Central Banks – FWIW: You Can’t Blame Them For Trying by Worth Wray, STA Wealth Management

Summary

  • It may seem like a stretch for some readers to believe central banks are quietly coordinating their policy decisions to weaken the US dollar and prevent a disorderly drop in China’s RMB.
  • That said, we could point to several examples in modern history when governments and/or central banks secretly intervened to steer foreign exchange markets and prevent larger crises.
  • In addition to the recent European Central Bank, Bank of Japan, and Federal Reserve policy moves (outlined in last week’s STA Market Report), Janet Yellen’s latest speech seems to confirm some level of coordination is happening behind the scenes.
  • While this fragile truce in the currency war cannot last forever, it may present a number of investable opportunities in beaten-up, dollar-sensitive asset classes like midstream master limited partnerships (MLPs) and politically stable emerging markets.
  • Ultimately, we believe the Shanghai Accord can either pave the way to voluntary and proactive international monetary reform toward a less US dollar-dominated system or break down into a global crisis that forces the major powers to adopt a new standard.

Central Banks – You Can’t Blame Them For Trying

It Wouldn’t Be the First Time

In last week’s STA Market Report (“Did Central Banks Just Save the World?”), I floated the possibility that the Federal Reserve (“Fed”), the European Central Bank (“ECB”), and the Bank of Japan (“BoJ”) may have intentionally coordinated their recent policy moves to contain the strong US dollar and prevent a disorderly Chinese RMB shock. While it’s still too early to say for sure, I explained how this quiet intervention – likely negotiated at last month’s gathering of G20 finance ministers and central bankers in Shanghai – might mark a major turning point for the global economy.

This week, I want to continue digging into the implications of this “Shanghai Accord” for the investment outlook. But first, a word of acknowledgement for the skeptics out there.

The idea of tacit international coordination may smack of conspiracy theory to some readers, but we have to keep current events in historical perspective. As Barry Eichengreen, Joseph Gagnon, and Fred Bergsten each outlined at the Baker Institute’s 30th anniversary reflection on the Plaza Accord, governments and central banks often work together in moments such as this to steer foreign exchange markets and prevent larger crises.

Sometimes these collaborative efforts are carried out in the light of day with an aim to shock market participants into a new psychology like the Plaza Accord in 1985 or the Louvre Accord in 1987; but at other times they are quietly coordinated in backrooms and implemented on a need-to-know basis like the Sterling-Dollar Stabilization effort of 1925 or the Fed’s extension of unlimited US dollar swap lines to the European Central Bank in 2010.

My point is that secrecy, misdirection, and policy coordination have been common practices throughout history – especially when political scrutiny threatens to derail what central bankers and/or finance ministers see as urgent policy adjustments. Its all part of the game.

So when – with the world on the verge an earthshaking crisis – the largest and most important central banks suddenly and simultaneously shift their policies in a way that inexplicably promotes global stability over and above their immediate domestic mandates, it’s not a stretch to think they may be working together. On the contrary, it seems like a bigger stretch to dismiss these moves as mere coincidence.

Unintended Consequences

If we learned anything from the Plaza Accord, it’s that foreign exchange intervention can have dramatic and unintended consequences. When the dollar fell by more than 50% against the Japanese yen and the German deutschmark from 1985 to the early 1990s, it helped to calm protectionist sentiment in the US and breathed new life into the dollar-sensitive emerging world… but at the expense of setting a series of economic and financial crises in motion for Europe and Japan.

The situation today is no different, except that there is far less room for error.

A concerted effort to weaken or at least contain the US dollar and stabilize global economic growth may put a temporary floor under commodity prices, open the door for a modest reflation in beaten-up emerging markets, and lead to a temporary reacceleration in US economic activity. But, if the dollar overshoots on the way down like it did thirty years ago, it could also resurrect a series of risks in two of the world’s most indebted economies.

In other words, an excessively weak dollar is just as destabilizing for global growth as an excessively strong dollar. And either direction likely leads to the same place – a global crisis where all of these imbalances shake out at once, albeit in a different order.

There is a reasonable range for the greenback in our highly leveraged, highly interconnected world that can revive global economic growth and inflation to some extent; but any movements above or below that range start to expose system-wide risks.

It’s a fundamentally unsustainable situation as the longer we hang in this “safe zone” the more US inflation pressures can build until the Fed has no choice but to start hiking interest rates more aggressively. But that’s a worry for another day.’

Do I have to spell it out for you?

With her speech this Tuesday to the Economic Club of New York, Janet Yellen basically just spelled out the case for the Shanghai Accord by stressing the global risks associated with “China’s exchange rate policy” and “the decline in oil prices… nearing a financial tipping point” which, in turn, threatened to “slow US economic activity.”

