Deutsche Bank's Jim Reid is one of the few strategists on Wall Street to admit he was wrong (although he may still end up being right). Previewing his annual credit outlook titled "Volatility Ahead", Reid confesses that "we’ve long felt that as we approached 2017 we would likely be at the turning point of the credit cycle. Indeed our forecasts are for wider spreads in our annual outlook for the first time since the Euro Sovereign crisis earlier this decade. However in the course of writing this outlook much has changed."
The strategist admits that, alongside virtually everyone else on Wall Street, he became bullish, overnight on just one catalyst: the election of Donald Trump, which was universally panned by most experts (if not here) as a major selloff catalyst only for everyone to pull a "Bill Ackman" and realize the next morning that (as we explained) that Trump is actually extremely bullish for risk assets.
"The forecasts are less bearish than they would have been when we started writing this publication in late October partly because spreads have widened notably since and also the probabilities of a US recession in 2017 have lessened given the possibility of aggressive fiscal spending from the new US administration."
Naturally, this is the bullish assumption which in the past two weeks has been adopted by all, namely that Trump will unleash a trillion dollar (or more ) debt issuance spree, aka "massive" fiscal stimulus, an assumption which we explained yesterday will soon be challenged by Congressional Republicans. However, more than a simple political hurdle, a greater gating factor is what happens to interest rates, a traditional buffer to risk assets any time the economy is on the verge of overheating: should they rise too high, the entire stock market house of cards falls.
It is here that Reid points out something truly fascinating, namely the interplay between monetary and fiscal policy, however not at the national level, but at the international, where the US is injecting hundreds of billions in debt in the global system, which then is soaked up not by the tightening (for now) Federal Reserve, but courtesy of foreign central banks such as the ECB and BOJ.
This is how the Deutsche Bank strategist explains the "post-Trump" flow of funds:
The main driver of 2017 will again be policy and we’re left with an intriguing combination where the US will likely implement serious fiscal stimulus but without Fed QE supporting it whereas Europe will have no meaningful fiscal stimulus but lots of QE. Japan is a hybrid as it will have monetary policy that easily allows for more expansionary domestic fiscal policy but without clear evidence – at the moment at least – that we’ll deviate too far from the status quo. However there is some evidence to suggest that we’ll effectively have cross border helicopter money.
So there it is: helicopter money is here... and nobody is talking about it because it is not national helicopter money but cross-border, i.e., between central banks, something which makes perfect sense in a globally interconnected world of fungible money, and yet because it does not comply with conventional models, has flown right under the economists' radar.
So how will the next stage in the global monetary-fiscal experiment look like, one in which cross-border helicopter money has now essentially arrived? Well, the answer will determine if Trump's attempt to make the American economy great again with trillions in investments (funded by individual investors in Europe and Japan) will succeed or fail.
Assuming the ECB continues sizeable QE all year, and perhaps more importantly if Japan defends the zero 10 year JGB rate, then this could easily help cap UST yields at lower levels than they would naturally be at given President-Elect Trump’s aggressive fiscal plans.
Ultimately, it all goes back to Trump:
Given his protectionist leanings it’s perhaps ironic that the President-Elect’s biggest global allies might end up being the BoJ and the ECB. The biggest risk to his plans and to market stability might be if the BoJ decides to abandon the defense of zero and/or if the ECB signals a taper earlier than expected.
Ironic indeed, that Trump who hopes to effectively isolate the US from the world, will be the one president more reliant on the rest of the world, than any of his predecessors, to bring his plan to fruition.
Finally, as to what all this means for the year ahead, Jim Reid is cautious. Here is his forecast.
We therefore think it’s a transitional year ahead with many contradictions. Transitional because with debt so high across the globe, expansionary fiscal policy without your own domestic central bank propping up yields is risky and only half way towards what still seems the inevitability of broader helicopter money. Much might depend on the ECB and BoJ continuing current large scale purchases of government bonds. For 2017 we think they will but the debate over the funding of increases in US (and perhaps UK) fiscal spending will increase over the next 12 months and is likely to lead to more volatility as the financial market swings from believing that fiscal spending will lead to higher growth, inflation and higher yields for a period of time to perhaps then believing that global central banks are likely to cap the rise in yields.
To be sure, this is a simplified model: one should also consider the risk of ongoing (and record) US Treasury liquidation by the likes of China and Saudi Arabia. Should they proceed to sell off US paper more aggressively, all bets are off. Which means that Trump will have to remain friendly with not only Japan and Europe, but also China and Saudi Arabia.
Or, another way of putting it, Japanese and European bond investors will now be unwittingly funding Trump's vision to "make America great again", while China and Saudi Arabia can hold the US hostage with threats of Treasury liquidation.
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So can Trump do it? For now the market is happy to answer in the affirmative, although as Jim Reid concludes, "the days of one-way dovish monetary policy, with no fiscal spending and low volatility in asset prices and growth are likely over."