Macro | How Sustainable is the US Dollar Rally

The dollar rally that started since the conclusion of US presidential election shows not much signs of abatement. 2014 was the year of crude oil, when the fantastic sell-off in crude set much of the moods prevailing in the world economy - from equities to rates. In 2015, this slowly turned over to dollar, partly through the surprise CNY depreciation, and later through Fed rate hike expectation. And without any doubt, despite all the noises around the Brexit and Italian referendum votes (early Dec), the dominating factor for risks is again US dollars. The figure below shows a quantitative look at the cross market risk drivers using Minimum Spanning Tree methodology (based on correlation). It shows clearly the dollar is in the center of the cross market driving force. A very similar situation to what we had back in 2013, but more concentrated role for the dollars to set the market sentiments. We already had a not-so-quite riot in rates following the dollar strength post election. The emerging market currencies and equities have taken significant beatings. And top houses are calling for this dollar strength to be one of the top trades in 2017. Naturally it begs the question how much leg is still left in this dollar rally.

To take a long-term look, the dollar rally is by no means extreme. In nominal terms the broad-based trade weighted dollar index is near its historical highs. However, when we compensate for the inflation differentials between the US and its trade partners, the rally is well within the historical range (still 13% off from the 2002 peak) - as the chart below shows. Note the rally in dollar since 2014 has been almost equal for the real and nominal exchange rate - 17% vs 20%.

But while this rally may not be extreme, it may not be sustainable either. A large part of the recent dollar strength has been on the back of expectation of US policy change, specifically a possible fiscal stimulus. The economic argument behind is that a fiscal stimulus, coupled with a budget deficit will increase interest rates and hence the exchange rate. In fact this is what was observed during early 1980s in the US (although it has not much support from observations in other non-US advanced economies). The actual mechanism is far from clear. There are extensive studies on budget deficit reduction and its impact on exchange rates, but reverse studies are rare. Theoretically, the direct impact (of increasing budget deficit) goes through the interest rate and asset return channel above and lead to a higher exchange rate (as demand for higher interest assets goes up among foreigners). On the other hand, increased budget deficit can increase the long term inflation expectation and hence expectation of future dollar depreciation. The second part of the policy is trade - which is basically a tightening pressure on the US current account deficit - if President-elect Trump follows though his promises. Typically for the US the current account in recent history has been driven to a large extent by demand for financials assets from overseas investors. This means a tightening of current account will have to be matched by reduced demand for US financial assets by foreign investors, resulting in a currency depreciation now (and possibly an appreciation later). In fact the post-crisis dollar weakness has resulted in a significant tightening of current account for the US already. A further sustained tightening in general may not be great for either the US or global economy. The other possible factors, i.e. the overall demand (or GDP differential) or real rate differential with major trading partners are relatively straightforward, an increase in both leading to a stronger dollar.

Looking in to the above set of arguments empirically, we run a quick vector auto-regression estimates with real dollar exchange rate, real rate differential, current account (% GDP), budget balance (% GDP) and GDP differential as endogenous variables (differential with GDP-weighted Euro area and Japan data representing rest of the world). The results are as shown in terms of impulse response - i.e. response of dollar real exchange rate for unit positive move in budget balance (FD), current account balance (ca), real rates differential (rates) and GDP differential (GDP). It seems at least for our data (spanning 1995 to 2014, quarterly), Trumps policy of budget deficit (negative fd) and tightening current account (positive ca) has off-setting impact for dollar real exchange rate. In fact there are good chances the current account tightening impact (negative for dollar in near term, positive long term) can overwhelm. An increase interest rates may make US assets attractive among foreign investors, but without matching trades the flows in to those assets will be difficult to sustain. Among other drivers, while inflation in US has been steady, including wage growth, we have seen some early signs of a come back of inflation in the Euro area. The main thing to look out there is the pick up in Euro area credit growth after a stall start of this year.

Given this ambiguous impact of policy, and hopefully a declining need for policy divergence and a head-room for trade-weighted dollars of only ~13% to reach all time high in real terms, it does not look like the dollar rally has much room left. one of the surprise trigger can come from ECB and/or BoJ in December, with QE in Europe still priced in. And the Dec Fed hike - which is almost a certainty now - will act to defuse this rally. 

