Macro and Credit - The Numbers Game

"Nobody trusts anyone in authority today. It is one of the main features of our age. Wherever you look, there are lying politicians, crooked bankers, corrupt police officers, cheating journalists and double-dealing media barons, sinister children's entertainers, rotten and greedy energy companies, and out-of-control security services." - Adam Curtis

Watching with interest the trade war escalation with Mexico, leading to de-escalation, triggering more volatility in already jittery markets, in conjunction with more dovishness expectations from Central Banks, and with the prospect of the introduction of the so-called “mini-BOT” scheme, named after Italy’s Treasury bills in Italy, when it came to selecting our title analogy in continuation to our previous Chinese game of "Banqi" reference, we decided to go for the Italian game of the "Numbers Game". The numbers game, also known as the numbers racket, the Italian lottery, or the daily number, is a form of illegal gambling or illegal lottery played mostly in poor and working class neighborhoods in the United States, wherein a bettor attempts to pick three digits to match those that will be randomly drawn the following day. For many years the "number" has been the last three digits of "the handle", the amount race track bettors placed on race day at a major racetrack, published in racing journals and major newspapers in New York. 

What we find of interest, before we enter our usual "Macro and Credit" musing is that closely related is a policy, known as the policy racket, or the policy game. 

There is more to our title that meet the eye given Peter Navarro wrote in 1984 (the famous "dystopian" year) a book entitled "The Policy Game: How Special Interests and Ideologues Are Stealing America". 

Peter Navarro being Trump's top trade adviser we find it interesting in the light of the current trade war developments to look more closely at his change of views as put forward by AXIOS in June 2018 in their article entitled "Peter Navarro's radical transformation":

"People think of Peter Navarro, the top White House trade adviser, as President Trump’s mind-meld on tariffs — the most hardline protectionist in the White House. But Navarro used to preach very different ideas in his early career as an economist.

The bottom line: In his 1984 book, "The Policy Game: How Special Interests and Ideologues are Stealing America," that's no longer in print — Axios got a copy from a university library — Navarro sounds a lot like the very administration officials he's sparred with on trade policy. And he argues that tariffs will inevitably send the global economy into crisis.

We asked Navarro what prompted the radical change in his views, and he explained how he went from a free trader to an economic nationalist. In response to "The Policy Game," specifically, Navarro told Axios:

It borders on the comical that Axios would spend so much time on a book written 34 years ago and completely ignore the insights of my later works like the 2006 Coming China Wars, the 2011 Death By China, and the 2015 Crouching Tiger.  Together, these books explain at length why the globalist Ricardian free trade model is broken and urgently needs fixing in the name of both the economic and national security of the United States.
— Peter Navarro

From the book...

"The clear danger of this trend [protectionism] is an all-out global trade war; for when one country excludes others from its markets, the other countries inevitably retaliate with their own trade barriers. And as history has painfully taught, once protectionist wars begin, the likely result is a deadly and well-nigh unstoppable downward spiral by the entire world economy.

If the world is, in fact, sucked into this spiral, enormous gains from trade will be sacrificed. While such a sacrifice might save some jobs in sheltered domestic industries, it will destroy as many or more in other home industries, particularly those that rely heavily on export trade. At the same time, consumers will pay tens of billions of dollars more in higher prices for a much more limited selection of goods. Sacrificed, too, on the altar of protectionism will be the very heart of an international world order that since World War II has successfully changed the aggressive struggle among nations for world resources and markets into a peaceful economic competition rather than a confrontational political or military one."— "The Policy Game," pg. 55

There are multiple passages in "Policy Game" that directly argue against Navarro's current positions. Navarro's go-to argument defending the White House's trade moves has been national security. In a June New York Times op-ed, he wrote:

"President Trump reserves the right to defend those industries critical to our own national security. To do this, the United States has imposed tariffs on aluminum and steel imports. While critics may question how these metal tariffs can be imposed in the name of national security on allies and neighbors like Canada, they miss the fundamental point: These tariffs are not aimed at any one country. They are a defensive measure to ensure the domestic viability of two of the most important industries necessary for United States military and civilian production at times of crisis so that the United States can defend itself as well as its allies."

But Navarro's own book topples that argument as well:

"On the benefit side, protectionism within certain basic industries like autos, steel, and electronics helps to create and sustain an industrial base that, in times of war or national peril, can be shifted to defense purposes, However, this national security argument — and the existence of any benefits resulting from protecting these industries — can be legitimately called into question for several reasons.

First, the existence of any sizable benefits rests on the assumption that import competition in our defense-related industries would not only reduce the size of these industries but also shrink them to the point where they would be too small to support our defense needs. The threshold of danger is a matter of some dispute. How big, after all, do our auto, steel, or electronics industries have to be to keep our borders safe? In spite of this uncertainty, few analysts would argue that import competition is likely to push a nation with as large and mature an industrial base as ours anywhere close to that threshold.

Second, it is highly possible that our defense capability might actually be enhanced — not damaged — by import competition. Without the umbrella of protectionism, our defense-related industries would be forced to operate at lowest cost, engage in more research and development, aggressively innovate to stay one step ahead of the competition, and modernize their plants at a faster pace. Thus, while import competition might shrink these industries, they would be leaner, tougher, more efficient, and more modern and in all likelihood outperform a bigger and inefficient (protected) version of those same industries.

On the national security cost side, the major effect of protectionism is to threaten the stability of the international economic order through a global trade war..."
— "The Policy Game," pg. 82

Navarro lauded the impact of tariffs on saving American jobs in a May op-ed in USA Today, writing:

"There can be no better way to make America — and American manufacturing — great again than to start to rebuild those communities of America most harmed by the forces of globalization. These new facilities will stand as shining testimony to the success of tough trade actions, smart tax policies and targeted worker-training programs."

But he warned against the harmful longer-run effects of tariffs on jobs in his 1984 book:

"American protectionism threatens employment and profits in the export-dependent nexus because it invites retaliation from our trading partners ...

From these direct and indirect effects, it is clear that over time, the major benefits of protectionism — more jobs and higher profits — are largely and perhaps completely offset by a reduction in jobs and profits in export and linkage industries and in those industries vulnerable to the 'end run.' Therefore, the argument that protectionism serves as a jobs and income assistance program must be discounted."
— "The Policy Game," pg. 79-80

And Navarro has emphasized that tariffs won't hurt American consumers, saying on CBS' "Face the Nation" in March that the Trump administration's moves' effect on the prices of consumer goods will be "negligible to nothing."

In 1984, Navarro held a very different view:

"The biggest losers in the protectionist policy game are consumers. Even here. however, 'consumers' do not constitute a monolith, for there are several different consumer categories.

Bearing the greatest burden of protectionism are American retail shoppers who pay over $70 billion annually in higher prices (and reduced consumption) for products ranging from autos, bicycles, and color TVs to shoes, shirts, and cutlery."
— "The Policy Game," pg. 65

We find it very interesting given we already discussed the trend of "de-globalization" in this blog on numerous occasions, particularly again in January 2018 in our post entitled "The Twain-Laird Duel":

"In numerous conversations we have mused around the rise of populism in conjunction with protectionism, which represents clearly a negative headwind for global trade and is therefore bullish gold. The rhetoric of the new US administration has gathered steam and there are already mounting pressure to that effect. Furthermore, in our recent conversation "Bracket creep", which describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation, we indicated that with declining productivity and quality with wages pressure building up, this could mean companies, in order to maintain their profit margins would need to increase their prices. Protectionism, in our view, is inherently inflationary in nature. To preserve corporate margins, output prices will need to rise, that simple, and it is already happening.

Productivity in the US has been eviscerated. We feel we are increasingly moving from cooperation to "non-cooperation", a sort of "deglobalization". " - source Macronomics, January 2018

It is a theme we approached in January 2015 in our conversation "The Pigou effect" when we quoted the books The Trap and The Response from Sir James Goldsmith published in 1993 and 1994. Hedge Fund manager Crispin Odey given in an interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February 2015:

“1994 is when we were all slathering about the idea of a world economy, and what it is going to do as we open up,” says Odey.

