A few thoughts on financial conditions

Apparently, that was enough doom and gloom for the time being.  It would seem difficult bordering on pointless to try and distill too many deep insights from yesterday's data; yes, CPI was a bit higher than expected (though still zero on a headline basis) and claims were great, but the Empire and Philly surveys were generally disappointing.  Bill Dudley, meanwhile, managed to defuse any controversy by saying more or less nothing- to wit, that he would favor a 2015 liftoff if his forecast is met.   That's a bit like saying the lady down the street will be rich if her lottery forecast is met; without knowing Dudley's (or anyone else's) near-term forecasts, any qualified comment on the timing of rate moves is more or less worthless.

Following on from yesterday's post, Macro Man would like to address the issue of financial conditions and potential downsides to maintaining ZIRP.   He will readily concede that this is largely of intellectual interest rather than an effort to glean insight onto the likely future direction of the market; if you're more interested where the AUD or Spooz might be going today, feel free to cut straight to the comments section.

One of the criticisms advanced towards a potential Fed lift-off is that financial conditions have already tightened, thus precluding the necessity for any actual rise in the Fed funds rate.   Of course, there's a bit of a catch-22 embedded here; if markets hadn't believed that the Fed's intention to raise rates was credible, financial conditions would likely not have tightened as much; if the Fed then reneges on the de facto commitment, then their credibility is eroded.  In any event, it is clear that conditions have tightened, though there is a debate as to how much.   Consider the differing messages sent by the GS financial conditions index and that of the Chicago Fed:

One measure (the GS one) says that conditions are tighter than they were during the US downgrade/Greek meltdown fiasco of 2011, back when Spooz were below 1200 and 3m LIBOR was above 0.50%...and the other says that they're nowhere near as tight.  Breaking things down, it looks like a lot of the argument in favour of the "conditions are really tight" view is the widening of corporate credit spreads; the spread of the Moody's BAA index to the equivalent maturity Treasury, for example, is at its widest level since the crisis.

On the one hand, that makes a lot of sense.  On the other, however, it seems like stuff and nonsense; after all, the rate that matters for corporates is the actual rate they borrow at, not the rate at which credit traders can spread to Treasuries.   Viewed through that prism, a modest back-up is evident, though the actual borrowing lending rates remain very, very low by historical standards.  Indeed, this yield is still below the earnings yield of the S&P 500, which remains an anomaly in the modern financial era.

Ah, Macro Man can hear you say, but corporate treasuries are sophisticated!   They do swap their debt to take advantage of low short-term yields, so spreads do matter!  This is true, but spreads work both ways.   Yes, the spread of the underlying debt to swaps is wide; however, given the steepness of the yield curve, so is the spread of the swap rate to 6 month LIBOR.  Macro Man constructed an index to proxy the all-in cost of swapping corporate debt to LIBOR, calculated as simply the Moody's BAA yield plus the spread of that yield to swaps, less the spread of swaps to 6 month LIBOR.  As you can see, conditions have tightened somewhat...but remain extraordinarily accommodative by historical standards.

Let's shave with Occam's Razor for a moment.   According to all of these charts, financial conditions started tightening in the spring of 2014, with the tightening accelerating in the spring of this year.   If this were really binding to the degree that some adherents claim, we should expect to see this in corporate borrowing levels, shouldn't we?  Macro Man pulled up a chart of quarterly corporate bond issuance from the Fed's flow of funds data:


Well, whaddya know.   The two strongest quarters of non-financial corporate debt issuance in history were the first two quarters of this year, with the last data point obliterating the previous record by a massive margin.  Not only does this not suggest that tighter financial conditions are binding, it warns of (dare we say) irrational exuberance in the corporate debt market!   This is particularly the case when one considers that this issuance has been accompanied by tepid capital expenditure but rampant stock buybacks, thereby a) underwriting corporate financial engineering with profits as a percentage of GDP already at record highs, and b) exacerbating income inequality.  One might also credibly raise financial stability concerns, insofar as 1) buybacks come and go, but debt lasts forever (or until it's paid back)  and b) market liquidity for corporate debt is almost certainly going to be worse than in previous down cycles.

What about households?  This is where it gets really interesting.   Demand for and provision of consumer credit (credit cards, auto loans, etc.) has been robust, suggesting that households have an appetite to borrow:


However, the total debt of the household sector has yet to reach its pre-crisis peak.

While it's difficult to be too upset about households failing to add to a mountain of debt, it is important to recognize that the credit boom has not reached them in aggregate.   Of course, much of this is to do with the mortgage market, where lending remains way, way below pre-crisis highs.  This is not, of course, because mortgage yields are too high; quite the contrary.  However, in contrast to the low interest rate environment prevailing in the early portion of the last decade, this has spurred little activity in the mortgage market.  A large part of this, of course, is that many would-be borrowers' current housing situation precludes them from moving house.  However, this should not impact would-be refinancers to the same degree, particularly as the number of negative-equity borrowers has more than halved over the past three years...and yet in aggregate, mortgages are still not getting written.  If mortgage credit decisions are not being allocated on the basis of price, therefore, it is difficult to see how a fairly modest uptick in the price is going to have a substantially deleterious impact upon activity.

