And so, risk sold off, safe havens were bid and the farmers (not to mention the cobblers) were restless.
That was the mood on Thursday morning, as China cranked the hyperbole knob to a Spinal Tap-ish “11”, PMIs out of Japan, Germany and the US rattled investors and an overriding sense of angst was a wet blanket over global equities.
10-year yields in the US dipped to their lowest since 2017. Bonds are “marking to misery“, to quote BofA.
But while there’s “misery”, there’s no “mystery”. “UST futures and ED$ Reds / Greens are again ripping higher… on the perception of increased Fed cut odds and there’s a pretty simple logic equation'”, Nomura’s Charlie McElligott says. That equation is as follows:
China / US trade war acceleration dynamic + Dollar strength (“USD Shortage” thesis picking-up new catalysts) + defiant “patient” Fed = further economic downside trajectory = DE-RISKING AHEAD OF THE GLOBAL GROWTH SLOWDOWN
“Simple” though the logic may be, there’s more than a little nuance to be had.
The trade escalation and the growth concerns it’s precipitating (manifesting themselves on Thursday in, for instance, plunging crude) are USD positive. Despite the rates rally, the greenback hit YTD highs on Thursday morning, even as it slipped versus “purer” havens (i.e., JPY and CHF).
This brings us back to the dollar quandary which has vexed more than few commentators this year. Generally speaking, the greenback’s resilience is attributable to a (still) relatively healthy US economy and a Fed that, while dovish compared to last summer, is (still) more hawkish than its global counterparts on top of having already completed a hiking cycle. Hence: Dollar strength and the return of the dollar shortage narrative.
Just like 2018, a strong dollar serves to exacerbate the disinflationary impulse and, in a bit of a tragicomedic turn, the Fed’s “patient” story has gone from being perceived as overtly dovish just a couple of months back, to now comparatively hawkish versus both market pricing and other central banks. Powell’s “transitory” narrative underscores that relative hawkishness.
McElligott weighs in at length on this in his Thursday note (a note which may well go down as one of his classics). Here’s Charlie:
I have been speaking on the “USD Shortage” thesis since early 2018—based upon 1) US Fed Policy Rate (currently) at 11 year highs; 2) ongoing Fed balance-sheet runoff / QT; and 3) increased Treasury issuance / deficit spending to pay for the tax cut / fiscal stimulus—all of which continues to feed tighter US Dollar liquidity & funding conditions—with USD strength recently being further accelerated by 4) Yuan weakness vs USD as a potential Chinese policy tool to offset negative trade impacts of the tariffs, as well as 5) a Fed which is clearly now digging its heels in and trying to remain “patient,” despite the STIRs market pushing-back towards two CUTS being priced-in over the next 12m (EDM9EDM0 back to ~-44bps despite yesterday’s initial “bear-flattening” post-Fed disappointment).
Now, the resilient dollar is colliding with the trade war escalation and a recalcitrant Fed. That’s a recipe for trouble. As Charlie writes, a “defiant Fed ‘patience’ message that policy will be appropriate for ‘some time’ is again clashing with market expectations—which typically doesn’t end well.”
He continues, noting that “the front-end move since the start of 2018 speaks to higher USD money market rates [and] tighter global trade financing conditions.” A quick look at 3-month bill rates, LIBOR, commercial paper and GC Repo shows that efforts to “loosen” thinks up following last year’s debacle (USD “cash” outperformed 90% of global assets in 2018) notwithstanding, “it’s still tight in here”, as McElligott puts it.
As a related aside, anyone looking for recession indicators could start here:
McElligott covers much more in his Thursday missive, but this point deserves separate treatment – that is, it deserves its own dedicated post considering the interplay between dollar liquidity and trade. Here’s Charlie again:
… global trade is clearly now being dragged into the mud by a ‘vicious spiral of not just the actual tariff barriers and the lack of corporate visibility therein, but perhaps most importantly, the ongoing strength in US Dollar, which further undermines a global economy which is dependent upon trade and financed by US Dollar liquidity.
Even as risk assets powered higher in the new year, the “dollar liquidity squeeze”/ “dollar shortage” story lingered – like stale cigarette smoke – despite the Fed’s efforts to engineer looser financial conditions.
To quote a better writer than myself, “There was much wine, an ignored tension, and a feeling of things coming that you could not prevent happening. Under the wine I lost the disgusted feeling and was happy. It seemed they were all such nice people.”