Interestingly, while from the emerging market point of view, the recent dollar rally was kind of risk-off, it was hardly so for Euro. Euro - which has lately became a funding currency like the Yen, sold off steeply. Arguably there was not much positioning to blame either, so this makes it a very interesting move. The Euro area as a whole has accumulated a huge current account surplus in its glut for savings in the post-crisis period. A substantial change in trade relationship with the US may start to unravel that. If you are positioning for the consensus Euro dollar parity, think again. 2017 may see a major reversal in Euro instead dollar.

Note: all data from the St Louis Fed FRED database.

Trade Ideas: Macro Trades - The Fall-Winter Collection

The speech from Fed Chair in the Jackson hole was quite uneventful. The far more interesting was this one. It was a while back the ever useful Michael Pettis hinted at how rate cuts can be deflationary - exactly the opposite of mainstream central bank thought process. This represents another argument, and how crucial fiscal participation is in delivering monetary objectives.

Talking of central banks, this month is another one for central bank focus. Starting with ECB next week, followed by BoE around middle of the month, and ending with Fed and BoJ towards the end, the mood of the market is expected to swing based on these policy outcomes. The general expectation is a hawkish Fed while the rest continues the dovish stance. Here are the top 5 trade to consider for the moment.

#1: Pay USD 10y swap spread: USD swap spread was hammered just after the last FOMC hike in December, but now on a slow yet firm upward trend. Theoretically, swap spread should be determined by the expected futures spread on GC rate vs libors. While empirically this had little influence for US treasury swap spreads in the past, still this is an important metrics. And if you have not been gone for long for the summers, it is hard to miss the sharp widening of the spot spread of GC vs libor - mainly influenced by the sharp increase in libor rate. There is a good reason for this, as the market regulations kicking in forced quite a few prime money market funds from bank-issued commercial papers to US treasuries, pushing up the borrowing cost for the banks. It appears so far this yet has to be passed through the swap spread prices in any form or substance. On top, a pay position in swap spread (pay swap, receive treasury) has been highly directional with general rates levels historically. Given this correlation and the current levels (near the bottom of the trend channel), this represents an efficient position for any FOMC hawkishness, especially unexpected ones. This also benefits from a positive roll-down. In addition, this position is empirically should be somewhat long volatility - quite an asymmetric position at current levels.

#2: Pay GBP 10s30s steepener: Following Brexit, the long end sterling curve steepened sharply, followed by an equally sharp flattening after the early August BoE. This is presumably a reaction from the QE announcement, but it is not entirely intuitive. While we had similar sharp flattening move in Euro after ECB QE in early 2015, the large difference in size between this two perhaps points towards a bit over-reaction (ECB's initial €60b per month, later €80b, compared to BoE's £10b per month, i.e. £60b over 6 months). Not only in terms of absolute size, the ECB QE is also larger in comparison with the supply - for example at the ECB capital key, Germany amounts to approx €20b per month currently, compared to a gross supply of around €16b per month (as per Bundesbank projection figures for this years). For the UK, this compares to £10b per monthly to £11b of monthly supply (as per UK DMO projections). This does not correct for the German securities trading at an yield lower than ECB depo rate (and hence not eligible for QE), and also the fact that ECB QE will extend beyond the BoE one, hence the actual difference in supply pressure is much more acute. The second interesting point to note is the maturity distribution (see chart below). UK has a squeeze in the middle segment (belly, i.e. 7 year to 15 year remaining maturities) of the curve, whereas the squeeze for ECB is mostly in the long end, putting a relative rally pressure in the belly UK Gilts curve. Add to this the facts that the market price of expected inflation spread between UK and Euro area (breakeven inflation swap) has actually widened following Brexit. This is presumably influenced by the sharp decline in GBP vs USD, but this inflation premium somehow has to be priced in the nominal rates which in general should exert a steepening pressure. This combination makes a steepening position for GBP 10s30s attractive. One of the possible reason for such a sharp flattening can be the expressed intention of the BoE governor to steer clear of negative rates and that remains a risk (somewhat mitigated by a still 25bps to go). Other risk is a sudden strong recovery in UK economy, which will weaken the case for steepening.