Moreover, if we look at the "other domestic loans" category for the entire economy, we see a picture of tepid growth after a meaningful decline after the crisis.

Now, one might argue that this last chart suggests that credit is finally beginning to flow, and that a rate hike could crush it- look how things have flat-lined for the last couple of quarters during the tightening of financial conditions.  Then again, if that were the case, why was corporate issuance so robust during the same period?

Macro Man chooses to view the credit market as bifurcated.  If you have access to credit, things are fantastic, as it's still incredibly cheap to borrow if you have the wherewithal to do so.  If you do not, however, you are stuffed, regardless of how attractive you find the borrowing rate.  The supply curve has shifted, and the demand for credit does not necessarily imply the access to credit.

None of this, of course, touches on another cohort impacted by ZIRP: savers and holders of cash and interest-bearing instruments.  The Fed has (rightfully, in your author's view) come under some pressure for rewarding (already wealthy) borrowers at the expense of savers, though the likes of Bernanke brushed this criticism aside with a casual wave of the hand.   Ah, the life of an academic!

What's remarkable is that despite the very low level of interest rates in the US, the interest income entry in the personal income accounts is actually very robust indeed.  It's not at the pre-crisis highs when you actually used to get interest for your cash (yes, it's true, kids!)....but it's surprisingly close.  This is in sharp contrast to the previous two rate cycles, when interest income reached local lows right before the Fed started hiking.


How the hell is it possible to earn that much interest income in ZIRP-world?  Obviously, savers are not literally getting zero on their holdings....and clearly, they must have increased the size of their portfolios.   By a lot.  Macro Man constructed a stylized model to attempt to gauge the magnitude.   Please bear in mind that the outputs are not to be taken literally, but the shape of the line can yield some insights.  He assumed that lenders earn the average of the 3m Treasury bill, the 30 year Treasury bond, and the Moody's BAA corporate bond yield.   Taking the annualized interest income as a given, he then figured out what face amount of this portfolio would be required, given the prevailing yield at any given point, to generate the required income.  The results are set out in the chart below.


As you can see, the amount held is currently about 60% higher than that prevailing at the onset of the crisis.  Admittedly, the output is lumpy, no doubt because of mismatches in market movements and the income reports.   Nevertheless, the trend is a clear one- households are holding a LOT more money in (presumably safe) interest-bearing accounts and securities than they did before the crisis.

Some of this may reflect a risk/asset allocation preference that has little do do with the return on offer- just look at yields in the front end of Germany!  However, given where the US is demographically, some of it also no doubt reflects a desire for retiring baby boomers to procure a given level of a fixed income.   The lower the yield on the portfolio, the bigger the portfolio needs to be.   By maintaining such low interest rates, the Fed is essentially forcing these savers to hold cash in unproductive investments paying low rates of interest, rather spending it or putting it to more productive use.   Small wonder the velocity of money is so low!

Finally, one more speculative question: could the Fed actually be keeping inflation low on a secular basis by keeping monetary policy artificially easy?  Regular readers will by now know Macro Man's argument that there is a secular global trend of disinflation thanks to excess global manufacturing capacity and firms' willingness to shift production to low cost producers (at the possible expense of quality.)

Michael Gapen at Barclays has produced an interesting set of calculations, disaggregating US inflation into domestic and tradable CPIs.  Lo and behold, after dipping during the crisis, domestic inflation popped to 2% and has been treading water ever since.  Tradable inflation, impacted by both commodities and the dollar as well as foreign goods prices, has been up and down and is currently negative.


Now, Macro Man would argue that the Fed can exert a lot more influence on domestic inflation than that from tradables, and in point of fact the trend there looks pretty healthy and in no way deflationary.   Obviously, in the near term putting rates up would likely exacerbate the trend in tradables via lower commodity prices and a higher dollar.

In the long run, however, the biggest issue for tradable prices is excess capacity.   Maintaining a super-easy monetary policy does little to disincentivize producers in other countries to continue to invest in productive capacity, of which there is already too much.  It'd difficult to find good data on global capacity utilization, but Macro Man found a series for global CapU in the chemicals industry, which would seem to be a reasonable proxy for global industrial CapU.  (Again, it's the shape of the line rather than the level that is worth watching here.)    Note the contrast with CapU in the US, which isn't exactly setting the world on fire in its own right.


That, in a nutshell, is why there is no inflation globally...and why there's not a damn thing the Fed can do about it.  Any policy that encourages even more investment in productive capacity is just going to make the problem worse down the line.

So, in sum:

* Financial conditions have tightened, though more modestly than some well-known indices would have you believe

* For those with access to credit in the US, conditions remain exceptionally easy and is encouraging behaviour that may threaten financial stability while appearing to confer few trickle-down benefits to Main Street

* For those currently without access to credit, the price is largely irrelevant anyways.  Housing, the classic "interest rate sensitive sector", is not currently very sensitive to interest rates

* ZIRP may in fact be tying up large amounts of otherwise usefully-deployed cash in low-yielding fixed income investments

* Domestically generated inflation in the US actually looks OK, and there's not much the Fed can do about tradable inflation anyways, given the dramatic excess capacity in the global economy.