“And Goldsmith basically says: ‘Hey, be careful about this because it is fine to have trade between peoples who have the same lifestyles and cost structures and everything else. But, actually, if you encourage companies to relocate and put their factories in the cheapest place and sell to the most expensive, you in the end destroy the communities that you come from. And there will come a point where the productivity gains from the cheapest also decline, at which point you have a real problem on your hands’ – And we are kind of there.” - source The Guardian

Sir Jimmy Goldsmith's great 1994 interview following the publication of his book "The Trap" which was eerily prescient. He violently criticizes the GATT and the curse of globalization as denounced as well by the great French economist (and scientist) Maurice Allais.

In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided):

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith

Real wage growth has been the Fed's greatest headache and probably the absence of it has been of the main reasons behind President Trump's election.

For those wondering what comes next, as discussed in January 2018, weak dollar policy is a natural extension of protectionist policies. FX policy should not be ignored in trade policy. They go hand in hand as a reminder.

We indicated in January 2017 in our conversation "The Woozle effect" the following:

"If indeed the US administration is serious on getting a tough stance on global trade then obviously, this will be bullish gold but the big Woozle effect is that it will be as well negative on the US dollar." - source Macronomics, January 2017

This we think has the potential to happen in the coming week/months provided there is no deal between China and the United States. The trajectory of real yields matter when it comes to gold.

In this week's conversation, we would like to look at a potential turn in the credit cycle, given the very weak tone coming from the latest US employment report and nonfarm payrolls coming at 75 K on a back of the blunt use of tariffs as economic policy which is already neutering gains from tax cuts.

Synopsis:

• Macro and Credit - Tariffs as a blunt instrument of economic policy? Handle with care.
• Final charts - Fed it taking it "easy" not "easing" yet.

• Macro and Credit - Tariffs as a blunt instrument of economic policy? Handle with care.

On the question of the "misuse" of tariffs as economic policy we read with interest the latest article on Asia Times from our esteemed former colleague David P. Goldman in his article from the 7th of June entitled "How I nailed the May payroll bust":

"Today’s data is a warning to the Trump Administration about the misuse of tariffs as a blunt instrument of economic policy.  The uncertainty generated by the threats to global supply chains from China to Mexico discourages capital investment. The tariffs already in place have taken back almost the whole of Trump’s $930 tax cut for the average American family, according to research by the New York Federal Reserve. That explains why retail sales are growing just 1% a year in real terms.

America’s growth spurt during the past two years has been Donald Trump’s great success. Tax cuts and deregulation (as well as the promise of more deregulation) revived the animal spirits of small business and produced an employment boom. But the president’s reliance on tariffs threatens to undo his good work, and prejudice his chances for re-election in 2020.

Paradoxically, the terrible, horrible, no-good, very bad payroll report is very good news for equities. It will strengthen the position of those among Trump’s counselors who have warned him that tariff wars are bad news for the economy. Sadly, the equity market depends more on how the president reacts to economic news than on the economic news itself." - source David P. Goldman, Asia Times

Already the trade war rhetoric is taking its toll on employment levels with US automakers coming under pressure recently. From China to the U.K., Germany, Canada and the U.S., companies have announced at least 38,000 job cuts in the past six months. Auto demand is increasingly becoming collateral damage when it comes to the ongoing tensions between the United States and China. As we pointed out in our last conversation, Germany is greatly exposed to the rising tensions. This can be ascertained by the latest industrial production print for April falling by 1.9%, the most since August 2014 and four times more than expected. 

As well, inflation expectations have been trending down, particularly in Europe with oil prices down 22% since its April high and as we stated before, where oil prices go, so does US High Yield and in particular the Energy sector as per the below chart from Bank of America Merrill Lynch for the month to date returns for May 2019, with CCCs being highly exposed to oil prices woes (Energy sector = 20.4% of face value, 15.1% of market value):

- source Bank of America Merrill Lynch

As the trade war intensifies, this doesn't bode well for both CAPEX and employment levels. Leaders from G20 countries will convene in Osaka on June 28 and 29 and markets are hoping for a deal between China and the United States.

In a context of weakening macro data on top of exogenous factors such as rising geopolitical tensions, no wonder the Fed has adopted a more dovish stance leading to market pundits expecting significant cuts to come during the summer hence the significant bounce we are currently seeing on the back as well of the end of the most recent true "Mexican standoff".

But what about the inverted yield curve and the potential for a recession ahead of us, one might rightly ask. On this subject we read with interest Nomura's take from their Japan Navigator note number 826 from the 3rd of June entitled "Inverted yield curve in UST market and monetary policy conduct":

"Many FOMC members have indicated that they would allow inflation rates in the 2.0-2.5% range during an economic recovery, but they are not willing to use average inflation rates from the past to constrain future policy conduct. They have also stated that monetary policy should not be used to pop asset bubbles. We believe that this question of whether the Fed should tolerate an inverted yield curve in the UST market will be a critical subtextual theme (discussed below). However, we believe that Fed Chair Jerome Powell and other mainstream Fed officials do not buy into this idea.

We expect the US-China trade dispute to reach the next stage between 4 June and the G20 meeting on 28 June, where Presidents Trump and Xi could meet. We sense that with every day that passes, markets become more convinced that an agreement between the two countries will prove difficult and a fourth round of US tariffs is on the way. Nevertheless, semiconductor stocks, which are more likely to be directly influenced, began to halt their fall this week, which suggests that the market has priced this scenario in to a considerable degree.

We do not think that a fourth round of tariffs alone would have an impact sufficient to trigger a global economic downturn. Moreover, judging from the actions of Chinese policymakers, they seem to have determined that weakening RMB would represent a risk for China as well (due to capital flight), and there are no signs that they will guide RMB to weaker levels. Unlike many economists, we believe that if negotiations essentially break down and the US goes ahead with more tariffs, China will beef up its subsidies to export companies rather than taking measures aimed at expanding domestic demand, and in this case the damage to China and the global economy would be lower than a simple estimate premised on a reduction in Chinese exports and other countries serving as substitutes. This is because Chinese companies would absorb most of the hit from tariffs and continue to export goods. No matter how much China bolsters domestic demand measures, it is difficult to paint a growth strategy for China’s economy that does not depend on US markets. Moreover, from a US perspective, it is easier to play up a “success” if tariff revenue increases and Chinese companies, rather than US consumers, are forced to bear the load. This kind of scenario suggests a high risk that US rates, which have priced in an economic downturn, will rise. This upturn could occur when the US government officially announces a fourth round. At this point, we expect EM currencies and equities as well as USD/JPY and Japanese equities to rebound, so investors should prepare for this scenario.

If the Fed cuts rates to correct inverted yield curve, it would essentially be trying to fix a problem it created itself

The Fed’s dovish members, centered on Vice Chair Clarida, view an inverted yield curve in the UST market as an important sign presaging an economic downturn, and advocate policy conduct that would avoid such an inversion. In fact, if we look at the three economic cycles since 1980, the yield curve inverted, with yields on 3m Treasury bills higher than 10yr UST yields, followed by an economic downturn (Figure 2).

We believe this inverted yield curve is not simply significant as a sign, but also indicates a situation in which a deterioration in financial institutions’ earnings environment is likely to set off a credit crunch. However, there are many problems with simplifying this issue and arguing that monetary policy should be conducted to avoid an inverted yield curve. 1) Inverted yield curves occur when the market begins to anticipate a future rate cut, but the market tends to almost automatically move in this direction when the Fed sends the message that it will end rate hikes. 2) In past cycles, there has been a lag of at least six months to two years before the economy enters a downturn after the end of rate hikes (Figure 3).

3) There have been cases, such as in 1998, when the yield curve has inverted, but the yield curve has returned to normal levels as the economy recovered. In other words, if the Fed itself decides to cut rates to correct the yield curve, which inverted in response to the Fed’s own message, it would essentially be fixing a problem of its own making. Of course, if the Fed can accurately predict the economy’s cycle (i.e., even if it stops raising rates, an economic downturn in the near future is inevitable), the Fed could probably use policy to minimize the damage of an economic downturn. However, if this is not the case, a premature rate cut could exacerbate the asset bubble and worsen the damage done by a future economic downturn. In fact, in the aforementioned 1998 example, the IT bubble worsened after the Fed cut rates.

Does the bond market have better foresight?

