Via Citi FX Technicals,
Big picture overview and thoughts regarding the likely backdrop in the coming 2-3 years
Both the 1980-1985 and the 1995-2000 USD rallies were preceded by:
A collapse in housing activity and economic data (1973-1975 and 1989-1991) and stresses in the banking system
A major easing by the Fed (From 13% to 4.75% in 1974-1976 and from 9.75% to 3% in 1989-1992)
By 1980 and by 1995 the situation had stabilized and bond yields had moved higher in nominal terms and continued to rise in real terms. (By 1983-1984 real yields (10 year yields minus core CPI) were close to 9% and between 1995 and 2000 real yields ranged from around 2 to 5%). This positive “real yield” was undoubtedly a strong factor in the positive performance of the USD during these periods.
For a good portion of the 1980-1985 period (About half) the US struggled with a “stagflationary backdrop” but from 1982-1983 in particular inflation fell sharply making bonds (And a cheap USD) look very attractive.
The 1995-2000 period was pretty much only good news in the US. Strong growth, strong equity markets, an internet/investment boom, a rallying bond market. If it had a “U.S.” tag it was bought.
The important message here is that it does not have to be good news for the USD to sustain its rally, but we are likely to need positive real yields in the medium term. We are getting there. Using core PCE as the inflation reference at 1.2% and a 10 year yield that just hit 3% positive real yields materialized and the USD-index reached a new high at 84.75 in August. However, in the near term, our charts (as seen below) suggest that we may be looking at another dip lower in longer term yields in the weeks/months ahead. This does not necessarily mean that the USD will go down a long way because we should remember that FX and yield differentials are a relative trade. In that respect we would not expect a move to a positive yield dynamic for the Eurozone (Germany) or Japan over the US. However this move lower in yields will likely stabilize sentiment with regard to Emerging markets and the Eurozone in the very near term. At the same time we believe that the Fed will be very cautious about returning to a tapering guidance (as we discussed here "Why the Fed did not taper”)
However from an FX perspective this 1989-1998 period really resonates with us. Why? It was a perfect example of the “interconnectivity of Global markets” and how when the “US catches a cold”, the “rest of the World catches a fever” (From a cross market/cross economy view, we think today resonates more with that period into the late 1970’s)
1989-1991 we had the savings and loan crisis in the US, a sharp downturn in the US economy, aggressive Fed easing and a weak USD. We pretty much replicated that scenario (Only worse) in 2006-2008
1992-1995 this “domino'd” into Europe with the falling apart of the existing “financial architecture” called the ERM (Exchange rate mechanism) which was replaced over the following 5 years or so by an equally flawed structure called the EURO. (Fast forward and we saw the Eurozone debt crisis blow up in 2009-2011). Then the stresses in the World’s 2 major economic zones at the same time as severe economic/financial market/deflation stresses in Japan led us to...
1997-1998 the next domino into emerging markets (Asia and Russia in particular) as well as the failure of LTCM in the US (On the back of leveraged European sovereign bond trades – Did anybody say “MF Global”?) Huge liquidity provision from the developed economies created financial bubbles in local (EM) markets. As we have seen in recent months, rises in US yields have seen a very negative reaction in Emerging markets. Funnily enough it only took a little “tinkering” by the Fed in 1997 when they raised the Fed funds rate by just 25 basis points to cause a spike in long term rates. Between late 1996 and April 1997 the US 10 year yield rose by about 93 basis points in about 4 ½ months. While they calmed down thereafter and headed lower all the way into October 1998 the EM turmoil had only just begun. (Interestingly another period of “tinkering” by the Fed under Greenspan had taken place in February 1994 when he also raised the Fed funds by 25 basis points. The difference then was that he kept going and continued to raise rates. In effect he got lucky, because:
- The economy was strong (Real GDP close to 5% and nominal GDP of about 7%).
- Unemployment was low and qualitatively good (Around 6.5% with a participation rate above 66% and rising)
- Housing was robust (Housing starts over 1.5mm compared to the present 900k with a much larger population)
- Equity markets were strong (Up nearly 70% from the modest 20%+ correction in 1990 and followed by a 5-6 year surge into 2000)
With all these indicators on a very firm footing they could absorb the subsequent almost 300 basis point move higher seen in 10 year yields. This time around the dynamic looks to be much more fragile than that seen in these both of these historical periods and we have seen 10 year yields surge 140 basis points in just over 4 months. As in 1997 the Fed appears to be backing away from its attempt to withdraw accommodation as financial conditions become stretched. In fact in 1998 they reverted to additional easing as the Emerging market /LTCM crises materialized in that period.
So where does that leave us? We anticipate a limited/short lived period of calm in the weeks and possibly months ahead. This should lead to lower yields, an initially weaker USD and calm in Emerging markets. It will not last. The “Genie is out of the bottle”. The Fed has injected uncertainty about their view of the future and led the market to question their credibility. They are the “Central bank of the World” with a new “leader” about to take control (Almost certainly Yellen). History has not been kind in that respect over the last almost half-century of leadership changes at the Fed
Fed Chairmen: 1970 to today (The period that covers all three major housing/credit/financial/economic crises in the US in the modern era)
- 1970: Arthur F Burns takes over the Fed: His overly loose monetary policy into 1973 gave way to a surge in inflation(1973-1975 aided by an Oil price shock core PCE went from a benign 2.7% to over 10%. This despite having been at similar levels to the 2009-2010 lows close to 1% in 1965 ), a collapse in housing similar to today (1973-1975), a collapse in the equity market similar to today (1973-1974) a collapse in economic activity similar to today (1973-1975). By 1978 he was out to be replaced by
- 1978: G. William Miller takes over at the Fed: He did not fare too well and was “on his way out ” by 1979. He continued the strongly dovish policy of his predecessor and inflation surged, housing rolled over again, equities went nowhere and economic growth faltered. (A.F. Burns + G. William Miller = Benjamin S. Bernanke + Janet Yellen = 1978 ??) In August 1979 he was replaced by
- 1979: Paul A. Volcker (Arguably…actually no argument. He was without doubt the greatest Fed Chairman in the modern era). He was fiercely independent and insisted on a policy to crush inflation even though it resulted in slowing economic growth and rising unemployment. Arguably however this policy of “taking the pain” also ”set the platform” for the following years of low unemployment and strong economic growth.
