Central banks – A muted second inflexion point

Market focus has shifted from elections to central banks’ next steps

Financial markets, having digested the result of parliamentary and/or presidential elections in the US, Austria, Netherlands, France and UK and expecting German Chancellor Angela Merkel to win a fourth consecutive general election on 24th September, have turned their focus to global central bank policy. Specifically, it has centred on the possibility of tighter interest rate policy in developed economies in the form of rate hikes and/or modifications to central bank balance sheets or quantitative easing programs.

 

End-2016 proved to be an important inflexion point for global central bank policy

Up until the summer of 2016, developed central banks were still very much in monetary easing mode, with the exception of course of the Fed which had hiked its policy rate 25bp in December 2015. But eight years of ultra-low (and in some cases negative) central bank policy rates and expansive bond-buying programs had helped stabilise global growth and inflation, albeit at low levels. 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, had started to outweigh the benefits.

This led to me to forecast that major central banks may refrain from loosening monetary policy further and that the ECB and BoE would keep the modalities of their QE programs broadly unchanged near term. At the very least I expected central bank policy rate cuts to become increasingly less frequent than in the past and that the world’s most influential central bankers would start tweaking a discourse which had in recent years largely focused on doing “whatever it takes” (see Global central bank easing nearing important inflexion point, 16 September 2016).

At the same time I argued that bar the Fed and possibly a handful of emerging market central banks still fighting weak currencies and high inflation, no major central bank was likely to hike policy rates or tighten monetary policy in the remainder of 2016 – that was a story for 2017, at the earliest.

 

This scenario has largely materialised, with the exception of the Reserve Bank of New Zealand delivering a final 25bp rate hike in November 2016.

  • Since then no developed central bank has cut its policy rate with a GDP-weighted average of policy rates bottoming out and more recently inching higher (see Figure 1).

 

olivier desbarres cb update fig 1

 

  • The only major central banks to have cut rates are the Central Bank of Russia and Banco Central do Brazil (see Figure 2). In May and June 2017 no major central bank cut its policy rate – the only other time this has happened in the past four years was in December 2016.

 

 

  • Central banks in Turkey and Mexico, in the face of still high inflation, have hiked their policy rates 50bp and 225bp respectively since August 2016.
  • The US Federal Reserve has already hiked rates 50bp this year and there has been growing talk of the Fed shrinking the size of its balance sheet.
  • This week the Bank of Canada hiked its policy rate (25bp) for the first time in nearly seven years.
  • Three out of eight members of the Monetary Policy Council of the Bank of England dissented in favour of a 25bp rate hike at the June policy meeting.
  • The European Central Bank has adopted a marginally more hawkish language in recent months. There is mounting expectation that the ECB will announce as early as September an extension of its quantitative easing program beyond-2017 but also a gradual tapering of the monthly amount of bonds purchased (from €60bn currently), with QE ending fully in late 2018 or early 2019.

 

This has led to growing speculation that we have reached a second inflexion point in developed central bank policy and one which could be sharp enough to dislocate global growth and asset markets, particularly in emerging economies. But financial markets, at present, expect only very marginal policy tightening by developed central banks. Specifically:

  • US Federal Reserve: Markets have all but priced out a September hike and are pricing in only another 12bp of hikes by year-end (i.e. a 50% probability of one more 25bp hike this year)
  • Bank of England: 12bp of hikes priced by year-end (i.e. a 50% probability of one hike this year)
  • Reserve Bank of Australia: No hikes priced in for the remainder of the year and only 15bp of hikes priced in for the next 12 months.
  • Bank of Canada: One more 25bp hike priced for this year.

This skinny market pricing of policy rate hikes is appropriate, in my view. At a global level, there are signs that GDP growth may have plateaued in Q2 2017 at around 3.1-3.2% year-on-year (see Figure 3), as I argued in H2 2017: Something old, something new, something revisited (23 June 2017).

 

 

Moreover, inflationary pressures remain muted in developed economies. Headline CPI-inflation in both developed and emerging market economies steadily rose between end-2015 and early 2017 but has since fallen (see Figure 4).

 

 

Perhaps more importantly, core CPI-inflation, which strips out food and fuel prices, has risen in emerging markets but after having flat-lined for years in major developed economies has in recent months dipped lower (see Figure 5). Only in the UK has core CPI-inflation risen and this is mainly attributable to higher imported inflation fuelled by the collapse in Sterling following the 23rd June 2016 EU referendum.

