Asymmetric data and event risk
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.
Fed and BoE have kept prospect of end-year 25bp rate hike well and truly alive
With the August lull behind us, developed central bank monetary policy has taken centre stage, with the focus in particular on the US Federal Reserve (Fed) and the Bank of England (BoE). Both clearly signalled at their latest policy meetings, on respectively 20th and 14th September, 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. With this in mind I have compiled a comprehensive macro data and event release calendar for major economies for the remainder of September and Q4 (see Figure 1).
The Fed is apparently willing to look through the mystery of why inflation is not rising (see Figure 2), focusing instead on healthy labour market dynamics amongst other developments. 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 (see We know what you did last summer, 1 September 2017).
While 7 out of 9 Monetary Policy Council (MPC) members voted to keep rates on hold on 14th September, the change in tone in its summary and meeting minutes was clear. The BoE seems intent on capitalising on a recent rebound in domestic economic activity (following a lacklustre Q2), the ongoing recovery in global growth and signs that Brexit negotiations may be back on track. While the BoE acknowledges that Sterling’s weakness has largely driven headline inflation’s rise, it may want to circumvent any risk of higher inflation becoming self-fulfilling while trying to gently wean households off mounting debt.
Markets are pricing in an 80% probability of the BoE hiking its policy rate 25bp to 0.5% at its 2nd November meeting (when it will also publish its updated quarterly inflation report), which would reverse the BoE’s post-Brexit emergency rate cut in August 2016. Markets are pricing in 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.
Precedent suggests a note of caution
The Fed and BoE have cried wolf in the past only to then u-turn and keep rates on hold and precedent suggests that a combination of weak domestic and global macro data and significant Brexit-related setbacks (for the UK) could derail these central banks’ aspirations to deliver an end-of-year hike. Markets have tended to focus on headline employment data in the US but the inter-linkages between modest real wage growth and still low inflation is perhaps more relevant and I would focus on releases of September inflation measures on 13th and 30th October (see Figure 1).
In the UK, strong retail sales and fiscal data for August and fall in the unemployment rate to a multi-decade low of 4.3% have given some weight to the MPC’s argument that a rate hike may be warranted “in coming months”. However, with real wages down 0.5% since April and the trade deficit showing no signs of narrowing, I would expect the MPC to want clearer evidence that inflation is not turning down and that broader GDP growth picked up in Q3 from a paltry 0.5% in H1 Q2. September inflation data are due on 17th October and the first Q3 GDP estimate on 25th October – a week before the MPC meeting (see Figure 1). As I will explore in forthcoming reports, the correlation between retail sales and broader household consumption is weak (see Figure 3) and in recent quarters the relationship between household consumption and GDP growth has been tenuous.
MPC member Gertjan Vlieghe, regarded as a dove, took a hawkish turn in a speech delivered on 15th September when he argued that “The evolution of the data is increasingly suggesting that we are approaching the moment when Bank Rate may need to rise” [my emphasis]. But his choice of words – “suggesting”, “approaching” and “may” – also leave him (and presumably other dovish MPC members) with the room to keep rates on hold for the remainder of the year. At least three MPC members will have to join Ian McCafferty and Michael Saunders in voting for a 25bp hike in order for it to become policy.
Asymmetric market response to macro data and event risks
But with both the Fed and BoE having laid out their stalls, my twin forecasts of the Fed hiking only twice this year and the BoE only starting to hike in 2018 are clearly at risk. Macro data and event risk would likely have to deteriorate quite significantly in coming months for the Fed and BoE to push out their next rate hike to 2018. 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 on the back of good data and/or positive event risk but not reacting as much to weak data and/or negative event shocks. If correct, this could mean further upside for the Dollar, which is up about 0.9% since the 25-month low recorded on 8-9 September, according to my estimates (see Figure 4). It could provide another leg-up to a resurgent Sterling which has confounded my expectation that Sterling would remain in a narrow range (see Figure 5 and UK: Land of hope & glory…but mostly confusion, 7 July 2017).
Federal Reserve balance sheet reduction designed to avoid another taper tantrum
The Fed confirmed at its policy meeting this week that it would start as of October reducing its $4.5trn balance sheet made up of $2.5trn in Treasury bonds and $2.0trn in mortgage-backed securities. It will start shrinking its holdings by $10bn per month, increasing its taper in steps of $10bn at 3-month intervals over 12 months until it reaches $50bn per month (see Figure 6). In effect, the Fed will in a year’s time be reducing its balance sheet by $600bn per annum.
The Fed had flagged this timeline and timescale at its June policy meeting and they should therefore have come as little surprise to financial markets. The pace of balance sheet reduction is clearly designed to be slow and gradual in a bid not to spook markets and avoid a repeat of former Chairperson Ben Bernanke’s 2013 tapper-tantrum. I estimate that $10bn per month equates to 0.22% of the (current) balance sheet and that based on the current schedule the balance sheet will be cut by about $900bn or 20% over two years (see Figure 7).
