Be careful what you wish for

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The rise in bond yields in developed economies in the past 6 weeks remains one of the over-riding themes as we head into the last seven days of the US presidential campaigns.

Markets are now fretting about the implications for global growth and asset valuations and ultimately whether elevated global risk appetite will correct more forcefully.

Higher international commodity prices, a pick-up in global GDP growth in Q3 and early Q4 and easing deflation fears suggest that interest rate policies in developed economies may have reached an important inflexion point – in line with the view I expressed six weeks ago.

Developed central banks may refrain from loosening monetary policy further near-term, with the exception of the RBNZ and possibly ECB. At the very least, policy-makers will tweak a discourse which has largely focused on doing “whatever it takes”.

Recent US data have paved the paved the way for a 14th December Fed hike, conditional on Democrat candidate Hilary Clinton wining the 8th November US presidential elections.

But with the exception of the Fed and possibly a handful of EM central banks, rate hikes are a story for the latter part of 2017 (perhaps) while further rate cuts remain on the cards in Brazil, Russia, Indonesia and India.

Higher global yields and still uncertain US election outcome are taming global equities and volatility has spiked but EM currencies have still managed to eek out modest gains.

Assuming Hilary Clinton wins next week, I would expect the initial reaction to be a rally in global equities, EM currencies and Dollar and an underperformance of safe-haven assets.

But I would also expect market pricing for a December Fed hike to rise a little further, which could in turn eventually curtail any rally in global equities and EM currencies.

In this scenario, the Dollar would likely end the year stronger, as per my January forecast of a third consecutive year of albeit more modest Dollar gains.

Whether global risk appetite avoids its early 2016 fate will depend on the interconnected factors of underlying macro data and the Fed’s credibility. In any case, market volatility could spike in the run-up to March 2017.

The self-reinforcing sell-off in Sterling and UK bonds has only very recently abated, with markets seemingly taken some comfort from a number of factors including the only modest slowdown in UK GDP growth to 0.5% qoq in Q3.

But optimism over UK GDP data is not warranted as growth has become more unbalanced and slowed in August-September despite a significant easing in UK monetary policy.

A blast from a distant past – Rising yields

The rise in global government bond yields, particularly at the long-end of the maturity spectrum, remains one of the over-riding themes as we head into the last seven days of the US presidential campaigns. Figure 1 shows that 2-year, 5-year and 10-yields yields have risen in the US, Germany and Australia by on average 13bp, 8bp and 14bp, respectively, since mid-September. The rise in Japanese yields has been far more timid, with 10-year rates actually a little lower in the past six weeks.

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Policy-makers and markets for so long concerned about the threat of global deflation and depressed yields are now fretting about the implications of higher yields for global growth and asset valuations and ultimately whether elevated global risk appetite will correct more forcefully.

A number of common and interconnected factors have driven yields higher in most developed markets. The (admittedly unsteady) rise international energy and commodity prices, including for crude oil, copper, iron ore and Nickel, and signs that global GDP growth picked up slightly in Q3 have eased deflation fears – fears which I had argued last year were overdone (see Deflation, what deflation?, 15 September 2015). This has in turn shed greater light on signs that interest rate policies in developed economies may have reached an important inflexion point – very much in line with the view I expressed six weeks ago (see Global central bank easing nearing important inflexion point, 16 September 2016).

 

Global GDP growth inching higher

My core view was, and still is, that eight years of ultra-low (and in some cases negative) central bank policy rates and expansive bond-buying programs have helped stabilise global economic growth and inflation, albeit at low levels, and there are early signs that both are inching higher. 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, may be starting to outweigh the benefits.

Global GDP growth likely increased incrementally in Q3 2016 after having stabilised around 2.8% year-on-year (yoy) in Q2. My estimate is derived from the rise in the global manufacturing PMI from 50.2 in Q2 to 50.9 in Q3 (see Figure 2) and preliminary GDP figures for the US, European Union, China, Korea and Mexico which in aggregate account for two-thirds of world GDP (see Figure 3). This ties in with my September forecast that “global GDP growth may have risen to around 2.9% yoy in Q3 based on global manufacturing PMI data for July-August”.

Moreover, strong country PMI data for October, including in China (highest level since July 2014), Russia (4-year high) and India (22-month high), provide an early sign that global GDP growth picked up further in early Q4. Monthly global manufacturing PMI data, released months before official GDP figures, continue to be a reliable forward indicator of global GDP growth yet receive only ephemeral market attention.

