aggregate amount of balance sheet expansion stalled in the latter half of 2014 through 2015, which coincided with a global slowdown.  To further illustrate, Chart 2 gives a disaggregated view of the “Big 4” central banks.  The green line shows that China’s balance sheet contracted to the tune of about half a trillion dollars in the latter half of 2015, amid a sharp drop in global risk assets, and a significant slowing in the global economy.  The Fed at the time was maintaining its existing balance sheet by rolling over maturing securities.  Japan and Europe were adding stimulus, but the China withdrawal was enough to offset their efforts.


I do not believe it is a coincidence that global growth reached a low ebb at the point when China stabilized its balance sheet, and accelerated when the central bank began buying securities again. Once China flipped to expansion, global central balance sheets started rising again at a rapid clip.  Within 6 months, the global economy had stabilized, and equity markets had recovered.



Chart 2

Big 4 Central Banks’ Disaggregated Balance Sheets (Trillions of US$)


Data Source:  Bloomberg


Liquidity-Driven Complacency

By last year’s U.S. presidential election, the global economy had started to accelerate.  This condition almost perfectly coincided with Republicans taking full control in Washington (the presidency with majorities in both the Senate and House of Representatives).  The knock-on effect of the election was to focus investors’ minds on the beneficial effects to be had from deregulation and corporate tax cuts.  In effect, magnifying the liquidity-driven global acceleration.


While the expectation of tax cuts and deregulation in the U.S. have added to the optimistic tone in U.S. markets, I don’t believe the current period of synchronized growth would exist had there not been a substantial increase in global liquidity.  The primary point I wish to make is that despite a universal desire to declare victory against “secular stagnation”, the “new normal”, or whatever one wishes to call the economic backdrop of the last decade, the primary dynamic has not changed.  Prodigious central bank liquidity is still a necessary condition for sustained growth in the global economy.  Or, at the very least, there has been no proof to the contrary. Which of course, once again, begs the question:  When will central banks (in aggregate) begin to slow the monetary faucets?  And when they do, will the global economy finally be able to stand on its own?


With the Fed starting to draw down its balance sheet, Japan starting to taper QE, and Europe likely to do the same this year, the liquidity tide looks likely to recede.  In addition, China has stated publicly that it is likely to move in the same direction ( China asks itself a tough question: Can it accept slower growth? ).  Positioning and sentiment indicators for markets are sitting at multi-year highs.  Stories abound of market complacency ( Overconfident? Wall Street worried by the lack of worry  ).  Bearish calls on the market have been made to look foolish for the past year, as pullbacks have been almost nonexistent. Calling recessions and market tops is always a precarious business.  In the age of quantitative easing, it feels downright suicidal.


However, one thing we do know from the last decade:  lack of liquidity infusions were enough to stall growth, and tank markets.  So should we expect to keep chugging along at a brisk pace in the face of outright liquidity withdrawals? I do not wish to oversimplify the complexity of the global economy by proposing that the only metric that matters is central bank balance sheets.  At the same time, I think investors should pay close attention to the shifting flow of liquidity.  In the last decade, no indicator has been as prescient.  For now, the flow is still positive on a global basis, but that looks set to change quite soon.  Investors would be wise to pay close attention.