#3:  Equity bearish protection: For all those bears out there, shorting the all time highs have been as appealing as it has been money loosing since June. The equity markets around the world has been quite oblivious to shocks. FTSE 100 had one of the best runs in Europe. European equities have been less spectacular, but nonetheless not in correction territory. Nikkei 225 handled strengthening yen better than expected. Even EM had a decent run. The key has been the amazing resilience of S&P 500 - and appears everything is now pending on a breakdown in the US equity market. As a result, S&P is now trading at tad lower from all time high, and tad higher than all time low realized volatility. On top, last print from CFTC traders positioning shows the highest ever short positioning in VIX. But there are potential issues on the horizon to be cautious, FOMC in September is the obvious one, South African political situation may be a trigger, or sometimes things just happen. Fortunately, we also have the S&P calendar vol spreads around the highs. This present a good cautious positioning of buying the near term puts vs long term (e.g. 3m/6m) - relatively less damning long gamma position. A large downside move in the US equity market will almost certainly have repercussion across the globe, and if triggered by FOMC, especially across the emerging markets.

#4: Pay Cross-currency basis widener in EUR: One for the long-ish term - this is a reversal of Euro savings glut trade. Since the start of the financial crisis, the cross currency basis widened as everyone panicked after dollar funding. Subsequently during the period of European sovereign crisis, this basis remained under stress, and only started normalizing after the whatever it takes promise from ECB's Draghi. However, after peaking at around mid 2014, this basis (not only in Euro, but across major currencies like GBP and JPY), started widening again. My theory is: this time it has less to do with financial market panic and shortage of dollar funding from the liability side, and more with the savings glut on the asset side. In such a scenario, asset managers willing to invest in higher yielding assets (like US treasuries or equities) will swap their euro funding with a euro vs dollar cross currency swap (effectively a dollar loan against euro) and paying dollar interest vs receiving euro interest. As more and more money chase this trade, there will be a receiving pressure on the euro leg, pushing the basis down. The fact that this is asset driven and not liability driven is corroborated by a flattish slope in the basis for different maturities. During the panic days, it was a strictly inverted slope (e.g. 1y tenor wider than 5y), which is now reversed or almost flat. Given this, any recovery in the euro area (and indeed globally) consumer and investment spending will set the direction in a reverse trend. Currently the levels are near short term support. Also given the slope as mentioned above, this benefits from a positive roll-down. This is a relatively low risk and low cost of carry trade for global economic recovery. The alternative is of course that long-dated forward trade in euro. But I like this one better at the moment: the long dated forward can remain stuck even after normalization (i.e. end of savings glut), but the basis will surely feel the pressure. Plus the once juicy carry in those long-dated forwards are mostly gone. Reportedly, there is currently a dollar funding shortage, on account of the money market regulation change mentioned above. But also reportedly a large part of the switch from CP to treasury is done.

#5: The ECB Trade: ECB is not BoJ and Euro area is not yet Japan. The question is if you see them converging or diverging. The chart below shows market reactions in rates and FX for recent major central bank decisions in Euro area and Japan. Note how in recent time, ECB meetings followed a rally in Euro and a flattening in the curve. Also note how the similar the reaction was in BoJ. And finally, how the last one from BoJ in July end, which underwhelmed the market, reversed the flattening trend, with less pronounced effect and in fact a net steepening. The story of QE is perhaps running out of steam.

I expect similar reaction for ECB even if they announce a QE extension beyond September 2017. The standard trade will be fading the move, which is as of today expected to be a steepener. However, a rally in Euro may be more difficult in the short term as the focus shifts immediately to Fed.

---

All data from respective treasury offices, and Bloomberg.

Macro: The End of QE-topia

Negative rate is much more than what it says on the label. One of the cornerstones of modern finance is what is called present value (PV). PV is used to evaluate real projects, value financial investments or price derivatives, you name it. Surprisingly, based on my personal experience, it appears many practitioners and investors are unaware of the fundamental assumption on which this all encompassing concept of PV is delicately balanced - an assumption of a properly functional lending and borrowing market. Without that, there is no mean to transfer values across time back and forth, and PV loses its real meaning. Negative rates makes one question the validity of this assumption.

Central banks, it appears, are having a hard time. Last week's BoJ's underwhelming policy outcome was scorned off by the markets with an emphatic rally in Yen and sell-off in JGBs. This week BoE is widely expected to kick-in with some Brexit easing, and the markets so far has greeted the possibility with a renewed sell-off in FTSE 100. ECB is also expected to up the ante with another QE extension sometime later this year, and the European equities do not seem overjoyed about it. To contrast, S&P 500 seems pretty much nonchalant about a plausible Fed hike. The usual QE-led risk rally, it appears, are drawing to an end. In fact a few are already calling out for a regime change - from QE to deflation dominance (or lack of demand).