These are among the reasons why Macro Man would prefer to see the Fed lift rates to some non-zero yet still generally accomodative level.  Of course, per yesterday's post, this is not a forecast.  None of this is particularly relevant for market strategy, therefore, but what's the point of having a blog if you can't go off on the occasionally geeky tangent every so often?  Normal service resumes next week.
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Anonymous
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October 16, 2015 at 7:32 AM ×

MM - This was an excellent post. Thx.

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Anonymous
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October 16, 2015 at 8:24 AM ×

Ditto. Geeky, perhaps, but important stuff. Thank you.

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Celeriac1972
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October 16, 2015 at 8:45 AM ×

Thank you. Spooz and I have fallen out so I'll bite (perhaps more nibble...) on this fascinating post.

The idea that "ZIRP may in fact be tying up large amounts of otherwise usefully-deployed cash in low-yielding fixed income investments" is wonderfully contrarian, and interesting to consider. Whilst it is easy to dismiss - perhaps by considering the relative attractiveness (vs equities) of bonds/deposits to ordinary savers once rates start to rise - I wonder if that is an over-simplification. There may be some second and third order effects that are harder to see.

Your post references corporate issuance. The buyback phenomenon of the last few years continues to worry me. ZIRP has sparked corporate treasurers into issuing bonds and using the proceeds to retire equity rather than to invest in productive business assets. This fire has met gasoline in the form of an unholy alignment of taxation and EPS-based executive incentivisation. It is possible that there has been a systemic misallocation of capital on quite a grand scale here. [If this were to start to unwind then shorting the buyback factor-specific ETF's against the wider market could be a nice trade...]

I'd be interested to read any further ideas on how ZIRP may have acted to tie up otherwise usefully deployed cash.

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CV
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October 16, 2015 at 8:59 AM ×

Good to see you flexing your writing muscle again MM, good stuff!

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Anonymous
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October 16, 2015 at 9:05 AM ×

ottimo commento. Bravo Macro Man

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Eddie
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October 16, 2015 at 9:24 AM ×

Excellent !

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Nico G
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October 16, 2015 at 10:11 AM ×

MM, that was a lot of work many thanks

but you did not tel us whether to buy spoos or short them

dunno if anyone mentioned Mester on Radio Fed yesterday - mentioning 'full employment and inflation gradually rebounding'

ergo, the need to hike

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Carry trader
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October 16, 2015 at 10:35 AM ×

Awesome work. Worth every penny.

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Anonymous
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October 16, 2015 at 10:54 AM ×

FT: kudos to MM for this brilliant and well researched piece;

One point which should not be overlooked is the law of unintended consequences; we saw the effect of simple rate hike expectations when, actually, the FED has been pussyfooting around the issue for a while. (EM and commodities collapse)
If they hike, it will be the death knell of USD/CNY peg withing a few months at most.
The tiny move sanctioned by the chinese authorities was a trial balloon and they had a serious bang for their buck.
Imagine what it will be if they devalue by 10%...
China had a credit cycle which dwarfed everything ever witnessed; with a popped equity buble, collapsing trade and exporters refraining from rapatriating these USD which appear in the trade balance, I think the devaluation is inevitable.
But if the FED hikes it will bring it forward by a few months.

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Anonymous
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October 16, 2015 at 12:27 PM ×

From DB's Jim Reid yesterday: "...the 'great' global central bank liquidity story of '2008-20XX' is far from over...".

Indeed.

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theta
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October 16, 2015 at 12:33 PM ×

Excellent post.
One question: could it be that the record corporate borrowing figures are skewed by the likes of Apple that borrow domestically to avoid repatriation of offshore cash? In which case should we instead check what the borrowing net of cash in the balance sheet is?

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Anonymous
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October 16, 2015 at 12:45 PM ×

"Bifurcated indeed". Also demographics I suspect. Aging population and the need to secure both capital and income doesn't lend itself to risk portfolios hence the rising balances in non-risk accounts.
Low rates leads to chasing fixed income yields makes for accessible finance for corporates. On the otherhand my firsthand experience of securing finance recently told me all that I need to know about the accessibility of mortgaging funds. IF it was that hard for me I pity the majority of others trying to get it.
I suspect there's a trade off going on between low rates and consumption. Loss of income revenue leading to austerity type consumption behaviour and rising low risk deposits particularly amongst the aging end of the population. The big question I guess might be is this offset more by debt driven consumption from the younger groups?.

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abee crombie
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October 16, 2015 at 12:45 PM ×

Mortgage lending standards have been loosened recently and yet demand is still down so I am not sure it's the only explanation but for sure its a big part compared to pre crisis.

There is something the fed and other central banks can do about global disinflation, it's called raising rates, but they will never figure it out. How about we use fiscal policies y to stimulate AD and monetary policy when there is a banking crisis. But it's not for this lifetime.

MM I agree that overall HY issuance costs are low so that financial conditions are a bit misleading but the HY market is still in some turmoil, new issuance is very tough still. Will be interesting to see the next few months if buyers come back.

