The third quarter begins with clarified monetary policy outlooks for the US, EMU, and Japan. At the end of Q2, the Federal Reserve signaled it would likely raise rates in September and December. The unwinding of the balance sheet, though, continues at a rapid pace. In Q3, the Fed will not reinvest the proceeds of the $40 bln of maturing bonds a month, reaching a terminal velocity of $50 bln a month in Q4.
The ECB will continue to buy $30 bln euros a month of mostly sovereign bonds through Q3. It will slow the purchases to $15 bln a month in Q4. It does not anticipate a rate hike for at least another year. The Bank of Japan is slowly reducing the amount of bonds it is buying, but no one is confusing it with tapering. It successfully managed to keep Japanese yields largely immune to the rise and volatility in yields abroad.
A common narrative was that the dollar’s decline last year marked the end of divergence, but it still has legs and will for a few more quarters. The US interest rate premium over the other high-income countries is either at record highs or multi-year highs. The US mix of tighter monetary policy and looser fiscal policy is as close to a currency elixir as could exist. It helped fuel the Reagan-Volcker dollar rally of the early 1980s. It was the policy mix in Germany after the Berlin Wall fell, which led to the Deutschemark overshoot that wrecked the Exchange Rate Mechanism, the Maastricht Treaty, and monetary union.
The US policy mix is extreme. The US has been gradually increasing interest rates since December 2015. Neither the ECB nor the BOJ has been able to raise interest rates even once. While the current monetary setting is still understood as accommodative, the Federal Reserve anticipates that policy will become restrictive by the end of next year. The fiscal stimulus that is hitting the US economy is as large as that from when the US was in the throes of the worst financial crisis since the Great Depression. Add in the particular details about the tax cuts that encourage companies to repatriate assets and the basis for the US sucking in the world’s capital is laid.
Global savings are coming to the US, and this displaces other borrowers. Among the first to feel the pinch are developing countries with large current account deficits and other challenges that could be overlooked amid the deluge of liquidity. The rising US yields also dampen the attractiveness of traditional high-yielding Australian and New Zealand dollars. Even Canada, which has hiked rates three times since the middle of last year, and is likely to hikes rates again in Q3, is no match. The US dollar rose to its best level in a year against the Canadian dollar at the end of Q2.
Economic disappointment in Europe and Japan make the US policy mix all the more potent. The eurozone economy slowed in Q1, and although some transitory factors were at work, growth does not appear to have picked up in Q2. In May, a little more than a third of eurozone government bonds, or 7.3 trillion euros, offered the still-confounding negative interest rates. The best days of the broadest economic expansion could well be past. The ECB staff forecasts slower growth in the next two years. The Japanese economy narrowly contracted in Q1 and appears to have been expanded a little in Q2. The Japanese yield curve is negative out eight years at the end of Q2 18. The Japanese government debt-to-GDP is among the most in the world, yet the US offers nearly 100 basis points more to borrow for four weeks than Japan offers to borrow for 40 years.
The consequences of the US policy mix in the context of developments in Japan and Europe may be the most disruptive force that investors will have to navigate in Q3. The main rival for this dubious honor belongs to trade. There are some US academics and policymakers who believe that if exchange rates are freely floating and trade is free, there should not be sustained deficits and surpluses. And since the US runs a chronic trade deficit, it follows as night does day that someone is circumventing the rules. The difference is that people who share those views have the reins of power.
Seeing the world through such a prism brings into focus the economic rivalry between leading industrialized countries and large developing countries.
The bilateral trade position becomes a critical metric in the relationship. Applying tariffs on allies like NATO members and Japan on national security grounds may not sit well, but the administration overlays this with a more aggressive stance toward China. The disapproval of Chinese trade practices is one of only a few issues with bipartisan support, and one that Congress urged even more forceful action on than the administration did (e.g., sanctions on ZTE).
