A Hyper-Proactive Fed and the ‘Dollar Smile’
February 01, 2008
By Stephen Jen | London
Summary and conclusions
We remain comfortable with the view that EUR/USD will end the year significantly lower than it is now, though in the near term the dollar may not rally. We have centred our call on a bounce in the dollar against the EUR and the GBP this year on the thesis that risk-aversion would spike so high as the US falls into a recession that fear-motivated bond flows would perversely support the dollar, just as they did in 2000-01. This thesis has partly worked so far this year, as the sharp erosion in the USD’s yield premium should have been extremely damaging for the dollar but the dollar has not collapsed with the FFR. We still feel comfortable with the ‘Dollar Smile’ framework. The new thought we have, however, is that, to the extent that a hyper-proactive Fed succeeds at limiting the duration of the impending recession to two quarters, negative real interest rates could help temper risk-aversion and somewhat temper the ‘left side’ of the ‘Dollar Smile’. We, along with the currency strategists, suspect that the dollar may not rally hard here and now, due to the Fed. However, the fact that EUR/USD has not breached 1.50 is remarkable and suggests that something else (the ‘Dollar Smile’) has been supporting the dollar. The rally we see in the dollar may be more back-loaded in 2H08, due to the hyper-proactive Fed. Two competing theses on the cyclical drivers of the dollar In considering the fate of the dollar, investors should keep in mind both structural and cyclical factors. On the structural side, issues such as (i) central bank and sovereign wealth fund diversification, (ii) currency valuation, (iii) the evolution of the US C/A deficit and its external indebtedness and (iv) declining financial ‘home bias’ are important. We will set aside these issues in our current discussion. On the cyclical side, there are two competing theses on the dollar. On the one hand, yield differentials – which are essentially a reflection of the economic de-coupling debate – suggest that the dollar should depreciate unambiguously and uniformly against most if not all currencies in the world. On the other hand, our ‘Dollar Smile’ framework suggests that the dollar, in an environment dominated by fear, would struggle to depreciate, and if risk-aversion were intense enough, the dollar could actually rally, despite the fact that the epicentre of the current crisis was made in the US. This is in fact our ‘Dollar Smile’ idea (see The Dollar Smiles in a Recession, December 10, 2007. So far this year, the tug-of-war between these two competing theses is not yet settled, as the dollar has been remarkably range-bound, despite the fantastic volatility witnessed in equities, bonds and credit markets. The USD’s yield premium has collapsed We have been tracking the USD’s yield premium for some time. In the first weeks of this year, this USD yield premium has collapsed from above 1.00% to a small deficit. In other words, the aggressive rate cuts by the Fed, which reflect its shifting focus from inflation to growth, and the rest of the world’s (RoW) focus on inflation, have led to a stark divergence on interest rates. Among the G10, the US now has the second-lowest interest rate, behind Japan. This sharp deterioration in the USD’s yield premium should, ceteris paribus, be super dollar-negative. However, the surprise – to those who believe in yield differentials being the most powerful driver of exchange rates – is that the dollar has remained in a range against the EUR and GBP so far this year. (We should also note that the two lowest-yielding G10 currencies – the JPY and the CHF – have performed very well so far this year.) Swings in investor risk-appetite and the ‘Dollar Smile’ While macro investors, after witnessing the aggression of the Fed and the inability of the dollar to rally, are now embracing the yield differential argument, it should be pointed out that the long-standing relationship between interest rate differentials and EUR/USD has broken down in a dramatic fashion in recent weeks. We believe that the forces at work behind this development are captured in our ‘Dollar Smile’ framework. Without going into details of the logic/intuition behind the ‘Dollar Smile’ framework, we simply note here that, as the US falls into a recession, whether the left side of the ‘Dollar Smile’ has significant leverage on the dollar will be a function of the intensity of investors’ risk-aversion and non-US policy-makers’ risk-aversion. The fate of the dollar, in the coming weeks, will therefore be determined by the relative validity of these two competing theses on the cyclical drivers of the dollar. By 2H08, we believe that the theme will flip to a risk-taking one, with altered dynamics for the dollar. Our