How markets digest this over the medium-run remains open to debate but in the near-term the more interesting development in my view is the clear consensus which has built around one more 25bp rate hike before year-end.
At their September meeting, 11 out of 16 FOMC participants assessed that a third 25bp rate hike would be appropriate this year, according to the Fed’s updated “dot chart” (see Figure 8). With the Fed having kept the Fed fund rate on hold this week at 1.00-1.25%, as expected, and the Fed running out of policy meetings for 2017, it was always likely that fewer (if any) FOMC participants would expect two more hikes this year. Indeed, only one FOMC member still sees two more hikes this year, down from four at the June meeting and, accordingly, the weighted average of the appropriate end-2017 fund rate edged lower to 1.33% or 20bp of hikes from 1.375% or a full 25bp hike in the June dot-chart (see Figure 9).
But the key take-away in my view remains that the Fed has taken a clear step closer towards another rate hike before year-end. Based on recent precedent this would likely be at its 13th December meeting when it will also be publishing its Economic Projections and Chairperson Yellen will take part in a press conference. Back in December-2016, participants – on a weighted average basis – had declared that 75bp of hikes would be appropriate in 2017. If the Fed pulls the trigger in December, it will have a gone some way of re-establishing its credibility, having significantly over-estimated the need for hikes in both 2015 and 2016 (it expected four hikes in both 2015 and 2016 but delivered only one in each year).
The FOMC participants’ assessment for the appropriate pace of rate hikes in 2018 is understandably more dispersed than it is for the next three months and the weighted average of the appropriate end-2018 fund rate edged lower to about 71bp of hikes versus 85bp at the June meeting (see Figure 9). But again the message is that they are slowly crystallising around the (credible) view that three hikes will be appropriate in 2018 – which would be a repeat of 2017 should the Fed hike in December. Indeed six participants see 75bp of hikes as appropriate next year (versus five at the June meeting) and only two participants expect more than four hikes (versus five at the June meeting).
German Federal Elections (24th September) – Much ado about nothing
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 my view has not changed materially.
CDU/CSU alliance likely to be largest party and Merkel re-elected Chancellor
Based on recent opinion polls, Angela Merkel’s centre-right Christian Democratic Union (CDU) party and its sister Christian Social Union (CSU) party are on course to once again win the largest number of seats in the Bundestag, and by a healthy margin, in Sunday’s federal elections (see Figures 10 and 11). This would put the CDU/CSU, currently in a grand coalition with the centre-left Social Democratic Party (SPD), in poll position to form a government and secure another 4-year term for Chancellor Merkel.
The CDU/CSU is currently polling about 37%, well ahead of Martin Schulz’ SPD which back in Spring was on the ascendancy but whose support has since nose-dived to around 22%. The SPD has run a lacklustre electoral campaign and Merkel and the CDU/CSU have adroitly borrowed some of the SPD’s more popular policies, including on gay rights. The odds of the SPD leading a ruling coalition are arguably small, despite polls showing that over 30% of German voters remain undecided.
CDU/CSU will be short of parliamentary majority in a more divided Bundestag
However, opinion polls also make clear that the CDU/CSU will fall well short of a parliamentary majority and will once again be forced into a coalition. At the same time, polls show four parties on about 10% support, pointing to a more divided and unprecedented six-party Bundestag. This in turn makes it more difficult to predict the make-up of this ruling coalition and could lead to drawn-out negotiations between the CDU/CSU and potential partner(s). In particular, both the liberal Free Democratic Party (FDP) party and far-right Alternative for Germany (AfD) look set to win seats in this weekend’s election.
- The FDP, which was in power alongside the CDU/CSU in 2009-2013, failed to win any seats in the 2013 federal elections but now looks set to cross the required 5% threshold.
- Similarly, the AfD is polling 10% with suggestions that this under-estimates the true support for the nationalist party which could become the third largest in the Bundestag. In any case, the AfD is on course to win seats for the time ever and thus effectively take seats from mainstream parties which have rejected the possibility of governing with the AfD.
- The post-communist Left Party remains a viable coalition partner for the SPD in the unlikely event of the SPD securing a sufficiently large number of seats to be in a position to build a majority coalition.
- The Green Party, which won an average 61 seats in the three prior federal elections, has seen its support ebb to around to 8-9% but will likely once again be a non-negligible political player.