In true central banking fashion, Ms. Yellen did not explicitly pin these concerns to the strong US dollar. But it doesn’t take a Fed economist to see that it’s the common thread through all of these factors.

It’s as if she just laid out the rationale for intervening to manage the US dollar lower, stabilize global growth, and lift the “economic headwinds [facing US economic growth]… more quickly than anticipated.”

Here’s an excerpt from her speech:

“One concern pertains to the pace of global growth, which is importantly influenced by developments in China. There is a consensus that China’s economy will slow in the coming years as it transitions away from investment toward consumption and from exports toward domestic sources of growth. There is much uncertainty, however, about how smoothly this transition will proceed and about the policy framework in place to manage any financial disruptions that might accompany it. These uncertainties were heightened by market confusion earlier this year over China’s exchange rate policy.”

“The second concern relates to the prospects for commodity prices, particularly oil. For the United States, low oil prices on net will likely boost spending and economic activity over the next few years because we are still a major oil importer. But the apparent negative reaction of financial markets to recent declines in oil prices may in part reflect market concern that the price of oil was nearing a financial tipping point for some countries and energy firms. In the case of countries reliant on oil exports, the result might be a sharp cutback in government spending. For energy related firms, it might entail significant financial strains and increased layoffs. In the event oil prices were to fall again, either development could have adverse spillover effects to the rest of the global economy.”

“If such downside risks to the outlook were to materialize they would likely slow US economic activity at least to some extent – both directly and through financial market channels – as investors respond by demanding higher returns to hold risky assets, causing financial conditions to tighten.”

“But at the same time, we should not ignore the welcome possibility that economic conditions could turn out to be more favorable than we now expect. The improvement in the labor market in 2014 and 2015 was considerably faster than expected by either FOMC participants or private forecasters. And that experience could be repeated if, for example, the economic headwinds we face were to abate more quickly than anticipated.”

Sounds pretty clear to me. Just as the world was starting to lose faith in central banks, it appears they have found yet another temporary way to avoid a major shakeout.

Though this fragile peace between central banks does little to address the core problems facing the global economy – other than buying more time for structural reform – we believe it’s creating a number of investable opportunities for the time being in beaten-up, dollarsensitive asset classes like midstream master limited partnerships (MLPs) and politically stable emerging markets within the context of generally defensive portfolio allocations.

As international monetary expert Jim Rickards explained in a note published late last week (“The Dollar Has Been Shanghaied”), “Having multiple central banks manipulate expectations and coordinate policy behind the scenes is complex. These efforts are doomed to fail because of unintended consequences and exogenous shocks. But that won’t stop the big brains from trying.”

In the end, we believe the Shanghai Accord can either pave the way to voluntary and proactive international monetary reform toward a less US dollar-dominated system or break down into a global crisis that forces the major powers to adopt a new standard (as they did three times over the course of the Twentieth Century).

We will absolutely revisit this topic in future letters; but for now, let’s just say that the conversation is well underway (see “IMF Launches Debate on Future of International Monetary System” & “Zhou, Finance Chiefs to Discuss Crisis Planning in Paris Forum”).

Stay defensive. Stay Diversified. And be on guard for opportunities where macro, fundamental, and technical trends intersect.

-Worth Wray,
Chief Economist & Global Macro Strategist
STA Wealth Management

DOW And S&P 500 Hold Above 200-day Lines…

Given the size of the market rally since mid-February, it’s not surprising to see it spend the past week consolidating. While the market had its first down week after five up weeks, very little changed on the charts of major stock indexes. Chart 1 shows the Dow Industrials still trading well above its 200-day moving average (red arrow). That red line should provide support on any pullback from here. The 14-day RSI line (top of chart) is pulling back from overbought territory over 70. That argues for more stalling in the market uptrend. Chart 2 shows a similar picture for the S&P 500. While those large cap indexes are trying to stay above their 200-day lines, some other indexes are trying to climb above theirs.

We will need to see more to drive the markets through the resistance than just lack of bad news. We will need earnings and economic improvement.

Central Banks

Central Banks

Central Banks

NASDAQ 100 Trust Tests 200-day Line…

For a market rally to continue, it has to have most market indexes rallying with it. A number of them aren’t there yet. The chart below shows the PowerShares QQQ Trust struggling with its 200-day line. In a strong uptrend, the technology-dominated QQQ usually shows upside leadership. That hasn’t been the case. The QQQ/S&P 500 ratio (top of chart) shows the QQQ lagging behind. That needs to change if the market is going to make more upside progress. When dealing with the Nasdaq market, however, it’s necessary to see what’s holding it back. The QQQ includes the largest 100 non-financial stocks in the Nasdaq market. Not surprisingly, technology is its biggest component (56%). The next two biggest components are consumer discretionary (20%) and healthcare (12%). Let’s compare their chart patterns to see what’s holding the QQQ back.

Central Banks

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