China Stimulus Package: Curb Your Enthusiasm

China officials recently announced that the government is accelerating 300 infrastructure projects valued at 7 trillion yuan ($1.1 trillion) this year. At first sight, that is considerably larger than the stimulus package of 2009-2010, which gave a significant boost to Chinese growth at the time. However, we doubt a re-play is about to occur.

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This time, China’s anticorruption pledges will have meaningful consequences for the speed at which investment can get done. The announced projects will be funded by the central and local governments, state-owned firms, loans and the private sector. At various levels of bureaucracy in China, officials are now far more worried about staying out of the crossfire of anticorruption initiatives than about boosting GDP numbers. This is a significant change since 2010: despite the larger stimulus numbers today, it will take much longer for investment spending to be delivered.

Our view continues to be that stimulus initiatives to date will not be enough to meaningfully change the outlook for China. The economy continues to grind away at or near 7%, which appears enough to keep unemployment in check. As long as this is the case, the Chinese government is unlikely to be forthcoming about “game-changing” growth-boosting policy initiatives.

FOMC: Oil Supports Fed’s Gameplan

Carnage in the oil market spells trouble for the short-end of the Treasury curve.

The FOMC Minutes from the December policy meeting reinforced the message that plunging oil prices and eroding market-based inflation expectations are not reasons to alter the Fed’s expected policy timetable. Oil’s impact on inflation should be temporary, and solid labor market momentum will justify a mid-year start to the tightening cycle. Indeed, some FOMC members suggested that the “…boost to domestic spending coming from lower energy prices could turn out to be quite large.”

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As for inflation pre-conditions, the FOMC set the bar low; the door to rate hikes is open as long as core inflation does not fall and policymakers are “reasonably confident” that it will reach the 2% target by 2016 or 2017.

One of our lingering concerns last year was that the U.S. economy might not be able to sustain above-trend growth throughout 2015. However, the oil shock changes the growth calculus. We agree with the FOMC that the stimulus from cheaper oil will provide a substantial lift to growth this year, despite the hit to the domestic energy patch. The positive supply shock comes at a time when interest rates are low, consumer deleveraging is well advanced and the labor market is humming.

The short-end of the Treasury curve is vulnerable if the FOMC is indeed on track for a mid-year rate hike. The market is discounting a path for policy tightening that is later and slower compared to the Fed’s roadmap. The FOMC attributed this divergence to a low term premium and/or a greater weight assigned to less favorable economic outcomes in the money market. It is difficult to disentangle those two explanations. Nonetheless, the implication is that short-term Treasury yields have a lot of upside potential if the Fed’s economic forecasts are realized. Market expectations for a September start to the rate cycle will likely shift closer to June in the coming months.

It is a different story at the long-end of the curve, which has been dominated by global events in recent weeks. A bottom in the 10-year yield will likely require some combination of the following:

  • a bottom in oil prices;
  • the ECB announcement of sovereign QE, followed by some positive economic surprises in Europe; and
  • policy stimulus in China that stabilizes asset prices in emerging markets.

The first two items could fall into place in the next couple of months, although long-term Treasury yields do not have much upside given the global backdrop.

2015 Commodity Market Themes

Three overarching themes will dominate industrial commodity markets in 2015, most particularly in the first half of next year: Weaker demand, resulting from tepid EM and DM growth ex-U.S.; surging supplies; and a strong dollar. Weak or lower industrial commodity prices naturally follow for next year.

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  • Oil preoccupies consumers, producers, investors and the media, as markets seek to rebalance abundant supply with slowing demand, but similar adjustments are being forced in iron ore, steel, and base metals markets, as well.
  • For oil markets, the pass-through of lower prices to consumers will be felt most in the U.S. There will be less impact on demand in high-tax provinces (e.g., eurozone), and in markets where subsidies and subsidy expenses are being reduced as prices go lower (e.g., China). Slower growth will force high-cost suppliers to dial back production, and for capex to be allocated to the most promising geology that can be developed at low cost.
  • A stronger dollar will limit demand growth ex-U.S. for commodities generally, oil and base metals in particular, as local-currency costs increase.
  • On the supply side, production costs incurred in local currencies are falling – the most visible example being Russia, where the ruble has fallen about 50% against the dollar, similar to the decline in oil prices – and may incentivize increased production in the short run as exporting states attempt to recover USD revenue via higher volumes.
  • Somewhat outside these global macro forces lie agricultural markets, which are in the process of adjusting to recent over-supply conditions – particularly in grains and sugar, which are coming off rare back-to-back ideal growing seasons. These markets offer the highest likelihood of delivering superior returns in 2015, in our view. However, this view is not without risk: Lower oil prices and weaker currencies in key exporting countries could incentivize higher production in ag markets, as well.

U.S. Dollar: The Only Game In Town

Turmoil in Russia and emerging markets is leading to a “safe haven” demand for U.S. dollars. Historically, the Japanese yen and the Swiss franc have also been safe haven currencies, but this is not the case today:

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The main support for the Japanese yen during times of risk aversion came from the behavior of domestic investors. The recycling of the current account surplus stops and foreign assets get repatriated, which work to push the yen higher. At the moment, Japan is no longer running a current account surplus and the public pension fund is aggressively buying overseas assets. Also, the BoJ has tended to respond slowly during crises. The BoJ is currently in the midst of an aggressive expansion of its balance sheet.

Switzerland has been viewed as a safe haven for hundreds of years. The country may continue to attract capital inflows, but it won’t translate into a stronger currency. The SNB remains steadfast in its commitment to prevent EUR/CHF from trading below 1.20. Indeed, the central bank introduced a negative deposit rate this week and stands ready to undertake FX intervention in potentially unlimited amounts.

Bottom Line: The U.S. dollar looks invincible. The Fed is intent on raising interest rates next year and there are no safe haven competitors. We are long the dollar against sterling, the Japanese yen and a basket of regional Asian currencies. The euro poses the greatest risk to the dollar bullish consensus. As highlighted in previous Insights, a €1 trillion expansion in the ECB’s balance sheet is already discounted and the technicals are very one-sided.

Euro: Window Of Upside?

Our FX strategists see asymmetric risks to the euro over the next 1-3 months.DIN-20141212-173326

The relationship between the euro and the ECB’s balance sheet broke down in the middle of the year. This could be a sign of currency traders front-running the ECB. The ECB has promised a lot and traders have aggressively shorted the euro. With the TLTROs and covered bond/ABS purchases having a muted effect (the take up for the ECB’s second TLTRO auction last week was underwhelming), traders are betting on an imminent sovereign QE. If the ECB fails to meet these expectations, currency speculators could begin to take profits on their short euro positions.

The sharp drop in oil prices further increases the importance of the ECB policy for the euro. The eurozone’s current account stood in a record surplus of €250 bn in the last twelve months. This has occurred even as oil imports have been steadily increasing. The eurozone’s oil import bill totaled over €300 bn over the last year. As this declines with lower oil prices, it will push the current account surplus to new record highs and exert greater upward pressure on the euro.

The way the ECB views the drop in oil prices will be vital. With headline CPI rising just 0.3% yoy, there is a reasonable chance that inflation could turn negative. If the ECB sees this as a temporary outcome and does not react with more monetary accommodation, the euro will be pulled higher by the growing current account surplus.

Our FX strategists are long the euro against a basket of the U.S. dollar and British pound.