All to play for
Sceptical FX and rates markets looking at Fed (and world) through dovish-tinted spectacles
The US Federal Reserve (Fed) has cried wolf many times in the past nine months, preparing the market for a rate hike only to then back down and further cut its estimate of the appropriate policy rate. As a result, the sceptical US rates and FX markets’ natural tendency is to look at US and global data and events through decidedly dovish-tinted spectacles, giving weight to “negatives” while seemingly discounting all but the most compelling evidence pointing to a December hike. The past eight days are a case in point.
Fed funds futures show that market pricing for a rate hike at the Fed’s 14th December meeting has actually fallen to around 13bp from 16bp in the wake of the Fed’s 21st September meeting. This is in line with my view, expressed in Federal Reserve – the Father Christmas of central banks (23 September 2016), that volatility in Fed fund futures will remain fluid in coming weeks.
This dovish repricing and grind lower in the US dollar (see Figure 3) has occurred despite a consensus view that presidential candidate Hilary Clinton comfortably won Monday’s presidential debate with Donald Trump, a jump in international oil prices since OPEC’s mid-week meeting, decent US data in the past week and stable global equities. It is clear that the rates and FX markets remain somewhat unimpressed, with some justification.
- For starters, Clinton had the upper hand in the first of three scheduled televised debates but fell well short of putting the election result beyond doubt. This is relevant as a Clinton victory at the 8th November presidential elections is a necessary, if not sufficient condition for the Fed to hike in December in my view, despite Chairperson Yellen’s understandable claim that the Fed is apolitical.
- OPEC’s agreement on 28th September to cut back aggregate oil output is an achievement in itself. But the Fed, other central banks and markets are likely to look beyond this week’s oil price bounce unless individual OPEC countries with conflicting constraints and objectives actually stick to their new, lower quotas and oil prices continue to rise. History suggests that this condition will be severely tested.
- Finally, US data have in aggregate been decent but have not dispelled concerns about the manufacturing sector. Ultimately, inflation and labour data – for which the Fed and thus markets have set a high bar – will need to impress.
A Clinton victory at the 8th November presidential elections, strong US macro data and stable global markets in coming months would help bridge the Fed’s credibility deficit ahead of a possible December hike (still my core scenario). But if the Fed is to avoid a collapse in global risk appetite (and a repeat of Q1 2016), it will have to play its part in putting a floor under the rate’s market pricing for a December hike. This would in turn likely imply a greater degree of unison from the ten voting FOMC members – which has not been totally obvious from their speeches in the past eight days.
I would therefore reiterate my expectation that financial markets are likely to remain particularly sensitive to weak US data, specifically on inflation and labour markets, dovish speeches by FOMC members, inconclusive presidential opinion polls and any reversal in international oil prices. Moreover, they could re-focus their attention on China’ own economic challenges – the question is not if but when in my view – which could in turn weigh on global risk appetite.
From Chinese cries to Chinese whispers
Unlike a year ago, China is seemingly no longer at the epicentre of every market move. Anecdotally, for example, the number of Google searches for “China hard landing” has collapsed since the PBoC’s token currency devaluation in August 2015 (see Figure 1). The Renminbi’s stability in the past five weeks, after months of depreciation, and signs that Chinese economic growth has stabilised may be contributing to the market’s seemingly agnostic take on China’s prospects (see Figure 2).
But the Chinese government has only just started to tackle issues of rising corporate and household indebtedness (as highlighted by the Bank of International Settlements), non-performing bank loans and industrial over-capacity. These issues have the potential to weigh on future Chinese economy activity at a time when China’s GDP growth (6.7%) still accounts for over a third of global GDP growth (2.8%) which is recovering only very slowly from depressed levels.
Trump vs Clinton Debate: Easy but inconclusive Clinton victory, bigger challenges ahead
The much awaited and hyped first televised debate between the Democrat and Republican presidential candidates on 26th September confirmed what we already knew. The consensus view amongst political experts, which I share, is that Hilary Clinton unanimously won this debate pretty comfortably (see Box 1).
The reaction of financial markets certainly suggests that Clinton had the edge, with US equities rallying modestly and the Mexican peso outperforming during and after the debate (see Figure 3). The Mexican economy arguably has the most to lose should Donald Trump come to power and carry out his threat of revisiting and potentially dissolving the United States’ international trade agreements, including NAFTA.
But opinion polls, still the best if flawed barometer of how the US electorate feels about the two main presidential candidates, show that Clinton has only slightly extended a wafer-thin lead to around 3-4 percentage points. Moreover, the Canadian dollar – which could have been expected to rally for the same reasons as the Mexican peso – was largely unchanged in the 24 hours following the debate (see Figure 3) while the S&P 500 and Dow Jones posted gains of only 0.7%. Finally, market pricing for a December Fed rate hike is actually 3bp lower today than it was following the Fed’s 21st September policy meeting.
The bottom line is that despite facing an inexperienced and ill-prepared political opponent, Clinton simply failed to put the election result beyond doubt and markets were not utterly convinced. Clinton needed to get out of her comfort zone and improvise in order to seize the initiative. Whether she was advised not to or whether she doesn’t know how to could be an important distinction come the second debate on 9th October.
Trump, after his damp performance, is likely to be better prepared and come out firing in the second debate, in which citizen participants and moderator will each pose half of the questions to the candidates. If Clinton is unable to find sixth gear, the bridge in popularity between the two candidates could narrow to a statistically insignificant gap. In this scenario, the rates market would likely further discount the probability of the Fed hiking in December and emerging market currencies and equities would also lose traction.
