U.S. and the world, or is it the other way around?

Dünya Executive - - BUSINESS - Gunduz FINDIKCIOG­LU Chief Economist

The Fed will take into considerat­ion the possibly negative impact of trade wars on the U.S. economy and the likelihood of EM meltdown. Hence, interest rates will be raised sequential­ly. Since the Fed is independen­t, whatever message conveyed by Mr. Trump is ignored, as we have seen once more. Pen in 1 + 3 hikes until end2019, which means 3.25 percent. Since there are at least two more urgent problems here, the unstoppabl­e change in the direction of Fed monetary policy comes second now. Neverthele­ss, I think syndicatio­ns will be rolled-over at around 100 percent, albeit with an at least 1.5 percentage points (visible) cost increase. At that point, Fed balance sheet changes and rate hikes will become a key variable again, even among local plays here. The other problem, i.e. the private sector’s FX debt, is waiting for a solution. The idea that the U.S. yield curve reversion, should it occur, would bring the Fed’s march to a halt seems unfounded now, especially given that the U.S. budget is in deficit – $900 billion until the end of the year - and the Fed is still selling securities at a speed of $50 billion a month. So, the U.S. has to incur debt anew, and the market rates are still too low to be equilibriu­m rates. Remember that 10-year U.S. Treasuries were carrying 4.3 percent

right after Lehman.

U.S. nd cators

Very good indeed. Not only employment, but also core PCE and durables orders, in addition to retail purchases, all point in the same direction. The U.S. economy is not set to slow down anytime soon. It is in the middle of its cycle. As such, looking at the diffusion across sectors and personal expenditur­es, I wouldn’t bet on the likelihood of the Fed coming to a halt in H1 2019. One thing is clear though: The U.S. yield curve risks becoming inverted unless 10-year Treasuries go up before the next two FFR hikes and adjust thereby, or the Fed stops hiking its FFR. The flatness of the curve is a danger because in the past, the 3-month LIBOR to U.S. 10-year spread running negative proved to be a sign of recession. Although a remote possibilit­y for now, many reports directly or indirectly state such a likelihood isn’t zero. Already the BIS, the WB Outlook and a recent PIMCO post conveyed such concerns. This is still a possibilit­y, but a remote and weak one. True, unless the yield curve becomes more normalized, there will always be a non-negative probabilit­y that the propensity to lend would be lower with an inverted curve as banks’ maturity transforma­tions will be curtailed. This is what might trigger a normally unanticipa­ted economic slowdown. Hence, intelligen­t and risk-averse analysts hinting at that possibilit­y aren’t entirely on unsafe grounds. Neverthele­ss, a PCE to consumer durables to non-food retail orders growth rates comparison has yielded a stabilizat­ion picture recently, but in the last decade the margins have widened all too often. We would like to note that in 1937, the economy was already on its way out of the depression but there was a temporary setback, a one-off mini-recession embedded within the picture. Such things happen because of monetary policy misalignme­nt. The Fed wouldn’t do that in reverse. I still conjecture that the possibilit­y of U.S. 10-years going up further – a normal outcome that is currently withheld from happening due to the return to safe haven behavior - would give way to a very unpleasant monetary arithmetic. Already TRY interest rates are high, inflation is still below its peak, and everything hangs by a thread. With U.S. 10-years going up to 3.25 percent only to climb further to give enough slack to the approximat­e three percent (2.9 percent?) new neutral FFR and the long end’s margin – hence resting above 3.50 percent eventually - the real rates of interest in terms of EM local currencies will have to adjust quasi-automatica­lly. The impact won’t be a mere 50-100 basis points. So, although I don’t see any need for further TRY policy rate hikes at this juncture, I am holding the view that a rapid comeback won’t be easy; high TRY rates will stay with us for at least two quarters longer. The only factor that might contain interest rates would be the fact that banks are not engaging in deposit collection wars because they don’t need extra funding; the loan demand is low. We should note that in Turkey loan growth is demand-driven most of the time. Causality runs from demand to supply with a two-quarters lag in a window of five years. Since earnings can’t catch up with high inflation, real earnings will drop in 2019 unless there is full backward indexation, which is impossible in my opinion. All the demand there is will come from corporates in dire need of operating capital, hence the recent reductions in VAT and

special consumptio­n tax rates and other reliefs. They not only aim at addressing the household debt issues, but primarily they aim at generating liquidity for firms. In consumer durables, for instance, spot or secondhand markets work well now because most households are constraine­d to keep even their necessary expenses at a minimum. Same for the car market.

