Since the beginning of the year, two major potential downside policy risks have receded, the risks of overtightening of financial conditions due to Fed and other central bank tightening and a further escalation of the tariffs associated with the U.S. China trade war. The combination has led to a strong asset market rally and reversal of the late 2018 sell-off. However macro conditions remain weak as the U.S. economic momentum seems to have slowed, following a slowdown of some of its key trading partners. This is in line with our expectations of a softer 2019, but not a U.S. or global recession. There are some signs of trade stabilization and Chinese local growth stabilization, but few of a meaningful re-acceleration of growth. This contrasts with some growth-influenced assets like equity which are again looking expensive in some developed economies – and may be cheap for a reason in some big emerging markets. I continue to worry the low volatility (amplified by central bank support) may be underpricing risks
Recent Russian reports provide more color on Russian official sector’s move out of the the USD in Q2 of last year. The big focus of the CBR reserves composition report (see thread here) was the move into CNY assets, making Russia is now one of the largest holders of offshore CNY reserve assets. Despite the speeding up of the reserves diversification (most of which continues to be into EUR). the USD continues to dominate in cross-border trade and financial transactions. The move, already visible in the US data last summer, raised questions about the impact on broader USD assets at a time of fiscal and monetary pressure on USTs. The risks of Russia purchases look overstated, given the relatively small size of its holdings, continued purchases by other countries (including other oil producers) and ability of the Federal Reserve to provide liquidity if needed. Bigger long-term concerns around USTs should focus around the fiscal position, which is going to increase the amount of issuance in coming years – likely increasing the US cost of financings. Local and foreign investors are likely to bear this cost unless there are any signs the U.S. willingness to pay is shifting.
Russia’s move to sell USD was political, following the April 2018 sanctions on Russia and the local press estimated realized losses of $1.5b – admittedly small compared to Russia’s stock of assets and not necessarily something of concern to the government.
The move sped up the shift away from the USD in Russia’s FX holdings. The increase brings CNY holdings up to $62 billion of Russia’s $430b+ portfolio, meaning Russia now accounts for about 1/3 of the $192 billion in global reported CNY reserve holdings (IMF COFER) and just about all of the $40 billion increase in global reserve holdings of CNY in Q2. This is but one of the increasing links between Russia and China, which I’ve previously cited as a source of resilience for Russia. Of course, CNY-denominated bonds are not very liquid, and bilateral trade in CNY is still quite low between the countries suggesting limited benefit for reserve assets, particularly given the likely interest rate moves.
What does this mean for broader USD holdings?
Figure 1: Holdings of Long-Term US Treasurys (USD million)
Compared to turnover of the USTs even the 100b is not something that big… but would be more important if other countries followed suit.
That doesn’t seem to be happening. Chinese holdings are pretty stable with ups and downs due to currency management and GCC countries (KSA but also Kuwait and Qatar) seem to have been parking funds in USTs at the end of last year- at least for now. The increase in Saudi holdings of USTs (net $40 billion) in Q3 partly offsets the sharp decline in Russian holdings, likely reflecting the increase in energy revenues. The increase in KSA holdings far outpaces its reserves growth suggesting that the Saudis may have been parking the funds in UST after raising the funds in some of the bond issuance.
The increase in cash flow from Saudi Arabia energy sales inQ2 and Q3 last year (and maybe the bond issuance) seems to have gone into USTs and may have helped them finance the outflows that resulted when locals and foreigners continued to flee after the Kashoggi murder. Given the fiscal dynamics there and fall in oil prices this increase was likely temporary. Still, there is reason to expect that any shortage of buyers and associated interest in rates, would likely bring in more pensions, insurers and others looking to match their asset and liability portfolios.
Of foreign holders, China remains key – and the PBoC seems unlikely to cut holdings for political reasons. As I’ve written in the past, Chinese Treasury holdings reflect domestic economic choices rather than geo-political ones suggesting that local capital outflows and FX management will drive its foreign portfolio. Attempts to reduce treasury holdings would put appreciation pressure on the renminbi, undermine global and Chinese financial stability and likely reduce the value of their existing holdings.
