Tantrums

Although the thermometer is forecast to reach 92 degrees Fahrenheit today (33 Celsius), the passage of the Labor Day holiday represents the unofficial end of summer so it's once more unto the breach, dear friends.  Accounting for revisions, the unemployment rate, and wages, last Friday's employment number was very solid indeed, even if it's just a distant memory now.

The odds for a September hike are roughly identical to what they were immediately before the number- to wit, a 1/3 chance, more or less the lowest of the year.  This in turn raises an interesting question, partially posed by the Fed itself: is it appropriate to hike rates if the market is not priced for it?

As readers are no doubt very much aware, the Yellen Fed has gone through extraordinary pains to reassure markets that the lift-off and subsequent cycle will be transparent and as painless as possible; if the whole QE/ZIRP policies have been monetary heroin, it seems as if the Fed wishes lift-off to be monetary methadone.  As such, to engage in lift-off at a meeting in which the market is not fully priced would appear to endanger the Fed's intention to make it as painless as possible; after all, this is supposed to be a removal of an emergency policy, not a legit monetary tightening.

However, there is a downside to letting the inmates run the asylum.  If the market throws a tantrum every time that it senses that lift-off is imminent, normalization can and will be delayed unnecessarily if the Fed slams on the brakes when it sees the toys flying out of the pram.  Moreover, market pricing is also a captive of conditional probability.

The market is currently pricing in a 75% chance that the Fed will go by the end of the year.   Using the logic of "meeting market expectations", that should naturally imply that they will indeed raise rates by the December meeting.  However, if (or perhaps when?) the Fed stands pat this month, some portion of that 75% will vanish into the ether- that represented by the chance of a September tightening.  Perhaps the market will then price December as a 50/50 proposition.  From that point, it would only take a little more stock market indigestion, coupled with apparent hand-wringing from the usual sources, to nudge that percentage lower again, and then voila!  The market will be priced at a 1/3 shot again, "too risky" for lift-off to commence.

Lather, rinse, repeat.

Of course, drilling down to the normative "what should they do"  rather than the predictive "what will they do" is fun, but generally not profitable- particularly when there is a wedge between the two.  From Macro Man's perspective, he's made a bit from the timely sale of January Fed funds the other week; he'll probably look to close that out over the next few days before he, too, becomes a victim of conditional probability.

Over the weekend, a reader asked an excellent series of questions about EM and the chances of a massive blow up.   Such a question is obviously an important one and merits its own post (or series of posts) to address.  The sexy answer is, of course, to say yes and start lobbing Molotov cocktails at the now-sodden BRICs.

The reality is unsurprisingly much more nuanced than that.   One of the major problems with China is the quality of the data available to us for analysis.  Simply put, no one has a properly complete picture of the state of the financial system in China- not even the Chinese, in all probability.  So to some extent, any view on the topic is at risk of "garbage in, garbage out", and should be risk-weighted accordingly.

That having been said, we do know that the currency has depreciated recently, bowing to pressure from the capital account.  At the same time, FX reserves peaked a few quarters ago and have trended lower since- and that doesn't even account for the big defense of the RMB since the devaluation.


One must be a little careful in interpreting the decline in reserves, however.   Note that the reserve pool is denominated in dollars, and the decline has been contemporaneous with a surge in the value of the dollar.    As such, the vast, vast majority of the decline witnessed to date in the official data simply represents the fall in the USD value of non USD currencies in the portfolio.

That having been said, the money spent in defense of the RMB over the past month is real, and obviously not sustainable on an ad infinitum basis.   Selling USD/RMB drains money from the system, which is not what an economy teetering on the edge of a dangerous slowdown needs.  However, one large mitigating factor is the continued ability of the PBOC to sterilize the intervention via its ability to generate further cuts in the RRR.  No, this will not drop packets of money into the hands of every man, woman, and child in China...but it will allow the PBOC to counter further depreciation pressure on the RMB as forcefully as it sees fit.  And given that a disorderly depreciation of the RMB is seen as a major tail risk for all sorts of assets, that should provide some comfort.  Even after the RRR cuts delivered this year, the reserve requirement ratio remains above the high seen immediately before the crisis- when China had an inflation problem, was accruing FX reserves like mad, and needed to drain money from the system.


Moreover, while the capital account is of paramount importance in dictating short-term FX flows, the current account does provide a useful anchor.  Macro Man has seen some suggestions that the RMB is as much as 20% over-valued.   That seems very, very difficult to square with record trade surpluses recently.

Edit:  Since this piece was written last night (but somehow delayed publishing until this morning NY time), data was released showing both a near-record trade surplus and a record decline in FX reserves.  However, the numbers for the latter- $93.9 billion- were much smaller than some of the figures bandied about a week or two ago, no doubt thanks to the mitigating circumstance of the $60.2 billion trade surplus.


In this, China does serve as a useful contrast to a country like Brazil, which has steadily seen its external account deteriorate during Dilma's (mal)administration.  Remember when Brazil was moaning about QE, the weaker dollar, and "currency wars?"   Be careful what you wish for, because you just might get it.


