Wednesday, 11 May 2022

Fading inflation (and the Fed?)


So last July I suggested that the Fed was behind the curve and while Treasury yields were likely to go lower in the short term, ultimately coming into this year with tight labour markets inflation would be picking up and the Fed would look massively behind the curve and yields would have to reset higher. 

That is more or less what happened, and even without the Ukraine war pushing up oil prices, wage inflation is driving service inflation and services are most of the US economy:


And with the Fed talking up 50bps a meeting until they get to a 'neutral' 2-2.5%  Treasuries have repriced to about 3% on the 10 year, and a modest amount of curve steepness priced in for when the Fed finishes hiking. 

So is this pricing accurate? Within the context of an ongoing recovery and inflation way above 2% target, the Fed has a legal mandate to bring it down via tightening, and that is what is priced and what they have been talking up recently. 

However many leading indicators like sentiment and new orders are heading towards contraction or levels associated with a recession scare. 

April saw quite a lot of sequential MoM slow downs (yellow highlight) in the CPI components, and outright energy price falls reduced the Core number from 0.6% MoM down to a headline CPI of 0.3% MoM. Some areas of ongoing sequential increase (blue highlight) should slow down as the Fed hikes. 

Looking at the NY Fed UIG inflation measure, CPI tends to be more volatile but mean reverts back (and through) the UIG measure. That may imply headline CPI heads towards 2-3%, or lower, in coming months as the volatile parts go flat or negative YoY.


So with everything that has happened (wages up, unit productivity down, costs like commodities up, margins squeezed, the Ukraine war related uncertainty, stimulus money gone and sentiment and new orders heading into contraction territory, China affected by Covid again etc) we are heading into a US growth slowdown. 

That should take the heat out of commodity prices and therefore both headline and core inflation.This then opens the door for the Fed to come up with excuses and only go 25 bps at some meetings or even miss a meeting hike.

That should initially trigger equity and fixed income rallies. But as the slow down continues into the summer equities should fail to make a new high and then sell off again while US 10yr yields head towards maybe 2%. So the equity rally, fail, fall pattern could look something like below:


So assuming Fed back peddaling on rate hikes, cooling commodity prices and inflation pressures plus ongoing fiscal support cause the indicators to turn back up into year end, we could see at that time, say Q4 or going into Q1 or Q2 next year within the context of an ongoing US expansion yields rise closer to 4 or 4.5% on the 10yr Treasury.  


And that may be enough for a genuine recession in late 2023.






Friday, 1 April 2022

Sri Lanka's pending default

So I wrote about the risks to Sri Lanka in Jan 2020: How close is Sri Lanka to a debt crisis?

2 years later and having lost market access in March 2020 as their bonds crashed, they had opted to try and muddle through, but over the period implemented few real reforms and instead actually expanded public sector payrolls. 

I did previously think that with a recovery in tourism and robust oil prices helping exports and remittances with the GCC countries, they could probably make it, if they prioritised debt service and self helped themselved with tax hikes and reforms. But they havent done that and have now been hit with much higher oil and food import costs. They are now on the cusp of default in my view.

After going through the Article 4 report and monitoring the news these are my current views:

Scenarios economic

1.    Keep paying the debt (current policy)
As we know Cabraal had wanted to stay current and rebalance the economy over time and on Sri Lanka’s agenda and not be forced into an abrupt adjustment such as abandoning the FX peg or a chaotic and uncertain default and IMF programme. 

So as described below in the Article 4 comments, domestic issues/ imbalances are the main problem, and they manifest themselves as external imbalances. So relying on debt issuance instead of taxation to locals, expats and foreigners led to an inflated economy, rising REER, double deficit and the Covid disruption brought it to a head. They have failed to hike taxes enough, no SoE reforms, public sector head count increase not reduced etc. They passed it off as a growth plan. Then they have been hit with the slow tourism recovery (might be worth $2.5bn this year down from >$4bn in 2018 peak) and now the oil price spike and food price spike (they export tea, coconut and rubber and import some food items).

