FX volatility trend - Convergent monetary policy leads to smooth exchange rates

A recurring hedge fund theme is that global macro investing is dead or at least much harder in the last decade. Who could be surprised with this assessment given there is no volatility in many major markets? For example, look at currency markets. They have been on a decline since the early 1980's. The volatility fall has only accelerated since the Great Financial Crisis. This fall has been on both an absolute and relative basis versus other asset classes such as commodities and equities. For a full report on currency volatility trends see the Brookings Institute draft paper, "Will the Secular Decline in Exchange Rate and Inflation Volatility Survive COVID-19?"

So, what is the cause of this long decline in currency volatility? Inflation across most countries has declined significantly with the standard deviation and median annual inflation well below the average for the post-WWII period and is even low for the post-GFC period. This decline is well below the period known as the Great Moderation. Nominal and real yields are also low and show limited dispersion by historical standards. 

There is every reason to believe that this low volatility currency environment will continue. Rates across advanced economies are all expected to stay low. The Fed has used its power to provide currency swaps to stabilize the dollar. Fiscal policy is being used to stabilize economic growth around the world. Currencies, as a relative price, are stabilized given the underlying economic drivers are stable. 

The question for 2021 is whether a stable global environment will continue or whether economic dispersion will return in growth, inflation, and rates. The consensus is on continued calm; however, when volatility is so low, the cost of betting on increased volatility is cheap. Minsky moments can occur in the global macro arena.    

The big November, alternative reality, and forward expectations

Simple question, if you were given the following information at the beginning of November what would have been your expectations for monthly returns? 

• Change in US leadership; however not a mandate and issues of election confirmations.
• COVID cases rising in US and rest of the world - a big new wave. 
• COVID vaccines developed from three different companies, but unclear when they would be distributed.
• No new fiscal package and the same monetary policy.

This is a game that should always be played by forecasters. Assume you are given perfect foresight of the news, then determine the price action. The expected results do not often match reality. In this case, uncertainty has been put aside and strong equity rotation suggests that investors are expecting a good post-vaccine world.

The SPX gained 10.95 percent, but there were more interesting equity dynamics for November. The equal-weighted SPX gained 14.30 percent and the S&P small cap 600 increased 18.17 percent. Value outperformed growth by over 300 bps with a monthly return of 12.88 percent. 

The strong benchmark gains have masked the significant rotation to value and size over growth and momentum. Of course, this is all relative because the supposed out of favor long-only factors still generated positive monthly returns. However, looking at long/short factors show significant declines for momentum, quality, and volatility factor portfolios. The worst names (shorts) saw significant rallies.

Another rotational shift will come from the increased dispersion in equities. More dispersion means there are more opportunities for stock pickers, active managers. An overweight to the high cap tech names may be ending with the signs of a new normality. Value and size needed a catalyst and that may be present through a shot in the arm. 

Inflation - Not what was expected, not what is wanted

 

The US inflation story has been a mash-up of different ideas. Go back two years and we were seeing Fed rate increases because of inflation concerns and a desire for normalization; four in 2018 and 9 since December 2015. 2019 saw rate cuts in an effort to support the economy and inflation. March 2020 caused the Fed to pull out all of the stops with monetary policy to push inflation above target given fears of recession and deflation.

The deflation threat has not materialized. The PCE has stayed above 2015 levels and never moved negative. CPI fell dramatically but has bounced back. The lockdown price behavior has not acted like a normal recession. 

Inflation numbers will be affected by many relative price shocks and will have a fair amount of noise, so a number of Fed banks have developed smoothed inflation series. 

• Dallas Fed - Trimmed mean PCE
• Cleveland Fed -  Median and trimmed-mean CPI
• Atlanta Fed - Sticky-price CPI
• New York Fed - Underlying Inflation Gauge 

The average of the smooth series shows inflation above 2%. The smooth trends are slightly downward but not suggestive of a deflation problem.

• Dallas Fed - trimmed PCE               1.7%
• Cleveland Fed - median CPI            2.5%
• Atlanta Fed Sticky-price                 2.0% 
• New York Fed prices-only UIG        2.1%

Did the Fed save the US from a deflation debacle through strong money growth or was the deflation threat never a real problem? We may need more information to provide an answer, but a vaccine that opens the economy will also prime inflation to move higher from a 2% base.

Public pension funds -There are no quick fixes

The National Conference on Public Employee Retirement Systems (NCPERS) produced a paper, "Ten Ways to Close Public Pension Funding Gaps" which tries to provide some solutions to the problem with public pension shortfalls. All have some merit, but all fall short of the real problem. More money, lots of it, has to be raised or benefits, lots of them, will have to be sacrificed. Without clear specifics for each proposal, it is hard to see how much of the funding gaps will be closed. For those public pensions that are close to full funding any of these choices may be enough to solve any small gap. For those that have significant gaps, the policy proposals will not solve the problem.

The choices:

Leverage and liquify - Borrow money to support pensions or liquify existing assets  

• Pension obligation bonds 
• Action of the Fed - For example, buying municipal bonds to allow leverage and liquidity 
• Bridge loans 
• Securitizing public assets - liquify public assets to pay for benefits

Structural changes - target payments to pensions, obtain scale, target contribution adjustments, increase taxes 

• Dedicated revenue streams 
• Stabilization funds 
• Monthly employer contributions 
• Plan consolidations
• Auto triggers to adjust contributions 
• Reforming revenue and increased taxes 

Why is this a global macro problem? The dynamics of pension will lead to long-term macro drags that cannot be easily solved by monetary policy or federal fiscal policy. If inflation increases or valuations decline, the impact on pay-outs will be real. Any inflation adjustment will not close the funding gap. Lower expected returns will only increase the gap. This is a problem that will have to be addressed by the new US president.