📜 The Fed v. The ECB - Who's Driving Global Yields? (w/ Juliette Declercq)
JULIETTE DECLERCQ: Firstly, thanks for inviting me back. I founded JDI Research about five years ago now. What we try to provide is a wide array of clients with a strong and accurate global macro outlook to feed into a top down strategy for whatever investment process they might be trading. I also have a unique 20-year experience in both portfolio management and strategy, which I think enables me to connect the dots from the micro strategy to actionable trade ideas. That's what made the success of JDI Research for the past five years now and give us one of the highest hit ratio in the research industry. Really, it started in 2018. Mid-2018, we started to recommend short inflation breakevens. Then from December last year, long 5-Year bonds, and there was two main reason for that which were not linked to China. Firstly, I think that quantitative tightening directly feeds through lower global liquidity, and naturally, low slower global activity. That's exactly what happened this year, and that was very easy to accurately forecast. The second thing is that the Fed really tripped into the trap that Trump put last year by increasing the real equilibrium rate, but only temporarily. What's really interesting is that the Fed actually at the time did totally take on board that real equilibrium rate was higher. They went into coding it short term equilibrium rate. What's interesting is that in 2019, the concept of short term equilibrium rate totally disappeared. You had basically, Fed hiking into rising equilibrium rate of, I would say, 1% in 2018, which basically dropped to zero, by the middle of this year just on gross converging to its potential, which I see around 1.7% to 1.8%. The problem is the Fed did forgot that it was a real, a short term equilibrium, and they were late to cut again. That really Fed's through my view that the Fed was going to start cutting from mid-2019. That's exactly what happened. Now, we've talked about the pas, I think no one is sitting in front of the screen to talk about the past. What I would like to discuss is really what's happened this summer. I think what happened this summer is that we got into a vicious cycle, where lower rates actually were calling for lower rates, even lower rates. The reason is that we look at microeconomics, not models, assuming that human behavior will be rational, and the rational idea when you have forward guidance and central banks telling you that rates are soon going to be zero or even negative, the rational behavior, at least in Europe is to readily jump at the last opportunity to get a positive yield. The issue with that is you get rational individuals turning into irrational collectivity, collective behavior. That means instead of having a model where lower rates mean high investment, and lower saving, higher spending, you actually get people like you and me thinking, "What am I going to retire on if I can't get any returns on my retirement funds?" You just save more. I've seen it, I don't know if you've seen it as well. Clearly, that's something that you can see on the charts, and something that's actually turned. They're actually saying that we've reached the reversal rate in Europe about three years ago and in Japan about five years ago. What that means is you've got real rates becoming lower rates and negative rates actually becoming contractionary. The more you lower rates, and the more you need to lower rates, and that basically causes the explosion in negative yielding debt that we've seen over the summer. That's basically what's happening in Europe, where negative yields actually become contractionary. What it does in the US as well is that it spreads like fire, it spreads into more inverted curve and that can in itself, as we both know, be self-fulfilling, and lead to recession. That's very much what happened this summer and the groupthink, irrational collective thinking. The way I started thinking is, when I heard Kansas City Fed, George, welcoming fellow central bankers in Jackson Hole saying, "Don't feed the bears." That's exactly the way I'm thinking at the moment. If you basically keep cutting because markets demand cuts, and that's what the ECB has been doing and it's, in itself, very detrimental not only to investment, but also to demand, then you're basically feeding the bears. What's needed in an effective liquidity trap is government spending to basically offset private saving, to effectively load the global saving glutes to be offset. The interesting part, especially in Europe, is that also the debt to GDP ratio have exploded since the last Global Financial Crisis by about 15% to 20%. Actually, the interest expenditures percentage of GDP has absolutely collapsed to all-time low. That's really interesting, especially in the context of Mrs. Lagarde now taking over the ECB. Actually, the IMF just put out a paper reviewing what's happened with NIP and the fact that they were also advising fiscal austerity at the same time, and they've been arguing that, clearly it was wrong, and that you can't just have monetary policy, you also need fiscal policy. Otherwise, it's just completely counterproductive. What I'm thinking is it's very much what's happening at the moment. There is really realization that debt to GDP ratio are becoming quite irrelevant, if you can fund negatively. You've got the French looking to cut taxes for the lower middle class by 9 billion already next year, the Germans are looking to do a climate saving program, the Dutch are also looking at the investment program. More importantly, as well, French and Italian governments are now back in love. I think that can really lead us towards more fiscal policy, especially with Lagarde having the political clout to properly explain why and how this needs to happen. Another thing that is really interesting on that side is that the Germans might not like spending, but