In addition, the theory that an inverted yield curve leads to an economic downturn tends to lead to the erroneous perception and belief that the bond market is better at predicting the economy than equities and other risk assets. However, this is simply due to differences in these financial instruments, and does not indicate any particular capacity for judgment. While bonds tend to perform better in economic downturns and periods in which inflation is falling, most risk assets are just the opposite. As a result, in economic recoveries, risk assets, not long-term yields, tend to identify the signs of a recovery and rise accordingly. Moreover, as noted above, the time lag from the inverted yield curve to an economic downturn differs considerably depending on the cycle. For example, in the cycle in the 2000s, after the yield curve inverted (from July 2006), the economy continued to expand for almost two years, and during this period long-term UST yields fell and then rose again, reaching their highest point in this cycle (June 2007). The subsequent subprime (Paribas) shock in August 2007 all but guaranteed an economic downturn (it officially began in December 2007), and we very much doubt that bond market participants predicted this shock and acted accordingly all the way back in 2006, when the yield curve began to invert.

We believe 10yr UST yields peaked at 3.23% in this cycle, but…

In this cycle, we believe that the Fed raised rates last in December 2018 and 10yr UST yields peaked just before this, in November 2018 (3.23%). As a result, in this cycle as well, observers will likely credit the bond market with having predicted an economic downturn before the risk asset market and acting accordingly (with an inverted yield curve a sign of an economic downturn). However, the bond market has not already accurately predicted the kind of event or shock that would ensure an economic downturn, which we expect to occur in the future. We suspect that, while bond investors continue to price in a rate cut and test out the market, they will coincidentally reach this kind of event. The period of time from now until the economic downturn is not predetermined, and before this event occurs, we expect to see a period (2019 H2) in which the market reverses its excessive rate cut expectations. For this reason, we believe it would make sense to wait for 10yr UST yields to rebound to about 2.60% rather than chasing yields down to 2.30% and buying." source Nomura Japan Navigator No. 826 June 2019

From a tactical perspective, we do believe that the long-end of the US yield curve has been "overbought" and we are already seeing signs of exhaustion, so no surprise to see somewhat a pullback in our favorite proxy being ETF ZROZ (strips of 25 years plus zero coupon). As well, gold is also marking a pause which can be ascertained by a bounce in real yields and the "risk-on" tone prevailing today.

When it comes to our title and the "policy game" being played, we think we are far from any meaningful "cease fire" between the United States and China. Volatility will continue to run high we think and in that context, we continue to view quality credit such as US Investment Grade as more protective than currently high beta, which in the case of US High Yield is tied up to the direction of oil prices. 

As we stated before, we would rather continue playing it on the defensive side given the many uncertainties surrounding a potential trade deal. With this ongoing "Numbers Game", while we might see unfolding a tactical bounce, fundamentals are rapidly deteriorating with this lingering confrontation. On the potential outcome we read with interest CITI's take from their Global Strategy and Macro Weekly note from the 10th of June entitled "Trade Wars: Game Theory Suggests Escalation Risk is Underestimated":

"The uncertainty around the negotiations makes for a challenging backdrop for investors. Recession risk is rising. As our Global Macro Strategy team points out; the 3m10y yield curve inverted on a closing basis for the first time this cycle at the end of May. This, they believe, could start the clock towards a recession mid- 2020. The tailwinds of fiscal policy are fading. Trade wars could be the additional shock that break the resilience of global, and US, economies (see: Global Macro Strategy Weekly: Trade War = Recession).

The GMS team offers three scenarios: (i) a trade deal at the G20; (ii) no trade deal and no Fed easing and (iii) no trade deal and aggressive Fed cuts (75bp quickly). Our current assessment is that we are in Scenario 2 but may be transitioning to Scenario 3.

Scenario One: Trade Deal at G20

• Equities sharply higher with EM significantly outperforming as so much more is priced here for slower global trade growth. SPX~2900
• Yields higher, probably parallel shift higher or bear flattening. 10y yields ~2.5%
• Gold lower, maybe $1300
• USD lower with risk on but not much as Fed easing would likely be priced out to some degree.

Scenario Two: No Trade Deal and No Fed Cuts

• Equities sharply lower, probable full scale bear market. SPX to 2350
• Yields sharply lower with curve twist/ bull flattening. 10yr UST to 1.50%, maybe
• lower
• Gold higher. $1600+
• USD higher bar JPY

Scenario Three: No Trade Deal, Fed Cuts (75bp or more)

• SPX higher; new highs. Other equities mixed.
• Yields lower with bull steepening 10yr UST 1.75-2.0%
• Gold higher on lower rates and lower USD. Target $1500
• USD lower as carry is eroded. EUR/$ 1.15

- source CITI

We think that, right now investors are displaying two cases of "overconfidence", one being the pace and number of rate cuts coming from the Fed, second being a clear resolution between China and the United States when it comes to this much discussed trade war. Fiscal policy results are starting to be obliterated by the blunt use as economic policy instrument of tariffs. They are being used way too much by the Trump administration and it is starting to bite, not only on the employment front but, as well on earnings.

Sure the Fed might be providing some much needed support to the strains already showing up in credit markets such as rising dispersion, but the continuation of the trade war could push the US economy and the rest of the world towards recession and led to a stagflationary outcome in conjunction with wider credit spreads and that would mean trouble ahead we think. We have not reached that point but, playing this trade war game into overtime is a recipe for disaster. In that context, gold prices look likely do well if the trade war escalates further. 

The ongoing trade war could turn into a currency war, further boosting investor appetite for gold hence our negative stance on the US dollar. On the subject of the US dollar's trajectory we read with interest Deutsche Bank's take from their FX Special  Report note from the 5th of June entitled "What happens to the dollar if the Fed cuts rates?":

"We have been worried about global growth and have positioned our FX Blueprint portfolio accordingly for nearly a month now. But what happens if the Fed cuts rates as soon as July or September? How would this impact our views and what does this mean for the dollar? In this special report, we show that Fed rate cuts are a necessary, but not a sufficient condition to drive the dollar weaker.

Near-term, the dollar almost always weakens in the run-up to Fed rate cuts. But dollar weakness usually does not follow through. We argue that the Fed would need to cut rates by at least 100bps for a sustained, large move lower in the dollar. In its absence, an “insurance cut” of 50-75bps will likely keep the dollar mixed with the JPY and CHF continuing to be the primary beneficiaries (they remain our favourite longs), Asia FX the primary casualty (we remain very bearish), and the EUR stuck, though vulnerable to a squeeze higher given market positioning.

If the Fed ends up cutting by a lot more, these conclusions would change however. In the event of a full Fed easing cycle, we would expect EUR/USD to head back beyond 1.20 and dollar weakness across the board, with the possible exception of Asia. Our portfolio at the moment is more closely aligned to the former, rather than the latter scenario.

Low growth tends to be good for the dollar

The dollar has been part of our defensive portfolio together with the Swiss franc and Japanese yen. Historically, the dollar tends to do well in global slowdowns. First, the US is one of the most closed economies in the world so that global slowdowns tend to be asymmetrically reflected in the rest of the world (chart 1).

Second, even though the dollar can’t claim the huge positive internal investment positions of the franc and yen (chart 2), it benefits from the shortage of dollar funding that has been well documented by the BIS, among others .

Fed rate cuts are not always bearish for the dollar

Does the dollar lose its safe-haven status when the Fed cuts rates? The short answer is, sometimes, but certainly not always. We start by looking at the last five instances of Fed easing. Two of these instances were Fed “insurance” cuts (1995 and 1998) while three were full-blown easing cycles (1989, 2001, 2007). The clear conclusion is that while the dollar nearly uniformly weakens into a Fed easing, the subsequent performance is far from consistent. Indeed, the dollar has ended up strengthening in 3 of the last 5 Fed easing cycles. The conclusion is valid for both EM and DM (charts 3 and 4).

What other central banks do matters

So, if Fed rate cuts are not a consistent driver of the dollar what else matters? The interest rate differential is a useful starting point. If the Fed is cutting but the rest of the world is cutting even more it may well be that interest rate differentials drive the dollar higher. This was indeed the case during the 1995 and 1998 insurance cuts which saw rates move sharply in favour of the USD even though the Fed cut (chart 5).

Is this a risk today? Highly unlikely. The US- rest of world differential is already sitting at record extremes and almost every other DM central bank is constrained by the zero lower bound. If the Fed is cutting rates, the rate differential should be worsening for the dollar.

