Article / 12 November 2015 at 10:57 GMT

Steen's Chronicle: Primitive Economy redux

Chief Economist & CIO / Saxo Bank
  • Years of flawed policy leave us in a USD-dependent mess
  • Stronger dollar reduces future growth, commodity prices and productivity
  • Emerging markets have been hammered by their greenback borrowings
  • Central banks quietly starting to doubt the efficacy of low yields
  • A weaker USD has become the path of least resistance 
  • USD is a token of a failed model and will weaken as the hike cycle resumes
One king
 There's only room for one king in this crude new world. Photo: iStock

By Steen Jakobsen

It’s time for this year's final update of our forward looking model for 2016. We present The Primitive Economy, the crude economic model we are now reduced to following after years of poor policy responses from central banks and a marked lack of reform by politicians. 

In The Primitive Global Economy all future scenarios are driven by one factor and one factor only – the direction of the US dollar.

Since the Great Financial Crisis total global debt/GDP has increased by 17 percentage points, that’s a cool $57 trillion of new debt – most of which is denominated in US dollars and was mainly raised by emerging market countries including China.

The selloff in emerging markets was really a huge margin call on USD debt – as emerging market currencies collapsed 20%,30%,40% and even in some cases 50%, the debt burden rose despite "lower yields for longer" being the operative policy response.

Faced with an uphill struggle to repay debt emerging market reduced their investment and capex, in the process reducing the export orders for global export names in Europe and the US. 

The stronger dollar not only made the debt harder to repay but through inverse correlation to commodity prices it also reduced the price of oil, metals and agriculture turning the “excess savings” from China, Saudi Arabia, Norway, Mexico and Brazil into deficits.

The net impact of lower global reserves being recycled has meant the cost-of-capital, COC, has risen 100 basis points for the lowest investment grade and 700 bps for junk rated entities.

HY ccc

Note how the low in spread was all the way back in June/July 2014
The correlation between lower reserves and higher yield is seen here through an excellent chart from Zerohedge:
Capture Note: Please observe right hand scale is upside down – higher is lower yield.

This tailwind for lower yield has in academic papers been put at an average of 100 bps discount over the cycle, i.e. yields, COC, has been 100 bps lower than without the recycling. This process will continue to drive the marginal cost of capital up with or without the Fed hiking rates in December.

Maybe it’s time to look at the primitive model used by policymakers:

The “game” is as follows: In an environment of ever higher debt forcing down growth, policymakers (read: central banks) lower COC to “float” asset values. The low yield makes the forward looking value of asset go up and voila! The world is “rebalanced” again. The problem, of course, is that the model is based entirely on collateral and the value of collateral is built on its present price but also its quality.

I just showed you how the junk bonds spread has risen to 1,400 bps from 700 bps in less than two years – does that make the “quality” better or worse? Worse, of course, and this before the Fed has even confirmed its ‘liftoff’ in rates.

What we have here is an extremely primitive economy. No one can tolerate a stronger USD as it reduces future growth, excess savings, commodity prices and productivity……..and it happens at a time where there are major paradigm shifts about to happen:

  • Fed feels forced to hike – December is now 60% likely as the starting date for liftoff – reversing seven years of easier monetary policy.

  • Global ‘dis-savings’ are offsetting the stimulus by the European Central Bank and the Bank of Japan.

  • Asset quality is under attack as disinflation/deflation, a strong dollar, and commodity prices remain near multi-decade lows (high for USD). Both the earnings power needed to pay the debt but also the price of carrying the debt is working against the collateral value of the “asset” – Elementary, Dr. Watson!

These are the monetary trends, but probably under reported is the fact that Fed, and certainly the Bank of Japan, are starting to think differently about the concept of “lower for longer…”

How did we get here?
BoJ, Fed, ECB
 Adjust your expectations.... Montage: iStock

Let’s do a rewind on how and why we ended up with this misfiring forward guidance by the Fed, the central banks of the UK, Japan and the Eurozone – the "go to" recipe when reaching zero bound interest rates.

The whole strategy of Ben Bernanke and his Fed was based on a 2003 paper by Gauti Eggertson (IMF) and Michael Woodford (Princeton University) called: "The zero bound on interest rates and optimal monetary policy" – the conclusion from the paper is included below:

lower for longer...

The concept “lower for longer….” was born!

Now however, the latest “manna” on the mountain is a new paper published this autumn by the Brookings Institute's Joshua Hausman, University of Michigan and the National Bureau of Economic Research, and Johaness Wieland, University of California and NBER titled: "Abenomics: An update".

The conclusion is not surprising to people on the main street but it seems to have changed at least for now BoJ’s appetite for more stimulus!


Policymakers are always looking for an academic “anchoring” of their policy. This paper cements the position which both Mario Draghi, Ben Bernanke, and now Janet Yellen continue to promulgate: Monetary policy can’t work on its own without support from fiscal policy!

Now how does this change the policy response? Clearly the US is not going to get a big fiscal push one year ahead of the next presidential election and recently in Japan the market has been surprised to see Bank of Japan talking about corporate tax cuts instead of reacting to lower than expected inflation and GDP by doing more money printing.

The central banks are simply doubting the effect of low yields on the economy and are beginning to acknowledge, academically – but still ignoring publically – the unintended consequences of an economy where the allocation of capital is deficient in its root (not allocating to the principle of marginal cost of capital – and almost exclusively through a “planned” economy process) and extremely inflationary on the assets.

This is a dangerous position. The value of the asset is now not only deteriorating due to less quality (smaller earnings power, deflation/disinflation, strong USD, and price of capital) but also through an inflationary jump in valuation based on “lower for longer…” necessitated to balance out the debt (as per the chart above).