They continue to pay the ISBs and reprofile the bilateral debt
I think this is possible on paper if remittances go up and the deval reduces imports. If we assume $500m remittances and a 25% reduction in imports:
Imports: -$1.35bn
Exports goods: $1.1bn and growing
Exports Services ex Tourism: $100m and growing
Tourism: $250m and recovering
Net income: -$175m
Debt service: -$450m
Remittances: $500m
Net -$25m

However this relies on remittances going back to $500m (peak was $650-700). I think without hiking taxes the continued money printing will cause remittances to be withheld. If remittances remain at $250m, the above net number is -$275m. ie their FX reserves will remain under pressure and they will need to keep finding net new money. As such I don’t see it as workable as they politically wont have the will to hike taxes following the devaluation.

They may continue with this policy for a little while longer though, but the import reductions manifesting themselves as power cuts, fuel shortages, food shortages and then impacts on tourism and industry and exports are bringing the issues to a head. Public protests are rapidly spreading now.

Default scenario
Either they default and restructure quickly or default and it drags on.

If the current government remains in power it will be politically very difficult to devalue, default and hike taxes simultaneously. The SLPP party has an absolute majority in Parliament and the coalition has a large majority, so they cant be forced from power easily.

So I think they default without a plan and then claim to be engaged in negotiations, while in reality struggle to agree a coherent plan that everyone signs up to and the Chinese project debt and the Common Framework equivalence will be an issue. They would save the $450m a month debt service and can stabilise their BoP even if remittances remain subdued and the FX grinds lower over time, so default should give them some respite even if there is no immediate IMF deal.

Even now after the Article 4 report is released and it clearly says Sri Lanka has to hike taxes there seems to be little news coverage or political discourse on this or recognition that the fiscal deficit is the main primary cause of their problems. Instead, the focus is on the instability and the shortages and then blaming ‘government incompetence’ and mobilising popular protests about the shortages. Sri Lankans seem to think they pay high taxes. When they do sit down with the IMF and start going through the practical steps necessary to agree an EFF deal I think they will struggle to come to terms with what is needed, and it will be a slow process.

Alternative political scenario
I don’t know the probability. But if the current government at some point, probably not in the next few months, admits it is unable to implement the necessary reforms, could the IMF oversee a technocratic government? In that scenario in the short term they can reprofile out the existing USD debt, agree an IMF deal and move forwards with the reforms. But there probably needs to be a lot more pain first.  

They have in a normal environment $600-700m in remittances and $400m+ in tourism, plus $100m in other net services and a net income balance of -$175m. Some portfolio flows should also be possible over time, but ignoring portfolio/ FDI flows the monthly balance is almost +$1bn a month in USD coming in. Could they service $300-450m in debt service from that? I think so they just need to produce more and improve the import/ export balance. More people working and work being more productive would lead to higher taxes. Something like 2/3rds of the private sector is informal and don’t pay any income taxes.

Restructuring scenarios
Assuming a 9, 15, 20% exit yield and they only start to pay coupons in 2024 I put below 3 scenarios. One with a step-up coupon and a year of capitalised interest (scenario 1), one with a reduced coupon (4%) and a 20% haircut (scenario 2), and a final one with a 5% coupon and 10% haircut (scenario 3). It is for the 2027 bond with a 5-year maturity extension.