Swaps and the y eld curve

The impact of Fed interest rate and liquidity management policy moves on EMs looks asymmetric in the sense that tightening has more of a marked adverse effect on EM capital inflows than loosening. However, as a recent CBRT study implies, the share of an EM country is a better measure of its vulnerabil­ities. The flow of funds can decrease overall but a specific country can manage to attract a larger share out of a shallow pool. The Fed fund’s futures offer a natural candidate with which to estimate the impact of the Fed’s future policies. As the expectatio­ns channel appears to be the main spillover channel, all expectatio­ns-related phenomena – politics, business conditions, rule of law, Central Bank independen­ce etc. - turn out to be crucial in securing a satisfacto­ry flow of funds in a world of tightening. The policy rate is perhaps key but this metric is not a sufficient statistic by itself. Now consider the curvature of the TRY yield curve and loan growth. If it is correct that the level is a long-term factor associated with inflation and the slope co-varies with the business cycle, then it may be that the curvature of the yield curve is associated with financial conditions. It is related to the cycle also. Domestic financial shocks matter more than they did in the past compared to inflation shocks, and weigh on the yield curve’s curvature, which in turn may have a bearing on its slope. A recent CBRT study estimates the swap yield curve through Nelson-Siegel. This we also find very promising because the Turk- ish banking sector has not only relied on ‘on balance-sheet’ external funding but also off-balance sheet contracts – mostly cross-currency swaps - reaching $50 billion. The fitted zero-coupon swap rates and forward implied (exchange) rates coincide largely, meaning it is possible at least to make some inferences based on the swap curve. Now this can be important because swaps are a crucial vehicle through which banks lend long-term, as in mortgages. On this front, the developmen­t of the USD/TRY swap curve since mid-August has been promising, as underlined by the CBRT last week.

Banks are st ll key here

Turkish banks are keystones of every boom and bust cycle. Because real loan growth and real GDP growth go hand-in-hand over the long-run, it is imperative that banks should always be well-capitalize­d. Non-bank finance is almost insignific­ant and the financial system is clearly bank-dominated. This is all the more so because the spread between global output and global trade varies much. It is now positive, i.e. trade is growing faster than output. However, the trade wars will likely change this relationsh­ip. There will be negative spillover effects. Relying on exports doesn’t seem an option at this stage. Furthermor­e, any harm to be done to the U.S. economy as a result of the trade war is unlikely to stop the Fed. Already, there is repatriati­on of flows, and this is what kept the 10-year U.S. Treasuries below three percent. It wasn’t sustainabl­e, of course. The risk indicator and spread movements have become complicate­d and hard to interpret lately. The BIS reports that T-bill yields drove the LIBOR-OIS spread, a fact generally seen as a sign of funding stress, as we already signaled a few months ago. However, this time around neither the CDS nor the CCB spreads widened, a fact amenable to explanatio­n by repatriati­on-cum-U.S. Treasury issuances due to tax reform and lower USD-hedging demand. That is, the spread between U.S. 2- and U.S. 10-years narrowed through shortterm issuances and repatriati­on but as the dollar interest rates went up, demand for dollar-hedging fell. Similarly, Asian dollar holdings dropped. I reiterate that the shape of the U.S. yield curve could still be deceptive. Negative term premia could indeed be conducive to a steep rise in long-term U.S. Treasury yields, and that is what matters most for EM credit pricing.

Amer ca, Stackelber­g and the Post WWII per od

There are many instances of sudden belief changes, or ‘belief cascades’, strategic voting, and grand coalition formations in American political history. Did Trump’s victory correspond to any of them? I am not sure but it seems clear to me that Trump won the electoral college not by a fluke; there was something of a rational kernel in the behavior of both part of the polity and the electorate. Excesses and fluctuatio­ns all too often observed by the public at large are due more to the style of leadership than its essence. The containmen­t of China is not a novel idea either. The reversal of strategy vis-à-vis Iran could also be anticipate­d to a certain extent. The short-lived peak of the new Cold War against Russia may be over, but the normal coldness continues nonetheles­s. That Iran has to be driven out from Syria and cornered in the wider Middle East is a sine qua non for Israel if Bashar Assad is to stay in power in the western part of Syria. Otherwise, brokering an even temporary peace may not be possible. Hence, the U.S. trade war with China is here to stay for a while, the other facet being coming to terms with Europe. The Iran issue is also serious in that it is a counter-Obama Doctrine initiative. There is a chance that Trump is put under further pressure after the fall elections, but these two moves are more likely to be shored up by the American polity than not. They will have enduring consequenc­es in the years to come.

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