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Booger
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October 16, 2015 at 12:46 PM ×

Great post MM and thanks for putting it together. I couldn't believe it when they didn't hike more aggressively in 1998, then in 2006 and now. This time they lost the plot with QE3, which it seemed was quite unnecessary. No one could accuse the fed of being serial bubble blowers, because no one can see a bubble even when it's in front of your face, like Greenspan said.

What I find most interesting about the current situation is that they are even later in hiking in this cycle than the previous 2 and may have missed the boat completely. What happens ? Either 1) We get a recession with zero rates to start with and asset markets with further to fall than otherwise or 2) they are very late in hiking but do get one or 2 in next year, way behind the curve because core inflation has been above 1% for ages. Currently I think it is 1.5-2%

The Fed has assumed inflation is not an issue if growth is tepid or decelerating. It is possible that growth is decelerating and we enter a recession but that inflation does not decline. I don't expect that but that outcome would be diabolical for equities.

I actually think Yellen did the right thing by not hiking. It may well have killed EM at that juncture. They should have hiked in 2011-13 but it is now 2015 and with the cards she was given, Yellen has done a good job.

Her predecessors were morons though. Greenspan was particularly insipid in claiming bubbles cannot be seen as an excuse for his bubble blowing. Bernanke was overcompensating in doing QE3 and equally moronic in not seeing the housing bubble. His trickle down wealth effect argument for asset inflation is likely to be seen in retrospect as a mistake. But at least he wasn't as foul as Greenspan in washing his hands of any responsibility for not leaning against any bubbles.

My gotten, does anyone remember Greenspan's gibberish speeches and how they were interpreted as profound at the time? That was pretty weird and amazingly after he ceased being Fed chairman, he overnight regained the ability to speak intelligible sentences again.

If anyone had told you in October 2009 that in 2015 the Fed funds rate would still be zero, spoos would be 2020 and the unemployment rate was 5.1%, you would probably tell them to stop pulling your leg or stop this crazy talk.

Reality ceases to amaze me over periods of 7 years. Things really change over that timeframe and yet over the last year nothing much seems have happened.

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Macro Man
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October 16, 2015 at 12:46 PM ×

@ theta I think that is an issue to some extent...issuance fell off in 2004/05 during the Homeland Investment Act repatriation spree, for example. That being said, it doesn't explain the explosion of issuance in H1 this year, nor does it render comfort given that a large chunk of money has gone into buybacks.

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marcusbalbus
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October 16, 2015 at 12:53 PM ×

so what. the Committee does not give a damn about your musings and analysis. And so this is all vacuous daft nonesense.

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Macro Man
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October 16, 2015 at 12:59 PM ×

You actually wasted 30 seconds of your life to write that?

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Anonymous
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October 16, 2015 at 1:48 PM ×

Net Percentage of Domestic Banks Tightening Standards for Commercial and Industrial Loans to Large and Middle-Market Firms

https://research.stlouisfed.org/fred2/series/DRTSCILM

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Anonymous
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October 16, 2015 at 1:52 PM ×

One more to your point about credit availability . . .

Chicago Fed National Financial Conditions Credit Subindex

https://research.stlouisfed.org/fred2/series/NFCICREDIT

"The three subindexes of the NFCI (risk, credit and leverage) allow for a more detailed examination of the movements in the NFCI. Like the NFCI, each is constructed to have an average value of zero and a standard deviation of one over a sample period extending back to 1973. The risk subindex captures volatility and funding risk in the financial sector; the credit subindex is composed of measures of credit conditions; and the leverage subindex consists of debt and equity measures. Increasing risk, tighter credit conditions and declining leverage are consistent with tightening financial conditions. Thus, a positive value for an individual subindex indicates that the corresponding aspect of financial conditions is tighter than on average, while negative values indicate the opposite."

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Cityhunter
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October 16, 2015 at 2:06 PM ×

Bravo MM. I can't agree with you more on global disinflation and the nonsense of ZIRP.

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shoeless
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October 16, 2015 at 2:24 PM ×

MM,

I had often guessed that borrowers would emerge en masse if the Fed telegraphed their intent to lift interest rates, as folks would scramble to lock in at these artificially low levels. What I had not factored in was the fact that many are completely shut out of the market due to lending tightness. Perhaps the big spike in corporate borrowing was driven by a collective last push of those with the capability to borrow exercising that option before the supposed lift off.

I would expect borrowing to come back to Earth over the next several quarters, as those that wanted to borrow (and had access) clearly did, while those that cannot remain shut out from both the banks and the capital markets. So corp balance sheets are now nice and levered as the deflationary waves come rolling in.

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Macro Man
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October 16, 2015 at 2:34 PM ×

Shoeless, I suspect that there's an element to what you are saying, and likewise that Q3 will have seen a slowdown in issuance thanks to market volatility. That having been said, if the primary function of ZIRP is to encourage corporates to lever up to buy back stock...I mean, that's a pretty lousy transmission mechanism, innit? I would re-iterate some of yesterday's comments re: the knee analog. Problem is that the folks at the head of the class of medical school, to extend the analogy, are also graduates of clown college....

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Anonymous
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October 16, 2015 at 3:05 PM ×

I disagree that spreads are not as important as the absolute cost of debt. What matters when borrowing is the spread between your project ROI and the cost of funds. If we assume that (economy-wide) the 10yr yield is a decent proxy for expected NGDP, then changes in the spread is correlated to changes in the attractiveness of investments.

