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...