However, even there, the situation does not look particularly dire on an aggregate basis.  Interest rates are extraordinarily high by global standards, but not by those of Brazil's own history.   External hard currency debt- including that of corporates-  is actually relatively low by the standards of Brazil's own history and several other emerging markets.  (China extraordinarily well on this metric.)


Of course, that doesn't mean that there won't be winners and losers.   For those corporates with large USD debt profiles, the two options are bankruptcy and bailout- and its hard to see the political will for the latter.  It is perhaps not a coincidence, therefore, that Brazil propped up the table on the global equity scorecard unveiled last week.

None of this is to say that EM will be all pony rides and lemonade from here on out.  It won't, and many firms in these countries will likely fall into the abyss.  But sovereign defaults look pretty unlikely at this juncture, as far as Macro Man sees it- even if that's not a sexy story.

From a normative perspective, he reckons that the Fed shouldn't over-react every time a developing country says "OH NOES!", any  more than they withheld from more QE when Guido Mantega moaned about currency wars.

From a predictive perspective, if and as he sees babies getting chucked out with bathwater in a Fed-related tantrum, he wants to have his buying list ready, because there should be some nice set-ups for attractive long-term entry points.   In some cases, we may be there already...
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Bruce in Tennessee
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September 8, 2015 at 12:43 PM ×

http://www.rttnews.com/2549298/china-exports-fall-decline-in-imports-signals-weak-domestic-demand.aspx

...The China export/import numbers were released yesterday during Labor Day...so I didn't see much headline news...they are brutal.

Imports fell >20% over the last 2 months...yes, months. Exports were a little better but also fell hugely...

....Not gonna be pretty...

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abee crombie
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September 8, 2015 at 1:35 PM ×

On brazil. the situation is full of reasons for the currency to depreciate but suggesting a default, while it should not be dismissed, is probably unlikely. 1) the central bank has swap lines which it has been increasing with the FED. Unless obama/trump really felt the need to shut them off, I dont see brazil facing a liquidity crisis. Politically its a mess, but at least moving in the right direction with all the trials. Likely the country will muddle through until the next election when hopefully something drastic will change

The depreciating currency should help stop the current account deficit, (and brazilian tourists to NYC and Miami). and while it doenst help with inflation (revised up again today) when the FX stops, inflation should slow as well.

As for investing in local equities, meh, I've looked, but havent found anything too impressive yet. Remember your discount rate probably needs to be around 20% (given were noiminal rates are)... I am finding more value in Dollar denominated debt that is likely to go down even a more before stabilizing.

The USD isnt king, its just the pin up of the month. When the COP or BRL are cheap enough (getting closer, but not convinced) money will flow there. All fiat currencies are crap, its just a trading game. When condo's in Ipanema are cheap, you can bet $$ will find a way to buy

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washedup
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September 8, 2015 at 1:41 PM ×

MM - thanks for that - China is relatively opaque of course, but they did tell is when we were interviewing for our first trading jobs, that 'tolerance for ambiguity' and 'ability to think in scenarios' would be key attributes.
Also, if you don't mind, a technical question for you - is it your understanding that foreign govt bond valuations to measure FX reserves for sovereigns (China in particular) are at purchase price, or at current market value?

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Anonymous
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September 8, 2015 at 2:35 PM ×

BBG: Central banks' foreign exchange reserves drop over half a trillion dollars in the last year

https://twitter.com/pdacosta/status/640480270550990848

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Anonymous
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September 8, 2015 at 2:42 PM ×

ABN Amro says ECB to step up QE buying program by €20bn to €80bn/month by yr-end

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Anonymous
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September 8, 2015 at 2:48 PM ×

WSJ:Element Capital Management LLC, run by a former Yale University math whiz, has been buying tens of billions of dollars of U.S. Treasury debt at recent auctions, drawing attention from the Treasury Department and Wall Street.

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Anonymous
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September 8, 2015 at 2:50 PM ×

BBG:China's Stock-Rescue Tab Surges to $236 Billion, Goldman Says

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Hwa Jurong
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September 8, 2015 at 2:52 PM × This comment has been removed by a blog administrator.
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Anonymous
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September 8, 2015 at 2:55 PM ×

JPM expects #China capital outflows to exceed $600bn in next 12 months, which is double
the pre-devaluation pace.

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Steadfast
admin
September 8, 2015 at 3:09 PM ×

I suspect part of the reason why Chinese RRR cuts haven't been faster is that the PBOC knows Chinese NPL ratios are understated (and probably deteriorating at the margin) plus the past memory that whenever they have lowered RRRs much in the past, it was followed in short order by a surge in irresponsible lending.

So, yes, agree that China can and will sterilize the intervention, but current constraints and past muscle-memory lead me to think they will stay a little behind the curve.

