Over the past few days, it is clear that the recent move on the US yield curve, with the 2Y10Y reaching new lows of 10bps on Thursday, have been starting to price in a potential earlier-than-expected exit from US policymakers concerning both their quantitative tightening and interest rate normalization. The market is currently pricing in an end of the tightening cycle for December 2019; however, uncertainty around Brexit, the Euro area slowdown, the shortage in USD liquidity impacting the EM market economies and more recently US macro data starting to price in a potential deceleration in the economic activity are all negative forces for US policymakers to sustain their hawkish tone. As a consequence, we think that an early exit will put downside pressure on the US Dollar, creating opportunities in the currency market (especially the Euro) and the EM space.
After peaking at $4.45 trillion in October 2014 and remaining at that level for the following 3 years, the Fed has been gradually shrinking its balance sheet since January this year, and now allows a maximum of $30bn a month in Treasury securities and $20bn a month in MBS to roll off its balance sheet. If we assume that the current pace continues through 2019, the assets should decline to roughly $3.7tr by the end of 2019, with $2tr worth of US Treasuries and $1.5tr of remaining MBS (+200bn of other assets). Figure 1 (left frame) illustrates the current and project path of the Fed’s balance sheet total assets for the next 12 months to come.
In addition, US policymakers are also hiking their target rate, with one hike priced in for the next meeting on December 13th (68% probability) and another 3 for next year according to the Fed’s dot plot. Hence, as some empirical studies have previously estimated that a $300bn increase (resp. reduction) in the Fed’s balance sheet assets would correspond to a 25bps cut (hike) in the target rate (i.e. Wu-Xia 'shadow' rate), the $400bn reduction currently estimated by the market would add a 25bps hike to the 1% priced in by the futures market, implying a total of 1.25% increase by December 2019.
However, market expectations have collapsed over the past few weeks and the current Eurodollar (ED) futures are pricing in just one hike for 2019. Figure 1 (right frame) shows that the Dec20 Dec19 ED yield curve has collapsed from 75bps(3 hikes) in mid September to 13bps (less than 1 hike) on Thursday.
We think that the Fed may exit earlier than the market anticipates, especially if uncertainty remains elevated, pushing price volatility to the upside each time we see some weakness in economic data. In addition, economists and researchers have estimated the ‘shadow’ rate when the Fed was only easing, but there may be an asymmetrical effect when the Fed tightens. A 300bps reduction in the balance sheet may correspond to a 50bps hike (instead of 25bps) in periods of high uncertainty.
We already saw dovish stance during Powell’s speech at the Economic Club of New York on November 28th. The Fed chair said that rates are ‘just below the broad range of estimates of the level that would be neutral for the economy’, which is quite different from his hawkish ‘long way’ from neutral message announced in his previous speech a month earlier (October 3rd).
On the top of that, with US fiscal deficits surpassing $1tr in FY19 ad FY20 (figure 2, left frame), the large amount of Treasury issuance in the couple of years may put the long-end of the curve under pressure. According to the Treasury Borrowing Advisory Committee (TBAC), there is 28% and 41% of the marketable debt maturing in the next 12 and 24 months, respectively (figure 2, right frame). For a total outstanding amount of USD15.3tr as of September 2018, that corresponds to $4.3tr and $6.3tr of marketable debt maturing within the next 2 years (marketable debt combines Bills, FRN Treasuries and TIPS). We saw previously that primary dealers holdings of US government debt are reaching record highs (here), which could be explained by the fact that banks cannot find buyers and therefore may emphasize the pressure on LT US yields. Higher LT yields next year will tighten financial conditions even further and weigh on risky assets such as equities due to their high duration after this long period of ZIRP policy.
In addition, over the past few months, one of the main developments we have seen in the market is clearly a slowdown in global growth. It first started in the UK, followed by the Euro area and emerging markets and is now coming in the US as well. In the past few weeks, we saw a series of chart showing the divergence between the economic and market reality and surveys data such as the ISM manufacturing (figure 4, left frame). Our leading economic indicator, which is built using a combination of surveys and price data, is showing potential weakness in the US underlying activity in the months to come (figure 4., right frame). Even though our indicator is not standing at a critical level, further deterioration of US fundamentals would eventually lead to lower GDP growth prints. Are the Fed officials comfortable in continuing their tightening policy if US growth is starting to fade?
Real M1 money growth (CPI adjusted) has also been decelerating in the US and usually tends to weigh on the economic activity; in figure 4 (left frame), we plot real M1 (12M lead) overlaid with the annual growth in industrial production. Therefore, rising inflation and economic growth in the first half of this year has reduced the excess liquidity, which we compute as the difference between real M1 and industrial production annual growth. As we can see it figure 4 (right frame), shrinking excess liquidity has limited the upside gain in equities, especially for financials (figure 4, right frame).
Therefore, slowing growth in addition to lower liquidity will continue to weigh on US equities, potentially forcing Fed policymakers to step out earlier-than-expected on their tightening policy.
We strongly believe that an early move combined with some dovish stance coming from the Fed officials in 2019 will weaken the US dollar. The USD index is up 5.8% YtD and roughly 10% since its low reached in mid-February, impacting most of the emerging market economies, which some of them are almost on the verge of experiencing a currency crisis. Therefore, weakness in the US dollar in the next 12M will create some opportunities in the currency market and in the equity space. In case our scenario starts to realize, we think that the euro will be the currency to hold in 2019. Even though the Euro area is experiencing an economic slowdown in addition to a very high uncertainty, the single currency appears clearly undervalued according to a range of FX valuation metrics. For instance, the Eurostat-OECD PPP ‘fair’ value prices a EURUSD exchange rate at 1.34, which is roughly 20 figures above the current levels (15% undervalued, figure 5, left frame). We are conscious that the US-EZ real growth rate differential between may weigh on EURUSD in the short term (with the 1.11 level to watch) as the Euro economy looks vulnerable for the time being (Italy may fall into a recession in the beginning of next year), however we think that a weaker USD will favor the euro.
Figure 5 (right frame) shows another interesting relationship between the US dollar (REER YoY change) and the relative performance of US equities (SPY) vs. World (ex-US, (VEU)) equities. As you can see it, in periods of a rising US dollar, US equities tend to outperform World equities and vice versa. Hence, if our 2019 scenario favors US dollar weakness, EM equities should outperform, especially oil-importer countries (such as India and Indonesia) due to the late fall in oil prices.
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