“Whoever controls the volume of money in our country is absolute master of all industry and commerce…and when you realize that the entire system is very easily controlled, one way or another, by few powerful men at the top, you will not have to be told how periods of inflation and depression originate.”
This quote was a statement made by President James Garfield…2 weeks before his assassination.
And not much about this postulate has changed since then. The most important variables in global macro are the economic conditions and how central banks respond to those conditions.
There is only one true trade and that is the price of money, everything else is just a derivative of that.
Central banks control the price of money and use monetary policy to get the economy moving and encourage people to move along the risk curve. And the most important point is that generally speaking, monetary policy among the G10 members is highly correlated.
So what happens when there is a divergence in monetary policy among the largest and most important central banks?
I’m not sure anyone can truly understand the true ramifications of diverging policies, especially considering the artificial environment global markets have been functioning in since The Crisis. But to be clear, this is the No. 1 factor that will drive markets for the foreseeable future.
I’m a big fan of evaluating what the markets are telling us in real time about future expectations. Markets will tell you far more than any pundit, economist or blogger (orme!) ever could about what to expect in the future. Markets are never wrong; you can't say the same thing about opinions.
For most of this year, markets have been pricing in slower economic growth here in the US and US GDP has reflected this reality. GDP growth peaked in the Q3 2013 with a 4.5% growth rate then fell sequentially for the next 2 quarters, posting a 2.1% decline in Q1 2014, and then popped back up to 4.2% in Q2 2014.
Despite the strong rebound in economic performance by the end of June, markets have been slow to confirm this positive trajectory. US Treasury yields didn’t bottom and begin to rally until the end of August, just 3 short weeks ago and are now up 10.9% over that time period.
Similarly, the US Dollar didn’t really catch fire until the middle of August and has now rallied 4.2% in the last month, which is a monster move for a currency. As far as the US equity market is concerned, sectors that generally do well in an environment where growth is slowing were handily outperforming both high growth and the broader market by a sizeable margin, in some instances over 1,000 basis points of outperformance.
The Growth Trifecta
However, in the last 3 weeks, this has begun to shift and favor the high-growth areas of the US markets. These slower growth areas have been outperformed by 300-400 basis points by higher growth sectors and the broader US equity market. So, in the last 3 weeks we have had the trifecta of signals that US growth is set to accelerate:
yields are up
the US Dollar is up
the S&P 500 is up
Generally speaking this is the ideal scenario for US economic growth to accelerate, just look at 2013, if you have any doubts.
But is this a reliable indicator this time around? Or is it simply the divergence in policy amongst the major central banks? Recent rise in the US Dollar is a perfect example of the point that I am trying to make.
As a reminder, the performance of the US Dollar is based on the performance of the US Dollar INDEX. The USD Index is an index that values the US Dollar relative to a basket of 6 foreign currencies with the following weighting: Euro 57.6%, Japanese Yen 13.6%, Pound Sterling 11.9%, Canadian Dollar 9.1%, Swedish Krona 4.2%, and the Swiss France at a 3.6% weighting.
The US Dollar’s return over the last month is in the top 10 of monthly US Dollar returns since 2007. What else could explain the US Dollar’s strength if not that investors are expecting the US economically smoke the other majors?
Europe's A Different Story
In the last month the Euro has declined 4.2%, making its total decline since peaking in May, 7.2%. Investors have been pricing in further easing by the ECB since the slide began in May. The ECB has cut rates twice since then and the core rate now sits a -15 basis points.
In addition, the ECB announced a couple of weeks ago that they would be conducting LTRO (long-term refinancing) with top commercial banks and asset-backed security (ABS)/covered bond buying in order to expand their balance sheet, fight falling inflation and attempt to boost the economic growth.
The ECB is having to do all of this because the Eurozone economy can’t seem to sustain upward momentum on its own. GDP has been declining for the last 2 quarters and manufacturing PMI has been declining each month this year since peaking back in January.
In addition, the latest ZEW survey, which is a representation of a survey of 350 economists and analysts about the economic outlook for the Eurozone for the next 6 months, just registered its lowest number since December 2012.
Most European equity markets followed the decline of the Euro by peaking in mid-to-late June and have been making a series of lower highs since then. The currency markets, the equity markets, economists, analysts and even the central bank itself is telling you that economic performance in the Eurozone is going to be subpar moving forward.
If you had money to put to work on the long side, would you invest in the Eurozone? Or does the US look like a better option? Forget about Japan, certainly.
Land of the Setting Sun?
In the last month the Japanese Yen has declined 5.9%, bringing its total decline since peaking in late may to 8.1%. Here again, we have an economy that cannot sustain growth without government intervention and a monetary policy that promotes easing.
Japan has had a slew of bad data points over the last month. Q2 GDP was just reported a couple of weeks back and it cratered 1.8% quarter over quarter and the year over year growth rate was -7.1%, which was a stunning decline from the previous quarter’s 6.0% year over year growth rate.
In addition, auto sales are at a 3-year low and Japan just reported its 41st straight monthly trade deficit. I think the trend here is pretty self evident and its then understandable why assets are finding their way to the US.
I don’t know if the Dollar’s strength and the capital flows into other US-based assets are based on future growth expectations here in the US. Or if it's based on a divergence in policies, which makes the US the tallest of the pigmies and most of the world’s money is “long-only” and has to be invested somewhere.
Only time will tell.
What I do know is that the moves in the US Dollar and US Yields over the last month are just the beginning and will significantly impact every market in the world. We planned to be well positioned for this transition.