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Anonymous
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September 8, 2015 at 3:26 PM ×

BBG: North Sea and Nigeria will ship the most crude in more than three years in October, adding to downward pressure on oil prices just as demand wanes from refiners shutting down for seasonal maintenance. Output of North Sea grades will reach the highest since May 2012 next month, according to loading programs compiled by Bloomberg. Supplies from Nigeria, the biggest oil producer in Africa, are set to reach a level not seen since August of that year.

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Anonymous
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September 8, 2015 at 4:38 PM ×

Appreciate outright default not foreseen, but how does Brazil get out of this loop without further soft default via FX (Appreciate the usdbrl has done 150% in 4 years, but is that enough?). An economy previously booming to some degree on domestic credit expansion and exporting commodities, neither of those is coming back anytime soon. No impetus for the govt to attack debt dynamics with fiscal cut backs, so path of least resistance is for Copom to stop even attempting to fight inflation and stop the hiking path (even cut the 14% rates?)? I'm just thinking out loud, maybe the horse has already bolted with the move to just inside 4 USDBRL, but would love to hear thoughts on what is a good "fair" fundamental measure for the f/x.

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washedup
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September 8, 2015 at 4:50 PM ×

anon 4:38 - re: Brazil the issue is when does the bad stuff get priced in to asset values is all - at some point further down moves in currency stop becoming an albatross, and commodity sectors go to cash value. Better buy than sell at that point IMO just like in 2002 - people often get over focused on headlines and forget that in a country with 200 MM people there are things other than commodities that get produced and consumed domestically - surely there is an underwear or local finance company that will get ridiculously cheap to buy in this mayhem!
Throughout the EM commodity 'axis' the name of the game next decade will be shift to an inward looking business model with whatever consumption and retail growth local conditions will allow - with the usual caveats about data integrity, let's not forget Chinese retail sales were supposedly up 10% in the last 3 months - right now is the painful transition where babies get thrown out with the bathwater of course.

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Anonymous
admin
September 8, 2015 at 5:03 PM ×

@ Washedup... Tks for comment and would 100% agree there must be oodles of money to be made for the Benjamin Graham types buying stocks at margin of safety. Though still find the question of when is enough of a blow out in FX intriguing.

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abee crombie
admin
September 8, 2015 at 6:15 PM ×

@ washed up the problem with equities in the em at this point is that the domestic names have only really started going down a few months ago ( in local currency) meanwhile the trends are pretty crap.

You can buy a brilliance (bmw partnership in china) for 10x, but who knows what car sales will be like since the big drop 2 months ago. Not saying there isn't any value here, bc you can find great deals on good companies but just that earnings haven't been in a recession in the em yet. And if this is going to be more like 2002 vs 2008, it can be a long ride.

But why buy brazil ( or indonesia etc) equities. Why not just buy 14% 10 year bond. Not many companies earn returns that high. Just have to wait for FX to slow down.

Imo, em FX is getting cheaper after a few years of very over valued. But nothing pointing towards out right stupidly cheap.

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Anonymous
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September 8, 2015 at 6:29 PM ×

What are your views on Glencore? Media gushed over Glasenberg few years ago. He doesn't look so smart today.

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washedup
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September 8, 2015 at 7:30 PM ×

abee - shd probably look at brl 10 yr - have a cusip I can go dig into? Much appreciated thx.

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Anonymous
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September 8, 2015 at 9:28 PM ×

Whoa!!!
$WFC sold $950MM in a new pfd issue. It was planning 2 sell only $250MM but obviously demand/price was there for $950MM

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Mr. T
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September 9, 2015 at 5:20 AM ×

As the numbers start rolling in its becoming increasingly possible that the whole August spasm was mostly a quant event. For (non-quant) market participants, this is about the best news possible. It's a much better narrative than "China is melting" or "the fed is coming". It's somewhat interesting that the last big quant meltdown also occurred in August (8 years ago).

With the benefit of hindsight people have linked the '07 blowups to the beginning of the credit unwind that led us into the 08 mess, but the difference there was credit got tight first (by just a couple days!), people started raising cash via liquid quant strategies, resulting in the '07 meltdown. I have not seen any evidence of that so far, this seems like much more of a "low liquidity + butterfly effect" resulting in wild outcomes. There is a lot of money in quant, but I don't think enough that negative outcomes will create liquidity issues elsewhere.

I see this turning into another "silly computers, real investors BTFD" episode.

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Anonymous
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September 9, 2015 at 8:33 AM ×

@Mr T: "real investors BTFD" episode"

Quite right. It is clear that the powers that be are NOT going to let equity indexes collapse, and will do "whatever it takes" to keep these asset prices inflated.

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abee crombie
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September 9, 2015 at 7:28 PM ×

washedup ...try this for the 10year BRL govt bond BRSTNCNTF170 (ISIN).. ODF25 Comdty is the interest rate you can trade on exchange

if you want to go further out, you cant buy fixed buy can get inflation liked for a 2040 bond, giving 7.3% real + inflation... kinda messed up.. BRSTNCNB3C6 ISIN

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