In the wake of the Great Financial Crisis, most central bank carried out a massive amount of monetary stimulus. One way to track the global monetary stimulus beyond policy rates is to track the combined balance sheet of major central banks¹, as we see below.

Few would argue against the unprecedented monetary stimulus led mostly by the Fed which served a crucial purpose during and after the crisis to restore confidence, liquidity and growth conditions. However, the effectiveness of QEs from other central banks have arguably been much weaker. ECB QE is so far hardly "successful".

Also, over time, the impact to real economy has grown visibly less dramatic. Below chart (left one) shows the growth in global major central bank balance sheet  vis-à-vis growth in M2 money supply as well as bank lending across major economies². Since the abatement of the European Sovereign Crisis in Q3 2012, all the measures have started moving in lock-step. What is more, the magnitude of global M2 growth has been lower than central bank balance sheet growth, meaning less bang for the QE bucks. The bank lending growth has been even lower than that. It is hardly a surprise we started to have quite a bit of noise around the effectiveness of QE and monetary stimulus around that time and since.

It is not hard to see why. As the right hand chart³ shows, irrespective of what the central banks have been doing, the global private sector still continues with deleveraging (with some exception, like US corporates). The excess savings - especially for Euro area (and a large contraction in dis-savings in the US as well) clearly underscores the problem. This arguably is an expected outcome of a balance sheet recession - wherein the private sector, afflicted with too much debt and in a process to repair their balance sheet, will try to increase savings and desist from borrowing no matter how low the lending rates are pushed down by QE. This is less a question about pricing and more about the capacity and willingness to borrow. On top, the increased regulatory burdens and negative interest rates certainly did not help the banking sector much to upsize their loan books. The combined effect - anemic global demand and as a result, stunted global investments (not helped by pre-crisis built-up over-capacity in certain sectors) - was given a new moniker, secular stagnation.

Economies can be stimulated using many forms and jargon. But in any case, to boost demand it must work to enable the demand side to afford it. And this increase demand must be paid for by either increased debt (i.e. borrowing) or equity (like increased transfer or wage). Monetary policy, in practice, mostly tend to fund this increased demand through debt in its standard transmission channel through banks. In a scenario where many are focused on reducing leverage, it is no surprise that this will have a less-than-expected impact. Monetary policy can enhanced equity based spending as well, like through wealth effect or inducing an increase in wage through increased inflation expectation. While this has worked in the US, for the rest of the world, especially in Euro Area and in Japan, this has hardly been the case. The dis-inflation remains very much alive.

There are some recent trends, however, that is slowly becoming a theme - and it involves the other side of the stimulus coin. 2015 has been the first year after the extra-ordinary time during the crisis, that major global economies have experienced a reversal of a combined fiscal tightening (see below⁴ on the left). We are past the fiascoes like sales tax hike in Japan and the excessive focus on balanced budget in Europe. And a few countries like Canada and Japan have already stated fiscal stimulus as their explicit policy tools. US may see similar moves after the election. Of course the downside of the government playing the role of "consumer of the last resort" is that this comes at a cost of debt concentration at government sector. 

We are on a cusp right now. Global consumption, despite all the allegation, has shown considerable resilience (although much away from their pre-crisis period, see chart⁵ above on the right). What we want now, more than ever, is avoiding any policy mistake. Given the fragile nature and very low margin of error on the policy side, it will be hard to recover from one. We are past the days of equity rallies with every new round of monetary easing. Markets will focus more and more on the underlying growth. This growth will of course have some costs - the key policy issue will be how to allocate that in a balanced manner between the fiscal and monetary side of this. One-sided efforts from central banks - increasingly larger asset purchase from a rather finite pool in a world characterized by negative interest rates and safe asset shortage - is perhaps past its used-by date.

---

1. source: national central banks
2. source: national central banks, IMF, Bloomberg
3. source: national statistics offices, IMF
4. source: national statistics offices, national central banks
5. source: national statistics offices, Bloomberg

Trade Idea: Top Thematic Trades For June

Trade #1: Positioning for Fed: Pay 2s5s in swaps (pay 5y point).

Rationale: After the latest minutes release from FOMC last week, we have seen a huge positioning for a rate normalization (we discussed this before). But in some sense, normalization in dollar rates already started a while back. Although the policy rate is still stuck at very low level, the shadow rate (Wu Xia shadow rate), a representation of effective policy rate has tightened a lot since late 2014. Also in nominal space, although the rates levels are historically low, we have seen considerable normalization in slopes and curvature.