The level of rates also matters

Is a narrowing interest rate differential enough to turn the dollar? It is a necessary, but not a sufficient condition. Take 2001 when the Fed started an easing cycle and rates collapsed against the USD. The dollar continued rallying for a year until it finally turned. What helped? First, the absolute level of US rates which made the dollar a high-yielder (chart 6).

Second, the continued strength in the US basic balance, with the dollar only peaking once the US current account deficit turned sharply wider and the dollar became a low yielder (chart 7 and 8).

Indeed, the broad dollar cycle tends to be more correlated to the absolute level of US yields that the relative changes.

Lessons for today

The dollar is in a remarkable global position today holding the developed world’s highest yields. Never before in the history of free-floating FX has the dollar held such a preeminent position. How much does the Fed need to cut for this to stop being the case? Assuming other central banks follow the forwards, the Fed would have to cut rates by 125-150 bps to a little below 1% for the dollar to lose its high-yielding preeminence. With the rates market pricing a terminal Fed funds of 1.3% we are still one or two rate cuts away from that level. This of course also assumes that central banks with high rates such as the RBA and RBNZ would not cut more than the forwards.

An alternative approach to answering this question is to look at when the dollar lost its sensitivity to changes in yields, i.e. when did the absolute level of rates start dominating over the changes in the rate differential? Looking at the beta of EUR/USD to the EU-US rate differential we note that the sensitivity of rates to FX peaked in 2017, just when the 5-yr rate differential crossed 2%. This differential is now back at 2.3%  so we are still about 30bps away from the relative changes in yields reasserting themselves in importance. Overall, we reach a similar conclusion to the previous analysis: we need to price 1 or 2 more cuts for the level of US yields to again become "low".

Two other important observations

Interest rates aside we would make two other observations. First, the developed market dollar is already at the upper end of its historical valuation bounds (chart 9).

Valuation is a powerful medium-term anchor and a natural constraint to further dollar appreciation. The conclusion is different for the dollar including EM, mostly due to the undervaluation of USD/CNY (chart 10).

This valuation discrepancy between EM and DM would support a conclusion that the dollar has far more room to strengthen against EM – especially Asia, given the nature of the global trade war – even if the Fed cuts rates. The second observation is that US flow dynamics are not sending a particularly strong signal. The dollar is strong but so is the underlying US basic balance, without any large movement either way. In other words, the market is already overweight dollar assets but there are no clear shifts either higher or lower for now.

Conclusion

Putting it all together, we conclude that Fed rate cuts are a necessary, but not a sufficient condition to drive the dollar weaker. We argue that the Fed would need to cut rates by more than 100bps for a broad-based and sustained move lower in the dollar. In its absence, an “insurance cut” of 50-75bps will likely keep the broad dollar mixed with the JPY and CHF continuing to be the primary beneficiaries of weaker growth, EM FX (especially Asia) the primary casualty, and the EUR stuck in the 1.10s.

These relative moves are already broadly in line with our forecasts, but these would change in the event of a full-fledged easing cycle from the Fed back down to zero. In this instance, we would expect the EUR in particular to more broadly participate in a dollar down-cycle, a topic which we will investigate in a future publication." - source Deutsche Bank

If big dollar cycles are dominated by flow as indicated by Deutsche Bank, then again, the dovish Fed has finally triggered a USD sell-off it seems with hedge funds selling from a long position. If flows are indeed turning against the USD, then a US dollar weakness could be sustained.

When it comes to market expectations, and the Fed in this "Numbers game" as per our final charts below we think the Fed is "data" dependent and has noticed the slowdown but is not yet ready to go full on the brakes as the market is expecting in "overconfidence".

• Final charts - Fed it taking it "easy" not "easing" yet.

Taking it easy is not taking it to easing and as per our above discussion we think investors are a little bit ahead of themselves when it comes to the number of cuts expected and the pace. One nonfarm payroll bad number doesn't yet make a trend though the most recent data highlights disappointment and worries from the ongoing trade war. Our final charts below comes from Wells Fargo's Weekly Economic and Financial Commentary from the 7th of June and shows the growing hints of the slowdown in conjunction with the appropriate pace of policy firming:

"Growing Hints of a Slowdown

In the midst of rising prospects of a prolonged and more pronounced trade war, data this week seemed to lend some credence to the idea that the domestic economy is beginning to succumb more materially to all the uncertainty. Nonfarm employers added just 75,000 jobs in May, missing even the lowest forecast, while downward revisions shaved off a further 75,000 from prior months’ reported gains. Average hourly earnings also missed expectations, up 0.2% on the month and 3.1% over the year, the slowest rise since September. The bond market reaction was swift; yields on both the two-year and 10-year immediately fell more than six bps, likely out of a belief that the growing hint of labor market weakness may force the Fed’s hand and induce a rate cut.

Indeed, the market has come to view a cut this year as a foregone conclusion; futures markets have priced in around 75 bps of easing this year. A more defiant stance from the Trump administration towards China and the threat of a new volley of tariffs directed against Mexico are likely driving the pessimism and risk-off attitude. Despite high-level negotiations regarding the U.S.-Mexico border situation this week, 5% tariffs on all imports from Mexico are slated to go into effect Monday, and could rise as high as 25% by October. This latest escalation more than doubles the total value of goods subject to tariffs to around $700 billion and, perhaps more worryingly, brings into stark view the willingness of the administration to use tariffs as leverage for political or diplomatic concessions, dropping even the pretense of an economic rationale. See Topic of the Week for more detail.

The question for the Fed, then, is whether markets are overreacting to trade uncertainty by expecting three cuts in a 3.6% unemployment rate economy. Noted dove James Bullard kicked off the Fedspeak on Monday, stating that a cut “may be warranted soon”, and noted that even if growth does not succumb to trade tensions significantly, lower rates would help bring inflation up to target more quickly. Chair Jay Powell took the baton on Tuesday, saying, “We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion”. Markets took these comments and ran with them, as the S&P 500 surged 2.1% on the day and remained buoyant the rest of the week. We would suggest a more leveled view, as his comments are not anything new, per se. Expectations of a ‘Powell put’ may be a bit premature, if we resist reading into his comments too deeply, and in light of Robert Kaplan’s call for patience amidst trade threats that could be reversed as quickly as the president can tweet. John Williams similarly suggested staying on the path of data dependence.

To that end, the ISM manufacturing survey fell 0.7 points to a 31-month low of 52.1, while the non-manufacturing survey rose 1.4 to 56.9, offering some evidence that the divergence between the manufacturing and the much larger service sector is persisting; in other words, the slowdown in the trade and global growth-exposed manufacturing sector has yet to spill over into the broader economy in a major way.

Still, the majority of economic data lags. The cyclical parts of the economy are already slowing, and the uncertainty over the entire economy is already here." - source Wells Fargo

To conclude we see two cases of "overconfidence", one is the pace and number of rate cuts coming from the Fed, the second is a clear resolution between China and the United States. We therefore think it is premature to bet in the "Numbers Game" run by the Fed and we would rather stick to defense and watch a little bit from the sideline rather than going again "all in" on a supposed return of the famous "infamous" Fed put. We don't think we are there yet and what matters for the Fed is financial stability overzealous markets racing ahead we think.

"The more people rationalize cheating, the more it becomes a culture of dishonesty. And that can become a vicious, downward cycle. Because suddenly, if everyone else is cheating, you feel a need to cheat, too." -  Stephen Covey

Stay tuned!

Macro and Credit - Prometheus Unbound

"Trust my folly then, since it is best for a man truly wise to be thought a fool." - Aeschylus, Prometheus Bound

Watching with interest "risk-off" unfolding with Emerging Markets continuing to bleed thanks to the ratcheting up in the trade war rhetoric, leading to more market turmoil, when it came to selecting our title analogy we decided to go for the Greek tragedy reference namely "Prometheus Unbound", a fragmentary play attributed to 5th century BC Greek tragedian Aeschylus. What is not to like in this title and the tragic element? It seems more and more probable that the United States and China cannot escape the Thucydides Trap being the theory proposed by Graham Allison former director of the Harvard Kennedy School’s Belfer Center for Science and International Affairs and a former U.S. assistant secretary of defense for policy and plans in 2015 who postulates that war between a rising power and an established power is inevitable:

"It was the rise of Athens and the fear that this instilled in Sparta that made war inevitable." Thucydides from "The History of the Peloponnesian War"

"Prometheus Unbound" is as well a four act-lyrical drama by Percy Bysshe Shelleyn Mary Shelly's husband, first published in 1820. In the Act II Asia the daughter of Oceanus and Thetys a water nymph and Prometheus love interest, and her sister Panthea descend in Scene IV in the cave of the Demogorgon, the demon ruler of the underworld. In this scene Demorgorgon promises the rise of a new world, triggered by Prometheus' revolution against Zeus/Jupiter. At the end of this act the revolution is triggered, leading to a new order but we ramble again...

