Global and international Archives - CC&L Financial Group Ltd.

Global six-month real narrow money momentum – a key indicator in the forecasting process followed here – is estimated to have moved sideways for a third month in June, based on monetary data covering 85% of the aggregate.

Real money momentum has recovered from a September 2023 low but remains below both its long-run average and the average in the 10 years preceding the GFC, when short-term interest rates were closer to recent levels – see chart 1.

Chart 1

Chart 1 showing G7 + E7 Industrial Output & Real Narrow Money (% 6m)

The expectation here has been that the fall into the September 2023 low would be reflected in a weakening of global industrial momentum into late 2024. DM flash PMI results for July support this forecast, implying a fall in global manufacturing PMI new orders from 50.8 in June to below 50, assuming unchanged readings for China / EM.

Chart 2

Chart 2 showing Global Manufacturing PMI New Orders & G7 + E7 Real Narrow Money (% 6m)

The stalling-out of real money momentum at a weak level suggests that economic expansion will remain sub-par in early 2025.

Global six-month industrial output growth, meanwhile, recovered in April / May, crossing back above real money momentum – chart 3. The implied negative shift in “excess” money conditions may partly explain recent market weakness / rotation.

Chart 3

Chart 3 showing G7 + E7 Industrial Output & Real Narrow Money (% 6m)

Global six-month real narrow money momentum was held back in May / June by weakness in China and Japan, discussed in recent notes. A US slowdown is a risk going forward.

A note in February argued that expansionary deficit financing operations – “Treasury QE” – have more than offset the monetary drag from Fed QT. Specifically, the Treasury relied on running down its cash balance at the Fed and issuing Treasury bills to fund the deficit in H2 2022 and 2023. The former represents a direct monetary injection while bill issuance is likely to expand broad money because bills are mostly purchased by money funds and banks. (A recent paper from Hudson Bay Capital makes a similar point, referring to variations in the maturity profile of debt sales as “activist Treasury issuance”.)

The February article and an update in May, however, noted that Treasury financing estimates implied that the six-month running total of Treasury QE would slow sharply in Q2 and turn negative in Q3. With Fed QT continuing, albeit at a slower pace, the joint Treasury / Fed impact on broad money was on course to become significantly contractionary.

Treasury QE has fallen as expected and the joint contribution has become negative – charts 4 and 5. Six-month broad money momentum has yet to slow significantly, although three-month growth in June was the weakest since November. Money momentum lagged when the joint impact swung from negative to positive in late 2022 / early 2023.

Chart 4

Chart 4 showing US Broad Money M2+ (6m change, $ bn) & Fed / Treasury QE / QT (6m sum, $ bn)

Chart 5

Chart 5 showing US Broad Money M2+ (6m change, $ bn) & Sum of Fed & Treasury QE / QT (6m sum, $ bn)

The approach here places greater weight on narrow than broad money for short-term forecasting. A US broad money slowdown, in theory, could be accompanied by stable or stronger narrow money expansion, for example if rising confidence leads to an increase in broad money velocity, with an associated portfolio shift into demand deposits. Such a scenario, however, is less likely the longer the Fed delays significant rate cuts.

The slowdown in Treasury QE explains a reversal lower in US bank reserves since April – chart 6. The prior rise in reserves, despite ongoing Fed balance sheet contraction, occurred because money funds were moving funds out of the overnight reverse repo facility in order to buy newly-issued Treasury bills, with the Treasury reinjecting the cash via the deficit.

Chart 6

Chart 6 showing US Federal Reserve Balance Sheet ($ bn)

Japanese bank reserves are also on course to fall as the BoJ embarks on QT – chart 7. Market speculation is that the MPC will announce a reduction in gross JGB purchases to ¥3 trn per month at next week’s meeting, from an average ¥5.7 trn in H1. With redemptions averaging ¥6.5 trn over the last year, this suggests monthly QT of ¥3.5 trn ($23 bn), equivalent to 2.6% of broad money M3 at an annualised rate.