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Developed central banks at inflexion point

Therefore, developed central banks may refrain from loosening monetary policy further near-term, with the exception of the Reserve Bank of New Zealand (RBNZ) which markets expect to deliver one final 25bp cut at its policy meeting on 10th November, and possibly the ECB.

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Since April, developed central banks have only delivered four 25bps policy rate cuts – the Reserve Bank of Australia (RBA) in May and the RBA, RBNZ and Bank of England (BoE) in August. I would expect policy rate cuts and expansions/extensions to QE current programs to become increasingly rare (see Figure 4). At the very least, the world’s most influential central bankers may going forward tweak a discourse which has in recent years largely focused on doing “whatever it takes”.

  • Australia: The RBA at its policy meeting today was seemingly intent on making clear that it sees no compelling reason to cut rates further given expectations of a pick-up in economic growth and inflation medium-term.
  • Eurozone: My core scenario since September has been that the ECB would keep it policy rates on hold and the modalities of its current QE programs unchanged until its 8th December policy meeting and so far the ECB has stayed on script. Stable eurozone GDP growth of 1.6% yoy in Q3 and the rise in CPI-inflation to a 27-month high of 0.5% yoy in October have, if anything, reduced the probability of the ECB extending its QE program, which expires in March 2017, before end-year.
  • UK: I am sticking to the view which I have held since late-August that there is little room or need for the BoE to either cut or hike its policy rate or extend its current QE program (see UK economy post referendum – for richer but mostly for poorer, 26 August 2016). Q3 GDP data did not provide a compelling case for the BoE to change its current course of monetary policy. Moreover, with Sterling and UK yields having stabilised for now, the already weak case for BoE intervention in the FX market has now all but evaporated (see below for a more detailed discussion).
  • Norway: The Norges Bank, which on 26th October again kept its policy rate of 0.5% unchanged, has adopted a neutral stance. It noted on the one hand the positive impact of higher oil prices on the oil-exporting Norwegian economy and slight rise in expected policy rates among trading partners but lower inflation on the other hand. The Norges Bank’s real policy rate – the policy rate deflated by headline or core CPI-inflation – remains very low relative to history and to other developed central banks. But with inflation on a downtrend and GDP growth of only 1.3% yoy in H1 2016, policy rate hikes are probably not on the cards any time soon.

 

Fed will hike rates on 14th December…assuming Hilary Clinton wins presidential elections

The elephant in the room is still the US Federal Reserve policy meeting on 14th December, with US macro data in the past year having proved a major hurdle for the Fed to clear.

But the rebound in US GDP growth in Q3 to 2.9% annualised, decent September macro data and higher international oil prices have in my view paved the way for a second consecutive December rate hike. Importantly, growth in private sector aggregate weekly payrolls rebounded in September to 4.3% yoy from a multi-year low of 3.5% yoy in August and retail sales, ISM manufacturing and  non-manufacturing and most measures of inflation measures also bounced back (see FX update: Dollar, Sterling and EM, 17 October 2016).

My forecast of a 25bp hike remains conditional on Hilary Clinton wining the 8th November US presidential elections (see Federal Reserve – the Father Christmas of central banks, 23 September 2016). Her victory is a necessary, if not sufficient condition for the Fed to hike in my view, despite Fed Chairperson Yellen’s assertion that the Fed is apolitical. Perhaps it is not totally coincidental that the market’s current pricing of a 75% probability of a 25bp hike in December is similar to the estimated probability of Clinton winning next week’s presidential elections according to FiveThirtyEight (which accurately forecast the voting outcome of all 50 states in the 2012 US presidential elections).

 

Rate hikes still very much the exception, not the norm

To be clear, bar the Fed and possibly a handful of EM central banks still fighting weak currencies and/or high inflation, no major central bank is likely to hike policy rates or tighten monetary policy in coming months, in my view. That’s a story for the latter part of 2017 (perhaps). Even the Fed has repeatedly stressed that any future rate hikes would be modest and gradual, a point it will likely reaffirm regardless of whether it decides to hike rates in December.

Since April 2016 only two major central banks have hiked their policy rates – Nigeria (in July) and Mexico (in June and September). Banco de Mexico could opt to stay on hold if the peso nominal effective exchange rate (NEER), which has appreciated 4.3% in the past six weeks, benefits from a Clinton victory and survives a December Fed hike.

