Deutsche Bank’s chief FX strategist George Saravelos attended a global investor “virtual lunch” today, and the below 4 points are a summary of the key discussion points.
1. If you don’t understand supply, you can’t understand this market.
Most commentators have insisted on adopting an excess demand framework throughout the year: “too much” stimulus leads to overheating demand, inflation and eventually a bond market implosion. While the post-COVID rebound has undoubtedly been strong, we have been arguing for months that this framework is incomplete. First, it ignores the large ongoing negative supply shock in the new COVID “normal”: consider that the US still has a negative output gap and yet inflation has already accelerated to a forty-year high. Consider that the US working age population is shrinking for the first time since WWII. Consider that US productivity last quarter shrunk at its fastest pace in more than half a century. Consider that looking under the hood, capex is disappointing. Bottom line, the supply side is anything but “gangbusters”, more reminiscent of a “secular stagnation” paradigm instead. This in turn prevents the market from aggressively repricing terminal rates: either supply recovers, pushing inflation back down – or, if it doesn’t, it means there is something seriously wrong with the economy’s potential.
2. We need to talk about excess saving too.
The second “post COVID normal” is structurally higher saving rates. Individuals may be spending a lot on goods but a) they aren’t doing so on services and b) they are saving even more. Yes, everyone loves bitcoin but also consider that the year has seen one of the biggest retail inflows into bond funds on record and huge bank buying of bonds recycling customer deposits. Consider that European capital outflows are at a record being sucked back into the US bond market while the US current account deficit has failed to widen materially. If this were simply liquidity hoarding, people wouldn’t be buying bonds – and global capital wouldn’t be attracted to the US bond market. Note that low labor supply and high excess saving may well be part of the same story: individuals are showing a growing preference for leisure over work, requiring higher equilibrium savings. The consumer signal is also aligned with a highly inverted yield curve. All of the above fits in with a market pricing of a low r*: massive excess saving keeps term premia depressed; weak supply keeps terminal rates low – both in line with the historical post-pandemic experience of the last thousand years.
3. The dollar will be a key barometer.
A flattening yield curve as a result of the forces above is historically dollar supportive and we’ve been more positive on the greenback over the last six months. How far the dollar can go, however, critically depends on the driver of the flatness: high precautionary saving and weak supply versus too much post-COVID liquidity that ultimately has to be withdrawn. If it is weak supply, the dollar move will not run for that much longer; the economy and financial conditions will tighten quicker than expected or supply will come back into line, giving the Fed some time. If it is excess liquidity keeping the S&P “too” high and bond yields “too” low, the Fed will have to keep going and tighten financial conditions more than expected: either equities will have to go down – or, if they don’t, the dollar should rally more as it becomes a high-yielder. The dollar-equity correlation would flip positive and this would not be helpful for EM FX.
Between the two competing narratives, regular readers will be aware of our emphasis on the more pessimistic side of the story for more than six months now. Both scenarios are dollar positive but the pessimistic one ultimately constrains dollar strength. Our EUR/USD forecasts next year assume an additional 50bps of re-pricing in the US front-end equivalent to a 1.08-1.10 EUR/USD equilibrium but not much more. We worry this would be enough to invert the US yield curve and have a bigger impact on commodities than assumed; we are bearish oil in 2022.
4. Beware omicron and China.
Many in recent weeks have asked whether omicron is a “game changer” for the outlook. Our view is that market pricing is here because of the persistence of COVID this year not despite it, and therefore omicron is likely to aggravate all preexisting trends: too much consumption of goods over services, low neutral, inflation for bad reasons, strong dollar, flattening US yield curve. We are especially worried about what omicron means for China. The zero-COVID policy has not been tested under a far more transmissible strain and the level of disruption that may be needed to maintain containment may entail even greater supply disruption than what has been seen so far this year. As far as FX goes, while recent policy actions out of China (the RRR FX increase, higher fixings and greater emphasis on growth) all signal greater official dissatisfaction with CNY strength, it can only be a policy shift towards greater capital outflows (QDII, “wealth connect”) that would be the true game changer.