Basically, current face-off between the United States and China, and also with the United States and Europe as well as internal rifts between the European Union mark a tectonic shift and validates our views that we are moving from cooperation to noncooperation. In a certain sense, the old Jupiterian order is being challenged by a new Prometheus. This is of course leading to even more instability and volatility in financial markets.

In this week's conversation, we would like to look again at the evolution of the trade war narrative and the rising instability we are seeing as well as the starts of widening spreads in credit which should put some additional pressure on equities at some point.

Synopsis:

• Macro and Credit - Trade war? It's on like Donkey Kong
• Final charts - Rollover risk? New debt is becoming more expensive...

• Macro and Credit - Trade war? It's on like Donkey Kong

As per our previous conversation, the recent turmoil seen in equities markets is a symptom of the prevailing "mercantilism" and trade war narrative:

"Returning to our core subject of "mercantilism" and trade wars, it is looking more and more likely that in similar fashion to the 1930s, we risk seeing tit for tat reactions from China to additional US sanctions. Obviously equities markets are reacting to this. Emerging Markets were the big beneficiaries of globalization and cooperation. Following NIRP and ZIRP implementation by DM central banks, EM have benefited from the high beta chase and massive inflows into funds. With the QE tide receding thanks to QT and with the escalation of trade war fears, obviously EM are coming under much pressure, hence our reverse macro osmosis theory we have been discussing various times playing out." - source Macronomics, June 2018

As we pointed out as well, any escalation of the trade war rhetoric would lead to some stagflationary effects, higher prices and lower growth. If indeed there are additional measures taken for example against China, Chinese President Xi Jinping said last week he will not hesitate to retaliate against the U.S. on trade. This is indeed something to take note of.

On this very subject we read with interest Deutsche Bank US Economic Notes from the 19th of June entitled "The tit-for-tat trade barbs intensify":

"Trade tensions continue to intensify

We recently noted that the Trump administration has intensified trade uncertainties on a number of fronts. Over the past week, this intensification has focused on trade relations with China, where the administration announce plans for tariffs on $50bn of goods imports. The first tranche of tariffs, covering $34bn of Chinese goods, will begin to be collected on July 6. The second set of products covering $16bn of goods will undergo further review in a public notice and comment process, including a public hearing. In addition, the Administration threatened 10% tariffs on an additional $200bn of goods in response to China’s retaliation, and potentially another $200bn if China retaliates again.

In terms of timing, recall that the Trump Administration announced tariffs on the original $50 billion of goods on March 22. The product list was then released on April 3 with public hearings held in mid-May and the tariffs are expected to be collected starting July 6. We therefore assume that it would take around two to three months for the process to proceed to the implementation stage for the next $200 billion of goods. Given that the annual Chinese party meeting will take place in October and the US midterms in early November, we would not be surprised if tensions remain elevated for the next several months.

US businesses and consumers will be the prisoners of the latest dilemma

As we outlined in a recent note in April, the initial list of $50 billion of goods targeted for tariffs was relatively benign with respect to the potential impact on US consumers. In order to expand the list of goods to $200 billion, the US Administration would be hard-pressed to avoid large sectors such as consumer electronics. As Figure 1 illustrates, computer and electronics products accounted for a substantial portion of Chinese imports last year.

In fact, as Figure 2 outlines, the top 10 product codes in the USITC classification system account for a little over $150 billion of US imports from China.

This is important because as we can see at the top of the list, cell phones are the single largest category of Chinese exports to the US by dollar value, followed by tablets and laptops. These sectors combined represent over $80 billion of imports. It is likely that sourcing these products from other countries is not a near-term option for large US companies such as Apple. Therefore, these firms will then have to choose between absorbing the higher tariff costs via lower profit margins versus passing them onto consumers.

Growth implications

In our initial detailed look at possible trade war scenarios, we concluded that a trade war light scenario in which reciprocal tariffs were enacted that target somewhere between $50 and $100bn in goods, or equivalently around $30bn in tariff revenues, would shave -0.1 to -0.2 percentage points off of US growth. The proposed tariffs target a larger sphere of goods but at a lower weighted average tariff rate than we originally assumed, raising about $32bn in tariff revenue, or about 0.16% of nominal GDP. As such, the growth impact of this scenario is likely to be only slightly larger than we assumed in our original assessment, likely on the order of -0.2 to -0.3 percentage points. There is considerable uncertainty around this conclusion, owing to the difficulty in assessing supply chain disruptions and the response of financial conditions and consumer and business sentiment to the introduction of tariffs on a broad swath of goods.

In addition, our colleagues in China have noted that the cumulative impact of an escalation of the trade dispute would subtract -0.2 to -0.3 percentage points from growth in that region. China’s Ministry of Commerce issued a short statement, which promised to retaliate with "comprehensive quantitative and qualitative measures" if the US imposes more tariffs. As they had previously discussed (reports here and here ), US firms sold US$ 448bn worth of goods and services to China in 2017, $168bn through trade and $280bn through local operation by US subsidiaries in China. China has not threatened officially to target the US firms operating in China, but as the trade tension builds up our Chinese colleagues see that risk rising.

Inflation impact

According to analysis by San Francisco Fed economists, imports account for about 13% of the core PCE price index. The $50bn of goods targeted for a 25% tariff rate accounts for about 1.7% of total imports in 2017, while the $200bn in goods targeted for a 10% tariff rate accounts for about 6.9% of 2017 imports. If we assume that the types of goods targeted by tariffs are broadly representative, we find that core PCE inflation would rise by about 15 basis points (bps) in response to the implementation of these tariffs. Importantly, this would act as a one-time increase in the price level and thus provide a mostly transitory boost to inflation that would largely unwind in the following year.

Fed implications

With growth well above potential, the labor market beyond full employment and inflation near the Fed’s target, the Fed may be willing to tolerate a modest negative impact on growth, and Fed Chair Powell’s press conference indicated that he will likely need to see the negative implications in financial markets or economic data for the Fed to respond. However, with some willingness to tolerate above-target inflation, we think the Fed would very likely look through any rise in core goods inflation as “transitory”. Monetary policy makers would be more concerned about the second order effects on growth. Powell noted reports of companies holding off on making investments and hiring due to increased trade uncertainties when queried on the topic at his post-meeting press conference last week. Indeed, in the Fed's May Beige Book, tariffs were mentioned 22 times and business contacts noted that trade uncertainty was contributing to "supply chain disruptions" and have caused some firms to tap "the brakes on projects in the planning phases." Atlanta Fed President Bostic (voter/neutral) echoed these sentiments yesterday, noting that he has shifted his balance of risks to growth on the back of the recent escalation of trade threats.

It may need to get worse before it gets better

How far the trade tensions escalate will be determined by some combination of political and market pressure that is brought to bear on the issue. At some point, the potential economic damage and uncertainty caused by the trade tensions will precipitate a meaningful pullback in risk asset prices, forcing one or both parties to the negotiating table. How much of a drop in risk may be necessary to force the two parties to a negotiated settlement? As our equity strategist, Binky Chadha has often noted, 3% to 5% pullbacks in the stock market are a frequent occurrence. At the same time, 10% corrections are rare and signal up to a 50% probability of a recession, and the market generally drops 20% or more around actual recessions. We surmise that a correction approaching 10% should be enough to terminate the trade conflict unless it has gathered substantial momentum. A smaller correction could be sufficient if it was clearly induced directly by trade policy actions, though we admit that gauging the Administration’s reaction function is difficult.

