Rabobank: The Fed Will “Only” Intervene If Stocks Go Lower, Or Yields Go Higher

Submitted by Michael Every of Rabobank

Waking up to the Bloomberg headlines today feels a bit odd. The main story is “BORDER CLASH” (which was then subsequently changed to “FIREFIGHT”) as 20 Indian soldiers have died and China has almost certainly suffered casualties too. The acerbic Global Times makes that clear but it says Beijing is refusing to release the figure “to de-escalate”: US intelligence sources estimate the figure could be as high as 43. That’s two nuclear powers and neighbours, and the two most populous countries on earth, fighting each other (and apparently in melee combat) for the first time since 1975.

The second story is North Korea blowing up the North-South Korea liaison office and moving military police into the DMZ and other strategic locations between the two states (who are still technically at war). That’s a proto nuclear-armed power acting rouge – and it had already stated it has no interest in ever speaking to the US again.

The headlines are odd because both of these were things to be worrying about yesterday, when they happened. Yesterday’s headlines, however, were instead about a USD1 trillion White House infrastructure package that is unlikely to arrive any time soon. It seems that we really don’t see things as one world even when we strive to.

Regardless, Asia had a risk-off session so far today largely because it realises that the above events do matter. It is not the immediate risk of war between the Koreas or between India and China, either of which would be devastating: yet both are necessarily still fat tail risks. It is more a recognition that Asia has fault-lines running through it which are only going to deepen now that the era of “Chimerica”-led globalisation is coming to an end.

How does one resolve North Korea? No good answers. A few years ago people were discussing when India would sign the RCEP trade deal with China: does that look likely now? The more realistic question is how quickly India instead integrates with countries around China such as the Five Eyes group, Indonesia, Japan, and Vietnam. As the world faces more and more binary ‘US or China?’ product choices this will mean disruption of the kind that business does not like. Consider the recent editorial from Singapore’s Prime Minister worrying that this won’t be the Asian century after all if a new Cold War splits the region. (Against which backdrop note that publication of former US National Security Advisor John Bolton’s warts-and-all book about his time in the White House is being delayed by legal action claiming it will compromise US national security: is it called “Spy Kvetcher”?)

Naturally such a scenario would not be win-win: there would instead be winners and losers. On which front, Nikkei Asian Review is running a story today that Huawei has delayed production of parts for its newest flagship smartphone series in response to tighter US export controls. Let that sink in for a moment: China’s flagship firm is having difficulty with its flagship product; and things are only going to get worse from here for it if the US is serious about the legislation and executive orders it has been rolling out from a hawkish production line.

Of course, Asia was also gloomy about the fact that the virus situation in Beijing appears serious. Schools are closed again, for example. Then again, in the UK they still haven’t even opened, and that does not seem to stop the government/public from pressing ahead with all manner of lockdown unwinding.

The virus is clearly also still spreading in the US: yet it seems to be focusing more on shopping. Retail sales jumped 17.7% in May, as we saw yesterday, which was a huge beat of consensus. Yes, that is encouraging, and largely reverses the equivalent plunge seen the previous month as shops re-opened again. However, can we do a little maths, people? Start at 100 and go down 20%: you get to 80. Start at 80 and go up 20% to reverse the fall: you get to 96. That’s 4% down from where you started – which used to be called a recession. Furthermore, this is while federal government cheques are still boosting people’s bank accounts, and as my colleague Christian Lawrence correctly points out, in 30 of the 50 US states current government support is above the median salary level. It’s not that we can’t see a sustained rebound or a V-shape; it’s that it will take a whole lot more to achieve it….and ironically the stronger the numbers like yesterday’s look, the harder it will be to persuade Congress to pass such legislation.

And from some elephants in the room, India and geopolitics/Cold War, to another, the Fed. Yesterday Chair Powell stated to the Senate “I don’t see us wanting to run through the bond market like an elephant snuffling out price signals and things like that.” There’s a quote for the ages. He continued: “We want to be there if things turn bad in the economy or if things go in a negative direction.” Did he mean “stocks” when he said “things”? Because that is how the market has been reading it. (I recall once seeing a baby elephant in Thailand trying to sneak across the floor on all fours to steal some spilt milk. You could see in its eyes that it genuinely thought it was being stealthy “Nobody can see me!”: it was still four-feet high in that position and had all the subtlety of a central bank.)

Powell also mentioned Yield Curve Control (YCC), noting the Fed had been briefed on what the BOJ and RBA have done on that front. “Absolutely no decision” had been made on it so far, but he admitted it might be used if Treasury rates were “to move up a lot, and for whatever reason, we wanted to keep them low to keep monetary policy accommodative, [then] we might think about using it on some part of the curve.” So YCC won’t be used unless Treasury yields go a lot higher…in just the same way the Fed does not act on stocks/things unless they go lower. It’s a market; in one direction. Moreover, can you also think of “whatever reason” the Fed might also have to keep yields low? How about the fact that the last time they used YCC was back in the early 1950s to help ensure that debt built up in WW2 could be inflated away?

So ironically some elephants in the room are now front-page news – which should be risk-off for emerging markets; and yet the Fed-ephant is stomping on volatility anywhere it sees it, which is risk-on for emerging markets. Short-term, which elephant should you back? And longer term? How did those WW2 era debs occur in the first place?