Last week in The Unintended Consequence of Open-Ended QE
I highlighted the rising risk of market volatility due to the nature of open-ended QE and the constant recalibration of the market discount. I also cited the important 150-00 pivot on the US 30YR bond contract, and the fact that a move away from that level in either direction should not be faded.
In preparing for the week ahead I was looking for answers to two simple questions:
There is no more important economic statistic than the monthly employment report, and perhaps the second most important release is the ISM manufacturing report. This week we will get both numbers which are the first since the Fed launched QE III. There are two important questions investors are facing that the market will be answering with each economic release.
What is the current bond market discount for how much QE is forthcoming?
How will the incoming data adjust this discount?
The twin ISM manufacturing and services numbers didn’t elicit much market response and the 150-00 pivot continued to see recognition and resistance with the high of the week just shy of 150-08 late Tuesday into Wednesday. Thursday we didn’t receive any particularly robust economic data but bonds were failing at resistance, and with the employment data on deck, the bond contract faded to close near the lows of the week below 149-00.
Payrolls came in pretty much in line at 114,000 but a rather large drop in the household survey produced a 7.8% unemployment rate, a post crisis low. This improvement saw the bond contract drop a full point, and despite stocks giving up their entire gain to close unchanged, the bond contract closed at the lows of the day and the week near 147-16, 2.5 points below the 150-00 pivot.
A Bloomberg First Word alert titled Unemployment Drop Moves Up Expected End of QE3
citing Nomura strategist George Goncalves summed up the market’s dilemma that I raised last week:
Duration of QE3 should decline by 0.9 month for every 0.1 ppt downside surprise in unemployment rate, implying that today’s 0.4 ppt surprise for Sept. (7.8% vs 8.2% Bloomberg consensus est.) “implies a 3-4 months reduction in QE3 related buying.”
“This large of a deviation should not be faded as our historical study shows that a selloff triggered by a strong jobs data event lingers for a few more days/weeks.”
Supply also a factor as 3/10/30 Treasury auctions begin Tuesday after a bond-market holiday Monday, Goncalves said.
Nomura economists led by Lewis Alexander in Oct. 4 report said FOMC probably does not have a “well defined rule that will determine when to terminate the program.”
This is exactly what I was talking about, and the market responded in kind. With uncertainty around the ultimate size of the program, a thin pre-holiday trading session, and supply forthcoming, no doubt bids and liquidity were scarce, however prepared and opportunistic investors were able to take advantage of this volatility. The bond market is oversold and it would not surprise me to see the supply taken down after a healthy concession, but you can now see how choppy trading could become into the end of the year. Volatility surrounding the recalibration of the QE discount is the obvious source of market instability, but what may not be so obvious is something that looks to be brewing under the surface. In Tuesday’s Economics Brief
, Bloomberg economist David Powell wrote a commentary titled Euro Versus US Dollar Weakened by Slowing FX Reserves
that I think highlights a very important development currently garnering scant attention. (emphasis mine)
The sum of foreign currencies held by central banks increased to $10.52 trillion in the second quarter from $10.43 trillion in the first quarter, according to data released on Friday from the International Monetary Fund. That $90.1 billion difference translates into fresh reserve accumulation of about $24.3 billion after adjusting for the changes in exchange rates during the reporting period.
The four-quarter sum of foreign-currency reserve accumulation adjusted for changes in exchange rates fell to $501.7 billion from $1.036 trillion in the previous quarter. The latest figure is the lowest since the third quarter of 2009.
This decline in the accumulation of FX reserves certainly got my attention. I ran a chart of the world FX reserves and deflated it by the DXY US Dollar Index. I overlaid the supply of US Treasury ("UST") debt outstanding and the ratio of China UST holdings per total UST debt outstanding. Powell was writing the article with the idea that the decline in reserves would be bearish for the euro. I, on the other hand, took on a different perspective.
Global FX reserve accumulation peaked in 2Q 2011. The following July, China’s holdings of USTs peaked outright and also as a percentage of total UST debt outstanding. Since China entered the WTO in November 2001 prior to last year the relationship between their reserve accumulation and their accumulation of UST debt has been highly correlated and in one direction, straight up.
Between June 2002 and June 2011 China’s FX reserves grew at 34% per year rising from $240 billion to $3.2 trillion. Over the same time China’s accumulation of UST debt grew at 33% per year from $96 billion to $1.3 trillion. But since June 2011 both of these parabolic trajectories changed dramatically. China’s accumulation of FX reserves has flat-lined at $3.2t and their ownership of UST debt has fallen from $1.3 trillion to $1.15 trillion in June 2012, a decline of $160 billion or 12% YOY. Over the same time frame UST debt outstanding increased from $9.8t to $1.1t for a rise of 13%, so China’s holdings of UST debt as a ratio of total outstanding has seen a material fall from 13% at the peak in 2011 to 10% today where it was in 2008.