Owing to the asymmetries of the trade relationship, there are many more goods coming into the US from China upon which tariffs can be levied than the other way around. This means that China cannot sustain a tit-for-tat strategy; there are simply not enough imports from the US. All else being equal, this seems to encourage China to look for other channels to express its displeasure, namely areas where it recognizes that the US wants something from it, such as dealing with North Korea, reducing purchases of Iranian oil, and the territorial disputes in the South China Sea.
The internationalist-wing among Trump’s advisers were unable to prevent the tariffs being applied to even Canada. However, they do appear to have won a concession on NAFTA: no withdrawal. Although reports have suggested that negotiations will resume over the summer, it may take some time before a new Mexican government will be in a position to resume negotiations. Part of the ability of Canada and Mexico to withstand intense US pressure is that they have begun coordinating their negotiations. If they are going to continue to resist things like a sunset clause, this relationship must survive Mexico’s election.
Trade tensions will most likely intensify in the coming months. Tariffs and retaliatory tariffs will begin taking effect at the start of Q3. Secondary rounds are possible. Still, we recognize these as low rungs on the escalation ladder of a trade war because the percent of world trade being penalized is modest. The auto sector is a different matter. A formal investigation of US auto imports on national security grounds has been launched. The process can take the better part of the next year. Tariffs on autos would double the amount of trade captured.
It is not clear how much damage has been done to the liberal world trading system that has evolved over the past half-century. US obstruction of re-staffing the judges retiring from the WTO panels may come to a head in September when reports indicate that there will not be enough judges to sit a single three-person panel. The groundswell of support for Democrats that bloomed like a flower in spring wilted by summer.
Projections of the Democrats taking control of both houses of Congress in November appears somewhat less likely. Trump’s base remains loyal. Several Republicans who have earned the President’s wrath are retiring, were defeated in primaries or have otherwise been neutralized, including former Republican presidential candidate Mitt Romney who predicted that Trump would be re-elected in 2020. The President’s support rose in the first half of the year and stood near 42% in an average of opinion polls, holding above 40% throughout Q2. No fresh Democratic narrative or personality has emerged to unify the party.
Trump has tapped into and articulated America’s ambivalence to free-trade: that it benefits some and hurts others. In aggregate, it is regarded as a net positive. However, for various reasons, it has become increasingly difficult to move from paying the costs to reaping the benefits of free-trade. Technological and demographic changes are disruptive. The gradual erosion of what households experience as social protections and economists call labor market rigidities - known in the pejorative sense as welfare - may have undermined support for free trade, for which there was a national consensus in the prosperous post-WWII era.
Europe is experiencing a different strain of the same virus. The Northern creditor countries no longer want to recycle their surpluses to the deficit countries. The ECB’s bond purchases may not have pushed down interest rates as much as some hoped, the 10-year German bund yield bottomed two years ago, and Italy’s 10-year bond yield saw its low-water mark in 2015. However, the purchases have papered over the recycling problem, and already TARGET2 imbalances are growing. These are only likely to accelerate.
There are some striking similarities between the US Federal Reserve system and the Eurosystem. However, a notable difference is that the accounts between regional Federal Reserve banks are settled periodically. In the Eurosystem, the Target2 imbalances are not settled. In part, this may have reflected a certain naiveté on the part of the original designers who may have shared that underlying assumption of Trump’s trade advisers that with the free mobility of factors, the imbalances would not get very large. This financial imbalance, like the US trade imbalance, spurs angst of potential political consequences.
Another powerful disruptive force in the United States and Europe is immigration. The Trump administration has taken a hard line, and this appeals to many communities. Imagine if all the refugees who came from Mexico and countries in Central America into the US were the financial responsibility of California, Arizona, New Mexico, and Texas. It’s similar in Europe. The first EU country a refugee lands in is responsible for their welfare. Given Europe’s geography, in practice, this means that economically challenged countries, especially Italy and Greece, are forced to bear an unusually large burden.
