China and the Fed

On Monday, the RMB fixed dramatically lower.  In developed markets, stocks sold off hard, short ends were bid, and the dollar rallied sharply.

On Tuesday, the RMB fixed dramatically lower.  In developed markets, stocks sold off hard until Spooz  ground higher to close up on the day, short ends closed up, and the dollar sold off sharply.

What gives?

There are a number of possible explanations; indeed, with a little imagination, Harry Hindsight could spend hours if not days conjuring rationales for the volte-face in Spooz and the dollar.  Three obvious possibilities, however, are the following:

* It's August.   In a world of five-minute macro, low-liquidity conditions in summer markets mean that algos and spot jockeys are quick to turn, so it doesn't take much to generate a stop-loss run or even get some to reverse.

* The Chinese are long RMB against everything; put another way, there are foreign currency liabilities not only against the USD, but other currencies as well.  What a weaker RMB implies, therefore, is a need to buy back the liability currencies as quickly as possible.  There may be something to this, though of course funding out of, say, euros to be long CNH is a practice that is hardly confined to the borders of the Middle Kingdom.  Regardless, what is without question is that the structured product TARN/TARFers have dollar liabilities that need to be either hedged or eliminated.

* A rally in USD/CNY represents a tightening of US financial conditions, thus implying that the Fed will remain on hold in September.   This logic appears relatively pervasive throughout the market, with the RMB representing the latest in a never-ending saga of excuses that the Fed rolls out to avoid tightening rates.   In fairness, it's really the market that rolls out the excuses; for the most part, the FOMC just sits there and does nothing.

Of these, the latter two are the most persuasive.    To be sure in the case of point number 3, some 20% of all US imports now come from China, a quite startling statistic.  It's difficult to say, however, what the pass-through of the currency move will be; after all, it's not like the steady rise of the RMB  from 2005 onwards generated much if any inflation.   Apple's margins have a lot more to do with the price of an iPhone than how much it costs Foxconn to make it for them.

Looking at how the market is priced, it certainly appears relatively extended and ripe for a correction.  EDU7, for example, nearly tickled the top of its recent range yesterday; it wouldn't (or shouldn't) take much to send it another 10-15 ticks lower.   Indeed, it's down 4 since Macro Man started writing this post on Tuesday night.

Frankly, it seems a little absurd to panic, and Macro Man doesn;t think that they will do so.  Although it's not exactly new news, it's worth reviewing once again exactly how easy US monetary policy is.   Macro Man compared the level of Fed funds with the 4 quarter moving average of y/y growth rates in nominal GDP (which captures both growth and inflation.)  Unsurprisingly, Fed funds have historically been priced at a discount to nominal GDP growth.

When he plots the difference between the two series, a number of regimes emerge.

It's interesting to note that other than a brief period in 2003-04 (didn't that end well!), the current spread is the highest since the uber-inflationary 1970's.   Given the level of accommodation, why isn't real growth higher?  The answer has been discussed ad nauseum, but suffice to say that neither the price nor quantity of money is restraining activity; rather, fiscal and regulatory factors have rendered the transmission mechanism of monetary policy to be relatively ineffective.  Put another way, you can drive in a nail with a shoe, but it's slower and more wearisome than using the proper tool.  And of course, you might want to actually use the shoe for its intended purpose if you ever encounter rough terrain.

For fun, Macro Man decided to take a look at some time-period averages.   Although the regimes to break neatly into decades, it's close enough that there is some utility in looking at decade averages for the nominal GDP/FF spread and real GDP growth:

The results are pretty interesting.   Macro Man was particularly intrigues to see that average real growth was essentially identical in the 70's, 80's, and 90's, though a "misery index" type number would capture the underlying sentiment better than the table above.

That being said, it's worth noting that the current decade has the worst ratio of policy accommodation to growth of any since the Fed began publishing Fed funds rates in 1954.  Again, it's not a big surprise, given that it comes on the heels of a bum-clenching economic and financial crisis.  The contrast with the 80's could not be more stark: three decades ago, policy was tight, regulation was dismantled, leverage expanded, and the economy grew after a couple of early recessions.  Now, policy is easy, regulation is overwhelming, non-financial private sector leverage is doing nothing much, and growth is tepid at best.

On the one hand, doom-mongers might say that this illustrates how fragile the economy is and that ba tiny only a modest rate hike could push it over the edge.   On the other hand, one might argue that if the transmission mechanism of monetary policy to the real economy has been strangled, the negative impact of a modest tightening will barely be felt, particularly as the Fed quits defrauding denying savers.

Perhaps it makes sense to keep banging in the nail with your shoe; from Macro Man's perspective, however, it's far better to put the shoe on your foot and walk to the hardware store so you can buy a hammer.