The lyrics of Genesis’ 1986 hit “Land of Confusion” were penned over 30 years ago, with the English rock band satirising Ronald Reagan’s US presidency (see Figure 1). Specifically, they allude to the confusion fuelled by opportunist politicians in a fast-changing world beset by acute challenges. But, in my view, they portray with uncanny accuracy the UK in 2017 as Prime Minister Theresa May and her government, Parliament and the Bank of England feel their way towards Brexit. Read more
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My macro & FX analysis is premised on both a detailed qualitative assessment of Emerging and G20 fixed income markets and economies and a rigorous quantitative analysis of data, trends, policy decisions and global events too often taken at face-value.
A picture can say a thousand words and a well-constructed and timely chart can shed light on often complex economic and market developments and challenge engrained assumptions.
Ideally, a chart will be forward-looking and a valuable tool in helping forecast economic and market developments and ascertain whether possible market mis-pricing may trigger turning-points or corrections.
There are of course limits to what even the best chart can do, with in particular the line between correlation and causation sometimes blurred. One should also be weary of reading too much into sometimes limited or patchy data sets and underlying data sources can add to or detract from the chart’s credibility.
Moreover, a chart can lose its potency over time, so while on average my research notes include about a dozen charts and tables I am constantly adding new ones.
I have re-published and updated below a small cross-section of the currency-specific charts which continue to play a central part in my narrative and forecasts, including:
- Global Nominal Effective Exchange Rates (NEERs)
- Euro and government bond yield spreads
- Sterling NEER
- Sterling NEER and annual pace of appreciation/depreciation
- The Renminbi NEER
- Renminbi NEER and monthly pace of appreciation/depreciation
I will in coming weeks expand on other notable charts and for a more detailed analysis I would refer you to my previously published (hyperlinked) research notes.
The Euro Nominal Effective Exchange Rate (NEER) appreciated about 8% between 20th April and late-August and outperformed all major currencies. However, since its multi-year high on 28th August the Euro NEER has weakened an albeit very modest 1%.
The question is whether/when the Euro may again find favour and set new multi-year highs or whether a more acute correction looms.
Part of the answer lies in the confluence of inter-related factors which contributed to the Euro’s steady climb in the first place but have recently lost some traction.
Prior to its take-off in April, the Eurozone NEER had been one of the more stable among the majors. The Euro was perceived as neither a “risk-on” nor “risk-off” currency and the ECB tacitly welcomed the Euro’s underperformance versus its key trading partners’ currencies.
While the French presidential election in April-May was an important catalyst for the Euro’s appreciation, the seeds for its rally and accession to “safe-haven” status had arguably been sown in 2015-2016.
However, some of these Euro-positive factors have become prey to far greater uncertainty and lost traction in recent weeks, undermining the Euro’s relative appeal while the Dollar and Sterling narrative has improved somewhat.
Financial markets have in particular reacted negatively to Sunday’s German federal election and uncertainty it has generated, both at a domestic and European level.
The Euro finds itself at a cross-road and I see little scope for rapid and/or sustained appreciation until the ECB announces the modalities of an extended QE program and a new German government is in place, with the risk biased towards bouts of Euro weakness.
Longer-term, however, a number of factors could drive renewed Euro appreciation, albeit at a likely slower pace than in April-August.
With the August lull behind us, developed central bank monetary policy has taken centre stage, with the focus in particular on the Fed and Bank of England. Both have signalled that they could deliver a 25bp hike before end-year.
Rates markets have adjusted accordingly and the focus as we enter the last leg of 2017 will be on whether macro data and events support this hawkish turn. Accordingly, I have compiled a comprehensive data and event release calendar for major economies (Figure 1).
Markets now have 17bp of Fed hikes priced in for the remainder of the year versus 7-8bp in early September – in line with my view that pricing was probably too skinny for the liking of a Fed keen to keep its options open while minimising any market fall-out.
