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The Chagrin of Beijing and the Problem of Time

Summary:
The central bank meeting cycle is over. Most of the important high-frequency data has been released until early January. The US debt ceiling has been lifted, avoiding an improbable default. A year ago, there was a sense of optimism, with a couple of vaccines being announced and monetary and fiscal stimulus boosting risk-appetites. Populism, which had been in the ascendancy after the Great Financial Crisis, seemed to be retreating in Europe and the United States.  Equities were rallying. In the last two months of 2020, MSCI's free-float weighted global index rallied around 17.8%. It closed the year with a 14.3% gain. Through last week, it was up about 14.5 this year. The US 10-year yield, a global benchmark, peaked in March near 1.77%. Following a disappointing

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The central bank meeting cycle is over. Most of the important high-frequency data has been released until early January. The US debt ceiling has been lifted, avoiding an improbable default. A year ago, there was a sense of optimism, with a couple of vaccines being announced and monetary and fiscal stimulus boosting risk-appetites. Populism, which had been in the ascendancy after the Great Financial Crisis, seemed to be retreating in Europe and the United States.  

Equities were rallying. In the last two months of 2020, MSCI's free-float weighted global index rallied around 17.8%. It closed the year with a 14.3% gain. Through last week, it was up about 14.5 this year. The US 10-year yield, a global benchmark, peaked in March near 1.77%. Following a disappointing jobs report, the yield spiked down to almost 1.33% on December 3.  It bounced to around 1.50% ahead of the FOMC meeting but ahead of the weekend, the 10-year yield traded back to 1.37%. Given the broad strength of the US economy and elevated price pressures, the low yields once again defy economists' expectations. Fed Chair Powell suggested that the low yields in Europe and Japan were making US bonds more attractive. There were around $13.7 trillion of negative-yielding bonds in the world at the end of last week, the most in four months.  

In 2020, the dollar soared in the initial reaction to news of Covid, but it peaked broadly near the spring equinox and then proceeded to trend lower. The losses accelerated after the US election and the vaccine announcement.   Given the risk-on drivers and the dollar's downside momentum, nearly everyone was bearish the dollar at the start of 2021. Yet, the Dollar Index bottomed, and the euro recorded its peak as rioters were thrashing the Capitol.   It trended higher. The euro and yen recorded their lows for the year in late November. Sterling and the Australian dollar recorded their lows earlier this month. So did the Norwegian krone, less than a fortnight before what is widely expected to be the central bank's second hike of the year.   

Few will be surprised that the Turkish lira depreciated for the ninth consecutive year and was the weakest currency. In 2012, the last year that the lira appreciated, the dollar closed a little above TRY1.78.   Last week, it traded above TRY17.14 after the president fired deputy ministers in finance and economics departments, and the central bank delivered another 100 bp rate cut.   The following three weakest emerging market currencies are Latam:  Argentine peso -17.5%, Chilean peso -15.7%, the Colombian peso -14.9%. Argentina has a different story to tell, but the others could not raise rates quickly enough to offset other risks, including inflation, weak institutions, and political concerns. With the Brazilian real's 8.5% decline and the Peruvian Sol's 10.4% slump, Latam currencies accounted for half of the 10 weakest emerging market currencies.  

Most emerging market currencies weakened against the dollar this year, whether monetary policy was tightened or not. There were three exceptions. The Russian rouble is up about 0.35%. Rising energy prices and an aggressive central bank, doubling the key rate to 8.5%, just ahead of the November CPI (8.4% year-over-year). The tensions over Ukraine and threats of retaliatory economic measures saw the rouble pare this year's gains. In late October, it reached the year's high, an almost 7% gain for the year. Since then, it has been among the weakest emerging market currencies.   

The Taiwanese dollar has appreciated by about 1.75% against the greenback. What is striking about the Taiwanese dollar is that its implied volatility (three months) is slightly lower than the offshore yuan. It has been hit was a positive trade shock. The trade surplus has averaged $5.45 bln a month through November this year, or about a 45% increase from the same period in 2019. 

To the chagrin of Beijing, the Chinese yuan is the strongest currency in the world this year, rising a modest 2.4% against the US dollar.   In word and deed, Chinese officials sought to discourage the appreciation. It set a three-year high against the greenback on December 9.   To ease financial conditions, reserve requirements were cut by 0.5% on December 6, effective December 15. A couple days later, the PBOC followed up by hiking the required reserves for foreign currency deposits by 200 bp to 9% (also effective December 15). Still, the record trade surplus and portfolio inflows seem greater still. If the dollar does not strengthen against the yuan now with the thrust of monetary policy divergence, the risk is that the PBOC announces additional measures next year.   

II.  A Problem with Time

Like many, we had thought that with the emergence of the vaccine, Covid would peak, and as an economic and social force, the public health crisis would dissipate. This was far from the mark even before the Omicron mutations. The Delta variant was ravaging Europe and picking up in the US. Social restrictions, mask protocols, and more aggressive campaigns to raise vaccination rates.   As more data on Omicron accumulates, it still seems as if it is magnitudes more contagious than Delta but somewhat milder systems. Raw numbers of vaccinated people who contract Omicron will rise, but it remains relatively low as a percentage of overall vaccinated people. The vaccine and booster shots appear to offer some protection from severe symptoms.   