As the charts show (the left: range since 2000; right chart: range of average rates through different rates cycle - hike, cut and neutral, red triangles mark the current values; data from FRED and Bloomberg), in most measures of higher orders, the current yield curve is not far from normal. There is little scope for a further significant flattening of the curve to price in further rate hikes expectation. Add to this, there has been a large increase in short euro dollar positioning lately for FOMC. Given this, the best way forward is not to position for the next hike, but rather the ones that may follow. The next round of normalization (if at all) will be in rates levels and especially in long term equilibrium rates (terminal rate). The ideal way to position for this to take advantage of the historically tight 2s5s. The spread difference prices roughly only one rate hike between 2 year and 5 year. This levels are usually seen around recession time - or a scenario of "few and done" as some may argue. If you do not believe we have a recession around the corner, this is arguably mis-priced. On top this can benefit asymmetrically for a much more dovish Fed than expected, as the front end positioning unwinds.

Trade #2: ECB on Thursday : Long Euro vs GBP in FX

Rationale: The latest balance of payments data (released end of May for March 2016) from ECB points to continued net outflow from Euro area fixed income markets (chart below; data from ECB database). This flow is massive. The Euro area has seen a net outflow of almost €580B since 2015 in debt instruments. This is roughly at $40B per month, a pace higher than the FX reserve depletion of PBoC of China. This, from pure flow point of view, puts upward pressure on long end yields. However, the QE from ECB has been more than effective to counter that. But on one hand, as this exports the downward pressure on yields to international bond market (similar to Japan), it also makes the long end yields vulnerable to technical sell-off from time to time. However, with FOMC around the corner and the negatively carry, it may not be the perfect timing now to position for such a move.

On Thursday, ECB is little expected to surprise the market. Euro area inflation print continues to print in the negative territory. However, given the recent recovery in commodities, with all probabilities the ECB economic forecasts on Thursday will not paint a dire picture requiring immediate further policy measure. This should put technical pressure on Euro for a tactical leg upwards. This is best expressed against GBP whose recent strength and technicals make it poised for a corrective move. Alternative positioning is on the long end of the Euro rates as discussed above.

Trade #3: Brexit hedge: Buy EUR/USD calendar vol spread in straddle

Rationale: The basic idea for this hedge is to avoid directionality and buy gamma instead. Since the cross-asset vol spiked early this year, we have witnessed most vols across asset classes getting cheaper (the chart shows 3m rolling average of number of 2σ moves in each asset class for one-to-one comparison; data from Bloomberg). Also, rates and equities vols are much cheaper than FX and commodities in general. Still it makes sense to express this hedge in FX. The relative performance of FTSE (compared to DAX, Euro Stoxx or even S&P) has been quite impervious to Brexit hopes and fears, and there are few reasons to assume we will see an effective hedge in the equity space.

However, in FX space, there appears to be a mis-pricing: Given a Brexit outcome, it is hard to believe we see a large move in the cable, without any commensurate move in EUR/USD. And EUR/USD vol, especially the calendar spread at flat log-normal vol points, is a much cheaper option to position for a hedge.

Trade #4: Brexit upside: USD 5s10s steepener vs GBP 

Rationale: The spread between USD and GBP swap curve slopes, e.g. 5s10s, is at historical low. 5s10s in dollar rates flattened a lot since last year pricing in an expectation of rates normalization (as discussed above). But what is still quite a bit away from "normal" (apart from the rates levels of course) is the level of curve risk premia - for example the ACM term premium - at historical low. Yield curve slope (adjusted for the level of rates) captures a large component of this term premeia. And it appears even conditional on the much lower term premium, we have some parts of the yield curve relatively flatter, like 5s10s vs 10s30s in dollar rates.

On the sterling rates side, however, all these actions have been missing - partly because of softer economic data, and partly because of the risk of a Brexit. This has led to a historical level of the 5s10s spread in dollar vs sterling rates. The USD leg has little further room to flatten, while a remain outcome in Brexit may lead to some bear flattening of the sterling rates. This can further be supported by better than recent prints for UK economic data once the Brexit is over.

