Long Scarcity Short Abundance
Capital preservation requires real assets
So far
Previously, we reviewed the macro trends for Q1 2024. We noted rising bond yields, dollar and commodity prices driven higher by a stronger than expected US economy, and a manufacturing recovery in China, all conspiring to make inflation sticky. These factors tightened financial conditions as investors began to expect fewer and smaller interest rate reductions for the year ahead.
QE that isn’t
More recently, we have noted some weakening signals from the US economy (jobs data) and emerging signs of stress in the global financial system (Asian and specifically Japanese currency volatility). Although this didn't move the FOMC (Federal Open Market Committee) to adjust US policy rates at their latest meeting, there was an important message about reducing its balance sheet. This lessening of Quantitative Tightening (QT) equates to a net boost in dollar liquidity and is QE by another name. Importantly, such loosening frees up balance sheet capacity elsewhere in the dollar system, easing financial conditions.
As liquidity watcher Mike Howell put it,
The Fed and Treasury are working together to control future duration supply. The latest FOMC and QRA (Treasury Quarterly Funding Announcement) show that Fed Chair Powell and Treasury Secretary Yellen are aware of the need to preserve liquidity.
Relief for risk assets
Subsequently, the dollar index (DXY), commodity prices, and US 10-year bond yields have all eased, and equity markets have risen. Crucially, for the world financial order, the value of the Yen has recovered and stabilised, and immediate fears of an Asian currency crisis have abated.
Turning Japanese
However, if the Treasury and Fed are working together to control future duration supply, this is Yield Curve Control (YCC), a policy adopted by Japan since 2016. YCC extends QE along the curve, artificially depressing longer-term yields. Usefully, we have just learned how YCC has been going for the Bank of Japan, and it isn't good.
Blew it
Last week, the Bank of Japan blew an estimated $50bn of reserves to protect the value of the Yen against the burgeoning carry trade opposing it. This move put upward pressure on US bond yields and undermined Yellen's prized borrowing facility. While the immediate pressure on the Yen has declined, it has lost ~15% of its value to the dollar year to date and over 50% over the last three years; the situation remains fragile. The world financial system is suffering from an over abundance of Yen.
Basket case
So, does this mean that US fiscal dominance and YCC will lead to the dollar's collapse? Probably not, at least in the short term. With its global reserve currency privilege and deep liquid debt markets, the dollar remains the yardstick against which all other currencies are measured. It is the cleanest shirt in the laundry basket. Yet, despite this, foreign central banks and other reserve asset managers have chosen to diversify into non-dollar assets, notably gold, raising the concern that dollar supremacy is not a forever certainty.
Structurally intransient
Is inflation now beaten? Probably, in the short term, particularly if the US slowdown gathers pace. However, structurally lower inflation requires the helping hand of productivity growth, which means accruing significant and widespread benefits from artificial intelligence (AI). Until this happens, financing government spending takes precedence over monetary policy, which means a compliant central bank with lower interest rates but elevated through-cycle inflation.
Improved
If the dollar is the least dirty shirt in the pile, then the UK pound is only slightly grubbier. Following the Truss 49-day think tank experiment, Sterling qualifies for the most improved player award among developed world currencies. It has traded in a narrow band to the dollar for 18 months and appreciated against most other major currencies.
Lower rates
Forecasters have consistently underestimated the UK economy's resilience and ability to fend off inflation. The release of the UK Q1 GDP data confirming the end of last year’s shallow recession has continued the UK’s ability to outperform low expectations. Combined with attractive asset values, commentators and fund managers increasingly suggest the UK is an appealing home for capital, implying policymakers can, in theory, consider lowering rates.
Upside
Will the UK be prepared to lower interest rates ahead of the US Federal Reserve? The answer is not clear or straightforward. But if they do, and June seems the favoured time, it will further boost UK equities, particularly smaller capitalised domestically focused companies. It should also benefit other domestic assets such as Gilts and house prices. Sweden and Switzerland have already cut. Does the Bank have the balls to follow them?
Downside rhymes
Yet, delaying rate cuts due to fears of currency volatility could mean financial conditions remain too tight and something breaks. The last time investors lost confidence in the UK's finances, the Liability-Driven Investment (LDI) blackhole within our pension funds set off a toxic doom loop in the Gilt market; this time, who knows? While history doesn't repeat itself, it could still spell trouble in rhyming couplets.
Firmer footing
For now, improved dollar liquidity re-injects life into risk assets, including equities. Further, the UK enjoys a better than expected economic and financial toehold in the global system, which could grow into a firmer foothold as volatility spreads elsewhere. However, the ticking time bomb of ballooning government debt remains.
Debasement
Fiscally dominant governments in an increasingly fractured world mean elevated inflation will persist beyond the current cycle without dramatically improved productivity measures or serious attempts to tackle debt-bloated government exchequers. Dollar debasement remains a long-term threat.
Investment strategist Lyn Alden said in her latest public newsletter,
most successful investing can be summed up as "go short abundant things and go long scarce things." In an era of fiscal dominance, bonds are among the most abundant things around. The U.S. government will be running $1.5-$2.5 trillion annual deficits for the foreseeable future, and going structurally upward from there. The Congressional Budget Office estimates that there will be $20 trillion worth of cumulative fiscal deficits over the next decade…In comparison, at current production rates and prices, somewhere in the ballpark of $2.5 trillion worth of refined gold will likely be mined and minted over the next decade. Similarly, at current prices about $70 billion worth of bitcoin will be produced over the next decade. Its supply growth rate is fixed regardless of its price action.
Keep it real
While equities remain an attractive long-term asset class, in a world of increasing fiscal dominance and its consequential uncertainty, the stock-picking skills of active management become more critical. But, weightings to real assets will prove to be preferable to bonds.
Jeremy