Chart 7

Chart 7 showing Japan BoJ Balance Sheet (¥ trn)

Chinese money trends are puzzling but ominous, suggesting – at a minimum – that the economy will remain weak through H2.

Q2 real GDP growth came in below expectations but there was better news on the nominal side: two-quarter nominal GDP expansion rose for a second quarter as the GDP deflator stabilised – see chart 1.

Chart 1

This improvement tallies with a recovery in six-month rates of change of narrow money and broad credit around end-2023. Money and credit momentum, however, has since slumped, reaching a new record low in June – chart 2.

Chart 2

A post a month ago noted that money – and to a lesser extent credit – numbers have been distorted by a regulatory clampdown on the practice of banks paying supplementary interest. This has resulted in non-financial enterprises (NFEs) moving money out of demand deposits into time deposits and non-monetary instruments such as wealth management products (WMPs), as well as repaying some debt.

The post suggested discounting narrow money weakness and focusing on an expanded broad money aggregate including WMPs. The six-month rate of change of this measure had slowed significantly but was still within – just – the historical range of six-month broad money growth.

That is no longer the case. CICC numbers on WMPs show an outflow in June. Six-month growth of the expanded measure has converged down towards that of conventional broad money – chart 3.

Chart 3

F/x intervention to support the yuan has contributed to monetary weakness but the effect has been minor. Net f/x settlement by banks – which captures spot intervention using the balance sheets of state banks and other institutions – amounted to CNY590 bn ($83 bn) or 0.2% of broad money in the six months to May (a June number is due this week).

Household money growth, it should be emphasised, is stable and respectable: broad money weakness is entirely attributable to a loss of NFE deposits – chart 4. The puzzle is the destination of the “missing” NFE money. Only a small portion is likely to have been used to repay debt: banks’ short-term corporate lending fell in April / May but rebounded to a new high in June.

Chart 4

The focus of monetary weakness on NFEs suggests downside risk to investment and hiring, with negative feedback from the latter to consumer spending.

An analysis of the Fed’s historical behaviour suggests that the conditions for policy easing are in place.

Chart 1 shows the fitted values and current prediction of a logit probability model for classifying months according to whether the Fed is in policy-tightening or policy-easing mode.

Chart 1

The model’s determination for a particular month depends on values of annual core PCE inflation, the unemployment rate and the ISM manufacturing delivery delays index known at the end of the first week of the month (i.e. after the release of the employment report for the prior month).

The model can be thought of as an approximation of the Fed’s “average” reaction function over the last 60+ years. It correctly classifies 87% of months over this period, i.e. the estimated probability of being in policy-tightening mode was above 0.5 in tightening months and below 0.5 in easing months.

There is no memory effect – the model ignores whether the Fed was in tightening / easing mode in the previous month, only considering the above data series (with no dummy variables for “shocks”).

The dependent variable takes the value 1 from the month of the first rate increase in a tightening phase until the month before the first cut in a subsequent easing phase, and 0 otherwise. So a rate plateau before an easing is still classified as part of a tightening phase (and a rate floor before the first hike part of an easing phase).

The tightening / easing phases were identified judgementally and are shown by the shaded / unshaded areas in the chart. The Wu-Xia shadow rate informs the dating of phases during zero-rate periods since the GFC.

The model estimates the probability of the Fed being in tightening mode this month (July 2024) at 0.23, the lowest value since September 2021. Equivalently, the probability of a start of an easing phase is 0.77.

A fall in the tightening probability from 0.62 in March reflects a 0.2 pp rise in the unemployment rate over the last four months (from 3.9% to 4.1%) and a 0.3 pp fall in annual core PCE inflation (from 2.9% to 2.6%).

The Fed is unlikely to announce a rate cut at the conclusion of its next meeting on 31 July, as this would be at odds with recent communications (although the probability may be higher than the 0.05 implied by market pricing on 11 July, according to CME FedWatch).