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washedup
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October 16, 2015 at 3:15 PM ×

MM,

First of all, great post - it may even get the 'post of the year' golden keyboard award.

I would submit that the reason corporate issuance is through the roof in fact supports, not contradicts, the idea that conditions are seen as steadily tightening - I know this for a fact having talked to a couple of corporate treasurers earlier this year in the oil patch, who basically panicked, went to their bankers, and said, get us a credit card now before everyone heads for the exits. Not entirely dissimilar to a mortgage borrowing spike right at the onset of rate hikes that we used to see back when we had a true mortgage market with normal dynamics. Ditto for the share buyback phenomenon.

Can I prove it? Of course not, but it smells right.

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Macro Man
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October 16, 2015 at 3:19 PM ×

I see no reason to assume that the 10y yield is any sort of proxy for nominal GDP growth in an LSAP world, as indeed it has not been since the Fed expanded its balance sheet. (Over the last 5 years, for example, NGDP growth has averaged 3.7% and the 10y yield 2.38%). Insofar as much of the issuance has gone to fund buybacks, the math becomes relatively simple...the cost of funds (adjusted for tax impact) relative to the earnings generated by the retired stock...which in this case remains very favourable for the issue'n'buyback scheme.

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Macro Man
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October 16, 2015 at 3:22 PM ×

@washed...but if they could access all the credit they want, it would appear that neither price nor availability were an issue...so how tight could conditions have been? (Yes, I know you are suggesting that there was an expectation of tightening moving forwards...but some indices such as GS's said that conditions have already tightened loads by the time of Issuepalooza....which doesn't pass the sniff test.)

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washedup
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October 16, 2015 at 3:33 PM ×

MM,
Fair question - the supply got absorbed because there was a lot of so called patient credit and hedge fund capital waiting for a slight increase in spreads so they could juice their returns slightly - I am talking about the likes of Oak tree and Och Ziff - recency bias played a part I'm sure - now that the early movers have been urinated upon, I would surmise newer supply will find it much tougher to get absorbed, especially since the appetite of, say, the Saudi, Norwegian, and Qatari SWF's to happily dole out capital in abundance to such purveyors is very much in question. Note that credit funds and Risk Arb funds are notable underperforms this year, and these are the ultimate buyers of the wares in question. So in that sense the borrowing amount is a lagging indicator.

Remind you of a certain earlier time in our lives?

Yup, you got it,H2 2007 - remember how happy everyone was to 'scoop up' cheap financial credit, and then, not so happy, and many years later reasonably happy but feeling cheap and dirty nevertheless knowing how close they had come to armageddon?

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DownWithTheBeanCounters
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October 16, 2015 at 4:55 PM ×

I'm afraid that Summers et al may be correct and that colors most of my thinking on Fed action and monetary policy. If I were at the helm I would issue a statement to the effect of: "We are not going to consider raising interest rates until we have seen two quarters of price increases that are substantially above the 2% target. Then we'll think about it for a while. Carry on."

It's the risk/reward argument that pushes me to this position. You all know it: if we are not in danger of slipping over the abyss into global stagnation then the worst of it is a couple quarters of hot pricing and some hard breaking, but at least Grandma sees a COLA next year. If we are on the edge then a hike would push us over and the damage could last generations.

(One of) The vulnerabilities in the argument above is the assumption that letting the pot boil over comes with known, manageable and acceptable consequences. I am very interested in arguments to the contrary.

Levering balance sheets because capital costs less than equity yields is not a great transmission mechanism and socially undesirable, but I don't think it rises (or has yet risen) to a serious threat level.

I am not on the side of the savers. That extra trip to the buffet in West Palm Beach comes at the expense of some kid getting or keeping a job. The economy is better off if that kid has the job (yeah that job could be swapping out the hot trays or whipping down the sneeze guard). Passive income is not going to save us.

The diminishing returns of easy money are more persuasive. Why risk the consequences of too much easy money if you aren't getting much in return, but, though the impact is blunted, there is still a positive impact on jobs and prices.

Thank you Marco Man for making the case for a hike in such a clear, well substantiated post.

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Anonymous
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October 16, 2015 at 5:02 PM ×

"I am not on the side of the savers. That extra trip to the buffet in West Palm Beach comes at the expense of some kid getting or keeping a job."

Buffet? West Palm Beach? LOL!

How about paying the rent?
Food (like, the "at home" kind)?
Medical care?
Maybe doing something nice once in awhile? Like taking "some kid" out to a ball game?
And what if I don't reside in that hot, humid, crime-ridden cesspool known as Florida?

You're terribly out of touch.

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DownWithTheBeanCounters
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October 16, 2015 at 5:07 PM ×

Sorry if I touched a nerve. Policy is about allocating resources. I think the resources are better allocated to the person looking for a job than for the person living on passive income. There is an argument to be made that, down stream, the person living on passive income is better served if you take care of the person looking for a job first.