Given the sound underlying fundamentals for US output growth over the next year, overall corporate earnings growth may be somewhat impervious to escalating trade tensions with China, but only up to a point. It is difficult to come up with direct effects from a tariff on $250bn of US imports from China plus a similar tariff on China’s $130 billion imports from the US ($160 billion including Hong Kong). This exercise becomes more complicated if regulatory measures are implemented that effectively act as capital controls. The book value of Chinese foreign direct investment in the US was over $27 billion in 2016 while that of US direct investment in China was over $90 billion. Our equity strategists estimate that a 0.2 to 0.3pp drag on GDP growth translates to a 1 to 1.5% hit to S&P 500 earnings growth. In the context of 2018 EPS growth which is on track to hit their forecast of 23% and 2019 growth estimated in double-digits, a 1-1.5% drag is not particularly significant. While the indirect effects of uncertainty and hit to business confidence are harder to gauge, they see corporates responding by putting more of their cash flow towards share buybacks, the primary driver of equities in this cycle from a demand-supply perspective.

In the meantime, China's review of Qualcomm’s $44 billion bid for NXP Semiconductors and the US handling of penalties against ZTE could be a litmus test of how this dispute could play out. A related issue concerns the progress of the Committee on Foreign Investment in the US (CFIUS) Modernization Act of 2018, which has been passed in the House but has not yet been debated in the Senate. This bill would provide a broad expansion of the government’s ability to review foreign investment. Further complicating matters is the Senate’s potential challenge to the Administration's handling of the ZTE penalties. Congress still has a busy schedule ahead of the August recess, which the Senate majority leader has threatened to cancel.

Other areas of potential conflict lie waiting in the wings as well. Soundings from the Administration indicate that tariffs on trade in autos could be in the offing, and important negotiations regarding NAFTA remain well short of a satisfying conclusion. Should the Administration choose to move ahead with auto tariffs and withdraw from NAFTA, the potential for an economic downturn will intensify significantly. In short, there will likely be no rest for the weary among trade warriors and their watchers in the months ahead. - source Deutsche Bank

Both Chinese elections and US elections could be seen as a catalyst for more posturing from both countries in the search for domestic political support. This will no doubt continue to create market jitters and increased volatility in the near term. Therefore we continue to see more pain ahead for Emerging Market (EM) and overall US stock markets should continue to outperform on a relative  basis. 

From an allocation perspective, we continue to think that any escalation in trade war would be bullish for gold, which recently has been weakening. We also think as well that the US long end is starting to be enticing.

Any escalation in trade war would have various consequences. On this subject we read Bank of America Merrill Lynch's take in their Liquid Insight note from the 20th of June entitled "Implications of trade war on rates and FX":

"Trade wars: near-term lower rates and flatter curve

As trade skirmishes continue to deepen, we see increased risk to our base case year-end outlook of 3.25% 10y rates, while our flatter curve view and wider 5y inflation breakeven view appear less vulnerable. The rates market impact of an escalation of trade tensions will naturally depend on the depth and severity of tariffs and retaliatory actions, but recent rhetoric suggests trade escalation may need to get worse before it gets better.
While views vary across outcome probabilities, our Global and Chinese Economics teams see an increase in trade risks.

Should trade tensions worsen, this would likely contribute to lower levels of nominal and real rates, an initially flatter curve, wider short-dated breakevens, and a stronger USD. The Fed would likely be undeterred from near-term hikes, but increased trade friction would likely force them into a slower medium-term path and lower terminal rate for this cycle. The sharp decline in payer skew (ie, declining cost of higher-rate protection) we think confirms the shifting of market probabilities toward the escalation scenario versus a benign outcome. With 3m-5y payer skew now at its lowest since 2007 (+25bp out vs - 25bp out), contrarian traders could take advantage of historically cheap valuations to position for a near-term benign outcome.

Should trade tensions increase, we would expect rates to initially decline with more severe risk off and the curve to flatten as the Fed likely remains on course for further rate increases later this year. However, over time, we would expect that the Fed will need to react to the weaker global growth backdrop by stopping their tightening cycle and potentially cutting rates, which would allow the curve to steepen. As discussed here, this environment would be supportive of wider short-dated breakevens and we also see risks of lower real rates along with a flatter breakeven curve. We also see risks that a material increase in trade tensions could result in less foreign investor sponsorship of US Treasuries, which would contribute to higher rates and term premiums in the longer run.

Fed’s reaction: flatter curve and lower long-term rates

Overall, we think a trade war escalation is unlikely to deter the Fed from near-term hikes but would likely result in a slower medium-term path and lower terminal rate for this cycle.

We see the Fed’s response to a trade-war escalation as occurring through two phases:

• Near term: the Fed will likely refrain from overreacting to the increase in trade tensions and aim to continue with two additional rate hikes this year. The Fed has repeatedly indicated it does not see a meaningful impact from trade tensions in the data thus far. Chair Powell responded to a question on trade in his most recent press conference by saying that “we don’t see [trade tensions] in the numbers at all. The economy is very strong. The labor market is strong. Growth is strong. We really don’t see [trade tensions] in the numbers, it’s just not there.” That said, Powell and other Reserve Bank Presidents (ex. Atlanta Fed President Bostic) have indicated risks from trade tensions are rising among their business contacts. We expect the Fed will likely refrain from altering the direction of policy until these tensions are more evident in economic data or through a sustained tightening in financial conditions.

• Medium term: the Fed may need to reduce the total number of rate hikes over the course of this cycle and realize a lower terminal rate. Although tariffs will likely place near-term upward pressure on inflation, we expect the Fed will look through this dynamic and instead focus on underlying softening global growth and consumer demand. This would pose risks to the number of hikes the Fed delivers in 2019 or 2020 and result in a lower terminal rate for this cycle. This assumes any near-term tariff-induced increase in the price of goods would be expected to be short lived and not spill over into longer-run inflation expectations, which is our base case view. If trade tensions result in a rapid escalation of tariffs and protectionist policies, a severe trade war could suppress growth and potentially cause the Fed to consider rate cuts.

Rates reaction: lower rates, higher breakevens, flatter B/E curve

US Treasury rates would likely decline with a further material increase in trade tensions. Rate declines would be led by risk-off dynamics and lower growth expectations. Based upon our expectations for the Fed, the initial response from the rates market would be to price in a flattening of the curve as the front end responds to tightening while 10y and 30y rates remain low due to declining growth expectations and a lower pricing of the terminal rate. As the Fed shifts their reaction function, we would expect the Treasury curve to steepen due to lower expectations for rates hikes and potential concerns about overseas demand for Treasuries.

Within the composition of the rate moves, we would expect wider near-dated inflation breakevens, lower real rates, and a flatter breakeven term structure. Based on market reactions to tariffs in recent years (Table 1) including Bush’s steel tariff, Obama’s tire tariff, and Trump’s recent washing machine and aluminum/steel tariffs, the clearest market reaction is higher breakevens and a flatter breakeven curve.

This was particularly pronounced following the 2002 tariffs on steel, and on average still holds for the more recent measures. While we intuitively anticipate a decline in real rates in the face of tariffs, on a historical basis the real rate reaction has been mixed: 2y real rates tend to decline, but otherwise real rate levels increased on average following the announcement
of a new tariff.

Given these expectations, we see upside potential in our 5Y breakeven widener view. We originally recommended this view due to the economic backdrop and positive carry dynamics, but also see this position benefitting from an escalation in trade concerns. Any surprise from OPEC later this week to not expand supply would also benefit higher short-dated breakevens.

Reserve manager impact: upward pressure on rates after the initial risk-off

Trade tensions are likely to result in weaker UST demand from foreign central banks due to slower FX reserve build and less likely due to trade retaliation. From a flow perspective, a key channel between trade tensions and rates is reserve manager demand. Foreign investors accumulated roughly $6.2tn of US Treasuries over two decades as a result of international trade and market intervention, and $4tn of them are held by reserve managers. China and Japan are the biggest creditors of the US government, holding about 7% of overall marketable Treasury securities each. According to the latest TIC survey, foreign central banks hold mostly front-end to intermediate maturities (Chart 1).

After an immediate risk-off episode, the medium-term reduction in bilateral trade deficit between the US and China should result in a slowdown in China’s FX reserve build, resulting in lower Treasury demand from China. Lower global trade volumes should result in a slowdown of global reserve accumulation, less central bank demand for USTs and upward pressure on interest higher rates (Chart 2).

