The removal of Secretary of State Rex Tillerson and replacing him with CIA Chief and former Congressman, Mike Pompeo, has implications for nearly all aspects of U.S. foreign policy, including Middle East relations. More specifically, Tillerson supported the Iran nuclear deal (Joint Comprehensive Plan of Action or JCPOA), whereas Pompeo was one of its fiercest opponents on Capitol Hill.
In addition to the recent changes at Foggy Bottom, there are also numerous press reports that White House Chief of Staff John Kelly might be paving the way for the return of National Security Advisor H.R. McMaster to the Pentagon with his elevation to the rank of four-star general. McMaster has been a supporter of the Iran nuclear deal, albeit a lukewarm one. Among his possible replacements is former UN Ambassador John Bolton, also a critic of the Iran nuclear deal.
Whatever one thinks of the recent (and rumored) personnel changes and the JCPOA itself, the negotiation of the deal in 2014 and its eventual adoption in July 2015 may have contributed to the collapse in oil prices by reducing the risk premiums embedded in WTI, Brent and other benchmarks. The easing of Middle East tensions that JCPOA came to symbolize may have led oil prices to catch up with economic reality on the downside.
Off The Charts! examines the pertinent economic issues of the day, providing a deeper dive into complex topics and framing the issues in a way that can lead to a better understanding of the financial and commodities markets.
Until the equity market’s abrupt correction in late January, Treasury options were in a state of deep slumber, with volatility near record lows for 2Y, 5Y, 10Y and 30Y Treasuries. Over the past month, Treasury options volatility has staged a mini-spike that seems significant by recent standards (Figure 1) but is unremarkable when viewed from the longer-term perspective of Merrill Lynch’s “MOVE” index (Figure 2). Even after the recent break out, volatility in Treasury options remains much closer to historic lows than to its average levels. The record highs of 2008 are a distant memory.
The trade war that could stem from U.S. tariffs on steel and aluminum is unlikely to affect GDP, freeing the Fed to raise rates at its March 21 meeting.
The official growth rate of China is of intense interest to economists and investors worldwide. The gross domestic product of the world’s second largest economy is also subject to a certain degree of skepticism. Observers ponder over its unusual stability and unfailing ability to fall within the consensus estimate. Among the skeptics is none other than Li Keqiang, the Premier of the People’s Republic of China. His remarks to a U.S. diplomat a decade ago describing the official GDP as “man-made,” inspired The Economist to create an index of his three preferred measures of economic growth in China that now bears his name: the Li Keqiang index.
The index, which comprises the annual growth rate of outstanding bank loans (40%), electricity consumption (40%) and rail freight (20%), shows a significantly more volatile trajectory for China’s growth than the official GDP. By the measure, China’s 2015 slowdown was much worse than the official GDP indicates, and the subsequent rebound much bigger. That the index is volatile should not be surprising as it narrowly focuses on just three sectors, would show more variability than a broader measure such as GDP.
Just as there are skeptics of the official GDP, there are those who doubt the Li Keqiang index. Several times in the past few years, the index has been pronounced dead. However, to loosely paraphrase Mark Twain, rumors of the death of the Li Keqiang index have been premature.
While the debate over the ideal measure of China’s economic performance is an interesting and important topic, this paper aims for a more modest and testable goal. It seeks to answer the question: which index, official GDP or Li Keqiang, is more relevant to investors? The answer, as we demonstrate below, is resounding: the Li Keqiang index dominates China’s official GDP in its importance to commodity and currency investors.
Before we delve into which index has done a better job of forecasting movements in commodities and commodity currencies in the past, let’s begin with which index responds more quickly and accurately to China’s own domestic interest rate market. As we have written in the past, China’s official GDP correlates highly with the slope of the 3Y-10Y bond yield curve (Figure 1). This is even more true of the Li Keqiang index, which responds to changes in the yield curve slope even more quickly (Figure 2).