 

 

Moreover, in the US and Australia positive employment growth and very low unemployment rates continue to go hand in hand with only modest growth in real wages, while in the UK real wages are falling – an issue which I first identified in The common theme of low-wage growth, 10 February 2017). The inability of workers to command larger increases in nominal wages is acting as a break on both inflation expectations and consumer demand, and in turn is likely to curb underlying inflation going forward, in my view.

 

Bank of England – Policy rate to remain on hold in August and potentially rest of the year

The weakness of the UK economy and uncertainty associated with the Brexit process are high enough hurdles for the Bank of England (BoE) to refrain from hiking policy rates any time soon (see UK: Land of hope & glory…but mostly confusion, 7 July 2017).

I maintain my view that the BoE’s eight-member MPC is unlikely to hike its policy rates of 0.25% at its August meeting. While I expect MPC member Andrew Haldane to join Michael Saunders and Ian McCafferty in voting in favour of a 25bp hike, new member Silvana Tenreyro is likely to vote in favour of no change which would result in a 3 versus 5 vote in favour of rates remaining on hold. Importantly, I believe that Governor Carney – who has the casting vote in the event of a 4 versus 4 tie – will again vote for no change, even if he has had a tendency to blow hot and cold.

 

US Federal Reserve – Skip September meeting, keep December alive?

The US Federal Reserve has hiked its policy rate 50bp year-to-date but markets, which are pricing only 12bp of hikes for the remainder of the year, are clearly divided as to whether FOMC members will stick to their end-2016 forecast that three hikes would be appropriate in 2017. My core scenario remains that the Fed will not hike rates again in 2017 although this is a modest conviction call. While the labour market is inching towards full-employment, measures of US core inflation have fallen as pointed out by a number of FOMC members, including Chairperson Janet Yellen (see Figure 6).

 

 

The Reserve Bank of Australia has given every indication that it will remain pat on interest rate policy for the foreseeable future and while the Bank of Japan is prone to tweaking inflation targets and yield targets I do not foresee major policy changes at this juncture.

 

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.

UK: Land of Hope & Glory…but mostly Confusion

The lyrics of Genesis’ 1986 hit “Land of Confusion” were penned over 30 years ago, with the English rock band satirising Ronald Reagan’s US presidency (see Figure 1). Specifically, they allude to the confusion fuelled by opportunist politicians in a fast-changing world beset by acute challenges. But, in my view, they portray with uncanny accuracy the UK in 2017 as Prime Minister Theresa May and her government, Parliament and the Bank of England feel their way towards Brexit. Read more

H2 2017: Something old, something new, something revisited

As we head towards the second half of 2017 and the one-year anniversary of the UK referendum on EU membership, many themes which have pre-occupied financial markets in the past 12 months are likely to continue dominating headlines.

These include Donald Trump’s US presidency and its longevity, merits and scope for tax reforms and infrastructural spending, Brexit negotiations which officially started on 19th June and the resilience of the ongoing recovery in global GDP growth.

Global GDP growth rose modestly in Q1 2017 to around 3.12% year-on-year from 3.06% in Q4 2016 and a multi-year low of 2.8% yoy in Q2 2016, according to my estimates.

But the global manufacturing PMI averaged 52.7 in April-May, down slightly from 52.9 in Q1 2017, suggesting global GDP growth may not have accelerated further in Q2. This could in turn, at the margin, delay or temper policy rate hikes and/or unwinding of QE programs.

Non-Japan Asian currencies have in the past month been even more stable than in the preceding month, in line with my expectations, but a more pronounced policy change – particularly in China – remains a possibility.

Other themes, such as the timing and magnitude of higher policy rates in developed economies and falling international oil prices, have recently come into clearer focus and will likely be of central importance in H2.

For the UK, I am sticking to my view that a 25bp policy rate hike this year is still a low probability event and I see little chance of an August hike.

The uncertainty over the MPC’s interest rate path and the government’s stance on Brexit complicate any forecast of Sterling near and medium-term but I continue to see the risks biased towards further depreciation.