The NPV is mainly determined by the exit yield, although the principal haircut has an impact:

IMF Article 4 report comments

IMF demands:
1.    Hike taxes
2.    Improve implementation of taxation and spending
3.    Cut spending in real terms/ public sector headcount
4.    Cut subsidies
5.    Reform SoEs, sell some
6.    Exchange rate flexibility, inflation targeting, CB increased independence
7.    Lift import restrictions on non-consumer goods

-    So a fairly typical mix

IMF recommendations:
1.    Increase social safety net for poorest (while lifting subsidies and hiking taxes in general)
2.    Reduce non-tariff barriers to increase the amount of higher value goods produced and exported, eg goods within global supply chains. They didn’t spell out the non-tariff barriers but it is not the easiest of places to do business and the tariffs would hinder access to key imported components that are processed and reexported
3.    Institution building on corruption, efficiency, loop holes, governance, SoE profitability, maintaining investment levels etc
4.    Continued technical assistance and training to taxation dept
5.    Bring about debt sustainability, as current framework projected forwards is not sustainable, although that is also linked to the fiscal deficit
6.    IMF recommend a new Article 4 in 12 months time

Highlighted points:

6-8% of GDP fiscal deficit became a problem as growth slowed under the previous Ranil government and then Covid accelerated the problems:


They passed a law that discouraged foreign ownership of local government bonds a few years ago, so foreigners exited (this should be reversible for index flows though):

Government was running an economic sector balance of -5-9% GDP most years.

My points on the below, which is a static analysis of the current situation:

GDP growth forcast is low if the government implement necessary reforms and economy started to rebound (so a GDP warrant could be good for bondholders)
They don’t allow for higher taxes, reduced govt borowing, reduced CA deficit
They still have imports growing faster than exports, despite the recent devaluation and expected reduction in government deficit
Nominal GDP growth should be much higher this year, probably 35-60%, they only have 13.4%, that will reduce domestic debt/ GDP from a dollarised standpoint and local currency standpoint
They have no revenue from privatisation expected, which will surely be part of any plan
In 2026 they have govt revenue of 11.3% of GDP vs an average of 15-16% for countries with Sri Lanka’s GDP level and spending of 21.6% of GDP
In 2026 they have a financing gap of about 5% of GDP

On BoP they have little improvement in goods imports/ exports
Slightly limited service export recovery inc tourism
They have a negative direct investment, ie lack of reinvestment and income repatriated
They assume limited USD soveriegn bond issuance, probably locally issued SLDBs
Negative bilateral flows, ie government net repayment
Little reserve accumulation

Assuming a decent part of the USD assets and liabilities are tied up in ISBs a hard default would impair bank equity while a reprofiling should not? Hotels and exporters are presumably most of the balance. 

They achieved none of the prior main requests from 2019

Achievable growth rates
They need reforms and foreign corproate investment to boost TFP along with capital stock, they may be able to get to 4.5-6% growth if they do that. Increasing labour force participation can offset slowing working age population growth.

IMF is a bit pessimistic on this I think

Debt sustainability
A lot of the problems are domestic and based around the government historically borrowing instead of taxing. The external issues are less IMO but are linked.

If the SoEs made a basic RoE then only the Road Development Authority is really a liability of the central government. SoEs should contribute positively to the budget not drain it and be a balance sheet risk.


External ISBs were $13bn in Dec 2020. I think there were $1.5bn in maturities since then (last July and this Jan). So we are talking $11.5bn or so externally owned Eurobonds. Its not the main issue.

The main issue is the dollar shortage created by domestic credit creation and the government is the main culprit there. Then secondary factors like tourism slowdown, lack of confidence, low reserves, remittances withheld in advance of an expected devaluation etc

The curent policy framework doesn’t reduce debt/ GDP hence it is deemed unsustainable.

Net investment positions is weak 

The IMF model implied a 17% REER devaluation requirement, but the currency just devalued 50% plus in one month. A 50% deval with 18% elasticity, implies a 9% import compression, or call it $160m/ month improvement? Seems low and the import compression might be higher. Exports should also be boosted.

They had stupidly let the REER appreciate as they tried to bring inflation down at the same time credit was growing strongly, then when the peg broke this month it has unwound massively.

SSN spending is low vs peers and could be boosted while taxes rise:

Lack of transparency of government finances

Monday, 7 February 2022

Are warnings about an 'imminent Russian invasion of the Ukraine' any more than a deep state intelligence operation?