thoughts about the dollar We make the following observations: 1. The Fed will ultimately remove the rate cuts. The more the Fed eases now, the more it will have to remove these cuts, likely later this year when the US economy recovers. We (our US colleagues, to be specific) have held the view that the US recession will be shallow and short-lived. The Fed’s remarkable aggression in recent weeks validates this forecast. As long as the dollar holds up as the Fed cuts, then the dollar will have a good chance of rallying in 2H when the Fed starts to remove the monetary easing. The reason why a prospective rise in the USD’s yield premium may help the dollar when its decline has not hurt the dollar is the switch in investors’ ‘mood’ or sentiment. When the Fed is ready to raise rates, it is likely that it will do so in an environment of recovering risk-taking appetite. The right side of the ‘Dollar Smile’ will likely kick in to support the dollar, with the left side of it now preventing it from being weighed down by yield differentials. 2. Economic de-coupling is still an unsettled debate. Most central bankers around the world seem to still hold the view that the RoW can and will de-couple from the US, the Bank of Canada possibly being an exception. Part of the reason for this thinking is that the US has only barely begun to enter into a weak phase; whether it actually falls into a recession is not yet clear, though we believe it will. Therefore, much of the arguments on whether the world will re-couple economically are based on personal impressions and subjective opinions, rather than hard data. (See The Dollar Smile Is Starting to Work (January 21, 2008) and On Economic and Financial De-coupling (January 16, 2008).) The hawkish monetary stance adopted by the likes of the ECB, RBA and PBoC is based on the expectation of economic de-coupling. This thesis will only be tested several months from now, which implies that there will be a period in which yield differentials and swings in investor sentiment could perturb EUR/USD within a range. However, when the US does enter a recession and the collateral damage is felt outside the US, monetary divergence will give way to partial convergence, or at least policy rates will start to move in the same direction, in our view. 3. EM and GCC currencies. The longer the world remains economically de-coupled from the US, the more the GCC pegs will remain under pressure, given the divergence in oil prices and the FFR. For the EM currencies, we maintain the view that their positive structural tendency will eventually resume when the US economy finds a bottom, and that this is a good opportunity to accumulate strategic longs in these currencies. Bottom line Our fundamental view on the USD remains unchanged, that EUR/USD will end the year significantly lower than the current spot rate. However, a hyper-proactive Fed may make the USD rally more back-loaded to 2H than we had thought.
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Celebrating the Birth of Russia’s SWF
February 01, 2008
By Stephen Jen & Oliver Weeks | London
Summary and conclusions On February 1, 2008, the world will officially gain another sovereign wealth fund (SWF), as Russia will formally launch its National Welfare Fund (NWF). This will become a large and important SWF, even though its birth weight – possibly tipping the scales at US$32 billion or so – is modest relative to China’s CIC. If oil prices remain supported, Russia will likely see this fund grow over time. In five years’ time, the NWF could be anywhere between zero and US$320 billion, depending on how much the budget and the pension fund draw on the NWF. At first, the fund will be managed conservatively, in ways not dramatically different from how official reserves are generally managed in other countries. However, as the NWF gains experience and confidence, we expect it to have a broad portfolio of risky assets, like other SWFs. Some facts about the NWF We first discussed this fund in Russia: The Newest Member of the SWF Club, April 26, 2007. Here are some facts and background information about this fund: - The birth weight of the NWF will be around US$32 billion. On February 1, 2008, the Oil Stabilisation Fund (OSF) – which forms a part of the official reserves, including gold, of US$479 billion – will be tiered into a NWF and a Reserve Fund (RF). The latter will be kept at an amount that is equivalent to around 10% of Russia’s GDP, which is currently around US$1.27 trillion, with the rest being funneled into the NWF. As of end-2007, the OSF was US$156.8 billion. Subtracting out 10% of GDP (US$127 billion), this leaves some US$29 billion for the NWF as of end-2007. By February 1, this figure will have reached around US$32 billion. This is larger than the US$24 billion expected by the Russian government last April.
