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By Neil Staines on 20/06/17 | Comment

"We all agree that pessimism is a mark of superior intellect”              J K. Galbraith

In the UK, ongoing domestic political inadequacies give an overall sense of uncertainty and ‘backfootedness’ to the start of the Brexit negotiations. However, we would caution against looking too closely at any early prima facie concessions. The structure of the EU, and the lack of precedent for any major economy leaving the EU mean that the EU27 have a strong interest in making any leaver (UK) appear to be losing out, in order to prevent an exodus of countries and disintegration of the EU. It is therefore likely that the ‘spin’ of the negotiations is that the EU has the upper hand, something that will likely be reinforced by the negative bias towards such proceedings from a large proportion of the popular press. Our preference is to assess the content of any deal as it evolves.

As David Davis has pointed out, it matters not how we start but how we finish. Tactically, if the EU is met with a conciliatory UK approach and the political elite take this as a win, so be it. Ultimately, the only thing that matters is the final outcome

Last week we discussed the implications of the gradual shift on the MPC towards a more hawkish monetary bias as the "subdued household spending growth is largely balanced by a pickup in other components of demand”. We stated our view that a more balanced trade off between near term spare capacity and more medium term rising inflation dynamics was a positive development. While last week’s MPC vote was 5-3, leading the market to price in a chance (albeit modest) of a rate rise as soon as August, Kristen Forbes’ departure leaves it at 5-2. The two newcomers (Silvana Tenreyro and another to be announced) are unlikely to ‘dissent’ in their first meetings.

This morning Governor Carney, weighed in to the discussion, stating that "domestic inflation pressures are subdued” and that it was "not time for a rate hike” (but still adding that "any rate increases will be limited, gradual”). Furthermore, he suggested that we "must see how the economy reacts to the reality of Brexit”. Carney’s also appears less convinced on the economic rebalancing in suggesting consumer spending and investment were giving "mixed signals”.

Carney is only one vote on the committee and he is clearly at the dovish end of the MPC monetary spectrum. His suggestion that rate hikes are not imminent should therefore not come as a surprise. However, our views remain at the bullish end of the currency valuation spectrum and as such we continue to expect GBP to outperform the ‘spin’ focussed negative sentiment of the market.

 

The Way Forward?

While the ‘fast’ FX market is focussed on the fact that David Davis may have conceded the order of the negotiations with the EU27 and even the fact that Carney has refuted a near term rate hike (that nobody had even considered until last Thursday), there is another clear dynamic playing out and one which has much more significant connotations for the value of GBP.

Philip Hammond, an increasingly audible voice in Government of late, has recently given clarity to his view of the Brexit path. A path with fewer immigration restrictions, greater access to the European markets, prioritising jobs and the economy throughout. This path is likely, at least for a number of years, to come with a significant contribution to the EU - a price worth paying for the ability to strike bilateral, taylormade trade deals with the fastest growing most dynamic countries of the world. This, in our view, is the most progressive, effective route for the UK and on a valuation basis would leave GBP significantly undervalued at current levels.

 

"How do we know when irrational exuberance has unduly escalated asset values?”                     Alan Greenspan

In the US, while inflation remains conspicuous in its absence, any hawkish US sentiment or comment has little (or at least significantly less impact) at the long end of the curve, when compared to the front end. This curve flattening amid a modest but firm growth backdrop continues to drive a hunt for yield and a positive backdrop for equities and risk assets. In this regard we are increasingly cautious.

Comments from NY Fed Governor Bill Dudley suggested that he was comfortable with the flatness of the yield curve suggesting that it was "not a problem” (despite its usual negative correlation with expectations for future growth prospects). Dudley also said that the Fed does not want to "slam the brakes on and cause a recession” but that to refrain from tightening would imperil the economy - a further dislocation from textbook economic theory. Dudley’s comments supported the front end of the US curve, and the USD but less so the longer end.

Dudley et. al may well be comfortable with a flat yield curve yet their rhetoric suggests perhaps they are becoming less comfortable with the continuation of the equity rally (S&P closed at yet another record high yesterday) and perhaps even "irrational exuberance”.

