Hawkish pendulum may have swung too far

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I have long argued that the risk of a collapse in global economic growth and inflation was over-stated and more recently that major central banks had likely reached an important inflexion point.

A global recession and global deflation have seemingly been averted and central bank policy rate cuts and extensions of quantitative easing programs have become rarer occurrences.

Donald Trump’s election has turbo-charged expectations that reflationary US-centric policies will drive global, and in particular US growth and inflation in 2017, that the Fed’s hiking cycle will step up a gear and that US yields and equities and the dollar will climb further, heaping pressure on emerging economies and asset prices.

But analysts and markets may now be getting ahead of themselves.

My core reasoning is that US inflation may not rise as fast expected, due to lags in the implementation of Trump’s planned fiscal policy loosening and immigration curbs, residual slack in the US labour market and disinflationary impact of higher US yields and a stronger dollar.

As a result, the FOMC, which will see important personnel changes in early 2017, may argue that the market has already done some its work and not be as hawkish as expected.

In this scenario, US short-end rates could lose ground while long-end rates continue to push higher, resulting in a steepening of a still not very steep US rates curve.

One corollary is that factors which have wakened the euro may lose traction as 2017 progresses.

 

Two years ago I started to argue that analysts and markets were over-estimating the risk of a collapse in global economic growth, pointing to the reflationary impact of years of monetary easing by the world’s major central banks (see The global growth story – cause for concern, not panic, 17 December 2014). This led me to conclude that concerns about global deflation were overdone (see Deflation, what deflation?, 25 September 2015) and a year later that central banks had likely reached an important inflexion point, with policy rate cuts and expansions of QE programs to become increasingly rare (see Global central bank easing nearing important inflexion point, 15 September 2016). The corollary was that the fall in global yields, to which we had all become accustomed for so long, may not extend further.

A global recession was indeed averted. GDP growth bottomed out in H1 2016 at around 2.8% year-on-year and rebounded to around 2.9% yoy in Q3 2016. Moreover, the latest indicators, including the up-tick in global manufacturing PMI, suggest that global GDP growth may hit or even slightly exceed 3.0% yoy in Q4 2016 (see Figure 1), broadly line with my expectations (see Be careful what you wish for, 1 November 2016). While global inflation remains low by historical standards, headline and core CPI-inflation have been broadly stable around 1.5% yoy and 2% yoy, respectively, for the past two years (see Figure 2).

Olivier Desbarres Hawkish Fig 1 and 2

Finally, central bank monetary easing has become an increasingly rare occurrence. Since early November, only two major central banks – in New Zealand and Brazil – have cut their policy rates and global yields, bar Japanese yields, slowly inched higher from mid-September to 8th November (see Figure 3).

Olivier Desbarres Hawkish Fig 3 and 4

Donald Trump’s election to US president on 8th November and his promise to boost infrastructural spending and cut taxes have arguably given greater weight to the argument that the US may export inflation to the rest of the world, that global deflation is no longer a risk and that major central banks may consider eventual policy rate hikes. Fund managers and markets did not stay on the sidelines for long. Global yields, with the notable exception of German yields, have risen further, particularly at the long-end of the curve (see Figure 4). US yields have surged by about 60bp and the US rates market, which for the past two years has correctly priced in a far slower pace of rate hikes than assumed by FOMC members, is now almost perfectly aligned with the Fed’s latest dot-chart in assuming three rates hikes in 2017 (see Figure 5).

Donald Trump’s election to US president on 8th November and his promise to boost infrastructural spending and cut taxes have arguably given greater weight to the argument that the US may export inflation to the rest of the world, that global deflation is no longer a risk and that major central banks may consider eventual policy rate hikes. Fund managers and markets did not stay on the sidelines for long. Global yields, with the notable exception of German yields, have risen further, particularly at the long-end of the curve (see Figure 4). US yields have surged by about 60bp and the US rates market, which for the past two years has correctly priced in a far slower pace of rate hikes than assumed by FOMC members, is now almost perfectly aligned with the Fed’s latest dot-chart in assuming three rates hikes in 2017 (see Figure 5).

