Sticking to forecasts: Fed summer hike, Dollar hat-trick still on the cards, Modestly weaker EM currencies, UK to stay in EU and Sterling to appreciate

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The Federal Reserve’s minutes of its 27th April policy meeting released last week set the tone for a possible June or July rate hike. On balance, recent US and global data are unlikely to have fundamentally changed the Federal Reserve’s view that a summer hike may be appropriate.

This is in line with my long-held forecast that the Federal Reserve would likely hike once or twice this year, with the first hike in June. I recently updated my forecast to a July hike as it gives the Fed more time to assess US and global data and the result of the UK referendum on 23rd June. The risk is that the very threat of a hike derails financial markets sufficiently for the Federal Reserve to postpone its second-hike-in-a-decade to later this year.

Surprisingly, this message was seemingly absent from the wafer-thin policy statement the Federal Reserve issued on 27th April.

I maintain my January forecast that the dollar’s nominal effective exchange rate (NEER)[1] may well end the year slightly higher, propelled by the resilience of the US economy and the Federal Reserve going against the global trend of easier (or at least easy) monetary policy.

Conversely, the recent modest weakening in emerging market currencies is likely to extend, as per my prediction in early April. Macro data are too weak to reassure markets that any economy can single-handedly steady slowing global growth but strong enough for the Federal Reserve to force markets to reprice the risk of tighter US policy.

My core scenario has been that the UK would vote to remain in the EU and, if anything, that conviction has strengthened following recent surveys. The lifting of this uncertainty would see a reasonably competitive sterling appreciate, albeit modestly given the UK’s underlying structural deficiencies.

 

Fed minutes preparing markets for a summer hike

All the focus last week was on the Federal Reserve minutes of its 27th April policy meeting, released on 18th May, which seemingly prepared the market for a possible 25bp rate hike at its 15th June policy meeting. This clearly took by surprise markets which had all but priced out a June-July hike and were only pricing in 14bp of hikes this year. The market is now pricing in a 38% probability of a June hike. The key paragraph in the minutes read as follows (my highlights):

Olivier Desbarres - Sticking to forecast 0

It has been my core scenario since January that the Fed would hike once or twice this year (see What if the Fed hikes, leaves rates on hold…or cuts?, 29 January 2016). Specifically, I had envisaged the Federal Reserve to pull the trigger in June (see Fed – This is what it sounds like when doves cry, 8 March 2016). But recently I pushed back my forecast of a 25bp hike to the 27th July meeting as the Federal Reserve would benefit from an extra month to prepare the market for a hike and from the outcome of the 23rd June UK referendum on EU membership (see US economy not at full employment, 13 May 2016).

Data released since the 27th April policy meeting have not changed my forecast of a summer hike and have on balance been broadly in line with the Federal Reserves’ expectations as detailed in its minutes (see Figure 1). Specifically, US GDP growth, inflation, consumer demand, housing market and equities have behaved largely in line with Fed expectations. The US labour market in April and global GDP growth in Q1 were likely a little weaker than expected while US industrial output will have surprised on the upside.

GDP growth in non-OECD countries may have inched higher in Q1 2016 but growth in OECD countries likely slowed from Q4 unless yet-to-be-released GDP growth in Australia, Canada, New Zealand, Switzerland and Turkey accelerated in Q1 2016 (economies which have so far released Q1 data account for 75% of world GDP).

Olivier Desbarres forecast review

Olivier Desbarres gpd growth Summary

Against this backdrop, US monetary policy remains stimulative with the real policy interest rate still deep in negative territory, whatever the deflator used (see Figure 4). And at the risk of stating the obvious, the Federal Reserve is not contemplating an aggressive hike or a quick succession of hikes – merely the second 25bp hike in a decade.

Olivier Desbarres - US real policy rate still in negative territory

The Federal Reserve’s minutes again made clear that it remains data (and event) dependent and Figure 6 highlights some of the forthcoming key data points which could either confirm or delay a summer hike.

  • Personal consumption expenditure measures of inflation softened in March, as did core CPI-inflation in April. The Fed will want this trend to arrest when April and May data are released on 31 May and 16 June, respectively.
  • May industrial output (due on 1 June) will help confirm whether the April pick-up was a one-off.
  • Labour data for May (due on 3 June) will be of particular interest given the slight cooling of the labour market in April.
  • Preliminary Q2 GDP data will be released on 29 July – after the July policy meeting – so the Federal Reserve will once again have to rely on relevant indicators to ascertain whether and/or by how much growth picked up in Q2 2016.

