This month we are watching several macro trends, each giving us some insight into what may come over the next year. For example, some bitcoin participants are taking confidence from successful decentralized events, like halving, that prove Bitcoin’s ability to self-regulate. We look at the difference between PCI and PCE when to comes to inflation, because understanding the difference between the indices is paramount in understanding inflation overall. We’re keeping an eye on the U.S. dollar and global responses from central banks to understand if there may be additional crosscurrents in currency markets. And finally, we’re examining Chinese industries and how overcapacity might impact global trade.
Bitcoin halving
April 19th marked a significant day in Bitcoin’s history, it was the date of bitcoin’s fourth block reward halving, an event which is unique to Bitcoin. Bitcoin’s block reward, how bitcoin is issued, was reduced from 6.25 bitcoin per block to 3.125 bitcoin per block, reducing bitcoin’s inflation rate to less than 2%.
To appreciate the significance of this event, a little background on the mechanics of the network might be beneficial. Issuing bitcoin is the result of mining, or the process by which unconfirmed bitcoin transactions are verified, confirmed, and grouped together into a new block and then added to the blockchain. This is an important service provided by miners, for which they are rewarded with newly issued bitcoin and transaction fees. The timing and amount of block rewards is strictly enforced by the bitcoin protocol and is designed to cap total bitcoin supply at 21 million, with block rewards getting cut in half roughly every four years.1
What makes this event so unique is that it is not managed by a central entity; there is no development team pushing software updates. Since its inception, the bitcoin protocol outlined the network’s complete monetary policy and halving schedule, which are automatically enacted by the bitcoin protocol.
In the past, block reward halvings have been catalysis for long-term price appreciation, with bitcoin hitting new all-time highs within 12 to 18 months after the halving. However, it should be noted that there have only been three previous halvings, so modeling with so few data points is problematic. Furthermore, it is likely that due to the small amount of rewards relative to the outstanding supply the impacts on price may be more muted.
Going forward under the new block reward schedule, an interesting dynamic to keep an eye on is the amount of mining power. As block rewards are reduced, miners’ revenue is reduced, forcing inefficient miners to shut down. In the past, miners were compensated with an increase in the price of bitcoin, offsetting the loss in block rewards from previous halvings.2,3 Should difficult market environments force miners to shutter, the Bitcoin network could be adversely affected.
While the future is full of uncertainty, many bitcoin participants are taking confidence from the successful automatic block reward halving. Such decentralized events prove Bitcoins ability to self-regulate, adding to the network’s permanence.
By: Scott Keller, Portfolio Manager
PCI versus PCE
Inflation has dominated the headlines since the onset of Covid. It has certainly cooled but has yet to reach the Fed’s 2% target goal. Understanding what comprises the different measurements used is important in explaining why inflation has been stickier than expected.
There are two core indexes used to measure inflation, the Personal Consumption Expenditures Price Index (PCE) and the Consumer Price Index (CPI). The Fed’s preferred measurement is PCE, which is used to judge progress towards their stated goal. Understanding the difference between these indices is important in understanding inflation, as they can tell different stories especially in the short term.
Although the Fed prefers PCE, CPI is used in headlines, colloquially standing in for inflation. Historically, CPI has been about 0.4% higher than PCE and although the basic components used to comprise the index are generally the same, their weightings and calculation methods explain the difference between their readings.
Both indices have food, housing, healthcare, financial, nonprofit, recreation, transportation, energy, and other components. In looking at the differences, the housing and health care components have the greatest divergence. In the CPI, housing makes up 32%, while it is 15% in the PCE. Healthcare makes up 9% of the CPI, while it is 21% in the PCE. Right now, the housing component is largely responsible for the divergence in readings, as the cost of homes and rents has increased significantly since Covid.
Time is also an issue. The indices are calculated differently which causes differing inflation readings. The weightings in the PCE are adjusted monthly, while the CPI’s weightings are adjusted yearly. When a consumer adjusts their spending habits by seeking cheaper alternatives, those readings will first be encapsulated by the PCE.4,5
There are certainly other differences in the way the indices are calculated that explain their divergence and the component weightings and measurement timing are the biggest reasons behind it. The last bit of inflation is the stickiest and will befuddle the Fed and investors, but understanding the difference between the indices is paramount in understanding inflation overall.
