Author Archives: Olivier Desbarres

Plan B

Global and US equity markets are hitting new all-time highs at an almost metronomic rate while the VIX continues to hover around a historically-low 11. Moreover, major currencies have remained within narrow ranges in the past couple of months.

Rising global economic activity, still accommodative central bank monetary policy, a historically average crude oil price and increasingly realistic prospect of US tax cuts, among others, continue to buoy global financial markets and tame asset price volatility.

Financial markets have seemingly largely ignored macro, political and geopolitical risks which include 1) monetary policy uncertainty and risk of central banks “getting it wrong”, 2) the impact on emerging markets from higher rates and stronger funding currencies, 3) the shaky underpinnings of global economic growth and 4) political uncertainty in Europe.

The question is whether governments and central banks have a Plan B to reflate their economies and/or support financial markets in the event of an exogenous shock to global growth and/or sharp correction in global financial markets.

The willingness of the private sector in developed markets to borrow more in order to fund economic activity would likely be greatly tested given already high levels of indebtedness and I would not expect corporates or households to be the main source of reflation.

Similarly, the ability and willingness of developed central banks to cut policy rates further and re-start QE programs would be limited in my view.

Precedent suggests that central banks in emerging markets, including China, would likely use considerable FX reserves of around $8trn to slow, if not stop, any shock-induced, rapid and/or sustained depreciation in their currencies.

However, aggregate data mask significant country-side variations while large percentage changes in FX reserves tell us little about their absolute size.

Governments in developed economies could ultimately take over from central banks in a more pivotal role while the governments of China and other Asian economies have repeatedly shown their willingness and scope to use a broad arsenal of measures. Read more

Euro impervious to Eurozone’s political pantomime

The Euro is trading near the top of a narrow range. However, messy Eurozone politics characterised by nationalist currents are taking the shine off the region’s economic faster recovery and could ultimately act as a headwind to growth and Euro appreciation.

In Spain, Catalonia’s independence vote on 1st October has cast a shadow on Spain’s undoubted economic turnaround. In Austria, the far-right Freedom Party will likely join a ruling coalition following national elections on 15th October, re-igniting concerns about European nationalism’s ascendancy.

German Chancellor Angela Merkel’s talks with its potential coalition partner, the Free Democratic Party (FDP), have collapsed with the ruling CDU-CSU and FDP unable to agree on the formation of a majority government which would also include the Green Party.  

Chancellor Merkel, who is trying to secure a fourth consecutive term, now has four options:

  1. Return to the negotiation table in the hope of forming a majority, tripartite coalition between her centre-right CDU-CSU, the liberal FDP and Greens;
  2. Form a majority coalition with the centre-left Social Democratic Party – a repeat of the 2005-2009 and 2013-2017 governments – despite the SPD’s wish to be in opposition;
  3. Form a minority coalition government with the Greens, for which there is no precedent at a national level; or
  4. Push for a new set of Bundestag (legislative) elections.

Merkel said she would prefer new legislative elections over a minority government, a possible ploy to force the FDP back to the negotiating table which could backfire.

A recent opinion poll suggests that in the event of new elections, which could take months to secure, the CDU-CSU, SPD and Left Party would all lose seats while the Greens, FDP and far-right Alternative for Germany (AfD) would gain seats.

New elections could thus further sap Merkel’s credibility and make it even harder for the CDU-CSU to form a majority coalition on its own terms. If coalition talks once again failed, Merkel would be back to square one and would conceivably be under pressure to resign – a scenario which I flagged two years ago and now seems plausible even if still unlikely.

Option (2) may thus be the least unappealing for the normally pragmatic Chancellor, while the SPD and Schulz may have more to lose from new elections than the FDP and Greens.

If Option (2) remains off the table, the CDU-CSU and SPD could opt for a “confidence-and-supply” agreement, a hybrid of Options (2) and (3) providing some policy continuity. The SPD’s annual conference in the second week of December is one for the diary.

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Bank of England – Trick rather than treat

The Bank of England (BoE) hiked rates 25bp yesterday for the first time in a decade, as expected, with recent domestic and global macro data seemingly helping the Monetary Policy Council inch over the rate-hiking start line.

But that was not the real story, with financial markets always likely to look beyond the headline decision and focus instead on the underlying message.

