Four No’s

Sometimes it is easier to have a sense of what will not happen, rather than a view of what will happen. 

No Negative Rates in the US:  Nearly every Federal Reserve official has argued against the deployment of negative interest rates in the US.  It is also not completely clear that the same Congressional authorization to allow the Fed to pay interest on reserves is sufficient to take-away reserves as negative rates imply. Yet the fed funds futures strip beginning next May indicate a negative average effective funds rate.  With surveys consistently showing that primary dealers and economists accepting the official comments at face value,  it appears to be a bit of an anomaly.  The most compelling argument links the negative rates to the demand for hedges, especially by those who swapped floating for fixed rates (businesses?) and those who had that legacy exposure (banks?).  Initially, we expected it to be arbitraged away apparently the 7.0-7.5 bp in ten months is not sufficiently lucrative.

Meanwhile, the Fed has tapered its Treasury purchases to $5 bln a day down from the peak of $75 bln in an ad hoc fashion, and it will likely want to introduce more regularity. Currently, it targets quantities (of Treasury purchases), not prices (yields). Many observers expected the Fed to switch tactics and target prices (yields), such as under the rubric of yield-curve control, and conducting the necessary transactions (quantities) to achieve the target.

No Change in the Hong Kong Dollar Band: Since 2005, the Hong Kong Monetary Authority has successfully kept the Hong Kong dollar in a band against the dollar. Recently, the interest rate differential between the US and the HKMA drew savings into Hong Kong, and officials intervened to defend the band. Hong Kong now finds itself caught between Beijing’s new security law and the US judgment that the said law encroaches upon its remaining autonomy. The market has expressed the rising anxiety by a surge in forward points, which is the same demanding a higher interest rate from the HKMA to compensate for the risk that the Hong Kong dollar is not in the same trading range. Both the three-month (proxy for the near-term) and 12-month (proxy for medium-term) reached the highest level in two decades last week before easing, but remain at elevated levels. Work from the Peterson Institute found that only about half of the $6.9 bln of US imports from Hong Kong would be subject to the same tariffs the mainland (Section 301 tariffs). Some high-tech US exports might fall afoul if  HK faced the same curbs as Beijing. The HKMA is unlikely to blink and will weather this storm. Beijing will not allow the US or foreign powers to force its hand. China wants to show the new security law, and its suppression of dissent makes stable markets more likely not less. A scenario some suggest is the re-pegging of the Hong Kong dollar to the Chinese yuan. It sounds reasonable, but given that the yuan is not convertible, the risk is that it adds to uncertainty and investor anxiety.  Changing the band is possible, but to do so now, under pressure,  risks credibility and stability.

No UK-EU trade deal:  The EU argued that the year-long standstill period for the UK now that it has left is too short to negotiate a new trade deal. And that was before the virus which infected the UK prime minister and both sides negotiating teams.  Here we are in June, and little progress has been reported.  There is pressure from businesses, logistic companies, and opposition parties to extend the transition period. However, the government seems adamant that delay only adds to the uncertainty.

Moreover, the pandemic creates a new opportunity with old supply chains and markets disrupted. Prime Minister Johnson has threatened to leave the talks if there was progress by midyear. That seems unlikely, too, as trying the best will be part of the defense if the no-deal exit from the transition period is as disruptive as some projections depict. Virtual talks continue this week, and both sides will provide an update ahead of the weekend.  Some observers who expect the Bank of England to adopt negative rates link it to a disruptive end of the standstill period.  

No EMU Breakup: Market sentiment often swings to extremes. Since inception, there have been many who warned that a great experiment of our generation, monetary union without a fiscal union in Europe, would not survive. Lo and behold, it is still here two decades later, and it has integrated more members without a single exit. Speculation of “redenomination risk” was seen as earlier in the spring when the Italian 10-year premium over German rose to 280 bp. The German Constitutional Court ruling that gave it primacy over the European Court of Justice seemed to show cracks in the legal union, let alone the monetary union.  

Now, the pendulum has swung in the other direction. Many embrace the Recovery Plan being negotiated at the EU level as the long await more toward fiscal union. We are hopeful but cautious. First and most importantly, German officials do not see it as such, and that may help explain why Merkel’s adversaries within the CDU have supported her initiative. Second, it is still not clear the form it will take or when the funds will be available. In the past, such efforts have been unable to secure the required unanimous support.  Senior German officials have tried to lower expectations that an agreement will be struck at the summit toward the middle of the month.  Third, what happens in a crisis, including the jettison of Germany’s “black zero,” should not be extrapolated in a linear fashion into a non-crisis period. Fourth, contrary to conventional wisdom, Europe has bonds for which there is joint responsibility. They are issued by the European Stabilization Mechanism, once heralded as Europe’s IMF, and the European Investment Bank. We recognize that the European Recovery Fund could be the scaffolding to a greater fiscal union, legitimized by the role of the European Parliament. Future battles will determine if a building can be erected from the scaffolding.   


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