How the dollar’s weakness is the rest of the world’s problem

Forex markets pose a threat to a synchronised recovery needed to validate stock prices

by: Mohamed El-Erian

The greenback has dropped dramatically this year as the reality of Republican political dominance has unfolded

While Americans visiting Europe find that their dollars buy less, the recent sharp weakening of the world’s reserve currency is a lot less of a problem for the US and much more for the rest of the world, where it increases already complex economic and policy challenges. It also continues a “hot potato” syndrome that highlights the underlying structural fragility of the global economy, as well as undermining the foundation crucial to solidifying and sustaining elevated asset prices.

Commenting on a dollar that had appreciated by 5 per cent from the time he won the elections to the end of that year, incoming President Donald Trump warned in January that the currency was “too strong” as it hurt the ability of US companies to compete internationally. Since then, the greenback has depreciated steadily, touching a 33-month low during Friday’s trading session in what amounts to a 9 per cent decline in the trade-weighted index so far in 2017. It has been a broad-based move against the currencies of both advanced and emerging economies, even some that maintain managed pegs with longstanding ties to the dollar, including China’s, which in the last few days, however, has started to resist.

The primary driver of the dollar’s decline has been a narrowing of the differential in market expectations for economic growth and monetary policy. During the past few months, actual and expected growth has picked up in Europe and Asia, both in absolute terms and relative to the US.

Concurrently, with the implied market probability of a December hike having fallen sharply (to below 30 per cent), traders have aggressively pushed back to June of next year material expectations of the next Federal Reserve hike — this at a time when they have also been internalising signals from the European Central Bank that it may move as soon as next month in announcing plans to reduce large-scale asset purchases.

While some segments of American households and companies will suffer from the recent depreciation, the overall economic impact is likely to be favourable. By enhancing price competitiveness, it provides a tailwind for economic activity and job creation. It is supportive of financial markets, given that companies in the S&P 500 derive a significant portion of their revenues from abroad.

Also, at the margin, it increases the chances of the Fed progressing with its “beautiful normalisation” after an unexpectedly prolonged reliance on experimental unconventional measures — that is, restoring policy rates and the balance sheet to less extreme and less distortive levels without derailing growth and causing financial instability.

The picture is less rosy for the rest of the world. Most economies now have to contend with a stronger headwind to growth and, in the case of Europe, downward pressures on an inflation rate that the central bank worries is already too low. With continued delays in implementing the much-needed set of pro-growth policies, this serves to weaken the cyclical growth impetus and amplify the effects of structural impediments to higher and more inclusive growth.

The dollar’s round-trip over the past 10 months also brings into sharper focus an important dimension of today’s currency markets. With limited exceptions, such as Germany, there are very few countries able to absorb and navigate easily a sustained period of sharp currency appreciation — and this for a simple reason: compensating growth engines are still too weak. As such, rather than be part of an orderly growth-enhancing global rebalancing, currency moves nowadays involve too many zero-sum elements that can also fuel economic nationalism.

John Connally, when Treasury secretary in President Richard Nixon’s cabinet, famously told his European counterparts in 1971 that the dollar “is our currency but your problem”. With the structural fragility of today’s global economy, and with continued overreliance on monetary policy, this dictum could easily be generalised to many currencies experiencing a sharp depreciation.

Until this situation is resolved through more comprehensive and better co-ordinated policy responses, currency markets will pose a threat to the solidification of a synchronised global recovery needed to validate stock prices around the world in a durable manner.

Mohamed El-Erian is chief economic adviser to Allianz and author of the book “The Only Game in Town”

Retirement accounts

Does ageing explain America’s disappointing wage growth?