I think what is happening overall is brinkmanship by a number of parties, which is not uncommon in geopolitics, and it is unlikely anything significant happens.

But lets discuss the interests of different parties in each state:

Ukrainian interests
There are interest groups in Ukraine that want Nord Stream 2 sanctioned as it going live in June 2022 would end $3bn of transit revenues that the Ukraine government gets. The oligarchs in the Ukraine owe a lot of their wealth to milking the state budgets. Then there are Neo-Nazi militias that were folded into the military without much ‘re-eduction’ who dream of taking Donbass region back and like to wear WWII Galician division insignia.

So we had a Ukraine forces build up last Feb/ March then a climb down (NS2 was supposed to go live last summer but a German court said the legal structure was not compliant and needed to be changed and then reapproved) now is the last gamble before it goes live. Ukraine built up forces in Oct and used newly received Nato weapons, such as a TB2 drone to strike 15kms behind the ceasefire line. ( They also crossed the ceasefire line and attacked two small villages with an armoured column. There are daily ceasefire violations of 100-1000 events that the OSCE record in a daily report published on the OSCE website. Here is a video of a Ukraine journalist firing a howitzer towards the area. They generally try and shell utilities to make the area as unliveable as possible but also routinely injure and kill civilians.

Meanwhile the BBC Kiev correspondent notes little frontline expectation of an invasion:

President Zelensky is a former slap stick comedian who was pushed forwards to power by an Oligarch. He won on a reform mandate with pro-western alignment, but has failed to challenge the oligarchs who can easily bribe officials, so has become dependent on the support of the nationalists. He has not implemented the Minsk agreement.

The Minsk agreement is a treaty that Ukraine, Russia, Germany and France negotiated. It would deliver a federal Ukraine and MPs from Donbass would go to Kiev. But the nationalists want to defeat the Donbass fighters and don’t want pro-Russian MPs in Kiev. So it has never been implemented.

So Russia responded to the events in Oct by increasing their troops near the border from circa 90k to 120-130k. Also there was evidence of more equipment rail way shipped into Donbass. So they were definitely trying to menace Ukraine into stopping the heavy weapons attacks with the implicit threat of a bigger conflict. But they only did the build up after Ukraine provocations.

Then the western media reports the Russian activities and is encouraged to conclude that Putin is about to invade.

Russia has repeatedly called for the Minsk treaty to be implemented. If it is not implemented this year there are calls in the Russian parliament for the Donbass region to have a referendum on joining Russia. Most of the residents have Russian citizenship now.

Russia recently seems to have decided to push back and use the reporting of their invasion threat in the western media to try and push for long term extra-territorial security guarantees, which the US/ UK have blown off, but there seems to be a serious discussion starting with France and Italy and by inference the EU in general.

A low probability event is a conflagration happens/ is engineered and Putin then annexes the sea front from Mariupol to Crimea and possibly the area around the Dnieper river/ canal to secure the fresh water supply. That operation might take a week or so, it is flat land and his tanks would literally just roll across it. Our understanding is that Putin, Medvedev, Lavrov and other centrists in Moscow see the sanctions fall out from that as not worth it, but there are hardliners who dream of doing this.

An invasion would also give the hardliners in the Washington ample excuse to impose much tougher sanctions and trade embargoes on Russia. I don’t see a broader invasion of western Ukraine as likely.

In the last few weeks various Russian officials have alluded to what they see is little more than a UK/ US intelligence operation aimed at misleading their respective political leaders and bouncing said leaders into further anti-Russian sanctions. 

“West cooked up ‘Russian threat’ to save face after Afghan flop, diplomat says”

America and the UK are unlikely to agree to any Russian security guarantees and are more likely to try and periodically antagonise Putin and his security people, as part of the old ‘great game’. Although this week it seems France and Italy are willing to negotiate security with Russia.