The 2003 paper simply was an entry only — a one-way street. There is not an orderly exit unless …… you get a weaker dollar, higher productivity, a technology breakthrough or an economic model allocating money according to my good old Bermuda Triangle of economics (stop supporting the 20% of the economy (listed companies and state owned companies) and instead focus on the 80% of the economy (the SMEs which create 85% of old new jobs and 95% of all productivity). 

A highly unlike event in a political world of non-accountability and ignorance of everything economic.

Of all the listed things which can unwind/mitigate the inflated collateralised asset bubble the lower USD not only seems the “path of least resistance” but also both the most likely and the cheapest.

How can a cheaper USD coincide with a Fed starting to hike interest rates?

Well, the fact is the USD is inversely correlated to the direction of US interest. In four out of the last five Fed hike cycles the peak of USD value has happened around the first hike – actually I seem to remember reading a paper arguing that the peak of USD statistically comes on average 33 days before the first hike!

What to expect for 2016

Yes, the primitive economy have reduced us to have one answer only to all questions regarding the future of financial markets: The USD......or more precisely the future direction of the USD.

 For the year ahead – first long, then short. Pic: iStock

As we leave 2015 I see these major changes to the macro environment as a conclusion to the above:

  • Be long USD into the first Fed hike – the first Fed hike is your catalyst!

  • Be short USD post the initial hike. Mainly vs. AUD and commodity based emerging market currencies (go short EM market currencies and markets that have benefitted the most from lower energy).

  • Monitor closely the spread between lowest investment grade bonds and junk bonds. The spread should continue to widen as asset quality weakness will increase supply (and downgrades from investment grades) creating a shortage of investable paper. Corporate debt implosion is a fat tail event which needs to be monitored!

  •  Expect attempts to restart fiscal expansion by governments and probably most likely in the “infrastructure space” – I expect to see big increase in public/private projects where private money funds public investments through guarantees issued by governments. Please see this excellent read on why, how and how much is needed from the FT’s John Auther: Infrastructure: Bridging the gap.

  •  Be tactical long government fixed income post the first hike from Fed as it will kill the weak growth in the US setting up a flirt with negative QoQ GDP from Q4 into Q1/Q2 – but respect that this is the final move down in yield before the combined compounded forces of the above will force rates up. 

A trader could be long government bonds, but an investor will stay out as the cycle low is in place. The low will in history be June/July 2014 and the confirmation will be the first Fed hike. The commodity cycled peaked in 2011 – we now nearing the point of both price and value being attractive – use this to average into commodities and EM currencies over next six months.

Fed cycles

Source: Historical lessons from Federal Reserve rate-hike cycles, Allianz Capital

We are also a full cycle from the collapse in real estate prices in 2007/2008 but to my horror I have recently found out this week while in Madrid that the Spanish banks now again offer mortgages at 113% of price! Yes, it’s a good thing EU/ECB bailed out the Spanish banks!

Spanish banks

We never learn from history and Yes, reducing the burden of debt is the only remedy for getting back to “normal”…..

Strategy for Q4-2015 into low in Q1/Q2-2016

By Q1/Q2-2016 we will have seen the low in:

Inflation and yield, emerging markets, gold, silver, platinum, growth, energy, CAPEX and investment.

And the high in:

USD, asset quality, non-performing loans, bank earnings, dividends and buy-backs.

new model

Over time, the market tends to move along the path of least resistance but recently economic gravity, the business cycle, was suspended for a full cycle through “lower for longer…”

Finally, it seems the full price of misguided policy has compounded into a very primitive economic model. One where no one benefits from a stronger USD. Hence the path of least resistance becomes a weaker USD.

Fortunately, the weaker USD in the cards, not only through its historic tendency to peak simultaneously with the start of a rate hike cycle but also through all the process explained above, the biggest take away from this in the next decade will be that China and the US will have to share the global leadership – the US through having the biggest and deepest capital markets, and China through its excess savings and growth. 

The RMB will be a top five traded currency by 2020 and the lesson from the expensive experience of the margin call on emerging market debt will be a driving force for more local funding and deeper capital markets throughout the emerging markets. Little was learned in 1997/98.

Yes, I call for the end of USD dominance but not for the end of the US. No one ever made money from selling the US short, but their currency is now a token of a failed model and reducing the indirect help the US has gained from being global reserve currency is about to help improve the US incentive structure to reform and start a proper infrastructure and productivity drive. Cheap money did not do the job.

The world has changed dramatically on the micro level, but trust it’s for the good of things.

2015 will in history be the end of an era of too much macro and too little micro – maybe there is still time for me to get that Noble Prize in economics for my Bermuda Triangle of economics theory?

Nah, unlikely – don’t forget the Nobel Prize in economics is instituted by the Swedish Riksbank and I don’t expect any favour from the Swedes, especially as we are about to face off to quality for the European Championship in football.

Safe travels,

Steen Jakobsen

– Edited by Clare MacCarthy

Steen Jakobsen is chief economist and CIO at Saxo Bank

Gord Vancouver Gord Vancouver
Comprehensive, insightful, and very helpful as always Steen. Not only for me and my Baby Boomer peers but also for our children which have already begun to show (eg., elections in Canada, Portugal and obviously elsewhere) that enough "macro meddling" is enough (and doesn't yield any substantial changes for most citizens anyway because only life-employed bureaucrats and their favored few get first dibs) and that micro level changes, effort, and innovation are what will prevail (albeit sometimes through some very trying times). A great read as always!
Steen Jakobsen Steen Jakobsen
Gord - you too kind - ty


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