Global FX, US Inflation Expectations, Real Yields and EMFX
US inflation indicators coming in on the soft side of market expectations suggest risk appetite should stay solid. This morning saw raw material prices breaking higher once again despite the release of slightly weaker Chinese PMIs (July non-manufacturing PMI declined to 54.5 from 54.9, manufacturing PMI fell to 51.4 from 51.7), continuing the bullish trend which started in June, with iron ore prices 38% higher. Asian materials producers have rallied overnight. Some indicators suggest that market participants are not relentlessly bullish: NASDAQ has weakened over the past several days; weekly Fed data suggest primary dealers increased their bill holdings to their highest level since 2014;and foreign investors reduced their holdings in the Korean stock market at the fastest pace since August 2015. It is this ‘wall of worries’ which should keep the bull trend intact. In order to reverse our bullish interpretation, we need to see higher US inflation rates, the Fed signaling a significant increase in its pace of withdrawing monetary accommodation, or US real rates rising with the help of stronger data releases, notably higher capital expenditures. These seem unlikely without a calmer US political environment.

Conditions for a risk reassessment are not yet in place. US real rates have declined over the course of the past week, eeping the USD on the back foot and allowing for a higher valuation of risky assets. It seems that overseas Treasury demand has contributed to keeping US nominal and real yields lower, supporting our thesis of viewing the current macro landscape through the lens of the 2004-2006 cycle. During this period it was US nominal funding costs staying below the anticipated nominal return of investment which led to a leverage boom. Consequently, foreign central bank holdings of US debt at the Fed have jumped to USD3.33tn, the most since 2015. The portion of the Treasury market held by foreign investors is climbing in 2017 after dropping last year.

Reserve managers increasing their foreign asset holdings suggests to us that there is too much hard currency in circulation, which we view as a late cycle effect of DM central banks increasing the size of their balance sheets via QE operations. Initially, QE increased onshore liquidity with DM central banks expanding their balance sheets, but funds remained largely onshore. This created an environment of USD shortage abroad, reflected in the widening of the cross currency basis. It is the new strength of the financial sector now driving offshore USD liquidity conditions. Banks and other investors are arbitraging onshore – offshore spreads, in turn reducing the offshore USD scarcity. The rise in offshore USDs increases reserves. Official institutions invest these reserves into US Treasuries, pushing US bond yields down, reducing the relative attractiveness of USD holdings for private funds, in turn boosting EM inflows and pushing EM FX reserves even higher.

However, the relative decline of US nominal and real yields can only partly explain USD weakness witnessed since the start of the year. Indeed, the USD trades at a politically derived discount as investors have priced out the probability of reforms increasing the growth potential of the US economy. Worse, reform uncertainty has held back investment, suggesting the return of a reliable policy approach could have a significant effect in pushing the US economy towards better growth.