Apparently, an MI6 dossier, no doubt drawing on Ukrainian sources, has been rubber stamped by the CIA/ State Dept and is the basis for the UK/ US claiming that Putin ‘could/ almost certainly will’ invade. Ie the deep state is bouncing the politicians to try and get more sanctions imposed on Putin and Russia. The Russians are aware of this and have alluded to it several times.

By claiming Putin might invade imminently they justify sending more arms (Germany would block a NATO MAP) and can provide NATO training to an Army that has neo-Nazi elements within it

Then when Putin does not invade they will be able to claim diplomatic victory and claim that they stared down the Russian threat. But it is almost certainly built on a series of false narratives and manipulated analysis and conclusions.


Later this year/ Resolution

Once NS2 is up and running in June and Ukraine has lost the >$3bn in transit revenues, it will be easier for Germany to pressure them to implement the Minsk agreement to make Ukraine a federal state as Ukraine will still want a closer EU relationship. If Kiev refuses to implement Minsk, which is quite likely, then perhaps Donbass would then join Russia, and having the Russian military directly in the disputed areas would necessarily end the low intensity conflict.   

Germany and Russia don’t want anything to happen that would sanction NS2, Biden has accepted that without NS2 gas prices in Europe would be too high and that affects global gas prices, hence the administration blocked a sanction attempt in the Senate recently on NS2. German industry don’t want high gas prices or their investments in Russia to be affected, hence the US has given up on the idea of disconnecting Russia from Swift.

So for now, there are multiple groups within each country that have competing agendas and some brinkmanship has suited a lot of them.

It is possible that there is a sizable ‘border incident’ but I think it would likely be contained quickly.

Then a permanent resolution is likely to be pushed for in H2 this year.

Update 8th Feb

With Putin now negotiating directly with Macron, Draghi and Scholz, this sidelines US-led NATO and is likely to force the US/ UK to also negotiate inorder for them to avoid a Russia-European security treaty that makes NATO effectively irrelevant and supports Macron's vision of an EU security organisation. 

So having started this operation with an objective of humiliating or sanctioning Putin, it is now in the process of backfiring on the deep state and is possibly leading to a long term security pact principally between Europe and Russia.

Update 22nd Feb 

It is possible that Putin concluded that for a Finland style deal for the Ukraine (EU membership, no NATO membership) they had to permanently settle the Donbass issue. But Ukraine would not/ could not agree to settle it, so Putin has settled it via an effective annexation and now a Finland style deal can be implemented, hence the limited sanctions being announced.  


Friday, 7 January 2022

What happened in Kazakhstan?

Seems like this roughly happened in Kaz:

Tokayev President in name only, Nazarbayev people in most ministries. They hike taxes, unpopular, Tokayev people organise protests where various paid protestors got drunk and started rioting and where the protests were surprisingly well attended by people who were not paid for.

Tokayev then uses that to force government resignation to take more control but Nazarbayev still in command of security until he is forced out of those roles as well.

While the protests happen an ISIS cell activates in Almaty and hits the banks for cash and locations of arms for weapons, they were organised in advance. The militants are now set up for an insurgency having been previously waved through Turkish airports coming back from Syria, albeit without money or gear. This is when the 24hr a day gun battles start in Almaty but not really anywhere else.

There are Salafist mosques in Kaz, Saudi funded, so they can draw brainwashed local plebs for an insurgency. Hence the immediate Russian/ CSTO response and Blinken boiler plate comments and various references to foreign terrorists and external interference.

The mountains immediately south of Almaty into Kyrgyz are a perfect hiding place and stretch way west into neighbouring countries. So Kaz closed the Kyrgyz border today. Hard to call this, but ISIS will fight to the last person so the authorities have to end it fast. The Russian planes are presumably to bomb in the Tien Shan mountains.

The militants have spread out in Almaty into ordinary buildings and the Kaz SF have to fight each one. Assuming they clear out Almaty they will end up having to fight them in the Tien Shan mountains if this is correct and the ISIS group can maintain the funding, weapons and people supplies. Those mountains also run through Kyrgystan and Uzbekistan.

