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Re: Inflation/Macro-Asian Contagion 2.0?
I wrote this at the beginning of this year to summarize my concerns for the macro setup. This thread delves deeper into Point #3
Pretty much everything on my list has since been litigated ad nauseum by everyone EXCEPT for my allusion to “’97-’98” which I will dub “Asian Contagion 1.0,” or “AC1” for short.
No, I’m not talking about a pandemic; I’m talking about a CURRENCY CRISIS and its impacts on everything else.
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In recent months, I’ve become increasingly worried that a runaway USD Wrecking Ball would lead to Asian Contagion 2.0 (AC2) – this time with MUCH BIGGER ramifications.
AC1 officially started 7/2/97 when Thailand let its USD peg go and devalued the Thai Baht (THB). Then, the dominoes started falling...
7/11/97: Philippine Peso (PHP) devalued next.
7/24/97: Malaysian Ringitt (MYR) puked hard, and PM Mahathir famously blamed it on speculators like George Soros. Politicians always finger-point in crises with scary policy ramifications.
8/14/97: Indonesian Rupiah (IDR) devalued. I was visiting Bali when this all first started and remember being happy to see IDR weaken from 2200 to 2500...
Little did I know that a year later, it would hit 16000! President Suharto was eventually forced out in May ’98 because of the crisis.
Notice the dates of these initial “devaluations” were during Summer ’97 whereas the charts don’t seem to show the singularities until 1998. I give you the Big Picture first to give context to both the MAGNITUDE and VELOCITY of these moves.
Let’s zoom in a bit for THB to see that initial devaluation in 7/97 and what followed:
Let’s zoom in for IDR as well since this was even more extreme:
FIRST TAKEAWAY: THE INITIAL DEVALUATION IN A CURRENCY CRISIS IS OFTEN JUST THE TIP OF THE ICEBERG.
By the end of the year, even more developed markets like South Korea were “caught in a mosh,” to quote a favorite song by Anthrax. Here is the Korean Won (KRW):
Even the mighty Japanese Yen (JPY) was embroiled.
What was EUR doing during all of this? Again, what initially seemed like a bastion of relative stability would prove ephemeral (in this chart unlike the others, DOWN = USD STRENGTH)
By Summer ’98, this little spark in Thailand during Summer ’97 wound up setting off a GLOBAL conflagration that would eventually cause Russia to devalue RUB on 8/17/98 and then default on its GKOs on 8/19/98.
The reverberations in global credit/equity markets ultimately culminated in the spectacular collapse and bailout of LTCM.
My time at Canyon Partners (1997-2002) gave me a front-row seat to witnessing how macro Black Swans in a remote corner of the world can transmit widely across asset domains and swamp idiosyncratic credit/equity theses. I’ll share a couple relevant lessons for a short digression.
When I joined in Fall ’97, pre-existing credit/equity positions demanded immediate triage and because my past background in commodities/derivatives was relevant, I focused initially on crafting hedging strategies to deal with this fallout.
Throughout this period, Oil experienced a spectacular downward demand shock and collapsed into “Super-Contango,” troughing at $11/bbl after the Russian default. Even though today’s Oil supply/demand situation is very different, I have never forgotten this experience.
I crafted an option strategy to take advantage of the contango to hedge a pre-existing oil- service equity portfolio that had always looked cheap and got A LOT cheaper. I learned an early lesson about commodity stocks:
In the wake of the LTCM meltdown, we also saw full-blown CREDIT CONTAGION impacting everything from HIGH-YIELD/LEVERAGED LOANS to even MERGER ARBITRAGE.
Little did everyone know that the rocket scientists at LTCM were MASSIVELY LEVERING negative-gamma profile positions like MERGER ARB as well as their bread-and-butter FIXED-INCOME ARB strategies. RESULT: CORRELATIONS WENT TO ONE ACROSS A BROAD SWATH OF ASSETS.