In France, the hype surrounding Emmanuel Macron’s presidential and legislative election victories is already giving way to whether, when and how smoothly the LREM-MoDem rainbow government can push through its reformist agenda.

Finally, while most European elections are now thankfully behind us, European financial markets are likely to attach great importance to the outcome of Germany’s general election on 24th September.

Conversely, the burning topic of rising European nationalism and future of the eurozone/EU has lost traction following recent presidential and/or legislative elections in France, the UK, Netherlands and Austria. Read more

GBP – Hawkish Surprise Presents Selling Opportunity

Financial markets in the past week have had to contend with two UK-borne shocks: The ruling Conservative party’s loss of a majority in last Thursday’s general election and three MPC members voting in favour of a 25bp hike at today’s Bank of England policy meeting.

Sterling, which sold off sharply after the election result, has recovered this week and the more hawkish than expected MPC meeting has given the modest rally further impetus.

Confirmation of an alliance between the Conservatives and DUP, which is expected in coming days, may see Sterling strengthen further, particularly with markets digesting the implications of two further MPC members calling for higher rates.

This would, in my view, present an opportunity to short Sterling versus the dollar or euro, for five reasons:

  1. Conservative-DUP marriage is not one of choice and arguably not even one of convenience;
  2. Question of which type of Brexit is unlikely to be answered any time soon;
  3. MPC has become more hawkish but rate hike still unlikely near-term;
  4. Concerns over falling wages are at the heart of a UK economy which remains at best soft; and
  5. EU/eurozone growth slowly picking up and European nationalism on the back foot

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UK Election: Clutching Defeat from the Jaws of Victory

With the votes having been counted for 649 of the 650-seats in the House of Commons, the ruling Conservatives have 318 seats, a net loss of 12 seats. Labour, the main opposition party, won 261 (+32).

Even if the Conservatives win the 650th seat, they will at best be 7 seats short of an absolute majority and 5 seats short of a working majority – a hung parliament.

Prime Minister Theresa May announced that the Conservatives would form an informal alliance with the Northern Irish DUP which won 10 seats. The DUP would support the Conservatives in key votes, likely in exchange for some say on government policy.

Theresa May’s future seems secure for now but medium-term I would expect her position to come under close scrutiny and a party-leadership battle remains a distinct possibility.

Sterling has weakened about 1.5% post election, in line with my and market expectations. The Conservatives’ loss of seats raises serious questions about Theresa May’s leadership, her decision to trigger early elections and the risk of a party leadership battle to oust her.

Moreover, markets will likely remain concerned about the shelf-life of a Conservative-DUP alliance and its ability to push legislation through parliament.

However, I also see scope for Sterling’s downturn to fade and even reverse in due course. To be clear, a V-shaped Sterling recovery would likely remain elusive.

Two key questions pertain to the likelihood of this new Conservative-DUP formal alliance 1) securing an advantageous EU deal and 2) opting for a “hard” or “soft” version of Brexit.

If anything, the past two months have reinforced my view that the government is ill-equipped, ill-prepared and lacking in institutional capacity to negotiate complex deals with the EU and non-EU partners.

The composition of parliament and its take on Brexit leave Theresa May in somewhat of a bind. The government may therefore have little choice but to seek support from some of the 322 opposition MPs who on the whole favour the UK remaining in the EU or at the very least a “soft” version of Brexit.

So while I do not expect a second referendum on the UK’s membership of the EU, I do see a possibility of the government toning down its rhetoric and potentially opting for a softer version of Brexit – a development which UK financial markets would welcome in my view. 

At the very least, this election has further weakened the idea that nationalist parties in Europe are gaining the upper hand.

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UK General Election Scenario Analysis Impact on Policy, Theresa May and Sterling

In less than 24 hours the British electorate will start voting in the election for the 650-seat House of Commons with the result expected early in the morning of Friday 9th June.

While the last general election was only held two years ago, there is arguably as much if not more at stake this time round than in May 2015.

Opinion polls still point to the ruling Conservatives winning a record-high 44% of the national vote ahead of the opposition Labour Party, but polling agencies which in the past have misestimated true voting intentions still display great inconsistency.

Ultimately it is the number of seats which British parties command which matters and the UK’s first-past-the-post electoral system makes it difficult to predict.