The model’s shift, however, suggests a strong chance of a dovish statement teeing up a September move.

Eurozone money trends remain too weak to support an economic recovery. A relapse in the latest business surveys could mark the start of a “double dip”.

Three-month rates of change of narrow and broad money – as measured by non-financial M1 and M3 – were zero and 3.3% annualised respectively in May. Current readings are well up on a year ago but significantly short of pre-pandemic averages – see chart 1.

Chart 1

May month-on-month changes were soft, with narrow money contracting by 0.1% and growth of the broad measure slowing to 0.1%.

Six-month real narrow money momentum – the “best” monetary leading indicator of economic direction – moved sideways in May, remaining significantly negative and lower than in other major economies. (The latest UK reading is for April.)

Chart 2

June declines in Eurozone PMIs and German Ifo expectations may represent a realignment with negative monetary trends following a temporary overshoot – chart 3. A recent correction in cyclical equity market sectors could extend if Ifo expectations stall at the current level – chart 4.

Chart 3

Chart 4

Growth of bank deposits is similar in France, Germany and Spain but lagging in Italy – chart 5. The country numbers warrant heightened scrutiny, given a risk that French political turmoil triggers deposit flight to Germany.

Chart 5

Institutional investors often grapple with the decision to hedge against currency fluctuations for non-domestic investments. A common concern is that currency exposure will increase the volatility of non-domestic equity returns.

This article explores when hedging is beneficial and when Canadian investors can gain from being unhedged.

Are domestic or global equities more volatile?

There is an assumption that investing outside of Canada, with exposure to various currencies and markets, can result in more volatile returns for global equities compared to Canadian equities. However, over shorter timeframes (rolling three-year returns), global equities have generally been less volatile than Canadian equities, although there have been exceptions.

Figure 1: Canadian vs. global equity relative volatility

Source: Bloomberg and MSCI.

Figure 1 illustrates the relative volatility of returns for Canadian equities (S&P/TSX Composite Index) compared to global equities (MSCI World Index unhedged). When the orange line is above 0%, Canadian equities were more volatile; below 0%, global equities were more volatile. The chart highlights that, over short-term periods, Canadian equities have often been more volatile.

Over longer periods (10-year rolling returns) and since the late 1990s especially, global equities have almost consistently been less volatile than Canadian equities (Figure 2), benefitting from a larger and more diversified universe of investment opportunities.

Figure 2: Canadian vs. global equity absolute return volatility

Source: Bloomberg and MSCI.

Does hedging reduce global equity volatility?

Contrary to the belief that hedging is necessary to reduce volatility, historical data indicates that this is not always true.

Figure 3 shows the relative volatility of hedged and unhedged global equity returns over rolling three-year periods. When the orange line is above 0%, hedged returns were less volatile; below 0%, unhedged returns were less volatile. Unhedged global equity returns have generally been less volatile, particularly since the mid-1990s, as currency movements tend to counterbalance equity returns for lower overall return volatility.

Figure 3: Hedged vs. unhedged global equities

Source: Bloomberg and MSCI.

What is the optimal currency hedge ratio?

The hedge ratio, the value of the hedge position relative to the total position value, varies by investor. If a portfolio holds $10 million in global equities and $3 million of the currency exposure is hedged, then the hedge ratio is 30%. While research often points to a 50% hedge ratio as optimal, individual decisions depend on specific currency exposure and risk perspectives. Figure 4 shows two investors with different hedging ratios, but the same net currency exposure.

Figure 4: Same net currency exposure, different hedge ratios

	Currency exposure (a)	Hedge ratio (b)	Net currency exposure (a-b)
Investor 1	60%	50%	30%
Investor 2	30%	0%	30%

Source: Bloomberg and MSCI.

From a risk management perspective, a 50% hedge ratio is sometimes used to manage “regret risk,” the potential disappointment of adopting an unhedged or fully hedged approach that later proves suboptimal.