SECOND TAKEAWAY: A CURRENCY CRISIS IN ONE CORNER OF THE WORLD CAN METASTASIZE INTO FULL-BLOWN CREDIT CONTAGION ELSEWHERE, IMPACTING ALL RISK ASSETS; THERE ARE MANY TRANSMISSION MECHANISMS.
Let’s now recap the root causes and lead-up to AC1. Remember the “East Asian Miracle” economies of the 80’s and 90’s? Basically, 8 countries (Japan, Taiwan, Singapore, Malaysia, Thailand, Indonesia, South Korea, Hong Kong) experienced hyper-growth for almost 2 decades.
Many of these countries pegged their currencies to the USD to jumpstart export growth and attract investment. These countries also gorged on debt – massive amounts of USD- denominated debt. Does this remind you of any countries today?
The most amazing and scary aspect of this AC1 analog is the relatively benign inflation and antidote that still set off this crisis.
From Feb ’94 to Feb ’95, FFR went from 3.25% to 6% in reaction to 6% CPI. As CPI cooled to 2.5%, the Fed pivoted and took FFR back down to 5.25% between July ’95 to Jan ’96. CPI began to reaccelerate in ’97, and the Fed hiked 25 bps in March ’97. That was the ONLY hike in 1997!
In response to 1998, the Fed eased 75 bps to 4.75% between September ’98 and November ’98. Of course, we all know that this set the stage for the euphoric prelude to the Dot Com Crash, which was set off by the 150 bps of hikes between June ’99 and May ’00.
This article gives a very good play-by-play of Fed actions since 1990. Note that the hiking/easing ranges got progressively larger, concomitant with progressively larger crises until we hit the zero-bound in 2008 and QE was born.
THIRD TAKEAWAY: INFLATIONS OF THE PAST 3 DECADES NEVER GOT STICKY AND EVERY CRISIS WAS SUCCESSFULLY PAPERED OVER WITH AGGRESSIVE MONETARY POLICY, BUT THIS INFLATION LOOKS VERY DIFFERENT THAN THAT OF THE 1990’S.
I WORRY THAT WE ARE ON THE DOORSTEP OF AN ASIAN CONTAGION 2.0 AND THAT WE ARE ALREADY SEEING THE INITIAL WAVE OF "DEVALUATION ICEBERG TIPS" A LA SUMMER ’97.
Here is my "USD Wrecking Ball World Tour Thread" from March, but I fear that these initial signs of devaluation are just the tips of the icebergs like we saw during Summer ‘97:
This time around, STRUCTURAL supply issues in OIL kickstarted Inflation, and I predicted that this would create a hawkish Fed that would in turn create the USD Wrecking Ball.
Because the Fed was asleep at the switch for too long (and frankly STILL asleep with respect to balance sheet reduction), Inflation has since taken on a life of its own, creeping into much STICKIER components of Wages and Rents.
The recent Risk Rip/Yield Curve Inversion/pause by the USD Wrecking Ball all seem to be signaling a Fed Pivot just because of softening Oil Inflation in recent months DESPITE no letup in Rent/Wage Inflation AND recent passage of FISCAL STIMULUS via IRA/Chips bills.
Welcome to the Vodka/Red Bull Economy. Good luck if you think we’ve licked Inflation.
Not only that, the USD Wrecking Ball has also taken on a life of its own at this point. Because FX is a RELATIVE game, the USD WRECKING BALL DOESN’T JUST GET FUELED BY A HAWKISH FED – IT IS EQUALLY FUELED BY RELATIVELY DOVISH CB’S EVERYWHERE ELSE.
KEY QUESTION: WHAT OTHER COUNTRIES HAVE ECONOMIES THAT ARE STRONGER THAN THE US ECONOMY TO ALLOW THEIR CB’S TO KEEP UP WITH THE FED? Europe? Japan? China?