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DUD OSO
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October 16, 2015 at 5:11 PM ×

I believe that the 5% appreciation of the trade weighted dollar index (USTWBROA Index) in the summer was the kind of financial conditions tightening that made the Fed take a pass in September.
The 5 year forward inflation expectation seems to be getting its lead from the trade weighted currency right now, although I have not done the granger casualty test on that.

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Macro Man
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October 16, 2015 at 5:45 PM ×

@ Down, here's the thing...the Fed's definition of "inflation" is an arbitrary one. Something like half of the CPI basket is already rising 3% or more...and if you happen to be weighted disproportionately towards that half, you're certainly not feeling like disinflation is the major problem. The problem with inflation targeting is that there is a naive assumption that the target level of the targeted measure is somehow an equilibrium level. Well, what if it isn't?

As for youth unemployment, etc. I'd suggest that if the economy hasn't been sensitive to rate moves on the downside, perhaps it won;t be as sensitive on the upside, either, for reasons I discuss in the post. Moreover, perhaps if corporates were unable to goose EPS through financial engineering, perhaps they'd have to make money the old fashioned way, through growing their businesses, etc. Moreover, do you not think a more robust consumption pattern from savers would benefit economic growth and thus employment?

Finally, I would note the precedent of Japan, which is not a perfect analogue but a useful one nonetheless. What we observed is that the longer that ZIRP took hold in Japan, the greater the proportion of household assets were kept in low-yielding bank deposits. Yes, some of this was demographic and some of it was a rational response to legitimate deflation (rather than the faux-deflation that the Fed worries about in the US)...but still...it's not exactly a ringing endorsement of perma-ZIRP. Indeed, I've observed that ZIRP adherents are very quick to trot out counterfactuals ("we can't raise rates because all sorts of bad stuff might happen") but very slow to provide empirical evidence that ZIRP actually works.

Ironically, in Japan, the two episodes of reasonable economic dynamism over the past 20 years have come when policymakers have adopted a bullish attitude (Koizumi and Abe) rather than the woe-is-us fare of the sort that has characterized much of the economic debate in the US over the past few years.

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DownWithTheBeanCounters
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October 16, 2015 at 6:30 PM ×

MM all fair points. I was listening to the radio this morning and there was a discussion of the index used to determine the COLA. The discussion centered around the accuracy of the basket. Are the goods and services representative of the consumption patterns of most seniors? The answer was "not really" so they came up with a second basket which underweighted education and overweighted healthcare as two examples. Anyway, the two baskets track each other pretty closely so there's been no groundswell to swap them. There wasn't much of a point to this anecdote other than to "yes and" your point that econ is messy and not all that scientific. The Taylor model has been much discussed in these comments and much of the discussion has been about whether or not 5.1% is really 5.1%. When your eyesight is untrustworthy a conservative approach is warranted. Per your post yesterday it sounds like this is codified at the Fed as some sort of inertial principle. What's really interesting to me is whether or not the conservative move is to leave rates where they are or to move them a little higher.

I think that corporations would prefer to make money the old fashion way, but demand is not very strong so they aren't able to. If the best way to boost that demand was by increasing the yield on money market funds then I'd be all for it, but I don't think the best way to get more money into the system (and moving) is by padding those checks. Strange things happening at the extremes of distributions, but you're implying that to boost demand you raise rates- unorthodox monetary policy indeed.

The consequences of being too quick on the trigger are evident in Israel, Yurp, and Sweden. Your Japan example is a strong counter, but weren't (aren't) there structural issues in addition to the demographic issues? My father spend a couple of unpleasant years working for Mitsubishi Trust in the 80s. I can't remember the precise quote but here's the gist. We were in the backyard checking on a couple of apple tree saplings. One of them wasn't going to make it so my father pull it out and said "Look they all lived- that's Japanese accounting."

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Anonymous
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October 16, 2015 at 7:05 PM ×

DWTBC,
"I think the resources are better allocated to the person looking for a job than for the person living on passive income. "
Why are you so certain that the first group would not be helped by helping the second group? If you increase fixed incomes in an aging population you support the ability of that group to consume and what does supporting consumption apparently bring? Employment.

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Anonymous
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October 16, 2015 at 7:08 PM ×

I might also have said that you probably get them Fixed income older group out of the workforce sooner has well thereby creating more job opportunities. Note that because the numbers shown staying in the workplace has been notable post 2008 and one cannot help wondering how that has helped to hold labour costs.
Frankly I think the FED view of pumping asset values and hoping for trickle down is simplistic in the extreme.

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Leftback
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October 16, 2015 at 7:16 PM ×

Nice post. Bifurcation indeed, in wealth, credit and even inflation (much higher for workers and renters than for home owners and rentiers).

LB is in Chicago. Here at Falling Knife Capital we are now well and truly back in the Hammock. The risk/reward ratio that launched our previous trade has changed substantially along with a collapse in volatility. After a pleasant three week sojourn long VGK and VWO, we are now back in cash and have resumed our supine position of midsummer. We will await the development of additional opportunities.