Figure 5 compares the rolling three-year performance differences between unhedged and fully hedged US equity returns (orange line) to those of unhedged and 50% hedged US equity returns (green line). When the lines are above 0%, the unhedged strategy outperformed, while the fully hedged and 50% hedge strategies outperformed when the lines fall below 0%.

Figure 5: US equity rolling 3-year relative performance

Source: Bloomberg and MSCI.

By design, the return difference for the 50% “regret risk” hedging approach (green line) was less volatile over the period. For some investors, experiencing smaller differences due to currency fluctuations may be preferred.

How should currency be managed in private markets?

There continues to be significant growth in allocations to global private markets, such as direct real estate and infrastructure assets in open-end funds. These less-liquid assets still require careful consideration of currency exposure that can affect their short-term value. Private market investors generally expect income and diversification through absolute returns, which can be materially impacts by currency fluctuation.

Hedging can manage these risks, but an assessment of each investment’s specific factors is necessary. This includes understanding the asset’s underlying revenues and expenses, potential natural hedges, hedging costs and the duration of the hedge. Matching the currency of net exposure with associated financing is also important.

For Canadian investors, relying on the private market investment manager to handle currency hedging is generally the simplest and most efficient way to manage currency risk.

A recovery in the OECD’s US composite leading indicator could be reversing, in which case recent underperformance of cyclical equity market sectors versus defensives could extend.

The OECD indicator receives less attention than the Conference Board US leading economic index but its historical performance compares favourably.

The correlation coefficient of six-month rates of change is maximised with a two-month lag on the OECD indicator, i.e. the OECD measure slightly leads the Conference Board index.

The OECD indicator recovered from early 2023, signalling that recession risk was (temporarily?) receding. The Conference Board index continued to weaken, although the rate of decline slowed.

The latest published numbers show the OECD measure still rising in May. New information, however, is available for four of the seven components. An updated calculation suggests that the indicator peaked in April, with small declines in May and June – see chart 1.

Chart 1

A firmer indication will be available at the end of next week, following release of data on the remaining three components – durable goods orders, the ISM manufacturing PMI and manufacturing average weekly hours.

The suggested stall in the OECD leading indicator recovery has coincided with larger month-on-month declines in the Conference Board measure in April and May.

The price relative of MSCI World cyclical sectors, excluding tech, versus defensive sectors has mirrored movements in the OECD US leading indicator historically – chart 2. A rally in the relative peaked in late March, consistent with the suggestion of an April leading indicator top.

Chart 2

Chinese May money numbers were weak even allowing for a distortion from a recent regulatory change.

The preferred narrow and broad aggregates here are “true M1” (which corrects the official M1 measure for the omission of household demand deposits) and “M2ex” (i.e. M2 excluding bank deposits held by other financial institutions – such deposits are volatile and less informative about economic prospects).

Six-month rates of change of these measures fell to record lows in May – see chart 1.

Chart 1

Chart 1 showing China Nominal GDP & Narrow / Broad Money (% 6m)

April / May numbers, however, have been distorted by a clampdown on the practice of banks making supplementary interest payments to circumvent regulatory ceilings on deposit rates. This appears to have triggered a large-scale outflow from corporate demand deposits.

The April / May drop in six-month narrow money momentum into negative territory was entirely due to a plunge in demand deposits of non-financial enterprises (NFEs), with household and public sector components little changed – chart 2.

Chart 2

Chart 2 showing China True M1 Breakdown (% 6m)

Where has the money gone? The answer appears to be into time deposits (included in M2ex) and wealth management products (WMPs), with a small portion used to repay debt.

NFE demand deposits contracted by RMB3.82 trillion in April / May combined. Their time and other deposits grew by RMB1.14 trillion over the same period. Total sales of WMPs with a term of six months or less, meanwhile, were unusually large, at RMB2.60 trillion, according to data compiled by CICC.