You Gov’s constituency-specific model forecasts the Conservatives winning only 304 seats as a result of a record number of “wasted” votes, a 26-seat loss and well short of both a working and absolute majority. Labour would increase its seat numbers from 229 to 266.

This would result in a hung parliament and either a coalition or minority government.

My own model points to the Conservatives winning around 360 seats (55.4% of total) and Labour 212 seats. Admittedly, this prediction is based on a number of assumptions, namely the net share of votes which Conservatives gain from other parties as well as voter turnout.

Whether the Conservatives significantly improve on their current 330 seats or fail to secure a parliamentary majority remains a tough call and there is an almost infinite number of possible outcomes.

However, I have narrowed down in Figure 10 the number of seats the Conservatives could win to eight possible scenarios, in each case assessing i) Their probability; ii) Their numerical impact on the Conservatives’ majority (or lack thereof); and iii) The risk of opposition parties and/or Conservative backbenchers high-jacking the policy agenda.

Figure 11 assesses for each of the eight scenarios their likely impact on iv) Theresa May’s standing within the Conservative Party and v) Sterling and currency volatility.

Regardless of what happens tomorrow, two events beyond British shores also scheduled for 8th June – the ECB’s policy meeting and Former FBI Director James Comey’s testimony to the Senate Intelligence Committee – will conceivably exacerbate Sterling volatility.
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UK Election Special – When Two Tribes Go To War

British voters will on Thursday 8th June vote on the composition of the 650-seat House of Commons – the third major popular vote in two years – after Prime Minister Theresa May’s decision back in April to trigger early general elections.

Theresa May’s motivations were arguably four-fold: (1) Win a popular rather than party mandate, (2) Capitalise on the massive lead in the polls the ruling Conservatives enjoyed over the opposition Labour Party and thus allow her to push through her own agenda, including a possibly softer form of Brexit, (3) Allow the government more time to secure a new EU trade deal, and (4) Strengthen the government’s stance in negotiations with the EU.

Objectives (1) and (3) will likely be met but objectives (2) and (4) may prove more elusive.

Opinion polls point to a trend-fall in popular support for the Conservatives to around 44% and sharp rise for Labour to 35%, with the gap between the two main parties halving to about 9pp from 20pp six weeks ago. Aggregate support for the Liberal Democrats, UKIP, SNP and Green Party is flat-lining around 18%.

However, there is still great discrepancy amongst polling agencies which in the past have misestimated true voting intentions. Moreover the UK’s first-past-the-post electoral system makes it difficult to translate share of votes into seat numbers. Whether the Conservatives significantly improve on their current 330 seats or fail to secure a parliamentary majority, as You Gov currently predicts, is a tough call.

Nevertheless, a number of important themes have emerged in recent months.

First, the slingshot campaign has exposed the frailty and flaws of the Conservative machine, including of its leader and manifesto, and reinforced my view, first set out in December, that the government is ill-equipped, ill-prepared and lacking in institutional capacity to negotiate complex deals with the EU and non-EU partners.

Second, it is a two-horse race between the ruling Conservatives and Labour, with the other parties on course to secure only a modest number of seats – a break with recent elections.

Finally, the political centre of gravity has shifted to the left, with in particular tax rates likely to rise regardless of which party wins next week’s election.

My core scenario is a hollow victory for the Conservatives: 360-370 seats with a low voter turnout. This would reduce the risk of opposition parties and rebel Conservative MPs torpedoing government legislation but would fall short of the landslide victory which Conservatives thought possible back in April.

Finally, a modest (or even significant) increase in the Conservatives’ parliamentary majority is unlikely to materially improve the government’s hand when negotiating with the EU.

 

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Asian currencies keeping their head in a world losing its own

Financial markets have had much to digest in recent weeks and the calendar for the remainder of May and June is anything but light, with the Fed and ECB holding key policy meetings and legislative elections in both the UK and France.

Nevertheless, most major currencies have either been flat or appreciated against a slowly weakening Dollar in the past month, with only the high yielding Brazilian Real, Russian Rouble and Indian Rupee (INR) and Australian Dollar weakening by 0.5% or more.

Conversely, European currencies have outperformed, with in particular the Euro Nominal Effective Exchange Rate (NEER) up about 3.4% since mid-April – in line with my constructive near-term euro outlook.