- Governance structure. The NWF will be managed by the Ministry of Finance, though some asset management responsibilities may be delegated to the Central Bank of Russia. The MoF has the autonomy to recommend the currency composition and asset allocation of the NWF, subject to government approval. The MoF will publish monthly reports to the media, and will report quarterly and annually to the government on accumulation, investment and spending of the capital of the Fund.
- The mechanism of fund accumulation. Going forward, all oil tax proceeds (including those from the first US$27 per barrel of Urals oil) will now be saved in the OSF. Further, tax receipts associated with natural gas transactions will also be diverted to the OSF. In addition, the budget can claim resources from both funds (the NWF and the RF), but the total transfer cannot exceed 3.7% of GDP; this cap will be effective in 2010, with the intermediate target being more flexible.
- A conservative investment style to start out. When the notion of the NWF was first conceived, the intention was to make the Reserve Fund be invested in ‘risk-free’ sovereign bonds (like official reserves) and for the NWF to be invested like a SWF, i.e., in assets with higher expected returns, such as equities. However, the Russian government recently announced that, for now, the NWF will initially be invested very conservatively, with the following guidelines:
(i) All must be in foreign debt, denominated in USD, EUR or GBP, rated at least AA-, from Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Luxembourg, the Netherlands, Spain and the US. (ii) At least 50% in foreign government debt, with the rest in foreign private/corporate debt. (iii) Up to 30% in foreign agency debt and central bank debt. (iv) Up to 15% in debt of international financial organisations (ADB, EIB, etc.). (v) Up to 30% in foreign bank deposits. The Ministry of Finance has until October 1, 2008 to propose a framework for wider investments, potentially including corporate debt, equity and investment funds, but actual investment in these assets will be at least another year away. Currently, the OSF is invested in AAA government debt. Our observations We have the following thoughts: - Thought 1. The NWF could potentially grow to US$600 billion in a decade. The evolution of the NWF is likely to exhibit a steep upward trend in the coming years, if it is unmolested by the fiscal authorities, i.e., if there are no extraordinary withdrawals from the government, above and beyond what is permitted under the 3.7% fiscal transfer rule.
- Thought 2. However, Russia is likely to draw heavily on the NWF, breaking the 3.7% fiscal transfer rule. This is, in our view, the most likely scenario. With pension shortfalls looming and pressure for infrastructural spending growing, we believe that it is likely that the government will draw on the NWF heavily, despite current inflationary risks. Assuming stable energy prices but also that budget spending out of oil and gas revenue does not decline as planned and remains at the 5.5% of GDP level planned for 2008 and 2009, we find that the NWF could grow gradually to US$160 billion in five years’ time, but be depleted in a little over a decade.
- Thought 3. The Russian government’s own projections are very conservative. The government’s own projections see inflows into the NWF ceasing after 2008 as energy prices fall sharply and oil and gas revenues fail to keep pace with nominal GDP growth (the government’s most recent, upwardly revised forecast is for Urals oil at US$62 in 2010).
- Thought 4. The NWF’s investment strategy is likely to evolve dramatically in the coming years, towards that of most other SWFs. While, with limited experience and resources, it is understandable that the NWF, in the initial stages of its operations, chooses to adopt a very conservative investment strategy, we believe that its investment strategy will gradually evolve in the coming years to resemble more closely those of the existing SWFs. Norges Bank had a similar experience. Specifically, Norway’s Global Pension Fund – Global began in 1996 with all of its investments in bonds. NBIM only gradually raised its exposure to equities over time. It is natural for SWFs to alter their portfolio, risk profile and duration of exposure as they mature. It is our expectation that Russia’s NWF will gradually evolve and take on more risk in order to generate higher returns.