 

 

Against the backdrop of a quiet data calendar, the EUR has been very quiet in its own right. This week’s CFTC data highlight further growth in speculative longs in EUR despite the fact that EUR failed to gain any further ground over the period of accumulation - Speculative EUR longs are at their highest level in at least 5 years. Above 1.13 that may not be a problem, below 1.11, however, it might start to become one.

By Neil Staines on 16/06/17 | Comment

"Fear and surprise… and ruthless efficiency”               Monty Python

Over the last week, market sentiment has been dominated of course by the fallout from the surprise failure of the UK Conservative Party at the snap election, but also significantly by the monetary policy developments of the ECB, FOMC and the BoE. All have confounded consensus market expectations.

We discussed the ECB decision shortly after it was taken last week. Essentially, the markets’ expectation was for a modestly less dovish iteration of the policy narrative from the ECB. The core focus was on the statement "ECB sees rates at present, or lower, levels until well past the end of QE” and the expected removal of the "or lower” part. However, fact that the statement "ECB stands ready to increase the size and duration of QE as needed” negated the expected hawkishness (simply offering an alternative preference for the transmission of monetary easing going forward, should it be required).

Overnight, the headlines were more supportive for the Eurozone, with the news that ‘Greece and creditors reach a deal on next part of the bailout’. On the face of it this seems a significant resolution. However, the details suggest that this is another case of the eurozone kicking the can down the road - of doing just enough to avoid disaster, without solving any of the issues going forward. In effect, all that the Eurogroup has done is reach an agreement to release the EUR 8.5B bailout tranche, to allow Greece to pay its creditors and avoid a default next month. While the headlines also infer the cooperation and agreement of the IMF, the reality is that IMF involvement is still contingent ultimately on debt forgiveness (not the 15 year ‘payment holiday’ suggestion from Eurogroup creditors) in line with their view that "Greek debt is not sustainable”. In short we would caution against Greece induced buying of EUR and narrowing of spreads.  

"Important not to overreact to a few inflation readings”           Janet Yellen

Next came the Fed. Expectations here were that the FOMC would deliver the 25bp rate rise that had been almost fully priced for several weeks - but that they would counter the rate rise with a sufficiently dovish statement that would flatten the curve and maintain the carry positive, risk friendly backdrop to financial markets. The reaction function of markets was, however, complicated by the release of a significantly lower US inflation reading just a few hours before the FOMC. This effectively accelerated the likely response to expected fed dovishness ahead of time.

In reality, however, the Fed statement surprised on the hawkish side, downplaying the recent disappointing (low) inflation readings as reflecting "some one-off price reductions” - a transient understatement of true price pressures? Furthermore, the Fed highlighted further gains towards the equilibrium employment level and rebounding growth after Q1 weakness.

Out of the Loop?

Lastly (both chronologically and in terms of expected impact), came the Bank of England. Following the Brexit-induced decline in GBP, much of the recent debate on the MPC has involved the trade off between a negative output gap and above target inflation (and, by extrapolation, negative real wages).

Previous meetings have explicitly stated that there are limits to the MPC’s tolerance of above target inflation. Also, while commentators have singularly focussed on the negative implications of higher prices - and low wage increases - on consumer spending, the MPC have also noted that "subdued household spending growth is largely balanced by a pickup in other components of demand”. On that basis it is less surprising that the vote for unchanged policy moved to 5-3, from 7-1 at the May meeting.

The fact that there is an increasing contingent within the Bank of England that are more focussed on the medium-term implications for inflation and inflation expectations - balancing those who consider rising spare capacity dominant - is positive for the credibility of the MPC, the stability of GBP (and thus any further currency / inflation negative feedback loop) and UK assets. Furthermore, with Kristen Forbes (one of the dissenting voters) leaving the MPC following yesterday’s meeting, and with Charlotte Hogg still to be replaced, the policy bias of the new members will be critical in the near-term balance of the MPC (5-4 or 7-2).  

"Is it ignorance or apathy? Hey, I don’t know and I don’t care”                       Jimmy Buffett

Despite the constant stream of surprises in financial markets, the reactions have been relatively muted. Reduced participation is surely playing a role, however, so too is the current dislocated macro backdrop. With risk assets high (overvalued in our view in many cases) but supported by flat (or near flat) monetary tightening in an economic uptick that is failing to generate inflation, options are relatively limited. Until we get inflation, a correction in risk assets or an external stimulus, they may remain so.