Markets’ dovish reaction in the past 24 hours suggests that they zeroed in on BoE Governor Carney’s view that future rate hikes would be gradual and limited.

The Sterling Nominal Effective Exchange Rate is down 1.4% to the bottom of a 5-week range and markets are now pricing only a 34% probability of a 25bp hike in February.

Carney’s cautious outlook for the policy rate’s path is in line with my expectations that macro data and the cloak of uncertainty which surrounds Brexit will limit the need and room for the BoE to tighten monetary policy.

Fundamentally, the UK economy remains fragile, with lacklustre GDP growth of only 1% in Q1-Q3 2017 lagging growth in other G7 economies, and the medium-term outlook remains uncertain at best, in my view.

Weak retail sales and household consumption growth of only 0.5% in H1 is clearly acting as a drag on overall economic growth.

A key reason is that growth in economy-wide real earnings has slowed sharply in the past two years, in turn the by-product of slowing growth in employment and real earnings.

Moreover, the household savings rate is an already very low 6% while commercial banks are looking to tighten lending standards and pass on yesterday’s rate hike to borrowers.

With this backdrop and likely slowdown in imported inflation, core and headline CPI-inflation may be close to peaking, in my view, although there is of course the no small-matter of Brexit, a known unknown of considerable magnitude.

Governor Carney’s clear message that the BoE may not need to hike much to get inflation back down to 2% in coming years is somewhat reminiscent of the US Federal Reserve’s policy stance in 2015 and 2016.

It is possible, in my view, that the BoE’s rate hiking cycle could mirror the Fed’s with the BoE only delivering one (or perhaps two) hikes in 2018, in which case markets may need to further reduce their expectations of a February 2018 rate hike. Read more

My Top Currency Charts

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:

  1. Global Nominal Effective Exchange Rates (NEERs)
  2. Euro and government bond yield spreads
  3. Sterling NEER
  4. Sterling NEER and annual pace of appreciation/depreciation
  5. The Renminbi NEER
  6. 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.

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Uncertainty threatens Euro’s safe-haven status, for now

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.

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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.

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Appetite for destruction… and procrastination

Financial markets continue to take into their stride a number of man-made and natural crises and the procrastination of policy-makers in the US, UK and Eurozone.

Global risk appetite remains seemingly well bid despite the still very opaque end-game for rising geopolitical tensions stemming from North Korea and the impact from Hurricanes Harvey and Irma.

In the world of FX, the emerging market carry trade is seemingly enjoying a mini-revival thanks to low yields in developed economies, signs that global GDP growth continues to inch higher and a surge in commodity prices, particularly industrial metals.

Event risk is clearly more acute in September than it was in August but it is not obvious to me that major central banks will deliver the kind of surprises which cause major dislocations in financial markets, including EM currencies.

However, these high-yielding EM currencies’ volatility versus the Dollar remains quite elevated, with perhaps the exception of the Turkish Lira and Indian Rupee.

Chinese policy-makers are seemingly intent, at least for now, on using Renminbi appreciation as a show of strength and I expect further currency gains near-term.

In the UK, the mammoth challenge facing Prime Minister Theresa May is coming into greater focus. Moreover, the Bank of England is unlikely to seriously consider a rate hike before next year, in my view.  With this in mind, I see the risk biased toward bouts of Sterling weakness.

The Euro, which eked out small gains versus the Dollar and Sterling following ECB President Draghi’s Q&A session, is ultimately behaving like a safe-haven currency.

I expect the common currency to benefit, not suffer, from lower interest rates for longer and the associated improvement in economic activity even if future Euro appreciation could be modest rather than spectacular.
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We know what you did this summer

The month of August has come and gone and I struggle to pinpoint any new, clear-cut common themes. There has been plenty of news and developments for financial markets to digest and react to, including North Korea’s recent missile launch over Japanese airspace, the devastating impact of hurricane Harvey in Texas, the looming US debt ceiling breach, President Trump’s threats of terminating/re-negotiating NAFTA, ongoing Brexit negotiations between the UK and European Union and French President Macron’s announcement of ambitious labour market reforms.