- Thought 5. The NWF is likely to outsource some of the fund management. Like other SWFs, some outsourcing is efficient. Building human capital in certain areas (e.g., equities and mortgage derivatives) may not be cost-effective. Also, outsourcing could provide an important performance benchmark for Russia’s own investment team. In the early stages of a SWF, it is likely that much of the equity portfolio will be farmed out to other fund managers, while bond management is mostly kept in-house. We expect this trend to prevail in Russia. Overall, we use the rule of thumb that 20% of the funds under management could be outsourced. (We suggested this 20% ratio for external management in How Much Assets Could SWFs Farm Out? January 10, 2008.)
Bottom line It is official now: Russia’s National Wealth Fund (NWF) is the newest SWF in the world. While its birth weight will be a relatively modest US$32 billion, if oil prices remain at the current levels, this fund could reach up to US$320 billion in the next five years, with our best guess being US$140 billion, depending on the oil prices and the extent of the fiscal withdrawals from this fund.
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On the Great March Upward of the Chinese Currencies
February 01, 2008
By Stephen Jen | London
Summary and conclusions The Greater Chinese currencies – the Chinese yuan, the Hong Kong dollar and the New Taiwan dollar – are on a great march higher. In the case of China, nominal appreciation will lead the real appreciation. For Hong Kong, we believe that the Linked Exchange Rate Regime will be preserved, with a very low probability of any modification (e.g., band widening) being made to it. Therefore, the HKD will appreciate in real terms purely through inflation, with no changes in the nominal parity vis-à-vis the dollar. The TWD, as well as Taiwanese equities, will likely be greatly supported by the political developments in Taiwan. Structural appreciation inevitable in the Asian currencies Whatever the debate about the fate of the dollar or the euro, what is clear to us is that the AXJ currencies are embarking on a structural, multi-year ascent. These economies have been some of the biggest beneficiaries of globalisation and, in particular, the rise of China. 3-5 years ago, there might have been some debate on whether the AXJC economies would be ‘crowded out’ by China’s low-cost base. What has happened in reality is perhaps the best-case scenario imaginable, whereby no Asian economy has been left behind as China rose. The complementary, rather than competitive, relationships between China and the AXJC economies will likely persist, as China’s domestic demand rises with its income and it becomes a major market for final goods as well as a production centre. What is perhaps more important is that virtually all central bank officials in Asia have accepted the philosophical shift on the preferred exchange rate policy. First, they now agree that the structural rise of Asia and its currencies is inevitable. Second, they no longer desire to accumulate a lot more official foreign reserves. Third, they will no longer conduct ‘level-defending’ currency interventions, though some ‘market-smoothing’ operations now and then are still possible. These observations underpin our long-held view that the AXJ currencies are in a structural ascent. Any negative shocks – such as the one we are experiencing now – should be seen as an opportunity to accumulate long positions in the AXJ currencies. In this note, I present an update of our thinking on the Greater Chinese currencies – the CNY, HKD and TWD – following my trip to Beijing, Hong Kong and Taipei last week. Risks rising for a more tempered ascent of the CNY The pace of CNY’s appreciation against the USD has clearly accelerated since November/December 2007. There have been several distinct occasions since July 2005 when Beijing decided to alter the pace of the crawl of USD/CNY. It is clear that the current phase is by far the most rapid pace of CNY appreciation since the CNY was floated in July 2005. Cumulatively, USD/CNY has declined by 13% since the float – implying that the CNY has appreciated by 15% against the USD, and it is currently on track to reach 5.9 a year from now, compared to around 6.3 implied by the NDF curve. That the pace of CNY appreciation has accelerated to help China deal with rising inflationary pressures is not news. However, there are at least two problems with this strategy that make us believe that the risk now is for USD/CNY to underperform the NDF market. 1. Beijing is assuming that the US will avoid a recession. In formulating its policies, Beijing maintains the assumption that the US will not fall into a recession. Its focus, like that of the ECB, is on inflation, and Beijing believes that China has a good chance of de-coupling from the US, particularly if the US only experiences a slowdown, and not a recession. The RMB appreciation is one part of the policy response in dealing with inflationary pressures (more on this below), even though non-food non-fuel inflation has been low and steady. Bank credit restraint (hard limits on bank lending – implemented on a bank-by-bank basis) is its number one tool, while interest rate and RR hikes are complementary tools that foreign investors tend to focus on more. However, the equity market developments in recent days may have alarmed Beijing. Our impression is that, if the volatility in global equity markets persists, and evidence of a sharper US slowdown becomes clearer, further interest rate hikes by the PBoC may be suspended and RMB appreciation tempered. 