Many of Wall Street’s tired cliches harken back to traders’ hard-drinking days.
‘The Fed is the straw that stirs the drink’, or ‘the Fed’s job is to take away the punchbowl just when the party gets going’, are but two such adages. And perhaps in the spirit of a barroom brawl, young traders are admonished to never ‘fight the Fed’.
It is no accident that each of those sayings invokes the image of an almighty Fed. But is it really true that the Fed’s actions are all that matter? Might it be worth paying heed to what is going on elsewhere, for example in China? In what follows, we suggest that diversifying perspectives makes sense.
To be sure, we are not diminishing the Fed’s importance. The US central bank remains primus inter pares (first among equals), when it comes to whom the markets watch.
And for good reason. After months of battling bond market fantasies of a Fed ‘pause’, or a ‘pivot’ to rate cuts, the Fed finally succeeded last week in bending the markets’ psychology to its will. Rare hawkish unanimity from Fed speakers, underscoring the need for ‘higher for longer’, coupled with a nasty personal consumption expenditures inflation print on Friday, forced markets to capitulate. By week’s end bond yields had risen to their highest levels since November 2022, and expectations for Fed rate cuts in 2023 had evaporated.
Meanwhile, the impact of rising US bond yields rippled across global markets. Equities, crude oil and industrial metals prices sagged, while the dollar soared.
The Fed reigns supreme.
Or does it?
A fascinating working paper written late last year—by no less than a team of Federal Reserve economists—suggests that global financial markets may enjoy a second drink, stirred by a different straw called China.
On the surface, that seems straightforward. After all, China is the world’s second largest economy and a huge buyer of raw materials. Changes in China’s economic trajectory induced by changes in its macroeconomic policies ought to have significant impacts on the world economy and, by extension, on capital markets.
- To be fair, the ‘punchbowl’ reference is ascribed to William McChesney Martin, Jr. during his two-decade stint as Fed Chairman from 1951-1970.
- Barcelona, W. et al, ‘What Happens in China Does Not Stay in China’, International Finance Discussion Papers, Board of Governors of the Federal Reserve System, November 2022 can be found at: https://www.federalreserve.gov/econres/ifdp/files/ifdp1360.pdf
But it has been fiendishly difficult to support that conclusion using China’s official data. The problem, as the Fed economists point out, is that those data are poor and, above all, under-report the ups and downs of China’s economy. In that regard, they join a legion of private sector economists who, for decades, have developed proxy measures for China’s GDP in order to better understand its economy.
By adjusting China’s dubious official GDP statistics to what they believe is a better representation of its economy, the Fed economists are able to provide plausible evidence that spillovers from China’s economic policies have significant impacts on global financial markets.
The Fed economists also make a second important contribution, noting that in China the distinctions between monetary, fiscal and regulatory policies are blurred. Hence, attempts to trace changes in Chinese central bank policy rates on domestic or international economic activity have generally been fruitless.
Instead, they argue that China’s credit impulse—the rate of growth of lending relative to GDP—better captures the aims of the combined efforts of policymakers in Beijing. Using that measure of policy stimulus, the authors are able to find statistical fits between China’s policy stimulus and global economic outcomes. Lastly, they point out that financial markets respond to China’s policy moves not only because of their impact on growth or profits, but also because of their impact on risk premiums.
So, why might this matter today? Well, for one, last month China’s credit growth surged to its largest monthly gain recorded in the past half dozen years. That outcome is no accident. It follows clear statements from China’s policy makers about boosting GDP growth in 2023.
Consistent with the Fed paper’s findings, markets inside and outside China are already reacting. In the final three months of last year, for example, Chinese corporate credit spreads rapidly collapsed to pre-pandemic levels, as enthusiasm about policy easing emerged. Similarly, prices of copper and iron ore, two metals for which China has a voracious appetite, have risen sharply since November 2022. China’s main stock indices have also been on a tear.
Sceptics, however, are right to wonder if China’s credit impulse will have as powerful a global impact as in the past. Might the Fed’s analysis, based on historical experience, be compromised by today’s realities?
The chief reason for skepticism is China’s property bubble. In the past, urbanization was the primary destination for credit growth. After decades of hellbent construction, excesses are evident, particularly via falling house prices. Indeed, over the past nine consecutive months prices of new homes in China’s 70 largest cities have been on the decline.
In short, legacy debt and investment excesses may dampen the response of China’s growth to credit this time. But another important factor is at work—the end of China’s zero-Covid policy. Here, the impact is likely to resemble a ‘J-curve’ in the data. During the initial phase of reopening, mass infections and deaths have probably hampered the return to work and to spending for many Chinese. Growth may have even faltered. But as infection rates peak and China learns to live with the virus, production and spending are apt to surge. Similar to elsewhere, Chinese are eager to normalize their lives.
Thus, a positive credit impulse is likely to coincide this year with a surge in pent-up demand, leading to a significant acceleration of China’s GDP growth. Most observers believe China will post growth in excess of 5% or even 6% this year, easily topping last year’s 3.0% rate (which was probably overstated in the unreliable official accounts).
Crucially, Beijing welcomes a surge in demand. Owing to last year’s draconian lockdowns, economic activity has been subdued and inflation is quiescent, with ‘core’ inflation near 1%. Unlike the US, China can afford to stimulate growth, and it has signalled that it will do so.
And so it is, that in 2023, the market’s favorite watering hole now serves two drinks—one made in America and the other made in China, each with its own straw. At the western end of the bar, it is a strong mix of rate hikes, recession fears, and weakening corporate profits. Down at the eastern end of bar, liquidity is more plentiful and is sweetened by growth and the promise of positive profits surprises.
Belly up.