Markets are pricing an 80% probability of the BoE hiking its policy rate 25bp to 0.5% at its 2nd November meeting and a further 30bp of hikes for 2018 – a very slow and gradual rate hiking cycle which would mimic the Fed’s tightening in 2015-2016.
The Fed and BoE have cried wolf in the past only to then keep rates on hold. Precedent suggests that a combination of very weak domestic and global macro data and significant Brexit-related setbacks (for the UK) could derail these central banks’ aspirations.
But my twin forecasts of the Fed hiking only twice this year and the BoE only starting to hike in 2018 are clearly at risk. Both central banks have, in my view, set the bar pretty low for a Q4 hike or put differently set the bar quite high to keep rates on hold.
The corollary is that financial markets’ reaction function to forthcoming macro data and events could be asymmetric, with bond yields rising and the Dollar and Sterling strengthening further on the back of good data and/or positive event risk but not reacting as much to weak data and/or negative event shocks.
The Fed confirmed at its policy meeting that it would start as of October reducing its $4.5trn balance sheet. The timeline and timescale, which had been flagged at its June policy meeting, is clearly designed to be slow and gradual in a bid not to spook markets and avoid a repeat of the 2013 tapper-tantrum.
I argued in Paradox of acute uncertainty and strong consensus views (3 January 2017) that “German general elections scheduled for September may well lead to a more divided parliament, making it harder to form a majority coalition government. But it is difficult at this stage to see who will realistically challenge Chancellor Merkel who is striving for a fourth consecutive election victory”. Nine months on and with German federal elections scheduled for Sunday my view has not changed materially.
The past year has been remarkable with political precedents set in the US, UK and France, still record-low central bank policy rates in most developed economies and financial markets and macro data at all-time or multi-year highs (and lows).
The US presidency is fraught with problems but markets are turning a blind eye…for now. The UK is still on course to be the first ever member state to leave the European Union come 29th March 2019, at least on paper. French elections have repainted the political landscape and present many opportunities but old (fiscal) hurdles still need to be cleared.
Central bank policy rates remain at record lows in the majority of developed economies, including the Eurozone, UK, Japan, Australia and New Zealand and I expect this to remain the case for the remainder of the year. Loose global monetary policy is likely to continue providing a floor to risky assets, including equities and emerging market currencies.
A number of central banks have hiked 25bp in recent months, including the Fed, BoC and CNB, in line with my year-old view that rate hikes would gradually replace rate cuts. But in aggregate the turnaround in developed central bank monetary policy is proceeding at a glacial pace and I see few reasons why this should change.
The Bank of England has not hiked its policy rate for 526 weeks – a domestic record – and I continue to believe that this stretch will extend into 2018.
In contrast to the Dollar and Sterling, the Euro – by far the most stable major currency in the past seven years – has appreciated over 7% since early April.
While the ECB may want to slow the current rapid pace of Euro appreciation, it is unlikely to stop, let alone reverse, the Euro’s upward path at this stage. For starters, Eurozone growth and labour markets continue to strengthen. The German IFO business climate index hit three consecutive record highs in June-August.
Perhaps the most obvious record which financial markets have broken is the continued climb in US equities to new highs and volatility’s fall to near-record lows.
Emerging market rates continue to edge lower in the face of receding inflationary risks and I see room for further rate cuts, particularly in Brazil given the pace of Real appreciation.
Non-Japan Asian (NJA) currencies continue to broadly tread water, in line with my core view that NJA central banks have little incentive to materially alter their currencies’ paths.
Year-to-date emerging market equities have rallied 24%, twice as fast as the Dow Jones (12%) which has rallied twice as fast as EM currencies versus the Dollar (6%). Read more
The odds of a 25bp Bank of England rate hike at next week’s policy meeting are all but dead in my view following tepid GDP growth of 0.3% qoq in Q2 2017.
Moreover, UK GDP growth and inflation dynamics, allied to forthcoming changes in the composition of the Monetary Policy Council, point to the record-low policy rate of 0.25% remaining on hold for the remainder of the year.