That’s not to say that de-dollarization is not something to watch, but it looks to be a slow moving machine. Other critical policies to watch remain efforts by the European authorities to skirt U.S. sanctions, which are so far having only limited rhetorical impact. More important is the fiscal outlook of the U.S. which will likely put pressure on a range of assets.
As 2018 winds to an end, and 2019 lookaheads are completed, its time to share a few books that stuck with me this year from the 50 non-fiction books I read or listened to this year. Given my IPE teaching this fall, and ongoing macro risk work for clients, my non-fiction reading was dominated by corruption, country risk cases as well as a lot on AI, future of work and big data. Surprisingly, I read a lot of fiscal policy, perhaps fitting in the year when the biggest expansionary policy in peacetime came into effect and in which the costs of unwinding the big monetary stimulus experiment began.
What were your favorites, what did I miss and what’s on your reading list?
2019 set to be a tougher year…
Growth momentum has weakened in the second half of 2018, particularly in European and Asian exporters, who are responding to the end of above potential growth of the last few years, which has moderated final demand growth. Tariffs, restrictions and tighter financing costs have reinforced this trend, making final harder to forecast and encouraging caution on new investment decisions, Meanwhile Fed tightening, exit from quantitative tightening and boost in available US Treasurys, have begun to increase debt service costs across a range of sectors and geographies.
Slowing final demand growth globally is not a surprise, and has been a part of our themes for the last year, but the trade disputes and restrictions have reinforced some caution from buyers and supply chains. The drivers of this slowing of growth include a) the disconnect between policy stance in the U.S,. and other major economies across fiscal and monetary policy b) the lack of structural measures to boost final demand growth, c) removal of the “sugar rush” of monetary policy support as quantitative tightening takes hold. The U.S. and Chinese central banks have been particularly focused on continuing with business as usual, with overall policy stances only partly supportive. In both cases, a relative disconnect between fiscal and monetary policy complicates the messaging, and exacerbates some of the FX pressure.
I’m off to the annual meetings of the World Bank and IMF this week, a good chance to take the pulse on global market consensus and the worries of policy makers. Global trade risks and their impact on an already decelerating global economy are likely to top the worry list – with the impact of tariffs, policy uncertainty on value chains in focus along with questions of policy and macro divergence, all of which have left many less optimistic than in the spring. Given the recent escalation of U.S. – China trade tensions, and signs of slackening in global export growth, the focus is likely to be on the downside risks to global growth, the divergence between U.S. economic activity and that of most of rest of the world.
To read the whole post with graphics, please download here. Last week many Emerging market assets came under pressure following the rise in the US 10 year yield. The sell-off was concentrated in Turkish and Argentine markets, whose FX and thus other assets fell sharply, and in USD sovereign debt more generally, but some other assets came under pressure, admittedly falling just outside recent trading ranges. The sell-off prompted a lot of questions about whether this is a broad-based crisis. I don't think it is? Rather it should be a reminder to look closely at national balance sheets, the quality of growth, fiscal space and resilience.
I’ll try to answer (briefly!) a few key questions in this post: What happened? How have affected central banks responded? How strong are EM fundamentals? Is this another EM-financial crisis (hint: probably not), What would it take for a broader sell-off? what might be the vectors of contagion if it escalated? should we be worried about pegs?
As one would expect given the portfolio effects, which are higher for hard currency debt and equity than local, some other liquid EM saw outflows including Mexico (NAFTA risk), Brazil (election), India and Indonesia (oil and some modest financial contagion) but these seemed modest and are likely to remain so unless there is a meaningful macro risks emanating from China or the U.S. These risks are likely to stay isolated, but add to some growth challenges across relevant regions. Other stronger assets caught in the cross-fire (and even some of the affected assets) may present buying opportunities.
This is unlikely to be the last such bout as investors test the resolve of the Fed to continue normalizing, the significant wave of US bond issuance is absorbed and growth rates stagnate or weaken due to the waning of stimulus and trade policy risks. Higher and rising oil prices – driven by the uncertainties about the Iran deal, continued implosion in Venezuela and profit seeking in Saudi Arabia, only complicate the outlook, causing concerns for oil importing regions and countries, and their consumption and external balance.
Rachel's musings on macroeconomic issues, policy and more.