Before we get on to the events of Jackson Hole and their impact on bonds and FX, we just wanted to pick up on where we left last week. We outlined some initial thoughts about structural problems affecting the US, although to be clear, the productivity and income inequality problems straddle the developed world. Our view is that both fiscal and monetary policies have been ineffective in tackling the structural issues that are holding back broad based economic performance, and could actually be making matters worse as arguably policymakers are failing to even (publicly) understand what the structural issues are. We do intend to elaborate on these in the weeks ahead, however, the market reaction to comments made at Jackson Hole last Friday demand our immediate attention.
Although Janet Yellen was clearly lined up to be top of the bill at the Fed’s policy making symposium at Jackson Hole, we feel that her speech was far too balanced. As always seems to be the case with Yellen, she likes to try and please everyone whilst never generating much clarity. This was a chance for her to either to clarify near term Fed policy (on which she was fairly non-committal), or to outline a new framework for future monetary policy, which she failed to do in our opinion.
The theme of the conference was “Designing resilient monetary policy frameworks for the future”. Well, if like us, you believe that Fed policy has failed to generate their desired economic outcome, then Yellen’s speech fell well short of setting the world alight. She said that asset purchases and forward guidance “will remain important components of the Fed’s policy toolkit”, and that these should be sufficient in tackling future recessions according to an internal paper (using simulations on their main economic model – the one that has never predicted a recession). She confirmed that the FOMC are not “actively considering” a higher inflation target or nominal GDP targeting, somewhat shooting down John Williams of the San Fran FED. She noted that the Fed could consider buying a broader range of assets (presumably corporate bonds or equities – we really don’t see the economic benefit of this) although thankfully she didn’t mention negative rates, which some take to mean that many at the Fed do not like NIRP or even think it’s a bad policy.
We will likely come back to the Jackson Hole papers in weeks to come, but we need to move on. What really got the market excited on Friday were comments made by Yellen’s deputy Stan Fischer who backed up comments made by a number of other Fed Governors of late. He confirmed the broad view on the FOMC that the economy has strengthened of late and that interest rates should be raised gradually; possibly again next month if next week’s employment report supports a rate rise.
With markets having traded in an ever tighter range in recent weeks, it did feel that a breakout of some sort was due. It would seem that the collective comments across the array of FOMC members was finally the catalyst for such a break out. So, with the signal from FOMC members that a near term rate rise is back on the agenda, bonds and rates sold off (higher yields) and the Dollar moved smartly higher across the board. Equities also wobbled, but the signal here is less clear. So, let’s get into the detail, starting with bonds.
Chart 1 below shows the yield on the 10 year bond yield. There is little doubt that bond yields are lower than they should be given economic fundamentals, no doubt driven lower by negative interest rates throughout Europe and Japan. However, low rates could only be justified so long as the Fed was on the sidelines. Assuming that the Fed will raise rates shortly, we see bond yields moving higher. Any move higher next week will be seen as a technical break out, and momentum funds will no doubt be sellers of bonds. Indeed, with volatility near historic lows, leveraged players (like risk parity funds) are likely to have to reduce exposure by selling bonds as well. Although we have an immediate target of around 2% on a breakout, we do feel this could be on the conservative side.
The situation is similar at the shorter end of the yield curve and the interest rate markets. The message is clear. The market is reluctantly buying into the Fed narrative that interest rates are heading up in the near term. However, the overall message is as nuanced as Fedspeak has become in recent years. The market is also very comfortable with the view that interest rates will remain low for a long period of time, and the rates market is still predicting a much shallower normalisation than the Fed. We think the market is right on this occasion, however, there is room for surprise if the Fed suddenly got more hawkish.
The other nuance here is that the yield curve continues to flatten. This is the bond market’s signal that future economic growth will be modest (something a lot of our work suggests). Chart 2 below is a little noisy, but the message is that the shape of the yield curve is a reasonable predictor of future growth patterns (please note the yield curve is advanced by 2 years in the chart below). When the yield curve is steep, future growth will be reasonably strong and when the yield curve is quite flat, as it is today, future growth will be subdued. Aside from the turbo charged late 1990s, the pattern holds reasonably well. Furthermore, the yield curve remains one of the best single indicators of looming recession, in that an inverted curve has a reliable record of being a harbinger of recessions.