Forecasting European Central Bank (ECB) monetary policy, including the timing and modalities of changes to its Quantitative Easing program, is arguably a far trickier proposition.
While the ECB may be incentivised to slow the current rapid pace of Euro appreciation, at this stage I do not expect the ECB to try and to stop, let alone reverse, the Euro’s upward path.
Market focus has shifted from elections to central banks’ next steps
Financial markets, having digested the result of parliamentary and/or presidential elections in the US, Austria, Netherlands, France and UK and expecting German Chancellor Angela Merkel to win a fourth consecutive general election on 24th September, have turned their focus to global central bank policy. Specifically, it has centred on the possibility of tighter interest rate policy in developed economies in the form of rate hikes and/or modifications to central bank balance sheets or quantitative easing programs.
End-2016 proved to be an important inflexion point for global central bank policy
Up until the summer of 2016, developed central banks were still very much in monetary easing mode, with the exception of course of the Fed which had hiked its policy rate 25bp in December 2015. But eight years of ultra-low (and in some cases negative) central bank policy rates and expansive bond-buying programs had helped stabilise global growth and inflation, albeit at low levels. At the same time, the costs of ultra-loose monetary policy, including asset price bubbles, distortions in bond markets, pressure on the banking sector and even rising inequality, had started to outweigh the benefits.
This led to me to forecast that major central banks may refrain from loosening monetary policy further and that the ECB and BoE would keep the modalities of their QE programs broadly unchanged near term. At the very least I expected central bank policy rate cuts to become increasingly less frequent than in the past and that the world’s most influential central bankers would start tweaking a discourse which had in recent years largely focused on doing “whatever it takes” (see Global central bank easing nearing important inflexion point, 16 September 2016).
At the same time I argued that bar the Fed and possibly a handful of emerging market central banks still fighting weak currencies and high inflation, no major central bank was likely to hike policy rates or tighten monetary policy in the remainder of 2016 – that was a story for 2017, at the earliest.
This scenario has largely materialised, with the exception of the Reserve Bank of New Zealand delivering a final 25bp rate hike in November 2016.
- Since then no developed central bank has cut its policy rate with a GDP-weighted average of policy rates bottoming out and more recently inching higher (see Figure 1).
- The only major central banks to have cut rates are the Central Bank of Russia and Banco Central do Brazil (see Figure 2). In May and June 2017 no major central bank cut its policy rate – the only other time this has happened in the past four years was in December 2016.
- Central banks in Turkey and Mexico, in the face of still high inflation, have hiked their policy rates 50bp and 225bp respectively since August 2016.
- The US Federal Reserve has already hiked rates 50bp this year and there has been growing talk of the Fed shrinking the size of its balance sheet.
- This week the Bank of Canada hiked its policy rate (25bp) for the first time in nearly seven years.
- Three out of eight members of the Monetary Policy Council of the Bank of England dissented in favour of a 25bp rate hike at the June policy meeting.
- The European Central Bank has adopted a marginally more hawkish language in recent months. There is mounting expectation that the ECB will announce as early as September an extension of its quantitative easing program beyond-2017 but also a gradual tapering of the monthly amount of bonds purchased (from €60bn currently), with QE ending fully in late 2018 or early 2019.
This has led to growing speculation that we have reached a second inflexion point in developed central bank policy and one which could be sharp enough to dislocate global growth and asset markets, particularly in emerging economies. But financial markets, at present, expect only very marginal policy tightening by developed central banks. Specifically:
- US Federal Reserve: Markets have all but priced out a September hike and are pricing in only another 12bp of hikes by year-end (i.e. a 50% probability of one more 25bp hike this year)
- Bank of England: 12bp of hikes priced by year-end (i.e. a 50% probability of one hike this year)
- Reserve Bank of Australia: No hikes priced in for the remainder of the year and only 15bp of hikes priced in for the next 12 months.
- Bank of Canada: One more 25bp hike priced for this year.
