Via Damien Boey at Credit Suisse:
Equities are selling aggressively and bonds are rallying on the back of recent escalation of trade wars. Investors are behaving as if the end of the world is nigh. But is this really the case?
Our thesis is that the world is suffering its worst uncertainty shock since the global and European financial crises. And as RBA Governor Lowe has helpfully pointed out, when people feel uncertain, they “sit on their hands, doing nothing”, causing economic growth to slow. Our preferred gauge of uncertainty combines market pricing (VIX) with newsflow-based measures to come up with a holistic measure. Our hope is that by including newsflow uncertainty, we can approximate what the average person on the street is feeling, and take a step backwards from the suppression effects of central bank intervention in financial markets. Currently, our uncertainty index is more than 3 standard deviations above long-term average.
A familiar chart doing the rounds shows the lead-lag relationship between the VIX, and the US yield curve inverted. The argument is that once the yield curve becomes inverted, central banks have overtightened, and it is inevitable that risk increases at some point in the period ahead. Our innovation is to look at the relationship between the uncertainty index (as defined above), and the slope of the US real (rather than nominal) yield curve.
What is interesting is that:
- The relationship between the VIX and US yield curve seems to have broken down in the era of central bank intervention.
- Yet over this same period, the contemporaneous, inverse correlation between global uncertainty and the US real yield curve has increased dramatically.
What this all tells us is that:
- The VIX is an incomplete measure of uncertainty, because it is being targeted by central banks.
- In the past, tight monetary conditions have led to higher volatility. But now, the relationship has changed, either in terms of lead-time, or causality. Perhaps now, high volatility leads to expectations for slower growth and central bank intervention. Reflecting this, high (low) uncertainty almost immediately correlates with a flatter (steeper) US real yield curve.
In other words, there is evidence that the central bank response function has changed. In the past, central bankers used to react to growth and inflation, or perhaps the leading indicators of growth and inflation. Now, they react to the uncertainty bands, or tail risks around their mean forecasts. Uncertainty about growth seems to be enough to prompt “insurance cuts” or balance sheet expansions from central bankers.
How then might policy makers respond to the recent uncertainty spike? To be sure, there is nothing Fed Chair Powell can do to stop US President Trump from communicating his intentions to the market. What Powell can do is deal with the consequences. Yet with asset valuations at such stretched levels across the board, investors are questioning the ability of central bankers to suppress volatility with their puts, because there is simply not much margin for error. This is where the US Treasury comes into play. Outright foreign exchange intervention technically sits within the US Treasury’s mandate. The Treasury can initiate such intervention, and engage the New York Fed in discussions about the merits of such policy. But in the end, the New York Fed is subservient – it must execute the preferred policy of the Treasury. Many are unaware of the authority structure around foreign exchange intervention, and understandably so, since the option has not been exercised since the 1970-80 period.
If the US Treasury initiates foreign exchange intervention, the Fed’s operations become much more complex, as it now has to marry up quantities of money supply with prices (rates) having already just re-plumbed the system in the wake of quantitative easing. The risk is that the Fed expands its balance sheet again, giving up some control over interest rates, as bond market investors are already (correctly) pricing in. And even if the US Treasury does not take such drastic steps, the Fed is now set on an easing path, with every action being scrutinized through the lens of competitive devaluation now that China has been labelled a currency manipulator by the US government. Between the US Treasury and the Fed, there is credibility to weaken the USD in the medium term.
For China, the news could not be better. CNY/USD devaluation has been sharp by the standards of market memory – but trivial compared with the quantum of tariff increases from the US. Yet investors have clearly been very sensitive to devaluation, because it disrupts capital flows. This makes sense if short-term capital flows are the binding constraint on Chinese liquidity and growth, because CNY devaluation emboldens foreign investors to repatriate capital even faster, forcing the PBoC to choose between “the lesser of two evils”. Either the PBoC lets the relative price of money (the exchange rate) drop, or it reduces the quantity of money in the system (CNY deposits no longer wanted by foreigners, and reserves) instead. In the event that it chooses the first option, the risk is that speculators short the currency even more aggressively. If it takes the second option, the risk is that Chinese growth slows sharply.
But the flipside of all of this is also true. Should the USD start to weaken, the capital flight constraint on China disappears. The economy starts to see net inflows rather than outflows. A “crowding in” problem starts to surface, where capital inflow causes easing of Chinese financial conditions, supporting growth. And even if the inflows do not occur immediately, the absence of outflows enables Chinese authorities to pump prime the economy with fiscal and credit stimulus. They need not fear printing money with one hand (fiscal and monetary loosening), while destroying it with the other (sterilizing capital outflows). All in all, China should want a stronger CNY/USD at this point, if offsetting tariff increases is not the main game, but for signalling.
From an investment perspective, this means that there is longer-term value to be explored in commodities and perhaps emerging market exposures. Shorter-term, the risk is that momentum traders underestimate the strength of the policy response function to uncertainty. If high uncertainty is a catalyst for easing, and easing options are credible, the reward-to-risk ratio of being in defensive momentum trades is extremely low. On the flipside, if momentum can do worse, value can do a lot better. It pays to pick up pennies in front of steam rollers when central bankers are credible in suppressing volatility. As the old saying goes, when the VIX is low, its time to go … but when it is high, it is time to buy.