Hawkish pendulum may have swung too far

The expectation that reflationary US-centric policies will drive global, and in particular US growth and inflation in 2017 and that the Fed’s hiking cycle will step up a gear may well provide further momentum to US yields, the dollar and US equities and continue to heap pressure on emerging economies and asset prices in coming months.

But analysts and markets may now have got ahead of themselves in expecting a sustained and rapid increase in global, and in particular US growth and inflation, unfettered dollar appreciation and the start of central bank rate-hiking cycles in major economies. Put differently, in the space of a few months markets may have gone from being too dovish to being too hawkish. If this proves correct, US and more broadly short-end rates and the US dollar may stabilise and eventually correct lower.

My core reasoning is that US inflation may not rise as fast expected, due to lags in the implementation of Trump’s planned fiscal policy loosening and immigration curbs, residual slack in the US labour market and disinflationary impact of higher US yields and a stronger US dollar. As a result, the US Federal Open Market Committee (FOMC), which will see personnel changes in early 2017, may argue that the market has already done some its work and not be as hawkish as expected. In any case, forecasting the number of hikes a changing FOMC will deliver in 2017 in response to a US and global macro environment pray to ill-defined policies set by a president with no political experience will stretch the even the most skilled rate-forecasters.

 

US fiscal policy – Devil in the detail and timing

What we don’t know or can only guess about US policy going forward still dwarfs what we know. The nebulous panoply of pseudo-policies which Donald Trump announced during his presidential campaign and since his election is admittedly slowly starting to come into focus; he has already u-turned or downplayed a number of policy-ideas previously espoused (including the building of a wall between the US and Mexico) while seemingly giving greater weight to areas of policy he had until now only touched on (including the United States’ relationship with China). Moreover, Trump has appointed all of his senior cabinet members, partly answering the key question of who will be pulling the strings in his inner circle.

However, Trump’s policies remain very fluid and many of the newly appointed cabinet members have little real political experience which we can draw on to predict which policies they will prioritise. Greater spending on infrastructure, immigration curbs and tax cuts are seemingly central to Trump’s doctrine but it is still unclear whether and when they will become law, either via executive order or the more traditional route of congressional approval.  Trump, who will only be inaugurated president on 20th January, and/or Congress may realistically only pass the bulk of these policies in 2018.

Moreover, while tax cuts can quickly translate into consumption and investment and feed through to the broader economy in the form of faster growth and inflation, costly and complex infrastructural projects are usually prey to significant leads and lags. Various levels of government often need to green-light these projects, funding earmarked and contracts put to tender. Assuming these projects get off the ground, it can be months or years before the economic benefits are felt at a local, state let alone national level. In the meantime, the US labour market may continue to struggle to provide a significant inflationary stimulus.

 

US labour market strong but large pool of available workers keeping wage growth in check

Despite the apparent tightness of the US labour market, growth in disposable income and wages has flat-lined around 4% yoy (see Figure 6), which has in turn likely held back a more rapid increase in measures of year-on-year core inflation in the past year (see Figure 7). There is evidence to suggest that there is still some slack in the US labour market, a point voting FOMC member Brainard has made repeatedly – and that people are being employed in low-pay sectors.

Olivier Desbarres Hawkish Fig 6 and 7

Markets tend to focus on the US unemployment rate, which has plummeted to 4.6%, but it is a crude and incomplete measure of the labour market. Three variables drive total wages: 1) the number of people working, 2) the number of hours they are working and 3) the wage/per hour they are getting paid.

The number of people working has risen but the number of people of working age has gone up even faster, resulting in a still low employed-to-working-age-population ratio (see Figure 8). Hours worked per week have stagnated at around 34.4 in the private sector, because the share of full-time workers is still quite low (see Figure 9) and the number of hours these full-time workers are working is not going up much. Finally, wage growth is not rising very fast, partly because there is still a large pool of potentially available workers.

From late-1997 to mid-2001 there were 10-11 million unemployed people and people not in the labour force but ready to work and wage growth averaged nearly 8% yoy. Similarly, from late 2006 to late 2007 there were fewer than 12 million such people and wage growth exceeded 7% yoy (see figure 10). That number peaked at 21.3m million in October 2009 at the height of the financial crisis and has gradually come down since. But it is still above 13 million, i.e. a couple of million more than when the labour market was really tight. Still, one would expect wage growth to be a little higher than it currently is. There are a number of reasons for this, including a large number of part-time workers.