However, the Economic Policy Symposium in Jackson Hole on 24-26 August promised a lot but as often the case delivered little for markets to hook their teeth into. Moreover, macro data in the past few weeks have not really told us anything really new. Gains in global GDP growth are incremental but 3% seems like a reasonably robust floor. Today’s global manufacturing PMI data for August (due for release at 16:00 London time) are worth paying attention to given the decent correlation with global GDP growth according to my analysis (see Figure 1).

 

Olivier Desbarres I know Fig 1

The mirage of much higher inflation in developed economies remains largely just that – a mirage – which I attribute in part to tepid real wage growth – at least in the US, Australia and in particular the UK. This presents somewhat of a dilemma for the Federal Reserve, far less so for the Bank of England and Reserve Bank of Australia as I discuss below.

This explains in large part the dovish bias in global rate markets, with government bond yields in the US, UK, Germany and Japan continuing to slowly edge lower (see Figure 2). This trend in developed market yields is broadly in line with the view I expressed six weeks ago that skinny market pricing of policy rate hikes was probably appropriate (see Central banks – a muted second inflexion point, 14 July 2017).

 

Olivier Desbarres I know Fig 2

 

The fall in yields has been pervasive across the maturity spectrum and only Australian 2-year bond yields have risen (albeit by a paltry 2bps since mid-July – see Figure 3).

 

Olivier Desbarres I know Fig 3

Markets showing Teflon-like qualities but September may offer more acute test

There is also an argument to make that markets’ threshold for change is seemingly quiet high. The VIX equity volatility index temporarily spiked to 14 a few days ago but is now back on a 10-handle and the Dow Jones is grinding back higher. Sterling has been reasonably well behaved in the past week while the Euro, the poster-boy of developed currencies for the past five months, is struggling to extend its gains (in nominal effective exchange rate terms).

Event risk is clearly more acute in September, as central banks resume their policy meetings and parliaments return to work (see Figure 4). Even so, it is not obvious to me that major central banks will deliver the kind of surprises which cause major dislocations in financial markets. Lessons seem to have been learnt since the Fed’s 2013 so-called “taper tantrum” and I would expect central bankers to be particularly cautious in both their actions and words, forcing markets to focus on second or third derivatives.

 

 

The focus will be squarely on the European Central Bank (ECB) and US Federal Reserve meetings on 7th and 20th September, respectively, as central banks in the UK, Japan and Australia are seemingly content with doing very little at present.

 

European Central Bank sitting pretty for now

The ECB is ultimately in a pretty comfortable position, in my view, and can probably afford to do and say little next week. The Euro Nominal Effective Exchange Rate (NEER) has appreciated 5.5% since early May, which amounts to a tightening of monetary conditions and has led to speculation that the ECB will try to jawbone the Euro weaker. The minutes of the ECB’s 20th July policy meeting – which stated that “Concerns were expressed about a possible overshooting in the repricing by financial markets, notably the foreign exchange markets, in the future” were interpreted as evidence of a central bank keen to arrest the Euro’s appreciation.

But I am sticking to my view that the ECB is unlikely to actively talk down further modest Euro appreciation from current levels (see no UK rate hikes this year and room for further Euro upside 28 July 2017), highlighting five reasons. For starters, two key words stand out in the ECB statement: “possible” and “future”. That’s a far cry from saying that the Euro has already-overshot. It is also telling that ECB President Mario Draghi did not mention (directly or indirectly) Euro strength at the Jackson Hole meetings.

 

 

More fundamentally, financial conditions remain loose thanks to the fall in eurozone bond yields (see Figure 3) and decent performance of European equities. Fourth, eurozone macro indicators, including in Germany and France, are pointing in the right direction. Finally, the Euro NEER has been range-bound for the past few weeks (see Figure 5). While it has appreciated versus the Dollar and Sterling, it is down against the Chinese Renminbi (see Figure 6). The upshot in my view is that short of the ECB taking a sledgehammer to the Euro, I see the risk biased towards further EUR/USD and EUR/GBP upside in coming weeks.

French and German politics are unlikely to pose a significant risk to this constructive view of the Euro. President Emmanuel Macron presented on 31st August probably the most ambitious set of labour market reforms in decades which are due to come into effect via presidential decree in late-September. Resistance from the still powerful trade unions and opposition parties has so far been measured but history points to the risk of a more pronounced popular backlash in coming months. While this may further take the gloss off Macron’s presidency and dent his already faltering popularity, markets will have seen this all before so the bar has been set low for Macron.