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Anonymous
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October 16, 2015 at 7:25 PM ×

Concerning the inflation comments . . . to many folks, inflation has been almost non-existent for ~3 years. No wonder consumers feel better.

https://www.aier.org/research/lower-gasoline-prices-offset-higher-food-prices

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DownWithTheBeanCounters
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October 16, 2015 at 7:34 PM ×

@ Anon- Paying people to get out of the labor force is one thing. Paying them to get out of the labor force by setting short term interest rates artificially high will cause people to lose jobs and hurt aggregate demand. If you give a pensioner a little more money you will stimulate some demand, but if you give that pensioner more money by keeping interest rates artificially high you will destroy more demand than you create. That seems to be what theory and practice tell us.

Witness Yurp: austerity and a premature hike has not lead to widespread prosperity. Sadly those depending on gyro yields are suffering more than the dollar based passive income crowd. I know, I know structure issues... but Mario fired and there has been some progress. The point is if you move to tighten too quickly you will do more damage to savers because you will be force to reverse course and the second cure will be more painful and take longer.

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Leftback
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October 16, 2015 at 7:38 PM ×

One's inflation depends a lot on one's personal circumstances. You probably don't know many poor urban Americans. It's not bad for the suburban Joe Sixpack family. It's actually a lot different if you are living in the inner city and don't drive, but have to operate in an area where the purchasing power of young IT workers and the wealthy perturbs the local economy in a way that disadvantages the lower paid. It's quite tough for the aged, minimum wage workers and unemployed.

On another topic, LB posits that the main risk to equities now isn't an imminent US recession, or a global economic slowdown, but is probably the very same hazard as it was in August. The PBoC is probably not done with a 2-3% move in USDCNY, and is quite capable of going for another round of devaluation one night. Sadly, they are probably not going to consult equity longs before they do so. We would be happy to let others scream in panic if this was to occur, but we have no wish to go to sleep one night and wake up to a portfolio haircut.... so it's Hammock Time™.

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DownWithTheBeanCounters
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October 16, 2015 at 7:46 PM ×

Let's settle on this: http://bpp.mit.edu/usa/

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Corey
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October 16, 2015 at 7:50 PM ×

Financial condition indices may have different baskets just like CPI, but the all important one is king dollar. While domestic conditions may warrant higher rates, global conditions - not so much. I'm slowly warming up to this currency war idea. You think it will be easier or tougher for the Fed to raise if/when the ECB steps up their game?

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Leftback
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October 16, 2015 at 7:55 PM ×

Fed clearly doing a Carney™. Do nothing, but talk out of both sides of your mouth.
Hawk talk when the economy heats up a bit, then show the doves some love when it cools.

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washedup
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October 16, 2015 at 9:14 PM ×

Scoop le poop capital is now completely out of all length as well, and beginning to scale in to some spoo shorts with a 200 DMA + stop.

Poop scooping reminds me - Nico - don't fall for the old cleaning your shoes scam in Rio - I fell for it around the same time I used to think Pets.com had a chance to reclaim old highs! Safe travels.

The last couple weeks has seen this blog at its best - hope it keeps up.
Everyone have a good weekend.

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Leftback
admin
October 17, 2015 at 1:23 AM ×

Agree it's been a good time on the blog, don't mind a bit of civilized disagreement as long as it doesn't get infantile. Of course it's also been enjoyable b/c we have been coining it. "Winning", [as Charlie Sheen used to say, in between hookers and coke binges.] Now we can watch for a while without giving a monkey's about Spoos until the next trading set-up materializes.

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nilys
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October 17, 2015 at 8:36 AM ×

"* ZIRP may in fact be tying up large amounts of otherwise usefully-deployed cash in low-yielding fixed income investments


* .... the dramatic excess capacity in the global economy.
...tepid capital expenditure but rampant stock buybacks...
...a secular global trend of disinflation thanks to excess global manufacturing capacity and firms' willingness to shift production to low cost producers...."

There seems to be a contradiction between the first point and the other points. Where are the useful high-yielding investment opportunities? Or put this way, is anyone still interested in producing anything? A corollary of that, is anyone still has disposal income and willingness to buy beyond essentials?

How much stock buybacks contribute to the share price? If a lot (as some claim), cut that off and the stock market tanks. Given that everyone tracks the Dow as an indicator of economic health, this sends us into a recession. Am I missing something here?

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Booger
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October 17, 2015 at 12:04 PM ×

I agree with Hisenraith (aka the mouthpeiece), it is amazing Bernanke didn't get the Nobel prize, if not for peace, then surely economics. His work on QE3 and the subsequent 800 point rally on spoos, although it will probably reverse at some stage, should be acknowledged in some greater way.

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abee crombie
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October 17, 2015 at 1:06 PM ×

As the global disinflation theme goes more main street I was interested to read Charles goodharts, recent message that global demographics will push up inflation in the coming years. Makes sense that actually a shrinking labour force will need higher wages. A lead indicator should be the already tight Japan. Also we seem to be on a path, in the US at least of more social spending ( unless the Donald wins) and the entitlement spending crisis looms overhead as well. Perhaps longer term interest rates will rise without the brilliance of the fed but for other causes.

Floating rate paper anyone. Being thrown out now.