Economists debate the effects of baby-boomer retirements

WHEN America’s unemployment was last as low as it has been recently, in early 2007, wages were growing by about 3.5% a year. Today wage growth seems stuck at about 2.5%. This puzzles economists. Some say the labour market is less healthy than the jobless rate suggests; others point to weak productivity growth or low inflation expectations. The latest idea is to blame retiring baby-boomers.
The thinking goes as follows. The average worker gains skills and seniority, and hence higher pay, over time. When he retires, his high-paying job will vanish unless a similarly-seasoned worker is waiting in the wings. A flurry of retirements could therefore put downward pressure on average wages, however well the economy does. The first baby-boomers began to hit retirement age around 2007, just as the financial crisis started. And since 2010, the first full year of the recovery, the number of middle-aged workers has shrunk considerably. They have been replaced partly by lower-earning youngsters (see chart).
Researchers at the Federal Reserve Bank of San Francisco think this could explain disappointing wage growth over that period. They split earnings growth into the portion caused by pay rises, and the portion caused by people joining or leaving the workforce. From mid-2012 until recently, changes to labour-force composition have reduced income growth by about two percentage points. By comparison, in early 2007 the drag was less than one percentage point.
For those in work continuously, pay is rising just as fast as it was then.
Does that mean the labour market is running hot? Not so fast, says Adam Ozimek of Moody’s Analytics. He points out that the number of workers aged over 55 is growing, not shrinking, as a fraction of the workforce. What is more, statistically controlling for ageing barely changes estimates of aggregate wage growth, according to his model.
So what is going on? The San Francisco Fed’s researchers also note that many low earners have recently joined the labour force (such workers are usually the last to benefit from economic expansions). Growth in low-skilled jobs can hold back average wage growth. But this explanation does not imply that the labour market has fully recovered, because more people may yet be tempted to look for a job. In fact, Mr Ozimek denies there is a wage puzzle to begin with. Replace the unemployment rate, which counts only those who are seeking work, with the fraction of 25-to-54-year-olds who are jobless, and wage growth is exactly where you would expect it to be (at least according to Mr Ozimek’s preferred measure of pay and benefits).
Another problem with the ageing explanation is that it is not just wage growth that has been disappointing. Inflation, too, has been puzzlingly low this year: the core consumer-price index, which excludes food and energy, has undershot forecasts for five consecutive months. Ageing cannot easily explain low inflation. True, retiring baby-boomers reduce firms’ wage bills. But if older workers earn their high pay through high productivity then firms’ unit costs should not fall as retirements rise.
Ageing is too often overlooked as an explanation for economic trends—politicians routinely promise that the economy will grow as fast as it did before baby-boomers started retiring and the workforce began to shrink. Yet when it comes to wage growth, the effect of ageing is probably modest.
Policymakers should not hide behind it. Despite low unemployment, the labour market is not yet simmering.

In North Korea, Perception Is Reality

By Jacob L. Shapiro

From the weekend came the usual song and dance of the North Korean nuclear crisis, right? On Saturday, the government in Pyongyang test-fired three short-range ballistic missiles to the usual mixed bag of effect. The previous day, Kim Jong Un had personally supervised a military drill in which North Korean special operations forces simulated the occupation of two South Korea islands. The tests also occurred roughly halfway through the Ulchi Freedom Guardian exercises, whereby the United States and South Korea simulate a North Korean invasion on the rest of the peninsula. Read one way, the missile tests are unusually provocative. After all, Pyongyang had not tested a missile since U.S. President Donald Trump threatened “fire and fury” against it for vowing to attack Guam. Trump and Secretary of State Rex Tillerson recently intimated that progress had been made on the diplomatic front, citing the absence of missile tests as evidence of its advancement. A missile test, then, sends a strong message: Pyongyang is unbowed, as defiant as ever. Maybe.

Read differently, however, the tests are benign, even encouraging. Far from being the familiar choreography of action and reaction, statement and response, the events of the weekend signify something more, a rare act of conciliation under circumstances that leave little room for compromise. Maybe.

A Rare Instance

This is a rare instance in geopolitics when perception matters just as much as reality. And the early signs from Washington suggest officials perceive the events of the weekend as signs of conciliation. The administration has been relatively quiet. Trump himself has offered none of the incendiary commentary for which he has become known. U.S. officials are, of course, discussing the matter privately more than they have discussed it publicly, but it’s notable that their first response was restraint, not escalation. (It is notable, too, that Seoul, which would incur more casualties than Washington from a conflict with North Korea, targeted as it is by conventional weaponry emplaced north of the demilitarized zone, has been relatively quiet. A statement from the president’s office in Seoul said the Ulchi Freedom Guardian exercises would proceed “even more thoroughly.”)

What was tested is further evidence that Washington’s read might be the correct one. Before Saturday, the last missiles tested were intercontinental and, as such, were meant to demonstrate that North Korea could strike the U.S. itself, not just Guam. Short-range ballistic missiles such as the ones tested this weekend are no threat to the United States. Washington would prefer that no missiles be tested at all, but if negotiations are in fact taking place, short-range missiles are the least likely to derail them.

And Pyongyang would have reason to test them, even if peace were a viable prospect. Major military drills are happening directly across the demilitarized zone, and the government can’t help but consider them an act of provocation. For a government that has staked its legitimacy on a viable nuclear weapons program – for a government that must show its people it is undeterred in the face of provocation – testing short-range ballistic missiles is actually a measured response.