So although the Fed may want to raise rates in the months ahead, this may well lead to a flatter yield curve. If rates rise enough and the curve inverts, then recession fears will rise substantially. That said, we are really only expecting one rate rise by the Fed, and the overall impact on the yield curve should be reasonably muted, hence our target of around 2% for the 10 year bond.
With our focus on FX, the message that we really take away from rising yields is the impact on the US Dollar, which rose quite sharply especially after the comments from Stan Fischer. Despite months of sideways price action against the majors (as measured by the DXY index – shown in previous weeks), we have maintained a fundamentally bullish view on the Dollar, for two reasons. First, as we know from FOMC members’ comments, US rates are likely to rise, whereas the ECB, BoJ and BoE (along with a number of other central banks) are still looking to ease policy. This policy divergence should be supportive for the Dollar. Second, despite our worries over the structural health of the US economy, we do believe that it is better placed than others. We still think that Europe and Japan have major structural issues that are mostly being ignored by policymakers, and the UK has the Brexit negotiation to resolve. So, from a structural point of view, we would argue that the US has more potential than other developed economies, especially if policymakers there would start to follow some better policies.
We have been nibbling away at the US Dollar in the last week or two in our discretionary FX mandates and the RMG FX Strategy UCITS fund (see information HERE). We pulled the trigger and increased exposure quite markedly on Friday afternoon, with the focus being short Asian and commodity sensitive currencies. We recently highlighted the New Zealand Dollar (see report HERE) which we have sold against the Dollar and that failed badly again last week. We are also short the Japanese Yen, Singapore Dollar, Chinese Yuan and Malaysian Ringgit (capturing both our short Asian and short commodity currency themes) as well as the Canadian Dollar and a very modest short Euro position.
Chart 3 below shows the US Dollar breaking out against the Singapore Dollar after a well-defined four month basing pattern. The chart for the Dollar against the Malaysian Ringgit is pretty similar. We know from the second half of last year that a strong Dollar causes more problems in emerging markets than developed markets, and the ingredients for a similar move are very much in place again.
Another set up to highlight is the Japanese Yen. There is no doubt that a) the most successful outcome from Abenomic’s (in very simple economic terms) was currency weakness, and b) Abenomics is increasingly seen as failing. With the recent supplementary budget being a bit of a damp squib, the pressure will grow on the BoJ to do something (next meeting on 21st September), and frankly we think that the authorities would be very comfortable with a near term move back to the 110 area.
Furthermore, the 100 area has been developing a reasonable level of support in recent weeks. However, the potential trigger for a rally could well be liquidation of long positions held by the speculative community. Chart 4 below shows the Dollar versus Yen and the commitment of traders report for speculative positions. Going back to 2000, there has rarely been a time when the speculative community has been this long of Japanese Yen and short of US Dollars. Although this only represents a small part of the FX market, we think it does capture the current mood in the Yen quite well, in that a 20% rally in recent months has encouraged speculative traders to get near record long despite QQE and negative rates and major structural economic issues. If the Dollar does indeed turn higher, we expect the speculative longs to begin liquidating, adding to potential Dollar upside.
So it would appear that the Fed is set to raise rates this year, perhaps as soon as next month, and maybe December as well (not our forecast though). The market was not quite expecting this and we now think we are in for a period of rising bond yields and broad Dollar strength. If we are right, the question is whether this is a multi week or multi month trend, and at this stage it is far too early to tell. The Federal Reserve has been blowing hot and cold all year, resulting in a lacklustre Dollar and yields being dragged down by global forces. Our structural view is of economic challenges in developed economies, and so we need to be careful about getting too gung-ho on our bullish Dollar theme. We will have to take our evidence as we find it, and maintain a flexible outlook.