Olivier Desbarres - Sticking to forecast 6

If the Federal Open Market Committee (FOMC)[2] leaves the Fed funds rate unchanged at 0.25-0.50% in June, the accompanying statement and updated forecasts will have to be sufficiently hawkish to convince markets that a hike on 27th July is all but a done-deal, let alone that another hike this year is on the cards. After all, the market is still only pricing in a 73% probability of a hike by July and 36bp of hikes in 2016 (i.e. a 44% probability of a second rate hike this year)[3]. With that in mind, I would expect only a minor tweak to the updated “dot-chart” after the seventeen Federal Reserve members halved their average forecast for the Fed funds rate for end-2016 two hikes at the 16th March policy meeting.

The risk to a summer hike, beyond markedly weaker US and global data (“known-unknowns”), is that the very threat of a rate hike derails financial markets sufficiently for the Federal Reserve to postpone its second-hike-in-a-decade to later this year. If markets “overshoot” by becoming overly hawkish in coming weeks, this could fuel a sustained appreciation in the dollar and rise in US yields, alongside a pronounced downturn in US and global equities. This could in turn edge the Federal Reserve to erring on the side of caution – seemingly the core scenario for a number of analysts.

 

Dollar hat-trick still on the cards

Back in January I forecast that dollar appreciation would extend to a third consecutive year in 2016, even if its gains would likely be more modest than in 2014 and 2015 when long dollars was one of the most profitable FX trades (see What to expect in 2016 – same, same but worse, 19 January 2016). I maintain my forecast that the dollar NEER may well again end the year slightly higher, propelled by the resilience of the US economy and the Federal Reserve going against the global trend of easier (or at least easy) monetary policy.

Year-to-date, the USD NEER has depreciated only 1%, having at one point been down 3.6% (see Figure 3). The dollar may appreciate further in coming weeks if the Federal Reserve continues to push the market into fully pricing in a June-July hike. Once the hike is delivered, the dollar may lose some traction as was the case after the 16th December rate hike, particularly if markets believe that the Federal Reserve will not hike until after the US November elections.

Olivier Desbarres - Sticking to forecast 78

But with the market still only pricing in a one-in-three chance of a second hike this year, there is scope for the Federal Reserve to again coerce the market into more fully pricing a second hike, which if supported by decent US data would give the dollar a lift. The Federal Reserve’s minutes showed that it is quite comfortable talking about rate hikes despite a still reasonably strong dollar.

Of course, the dollar’s NEER will be determined by how the currencies of the United States’ main trading partners perform, in particular the renminbi, euro, Canadian dollar and Mexican peso which account for respectively 21.6%, 16.6%, 12.7% and 12.1% of the dollar NEER according to the Federal Reserve.

  • The renminbi has modestly appreciated versus the majority of its trading-partner’s currencies so far in May but importantly has weakened versus the US dollar (see Figure 7). Going forward, the Chinese central bank is likely to continue capping any currency appreciation versus the dollar in order to keep the CNY NEER in check and maintain export competitiveness.
  • The EUR/USD cross has traded in a narrow range around 1.10 in the past year and the euro NEER has been remarkably stable (see Figure 8). If this stability extends, the euro may only have a limited impact on the dollar NEER.
  • The gravity-defying yen is down only 1.6% in NEER terms so far in May. But it has been an uneven performance, with the yen depreciating 3.5% versus the dollar. While Japanese monetary policy has so far failed to materially reverse the yen’s appreciation (and loss of competitiveness), the risk is biased towards a slowing Japanese GDP growth forcing policy-makers to act more forcefully and weighing on the yen. In any case the yen accounts for only 6.5% of the dollar NEER and is thus likely to have only a modest direct impact on the dollar NEER.
  • The dollar may weaken versus sterling in the second half of the year if, as I expect, the UK electorate votes for the UK to remain in the EU at the 23rd June referendum. But again sterling accounts for only 3% of the dollar NEER and therefore even an aggressive and sustained sterling rally – not my core scenario – would still only have a modest direct impact on the dollar NEER.

 

Usefulness of Fed statement-light is debatable

Surprisingly the FOMC policy statement on 27th April seemingly gave little indication that a rate hike in June-July was a real possibility. I had expected the FOMC to be constructive enough to keep US yields in reasonably narrow ranges but to stop short of encouraging a significant repricing for a June hike (see It’s a Fed hiking cycle Jim but not as we know it, 26 April 2016).

Instead, the accompanying statement was almost a copy-and-paste of the 16th March policy meeting statement, containing only 40 new words and very little new information for the market to interpret (see Fed pulls off 40-word Houdini, 28 April 2016). The market saw nothing to change its underlying stance and all but priced out a June hike, US treasury yields fell further and the US dollar sold off.

This raises the question of whether the FOMC failed to clearly communicate the essence of its April policy meeting and ultimately whether a skeleton-statement without more detailed forecasts and/or a press conference is of much use. There are three possible drawbacks with the Federal Reserve’s current approach of releasing an information-light statement followed by detailed minutes three weeks later[4].

