In PIMCO’s Cyclical Outlook published last week, we highlight the importance of three swing factors (the “three C’s”) for the global economic and market outlook: China, commodities and central banks. While our baseline view is for relatively calm C’s ahead, it is easy to imagine different shades of darker or brighter economic and market outcomes depending on different paths for the three C’s, and this calls for a careful approach in portfolio construction.
In fact, developments in each of the three C’s over the past week highlight the fragility of the global macro environment and call for some near-term tactical caution. Commodities were weaker across the board, several Federal Reserve speakers raised the specter of a near-term rate hike potentially as early as April, and China’s central bank allowed its currency (the CNY) to weaken by almost 1% against the U.S. dollar (USD) over the past week – the most since early January, when a 1.1% depreciation sparked a major risk-off move in global financial markets.
These developments are interrelated. As I see it, what sparked last week’s risk-off move in commodities, equities and credit and the weaker CNY fixings was the concerted effort by Fed speakers to correct an overly dovish interpretation of the 16 March Fed statement, press conference and downwardly revised “dot plot” of participants’ appropriate policy rate paths. As a consequence, the USD strengthened last week, which helped push commodities and other risk assets lower. And with the dollar appreciating against the yen and the euro, which together have a similar weight in China’s reference currency basket as the USD, China allowed the CNY to depreciate more rapidly versus the USD.
So are we already seeing the demise of what I have called the “Shanghai Co-op,” a tacit agreement among the major central banks struck at the G-20 summit last month to stabilize the USD in broad ranges? I favor a more benign interpretation: The Shanghai Co-op is about preventing both excessive strength and excessive weakness of the USD. The former poses problems for China, dollar-debtors in emerging markets, and U.S. manufacturing, while the latter is undesirable for Europe and Japan, which are still struggling to overcome persistent disinflationary pressures. Euro and yen strength in the weeks before last is likely to have raised some concerns in Tokyo and Frankfurt about excessive currency strength.
So the good news is that a less dovish Fed reduces the need for the European Central Bank and the Bank of Japan to push interest rates more negative, which could have adverse consequences for the financial sector and raise “currency war” fears again. Yet, the flip side of the coin is that a more hawkish Fed and a strengthening of the dollar could lead China to allow more rapid CNY depreciation, as we saw last week.
Clearly, the global macro environment remains fragile. The Shanghai Co-op has more work to do to soothe markets.