During that period, emerging market central banks have delivered 14 policy rate cuts, in line with my forecast last year that EM central banks would continue cutting their policy rates (see More EM central banks to join rate-cutting party, 30 September 2015). Even since August 2016, major EM central banks have delivered five rate cuts, broadly as I had expected (see Right or wrong further central bank rate cuts still on the cards, 19 August 2016).

With central banks’ real policy rates still high in Brazil, Russia, Indonesia and India, further rate cuts remain on the cards, particularly in Brazil and Russia where GDP growth is weak. These countries’ central banks may admittedly want to first gage the impact of the US elections and a possible Fed hike on their currencies before cutting rates further.

 

Dollar hat-trick, EM currencies choppy

Higher global yields and the still uncertain US presidential election outcome have perhaps unsurprisingly been a headwind for global equities unchanged from six weeks ago (see Figure 5) while volatility has again spiked (see Figure 6) – a pattern which has so far matched my expectation that “In this context higher volatility is likely to prevail and global risk appetite may struggle to forcefully regain traction for now”.

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A GDP-weighted basket of emerging market currencies has been treading water versus the US Dollar and has depreciated slightly if the weaker Chinese Renminbi is included (see Figure 7). But this partly reflects the Dollar’s strength and a basket of emerging market NEERs (excluding the CNY) has appreciated about 1.5% since mid-September (see Figure 8). Commodity and high-yielding emerging currencies, including the Brazilian Real, Mexican Peso, Russian Rouble and South African Rand, have outperformed other currencies by significant margins – understandably given the backdrop of higher international commodity prices and rising developed market yields.

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But the next six weeks could prove pivotal for global equities and EM currencies. Let’s assume that Hilary Clinton wins the 8th November US presidential elections – a reasonable assumption given her still modest lead over Donald Trump in the majority of polls. I would expect the initial reaction to be:

  • A rally in global equities;
  • US Dollar appreciation, particularly against other majors including the Euro and Sterling. This would likely suit the ECB and BoE just fine, with both central banks seemingly intent on at least keeping their currencies near current levels in order to support domestic economic growth;
  • An appreciation in the currencies of EM economies reliant on trade with the US, including the Mexican Peso and Brazilian Real, given concerns that Donald Trump would opt for a less open US economy, and;
  • An underperformance of safe-haven assets, including gold.

But I would also expect market pricing for a December Fed rate hike to rise a little further (from 21bp currently), which could in turn eventually curtail any rally in global equities and EM currencies. Assuming no exogenous shocks between the US elections and 14th December and that the Fed hikes its policy rate 25bp, I would expect:

  • Broad-based USD appreciation;
  • Other major central banks to be more inclined to maintain their stance on monetary policy and policy rate cuts to be less frequent;
  • EM currencies and global equities to struggle to hold onto post-US election gains.

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Volatility will key metric in Q1 2017

Net-net, in this scenario, the Dollar NEER – which is now up 0.2% on the year for the first time since March based on Federal Reserve currency weights (see Figure 9) – would likely end the year stronger, as per my January forecast of a third consecutive year of albeit more modest Dollar gains (see What to expect in 2016 – same, same but worse, 19 January 2016).

The Fed will certainly want to avoid a repeat of Q1 2016 when global equities and EM currencies sold off and the Dollar appreciated sharply following the Fed’s December 2015 hike. The probability of this scenario materialising once again will, in my view, depend on two sets of interconnected factors: underlying macro data and the Fed’s credibility.

If US macro data in early 2017 take a turn for the worse, markets may query the suitability of the Fed’s hike in December 2016 and global risk appetite could come under pressure. Even if US and global data prove resilient, markets will look to the Fed for reassurance that the Fed’s hiking cycle will continue to be slow and gradual. I would therefore expect FOMC members at the 14th December meeting to further revise down their estimates of the appropriate policy rate as they did at their December 2015 meeting. Their success in communicating this message to a market sensitive to even the most benign Fed utterance will be a key determinant of whether global appetite risk appetite corrects in the weeks following 14th December.

Volatility in Fed fund futures and market pricing is thus likely to remain fluid in early 2017 and, in any case, market volatility could spike in the run-up to March 2017 as this will mark:

  • The Federal Reserve’s policy meeting on 15th March with Q&A session hosted by Chairperson Yellen and updated FOMC forecasts;
  • The end of the ECB’s QE program, assuming it is not extended in December; and
  • British Prime Minister Theresa May’s self-imposed deadline to trigger Article 50 which officially sets in motion the 2-year timeframe for the UK to leave the EU.