what they hate even more is negative yields. I think that is thinking that is really spreading in the rest of Europe as well and that's really the main problem. That's a really great question, because for the first time, as far as I can remember, I actually think the Fed is much less important in terms of thriving global yields. What we've really had and what I thought what happened, so we knew two things. Firstly, that NIP is not working. Secondly, that sentiment is spreading on the fact that it is not working. It's quite a big U-turn this summer because just before Sintra in June, and there was an ECB paper, looking at the fact that negative interest rates were still working. The reason is that the central bank was looking before at the supply side of credits. What I mean by the supply side is our banks still lending and because banks were still lending, they were just assuming that everything is fine. Obviously, they failed to really look at the demand side of credit, which is that you and me saving much more, which means that their models are broken. The second thing to look at as well is all these insurance, pensions and et cetera. As far as yields continue to go down and you can keep getting a capital appreciation, everything is fine. When you're not getting capital appreciation anymore, when we stall, you're basically left with negative yielding assets and that's an even bigger problem. I knew on one side that there would be a U-turn in terms of thinking that monetary policy on its own can be portent. I strongly believe that monetary policy needs to work in cooperation with fiscal policy. That's something that I'm not on mown, thinking about at the moment. The second thing I knew was that we were pricing 42 basis point of cuts at the end of August on the [inaudible] curve. We were basically pricing that lower rates forever were going to be the answer to the next downturn, which I thought was completely wrong. What I recommended at the end of August was to get out of long fixed income and look to stop selling bubbles, so Germany 5-Year at minus 93 basis points. What I knew as well was that a lot of the US curve as well, was the 1.43 prints in the 10-Year Yield in the US wasn't due to escalation of the China versus US conflict. It was, in my mind, mainly driven by expectation of the bazooka that Draghi was going to come for in in September. For me, that was the mind blowing risk reward trade where you know on one side that the ECB is not going to respond markets expect them to respond, and that it will basically drive rates everywhere else in the world. I think that's really what happened. What we've seen is a decompression of term premia just on the basis of, "Okay, we're done with the vicious cycle of lower rates, calling for lower rates, and now, we're going to look for something different." Suddenly, we don't really know what that different thing is going to be. What we do know is that the dispersion of risk is not one way as we saw it was in August. I think that was really the gamechanger in terms of monetary policy. Sometimes, a trade that is just a great risk reward because you can see the different dispersion of risks than what market is pricing, which is really how the trade started at the end of August in short bubbles. Sometimes, this trade, which is initially completely tactical, can become a bit more strategic. I'm not calling for a global boom. Clearly, that's not my point. What I do think is that we had a few game-- also gamechangers in September that were not all linked to monetary policy. The first thing maybe would be Brexit. I think there was a gamechanger in September with Brexit. With Boris Johnson losing his majority in Parliament by more than 40 MPs, suddenly, the DUP wasn't the kingmaker anymore. That's a big deal, because it means that a potential deal with Europe can involve Northern Ireland on the backstop whether it is by having agriculture deal, or something like that. That would also allow Boris to basically go with the Canada-style agreement that he's been looking for. The second thing is that the Lib Dems have been going, basically, we want to remain if there is a general election and we win, we want to remain and we're going to call off Article 50. That's a big deal for labor, because that means that if there's a general election before UK is out of the EU, Lib Dem becomes irrelevant. If it's after its labor, that it's so becoming irrelevant. I think that's the gamechanger in terms of getting Labor MPs to basically vote for the deal eventually because they want the election of after being out of the EU. That's two things. The third thing is probably that Macron and Michael definitely want to get done with Brexit. I think Macron doesn't want the second part of his mandate to be all about Brexit, he wants to be the post-Michael who is basically leading Europe to different macro policy, whether it's fiscal, and obviously, in very close contact with Mrs. Lagarde, as well. That's for breaks, basically, much higher chance than we had in August of soft Brexit on 31st of October. That's obviously really important for Europe. The second really important gamechanger which very few are talking about, is that the same reason I was calling for US yields to go down from December last year because of global tightening and the fact that US monetary policy was too tight for the rest of the world. Well, suddenly, we've seen US ISM collapsed and effectively converged to global PMIs. I think a lot of traders, portfolio managers saw the below 50 print in ISM manufacturing as that said recession is coming. Actually, I thought, brilliant because US is converging to the rest of the world. That means we're going to have global policy, which is going to be much more appropriate for the world. If you look at a chart that we love to look at, you'd actually end-- you're going to be showing on screen, you can actually see that the mini cycles that we've seen