This skinny market pricing of policy rate hikes is appropriate, in my view. At a global level, there are signs that GDP growth may have plateaued in Q2 2017 at around 3.1-3.2% year-on-year (see Figure 3), as I argued in H2 2017: Something old, something new, something revisited (23 June 2017).
Moreover, inflationary pressures remain muted in developed economies. Headline CPI-inflation in both developed and emerging market economies steadily rose between end-2015 and early 2017 but has since fallen (see Figure 4).
Perhaps more importantly, core CPI-inflation, which strips out food and fuel prices, has risen in emerging markets but after having flat-lined for years in major developed economies has in recent months dipped lower (see Figure 5). Only in the UK has core CPI-inflation risen and this is mainly attributable to higher imported inflation fuelled by the collapse in Sterling following the 23rd June 2016 EU referendum.
Moreover, in the US and Australia positive employment growth and very low unemployment rates continue to go hand in hand with only modest growth in real wages, while in the UK real wages are falling – an issue which I first identified in The common theme of low-wage growth, 10 February 2017). The inability of workers to command larger increases in nominal wages is acting as a break on both inflation expectations and consumer demand, and in turn is likely to curb underlying inflation going forward, in my view.
Bank of England – Policy rate to remain on hold in August and potentially rest of the year
The weakness of the UK economy and uncertainty associated with the Brexit process are high enough hurdles for the Bank of England (BoE) to refrain from hiking policy rates any time soon (see UK: Land of hope & glory…but mostly confusion, 7 July 2017).
I maintain my view that the BoE’s eight-member MPC is unlikely to hike its policy rate of 0.25% at its August meeting. While I expect MPC member Andrew Haldane to join Michael Saunders and Ian McCafferty in voting in favour of a 25bp hike, new member Silvana Tenreyro is likely to vote in favour of no change which would result in a 3 versus 5 vote in favour of rates remaining on hold. Importantly, I believe that Governor Carney – who has the casting vote in the event of a 4 versus 4 tie – will again vote for no change, even if he has had a tendency to blow hot and cold.
US Federal Reserve – Skip September meeting, keep December alive?
The US Federal Reserve has hiked its policy rate 50bp year-to-date but markets, which are pricing only 12bp of hikes for the remainder of the year, are clearly divided as to whether FOMC members will stick to their end-2016 forecast that three hikes would be appropriate in 2017. My core scenario remains that the Fed will not hike rates again in 2017 although this is a modest conviction call. While the labour market is inching towards full-employment, measures of US core inflation have fallen as pointed out by a number of FOMC members, including Chairperson Janet Yellen (see Figure 6).
The Reserve Bank of Australia has given every indication that it will remain pat on interest rate policy for the foreseeable future and while the Bank of Japan is prone to tweaking inflation targets and yield targets I do not foresee major policy changes at this juncture.
Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.
Sticking to forecasts: Fed summer hike, Dollar hat-trick still on the cards, Modestly weaker EM currencies, UK to stay in EU and Sterling to appreciate
The Federal Reserve’s minutes of its 27th April policy meeting released last week set the tone for a possible June or July rate hike. On balance, recent US and global data are unlikely to have fundamentally changed the Federal Reserve’s view that a summer hike may be appropriate.
This is in line with my long-held forecast that the Federal Reserve would likely hike once or twice this year, with the first hike in June. I recently updated my forecast to a July hike as it gives the Fed more time to assess US and global data and the result of the UK referendum on 23rd June. The risk is that the very threat of a hike derails financial markets sufficiently for the Federal Reserve to postpone its second-hike-in-a-decade to later this year. Read more
Central banks’ tinkering with monetary policy and frequent u-turns are seemingly doing more harm than good. The Fed and the Bank of England have provided little clear forward guidance and the Bank of Japan’s move into negative rates only had a passing positive impact. While safe-haven flows may continue to appreciate the yen, a less competitive currency is likely to ultimately weigh on the economy and in turn the yen. In contrast the Korean won looks reasonably attractive at these levels. Read more