German Chancellor Merkel is slowly gearing up towards federal elections in three weeks’ time. While the composition of the Bundestag, Germany’s house of parliament, may change to the detriment of Merkel’s Christian Democratic Union (CDU), she looks assured of a fourth consecutive term as I argued earlier this year (see Paradox of acute uncertainty and strong consensus views, 3 January 2017). Whether this is the optimal outcome for Germany is open to debate but markets are likely to welcome the political continuity.

 

Federal Reserve is elephant in the room but I expect EM markets to avoid stampede

The Fed has arguably a trickier set of conditions to navigate. GDP growth is strong, the labour market is nearing full employment but real wage growth remains modest and core inflation is falling. The quarter-on-quarter seasonally-adjusted and annualised growth in the US was revised upwards to 3% for Q2 2017, the fastest growth rate since Q1 2015 (see Figure 7). But as Figure 8 shows, three key measures of core inflation continued to fall in July. Some FOMC members are seemingly keen to look through the lack of inflationary pressures and there is scope for US macro data to surprise on the upside in coming weeks.

 

The bottom line is that I am sticking to my long-held view that the Fed will only hike its policy rate twice in 2017 (see Politics suspected of interfering with economics and markets, 19 May 2017). However, very skinny market pricing of 8-9bp of hikes for the remainder of the year may not sit that well with the FOMC. I would therefore expect some kind of verbal intervention by Chairperson Yellen and other FOMC members to push up market pricing closer to around 15bp to help keep the odds of a December rate hike alive.

While the economic impact of Hurricane Harvey remains difficult to estimate, precedent suggests that major hurricanes have not stopped the Federal Reserve from hiking policy rates. Moreover, the Fed has flagged that it would likely announce at its 20th September policy meeting the beginning of a reduction in its balance sheet (effectively not buying back maturing bonds).

If misjudged and/or ill-timed these announcements could cause wobbles in wider financial markets, including emerging market (EM) equities, bonds and currencies which are already having to deal with the fall in crude oil prices. The consensus seems to be siding with a potentially sharp correction in global equities and EM asset prices. I am somewhat more sanguine about Fed announcements causing a wholesale disruption in EM markets. Macro data out of China are pretty buoyant, EM inflation is falling overall which gives central banks some scope to cut interest rates if necessary while FX reserves (particularly in Non-Japan Asia) provide central banks some room to support their currencies if corrections are disorderly and/or sustained.

 

UK – Glacial pace of change

While May and June provided markets with plenty to ponder – including the ruling Conservatives’ botched general election and the slim possibility of the Bank of England (BoE) gearing towards a rate hike – the past couple of months have been low on excitement. I argued back in March that the BoE would not hike its policy rate this year and I have seen little evidence to change my view (see Bank of England and inflation – sense of déjà-vu?, 24 March 2017). GDP growth in coming quarters is unlikely to rise much from 0.55% in H1 2017 as growth in aggregate real weekly earnings remains turgid despite the record-low unemployment rate (see Figure 9).

The news flow on Brexit has somewhat cooled from the fever pitch earlier in the summer but two developments (or lack thereof) stand out. First and importantly, there is a now a seemingly solid consensus view among senior cabinet members, including Prime Minister Theresa May, that a transitional or implementation period would be required once the UK had left the EU in March 2019. Chancellor of the Exchequer Philip Hamond, Foreign Secretary Boris Johnson, Secretary of State for Exiting the EU David Davis, International Trade Secretary Liam Fox and Secretary of State for Environment Michael Gove have all in recent weeks given their backing for such an arrangement.

This is line with my expectation that a transitional agreement was the more likely outcome (See When two tribes go to war, 2 June 2017). Until recently the British government had repeatedly played down the need for such an agreement between the UK and EU. While the government’s position has yet to be formalised and finalised, markets have seemingly welcomed cabinet members’ meeting of minds. However, there is still much disagreement about a possible transitional agreement’s length and modalities, with estimates ranging from one to four years.

This uncertainty is being compounded by a lack of progress over the UK’s potential “divorce bill”. EU negotiators have repeatedly said that this stumbling block would delay the start of official negotiations over the terms and conditions of a new deal between the UK and EU.

Broken Records

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

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