This is also an asymmetric positioning. Even if we have a Brexit outcome, there is a good chance of dollar spread sharply steepening in a risk-off mood, and sterling undergoes a panic bull flattening. The structure above will be benefit from that. 

The ideal structure is at least the GBP leg through swaptions, i.e. conditional bear flattener (sell the payer on 10s). Even though it is themed around Brexit, longer expiry is preferred. to take advantage of bull flattening in adverse outcome and better economic data in favorable outcome as discussed above.

Inflation: Think Global (In Chart)

A few observation on inflation from a global perspective

#1: Global inflation has been weak, but core has been steady. Here the global data points (like headline or core inflation) are calculated using the GDP weighted national measures of the top 20 countries in terms of GDP in current dollars (representing 79.9% of world GDP. Pareto!!).

The difference between the core measure and the headline is even more important as the wedge between them is currently driven mostly by a single factor - energy prices. The concept of inflation is an overall price rise. A change in a particular component is mostly a relative price change, not an overall price change. Central banks have little controls over production of individual goods and services. If there is a large relative price rise for doughnuts for some reason, a hike in policy rates most probably is not going to help it (unless this relative price rise permeates through the economy and finally in wage expectation through second round effect).

#2: The smack-down of inflation in commodity exporting countries is most prominent for the ones with fixed exchange rate regimes. With a few exceptions, most of the metal and energy exporters are not suffering any great dis-inflationary pressure in core measures otherwise.

#3: In terms of professional forecasts, inflation expectation remains steady, but the market based measures for the US are not so. 

#4: The consumer demand is weak. Especially if we measure in dollar terms. We have a scenario of low rates, a strong dollar, very weak commodity prices and weak global demand. Commodity prices respond a lot to investments expenditure globally. However, the consumption expenditure has been a relatively stable component of economies across countries and time historically. Since mid of last year the consumption expenditure globally in dollar term has been in a strong contraction phase, approx 6% from peak till Q2 2015. This is only matched by an approx 8% drop during the GFC. And this is not driven by US or China much, rather rest of the world, including Euro area and Japan. It is hard to say if this has bottomed out and we will see the savings from drop in energy prices being channelized to recover consumer demand. 

Nonetheless, the possibility of a wage driven inflationary pressure cannot be dismissed. The chart on the left shows scatter plot of job opening rate (JOLT), Employment Cost Index and PCE core inflation against headline unemployment rate on x-axis, since 1980. The starting points are marked in red and end points in green. As we see in case of job opening, there has been some significant hysterisis (unemployment rate higher, given the job opening, if we measure the slope from the earlier part of the curve). This may points to a case of structural problem in unemployment. That will put forth a case against a downward revision of Fed's unemployment target (NAIRU). On the other hand the wage inflation (here ECI) and broader inflation (PCE) still shows inverse relationship. The Phillips curve is still alive (esp. for wage inflation), although flatter in recent times. Given the fact that Fed action has always a lag before it affects the real economy, this will keep the case for a early hike on the table.

#5: And related to above point of global consumption, the global imbalance in excess savings seem to be heading towards a forced reduction. The left chart shows excess savings (or equivalently current account balance) in nominal dollar terms. As we can see the large CA deficit of US has historically been balanced by large surplus of Japan and lately China. The EM had a spike just after the late 90s Asian Crisis. But that is mostly negated now. The recent cause of concern (Euro Glut) was a large and ballooning surplus of Euro Area. With the fall in oil prices, the Petrodollar balance is now going the other way to counter it. These low commodity prices may play a crucial role in re-balancing the flow of trades and capital across the globe. ( it is evident from the chart that trade volume has come down significantly.) It is not clear to what extent this balancing act will help consumption and through what channel, but it is definitely better than exploding imbalances in the medium to long term.

Also since the financial crisis, after the very initial period, it has been mostly a battle fought by central bankers, with fiscal stimulus sitting mostly on the sideline. In fact the withdrawal of high fiscal stimulus just after the collapse might as well have countered central bank efforts. We are politically getting in a better position to consider and use fiscal stimulus than the height of European Crisis and talks of austerity. The global budget balance is in fact back to the pre-crisis average level. And if the economy is not, there is a good reason and scope for fiscal stimulus in coming years.

The key takeaways: Despite the weak global demands and large savings imbalance (which are related), there is a case that the commodity prices has done some corrections, and a persistent weak demand/ high global excess savings may not be realized. And we still have the upside of fiscal stimulus in case consumer demand needed a booster does. At a global level, most measures of core inflation, and non-market based inflation expectation remains robust. However, the market seems to be pricing a very pessimistic outlook for inflation globally. And also as mentioned earlier the inflation skew pricings are improving on the upside surprise.