Let’s talk about Europe. Much ado was made of the ECB’s “surprise hike” of 50 bps...from zero. Does this presage a brave, new hawkish ECB? With Germany facing the prospect of no gas from Russia this winter?
I didn’t call it “Eurasian Contagion,” but maybe I should have. Forget about the ECB outpacing the Fed in hawkishness – frankly, I don’t think EUR has EVER faced greater Fracture Risk than now.
Let’s talk Japan. First, Japan has had the OPPOSITE of an Inflation problem. They’re still pursuing YCC near the zero-bound even though the BOJ already owns 50% of all JGBs! BOJ is truly boxed.
Faced with the choice of letting JGBs go or JPY go, I think they will have to capitulate on JPY, because capital controls are not an option.
And now we get to the elephant in the room – China. First, let’s compare China current-day economic clout to that of East Asian Miracle countries in ’97. Was hard to find good data, but I think these charts illustrate the relative magnitude. My source:
A couple key China observations:
1. China’s last several decades of hyper-growth were fueled by the SAME debt-driven/export- driven/USD peg dynamics as the East Asian Miracle Countries.
2. BUT China’s MAGNITUDE is MUCH LARGER.
3. China gave the world a once-in-a-lifetime DEMOGRAPHIC DIVIDEND which kept inflation tame and allowed our Fed the Liquidity Lottery License, but that is ENDING now.
The implication is that even as China’s economy is imploding now (see below), it means HIGHER STRUCTURAL INFLATION for RoW – especially the US which has gotten used to cheap Chinese offshoring.
A source on the ground tells me that even decades-long SOE-fueled “projects to nowhere” have ground to a halt. He tells me that the unemployment rate for the 16-24 cohort is now 20%!
This means that the PBOC, like the BOJ, will be in EASING mode for the foreseeable future even as our Fed continues to HIKE.
Like the BOJ, the PBOC is faced with the same Impossible Trinity and needs to choose:
Finally, look at the DXY level in 1997 vs. today’s pre-crisis starting level. Scary.
Now look at CNY over that same time period. Led Zeppelin’s “When The Levee Breaks” comes to mind.
FOURTH TAKEAWAY: A CHINESE DEVALUATION OF THE CNY COULD CATALYZE AN ASIAN CONTAGION 2.0 WITH MUCH BIGGER GLOBAL RAMIFICATIONS THAN ASIAN CONTAGION 1.0.
1. FX Crises often start off as “slow-motion train wrecks” but can end in spectacular “high- speed explosions.”
2. Transmission mechanisms are unpredictable; even seemingly uncorrelated assets can get correlated.
3. This Inflation Cycle looks very different and stickier than that of the 90’s, which enabled the Liquidity Lottery as panacea for every downturn -- no longer?
4. CNY Devaluation could spark Asian Contagion 2.0 with much bigger ramifications than the THB Devaluation of 1997.
The sobering implication of all this:
Even if AC2 happens, I am not sure it is “curable” with a return to QE like the all the last crises since 1990, because I believe we are in a new era of STRUCTURALLY HIGHER INFLATION.
Despite being LT bullish on Oil, I have turned cautious in recent months, because AC2 would create a severe downward demand shock into an inelastic supply curve and exacerbate the move down.
AC2 would most assuredly bring about a ST deflationary shock, but it would NOT solve the underlying STRUCTURAL ISSUES (e.g. LT CAPEX STARVATION in the Oil sector).
A Fed Pivot back to QE would only EXACERBATE these issues and put us in a “Stop-n- Go/Stagflationary” setup like the 1970’s.
Didn’t mean to leave everyone in a lurch on a Friday, but this has been weighing on me for a while.
END ORIGINAL THREAD.
Some updates to this thread:
Two words: BU HAO.
MYR, YTD (this one looks BAD):
JPY, YTD (Totemo warui desu):
By the way, I forgot to mention the currency of that other small country in Asia. Here is the Indian Rupee (INR) from 1990 to now:
EUR has officially “broken the buck.”