Kaz is so physically big I don’t think this threatens the country overall, at least for now, but its hardly an economic positive.  


The Kazakh Liberation Front released a video promising to fight, and they dont look like vodka addled rent-a-protestor types.

Friday, 20 August 2021

Ethiopia's likely coming bond default

If you follow the news then you know what has been happening there, if not this is a cliffs note summary:

The EPRDF coalition political party ruled Ethiopia with an iron rod from 1991 to 2018 with the Tigrayan Peoples' Liberation Front, TPLF, faction being the most powerful. Federal power based along Ethnic/ tribe-based Federal states kept the ethnic/ tribal differences and conflicts subdued. PM Meles Zenawi, and after he died, his successor PM Hailemariam Desalegn, ran the Federal state as a technocratic economic development project and the economy grew about 10% a year for many years.

But the largest ethnic group, the Oromo and the Oromia Liberation Army, felt subdued by the prior Amhara kings and then the EPRDF, which was dominated by the Tigrayans. (Amhara is the second biggest state and created modern day Ethiopia via the prior Abyssinian Empire via the invasion of the surrounding tribes). 

Protests and violence came to a head in 2018 and via a parliamentary reshuffle PM Abiy Ahmed, whose parents are both Oromo and Amhara came to power. Abiy was initially greeted as the new face of Africa - a young, reform minded, peace maker. In 2019 he was awarded the Nobel Peace Prize for securing peace with Eritrea. 

However, the TPLF did not support him and the EPRDF party split into the TPLF and Abiy's new Prosperity Party. 

Anti-corruption drives and other measures were viewed as an Abiy-led purge against the TPLF and things came to a head in late 2020. 

Abiy sent 300 special forces to Mek'ele, the Tigrayan capital, who attempted a night time raid on TPLF leaders on the 3rd-4th November 2020. This failed and the TPLF and their paramilitary wing, the TDF, launched a counter attack on the Ethiopian National Defence Forces Northern Command bases on the 4th November.

This led Abiy to declare war on them and initiate a prepared invasion with the ENDF, and he was supported by the Eritrean Defence Forces, Amhara Special Police and crucially drone support from the UAE, who had a drone base in Eritrea, plus a few hundred Somali Army trainees. 

As has been documented the UAE drone support destroyed the TDF's heavy weapons and they quickly abandoned a conventional warfare strategy and melted in the mountains. Bringing retired military commanders out of retirement, most notably General Tsadkan Gebretensae, they then trained over 100k volunteers, while carrying out hit and run attacks on the invading forces. 

The invading forces adopted pretty much a scorched earth policy and all sides have been accused of numerous war crimes. 

The first turn in favour of the TDF was in February the UAE was forced by the US to disengage, which left the ENDF without much aircover. 

Then at some point in May the Eritrean troops stopped engaging fully in the new attacks. This left the ENDF exposed to concentrated TDF attacks. The ENDF mounted two failed efforts to take the highlands and lost thousands of troops in the process. The TDF had also been building troop numbers and launched Operation Alua, which led to the total collapse of the ENDF in Central and Southern Tigray and the recapture of Mek'ele, the state capital. Eritrean troops withdrew to the northern border areas.   

The TDF then invaded part of the barren Afar region, to the east of Tigray, threatening to capture the Main Supply Route from Djibouti to Addis, but this turned out later to be diversionary and instead the main forces invaded the Amhara region heading towards Debark in the north west and Weldiya in the east. 

After capturing Weldiya the TDF have headed south towards Dessie and west towards Debre Tabor, which has been captured this week. Debark, which sits by a mountainous ridge line, has been so far defended by the Amhara forces.

This month they have also agreed to cooperate with the Oromo Liberation Front's Oromo Liberation Army to bring down Abiy. The TPLF and OLF were arch enemies in the past, so this is a remarkable redrawing of alliances. 