Non-Japan Asian (NJA) NEERs have seen only very modest moves in the past month. Bar the Malaysian Ringgit NEER which is up about 1.1% and the INR NEER which is down about 1.7%, NJA NEERs have appreciated or depreciated by less than 1%.

The question is whether this relative calm in NJA currency markets is likely to become more entrenched or whether FX flows and/or central bank policy are likely to fuel greater volatility or see some currencies adopting a clearer direction.

As a starting point, I would again note that the pace of depreciation and appreciation in most NJA currencies tends to be confined to reasonably narrow ranges.

While this is partly a by-product of seasonal patterns in current account balances and the ebbs and flows in capital migrations, it also arguably reflects central banks’ desire and scope to control their currencies.

At this juncture I would conclude that few central banks – including the MAS and PBoC – face overwhelming economic reasons to markedly alter the paths of their currencies via the bias of FX intervention and/or interest rate policy.

There is however perhaps a case for Bank Negara Malaysia to favour a weaker or at least stable Ringgit NEER which has appreciated about 2.7% since mid-April.

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Politics suspected of interfering with economics and markets

In the US, political intrigue, seemingly lifted straight out of a John Le Carré novel, has reached a crescendo and there are now multiple investigations running concurrently.

If we assume these investigations will run over weeks/months, the question is whether and to what extent this political backdrop is likely to impact financial markets, US government policy-making, the US and global economy and Federal Reserve monetary policy.

US equities have corrected lower, volatility has spiked and markets are seemingly ignoring positive data surprises

It has all been rather orderly so far but it is difficult to see how at this juncture, with major policy initiatives likely kicked down the road, US equities can launch another meaningful rally. If anything big data misses are likely to further pressure stocks. 

The Dollar’s performance has been mixed in the past month, posting its biggest loss against the euro in line with the fundamentally bullish euro view I expressed in December and April.

Capital inflows into the eurozone allied to a 2% of GDP current account surplus, a pick-up in economic activity and receding political risks following the French presidential elections are likely to extend the euro’s current rally near-term.

However, the ECB’s stance on its quantitative easing program will be key in shaping the euro’s medium-term path.

US economic indicators paint a blurry picture while solid global GDP growth is seemingly struggling to make further gains.

The Fed and US rates market have the unenviable task of making sense of these macro trends and a quickly changing political landscape.

The apolitical Fed will of course stay above the political fray, even if markets do not with pricing for the probability of a 25bp hike at the 14th June policy meeting continuing to oscillate between 60% and 75%.

My core scenario is that the Fed will hike rates only once more in 2017 although I acknowledge that this is not a high conviction call. The market seems still on the fence, pricing in a further 32bp of hikes in the remainder of the year.
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2017 French elections – They think it’s all over…it isn’t

Emmanuel Macron, the centrist founder of the En Marche! movement beat National Front candidate Marine Le Pen by two votes to one in the second and final round of the French presidential elections on 7th May, in line with my core scenario.

But for President-elect Macron (and arguably the other main party leaders), the hard work starts now. Macron is expected to appoint next week his Prime Minister and there has been much speculation.

I would expect Macron to pick a head of government and approve cabinet ministers who will not polarise political opinion. The appointment of a “rainbow government” would likely help his party – recently renamed “La République En Marche” – secure the largest number of deputies at the forthcoming legislative elections on 11th and 18th June.

If his party succeeds as opinion polls suggest – no mean feat for a party which is only a year old and currently has no parliamentary deputies – this would in turn help reinforce Macron’s position and his choice of Prime Minister. 

However, polls suggest that La République En Marche may fail to secure a majority of the 577 seats in the National Assembly.

If the party falls well short of that number, it would likely seek a loose coalition with either the Republican Party or less likely with the beleaguered Socialist Party, in my view.

The National Front is likely to cement its position in French politics but it will need to reform itself and I would expect personnel changes and policy tweaks.

Marine Le Pen fell well short of securing the presidency and this should have come as no great surprise as nationalist parties in other EU member states have also come up short.

This is in line with my view that while nationalist/populist parties may have greater influence on the political landscape they will in most cases fail to exercise true power, let alone dismantle the eurozone and/or EU.

Finally, opinion polls which predicted with great accuracy the second and in particular first round of the presidential elections, are back in favour – at least in France.

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