The number of unemployed, those not in the labour force but want a job and part-time workers (i.e. potential labour supply) is, at about 41 million, still far higher than during boom times when it was as low as 33 million (figure 11). So, despite decent employment growth, employers still have a decent pool of potential workers to fall back on and that is probably helping to keep wage growth in check.

It would be a stretch to argue that the US labour market is weak or that wage growth and core inflation will not rise. They probably will. But in order for the pool of available labour to shrink and wage and inflation growth to rise rapidly, the labour market may need a boost from large-scale infrastructural projects, curbs in immigration and broad-based tax cuts. If these policies are delayed or mothballed, aggregate wage growth may struggle to accelerate and inflation continue to rise only slowly, which the Fed would likely have to take into account.

 

Federal Reserve monetary policy – Compounded uncertainty

The seventeen members of the Federal Open Market Committee (FOMC), of which ten are voters, estimate that three 25bp rate hikes will be appropriate in 2017. This is seemingly more credible than their estimate of four hikes in 2016 and there has been much focus on the possibility of a more pronounced pace of hikes in 2017 than in 2105 or 2016.

The US rates and FX markets have already priced in that the Fed will have to react more hawkishly to potentially higher US inflation – US yields have surged (see Figure 12) and the dollar nominal effective exchange rate (NEER) has appreciated 5% since Trump’s election and nearly 30% over the past three years according to my estimates (see Figure 13). Markets have in effect already done at least part of the Fed’s work. The risk is that the Fed decides that US monetary policy has for now tightened sufficiently relative to the fiscal policies which Trump’s administration could conceivably deliver over the next twelve months. Put differently, the Fed may not want to see further tightening of monetary policy until approved and enacted policies start feeding through to macro variables.

Olivier Desbarres Hawkish Fig 12 and 13

This uncertainty, which Chairperson Janet Yellen has acknowledged and is endemic to any central bank’s policy outlook, is compounded by the forthcoming changes in the FOMC.

Olivier Desbarres Hawkish Fig 14

At the Fed’s first scheduled meeting of 2017 meeting, on 1st February, the four voting regional bank presidents will be replaced as per the FOMC’s policy of one-year term rotating terms[1]. Regional Reserve Bank presidents Charles Evans, Patrick Harker, Robert Kaplan and Neel Kashkari will replace James Bullard, Esther George, Loretta Mester and Eric Rosengren. This is significant as, historically, regional bank presidents have had more contrasting viewpoints and been more willing to dissent then members of the Board of Governors.

While Charles Evans was a voting FOMC member in 2008, 2011 and 2014, it will be first time that Kashkari, Kaplan and Harker are voting FOMC members and they have yet to earn a cast-in-stone hawkish or dovish label. However, in aggregate, the four new voting FOMC members are arguably more dovish than the members they will replace (see Figure 14).

Moreover, appointments to the two empty seats on the board of governors could change dynamics further (see Figure 15). President Barack Obama announced in early 2015 Allan Landon and Kathryn Dominquez as his nominations but they are still awaiting confirmation from the US Senate and could conceivably be derailed by Trump.

Finally, Atlanta Federal Reserve Bank president Dennis Lockhart – a non-voting FOMC member in 2017 –will step down on 28 February 2017. There is no set timetable for naming a new president and Marie Gooding, first vice president and chief operating officer of the Atlanta Fed, would serve as interim president if a successor is not chosen before 28 February. Therefore, at the 1st February policy meeting, either Lockhart or his successor will be one of the seven non-voting FOMC members. From March onwards, either Lockhart’s successor or Marie Gooding (if no successor has yet been appointed) will be one of the seven non-voting FOMC members.

Olivier Desbarres Hawkish Fig 15

A more dovish FOMC, faced with still modest inflation, residual slack in the labour market and uncertain fiscal policy program, could conceivably hike fewer than three times next year, capping or reversing the rise in US front-end yields (incidentally the last time the Fed hiked three times in a calendar year was in 1999).