However, against the current backdrop, we maintain our view of USD and GBP outperformance in the short and medium term, as expectations of the backdrop for the eurozone have become overegged and those for the US and UK, quite the opposite.


By Neil Staines on 13/06/17 | Comment

"Nothing in politics is ever as good or as bad as it first seems”          Willie Whitelaw

Last week, on the eve of the UK General Election we outlined our view, and that of the vast consensus, that the Conservative Party would likely increase their 17 seat majority.  Failure to do so has thrown up a number of issues and questions - some positive, some less so. From here, however, we would paraphrase Willie Whitelaw in suggesting things are not as bad as they may have initially seemed - despite the surprise outcome.  

In retrospect, the wisdom of the snap election will clearly be questioned, as will the more obscure focal points of the May (and her team - or, perhaps more pertinently, lack thereof) election campaign. On the flip side, the lack of an organised and relevant social media campaign - not to mention the perils of a distinctly negative campaign over a positive one - will all, I’m sure, be revisited and reviewed.

Prior to the election we argued that "except for a prolonged period of hung parliament, it is not clear that they [outcomes other than an increased Conservative majority] would be outright GBP-negative in anything but the initial knee jerk reaction (when a softer approach to Brexit - perhaps including single market access in some form - and the current undervalued level of GBP are taken into account)”. We maintain this view. 

Catch 22?

Following her grilling from the 1922 committee (known as "the 22”) and the likely ‘deal’ with the Democratic Unionists (DUP), May has a workable majority in Parliament. However, a reduced majority and weakened credibility likely diminish her negotiating strength in Brussels. In a nod of acceptance to this May appears to be sounding out the possibility of a more cross party approach to the Brexit negotiations as May faces greater pressure to find a deal that works for all sides.

The difficulty in achieving this is that both Conservative and Labour campaigned on the basis of restricting free movement of people, which precludes access to the single market and the customs union. Being a full member of the customs union usually precludes striking one’s own bilateral trade deals. Tricky. The notion that allowing immigration from the EU, for people with a confirmed job to go to, might be enough for largely unrestricted access to the single market - a concept being mooted amid calls for (and speculation of) a softer Brexit. But that falls short of what many would view as a Brexit.

While we continue to advocate the economic positives of a UK outside the restrictions of the EU, there may well be advantages (not least in narrowing the emotive popular divide) to a ‘halfway house’ on the way to a more committed Brexit at some point in the future.

For GBP, this is potentially the most positive backdrop beyond the near term (self induced) political uncertainty. On a valuation basis, GBP is cheap - significantly more so if the near term harder dislocations of leaving the single market altogether are to be avoided (or at least delayed for a significant period). The same argument can be made for UK consumer and business confidence and, by extrapolation, interest rates. While the options are now limited, the government position is not clear yet. However, from our perspective the balance of risks is moving against the consensus and in favour of the pound.

"Progress is impossible without change”                        George Bernard Shaw

The big (scheduled) event of of the week is Wednesday evening’s FOMC meeting where the Fed are widely expected to raise interest rates 25bps, to a target range of 1.00-1.25%, shortly after the latest readings on inflation and retail sales are released. While the market has a high conviction of a rate rise this week, its conviction level thereafter tails off pretty sharply, with only another 18 bps priced into the curve for the rest of the year, and only 26 bps for the whole of 2018.

On the wires, US Treasury Secretary Mnuchin has been making some more encouraging comments on the progress of fiscal stimulus measures - tax cuts and infrastructure spending predominantly. From our perspective, we are at a point where the balance of risks is shifting towards a higher USD. If the Trump administration can make progress on fiscal stimulus, it would likely warrant an upward repricing to growth, inflation, interest rate and USD trajectories going forward. However, this time round we would not expect fiscal stimulus projections to be supportive of equities - indeed it could well be quite the opposite.
By Neil Staines on 08/06/17 | Comment

"...just seventeen. You know what I mean”         Beatles, I Saw Her Standing There

 

As the UK goes to the polls today, seventeen is the magic number. An increase in the 17 seat Conservative majority in the House of Commons will justify the PM’s snap election call, strengthen her (domestic) position in the upcoming Brexit negotiations, and likely be enough to see "her standing there” a while longer at least.

