Global FX, USD, FED and China
Ahead of tomorrow’s Fed meeting, markets are staying within tight ranges as tactical versus structural forces maintain balance. Tactically, investors fear the Fed emphasizing the gradual but continued tightening path projected by its dots, which, for a market that is heavily underpricing, the Fed could be a major headache. Structurally, excessive liquidity conditions will stay in place even if the Fed delivers according to its projections. The prospect of US financial sector deregulation has added a new source of capital availability, allowing capital costs to diverge significantly from nominal GDP expansion rates not only in the US, but also globally. Indeed, the testimony of Randy Quarles, who has been tapped by President Trump to serve as Vice Chair of Supervision, on Thursday is likely to support this effort and will have the means to do so. Spreads have stayed tight against warnings that credit spreads should widen when approaching a late cycle. The continued tight spread reading suggests either the market does not believe in the late cycle mantra or that investors, blessed with liquidity looking for yield pickups, are willing to ignore late cycle related credit risks. Regardless of driver, the message remains a risk positive one pushing financial conditions towards new highs.

The Fed may lean against a further valuation acceleration of risky assets. Given FX market positioning, there could be a significant short-term USD supportive impulse created by the outcome of the Fed meeting should its communication signal an earlier-than-expected balance sheet normalization or a faster-than-expected rate path. However, the USD is unlikely to return to its previous long-term bull trend. Indeed, the combination of US growth not accelerating meaningfully from its recent 2% path and financial sector deregulation has created a textbook environment for USD weakness. For the USD to rally lastingly, the US has to shift its growth potential closer towards 3%, which would require critical structural reforms. Fed policy changes may impact the USD tactically, but structurally it is the amount of USD made available for international use driving the USD.
Often we hear investors talking about China’s weakening credit impulse dampening demand for commodities via slowing Chinese economic growth. According to China News, the 25-member group of the Politburo stressed that the government would further regulate “financial chaos”, curb the increase of illegal debt raised by local governments, and stabilize the real estate market. The “barbaric” growth of the Public-Private Partnership projects will be controlled through better management of local government debt, the committee suggested. It seems China is heading towards a period of monetary tightness which does not bode well for the credit impulse. North Korea-related tensions have come back onto the agenda too, with the WSJ reporting that China is preparing for tensions with North Korea.

However, CNY swap rates and bond yields have eased since May. Interestingly, despite the PBoC ‘s tightness, China’s economic growth rate has accelerated over recent quarters. Here too the availability of capital plays in. When China faced strong capital outflows in 2015/16 it was its weakening asset base driving domestic monetary conditions tighter. The now-sealed capital account has stabilised domestic capital supply, allowing CNY spreads to tighten, bond yields to come down, and local equities to rally. This morning China’s Security Journal wrote that the liquidity situation is expected to improve further in the near term as the PBoC is showing a clear bias toward maintaining liquidity stability while positive changes in capital flows are providing additional support. All in, China’s liquidity and capital position is not overly tight.