for the past five, six years, have been driven by the differential of activity between the US and the rest of the world. Meaning when the US does well, it plunges the rest of the world into a slowdown because the Fed has to hike rates and obviously, 80% of global transactions are still in dollars. That's the other gamechanger that basically US is converging to the rest of the world which means the Fed, given the Fed is going to be just doing what markets are pricing. That means monetary policy, global monetary policy is going to become appropriate. The third gamechanger which I identified after the Biarritz G7 is that clearly, initially, I thought it was just Trump who just would be taking a much softer stance with China, but it appears that China is willing to play a game as well. I think something happened after that Friday where there was huge escalation and in my head, it was really capitalization, then the G7 happened and we got them, 2% down in stocks. Suddenly, Trump came out and like, "I got a call from China." I think what's really clear that is that the US's main weakness is its financialization, meaning the economy is going to be extremely linked with the stock market. That means if you get 5% downside in stock markets, the economy's not going to be as resilient as it was last year, especially given Trump can't come out with another fiscal plan before the next election. That really just told me that as a dealmaker, it would make a lot more sense to get a much softer tone. I think that's really what happened. I'm not saying there's going to be a great deal, I think it's just going to be a cosmetic deal, but really, what's important is we don't get escalation. That's three gamechangers following a major gamechanger, which was the fact that the ECB wasn't looking to keep digging a hole for itself if you prepare. Firstly on the ECB, I was actually amazed to see my view completely validated so quickly. I actually thought it was going to be Draghi not saying too much and then Lagarde coming out with, "Look, monetary policy is not really working anymore. At the minimum, we need cooperation." Actually, Draghi just came out and suddenly, it was not about monetary anymore. Every single question was about just spend more money. That was really the interesting part. Also to the question about whether we had hit the reversal rates, he was much less optimistic than he was injured and saying, clearly, it was going to be something that would be discussed in the future. Also, obviously, the QE infinity is an enabler for more fiscal policy, it's giving a white card to government to spend. I think the message from the ECB was extremely clear and I didn't expect that it would be so clear. If you look at what's happened in the US, for example, the cyclical versus defensive move has been completely in line with the repricing of the Fed. I think we've priced out 30, 40 basis points, that's exactly in line with the rebounding in cyclicals versus defensive. That's a lot of to look at in terms of figuring out whether it's going to be a shock, a yield shock, and a mini tantrum, or whether it's a positive thing. That's really telling me that it's a positive thing. Obviously, European stocks have been trading really well since the ECB and that's being led by banks, which is the interesting thing as well. I think talking about the dollar and Eurodollar, the interesting thing is that it puts less pressure on the Fed to deliver immediate cuts because if the ECB is not cutting anymore, not digging its hole anymore, then suddenly, you get some support for euro versus dollar, which means, "Okay, the Fed is still relatively quite hawkish and the dollar is supported, but it's not making new highs." I think that's really what we've seen in September. What I've been recommending since-- also end of August was short Germany 5-Year, I got out of long US as well. I'm feeling very bullish European stocks. I think that ship, they're very leveraged to the global cycle, which I think was to bend towards imminent recession. I think there's a possibility that we have another mini cycle. I don't see huge vulnerabilities within the US or in Europe, or at least not as much as what the market chatter is about. I like European stocks. I like short bonds in Europe. I think one of the theme that's going to be really interesting is monetary policy in the US where it's easier to sustain the price cuts than obviously, in Europe, so we're going to have Europe doing fiscal versus US doing monetary. I think that's going to keep the dollar from strengthening much. I think that will keep you off supported and eventually means a higher euro. I don't think that's an imminent story. In terms of US the fixed income, I think we've probably done 75% of the move in terms of decompressing premia, I would be looking to reenter 10-Year Yields closer to 2% and to basically run the trade short bubbles versus long US. I think that could be something that really starts trending into next year. Well, we've literally seen almost nothing now so far in terms of convergence, because it was really, the first part of the move was term premia decompression. In fact, I think the US has moved more than Europe since the beginning of September. I'm not exactly sure about that, but I think it does. I think that's the first step. I think the second step is basically, US is still-- there's no imminent recession, but we're still going to be slowing down. I don't have any question about that. I think probably, we're currently around zero in terms of real yields. I think probably equilibrium would be a bit negative. I'm still looking for another cut, at least, this year. That really should fit through the new theme, which is Europe fiscal versus US monetary. Oh, we'd be looking for a steepening there. I think we're still pricing too much negativeness around Europe. If you really look at what's happened in Europe, the interesting thing is that a lot