Our central projection is an increased Conservative majority, up from the current 17 (or 331 parliamentary seats) - likely bringing relief for the government, Theresa May and GBP. Gilt curve may flatten somewhat and market focus can filip back towards the economy and impending Brexit negotiations and away from domestic politics. Other connotations would be more concerning for financial markets, and specifically for GBP, but except for a prolonged period of hung parliament, it is not clear that they would be outright GBP-negative in anything but the initial knee jerk reaction (when a softer approach to Brexit - perhaps including single market access in some form - and the current undervalued level of GBP are taken into account).

 "Today the UK is going to the polls, or the dogs, or both.”                   Kit Juckes

At around 10pm UK time the first exit polls will be released, shortly followed by the first ‘declared’ results, usually from the Sunderland area (traditionally safe Labour seats) around 11pm. A May majority means that the country will move forward, almost immediately, with Brexit negotiations, while other scenarios may well see the UK going backwards (with some of the Labour Party’s economic policies, about 50 years backwards) at least for a recalibration period.

 "We’re one, but were not the same”                      U2, One

Earlier today the ECB left its policy accommodation (both benchmark interest rates and QE purchase amounts) unchanged as expected. However, there were some specific changes to the accompanying policy narrative where the governing council omitted the reference "or lower” to the statement "ECB sees rates at present [or lower]well past the end of QE”. However, this notional tightening was widely expected, and in the event it was further tempered by the inclusion of the line "ECB stands ready to increase the size, duration of QE as needed”.

Euro area policy focus was also heightened yesterday, with the release of draft ECB inflation projections lowering the official inflation forecasts for the region down to around 1.5% for each of the next three years (from 1.7% in 2017, 1.6% in 2018 and 1.7% in 2019). We have highlighted our expectations of a downward revisions to inflation forecasts at this week’s ECB meeting a number of times recently. We do not think that the downward revision should have been a shock to the market (more than likely an attempt to dampen market reaction to the announcement).

The ECB also left unchanged the implied sequencing of policy normalisation - or the desire to end asset purchases under QE (pledged until the end of the year) before raising interest rates. Furthermore, while the staff projections for GDP growth was revised higher over the forecast relevant horizon, the downward revisions to inflation were of a greater magnitude than suggested by yesterday’s ‘draft’ - dipping as low as 1.3% in 2018 and 1.6% in 2019.

Ultimately, the global recovery continues to support eurozone exports and stimulus pass through supports eurozone domestic demand but the recovery is not yet sufficient to generate inflation and thus "a very substantial degree of accommodation is needed” still. This reinforces our negative bias towards the EUR relative to USD and (election dependent) GBP.

Similarly, the Japanese economic dynamic is essentially a mirror image of the eurozone. Expectations are also growing that Japan will upgrade its economic assessment as early as next week signalling its growing conviction in a recovery that is gaining momentum. The prospect of tighter monetary policy however remains damped by continued stubbornly weak inflation that may force the BoJ to cut its price target once more, despite employment and income conditions improving.

Trumped Up?

In the US, the release of the opening statement of former FBI Director James Comey ahead of today’s inquisition also likely damped potential volatility in respect of this specific market concern. Comey confirmed the President’s claim that he was give assurance he was not being investigated personally. Furthermore, and more critically, the statement suggests that Comey will stop short of suggesting that the President may have obstructed justice (in relation to the enquiry into National Security Advisor Michael Flynn), which is the impeachable offence, and ultimately the core tenet of the investigation - from a financial market viewpoint at least.

In that sense markets can get back to focussing on the economic backdrop for the US. It seems that the US economy is in a fundamentally dull place, constrained at pedestrian growth levels with low productivity, huge disinflationary forces, and structural changes that fuel political discord. However, we would argue that - provided there are no unexpected developments at this afternoon’s inquisition - expectations of Trump’s ability to pass election pledge legislation is at its lowest ebb, and the risks for fiscal policy expectations, growth and interest rate expectations (and maybe even wage inflation) are increasingly skewed to the topside.