2. The RMB policy has actually helped to fuel inflation. An undervalued CNY may have been a factor behind the large trade surpluses China has enjoyed in recent years, so the argument goes. And to deal with what is fundamentally a balance of payments-fuelled inflationary problem, the CNY should be revalued or guided stronger. While this argument may be correct if we compare ‘Point A’ (where China was before the float in 2005) and ‘Point B’ (when the CNY is no longer under-valued), in terms of the levels of USD/CNY, the process of moving from Point A to Point B could be inflationary. In 2007, China’s estimated balance of payments surplus was around US$462 billion, while its trade surplus was US$264 billion. This means that net capital inflows amounted to close to US$200 billion last year. This is a massive figure. It should not be a surprise that if Beijing leads the world to believe that USD/CNY can only head in one direction and that this movement will only accelerate over time, capital will find its way into China. In turn, the irony is that the execution policies towards what is a sensible objective could themselves cause inflationary pressures. In fact, the higher the expected future appreciation of the CNY, the higher inflation in China could be. In short, while we are strong believers that the CNY should and will continue to appreciate, we are not convinced that USD/CNY will outperform the NDF path. Hong Kong’s LERS will remain rigid We believe that the peg is here to stay, with no modifications made to the band width. In contrast to the popular interpretation in the market, the monetary operations in the past several weeks have nothing to do with monetary policy and everything to do with a spike in equity market turnover and the cash-settling glitches in the HK banking system that required an injection in the supply of finance bills, which was essentially a swap of the HKMA’s liabilities. With such a rigid rule-based exchange rate regime, the HKMA will look through business cycles. Just as it tolerated and absorbed years of deflation following the Asian Crisis, it will tolerate and look through a period of inflation. As the Fed eases, the HKMA has no choice but to allow the Fed’s policy be replicated in HK. This is a regime that has worked very well for a long time, and the key is to ensure that the economic agents in HK are flexible enough to absorb the swings in inflation and interest rates. There is no consideration of any band widening by the HKMA, in our view. As a result, like the CNY, the HKD will also march higher, in real terms, not through nominal appreciation. High inflation, however undesirable, will be permitted in Hong Kong, as will negative real interest rates and the associated risks of asset bubbles. TWD to be propelled higher by positive political changes The recent political shift in Taiwan is nothing less than monumental, though this process will need to be cemented by the presidential election on March 22, 2008. We are bullish on the TWD and TWD assets on the back of the prospect of normalised relations with the Mainland, but not because we believe that Taiwan’s potential growth will accelerate. Greater economic and financial integration will offer innovative firms and individuals in Taiwan the chance to capitalise on the opportunities in China but will, at the same time, severely pressure the remaining traditional industries in Taiwan. While we are optimistic that Taiwan should ultimately prosper due to the business acumen and entrepreneurial adventurousness of its people, the initial impact of economic integration could very well not be that positive. Rather, normalisation of economic relations with the Mainland will remove a major ‘penalty’ (or price discount) that international investors have imposed on Taiwanese companies. Even if Taiwanese equities don’t become more richly valued than other markets, a mere normalisation of their valuation would translate into a substantial upwards move in prices. Taiwanese equities are the cheapest in the world’s EM space. They are under-valued and under-owned. The TWD is also well-priced for a rally, in our view. Further, the CBC will likely not stand in the way of this ascent in the TWD, in our view. Bottom line We believe the CNY, HKD and TWD are all marching higher, in real terms. USD/CNY will continue to drift lower, though there is a rising risk that Beijing will slow down the rate of crawl of USD/CNY in light of the US slowdown. The LERS in HK will not be altered, and the HKMA will accept imported inflation. The TWD will likely be strongly supported by the political shift toward economic pragmatism, and away from ideological dogmatism.
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