- 1987: Alan Greenspan took over the fed in August 1987 and within 2 months had an event that arguably became the catalyst for policy over his entire tenure i.e the Greenspan put (Later to morph into the Bernanke Supersize put and potentially eventually morphing into the Yellen Super-duper sized put…but time will tell on that). The stock market crash of 1987 was without doubt the “seminal moment” in his chairmanship. For his entire tenure every “asset market/economic shake” was met with that Greenspan put. He handed this bubble over to
- 2006: Ben Bernanke took over the Fed in 2006 and like Greenspan was shaped early in his policy making when we saw the Property market crash/credit crunch of 2006-2008. So was born the Bernanke put, which, despite tentative attempts to rein in at the end on QE1; QE2; operation twist and QE infinity is alive and well.
- 2014: So what is Janet Yellen (Or A.N. Other if not Yellen) inheriting? Are we in for a period of stress in 2014 just as we appear to have been after other “handovers” at the Fed? We are certainly not getting a Paul Volcker. Are we shortly getting another G. William Miller who is going to continue to maintain the easy money policies of the prior Chairman??? It would seem that way.
Volcker seems to have been the only Fed Chairman in nearly a half century that has fiercely and independently been prepared to pursue “today’s pain” for tomorrow’s gain.
(This is likely one of the reasons that he did not get reappointed in 1987) Pretty much every other Fed policy in this era has been “kick the can” and hope. The track record (result) for that policy looks pretty poor in hindsight (ultimately inflation and or asset bubbles) and it is difficult to see why it should be any different this time.
We have been on the page (and continue to be so) that we are in danger of entering another “stagflationary” period. That does not necessarily mean nominal statistics like we saw in the late 1970’s. Everything from a change in the way we calculate inflation , the present spare capacity in the economy/labour force, the poor quality of job growth and the high levels of personal debt create a less “sticky” inflation dynamic than then. However that is not a reason to be complacent.
The “average Joe”
- Does not have a “bustling” brokerage account “bursting at the seams”.
- Has seen limited wage growth in the last 20 years
- Has built up debt facilitated by the housing bubble and cheap and easy credit. Quite possibly he removed
- Equity from his house in the refinancing boom in the early 2000’s and has seen a lot of the remainder (if any) equity wiped out in the housing crash.
- Is seeing poor quality job creation (Low paying and or part time jobs being created with a lot of it in the 55 year+ age group) in a lot of instances.
- Earns little or no interest on what little savings he has
- May not be experiencing much inflation if we use the core PCE measure of 1.2% as a reference point (or today’s GDP PCE core index at 0.6% Q on Q .The only time in 54 years that this number ever printed lower was Q4,2008-Q1,2009) However if we look at the “necessities” in life- Food; clothing; fuel; rent; utilities; transport costs; tolls; health costs, education costs etc etc. does anybody really believe we have close to 1% inflation?
This is at a time when we have real economic growth barely above 2% and nominal growth of just over 3% (Abysmal by any standards) after
- Six years of monetary easing and 5 years of QE1; QE 2; Operation twist; QE “infinity” and huge fiscal deficits.
- After last week it is not clear that this set of policies is going to end anytime soon as per our “Hotel California” analogy (Ben can check out anytime he likes but QE can never leave). It seems far more likely that these policies will be continued as far as the eye can see and even if there are “anecdotal” signs of inflation this Fed (Or the next one) is not a Volcker fed. This Fed does not see inflation as the evil but rather the solution. This Fed will stay deliberately behind the curve. As Friedman said “inflation is always and everywhere a monetary phenomenon”
- That can very well be good for the USD as bond yields ultimately move higher again in this stagflationary environment as they did in the late 1970’s. Gold should also do well as it did from 1977-1980 (While the Fed stays behind the curve). It is not likely to be so good for a struggling economy, an equity market that is very elevated and an employment backdrop that is qualitatively poor. That is before we even talk about the external economies that have benefitted from the exceptionally low bond yields seen in the World’s reserve currency and may see an increasing “negative feedback loop”
Unfortunately we fear that the backdrop we will be looking at will more closely resemble the late 1970’s/early 1980’s than the “Golden period” of 1995-2000 and that we will have a quite difficult backdrop to manage over the next 2-3 years.
As a consequence we believe that:
This USD weakness should be faded in the weeks/months ahead but probably not just yet.
We can see lower Bond yields in the weeks and months ahead but likely much, much higher in the years ahead as the Fed gets caught behind the curve (As they did the other way around in 2007)
Gold should perform well in this environment against all paper currencies particularly as there is every chance places like the UK, Japan and Europe stay a little tighter fiscally and thereby end up loosening even more aggressively (On a relative basis) than the US which has already done a lot of the heavy lifting.
The Equity market is likely to struggle to make incremental gains from here in this environment as companies struggle to generate pricing power in a sluggish economy. We still believe that signs are growing of a negative feedback loop that could see equities under pressure in the months ahead and ultimately give us that 20%+ correction that everybody believes is no longer possible.