 

UK bond prices and Sterling finding their footing after multi-week pounding

The case of the UK is somewhat unique as the far larger jump in yields (than in other developed economies) has gone hand in hand a collapse in Sterling, as per Figure 10 (See Sterling: The lady’s not for turning (yet!), 14 October 2016), a co-existence one would normally associate with emerging markets. A large UK account deficit allied to concerns about the UK’s future relationship with the EU have seen investors shy away from long-Sterling positions, with Sterling’s depreciation in turn raising fears of imported inflation and acting as a headwind to foreigners’ gilt purchases, putting further pressure on the currency.

This self-reinforcing sell-off in Sterling and UK bonds has only very recently abated (see Figure 10). Markets have seemingly taken some comfort from a number of factors, including:

  • Mark Carney’s announcement yesterday that he would extend his stay as BoE Governor until June 2019, easing speculation as to whether government criticism of his tenure would see him stay only until 2018;
  • Nissan’s decision to maintain its UK car plant, in exchange for somewhat opaque government promises regarding the future of the UK’s automotive industry and the UK’s broader relationship with the EU; and
  • The only modest slowdown in UK GDP growth to 0.5% quarter-on-quarter in Q3 from 0.7% in Q2 (seasonally adjusted), as shown in Figure 11.

 

Optimism over UK GDP growth not warranted

However, I would argue that the positive spin surrounding these GDP data is not fully justified, for a number of reasons:

  1. This is the first estimate of Q3 GDP growth (data content is less than half of the total required for the final output estimate) and will likely be subject to (albeit usually minor) revisions. The second and final estimates are due to be published on 25th November and in late-December, respectively.
  1. Growth, if anything, became even more imbalanced in Q3. All of the growth came from services, which account for 79% of national GDP and rose 0.8% qoq in Q3. The index of production (15% of national GDP) contracted 0.4% qoq and thus subtracted 0.05 percentage points (pp) to headline GDP growth (see Figure 12). In comparison, in the previous six quarters production had on average added 0.07pp to headline growth. Similarly construction output (6% of national GDP) fell 1.4% qoq and subtracted 0.09pp to headline GDP. In the previous six quarters it had added 0.04pp (I omit from these calculations the agricultural sector which accounts for only 0.7% of UK GDP).
  1. About 70% of the GDP growth in Q3 materialised in July when presumably the effects of the referendum result had yet to kick in, according to my estimates using monthly Office for National Statistics As Figure 13 shows, in July the index of services was up 0.4% mom, the index of production was flat on the previous month and construction output was up 0.5% mom. But growth in all three sectors slowed sharply in August and only rebounded marginally in September based on ONS forecasts and early responses to its September Monthly Business Survey. If growth rates in these three sectors did not pick up in October and do not pick up in November and December, real GDP growth in Q4 will likely be far slower than in Q3.

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  1. Even if we assume GDP growth remains stable at 0.5% qoq for the next four quarters, which I would in itself query (see below), the UK’s real GDP will be 1% lower in a year’s time than if the economy had continued to grow at 0.7% qoq.
  1. It is conceivable that GDP growth could have picked up in Q3 had the British electorate voted to stay in the EU. After all global GDP growth rose in Q3 to around 2.9% yoy from 2.8% yoy in Q2 according to my estimates.
  1. UK GDP growth slowed despite the BoE cutting its policy rate 25bp, introducing a new term-funding scheme and re-launching quantitative easing at its policy meeting on 4th August 2016.
  1. But most importantly UK GDP growth slowed despite a significantly more competitive currency. While September trade data will only be released on 9 November, Figure 14 suggests that while the Sterling NEER depreciated about 17% between November 2015 and end-September 2016 the UK’s goods and services trade deficit is unlikely to have narrowed much in Q3 (see Barbarians at the Sterling gate, 7 October 2016). If true, net trade will have made only a small positive contribution to GDP growth in Q3, the extent of which will be revealed when second and third estimates of Q3 GDP are released.

At the same time a weaker Sterling is driving domestic inflation higher. So UK households have borne the costs of a weaker currency, including higher inflation (which is eating into already tepid real wage growth) and a significant haircut to their wealth (when expressed in foreign-currency terms) but have yet to see the potential benefits as GDP growth has slowed, not accelerated. Moreover, the outlook for UK growth is not particularly encouraging in my view. Uncertainty over the UK’s future relationship with the EU is likely to continue weighing on domestic and foreign investment in the UK while the scope for interest rate and fiscal policy easing is limited.

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Olivier Desbarres

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.

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