Over the last few months the OLA has grown from a small force into one fielding divisional sized forces and they have been capturing land north west and to the south of Addis.

Wikipedia and Ethiopia Map on Twitter are keeping up to date maps of territory held and lost. 


This week the OLA claim they have control of the road down to the Kenyan border and have attacked Suluta, just 12kms outside of Addis to the north.

Simultaneously the TDF are now marching towards Bahir Dar, the Amhara regional capital. 


Abiy's regime has gotten to such a desperate state that they seem to have accepted sanctioned military drones from the Iranians and have been asking the Turks for additional military support, but it is likely too little, too late. 


So in summary, I think we can see that the Abiy regime is a few key battles away from collapsing and the siege of Addis is now beginning.


Ethiopia's only bond

Which brings us to the bond. 

A 10-year $1bn bond was issued in 2014. 

Ethiopia to get to 10% GDP growth ran up 60% debt to GDP, ran CA deficits/ borrowed from abroad and has taken part in the DSSI programme. 

Annual GDP growth:

Debt/ GDP:

Current Account/ GDP:

Multi-billion projects like the $5bn GERD dam cost a lot of money upfront for years before generating anything yet are key to economic development, for example. 
In January 2020 they entered an IMF Extended Credit Facility programme. The IMF expected them to slow growth, reduce current account and government deficits, lower debt/ GDP, engage in economic reforms and build reserves. 

They were then hit with the Covid pandemic and took part in the DSSI initiative to reprofile $1.2bn of bilateral debt servicing cash flows.

They have since announced an intention to reprofile debts on a 'voluntary basis' and have so far indicated that this would not include the Eurobond. 
Excluding the Eurobond goes against the G20's 'Common Framework', which calls for all debts to be treated equally.

The biggest holder of the Eurobond, according to Bloomberg's analysis of 13F filings is Franklin Templeton fund manager, Dr. Michael Hasenstab, who shall we say is not unfamiliar with sovereign stress and distress.

He held a baseline position of $70-90m at least since 2015. It is hard to criticise that, he was supporting a growing, low-income country, with what was initially taken as a new reform minded Prime Minister, Nobel Peace price winner, Abiy Ahmed. 

However in Q1 when the bond prices sold off into the low 90s, he bought more and took his holding up to $130m of par value in total. The main portfolio holding the bond seems to be the Templeton Emerging Markets Bond fund.

According to the fund holdings he took it to a 2% position there.

I am not sure what the Franklin Templeton ESG policy is, but he did this while Ethiopia was financially stressed, asking for debt relief, in an IMF programme and additionally when there were numerous reports of widespread war crimes being committed by Abiy's combined forces in Tigray. 
The bonds are currently indicated in the high-80's, but hardly trade. 
Default and Restructuring
The IMF would typically want a low income country to peak at 60% debt to GDP, net of an IMF programme, yet Ethiopia went into the last 18 months at that level of debt/ GDP. 
In my opinion, the country will end up with a restructuring and a meaningful NPV debt haircut.

In my opinion the Eurobond will be included in the debt restructuring. If the new government is quickly recognised by the US and IMF then perhaps a 65c recovery at an 11% exit yield may be achieved by the end of next year. However the bonds should trade significantly below that before and after the restructuring as the negative news hits, perhaps they trade down to 30-40c. 

If the US/ IMF don't recognise the new government then it becomes a hard default against a possibly sanctioned regime, if that happens, then sub-10c will eventually be realised. 

I do think the former outcome is much more likely but the bonds could easily trade under 30c amidst the initial uncertainty and the time frame for normalisation can draw out easily. Post restructuring bonds are often trading at 15-20% yields for at least 6-12 months in many recent instances before cross over investors start to buy back in and yields normalise.

