Geopolitical risks are definitely high
Let’s look at this through the lens of three broad statements. First, in the short or medium term, politics don’t drive the economics. It’s the reverse. Second, the forgoing notwithstanding, this year began with an unusual bevy of geopolitical risks. And despite starting the year in a synchronized global economic boom, I was worried about the geopolitical risks.
Now, in January, I initially explained my worry as stemming from the incomplete and unequal nature of this upturn. But my third broad statement makes the reality clearer: Donald Trump is now taking a new and more aggressive approach to nearly everything –from trade with China, to trade with US allies, to sanctions on Iran, to the approach to North Korea. Anyone of these situations could spell instant economic turmoil.
Economics before politics
I still come out with the economics driving the politics though. And that’s true in the eurozone too, where there’s been a lot of commentary about a new Italian government forming. And so, for me, ‘policy divergence’ is the catalyst to watch.
The Federal Reserve is on its own in tightening policy sharply. At the beginning of the year, it seemed other central banks would follow suit. But, that looks somewhat less of a sure bet now. For example, look at the eurozone where Italian spreads are gapping up. That will give the European Central Bank pause in removing accommodation.
So, the Fed will continue to be on its own for now. And emerging markets will experience turmoil as a result. This is another source of risk. Let me outline how I see each of these issues in a bit greater detail — and what the economic and financial implications could be.
What policy divergence means
The US dollar is still the world’s largest reserve currency and a funding currency for many a foreign debtor nation and company. So, a market belief that the US central bank is tightening more aggressively than the rest of the world will have a huge impact.
Look at the currency effect. Here’s the US Dollar Index over the past year.
Source: Bloomberg
What you see is a rising dollar due to the recent regime change at the Fed. The dollar was falling into the new year as expectations for policy convergence increased. But when incoming Fed chair Jerome Powell signalled a more hawkish policy, the downtrend stopped.
Then the dollar began to rise as the impending convergence of central bank policy looked delayed. You can see this in the increasing spread between US 10-year rates and German 10-year rates.
Transatlantic gap continues to widen. 10y year US/German yield spread jumps to almost 2.5ppts, highest level since 1989. pic.twitter.com/QaSE5s8987
— Holger Zschaepitz (@Schuldensuehner) May 16, 2018
Policy divergence creates turmoil because the US dollar is a funding currency
I don’t know if you’ve seen this but Atlanta Fed President Raphael Bostic has just walked back some of the hawkish rhetoric from the Fed. Bloomberg quoted him yesterday as saying, “I have had extended conversations with my colleagues about a flattening yield curve” Regarding the curve going from flat to inversion, he said “We are aware of it. So, it is my job to make sure that doesn’t happen.”
Translation: Chill out. We aren’t fools. We aren’t going to tighten so much and so quickly that the US has a recession because of it.
So, the Fed is definitely watching the yield curve. And though different people have different ideas about what signal it is sending now, the Fed is on the case. They are now promising not to create the next recession by overtightening.
That’s a great signal for the US economy. But for marginal US debtors and for foreign debtors, this is pretty much irrelevant. Bostic is still talking three rate hikes for 2018 and more to come in 2019 and 2020. And, in the absence of tightening elsewhere, that means the US yields will rise and the US dollar will rise too.
Marginal debtors will feel pain. This is not an environment favorable to workouts for bankrupt retailers like Bonton and Toys R Us. And it’s bad three times over for bond deals like the Argentina century bond because of the yield, the currency and the duration.
Economics leading the politics
So, what happens economically then? The almost 30-year high in the spread between 10-year German yields and 10-year US yields says things are extreme right now. And we’ve seen some soft macro data of late, particularly in Europe. So, things could become even more extreme.
But the soft data flow could be temporary. If it is, expect the policy convergence trade to come back on. And danger would subside as a result. However, if policy convergence continues, and the Fed dials up the rate hikes, we’re going to see market turmoil spill over into economic turmoil.
Right now, I’m not worried about Italy yet. The Italian 10-year has backed up some 40 basis points in the last two weeks on the prospect of a coalition eurosceptic government forming. But Italian rates are still nearly 100 basis points below US rates. And Italy still has a backstop from Mario Draghi and the ECB.
The risks are longer-term then.
Geopolitical risks
One acute risk is in North Korea where Kin Jong-un has made it clear he doesn’t want a Libya-style denuclearization. Will the Trump Administration issue an ultimatum to Kim – and if so, does that mean military action? That’s a big risk, even in the near term, if it leads to war.
The rejection of the Obama-era Iranian nuclear deal is another big risk, particularly because Iranian sanctions disproportionately impact European companies. With the US threat of tariffs against Europe and the Trump Administration’s public admonishment regarding NATO contributions, we have the makings of a potential permanent rift between the EU and the US. But I don’t see this rift having a massive near-term economic impact.
Risks point to 2019 more than 2018
Therefore, I see a continued global expansion through 2018 as a base case here. Policy divergence will be the big driver of market vulnerabilities. The longer the US stands alone in tightening policy, the greater the stress on the financial system. And this could eventually lead to a crisis regardless of the Fed’s promises to keep the US yield curve from inverting.