We think it is unlikely, however, that central banks would sell Treasuries as a retaliatory measure in trade discussions. It is unclear if Treasury selling would have the desired market impact given the mixed history. From 2015 to 2016, foreign official investors sold over $400bn in Treasuries (per TIC data), yet 5y and 10y UST rallied by 60-100bp. In theory, any sizable selling from CBs may be more concentrated in the shorter duration bucket, where the majority of central bank holdings are located. Given the significant demand in the front end this year (Chart 3, 70% of government mutual fund inflows have been concentrated in the very front end as demand for cash like assets surged), the impact of outright UST selling from CBs may not override the flight to quality bid and the repricing of Fed path, as observed in 2015-16. However, such reserve manager selling would likely serve to tighten swap spreads.

USD: accelerated appreciation

In our view, an escalation of trade war rhetoric would serve to accelerate USD appreciation that is already well underway as a result of cyclical and monetary policy divergence, with the added boost to the dollar essentially a function of the severity of perceived global trade deterioration. Under a scenario of a sharp pickup in trade policy deterioration, we would expect the dollar to sharply appreciate bilaterally against most currencies with the exception of the yen, which despite its substantial export sector tends to be supported in risk-off situations due to its large net foreign asset position. USD returns would likely be highest against the higher beta currencies of economies perceived to be most vulnerable to a slowdown in global and/or US trade, a list traditionally including CAD and AUD among others. Recent sharp deceleration in Euro Area data as a result of rising trade tensions early in the year suggests to us that EUR is also perceived to be included here." - source Bank of America Merrill Lynch

Escalation of trade war would see risks of lower real rates along with a flatter breakeven curve in the near term while obviously a rising US deficit would be negative in the long run for the US yield curve overall as foreign investors might shun purchasing additional US Treasuries.

There indeed mounting signs that in some places global trade and growth are slowing down. The trade war rhetoric is adding to this trend as of late. The risk-off environment can again be ascertained from fund outflows as indicated by Bank of America Merrill Lynch Follow The Flow note from the 22nd of June entitled simply "Cutting risk":

"Trimming longs

With credit spreads been broadly flat over the past couple of weeks, it seems that high grade investors have been trimming risk (chart 1) amid fears that Italian risk will not subside any time soon.

Notably all the major asset classes we track have recorded outflows last week, as trade wars have also supported the risk-off momentum.

Over the past week…

High grade fund flows were negative for a fifth week in a row; note that the majority of the outflow came from two funds.

High yield funds continued to record outflows (32nd consecutive week). Looking into the domicile breakdown, global and to a lesser extend European-focussed funds have recorded the largest outflows, followed closely by the US-focused funds.

Government bond funds recorded a third outflow last week; however the pace of the outflow has more than halved w-o-w.

All in all, Fixed Income fund flows were for a fifth week in negative territory, as the major individual pockets recorded outflows.

European equity funds continued to record outflows for the 15th consecutive week; over that period the asset class has suffered $39bn of outflows.

Global EM debt funds also recorded an outflow last week - the ninth in a row - with the trend deteriorating w-o-w, the dollar strength is heavily weighing on the asset class. Commodity funds recorded sizable outflows, the largest since 2013.

On the duration front, short-term IG funds recorded outflows, reversing last week’s inflow. Mid-term funds recorded their fifth weekly outflow in a row. However, long-term funds have seen inflows after a week of inflows." - source Bank of America Merrill Lynch

What is of course of interest to us from a credit perspective is the developing weakness in credit spreads. We did notice that US Investment Grade has so far clearly underperformed US high beta in the High Yield space, partly because of the Energy sector being a heavyweight in the CCC rating bucket. This disconnect has been highlighted in another Bank of America Merrill Lynch report, their latest Situation Room report from the 25th og June entitled "Let's get back together":

"Let’s get back together

Recently IG underperformance vs. HY in USD credit markets has been remarkable (Figure 1).

Reasons for IG weakness include first and foremost supply pressures in an environment of reduced demand that began in March and extended through last week, plus the Italian situation, which is about systemic risks running through the global IG financial system. Reasons for HY strength include the lack of supply, etc. Trade war risks are probably more neutral across the credit spectrum, as we saw today. We think IG spreads are somewhat predictable based on seasonal supply volumes and that we increasingly will be able to decouple from the Italian risks. That leaves IG spreads currently at the wide end of the range and with our HY strategist, Oleg Melentyev’s, outlook for wider spreads (see: High Yield Strategy: Scarcity of Yield is Now History 15 June 2018), that suggests decompression." - source Bank of America Merrill Lynch

What is of course of interest to us is that the recent in Investment Grade credit in the US in conjunction to a rising US dollar should seduce again foreign investors, and even Japanese investors, given their yield appetite. This is confirmed by Bank of America Merrill Lynch Credit Market Strategist note from the 22nd of June entitled "The return of foreign investors":

"USD corporate bonds now again offering better hedged yields than EUR

A couple of Fed rate hikes later, some spread widening and the USD corporate bond market is now again offering higher currency hedged yields for foreign investors than its EUR counterpart for most relevant maturities (Figure 6, Figure 7).

Specifically higher hedged yields can be obtained in USD credit inside 7-8 year maturities, which includes more than two-thirds of the EUR market."  - source Bank of America Merrill Lynch

Clearly, it appears to us that the divergence between US High Yield and US Investment Grade is not warranted. The recent decoupling to us should correct itself. Although high beta has been performing strongly, we think that in the second part of the year we could see a reversal with Investment Grade outperforming should a deceleration in growth materialize.

As pointed out in our most recent musing, US High Yield has had a much better performance overall than EM High Yield and even against US Investment Grade. But, US High Yield has started to look expensive. On that note we agree with Deutsche Bank's US HY Strategy note from the 26th of June entitled "USD HY looking increasingly expensive":

"In a year that has proved challenging for credit market returns, the USD HY market has proved something of a relative bright spot. In Figure 1 we show YTD total returns across the credit spectrum in local currency terms, ordering performance from best to worst. We can see that USD HY is one of the few parts of the credit market that has provided positive total returns, with CCCs and Bs, the standout performers. This is very much in contrast to the performance of USD IG credit, which has seen the worst of the YTD performance, weighed down by the extra duration and associated impact of rising Treasury yields.

The higher yields available in USD HY, particularly for lower ratings, certainly help to provide higher returns, but as we can see in Figure 2 it is also the only part of the credit market that has seen tighter spreads at an index level so far this year. It is worth highlighting that the strength of this performance is really being driven by CCCs and Bs, with the returns and spread moves for BBs much closer to what we've seen from USD IG credit, even though BBs have still outperformed IG.

Given this relative strength from USD HY we try to assess whether such outperformance makes sense and whether this part of the credit market is becoming excessively expensive.

USD HY broadly in line with volatility

In the left hand chart of Figure 3 we update our analysis comparing USD HY credit spreads against a volatility implied spread series.

(click to enlarge) 

We can see that spreads have continued to broadly track the volatility implied series, although it's clear that the reaction of USD HY credit spreads to the spike in volatility earlier this year was limited. As recently as a couple of weeks ago, the two series were in line but HY spreads have generally remained firm, even as we've seen a rise in volatility around trade tensions. The current differential has USD HY spreads around 70bps tighter than the volatility implied level. So this measure is suggesting USD HY is on the expensive side now. Interestingly, a quick comparison of the same measure with IG credit spreads shows that the opposite is currently true, with USD IG credit spreads actually wider (around 10bps) than the volatility implied level, even after the recent move higher in volatility.

HY vs. IG

We've already highlighted in terms of total returns that USD HY has comfortably outperformed USD IG. In Figure 4 we show the relative spread ratio which shows that at the start of 2018 the ratio was as high as it had been since the GFC.

This would arguably suggest that HY looked relatively cheap to IG at this point and therefore it is understandable that HY has outperformed. That said, the ratio is now towards the lower end of the post GFC range so the same indicator is now suggesting USD HY looks expensive compared to USD IG. If you remain bullish on USD HY you may point to the fact that the more domestic based issuers are less trade war sensitive than say IG companies. However if it eventually leads to a recession, these companies will eventually be hit hardest, so it is very hard to say they are a safe place to hide, in our view.