Through some combination of less-lethal mutations, vaccines, and better treatments, Covid can be reduced to the status of the seasonal flu, but it has not reached that point yet.   However, the Omicron variant could help further the process in several ways. First, there does appear to be some pick-up in vaccination rates in the US and Europe. Second, the mutations may encourage the labs to develop a vaccine that attacks the virus at a deeper level, which, in turn, could facilitate a more efficient vaccine going forward. Third, while additional mutations are likely, Covid may follow the Great Influenza (1918) pattern, which is still referred to as the Spanish flu (the first reported case was in the US), and whose origin is not known to this day.  

After infecting something of the magnitude of 500 mln people (~1/3 of the world's population) in four broad waves over two years, the virus mutated to less deadly and more akin to what we think of as the seasonal flu.  By the end of this year, some 300 million people would have contracted Covid. Many developing economies in Africa and Central Asia have not begun or just started their vaccine efforts. There is some risk that some vaccines, like the Sinovac, which China delivered on a large scale, may not be as effective as others to prevent Omicron. The risk is that new mutations may arise, and to be successful, they would need to be more contagious (successful in reproducing) than Omicron.  

Vaccine hesitancy needs to be studied in a granular fashion. The pop-psych narrative about American individualism and distrust for centralized authority makes little sense when some parts of the US, like California and NY, have over 80% vaccination rate (at one jab), higher than in some European countries. Bloomberg's Covid Tracker puts Cuba as the most vaccinated country (256 jabs per 100 people as of December 14). The EU has done only marginally better than the US (155 v 146). The UK has done better still (177). 

Vaccination rates, however, in Bulgaria, for example,  are around a third of the EU levels (50), while Malta (201) leads the EU. Hungary, the only EU country not invited to the recent Democracy Summit the US hosted, has surpassed the US on this metric. There may be some function role for social trust, but it is likely to prove more complicated than some narratives suggest. And we might not know the hesitancy rate in some low-income countries until the availability has improved, it would seem. 

The initial economic impact of the new variant has thus far been limited, as many employees in the US and Europe have not returned to the office full-time. Businesses were better equipped to manage it, unlike when the pandemic first struck. On the other hand, the groping for a new normal in work patterns will take longer to sort out. Some large businesses are postponing the imposition of mandatory return to work requirements. The UK government has encouraged workers who can work from home, resume doing so. 

If the error underestimated the time it would take to get the virus under control, perhaps the same mistake has been made about price pressures. The fact is that Federal Reserve has dropped calling it transitory does not change the facts on the ground. Economists and many market participants expect price pressures to ease.   The median in Bloomberg's survey sees inflation (CPI and PCE deflator) peaking here in Q4 and gradually falling every quarter to finish next year at 2.6% and 2.3%, respectively. Other surveys show similar results, and Powell cited the Blue Chip forecasts.  

The uneven re-opening, supply chain disruptions, strong demand, and shifting consumption patterns have been greater and lasted longer than initially projected by investors and policymakers.   However, this does not necessarily mean that the US is returning to the inflation of the late 1970s, which scarred many of the now elderly elites. True, it has taken longer to bring covid under control, and it will take a little longer for price pressures to subside, but the extra time does not mean that is not going to happen. On the contrary, we expect this year's inflation worries to give rise to growth concerns by this time next year; perhaps it might even be an issue during the mid-term elections.    

Fiscal policy is past its peak, not just in the US but in most high-income countries. Japan is a notable exception, which the OCED expects to have a larger deficit next year than this year. Moreover, monetary policy is past its peak accommodation. Not only are bond purchases winding down, but next year, the Federal Reserve, Bank of Canada, and Sweden's Riksbank will join the Bank of England, Norway's Norges Bank, and the Reserve Bank of New Zealand, among the high-income countries to lift rates. In addition, the Reserve Bank of Australia will likely end its bond-buying in February. It has pushed against market expectations for a hike next year, but the swaps market is largely undeterred and has almost 90 bp of tightening discounted.  

Consumption will not benefit as much from transfer payments, and the pent-up demand will be satiated. Business inventories will be replenished, and this will help extend the recovery. However, many businesses that played catch-up to meet the stronger demand may be left with excess capacity. The chronic problem that market economies experience is the lack of sufficient aggregate effective demand relative to the vast capacity it creates (an expression of surplus savings). We are arguing here that this historical problem is likely to re-emerge. The quarterly forecasts for growth (Bloomberg survey median) are consistent with this:  5% this quarter as the economy bounces back from the disappointing 2.1% annualized pace in Q3.  However, it has growth slowing for the next six quarters; from 4.3% in Q1 22 to below 2.2% in Q2 23. Perhaps rather than inflation being transitory, the Federal Reserve would have had better success in explaining why the above-trend growth would be temporary.  




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Marc Chandler
He has been covering the global capital markets in one fashion or another for more than 30 years, working at economic consulting firms and global investment banks. After 14 years as the global head of currency strategy for Brown Brothers Harriman, Chandler joined Bannockburn Global Forex, as a managing partner and chief markets strategist as of October 1, 2018.

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