It has been suggested that banks were paying supplementary interest to meet lending targets – the additional payments gave NFEs an incentive to draw down credit lines while leaving funds on deposit at the lending bank (“fund idling” or “roundtripping” in UK parlance). Repayments of short-term corporate loans, however, were a relatively modest RMB0.53 trillion in April / May.

The appropriate response to regulatory or other distortions to monetary aggregates is to focus on a broadly-defined measure that captures shifts between different forms of money.

Chart 3 includes the six-month rate of change of an expanded M2ex measure including short-maturity WMPs. While momentum is stronger than for M2ex – and not quite at a record low – a decline since December 2023 continued in April / May, suggesting still-deteriorating economic prospects.

Chart 3

Chart 3 showing China Narrow / Broad Money with Adjustment for WMPs (% 6m)

The Bank of Japan’s attempt to withdraw policy accommodation is understandable but misguided. Monetary weakness suggests that the economy is on course to return to deflation.

The BoJ’s difficulties stem from the inflationary policy mistake of the Fed and other G7 central banks in 2020-21. Subsequent tightening to correct this error works partly by boosting currencies to export inflation to – and import disinflation from – countries with responsible policy-making, including Japan.

What about Japan’s home-grown inflation? This was minor and is fading fast. Annual broad money growth peaked in 2020-21 at 8.1% in Japan versus 24.5%, 12.5% and 16.0% in the US, Eurozone and UK respectively. Japanese growth was back at its pre-pandemic (i.e. 2010-19) average by end-2022.

A bumper 5.08% pay award in the spring Shunto is an echo of an inflation pick-up driven mainly by a weakening yen. Most workers are non-unionised / employed by SMEs and will receive smaller increases. Falling inflation, slowing profits and a softening labour market suggest a much lower award next year.

The latest money numbers are ominous. Broad money M3 fell by 0.1% in both April and May, following the BoJ’s removal of negative rates in March. May weakness was driven by f/x intervention– record yen-buying of ¥9.8 trillion last month equates to 0.6% of M3.

Annual M3 growth slumped to 1.3% in May, the lowest since the GFC and half the 2010-19 average, suggesting a fall in annual nominal GDP growth below its respective average of 1.2% – see chart 1.

Chart 1

Chart 1 showing Japan Nominal GDP & Narrow / Broad Money (% yoy)

The BoJ, meanwhile, had moved towards QT before the June MPC announcement of a reduction in JGB purchases from July, with gross buying in May well below the run-rate of redemptions – chart 2.

Chart 2

Chart 2 showing Japan BoJ JGB Purchases (¥ trn)

Monetary weakness contrasts with respectable bank lending expansion – commercial bank loans and leases rose by an annual 3.0% in May. The contribution to money growth, however, has been offset by a combination of increased non-deposit funding, reduced BoJ JGB buying and, in May, a fall in net external assets due to f/x intervention – chart 3*.

Chart 3

Chart 3 showing Japan M3 & Credit Counterparts Contributions to M3 % yoy

What should the BoJ do? A monetarist purist would argue for reversing policy tightening and accepting the currency consequences. Likely further yen weakness, however, would prolong current high inflation – a significant cost to balance against the benefit of avoiding a medium-term return to deflation.

The least bad option may be to signal tightening but delay meaningful action in the hope that a dovish Fed shift will lift pressure off the currency soon. This could be a reasonable description of the BoJ’s recent behaviour.

*Note: the counterparts analysis is available through April.

Previous posts suggested that a recovery in US money growth would stall in Q2 / Q3 as Fed QT was no longer offset by monetary deficit financing (at least temporarily).

The broad M2+ measure – which adds large time deposits at commercial banks and institutional money funds to published M2 – fell by 0.1% in April, with available weekly data suggesting marginal growth in May.