Is this a case of peak (dis-)inflation worries and significant consolidation and upside from here. Hard to be sure, but I would say chances are good than they were before. Of course inflation can go either way from here, but in most scenarios they have a better chance of ending up higher than current levels. And a reasonable dollar weakness from here can tilt the balance in its favor further.

Trades

1) In case Fed is on time (which we will only know with the benefit of hind sight): long inflation upside and nominal rates sell-off with short dollar for cheapening.

2) In case Fed is delayed: long vol - a sharper rate of hike will catch many unsuspecting asset classes on the wrong foot.

Euro Glut: A Global Look

If you have not already read the latest note from Michael Pettis, then please do.

And also do read the note from George Saravelos on what he terms as "Euro Glut".

These are not particularly fresh new ideas, but definitely worth mulling over and have got much less attention in the media, as well as in the blogospehere, than the "new normal" and "secular stagnation" theories. In fact the original piece from George Saravelos also has a scary graph of the current account of Euro area, China and the US.

However, this graph becomes less scary in a slightly expanded perspective. Below is what I gleaned from IMF database (via Bloomberg) on excess domestic savings vs investment (equivalent to the graph mentioned above).

When you take a closer look, the "Euro glut" post 2010 is worryingly out of line. But if your focus is global, then perhaps you should also not miss the sharp drop for China post 2008 and Japan two years later. The gap between required investment and savings for emerging markets have grown stronger and the rest of the Anglo-Saxon world (the UK and the dollar-bloc) still provides a good demand for exported savings. Although it is not clear how much of it is sustainable in a world where Europe continues to build up and export excess savings. And China heads for a soft landing.

What is truly remarkable is the correction in the US, which is equivalent in magnitude in Europe. Nobody seems much concerned about it as correcting a negative current account balance is supposedly good for the economy. The question is if the US stops buying, then who else?

As pointed out in Mr. Pettis' note, there should be plenty of opportunities to invest surplus savings. The trouble will be if the excess savings export remains focused on the return of capital, than return on capital. And of course positive return investment globally can perhaps more than match exported savings from Europe in magnitude, but not necessarily in speed.

In the short run, it is speculative to worry about this. For one, apart from Europe, the world as a whole is already moving towards balance. And European imbalance is a recent phenomenon. It is not clear how long it will continue to build up. Even including Europe we are much closer to a balance than we have been in a long time among the developed economies. Which is good, as balance is good. Cheap capital for proper investment is good. But this is also a bad news, as the US apparently now have a lower capacity to absorb investments. The CAPEX figures from the Fed Flow of Fund data have been less than encouraging for years now. Excess savings in an environment of less investment opportunities mean basically a globalized version of Japan. So it all depends on if this will continue, and if yes, how much it will build up and where the savings will head to.

Of course, this assumes only the flow matters, but stock is important too. We do not know how much Chinese or European investment stock is on the sideline and waiting to be exported. (or conversely, how much unmet demand in peripheral Europe is being neglected by banks unwilling to lend, and how fast this "Euro glut" can reverse on active policy and optimism.) If they do flow out, it is positive for foreign assets in the short run. And if they do find a home in real positive return investments it is great in the long run too. If they overcrowd economies with little investment opportunities, it will push the real rate down and impact investment. So on the optimistic side, this is positive for emerging market economies (including India) in the long run. And as long as we can keep the global demand up, it is positive for pretty much everyone.

And finally, yes the absolute numbers are large. But when you compare them to world GDP, this total imbalance appears much less benign (less than 1% of world GDP for Euro area, China and Japan combined). In a world with perfect trade and capital flow, this should take care of itself. In real world, this is large, but not earth shattering!

So short the euro by all means, but not solely because of "Euro Glut". It is perhaps way too complicated than that. At least more than what Mr. Pettis seems to suggest how important the trade balance is. And more than just exports of savings. In fact in early 90s, the yen and the Japanese current account balance (as a percentage of GDP) moved in pretty much lock-step. In the way a simple trade model would suggest, currency strengthening in auto-correction when current account surplus builds up. Exactly opposite of what Mr Saravelos suggests.

People were way too complacent about Europe a decade back. And now way too pessimistic!