The CrossBorder Capital Blog

There is an ever more distinct Asian financial cycle. Structural economic changes are altering the shape of the World economy, largely, in recognition of China’s increasingly dominant role. Policy-makers are responding. We do not mean by this the latest reactive moves by US President Trump, rather the longer-term strategic adjustments being implemented by Asian regional policy-makers. Foremost are the implied shift by Japan towards Yen-targeting and the suggestion that China has stopped building forex reserves. If we are correct, these moves prospectively represent the biggest policy changes in Asia for three-decades.  

We continue to be more concerned by developments in the core economies than in EMs, but we also acknowledge that when the liquidity tide goes out, then EMs can look vulnerable. In this report, we argue three things: (1) every EM crisis is first-and-foremost a currency crisis; (2) EM fundamentals appear far stronger than in past EM currency crises, and (3) the Chinese economy is now more important than the US economy to the fortunes of EMs. Although we remain negative about global markets, we are more upbeat about medium-term EM prospects and conclude that the latest shake-out is nothing like 1997, 2001 nor 2008. Therefore, buying into EM weakness makes sense.  

The background of rising Treasury yields and flattening yield curves rarely leads to good economic outcomes. We show, in this report, that the currently flat US yield curve reflects poor domestic liquidity conditions. This, in turn, is leading investors to move deeper into already expensive ‘safe’ assets, and the resulting skewed distribution of term premia warns of slowing US economic activity over the next 6-12 months. We argue that the skewness of the distribution of term premia is far better at predicting future economic slowdown than the flatness of the yield curve slope. Slower economic activity should ultimately cap the rise in bond yields. We continue to see 3.5% yields on 10-year Treasuries tested this year, but with the growing odds of a bond rally thereafter. The FOMC project seven policy rate rises to end-2020: we foresee, at most, three, largely because US liquidity is already very tight. Fed Funds may reach 2½% and stop.  

Quantitative analysis shows that three liquidity-based factors, above all, often combine to warn of an approaching bear market (6-12 months ahead) in global risk assets. Today, all three are signalling caution: one measures the skew in exposure – investors’ risk appetite – and the other two a peak in the flow of liquidity into markets – Central Bank liquidity injections and cross-border capital flows. A correction is not certain, but the track record of these factors is sufficiently good for us to pay attention.