Who’s worried about geopolitical risk?
Apparently not too many market participants.
And do you know why? It’s the same perverse dynamic that makes everyone hope for bad econ. The worse things get, the more unlikely it is that central banks will move too aggressively on normalization.
So if you needed a reason to “stop worrying and love carry again,” the irony of ironies is this: the only reason you need is heightened geopolitical concerns.
But just thinking out loud here, nuclear war is something central banks would likely have a hard time offsetting and then you also have to think about what might happen to the global economic “recovery” (if you want to call it that) should oil prices suddenly move sharply higher on the back of some kind of tail event.
Remember, oil’s banner week wasn’t completely attributable to an improving supply-demand backdrop – the rapidly deteriorating situation in Venezuela played a role and as we wrote in “They’re Playing With Fire!“, there’s no geopolitical premium in prices right now.
Of course in addition to Venezuela, you also have to consider the ongoing spat between Riyadh and Doha. Although there are signs of progress, the crisis is far from over.
Now think about what sharply higher oil prices would mean for inflation. If inflation were to suddenly turn higher, it would back central banks (who are already predisposed to hawkishness) into a corner, forcing them to tighten in a hurry. Clearly, that would be a headwind for the vol. sellers.
Well, for those interested to know what Barclays thinks are “the five main tail risks” for markets and also why the bank has “learned to stop worrying and love carry (again),” you can find some excerpts below…
How I learned to stop worrying and love carry (again)
Although the environment generally remains supportive of carry, positioning and valuation suggest it would be prudent to add tail risk hedges. We see five main tail risks: geopolitical risks leading to a rise in oil prices, a China slowdown in H2 17, US debt ceiling brinkmanship triggering a US technical default, a significantly more aggressive Fed hiking cycle, and a coincident tightening of global rates.
We continue to stand by the message that a window of opportunity for carry trades remains open, through at least end Q3, against a background of subdued cross-asset volatility.
However, we are cognisant of various tail risks that have the potential to derail such trade, amid stretched positioning and valuations. We see five potential catalysts and suggest options hedges for each.
A set of known unknown tail risks
Geopolitical tensions leading to materially higher oil prices Although market reactions to geopolitical events have been rather muted over recent months, there are plenty of flashpoints globally that could still spoil the party for risk assets. The implications of these are not entirely clear, given the multiplicity of outcomes and non-linearities in terms of how they might develop. Among these, we are keeping a close eye on those in the Middle East, which may have a broader economic effect as they risk sharply higher oil prices.
While markets have become used to low and falling oil prices in the past few years, the risk of a sharp rebound has faded from the market’s imagination. A sudden spike in oil prices, as a result of potential supply disruptions associated with geopolitical tensions, would weigh on global growth through its effect on consumption, particularly among oil importers, and, in turn, on risk appetite. The consequent unexpected sharp rise in inflation also would find most investors ill-protected from any prospective monetary policy tightening, after years of ‘missingflation’.
With the exception of a few oil exporters, the steepening of DM curves would be negative for EM FX and local markets, in our view.
China growth/deleveraging risks China’s growth already is slowing, but at a gradual pace. Recent growth surprises have been on the upside. However, avoiding a sharper growth slowdown will be no easy task, given declining credit efficiency and the continued focus on deleveraging. Indeed, the recent National Financial Work Conference set a hawkish tone in tackling the unsustainable build-up in credit, suggesting that it will be an important focus in the months ahead. As such, we think corporate deleveraging, including debt-to-equity swaps and the closure of “zombie” companies, could gain momentum in the coming quarters. To help facilitate this, a tight monetary and regulatory stance is likely to be maintained.
Some clues to the reaction of markets to a more rapid growth slowdown can be gleaned from events in August 2015, when China shocked markets by announcing a sudden change in its exchange rate mechanism. At the time, this was seen as an implicit acknowledgement that growth was much weaker than expected. We estimated that a 200bp negative surprise for growth in China compared with our forecasts would reduce global growth by 40-50bp. In this event China’s currency could face pressure as capital outflows intensify, while commodities may face renewed downward momentum. EM FX, commodities, commodity currencies and countries reliant on trade with China would be particularly exposed and the CNH/CNY spread would likely widen.
US debt ceiling driven technical default The risk of a US technical default remains very real even as Republicans hold both houses of Congress and the White House. The last suspension of the debt ceiling expired in March 17 and since then, the US Treasury has used a combination of “extraordinary (accounting) measures” and seasonally strong tax flows to operate with an expired debt ceiling suspension. However, without an increase in its borrowing authority, it will run out of cash and risks interest and payment delays before the end of the year. The CBO projects that this will happen sometime in October.
Concerns of a repeat of 2011, when a lack of agreement between Republicans and Democrats led to a US sovereign ratings downgrade, have grown. The consequences may be much higher volatility, distortions to short-term funding markets, a weaker USD versus reserve currencies, higher US Treasury yields, and a sell-off in risk assets globally.
More aggressive Fed The Fed continues to forecast a return to 2% inflation, based on expectations of further labour market tightening. Markets, however, remain sceptical and have pared back expectations of tightening in light of a weaker rebound in Q2 17 growth and given that tightening in the labour market has not yet yielded additional wage pressures. Nonetheless, the Fed is facing a positive output gap that necessitates a trend increase in policy rates, in our view, with the main question being the slope of the trend rise in rates.
Should US growth rebound more quickly, due perhaps to the US administration moving more rapidly on fiscal stimulus or tax reform, market expectations of Fed rate hikes will be prone to a sharp adjustment. Additionally, we expect the Fed to begin balance sheet normalisation in September, but it could move earlier and/or more aggressively if growth or inflation picks up more strongly. We think a passive Fed balance sheet reduction will have a muted response in FX and local markets, but a more aggressive reduction in the balance sheet could bring back memories of the 2013 Taper Tantrum.
A coincident tightening of global policy rates G10 central banks have become more hawkish in terms of rhetoric and in some actions. In our view, this is a reaction to a coincident improvement in domestic fundamentals and the exogenous risk environment and is aimed at removing ‘insurance’ policies instituted since the GFC. We think that only a few economies are facing sufficient capacity constraints to warrant a sufficient trend rise in rates. However, if we are wrong in our assessment of capacity constraints in the G10 economies and the propensity for central banks to embark on a trend rise in rates (not withstanding what is already priced in), the subsequent re-pricing in DM rates would be negative for carry trades, especially if volatility rises.
Indeed, there are some nascent signs that the trend on inflation is turning around. We have noted that while low inflation has struck back with a vengeance, the inflation trends look to be bottoming. As such, inflation pressures could return as swiftly as they disappeared, catching cautious central banks flatfooted and markets ill-positioned.