Global FX and NZD
NZD gaining more than 1% despite the RBNZ cutting rates by 25bps provides a very powerful argument for remaining long the EM asset class. This is about‘exploited’ yield curves steering global capital flows into areas where yield can still be earned. The BoE’s additional GBP70bn QE operation and continued central bank balance sheet expansion of the ECB, BoJ and SNB have pumped additional liquidity into the system. If this additional liquidity is not absorbed by better economic activity or a decline in monetary velocity then it ends up in financial markets, ‘lifting all boats’. Bond yields fall globally and there where yield curves are still reasonably steep, real yields come down too allowing a higher valuation for local risk assets. This is why the US equity market has outperformed this year.
Yield richness is generally found in EM and the commodity currency bloc. Within the G10, New Zealand has the highest rate and yield levels, causing capital to pour in, pushing the NZD higher. Bullish fixed income traders putting increasing amounts of funds into EM receive support from various angles.
First, on aggregate, global central bank balance sheets are still growing via QE operations and what is often forgotten is rising global currency reserves. Today represents the one-year anniversary of China allowing the RMB to drop. From June 2014 to February 2016, the PBoC lost about USD800bn of reserves, draining global liquidity conditions leading to two episodes in August/September and January of equity market corrections, volatility spikes and EM sharp sell-off. Today, China’s currency reserves have stabilised while reserves elsewhere have increased suggesting that USD shortage has converted into USD oversupply. This USD oversupply has been recycled into global fixed income causing bond yields to fall. Secondly, globally high debt and deficit levels project future balance sheet consolidation needs, suggesting savings to exceed local (real) investments. The consequent excess of savings should first push for higher asset valuations, but once valuations have reached overly ambitious levels, it will reduce monetary velocity.
Third, inflation expectations will keep falling with prospects of fiscal expansion not changing the outlook markedly. So far, higher government expenditures did lead to a ‘crowding out’ of private sector activities as higher government deficits often lead to precautionary savings of the private sector. Inflation expectations will only rise should central banks fund government expenditures directly, breaking the Ricardian equivalence. Falling oil prices did push inflation swaps lower overnight. Saudi Arabia and Iran oil production have kept rising, making it more difficult for OPEC to impose a credible price-targeting policy. Oil inventories had declined from May to June, but have now started to rise again. Market participants should not fall into the trap of associating falling oil prices with increasing EM investment risks. First, oil has decoupled from the USD and from other commodities. Commodities associated with demand from China (iron ore, coal, copper etc) have remained strong. Second, the EM rally is no longer fed by ‘petrodollars’ as was the case from 2009-13. Third, falling oil prices pushing inflation expectations down globally including the US may convince the Fed to stay accommodative for longer.