By: Brandon Rick, Investment Analyst - Equity Research
Strong U.S. dollar puts global central banks on alert
A resilient U.S. economy, coupled with the Fed adopting a higher-for-longer monetary policy stance in the face of persistent inflation, continues to strengthen the U.S. dollar (USD) against every major currency. The Bloomberg Dollar Spot Index, which tracks the greenback against 12 major currencies, has risen by more than 4% in 2024. Moreover, the Fed’s policy rate, which has remained unchanged since July 2023 at 5.25%–5.50%, is higher than the borrowing costs in many DM and EM countries, thus discouraging carry trades among investors and currency conversions among exporters.6
A stronger than expected CPI and PCE inflation number for March resulted in a drastic shift in market expectations regarding the Fed policy easing. This put additional pressure on major currencies like the Japanese Yen (JPY) and Chinese Yuan (CNY) as the greenback strengthened. Despite the BoJ pivoting away from the long-standing negative rate regime, a yawning gap with Fed fund rates triggered an unprecedented sell-off in JPY, sinking it to a 34-year low. The Chinese central bank’s accommodative policy stance to support growth also put pressure on CNY versus USD.7
Pressure on JPY and CNY translated to additional weakness in broader Asian and EM currencies, prompting central banks to step in with both rhetoric and market interventions. The strong greenback has pushed 29 out of 32 major EM currencies into losses, with major countries like Vietnam, South Korea, China, Malaysia, Thailand, and Taiwan having policy rates below the current Fed rate. Exporters from EM are also showing increasing preferences to maintain revenues in higher-yielding dollar deposits relative to converting back into their local currencies.8
The adverse EM currency moves and negative carry are also resulting in heavy losses for investors undertaking ‘conventional’ carry trades of borrowing U.S. dollars and investing in higher-yielding EM currencies.9 This is making investors prefer lower-yielding currencies like JPY to fund carry trades in EM and even pivot towards ‘reverse’ carry trades, that is, borrowing in EM currencies and buying U.S. dollars. Overall, if U.S. policy divergence persists, changing investor expectations along with central bank interventions are expected to create more crosscurrents in currency markets.
By: Navaneeth Krishnan, Vice President - Investment Analysis
Chinese overcapacity threatening trade tensions
A factory producing less than its full capacity may seem innocuous enough. The situation might be an isolated problem for the plant’s owner or could just be the result of normal demand fluctuations as part of the business cycle. Although it’s usually harmless, when overcapacity overtakes entire industries and persists for extended periods, often due to policies that relax pressure on firms to operate efficiently and profitably, the situation can be characterized as structural. When this occurs in an export-oriented economy as significant as China’s, the implications reverberate well beyond the country’s borders.
A recent report from the Rhodium Group argues that, after years of retreat, structural overcapacity has returned to China and now affects the industrial sector as a whole, with far reaching implications for global trade relations.10 Clean tech manufacturing is one clear example. As the report’s authors note, “Capacity utilization rates for silicon wafers have dropped from 78 percent in 2019 to 57 percent in 2022. China’s production of lithium-ion batteries reached 1.9 times the volume of domestically installed batteries in 2022.” The issue, however, isn’t just limited to these products, “In early 2023, aggregate capacity utilization dropped below 75% for the first time since the worst point of China’s last overcapacity cycle in 2016, with a slight rebound since.” Property-related sectors, as well as machinery, food, textiles, and chemicals are also seeing declining utilization rates. With China’s National People’s Congress recently having concluded emphasizing industrial policy in high-tech industries, like renewable energy and electric vehicles, and limited support for domestic consumption, many observers expect the flood of affordable Chinese goods into American and European markets to lead to rising trade tensions, particularly as both blocs hold elections in 2024.
Despite recent moves towards détente, Treasury Secretary Janet Yellen has consistently raised overcapacity concerns with her Chinese counterparts, as US policymakers worry that dumping could undercut the Biden Administration’s efforts at stimulating domestic manufacturing of renewable energy technologies, EVs, and advanced chips.11 The European Union has raised similar concerns and opened an investigation into Chinese EVs.12 As the world rapidly warms, cheap technologies that enable a transition away from carbon emissions as a necessary byproduct of economic growth would hardly be a problem if not for the need to ensure ongoing political support for such a transition. US and European policymakers are hoping that defense of their early efforts at reindustrialization via green tech and chips and protection of legacy automakers as they transition to EVs will help ensure that support, even at the price of slower decarbonization.
Noting that an aberrantly low “37% of China’s national income is spent by Chinese households on goods and services,” economics reporter, Matt Klein, argues that the problem is not so much overproduction, but underconsumption, which encourages Chinese firms to dump products abroad and limits imports to China.13 This framing may more conciliatory and constructive, but, at least a present, it doesn’t appear to be the dominant lens in Beijing, Brussels, or Washington, which likely portends heightened trade tensions that have the potential to spill over into capital markets and to slow the energy transition.
By: Michael Wedekind, CFA, Senior Investment Analyst - Fixed Income Research
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