This would be a challenging backdrop for markets ahead of the third and final presidential debate on 19th October – arguably the most important of the three debates as it will be freshest in the electorate’s mind. In that regard the televised debates ahead of the 2012 US presidential elections between sitting President Barak Obama and Massachusetts Governor Mitt Romney provide an interesting template.
Obama was widely considered to have lost the first debate on 3rd October 2012 and by a significant margin. But he got the upper hand in the second debate (on 16th October) and pulled clear in the third and final debate (on 22nd October). Obama was able to find sixth gear, the first debate was largely forgotten, and he went on to win the 6th November presidential elections by 332 electoral votes to Romney’s 206.
OPEC agreement to cut oil output fillip for oil sector…and inflation?
The Organisation of Petroleum Exporting Countries (OPEC) on 28th September agreed to a cut in crude oil output and the price of Brent Crude has since jumped 7% to just under $50/barrel. Any agreement between OPEC’s disparate members, including Saudi Arabia and Iran, is always an achievement in itself and unsurprisingly the Nominal Effective Exchange Rates (NEERs) of oil-exporting economies, including Norway, Canada and Russia have rallied (see Figure 4).
The Malaysian Ringgit is a notable exception – the NEER has flat-lined since OPEC’s announcement despite Malaysia being a large regional oil and gas exporter, suggesting that domestic factors still matter. Moreover, non-oil commodity currencies have not benefited from this up-tick in oil prices. The South African Rand has more than unwound the gains it made in the wake of the first presidential debate, while the Brazilian Real and Australian Dollar are both down.
Higher oil prices should provide some modest relief to the US shale sector and further reassure the Fed that the US energy sector is no longer on a downward trajectory. Chairperson Yellen in her Q&A statement at the Fed’ 21st September meeting nuanced her concerns over depressed business investment by noting that drilling in the energy sector was stabilising. The US dollar NEER has recouped half of its post televised debate losses.
The rise in crude oil prices to a 3-week high should also, at the margin, give credibility to the Fed’s view that lower energy prices were transitory and help put a floor under global headline CPI-inflation which has flat-lined around 1.5% year-on-year since late-2015 (see Figure 5).
Higher oil prices and central bank policy inflexion point
If anything, this would in turn tend to support my view that global central bank monetary policy may have reached an important inflexion point and that major central banks, with the exception of the Band of Japan and Reserve Bank of New Zealand, may refrain from loosening monetary policy further near-term (see Global central bank easing nearing important inflexion point, 16 September 2016). At the very least, I would expect higher international oil prices to give further credibility to my view that policy rate cuts in developed economies will be increasingly less frequent than in the past.
- The Norges Bank, which on 22nd September kept its policy rate of 0.5% unchanged in the face of stronger than expected inflation and growth, will if anything have become less dovish given i) the positive impact of higher oil prices on the oil-exporting Norwegian economy and ii) a very low real policy rate (see Figure 6).
- The Bank of England (BoE) will maintain a dovish rhetoric but will refrain from cutting its policy rate to zero or increasing its QE program for now, in my view. The collapse in sterling following the June referendum has been a key driver of the stronger-than-expected rebound in the UK economy and rise in inflation expectations to a 2-year high and the BoE will want to keep sterling on the back foot. This will require the BoE to convince markets that further monetary policy easing is at least on the table – which was exactly its message at its 15th September policy meeting.
In emerging markets the picture is admittedly more nuanced, given that in a number of economies the central bank real policy rate (calculated as the nominal policy rate minus headline CPI-inflation) remains high by historical standards (see Figure 6). I would again flag that this is the case in Russia, Singapore and Indonesia. Unsurprisingly perhaps both the Central Bank of Russia (CBR) and Bank Indonesia (BI) have cut their policy rates in the past fortnight and further CBR and BI rate cuts remain on the cards, in my view. Moreover, the Monetary Authority of Singapore (MAS), which cut the pace of SGD NEER appreciation to zero at its semi-annual policy meeting on 14th April, is unlikely to tighten monetary policy at its October meeting (for which an exact date has yet to be set).
OPEC – Devil in the detail and implementation
Financial market’s reaction to OPEC’s announcement, however, has faded in the past 24 hours.
- US equity indices, which include a number of large energy companies, have given back all of the gains they made following the televised debate and OPEC announcement.
- Oil currencies either flat-lined yesterday (Russian Rouble) or gave back some of their earlier gains (Norwegian Krone, Canadian Dollar).
- Pricing for a December Fed rate hike has not moved higher since OPEC’s announcement
There are good reasons for this loss of initial enthusiasm. For starters, the price of Brent crude oil, which is still only $3 above the average of the past six months, has on a number of occasions this year failed to sustain increases above $50/barrel. With global demand still weak and global trade slowing to a 2-year low in July according to the CPB’s World Trade Monitor, the onus will mostly be on supply curbs to generate a sustainable oil price increase.
But analysts estimate that OPEC’s agreed aggregate cut of up to 700,000 barrels a day amounts to only 1% of world oil supply, even assuming that OPEC allocates this new, lower production target to individual countries and these countries actually deliver these output cuts. History suggests that this will be a tall ask with a number of OPEC countries (including Iran) and non-OPEC countries (including Russia) having refused in the past to curb their oil output in a bid to maximise oil revenues.
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