At the same time US long-end rates could continue to push up, as i) delayed Fed rate hikes in H1 2017 could result in a greater need for hikes down the line, particularly if Congress/Trump start to push through and enact reflationary policies in 2018; ii) hawks fill the two currently vacant FOMC seats and iii) the four voting FOMC members who take their seats in 2018 are more hawkish than the outgoing ones. The net result would be a steepening of the US yield curve, which is still pretty flat by historical standards (see Figure 12).

 

Factors which have driven euro weaker may lose traction as 2017 progresses

The German yield curve has followed a somewhat different dynamic, with short-end rates falling following the ECB’s decision on 8th December to extend its QE program by nine months until December 2017 with planned bond purchases of €540bn (see Figure 4). However, its decision to cut its monthly bond purchases from €80bn to €60bn as of March has likely contributed to fears that inflation may pick up in the long-term and to higher long-end Bund yields. This “hawkish easing” or “dovish tapering” has ultimately led to a steepening of the German yield curve.

 

A number of factors have pushed the EUR/USD cross lower towards parity, in line with my January forecast (see What to expect in 2016 – same, same but worst, 19 January 2016), and the euro NEER to a one-year low according to my estimates (see Figure 16). These include i) the widening spread between US and eurozone yields, ii) concerns that immigration and terrorism issues are fuelling European nationalism’s ascendancy and in turn political risk which could ultimately lead to a break-up of the eurozone and/or European Union, and iii) the weakness of the Italian economy.

The 2017 calendar is certainly peppered with European event risk. There are planned elections in Germany (parliamentary) and France (presidential and parliamentary) – the EU’s two largest economies. The Netherlands and Norway will hold legislative elections on 15th March and 11th September, respectively. There could also be potential parliamentary elections in Italy, the eurozone’s third largest economy.

But if, as I expect, the eurozone economy starts to benefits from the euro’s depreciation and US yields stabilise or fall, this yield spread may no longer be sufficient to push the EUR/USD cross lower. Moreover, while posturing between European and Italian leaders may delay any agreement and implementation of a comprehensive rescue package for the Italian banking sector, history suggests that a fudged compromise will eventually be reached (see Renzi referendum – storm in a brittle tea cup, 2 December 2016).

 

European political risk is real but probably exaggerated

Finally, the risk of European nationalist parties acceding to the highest echelons of power has been over-stated, in my view (see Black swans and white doves, 8 December 2016). Specifically, the probability of the euro-sceptic leader of the French right-wing Front National party, Marine Le Pen, upsetting the status quo and being elected president in the April-May elections is still low (see EM currencies, Fed, French elections, UK reflation “lite”, 25 November 2016).

Italian elections could trump French presidential elections if President Sergio Mattarella brings forward general election currently scheduled no later than 23rd May 2018 and markets are forced to consider the early departure of Paolo Gentiloni’s technocratic government. But again the odds of the populist Five Star Movement securing the greatest number of seats in parliament and premiership are modest rather than high. Germany is due to hold legislative elections in August-October but a credible challenge to Chancellor Merkel being re-elected for a fourth term remains elusive.

Of course a number of economic and political events could throw off course this sanguine outlook for the eurozone and I am cognisant that opinion polls have proved of little use in forecasting the British general elections in 2015, British referendum in June 2016 and US elections in November 2016. It may be premature to go long EUR/USD but this may well be the trade to consider, particularly in the run-up to the French presidential elections in April-May 2017.

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.

 


[1] According to the US Federal Reserve, “The Federal Open Market Committee (FOMC) typically consists of twelve members – the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. The rotating seats are filled from the following four groups of Banks, one Bank president from each group: Boston, Philadelphia, and Richmond; Cleveland and Chicago; Atlanta, St. Louis, and Dallas; and Minneapolis, Kansas City, and San Francisco. Nonvoting Reserve Bank presidents attend the meetings of the Committee, participate in the discussions, and contribute to the Committee’s assessment of the economy and policy options.”  However, two of the Board of Governor seats are currently unfilled and therefore there are only ten voting members on the FOMC.

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