Equations Change

The fact remains that North Korea still has a nuclear weapons program it will not easily abandon. The reason it pursued such a program in the first place was survival, which is of the utmost importance for the government in Pyongyang. Deterring attacks by foreign powers with a nuclear weapon ensures its survival; attacking the United States with a nuclear weapon ensures only its destruction, considering how forcefully Washington would respond.

This undated photo released by North Korea’s official Korean Central News Agency (KCNA) on Aug. 26, 2017, shows military exercises at an undisclosed location in North Korea. AFP PHOTO / KCNA via KNS / STR/AFP/Getty Images

But if North Korea already has a viable deterrent to attack – as it believed it had in its artillery aimed squarely at the Greater Seoul area – then its behavior in recent months may reflect not merely its need to survive but its course of action in the event it does survive. Its plan: to become powerful enough to unite the Korean Peninsula under Pyongyang’s rule, or at least to put enough pressure on the U.S. to withdraw its forces. The pressure came in the form of ICBM tests, which it believed may go unheeded if Washington was overly occupied with its own political drama. Here, North Korea miscalculated. The U.S. has made it clear that it will not tolerate a North Korean nuclear weapons program, its political distractions notwithstanding. Still, Washington has also made it clear that it prefers not to go to war on the Korean Peninsula, and so it is exhausting all diplomatic options before it does.

Does Kim think that the United States is bluffing, or does he think that the U.S. will strike North Korea to prevent it from advancing its nuclear weapons program? If Kim thinks the U.S. will not intervene, or if he thinks he can survive a U.S. attack, then he will continue to pursue a nuclear weapons program, integral as it is to his grand plan to unite the peninsula. If, however, Kim thinks the U.S. is willing to go to war and, in going to war, defeat him, he will likely subordinate his long-term ambitions to more pressing matters of survival.

This is why perception matters, even in the face of reality. We can compare the objectives and imperatives of the U.S. and North Korea and predict their behavior accordingly. But that assumes everyone understands exactly what the other wants and fears. If North Korea’s perception of U.S. imperatives does not align with its actual imperatives, the equation changes, making the perception just as important as the imperative itself. Judging by Pyongyang’s actions of late, North Korea is scared, seeking to amend its behavior so that it can survive through talks rather than through action.

A Surprise Lift From China for U.S. Steel

China has crushed U.S. steel producers, now the industry might get a boost from its long-time rival

By Nathaniel Taplin

China’s net steel product exports have fallen nearly 40% in June and July compared with last year. Above, from April 2016, a worker walks through a steel plant in China. Photo: wang zhao/Agence France-Presse/Getty Images

U.S. Steel producers are poised to get a surprising boost from China, the same place that caused the industry more than a decade worth of pain.

While the focus has been on rising Sino-U. S. trade and geopolitical tensions, China has been quietly chipping away at one of the main sources of friction: massive overcapacity in its domestic steel industry, which has tanked global prices and helped gut overseas producers.

Beleaguered U.S. Steel, with its volatile shares and heavy debt burden, is a risky but potentially rewarding bet on a rebound for global steel producers. Investors have pushed shares down nearly 24% year to date, despite the company posting its best margin since 2008 in the second quarter. U.S. Steel’s profitable European operations are poised to benefit further from the same forces lifting Chinese margins: steel prices at multiyear highs paired with low prices for imported iron ore. The company’s flagship U.S. business, would get a further boost from any movement on Trump’s infrastructure or trade agenda.

Index, June 2012 = 100

As with everything in the steel industry, the driving force is China. Since commodities bottomed in early 2016, steel prices have risen to nearly where they were at the tail-end of China’s last big stimulus in 2011, but iron ore prices are less than half 2011 levels of around $180 a ton.

The reason is that iron ore producers ramped up supply to serve what they believe was an insatiable Chinese appetite. Now, stocks at Chinese ports are near record highs—but the nation’s net steel product exports are down over 30% from last year, due to a combination of furnace closures and buoyant construction.

Net Chinese Steel Products (metric tons)

U.S. Steel’s European unit is poised to benefit from this same dynamic. If lower iron ore costs push third quarter earnings per ton back near the postcrisis highs touched in the first-quarter, that alone would raise earnings before interest, taxes, depreciation and amortization for U.S. Steel by about 10%. That assumes actual steel shipments don’t get a boost from surprisingly strong European growth.