Unexpectedly, however, the narrow M1A measure tracked here – comprising currency in circulation and demand deposits – rose by a bumper 1.8% in April. This follows a 1.3% gain in March – see chart 1.

Chart 1

Positive narrow money divergence typically occurs when rates are falling. Lower rates encourage a shift of money holdings from time deposits and savings accounts to demand deposits and cash. Such a shift is usually a signal of rising spending intentions.

Are money-holders front-running rate cuts? The narrow money pick-up is a hopeful signal but there is a risk that it goes into reverse if the Fed continues to delay.

The impact of the US April rise on the global aggregate calculated here was offset by a large monthly drop in Chinese narrow money, as measured by “true M1”, which corrects for the omission of household demand deposits from official M1.

So the six-month rate of change of global real narrow money was little changed in April, following a move back into positive territory in March – see prior post for more discussion.

US six-month momentum moved to the top of the ranking across major economies in April, while China returned to negative territory – chart 2.

Chart 2

Falling interest rates suggest that the Chinese relapse will prove temporary – chart 3 – but the signal for near-term economic prospects is negative.

Chart 3

Eurozone / UK real narrow money momentum continued to recover in April but remains negative. The current UK lead may prove temporary unless the MPC follows the ECB in cutting rates soon.

The Chinese relapse resulted in E7 real money momentum falling back in April, while G7 momentum crossed into positive territory – chart 4.

Chart 4

The still-positive E7 / G7 gap coupled with a recent cross-over of global six-month real narrow money momentum above industrial output momentum could signal improving prospects for EM equities. The MSCI EM index outperformed MSCI World by 10.5% pa on average historically under these conditions.

G7 annual broad money growth recovered further in April but, at 2.8%, remains well below a 2015-19 average of 4.5% – chart 5.

Chart 5

The roughly two-year leading relationship suggests that annual inflation will bottom out in H1 2025 but remain at a low level into H1 2026.

Global (i.e., G7 plus E7) six-month real narrow money momentum returned to positive territory in March, consolidating in April. It has also crossed above six-month industrial output momentum, turning one measure of global “excess” money positive – see chart 1.

Chart 1

Should investors, therefore, adopt a positive view of economic and market prospects? The judgement here is no – or at least, not yet.

Six-month real narrow money momentum bottomed in September 2023 and lows have preceded those in industrial output momentum by between four and 14 months so far this century. This suggests that a recent decline in output momentum will bottom out by December.

The lag may be at the top end of the range on this occasion, for three reasons.

First, lags tend to be longer when real money momentum reaches extremes, and the September reading was the weakest since 1980.

Secondly, the real money stock is below its long-run trend relationship with industrial output – chart 2. A prior overshoot cushioned the impact of a negative rate of change in 2022-23; the reverse effect could apply in 2024-25.

Chart 2

Thirdly, prior recoveries in real money momentum from negative to positive were followed by a recovery in output momentum always in the context of a positively-sloped yield curve (10-year government bond yield minus three-month money rate) – chart 3. The curve is still inverted.

Chart 3

The recovery in real narrow money momentum is a hopeful signal for H1 2025 but there remains a risk of surprisingly negative economic data over the next six months. A pessimistic bias will be maintained until real money momentum returns to its long-run average and the yield curve disinverts.

The cross-over of real money momentum above industrial output momentum is similarly judged to be a necessary but not sufficient condition to adopt a positive view of market prospects.

Global equities have outperformed cash on average historically only when a positive real money / industrial output momentum gap partly reflected above-average real money expansion (measured as a 12-month rate of change). The latter condition is unlikely to fall into place before late 2024 at the earliest.

The current combination was associated with mixed equity market performance with some notably bad periods, e.g. mid-2001 and late 2008 / early 2009 – chart 4.

Chart 4

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CC&L Financial Group Ltd.

Identifier: Global and international

Are domestic or global equities more volatile?

Does hedging reduce global equity volatility?

What is the optimal currency hedge ratio?

How should currency be managed in private markets?