USD vs. EUR HY

Last month we published a more detailed note considering the relative value between EUR and USD HY ( link ), and here we provide an update of the simplest part of that analysis comparing broad index spreads for USD and EUR HY. At the time USD HY spreads had been tightening relative to EUR HY spreads but at an index level were still wider. As we can see in Figure 5 that is no longer the case with USD spreads now around 20bps tighter than EUR spreads.

 (click to enlarge) 

That said, the outperformance of USD HY can, in part, be justified by the fact that on this measure in Q4 2017 EUR HY was about as tight to USD HY as it had been since the GFC. However with this differential now back in positive territory and towards the upper end of the post-GFC range, USD HY is now looking fairly expensive on this measure and this does not even take into account the lower credit quality of the USD HY market compared to EUR HY.

We've shown that USD HY has compared favourably, performance wise, to other parts of the main corporate bond markets and that this outperformance has not been entirely unjustified. However there is certainly evidence that it is looking increasingly expensive. We now compare with some other parts of the broader credit spectrum; starting with EM.

DM vs. EM (USD HY vs. USD EM HY)

It's certainly interesting to look at how these two asset classes have performed relative to one another this year. YTD total returns for EM credit are currently less than -5%. This is not only weak compared to the positive total returns produced by USD HY but also compares unfavourably with other parts of the credit spectrum we have already used for comparison.

Interestingly, through Q1, total returns for both HY and EM were around -1%, so all of the divergence has really occurred during Q2. This is fairly well highlighted in Figure 7 which looks at the relative spreads of the two asset classes. 

 (click to enlarge) 

The spread differential had fluctuated in the 20-80bps range from late 2015 to the end of Q1 2018. However over the course of the last few months this has widened from less than 30bps to more than 150bps. Whether this says something about the relative attractiveness of USD HY now is probably a little more complicated. It can be argued that these relative moves are justified by the implications of Fed actions of late. USD HY should benefit from the same growth dynamics that have allowed the Fed to hike rates and therefore it's reasonable for spreads to keep tightening or at least remain tight. At the same time higher rates in the US can have negative implications for EM currencies and expose potential economic weakness and therefore lead to spread widening for EM sovereign credits. We have seen this recently for countries such as Argentina, Brazil and Turkey. We can also look to 2013 when there was also a notable divergence. This occurred around the time of the taper tantrum with the potential for the removal of monetary accommodation a likely factor here too. The EM-DM differential went from around 0bps in Q1 2013 to nearly +200bps by the end of September and as much as +280bps during Q1 2014 before hitting a peak differential of more than 400bps in early 2015. The differential only closed at the height of the recent energy/commodity crisis.

Given the likely drivers of the divergence, we're not sure in isolation whether the underperformance of EM in recent months is a particularly strong barometer. That said, given that other measures are suggesting USD HY looks expensive then it only adds to the story.

Bonds vs. loans

One comparison that is not so flattering for USD HY is the performance compared to the loan market. Figure 8 shows YTD total returns for bonds against loans and highlights that so far in 2018 loans have outperformed bonds by more than 1.5%.

So based on this comparison with broadly similar rated securities, there is nothing exceptional about the performance of USD HY. Clearly the floating rate nature of loans has helped here but we can see that loan returns are also much less susceptible to mark-to-market volatility and have therefore provided a more steady accumulation of carry this year. Looking at relative spreads in Figure 9 we can see that despite the underperformance in returns, spreads for USD HY do not look attractive on a relative basis.

In fact, current bond spreads are tighter than loan spreads at an index level and whilst this has largely been the case for the past 18 months or so, it is actually a fairly rare event historically. So in this instance, the performance of USD HY does not standout but it still looks relatively expensive on this measure.

Based on all of the simple relationships we have analysed, USD HY looks quite expensive. Our expectation for the remainder of the year, as we highlighted in our recent outlook update , is that USD HY is likely to underperform other parts of the credit universe." - source Deutsche Bank

Simply put, there is potential for a reversal of fortune for US Investment Grade credit versus US High Yield particularly in the light of the performance in High Yield being in the high beta bucket with CCCs taking the lead. As liquidity is withdrawn by central banks and financial conditions start tightening, it will become more and more expensive to issue debt for the weakest players. Some might say that the lack of issuance will therefore continue to provide a technical bid to the asset class, given the very high correlation with the S&P 500, we do not think US High Yield will be spared as it was in the second part of 2018. 

If indeed financial conditions are tightening and liquidity is being withdrawn, then again high beta such as EM will continue to suffer as per our final charts, this mean debt is becoming more expensive. 

• Final charts - Rollover risk? New debt is becoming more expensive...

Many pundits have pointed out the correlation between liquidity being withdrawn and tightening financial conditions. Obviously the credit spigot is being gradually closed by the Fed and it remains to be seen when corporate America's debt binge to finance buybacks will turn. On this subject our final charts come from Wells Fargo Economics Group report from the 20th of June entitled "Corporate America's Debt Binge: An Issue When Rates Rise?":

"Corporate debt has risen to 45 percent of GDP, equal to the peak of the previous expansion. Low interest rates and longer payment periods have kept corporate debt cheap, but these trends are beginning to reverse.

Nonfinancial Corporations Load on Debt

The overall U.S. economy has become less indebted since the Great Recession, with domestic debt outstanding as a percent of gross domestic product (GDP) falling to 330 percent in Q1 from more than 370 percent at the start of 2009. Shrinking debt relative to GDP is mainly due to deleveraging in the household and financial sectors, while debt has grown faster than GDP for government and nonfinancial business (below chart).

Aside from government, the largest debt gains have occurred in the nonfinancial corporate business sector. Corporate debt growth turned positive in 2011 and has averaged 5.8 percent a year since, propelled higher by low interest rates and robust investor appetite for fixed income securities. As a percent of GDP, corporate debt is currently sitting at its highest level of the cycle (45 percent) and is equal to the peak of the previous expansion.

Lower Interest Rates and Longer Payment Periods

The interest rates corporations are paying on their debt remain far below historical levels, which has helped to keep debt servicing costs low relative to the amount of debt corporations are holding on their balance sheets. We look at interest expense as a share of total short-term and long-term debt as a proxy for the average interest rate paid by corporations (below chart).

This measure fell substantially after 2009 as the Federal Reserve cut the benchmark rate, and remains below the lows of the 2001-2007 cycle for retail trade and all major manufacturing industry categories. Also limiting the corporate debt burden is a shift toward more long-term debt, which means lower principal payments due in each period (bottom chart).

Short-term debt (due in less than one year) represented 9.4 percent of debt held by manufacturing and retail corporations in Q1. This compares to over 13 percent at the end of the previous expansion.

In Q1, manufacturing corporations owed $505 billion on their debt in the coming year (short-term debt plus installments due on long-term debt), while large retail corporations owed $73 billion. These obligations amount to 19.1 percent and 12.6 percent of current assets, respectively. Even though interest rates and the short-term share of debt are lower than during the 2001-2007 expansion, high debt loads mean that debt payments coming due relative to current assets have far surpassed levels of the previous expansion.

But… Debt is Becoming More Expensive

In the past year, the short-term share of debt and the interest rate proxy have risen for corporations, reversing previous trends. Therefore, debt is set to become more expensive. Given strong economic growth and profits, leverage is not overly concerning at present. However, should investor appetite for debt wane or benchmark interest rates go up quickly, funding new debt could fast become more onerous for U.S. corporations." - source Wells Fargo.

Looks like Prometheus is indeed "unbound" and that there could be some "revolutionary" changes down the line for financial markets. For many years the Fed had your back. Not anymore. If indeed there is an escalation in trade war leading to a stagflationary outcome, then one would expect US long Treasuries and long duration Investment Grade to start outperforming again in the near term. In similar fashion to Demorgorgon promising the rise of a new world, triggered by Prometheus' revolution against Zeus/Jupiter, liquidity withdrawal should be taken very seriously , particularly for EM. As we stated before, liquidity matters more than fundamentals in many instances as our reverse macro osmosis thesis discussed recently played out which is an illustration of "Sudden Stops: A Primer on Balance-of-Payments Crises" as we were reminded by this excellent article (H/T Alibey Tuncer). Things are starting to get interesting...

"The story of 'Prometheus' is the idea that if you're given a gift from the gods, do not abuse it, and do not think you can compete." -  Ridley Scott

Stay tuned !