Parliamentary arithmetic points to a number of possible (tested and untested) ruling coalitions
Depending on the parliamentary arithmetic – rendered more complicated by the election’s inner mechanics – and the number of seats which the CDU/CSU and other parties secure, Merkel could seek to form a majority coalition with the following party or parties:
- The SPD, effectively a continuation of the current grand coalition. However, the rank and file and some senior SPD members have ruled out another term alongside the CDU/CSU. The SPD may be particularly reluctant to be a junior partner in the event of it winning only a modest number of seats.
- The FDP, in a repeat of the 2009-2013 government, which would likely be Merkel’s preferred outcome;
- The Greens, in a coalition which has been tested at a state but not federal level;
- Both the FDP and the Greens, which has been labelled the “Jamaica” coalition. This broad coalition, which has been tested at a state but not federal level, is likely the least appealing outcome for Merkel. The laissez-faire FDP and interventionist Greens disagree on a number of key issues, including the direction and future of the EU, immigration and the environment.
Note that the CDU/CDU has categorically ruled out a coalition with either the AfD or Left Party.
Policy continuity on the economy, Europe and Brexit for the 4×4 Chancellor
Whatever the make-up of a CDU/CSU led coalition, I would expect a degree of policy continuity, both in terms of substance and style.
For starters, the FDP and/or the Greens would likely be junior partners, with Merkel benefitting from 12 years in power as Chancellor. Moreover, in the event of both the eurosceptic FDP and pro-Europe Greens being part of the government, their respective policy stances would potentially cancel each other out although decision-making could be more protracted.
In particular, I would expect Merkel to continue to push for a German rapprochement with France and President Macron following the frosty relationship between the Chancellor and former French Socialist president Francois Hollande. At the same time, Merkel and her party are likely to continue resisting Turkey’s possible membership to the EU and wholesale financial bail-outs of other EU countries, while taking somewhat of a back-seat on the issue of Brexit.
It is noteworthy that Brexit was not discussed during the televised debate between Merkel and Schulz on 3rd September and Merkel has seemingly been content to let European institutions take the lead on the UK’s planned exit from the EU in March 2019. The German government has a vested interest in ensuring that Brexit does not incentivise other member states to consider leaving the EU. The UK will also remain a key trading partner for the UK beyond Brexit (see Figures 12 and 13), as I detail in Appetite for destruction… and procrastination (8 September 2017). However, at this juncture Brexit is simply not at the top of the list of Merkel’s concerns, unlike domestic security for example. I would expect Merkel to continue relying on the European Commission and European Council to conduct complex and drawn-out negotiations with UK counterparts as long as they stay broadly on track.
Moreover, Merkel has already started to backtrack on some of her less popular policies, including allowing mass immigration into Germany (asylum applications collapsed to 110,000 in H1 2017 from 750,000 in the full-year 2016). This has somewhat curbed the mass appeal of the AfD‘s nationalist policies, in the same way that British Prime Minister Theresa May and French President Macron have incorporated some of their respective countries’ nationalist parties’ less controversial policies. May and Macron have effectively taken away much of these parties’ thunder, supporting my view that markets had over-estimated the reach of European nationalism (see Nationalism, French presidential elections and the euro, 18 November 2016).
German economy robust, markets to refocus on other drivers of European equities, bonds and FX
Finally, the German economy is strong – GDP growth is ticking around 2.5%, exports are flying, the seasonally adjusted harmonised unemployment rate has fallen to 3.7% and the fiscal surplus was a record-high of €18.3bn in H1 2017. Therefore, political parties – irrespective of their leaning – will likely be cautious in pushing for wholesale changes to economic policies which have delivered and be forced to tinker at the edges. Specifically, repeated calls – both domestic and foreign – for the government to loosen fiscal policy in a bid to stimulate domestic consumption are likely to continue to fall onto largely deaf ears. Finance Minister Schauble, Germany’s longest-serving politician, will seek a third term although the pro-business FDP has said it would seek the Finance Ministry position if part of a ruling coalition.
The Bundestag will likely look different next week and European financial markets may be jittery near-term, particularly if coalition talks are drawn out and political gridlock ensues. Ultimately, however, Merkel’s authority and policy-direction are unlikely to be seriously tested. I would thus expect markets to eventually refocus on the fundamental drivers of European bonds, equities and common currency, including the pace of the European economic recovery and ECB monetary policy.
 The Bundestag currently has 630 deputies but due to the proportional representation voting system, the number of deputies varies from one election to the next and some experts have predicted that following this year’s election the Bundestag could have up to 800 deputies.
 The colours of the three parties are the same as those of the Jamaican flag – black (CDU/CSU), yellow (FDP) and green.
 The United Kingdom Independence Party (UKIP) failed to secure a single seat in the June 2017 British general elections while the nationalist Front National party and its leader Marine Le Pen were comprehensively beaten in this year’s French legislative and presidential elections. Both UKIP and the Front National have since been in disarray.