Morning Commentary: Nothing is Free

Foreign Exchange - Morning Commentary
Nothing is Free
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
Yesterday, the Fed kept its policy stance unchanged and stated that Congress will need to spend more and that now isn’t the time to worry about the debt.  In a similar vein, the ECB will offer new long-term loans and stands ready to increase its asset purchases as euro area GDP craters (see bullet point #1 below).  

The reality remains that policymakers around the world have the unenviable task of choosing between two bad choices: allowing the economy to plunge into depression or spend their way out of it.   Based on the tsunami of stimulus spending, policymakers have resoundingly chosen the latter option.  The big question now is how high can government debt climb before it’s an issue?  

As with most complex questions, the answer is that it depends.  In a country like Argentina with a history of defaults, any hint of eroding fiscal discipline sends investors rushing out the doors.  This raises borrowing costs and forces an organized or disorganized default. 
Conversely, a country such as the US, that is the center of global capital markets and has a long history of repaying debts, gets a lot more leeway.  Also working in the US’s favor is the USD’s status as the ultimate safe haven.  China’s yuan is too illiquid and the markets are too opaque.  The euro suffers from questions around its long term sustainability and markets in the UK and Japan are too small.  These two factors give the US a high capacity to borrow.  

A look at historical episodes of stress shows the following: through repeated government shutdowns, the financial crisis in 2008-9 and recent attacks on Fed independence, the risk premium in the treasury markets remain nonexistent.  But, there is no free lunch.
Heavy government borrowing normally risks “crowding out” of private investments, a risk lessened by a deep recession.  But during a recession, heavy government spending does reduce market efficiency.  Ultimately, the government, not markets, is picking winners and loser.  Case in point, the enhanced unemployment insurance pays many unemployed workers significantly more than they were earning while employed. This, by definition, distorts the allocation of capital away from what would be the optimal allocation under a free market system.  

All of this suggests an obvious conclusion: the quicker the economy can get back to normal, the better.  There is a clear trade-off between social protection and encouraging risk taking, and this has been distorted.  Politicians need to find the right balance and rediscover fiscal discipline.
  • Euro area GDP suffered sharp losses with the pain evenly spread out among the countries.  France, Spain and Italy contracted -5.8%, -5.2% and -4.7% QoQ, respectively.  These numbers are not annualized.  For example, if France’s number was annualized, the drop would be over 20%.  ECB President Lagarde has stated that a -15% Q2 contraction in Europe is possible.     
  • Germany’s jobless claims came in at a record high of 373K claims and illustrates that while job protection programs can help control the damage, COVID-19-associated disruption is inevitable. 
  • US jobless claims came in at 3.84 million claims.  While this number is an improvement on last week’s number, and continues a downward trend, it still represents a historically large number of claims.  This week’s print brings the 6 week pandemic total to over 30 million jobs.   Next week brings the US nonfarm payroll report where 22 million jobs are expected to be lost with the unemployment rate rising to 16.3% from 4.4% prior.  
  • Chinese manufacturing PMI fell to 50.8 from 52.0 last month and non-manufacturing PMI rose to 53.2 from 52.3 last month.  The rise in non-manufacturing PMI represents the re-opening of China’s economy while the fall in manufacturing PMI reflects continued demand weakness as countries around the world remain in lockdown.  
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