The Won lost.
Wish the “USD Wrecking Ball” was trademarkable!
A bunch of folks asked about HKD.
Know what that flat line at the top of the range means? Bleeding reserves.
Hate to say it, but if these are the policies the EU wants to adopt even now, it kinda deserves a fracture. H/t @strandfund
When you pour more Red Bull, you’re also gonna need more Vodka to balance things out.
If the “OPEC+ Put” is really restruck at today’s much higher prices, it will REALLY crowd out the “Fed Put,” and the USD Wrecking Ball will get even stronger.
What he didn’t say but implied:
THE MORE FIGHT WE GET FROM THE DEMAND SIDE, THE MORE THE FED NEEDS TO DO AND THE LESS ABLE WE ARE TO PREVENT A HARD LANDING.
Even without an “OPEC Put,” we will have a problem, imho.
Uh huh. Got it.
Too late on that “embedded” part.
Color me skeptical on the ECB out-hawking the Fed.
This is the CORE of the problem. Source: GS.
Gonna take the “under” on that.
Implication: USD Wrecking Ball keeps on wrecking.
BOK is also boxed.
Sayonara. It’s just a matter of time when JPY 140 gets breached.
JPY levee is about to break. Note that we are approaching 1998 levels.
A storm is coming, folks. Buckle up.
Very worrisome regarding Oil.
Remember what I said about dominoes falling at the beginning of this thread? JPY at 150 is a hell of a bigger butterfly than Thai Baht in 1997!
IF this is true below, the implication of the JPY levee break also means the REVERSAL of whatever “assistance” may have been rendered. Watch BONDs.
Jerome might not even need to call Janet for that Bear Steepener.
Fun times in Asia overnight right now.
JPY is at 140. There is nothing magical or technical about 140 except that it is a psychological level indicative of BOJ GIVING UP ON JPY. And that's a big deal.
That said, "Thar be stops above 140."
"Thar she blows!"
Guess what the stops fishermen just found.
The USD Wrecking Ball is not resting this weekend apparently. Wow.
Musing of the Day:
The unprecedented COVID-induced Liquidity Lottery defied economic reality and borrowed heavily from the future.
The problem is: that future is NOW, and the price is possibly the (Eur)Asian Contagion 2.0. Mythology always teaches as well:
Persephone (Risk Assets) happily ate up the Pomegranate Seeds (Liquidity Lottery) that Hades (The Fed) proffered.
Now Hades owns her.
I hear the arguments for Europe having adequate buffer for the winter. Then what exactly?
Here is a counterpoint to the AC2 thesis. The cure for high prices is high prices...including the USD Wrecking Ball. That said, I’m just not seeing the catalyst for a USD crash yet.
@BurggrabenH is a must-follow if you want to understand how dire the European gas dependency on Russia is.
I think everyone needs to pull back and look at the BIG PICTURE and then judge for themselves what the current regime looks like relative to history.
Read this article while you follow the chart of the DXY over the decades.
Not saying we go back here, but just note where DXY peaked during the last bout of serious structural inflation.
This perfectly describes a reflexive, positive feedback loop. Positive feedback loops by their nature don't have easy off-ramps and usually result in systemic breakdowns...like, say, maybe an (Eur)Asian Contagion 2.0?
I wrote a couple threads about positive feedback loop analogs. Here is one:
Here is another Mental Model taken from Computer Science. In this case, "Stack Overflow" = AC2
Re: HKD, Since I’m in a LOTR kind of mood, does anyone remember Grond?
You can bet that CBs around the world are watching the JPY implosion right now.
Wondering how many napkins with “Shall we try YCC too?” just got crumpled up and tossed in the trash.
At this rate, Fed can pause NOW and USD Wrecking Ball could STILL keep wrecking. FX is a RELATIVE game.
Shades of 1997-1998...
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