“Books are useless! I only ever read one book, To Kill a Mockingbird, and it gave me absolutely no insight on how to kill mockingbirds.” –
This week has seen a growing focus on a not particularly new story as some commentators look for fresh ways to imagine the end of the global financial world. This time it is emerging markets foreign exchange reserves, with the tide more noticeably turning on the vast sums of dollar assets, in particular Treasuries, accumulated over the last decade. As an important net buyer of US Treasury assets becomes a net seller, will this force yields across the curve higher, choking off a US and global economy that is simply unprepared and unfit to digest higher borrowing costs? Is the depletion in massive Chinese FX reserves a symptom of a more pronounced slowdown in the Chinese economy and therefore the world economy?
Follow the money
The idea that to understand the prospects for the world economy and associated moves in capital markets, one should simply follow the money is seductively simple and surely entirely logical. The theory that the amount of money in circulation, multiplied by the number of times it is used, equals the number of transactions in the economy, multiplied by their prices (MV=PT) remains central to many economists’ understanding of the world. However, for one reason or another, it delivers few, if any, satisfactory investment conclusions. The same tends to be true of flow of funds data, be they central bank or private sector. The data are either not terribly timely (and so sometimes help explain moves in asset prices several months ago, but tell us little of what is to come) or are simply patchy and incomplete (or both).
Of course, that does not stop everyone with column inches to fill expounding varying and often dizzying arguments based on the idea that emerging markets central bank foreign exchange reserves are now likely to reverse much of the accumulation seen over the last decade. Most of these arguments rely on these movements being both predictable over the next several years and also a likely dominant factor for us to consider over that period. There is, of course, every chance that they will be neither.
Emerging markets central banks have surely provided an important source of demand for US Treasuries in particular over a period when supply increased dramatically (the supply of US Treasury debt, excluding that bought by the Federal Reserve through its QE programmes, rose threefold between the start of 2004 and the start of 2015). It stands to reason that a reversal of these flows will be a similarly important source of supply at a time when the Federal Reserve is starting to think about beginning the long road to monetary normalisation.
However, there are a wide range of variables that could affect this somewhat simplistic assessment – from the path of commodity prices over the next several years (and the related knock-on effect on commodity exporting country’s ability to accumulate further reserves), through to a guess at how tough a battle the Chinese authorities are willing to fight to contain further currency weakness if that does indeed materialise.
Our view that the world economy is not irreparably broken and is still capable of generating levels of growth and inflation consistent with much of the last few decades is the more important driver of our recommendation that clients should tread lightly within the fixed income space. In such a context, a rise in interest rates, even if some of that rise is fuelled by money changing hands from more risk averse central banks to a private sector likely more comfortable with risk, would not be a sinister phenomenon, but a healthy function of the continued rehabilitation of the world economy from the long shadow of the great financial crisis.