Via Guy Haselmann of Scotiabank,
Good Morning,
I went to a meeting last night hosted by the University of Chicago called “Economic Outlook 2014”. The panelists leading the discussion were Austan Goolsbee, Randall Kroszner, and Carl Tannebaum. I will not go into the obvious, or things discussed in my notes, but rather a few things that I learned.
First some background. Internally we have been forced to discussed pressures in Emerging Markets. The challenges are great – yet many countries until recently have had isolated troubles. Capital outflows, current account deficits and sinking currencies are one of the common themes. The questions for us – i.e. players in the Treasury Market – is how will those stresses effect Treasury prices or impact the Fed who is expected to taper by $10BB at each meeting in 2014.
On the one hand and in a stable state, tapering should lead to a gradual ‘normalization’ of yield levels – which mean that the 10 year should (assuming no crisis) ‘gradually’ trades toward nominal GDP minus some liquidity premium. However, I’ve mentioned in earlier notes that should concerns build that global growth and inflationary expectations begin to drop too much (either due to Fed Taper or Geo-events), then Treasury values will recalibrate and yields could drop precipitously 2.5%. If things got really bad, yields could fall quite a bit further. We don’t seem to be in this latter position - quite yet.
While the situations in Turkey, Ukraine, South Africa, Brazil, Argentina, India, Indonesia, Thailand, Syria, etc. are signification to those countries, their problems for the most part have until recently been contained. However, pressures are building and many of their central banks have been forced to raise rates meaningfully to combat capital outflow, and currency drops that have aggressively spiked domestic inflation rates. It is assumed that hiking rates to fight inflation will build their credibility. However, these large rate hikes will cause domestic growth damage: combined with the drop in their currencies, markets are beginning to lower expectations for demand coming out of these countries….less demand, then less growth and downward price pressures.
The biggest issue of all, but unfortunately the most uncertain as well, is with the Chinese Trust products. As I mentioned, $660 Billion of this product comes due this year. Investors who had purchased them in the past now know that they are indeed NOT a guaranteed product. Rates in China will have to rise to compensate the newly found investor caution toward these products. In turn, growth will slow as credit will slow; and employment will slow and wages with it.
Slowing demand from China will further hurt EM suppliers of materials, thus fueling EM challenges. The result is causing global growth and inflation expectations to fall. China is best positioned to limit the damage. Yet, are they willing to write a check for all these products many of whom could default? China has a closed capital account and many ways to deal with problems. But they could lose control of the process – Beijing’s number one fear is social unrest that could grow.
Back to the U of C meeting last night. Carl Tannebaum made an interesting point last night. He said the US fiscal deficit is falling far faster than anyone had forecast and there are many perplexing reasons why this is the case. The main reason, according to the CBO, is that Health Care costs are dropping much more than anyone expected. This is the result of generic drugs, better medical device efficiencies and a few other less dramatic reasons. The point here is that this is causing downward pressure on inflation and a material fiscal deficit drop. Both of these factors in the short-term are positive for Treasury PRICES. In fact, Carl said that the drop in HC costs is so dramatic that should it be maintained for the balance of the year, that the Deficit Reduction would equate to 90% of what Simpson- Bowles was meant to accomplish.
As far as the Fed, I believe there is an infinitesimal chance that the Fed pauses from tapering today. The greatest outcome - a very high probability - is that they taper by another $10BB. However, there is a small chance that they announce a $10 BB taper for February and another $10BB taper for March. This is because the next Fed meeting is not until March 19th. The chances of this occurring is quite small particularly after the lousy employment report earlier this month and yesterday’s lousy durables report. However, maybe they can blame those on the weather.
There are many members who would like to exit as soon as possible, so a monthly $10bb is possibly.
On the other hand (again), the markets might interpret this as an acceleration in the pace, so the market could then price in an earlier hike in rates. This is because the Fed has tied the first hike to a 6-month (or so) period after QE ends (i.e. earlier end to QE, earlier hike). The market in this scenario - and because of the current global situation - might have a perverse reaction in that risk assets might get smoked, and growth and inflation expectations might fall even further, and so after a brief dip in Treasuries, they would surge higher in price.
In the meantime, Treasuries will have a difficult time going down a lot in the near term; such would need both the EM situation and equity market heaviness to stabilize.