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Summary

  • Two glaring macro trades are (1) a global reflationary trade entailing overweighting equity vs. bonds and (2) taking advantage of US virilence vs. a sclerotic eurozone via FI and FX.
  • Yellen’s speech was rich in labour market interpretation, yet purposefully neutered in policy content. Whilst the US economy recovers speedily, the very structure of the labour market has changed.
  • The US and Euroland began the healing process together, but in 2011 Europe fell into recession again. Monetary, fiscal and structural measures are needed, but not forthcoming.

Fed Chair Janet Yellen's speech was rich in labour market interpretation, yet purposefully neutered in policy content. Her key message was that whilst the US economy is recovering speedily, the very structure of the labour market has been altered. The great recession through sheer devastation has displaced workers from the labour force, some of which will never return.

In addition demographic shifts and the retirement of the baby boomer generation has skewered labour force participation. Taken together the great recession and demographic shift have rendered traditional measures of output gap and labour market slack inappropriate. This leaves the Fed with inflation as the sole viable macroeconomic metric. Therefore the Fed is dealing with an extraordinary period of history and flying partly blind as traditional measures fail us. Yellen and co. have resolved this issue by erring on the side of caution, i.e. keeping monetary policy too lax rather than too tight. With inflation below target and wage pressures non-existent there is little that the hawks can do about it.

The ECB chair Mario Draghi's speech was an excellent synopsis of what is plaguing the olde world. The chart below shows how both the US and Euroland began the healing process together, but since 2011 Europe fell into recession again. Monetary, fiscal and structural measures are needed. Quantitative easing from the ECB, an end to budgetary austerity and in terms of structural reform an imposition of Germany's highly effective Hartz measures across the periphery. One cannot but feel that perhaps Draghi was explaining why he is faced with an insurmountable task.

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The fundamental problem of the Eurozone is inbuilt, i.e. it is a partial economic union. A single monetary policy cannot do it alone. A coherent economic architecture entails fiscal policy and the potential for structural reform. In a more ancient world approximating neoclassical models such as the 19th century this might not have been an issue, since wages and prices would adjust. Today however, even the most flexible economies such as the US, UK and Ireland are rigid in comparison to the gilded age of the 19th century. Hence welfare state laden economies necessitate a complete economic package, i.e. a common monetary, fiscal and political structure such as in the US. The good times hid this design flaw, but as Warren Buffet says, it is only when the tide goes out that you find out who's been swimming naked.

In terms of asset allocation the two most glaring macro trades are (1) a global reflationary trade entailing overweighting equity vs. government bonds. No need to stack up on gold, guns and antibiotics. The great recession has changed lead/lag times, but we are still in the upswing section of the global business cycle.

In terms of relative value one should take advantage of the virulence of the new world against the old. US economic dynamism relative to Euroland has not been fully priced in FX nor FI markets. Macroeconomic divergence will continue unabated as the old world continues to languish in relative terms. The thing to watch out for is that in the short run Eurozone weakness may prove to be an asset as QE speculation takes hold. Timing, the bane of every macro trade is key and contingent on Draghi rhetoric. The ECB press conference on the 4th of September should provide more clues.

(click to enlarge)

Source: No Fire In The Hole - Two Macro Trades For The Rest Of 2014