First, while markets have become adept at interpreting the subtleties of major central banks’ statements and communiqués, they may need more to go on than one paragraph of mostly factual observations. Second, three weeks worth of US and international data will have been released during that period – data which, in theory at least, will not be captured in the minutes. Finally, during that three week interval, FOMC members will be making statements and conducting interviews which may not tie in with either the sparse FOMC statement or the minutes, adding to the confusion.

The Bank of England has tried to overcome these challenges by publishing the meeting minutes and a detailed statement concurrently with the announcement of its policy decision[5].

 

Modest depreciation of emerging market currencies likely to extend

In early April I forecast that “the risk in coming weeks, and in particular as we get closer to the Fed policy meeting on 15th June and UK referendum on EU accession on 23rd June, is that EM currencies [which have been stable since mid-March] start to weaken for reasons which are ultimately familiar” (see Emerging market currencies – don’t call this a comeback, 6 April 2016).

EM currencies held their ground in April, thanks in part to an uptick in Chinese economic activity, stronger equity markets, a surge in commodity prices and the market’s impression that the Federal Reserve had lost its (hawkish) bottle, but started to slowly weaken in May. Fundamentally, macro data have been too weak to reassure markets that the US or any other economy for that matter can single-handedly steady slowing global GDP growth, they have been strong enough for the Federal Reserve to tilt its outlook and force markets to reprice the risk of tighter US policy.

Olivier Desbarres - EM currencies have weakened almost across the board since 6 April and not just against the dollar

Since 6 April, a GDP-weighted basket of EM nominal effective exchange rates has modestly weakened 0.3% or 0.4% if the CNY is excluded (see Figure 5). This modest sell-off has been reasonably uniform regionally, with a basket of Latin America, Emerging Europe and Africa NEERs down 0.1% and a basket of non-Japan NEERs down 0.3% (see Figure 9). Commodity currencies have had a mixed performance, with the MYR and ZAR depreciating due in part to ongoing political scandals in Malaysia and South Africa.

Amongst the fifteen major EM currencies analysed, only four – the Brazil real, Russia rouble, Taiwan dollar and Thai baht – have appreciated in NEER terms since 6 April according to my estimates, albeit from still depressed levels in the case of the RUB and BRL. Importantly, the dollar’s appreciation has only contributed significantly to weaker NEERs in the case of the MXN (see Figure 8). Put differently, the PLN, MYR, ZAR, KRW, IDR, SGD and TRY have weakened against the dollar and most of the currencies of their main trading partners.

The majority of emerging market central banks have ample FX reserves to defend their currencies in the event of sharp and/or prolonged currency depreciation (see FX reserves – all things considered equal, 14 April 2016). But they are unlikely, in my view, to intervene in the FX market to slow let alone stop modest FX depreciation given generally subdued inflation and exports.

 

UK referendum on EU membership: “Remain” vote gaining traction

A survey which I recently conducted, the latest popular opinion polls and bookmakers’ pricing tend to back my view, expressed in What to expect in 2016 – same, same but worse (19 January 2016), that the electorate will vote for the UK to remain in the EU (see EU referendum survey results: UK will very likely remain in EU and sterling may appreciate, 18 May 2016).

The latest ORB poll, conducted on 18-22 May, found that amongst those who definitely plan to vote, support for the “remain” vote stood at 55% and for the “leave” vote at 42%. This gap is more than twice as large as the 6 percentage point gap recorded in a similar poll conducted on 11-15 May. Moreover, ORB concluded that undecided voters were twice as likely to vote “remain”.

It would be foolhardy to draw firm conclusions from two polls conducted only a week apart. However, it is conceivable that vocal support for the “remain” vote from the UK Treasury, Bank of England, Institute of Fiscal Studies, IMF, World Bank, G7, World Trade Organisation and the majority of CEOs of large companies is starting to have an impact. Furthermore, there are signs of infighting between the two main “leave” campaigns.

Should the UK vote to remain in the EU, the lifting of this uncertainty would likely see a reasonably competitive sterling appreciate. But any currency rally is likely to be moderate given the UK’s structural deficiencies, including a large current account deficit, low productivity and weak wage growth, and a dovish central bank. A “remain” vote will not address these vulnerabilities near-term.

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] The Nominal Effective Exchange Rate is also referred to as the Trade Weighted Index (TWI). Both measure a country’s currency performance (in nominal and weighted terms) versus the currencies of this country’s main trading partners.

[2] The Federal Open Market Committee 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. There are currently two vacancies.

[3] This is calculated as the weighted average of the probabilities of one or multiple hikes, as provided by the CME Group.

[4] Until December 2004, the FOMC minutes were released almost six weeks after the policy meeting (i.e. after the subsequent policy meeting). See https://www.federalreserve.gov/monetarypolicy/fomc_historical.htm#policy

[5] The Bank of England adopted this approach in August 2015. Inflation reports are still published once a quarter, on what has been dubbed “super Thursdays”.

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