The four macro heartbeats of global finance in 2018
By Matein Khalid
Published: Sun 14 Jan 2018, 4:12 PM
Last updated: Sun 14 Jan 2018, 6:15 PM
When I first started on a Treasury bond futures trading desk in New York fresh out of Wharton, a senior mentor once advised to keep track of the 4 heartbeats of gold finance in real time. The price of money (interest rates), the price of currency (the US dollar), the price of oil and the price of gold.
The price of money can be expressed by the 2-year and 10-year US treasury bond yield curve. The 2-year treasury note is 1.99 per cent while the 10-year Uncle Sam note is 2.55 per cent. The US economy is at or even beyond full employment with the jobless rate at 25-year low and consumer confidence at 15-year high. Trump's tax reform will kick start economic growth and a new capex cycle that could easily mean 3 per cent GDP growth in 2018. There will also be a regime change at the Federal Reserve as Jay Powell becomes chairman of America's central bank in March.
The Federal Reserve will impact global financial markets in 3 critical ways. A rise in wage inflation above 3 per cent will cause the Powell Fed to raise rates more than the planned three times in 2018. The Fed is also scheduled to reduce its balance sheet by $470 billion as quantitative tightening accelerates. Powell and Trump's Treasury Secretary are also both proponents of aggressive bank deregulation on Wall Street.
My call? The yield on the 2-year treasury note could rise 100 basis points while the yield on the 10-year treasury note rises 50-70 basis points.
The result? The flattest yield curve in decade. If the treasury yield curve inverts (short rates are higher than long rates), a US recession could be possible in 2019. This scenario is catastrophic for global equities and risk assets.
The price of currency is another dilemma facing global investors. The US dollar index fell 10 per cent in 2017 as Europe's GDP growth accelerated, the National Front did not win the French election and China did not have a hard landing, the catalyst for an epic rally in Asian/emerging markets.
Yet foreign exchange is all about relative economic growth, relative central bank policies, and relative fund flows. The ECB does not want a surge in the Euro much above 1.20 as the EU is an export colossus. ECB President Draghi is only expected to begin scaling back debt purchases in September and the Italian election could well lead to a leftist, populist Five Star government. In short, King Dollar could well be resurrected in 2018 as the Euro falls to 1.06. Sterling, as always, is a play on Brexit, Westminster politics and the monetary mandarins of Threadneedle Street.
The unrest in Iran, Opec's third largest producer, adds an ominous dimension to a geopolitical supply risk premium, elevated due to events in Libya, Nigeria, Iraqi Kurdistan and Venezuela. The Saudi-Russian output pact will continue in 2018 as strong global growth boosts distillate demand. I can envisage Brent trading in a $60-70 range. If Iran's oilfield output is impacted by strikes, the world could well face its biggest supply shock since October 2011, when Nato bombing and a local militia revolt led to the collapse of the Gaddafi regime and the lynching of the "Comrade Colonel". Brent traded at $128 as Libyan output plunged to near zero.
However, the surge in West Texas above $62 means a rise in US shale rig counts and output. US output could well hit 10MBD in 2018. Every oil boom creates the seeds of its own destruction, a bitter macro lesson I learnt the hard way in life. I am impressed that gold has managed to rally to $1,325 an ounce despite the outlook for sharply higher US Fed interest rates. Of course, gold has been a disaster as an investment in the past decade, down from its September 2011 high of $1930.
So why is Auric above $1,300? One, wage inflation risk. Two, geopolitical risk sin the Middle East, notably in Iran and North Korea. Three rising jewellery demand in Asian emerging markets. Four, a delayed reaction to the US dollar index's 10 per cent fall and Dr. Copper's 30 per cent rise in 2017. Five, a cheap hedge against an overvalued Wall Street. Six, Brent's double bagger since its $28 bottom in 2016.
Is gold sending us an inflation SOS? Not yet - but if the yellow metal hits $1,500 an ounce (it will not in 2018), all bets on inflation are off and the world has changed.