Macro Reflections #1

The post liquidity Era – from buoyancy to uncertainty

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Without doubt, 2018 will prove to be a transitional year. After almost a decade of outsized liquidity cushion, markets have witnessed in disbelief a succession of sharp market adjustments: the burst of the Bitcoin, a sudden weird drop in equities, a widening of the Libor-OIS spread, the selloff in leveraged Loans, and finally Emerging markets… a sequence of events reviving some forgotten memories of the 2007 crisis.

Are these Sharp moves simply temporary knee jerk moves related to the end of quantitative policies, or a more worrying harbinger of a switch to a new equilibrium where uncertainty is the “new” – “new normal””? Given the context, there must be a meaning to these sharp moves. If so, we need to worry about a reversal in risk premiums, as growth tail risk scenarios become ever fatter. And in investment terms, within such a context characterized by unforecastable breaks and disruptions, “long only” strategies or pure quantitative methods becomes insufficient for investors

Volatile market moves have become increasingly frequents this year. This is occurring as the unwinding of quantitative monetary policies finally started and gradually awakened investors’ uncertainty. In hindsight, 2018 will mark the true end of this amazing QE area that started intellectually 16 years ago, with the prophetic helicopter speech by Ben Bernanke in 2002. This experimental idea of massive purchases of bonds by central banks has been extremely successful but has had the major unexpected side effect of massively suppressing volatility (as ECB’s B. Coeuré recently reminded). With the increased predictability of monetary policies, all risk premiums (term premium, inflation premium…) have tightened durably, and risk assets have been supported. This lengthy period, exceptional in all aspects, ends this year, as the Fed’s balance sheet contracted by $100bn in Q1. Probably even more meaningful, forward guidance which was the ultimate certainty provider has just officially ended at the June FOMC. This 16-year period is now over. Doubts, policy debates, data shocks should now be expected to engender more uncertainty – as it used to be the case – with impacts on all financial asset classes.

Beyond this normalization, the next major source of uncertainty is shaping up amongst Central Banks as we approach R*.When QE had to be implemented, the intellectual challenges to this new policy were quickly removed : there was emergency, and free liquidity was the only obvious solution. Since these policies have to normalize, the beautiful consensus is fading fast. For a couple of months now, some quite striking and rare public disagreements have occurred between central banks on central concepts around potential growth, output gap, and R*. Successively the BOC, the ECB, and the Fed have not only questioned the hysteresis effects [1] (slowing potential growth during an economic crisis, developed by O. Blanchard), but also come up with contrasted views, if not opposing. The BOC [2] has shown a refreshing though childlike faith in the new technologies ability to drive up productivity and potential growth. The ECB [3] on the contrary, suggested that potential growth had probably merely fallen during the financial crisis, against all previous estimates. And finally, the Fed [4], maintained its view that the long-term potential growth had unfortunately not moved up an inch after its drop. These diverging views have interestingly allowed each central bank to justify some very different reaction functions. The BOC finds grounds to keep its rates low despite obvious inflationary pressures thanks to this ever-output gap “eternity” (as the potential growth rises, while growth rises, growth remains non-inflationary). The ECB on the contrary, thinks it has to start its exit sooner given that the accommodation has been much larger than justified. And finally, the Fed can maintain its steady pace despite record low unemployment. It is very likely that this growing discordance is going to feed increasing doubts about central banks reaction functions. Furthermore, the departure at the Fed of the all-star team of intellectual reference economists – Fischer, Bernanke, Yellen and Dudley – is going to make the debate even more difficult to grasp.

In parallel to these monetary matters, the other major factor feeding uncertainty is the potential extreme economic and institutional consequence of Trump’s policies. Within OPEP, NATO, or WTO, the Trump’s administration upsets the status quo. In the end, whether it proves to be merely a frequent use of aggressive negotiation tactics, or a major long-term strategic shift aiming at countering China, it is now clear that the disruptive impact is going to be real. The dollar for instance, one of the two pillars of the global financial system should be impacted in at least two of its core functions: its use as an intermediary in exchanges, and as a store of value. Indeed, the demand for dollars is impacted already by the systematic use of financial sanctions. The exorbitant privilege in a sense is moving from the economic arena to the geopolitical one, pushing the world towards alternatives to the dollar. More worrying in terms of growth scenarios, if the aim of the trade war is to slow the ruthless Chinese IT acquisition strategy, whose pace threatens the US military and its geopolitical hegemony, then the tensions have a long way to go. This could prove to be the end of Bretton Woods institutions and of the globalization move started 70 years ago – two key buildings of global stability. For sure, if the last decade’s consensus was defined by secular stagnation and QE infinity, they have been replaced by a universe of extremely diversified possible scenarios with much fatter extreme tails, such as the reversal of globalization.

In this context of policy uncertainty of and fat tail macro-economic scenarios, what are the consequences for financial assets and investment methods? Rising uncertainties will necessarily translate into financial assets. Some degree of reversal in ever tighter risk premiums seems unavoidable under all forms: term premium, credit spread, yield curve. What would be the sequence? Most likely, the first to be affected should be the 10Y USD yield – the other key anchor of the global financial system (with the dollar).

Its observable components (real yield reflecting growth, and breakeven inflation reflecting inflation expectations) have already risen significantly in the last semester. Yet, the term premium remains close to its lows (graph 1, around -50bp today against +150bp before the crisis). The decline in the premium was explained by many factors, such as the demand for riskless assets, budget deficits, financial volatility. But, the IMF in its latest global financial stability report has warned that it will rise significantly should investors become more uncertain about growth, inflation and monetary policies. That’s precisely what is shaping up. In other words, it is not just inflation that is going to determine whether US 10Y yields break the 3% threshold, it is more likely to be the term premium’s normalization as we see a reversal in the certainty about economic scenarios and readability of monetary policies that has characterized the previous decade.

After the years of airiness engendered by QE, uncertainty is now about to trigger a reversal in the compression of risk premiums. Bernanke, specialist of the 1929 great depression, proposed QE policies to avoid the catastrophic spiral of crisis, unemployment and austerity, that led to trade wars and rising populism. Isn’t it ironical and scary that despite the success of QE in economic terms, we are to some extent flirting with the same outcomes – trade wars and populism? Markets are not reflecting these fat tail scenarios. And this is happening precisely when a major debate about monetary policy is shaping up.
In such a context of rising uncertainty, the rise of Term premiums will spread to all assets. Subsequently, only active managers seeking absolute return, and relying at least partly on discretionary inputs and not exclusively on quantitative tools will be able of navigating the unforecastable breaks of unsteady equilibriums that accumulated over the QE area.

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Etienne de Marsac – Head of Absolute Return Strategies –https://twitter.com/etiennedemarsac

David Deddouche – Independent Macro Trader – Ex Macro Strategist at SGCIB & SAC Capital – https://twitter.com/DDeddouche

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