Klaus Vedfelt
I am on vacation, and then on a business trip that will interrupt the commentary until the weekly note on April 30. The May monthly analysis will be published the following week after the FOMC meeting and April employment report. I wanted to weigh in on a few key market issues before leaving.
New Divergence
The continued robust US jobs growth (276k average in Q1 24 and 251k average in 2023) and above-trend growth allow the Federal Reserve to remain focused on inflation. And for good reason: CPI has consistently been reported this year above expectations. The headline rate stands at six-month highs. Fed Chair Powell has drawn attention to the core services excluding housing, and it rose at around an 8% annualized pace in Q1. For all practical purposes, the Eurozone and UK are nearly stagnant, and price pressures are moderating quicker than in the US. The widening two-year premiums capture this divergence. The US pays around 200 bp more than Germany to borrow for two years. Last year's peak was about 205 bp. The US pays nearly 60 bp more than the UK for two-year money. That is the most in a year. One is paid to be long dollars. The next targets may be near $1.06 for the euro and $1.2400-50 for sterling.
Japanese Yen
The threat of intervention helped cap the dollar near JPY152 last year and in recent weeks. However, the US CPI proved too much and the dam burst. Stop-loss and option-related buying lifted the dollar beyond JPY153. Resistance, or where economists might talk about supply, is difficult to assess given that these levels have not been seen in 34 years. We have talked about JPY155. The high in 1990 was slightly above JPY160. We argue that Japanese officials made a tactical mistake by not intervening in the thin markets around Easter. That could have knocked the dollar down before what had been expected to be a solid US jobs report and a sticky CPI. We also argued that the likelihood of Japanese intervention during the first state visit in nine years was slim. Intervention to knock down the dollar, which ostensibly is important in the efforts to restrain prices, would be a diplomatic insult. Japanese officials stress the pace of the move rather than a particular level. One-month implied volatility is near 9%. When the BOJ intervened in Sept-Oct 2022, it was around 14%-17%. Three-month implied volatility is also near 9%. During the last bout of intervention, it was 13%-14%. Actual or historical volatility over the past month is around 6%. It was around twice as high around the time of the 2022 intervention.
Chinese Yuan
If Chinese officials stopped managing the yuan, it would likely fall sharply. It is off almost 2% this year. Among the other major currencies, it is virtually tied with sterling as the best performer. The point is that Beijing is resisting the pressure from a strong dollar. It is not seeking export advantage through the exchange rate. Before the recent holiday, another way that the approved band can be defended was illustrated. Without resorting to overt or covert intervention, trades on the electronic platform that would imply a price outside of the band were blocked. China has the resources to mount a more serious defense of the yuan, but why should it? It is a story about a strong US dollar. The resilience of the yuan has meant that it has strengthened against many of China's trading partners. The tolerance, though, has limits. We suspect the dollar can move back into its previous range CNY7.25-CNY7.30.
Surplus Capacity
Two ways have emerged to deal with the surplus generated by modern economies. The traditional way is China's path. The surplus capital is used to expand productive capacities. The surplus capital is transformed into excess capacity, surplus production, and exports. After Europe and Japan rebuilt after WWII, a crisis emerged in part driven by the surplus savings and falling rates of profit. As capital became more abundant, it began running into the rigidities of the institutional constructs of fixed exchange rates, limited capital mobility, and (relatively) strong unions. Capital went on the offensive. Floating exchange rates were introduced. Capital was unshackled, mobility began in earnest, and financial innovation was encouraged. Unions were purposefully weakened; wages were de-indexed and decoupled from inflation and productivity.
A new strategy to absorb surplus capital emerged as a solution to the crisis of the 1960s and 1970s. It entailed an enhanced role for the US as the banker of the world. The US would absorb the world's surplus production and savings. Since the early 1980s, the US has been recording a current account deficit. That it has been buying more goods and services from the world than it sells is broadly understood. US stocks and bonds attract the world's private and public savings. They are the deepest and most liquid capital markets in the world. The latest figures show foreign investors own about 25% of US Treasuries, 15% US equities, 25% of corporate bonds, and 17% of Agency bonds. Combined, foreign investors' holdings of paper and real assets are worth about $54 trillion.
The US has created an enormous financial superstructure that can absorb the surplus capital, siphon it away from redundant investment, and surplus production. The shift from defined-benefit pensions to defined-contribution plans force-fed an equity culture. The new strategy also required the rationalization of production, which means that many industries are oligopolies and not competitive in the classic understanding. Another cost of the financial superstructure strategy is that it appears to extenuate the divergence of wealth and income.
China's adoption of the traditional strategy on a huge scale is causing trade tensions. The US innovation poses its own risks. The price of capital was to absorb the shocks so that the real economy could be more stable, but what we have experienced is serial financial crises. Surely the end of the US property bubble in 2008-2009 had a greater global impact than the collapse of China's property bubble. To be sure, the US generates a surplus, despite having a current account deficit. Consider, for example, since 2020, US corporations have bought back around $5 trillion of their own shares, something that was illegal, and regarded as unethical, until the early 1980s, to cite but one illustration. The political scientist, Frederick Thayer (Rebuilding America: A Case for Regulation and End to Hierarchy, an End to Competition) deduced excess production from the logic of market economies and competition.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