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Booger
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October 17, 2015 at 2:11 PM ×

There was a McKinsey report on the high inverse correlation between the birth rate and the indebtedness of a country. Their conclusions were pretty commonsense: increasing leverage leads to higher asset prices. Policies therefore tend to promote growing leverage. Unfortunately this resulted in life becoming expensive (particularly buying a house, but also going to college etc.) so couples had fewer children. Another consequence of the asset inflation was there were more 50+ year olds who were asset rich and could leave the workforce resulting in the participation rate dropping and reduced societal productivity.

I don't know what is wrong with the younger generation. Why would having a large mortgage put anyone off having more children? Or the older generation, if you didn't need to work, wouldn't you keep working anyway ??

Abbe: I think Japan is very interesting. Their inflation rate has not ticked up despite unemployment being very low recently. It seems like things are at an impasse. The younger generation have said FU to taking on more leverage to buy real estate off the older generation, perhaps because they have not been able to secure any increase in wages. But why can they not get a raise? It will be interesting to see if inflation picks up in Japan if unemployment falls below 3%.

I think it is one of the macro puzzles of 2015: is there a NAIRU for Japan ? That could have interesting implications for usd.jpy. If there is even short term inflation in Japan, rumors that the BOJ will run out of assets to do further QE on by 2017ish are true or there is risk aversion before then, UJ could have a run to 110 or below.

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Bruce in Tennessee
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October 17, 2015 at 2:55 PM ×

http://www.rttnews.com/CorpInfo/EconomicCalendar.aspx?PageNum=2

China imports down more than a third in the last 2 months and down 11 straight months...this seems to fit the definition of a hard landing to me...

...also US exporting jobs are leaking oil...

...2016 global weakness increases?

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abee crombie
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October 17, 2015 at 7:32 PM ×

Booger, it's not just the birth rate, but the population pyramid. Ratio of working age to dependent (mostly old aged) as the west and even many of Em pass the period where a smaller base needs to support a larger one, pressures on wages seem logical, especially if we need to have inflation to slowly reduce the unattainable pension plans we gave out in the west at least.

Japan for sure has seen some interesting developments but I think things like this take a lot of time to play out. Lots of women re entered Japanese workforce in recent years, which skewed stats as many work part time. But Union wage pressures in Japan have been increasing above inflation. Japanese disposable income is up nicely though even as gdp is in the toilet.

Any China experts here's? Thoughts on the new 5 year plan. To me that is much bigger than q3 earning.

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Polemic
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October 17, 2015 at 9:38 PM ×

Watching NZ give a masterclass in rugby.. and its still not full time. Incredible

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Anonymous
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October 17, 2015 at 11:02 PM ×

Come on Ireland!

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Anonymous
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October 18, 2015 at 1:55 PM ×

FT@ abee re china 5 year plan

Disclaimer: I don't claim to be an expert on China;

Everyone is fixated on whether they will propose a growth target at 7% again or lower it a notch around 6.5%.

I know there is a large proportion of analyst who built their own models which approximate "real" GDP growth in China as there are a lot of suspicions regarding official figures. Most of these models (usually based on a mix of raw materials consumption, electricity production, transport stats....) will estimate current growth anywhere between 3 and 6,5%.

What I take from this is that published data or target data is more or less useless regarding China (the whole notion of a 5 year plan which could magically set GDP growth over 5 years rather than let economic private entities maximize growth and profit is ludicrous as the USSR or countless communist countries eventually found out).

Which leaves us with the significance of the message if they target slightly inferior growth.

You might get a knee jerk reaction in market (especially AUD and regional equities) but I don't think it's a driver as the China growth story narrative died with the currency devaluation (by the way, I think it was intended as a warning shot to the FED if they so much as dared to contemplate a hike) and the Murdoch media empire will spin the story as an acknowledgment of the new state of affair.

The real story is the impact of China and EM's slow down which is starting to be felt on DM growth. Manufacturing surveys have rolled over, profit have rolled over and the next shoe to drop will be service ISM.

The "DM market are more or less immune to EM's woes and the CBs have our backs" narrative is going to be tested. I do believe it will prove true eventually but only 3 to 6 months away. To reverse things, it will take an ECB extension of its QE and a FED officially on hold.

But the path to there will be volatile.

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Anonymous
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October 18, 2015 at 2:12 PM ×

FT: moreover

I changed my mind last week about US equities and DAX...scaled out of my longs and now squared at end of week. Looking for short entry points.
There is a cognitive dissonance between what people realize about DM growth prospects and Q3 numbers on one side and equity levels (beating lowered estimates is for CNBC's audience, intraday punters and Bloomberg or Yahoo finance financial pundits since you can beat guidance all the way from profitable to loosing money).

I now believe there is another down leg to this cyclical bear over the next 3 months.

For the agnostics, I would recommend short NDX/DAX vs STOXX; for the believers, outright shorts in DMs (including australian banks which depending on which one you look at have 70% of loan exposure to an insane real estate bubble)

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Anonymous
admin
October 18, 2015 at 6:54 PM ×

Macro-man: can you do a piece on your thoughts on the Yuan? I'd love to hear your opinion. It's hard to know what to think given that:

On the one hand: dollar bull market, growth slowing in China, growth doing well in the US, large scale capital outflows/portfolio diversification

On the other: still huge current account surplus, interest rate differentials, China doesn't seem to want it to

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