Why is this important?
China FX reserve accumulation is a large source of global demand for both financial assets and commodities. The US exports the reserve currency and China imports US dollar denominated assets. History has shown that when FX reserves decline on a YOY basis, as they appear to be doing now, it has the potential to manifest itself into a financial market disruption.
It can’t be a coincidence that global FX reserve accumulation peaked when the Federal Reserve ceased QE in June 2011. When the Fed opted for a balance sheet neutral Operation Twist they would cease exporting excess liquidity into the global financial system and thus the USD strengthened. With an open-ended QE the big question now is whether this deflationary influence from the deleveraging US consumer can be offset by the inflationary influence of the Federal Reserve. If not we should see markets trade with a more deflationary bias. Two of the most cyclically sensitive market indicators are the price of copper (HG) and the Semiconductor Index
(INDEXNASDAQ:SOX) both of which are highly correlated with each other and can be seen as a proxy for Chinese economic activity. Copper and the SOX both peaked in Q1 2011 and have made lower highs while US stocks (S&P 500
(INDEXSP:.INX)) have made higher highs. This is notable divergence and should not be ignored.
This past Thursday I had the opportunity to hear the esteemed bond fund manager Dr. Lacy Hunt of Hoisington
Investment Management speak at an investment conference. The discussion was a brilliant walk through history of debt cycles and deleveragings. He reiterated many themes he has cited in the past, but what really stood out to me was his discussion of the velocity of money.
Dr. Hunt distinguished between productive debt, which is used for investment to generate an income stream, and unproductive debt, which is used for consumption. I knew what unproductive debt was, but I had never associated it with the impact on velocity. Velocity is the most critical variable,
he said. Velocity will only increase if money goes into productive debt. Hmmm.... Of course.
When he showed the chart of velocity peaking in 1997 and subsequently collapsing I thought to myself that he was exactly right. This was the essence of the predicament we find oursevles in today. We spent over a decade accumulating unproductive debt encouraged by easy money from the Fed and financed by subsequent reserve accumulation from China that was recycled back into dollar denominated assets creating an unsustainable imbalance between consumption and investment.
Now that one-way relationship between US consuming and China accumulating reserves and thus USTs has come to a grinding halt. This could be the next phase of the financial crisis unfolding as a new paradigm develops between China and the US. The credit bubble collapse, to a large degree, was the first phase of adjusting this imbalance. The second phase could be a reversal of the trend of the prior decade whereby both economies work off their respective excess capacity generated by the symbiotic relationship that led to the imbalance. The US has to work off excess consumption by saving more and increasing investment. China has to work off excess investment by spending more and increasing consumption.
China economic expert Michael Pettis
certainly thinks a rebalancing is underway and he calls for a collapse in commodity prices over the next few years as a result. In a recent post from his blog China Financial Markets
But even this underestimates the change in demand for commodities. For 30 years, and especially for the past 10 years, China’s extraordinary GDP growth was driven by even higher rates of investment growth – generating for China the highest investment rates and investment growth rates in history. Consumption growth failed to keep pace during this time.
But rebalancing means, by definition, that for the next few years consumption growth must outpace GDP growth, and so also by definition investment growth must be less than GDP growth. Even if China is able to achieve 5-7% growth rates over the next decade, which I think is almost impossible, this implies that consumption growth will rise to 7-10% annually, and so from 25% growth in the last few years Beijing will be able to allow investment to grow no more than 2-4% annually, and much less if GDP growth rates are as low as I expect.
If this paradigm shift is underway it presents a very tricky and potentially volatile environment for investors because the old rules will not apply. The consensus trade coming out of QE III is to get long the same reflation trade that defined QE II, short the US dollar and long risk assets which had also defined the old US/China paradigm.
This Sunday morning PIMCO’s
Bill Gross tweeted
: "Don’t fight central banks but be afraid of inflationary consequences. Buy what they want you to buy – for now: risk assets."
I’m not sure it will be that easy. Since the QE III announcement markets have not followed the old playbook as the correlation trade has somewhat broken down. Yes, stocks are up, but beta has lagged. Sure, gold has rallied, but oil has collapsed. Mortgage rates are lower, but at the expense of the yield curve.
These cross currents could be indicative that some turbulence is brewing under the surface and if a paradigm shift is indeed underway you would expect volatility at the turn. With implied volatility relatively cheap into an environment that could be increasingly volatile, investors may be well served to play some defense into the year end performance grab.