So on a $130m of par, a $100m mark to market loss is not inconceivable with maybe $40-50m in permanent losses, post restructuring, over the medium term.
Complicating factors could be the expected secession of Tigray, which would cost Ethiopia 7-8% of GDP. Tigray could also claim war reparations at least against the Amhara state, which represents about 25% of GDP. 

There is also the likelihood that the TDF will go after Eritrea's totalitarian dictator Isias Afwerki and invade Eritrea. Whether that results in a new democratic, independent Eritrea, a merged Tigray/ Eritrea which delivers a defacto secession quickly, or Eritrea is again assumed into Ethiopia, that remains to be seen. I think it is inconceivable that the TDF will make the mistake of leaving Afwerki in power again as it did in 2000 when the Army was ordered to stand down by PM Zenawi.

Friday, 9 July 2021

How far behind the curve is the Fed?

Over the last few months Treasury yields have dropped and retraced a large amount of the Q1 sell off.

Commodity prices have peaked, in my view, stimulus has or is peaking, and the usual suspect deflationists are calling for lower bond yields. 

Set against this is the ongoing economic recovery and, in my experience, without a massive unexpected shock and with the ongoing fiscal and monetary stimulus, its hard to see why the US economy would relapse into a recession and deflation. 

The fact that the US Current Account has widened suggests that there is ongoing excess demand in the economy.

Instead, the drop in US 10yr yields since March is probably more down to the combination of a normal consolidation phase following a large move and then some short term supply/ demand technicals, concentrated positioning, stop losses and regulated buyers vs the fact that the 10yr-plus part of the Treasury market is a relatively small amount of the outstanding, with 10-30 year bonds being about 20% of new Treasury issuance.

Instead we are likely to see a normal reflationary cycle of unemployment falling, capex rising/ service industry job creation, wages rising and ultimately a hiking cycle followed by a recession. 

So where are we in this cycle? 

The Fed today published its monetary policy report. Their ongoing conviction is that yes the economy needs more support in the form of ZIRP and continuing QE and that they are not ready to commit to tapering, but might be later in the year. In fact, over half of the FOMC participants expect Fed funds to have zero to two hikes by the end of 2023 with 5 of those expecting zero hikes! 

Unfortunately for them, the strong recovery in the US economy has now led the number of job openings to be larger than the number of U3 unemployed.

The last and only time this has happened before was in early 2018 when Trump was stimulating the late cycle economy and the Fed was half way through their hiking cycle. US 10yr Treasuries were yielding around 2.4-2.5% and fed funds were at 1.4%. 

So even by the Fed's own track record in the most recent cycle, they are far behind the curve, their projections are absurd and the excess stimulus and Fed balance sheet growth is causing many asset bubbles to extend. 

The excess balance sheet growth in the last cycle never really led to a wage-price inflation spiral. So the Fed never got trapped with a large balance sheet leading to excess reserves in the system that then lead to credit growth and rising monetary velocity. 

When asked about when the Fed would unwind its balance sheet, Bill Gross famously quipped 'never'. And for the most part he was right. 

In this cycle however the starting point is with over 3% wage growth whereas in 2009 it was well under 2%. In the last cycle job switcher wage growth almost hit 5% before the recession. 

In this cycle, given we already have more job ads than employable unemployed, most probably wage growth will exceed 5%.

If that combines with credit growth and a weak Dollar then the Fed will be forced to act much earlier than expected. 

Dec 2022 and Dec 2023 Eurodollar futures have diverged this year but Dec 2023 is only pricing in 3-4 hikes and Dec 22 only 2.


As mentioend above the last time the employment market was this strong the Fed was already at 1.40% in early 2018 and by year end had hiked to 2.4%. That sent the 10yr from 2.4% in early 2018 to 3.2% by year end, the cycle high, as in 2019 the economy slowed and manufacturing went into recession.

Fed funds rate:

So if wage inflation starts to rise and point towards higher inflation going into 2022 the Fed will be under immense pressure to speed up policy normalization and hike rates.