of the weakness has been completely driven by Germany, and Germany manufacturing. The thing there is that Germany has by far the largest fiscal space. I think in Germany, you could basically run deficits up 2% per year and still keep your debt ratio stable. That's almost a no brainer. If you start seeing employment going down in Germany or unemployment going up, I think straight away, you can resort to fiscal policy. If you look at the services sector in Europe, everywhere, it's actually been trending up for the past six months. We've had a little bit of a coming down at the beginning of the year, which was totally making sense, but we've actually been trending up in services. I know there's a lot of the narrative that manufacturing always leads services but this time, it's not. I think we've got the biggest divergence and on up the top in front of me, but I think we've got the very large divergence, which is unprecedented in terms of our long way, we tend to reconverge. I think it could be well explained by the fact that everything is based around China and the trade war, and manufacturing, but right now, it's clearly not spreading. I think China is trying to join the reflation party, but not to benefit the rest of the world. I still don't think that we're going to see the same big upturn that we've seen in 2016-'17, or even 2009, we're not there at all. What's happened in China is, firstly, the leading indicators have picked up six months ago, and they tend to be six months leading. We actually-- and also, in September, which was another force gamechanger, maybe, is they've really joined fiscal to monetary as well, by accelerating the ROE cuts and really moving forward the investment quota. I think China is not going to be having a big rebound, and especially not for the rest of the world, because I think they really want to be focused on domestic consumption. What I think as well as we could be stabilizing as well there, meaning we're not going to get a big rebound, but we're not going to see anything much worse. We'd not rule inflation out, especially not in the US, and what I saw- and I've been always deflationary, I've been recommending short inflation for the past number of years. What's really interesting in the US is that Powell yesterday, was still absolutely talking about muted inflation. We're worried about that, when we now have core CPI running on an annualized basis as 3.4. That's nothing to be another Fed would have been starting to be a little bit worried about that, especially given the consumer is really driving inflation. Of course, that could just be temporary. I wouldn't totally rule out a bit more of an inflation burst in the US. Then I think it's a good thing that the Fed is going slowly, because the risk would be that suddenly, the curve steepens and that would be the real risk as to assets, financial assets, and eventually, a recession risk. I can see a reason why you wouldn't go and cut 50 and steepen the curve, weaken the dollar. You might lose control of-- a little bit control of inflation, and eventually, steepen the curve, and basically crush assets. It could take a long time, but it could get priced quickly. We're in the middle of budgets at the moment in Europe, no one is going crazy, for sure. I think there is a move to simplify the physical rules in the EU. That's one important thing. Looking toward some more of in the future, I think what we could have is Lagarde has been talking about central bank issued digital currency. When it was first floated two years ago, the idea was that, you and me would have money at the central banks and so I'm not talking about Bitcoin or anything, I'm just talking about you and me having money at the central banks, at a public entity instead of a private entity. What they were thinking at the time is that they could basically cut rates as far as they wanted because they don't have the same constraints as a bank. I think that idea is completely gone now, because of what we explained them before that it would be totally contractionary. The way you could use it is basically by doing people QE and that's one thing that was actually mentioned in Draghi's press conference, and he did say that it would be something that would be part of a strategic review when Lagarde comes in place. That's an interesting thing. Then you're just talking about different countries, different policies, but in Japan, you could easily have monetization. Basically, monetization is debt financed by QE, which is very much already possible, but Japan is not using. It might sound really controversial, but actually, it was very widely used before the '80s. It's been used in France, Italy, UK, and Sweden. It's not really that controversial, it's just that then we got the inflation going out of control and we went into the '80s, really wanted central banks to be independent and with a strong inflation mandate. That's the different forms that we could be thinking about, people QE, monetization. You could have governments having an account at the central banks as well, which makes the whole fiscal program much more nimble, and much more, in terms of moving markets expectation, much more transparent, because the problem at the moment is everybody's asking, "But what are they going to do? When are we going to know it? But the Germans, they still want to spend? What's that program? What is it going to do, like climate change program? What exactly does it mean?" I think if you had basically a government account that can be basically filled by the Central Bank, also means that the central bank's not losing its independence, then suddenly we'd be like, "Okay, we can see it, maybe recession is not tomorrow." I think we are at a really interesting crossroad, whether it's Brexit, whether it's China, US, the US election, the ECB and the C-change in monetary policy and I would urge you to call me and navigate those rough waters together in the future.