The company has reduced net debt by 40% since March 2016, when net debt to equity hit a high of 124% during the dark days of the commodity bust. U.S. Steel is now valued in line with competitors like Nucor and Steel Dynamics at 12 times forward earnings.

The main risk for steel right now is that the Chinese real-estate sector, the biggest source of global steel demand, cools abruptly. Plans to shutter more mills China this winter during the peak pollution season, could offset some of that. A longer term risk is a broad slowdown in the Chinese economy, likely sometime in 2018.

The global steel industry is in the best shape in years and U.S. Steel, while still risky, is well positioned to ride the good times.

World’s biggest banks square off over Noble credit default swaps

Goldman and JPMorgan among groups embroiled in dispute over claim settlements

by: Robert Smith and David Sheppard in London

There is more than $1.2bn of CDS written on Noble’s debt, according to ISDA data © FT Montage

The plight of heavily indebted Noble Group is pitching some of the world’s biggest investment banks against each other in a tussle over credit default swaps written against the troubled commodity trader’s borrowings.

Goldman Sachs, Nomura and hedge funds who stand to gain from having bought CDS protection on Noble are facing off against JPMorgan, BNP Paribas and other traders. It is shaping up to be an important test for reforms made to the $10tn CDS market a decade after it was widely blamed for exacerbating the financial crisis.

The dispute rippled through debt markets in London and Asia last week after banks and funds served notice to sellers of CDS protection, which pays out in the event of a default. They claimed that a recent extension to Noble’s loan repayment terms amounted to a debt restructuring.

The move was unusual, as the CDS market has agreed since the financial crisis to rely on the rulings of the International Swaps and Derivatives Association (ISDA) to determine when a company is in default, seeking to avoid widespread confusion or drawn-out legal disputes.

But earlier this month the ISDA committee responsible for deciding on the status of Noble’s debt said it was unable to determine if the Singapore-listed commodity trader was in default or not, creating a vacuum that allowed bilateral claims to proliferate across the market. It is the first time ISDA has dismissed a question of default without making a ruling either way.

There is more than $1.2bn of CDS written on Noble’s debt, according to ISDA data, and banks and hedge funds often hold offsetting positions or hedges in the same products.

This meant that, after the first claim was filed early last week, it forced a chain reaction of claims and counterclaims that spiralled through the market, with one source saying 12 institutions had triggered notices of default. The net total owed by sellers of CDS protection on Noble could be up to $157m.

“Notices were flying all around the city,” said one hedge fund trader involved in the CDS market. “They wanted to be below the radar on this but the banks receiving the notices were obviously freaked out.”

JPMorgan and BNP Paribas, which are said by traders in the CDS market to stand to lose in the event of a Noble default, have now filed questions with ISDA to move the process back in front of the industry body’s so-called determinations committee, which will meet on Tuesday.

Goldman Sachs, Nomura, JPMorgan and BNP Paribas all declined to comment on their CDS positions. ISDA also declined to comment.

In the absence of a ruling from ISDA, banks and funds that have bought or sold Noble CDS are essentially flying blind, with no precedent to follow, except how the market operated pre-2009.

“It’s like the whole last 10 years of market development have been put to one side,” said Nigel Dickinson, a derivatives lawyer at Norton Rose Fulbright.

“Because the ISDA determinations committee mechanism was supposed to avoid problems like this — market participants would ideally not need to trigger credit protection bilaterally.”

ISDA introduced the determinations committee system eight years ago in response to the chaos that credit derivatives caused in the financial crisis, after the mass triggering of protection linked to subprime mortgage bonds had to be settled between financial institutions bilaterally at the peak of the crisis.

The $85bn bailout of AIG by the US government came after the insurer almost collapsed due to CDS exposure.

Noble was once Asia’s largest independent commodity trader but its large debt load and questions over its accounting have taken the Hong Kong-based company close to the edge. Despite embarking on a shrink-to-survive plan, its share price has fallen 95 per cent since early 2015 and it is on life support from its lenders.

The quarrel over Noble is the latest in a string of controversies in the CDS market.

The collapse of Spanish lender Banco Popular sparked a dispute over the payout on CDS due to a dispute over legal claims against the bank.

The ISDA determinations committee has also faced criticism for being made up of representatives of the same banks and investors that stand to lose or benefit from their decisions.

Going back to the old system of bilateral settlements, however, raises the prospect of more disputes and expensive court cases. Senior bank CDS traders say there is little appetite for a return and are looking for ISDA to make a call.

“The CDS market has made a lot of enhancements over the years,” said one person familiar with the business. “Moving to a determinations committee framework has definitely been a positive move.”