Moreover, the EU struggles to enforce the existing relocation of refugees. Eastern and Central European countries have balked at taking practically any refugees. The populists are united in their staunch anti-immigration rhetoric, and it strikes a responsive chord among the nationalist movement too. A new political block in the EU is emerging in the form of the interior minister in the new Italian government, the German interior minister, and the new Austrian government, all complements to the Visegrád Group.
Horst Seehofer, German interior minister and head of the CSU in Bavaria, is advocating tougher anti-immigration enforcement to prevent what has been called asylum shopping. Bavaria goes to the polls in October, and the AfD may deny the CSU its customary majority. As the second quarter draws to a close, tension between Seehofer and Merkel is rising, but it is in no one’s interest to topple the government.
The disruption and finger-gnashing of Brexit are set to continue. Prime Minister May has either proven more politically savvy than her adversaries suggest or the position is so untenable that her potential successors are forced to check their ambition. Former Prime Minister Cameron and his allies argued that a referendum was the only way to keep the party together. This has proven far from the mark. In fact, the inability of the Tory Party to come together is arguably the main impediment to the Brexit negotiations.
To be sure, the EC is pressing its case vigorously. From the EC’s vantage point, the UK wants to pick the pieces of the Union that it likes, and none of the responsibilities. Ironically, rhetoric linking UK social and economic problems to EU immigration rules may have been an important consideration in fueling the push for Brexit, and such views would find allies in the EU. The UK might find that it is considerably less isolated in the EU than it may have seemed when the increased use of qualified majority voting reduced the value of the UK’s veto.
The broadening of the Union rather than deepening of it was long advocated by the UK. Its success is why the governance style had to change from unanimity to a qualified majority, which is a majority that is bigger than the one that decided that the UK should leave the EU. Oscar Wilde captured the essence of this moment in the UK when he observed, “There are only two tragedies in life: one is not getting what one wants, and the other is getting it.”
It is not just in monetary policy that Japan is moving in a different direction than the US and Europe. Hostility to immigration is strong even in countries in which employment is full. In fact, the JOLTS data indicates that there are more job openings than unemployed people in the US. Japan is gradually becoming more hospitable and welcoming to foreign workers. In October 2017, there were 1.28 mln foreign workers in Japan, nearly a 28% increase year-over-year.
It is actively seeking foreign workers in agriculture, social care, construction, ship-building, and the hospitality industry to ease labor shortages. It is a gradual process, and the guest workers are not allowed to stay for more than a few years or bring their families. Also, Japan is taking other measures to make foreign visitors more at ease as it prepares for the 2020 Olympics.
Prime Minister Abe and President Trump seem to get on, and there has been no drama compared to the US president and other leaders. However, Abe has precious little to show for it. Japan, unlike Europe, Canada, and Mexico, was not given an exemption from steel and aluminum tariffs, no matter how brief. At the recent summit, the US reportedly did not bring up the issue of kidnapped Japanese citizens in North Korea. Trump declared the North Korean threat had been neutralized even though Japan remains vulnerable and its waters have been targets for missile tests in the past.
Trump’s complaints about the cost of extending the US nuclear umbrella plays right into Abe’s political agenda of a stronger Japanese military. However, Abe’s domestic political clout may not be much better than it is with Trump. It has been spent defending claims of corruption that is not so much about the feathering of one’s own bed but showing favoritism for friends.
Also, the key to succeeding on the political agenda is economic strength. Japan’s long expansion ended with a contraction in Q1. The economy appears to have grown marginally in Q2, and this is despite a monetary policy that by most measures is full throttle and a fiscal deficit expected to be around 3.5% of GDP. The BOJ owned about 47.5% of the outstanding JGBs in April, up from 43.3% in April 2017. Even if price pressures remain nearly non-existent, there is one thing that it has accomplished. A traditional debt crisis that one might expect, and many have predicted in Japan, seems highly unlikely. The consolidated balance sheet of the government has improved. Looming just over the horizon is the unpopular and economically harmful retail sales tax increase scheduled in October 2019.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.