This morning we have already seen a bounce in US yields and a steepening of the curve both from significant levels. If we are correct in our assumptions and the balance of risks above, then the backdrop for the USD is by default increasingly positive.

By Neil Staines on 06/06/17 | Comment

"I am an optimist. It does not seem too much use being anything else”         Winston Churchill

 Last week we discussed the narrowing of the UK general election opinion polls and the likely implications. It is clear that the pollsters have changed their methodologies in light of the large forecasting errors experienced recently - the 2015 election and of course in the UK referendum on EU membership, or the Brexit vote. It is also clear that the different polls have a bimodal distribution (presumably based on their underlying assumptions) that suggests either just a few points between Labour and Conservative (YouGov, Survation) or around a 10 point lead for the Conservative Party (ICM, ComRes). By the end of this week all will be revealed.

The popular press by and large maintains its negative bias towards the UK economy, largely based on a slowdown in consumer activity as real spending power is eroded by (a fall in GBP induced) rising inflation. However, our view is more positive on the UK economy. We echo the sentiment of external MPC member Michael Saunders; we expect business investment and exports to continue to pick up and in addition to this positive economic rebalancing we also expect currency and energy effects to limit the upside inflation drag on consumer activity and sentiment.

The election remains a core uncertainty for the UK and for GBP. However, beyond this (and assuming the election does not result in a hung parliament and a drawn out power struggle) we maintain a bullish view on GBP relative to the market and its peers.

"We are all reflationists now, hoping prices rise”                      BoJ Yutaka Harada

In the US the economy was essentially summed up by one set of data on Friday. The US employment report showed that the US had generated 138,000 jobs in May, a gain large enough to continue to erode spare capacity and labour market slack, a number big enough to lower the unemployment rate but also, critically, a number that was lower than expectations and too small to drive wage prices any further.

A US economy that is growing at a satisfactory, yet uninspiring, rate with inflation that is underpinning the concept of gradual rate normalisation (but not necessitating an acceleration) likely drives the low volatility risk positive (equities higher along with record low levels in equity volatility), duration extension (yield grab for higher yielding longer dated bonds), carry positive backdrop that we have witnessed over recent months. However, we do not expect this to continue.

Our inclination is to see the the recent fall in US yields as the last leg of the rally in bonds - a rally that, once the uncertainty of the current backdrop dissipates over the summer, will be viewed historically as a cyclical base in yields. A rise in yields (and essentially a rise in wage inflation) provides a significantly more positive backdrop for the USD. Any progress on fiscal stimulus of infrastructure spending from the Trump Administration will accelerate this process.

"You can NOT have a union without convergence”       Mario Draghi

In the eurozone, core rates have fallen back in tandem with US rates over recent sessions. However, in our view the relative level (and the flatness of) the eurozone yield curve seems more sensible to us. The implications for the FX market are significant.

In our view, EURUSD continues to rise faster than is justified by the move in relative yields, driven by a swing in sentiment and positioning. Furthermore, as we rapidly approach Thursday’s ECB meeting, expectations of a hawkish monetary policy iteration are dominant. We are more cautious in this respect. While it is certainly likely that Mario Draghi announces a recentering of the perceived balance of risks (explicitly, the effective replacement of ‘downside risks to growth’ with ‘risks to growth are broadly balanced’) we remain skeptical that there will be any movement on either the level of rates or the implied sequencing of eventual removal of monetary stimulus.

Furthermore, the rationale for maintaining the level of monetary stimulus (even if the promise of further accommodation is removed) will likely have been reinforced by the recent pullback in inflation across the region, continued economic divergence and the prospect of renewed political uncertainty after the summer (German elections in September, but more critically the potential for Italian elections around the same period).      

 Essentially, we maintain our core views against a fractious political and uninspiring economic backdrop at the current juncture. However, in the near term the concentration of event risk on Thursday means that we would expect less activity over coming sessions. Once a quarter the announcement of the Bank of England’s Quarterly Inflation Report, policy announcement and policy meeting minutes earns it the moniker ‘Super Thursday’, this week with the UK General election, the ECB policy meeting and the potentially significant testimony of fired FBI Director James Comey, we may be in for a Super Duper Thursday.

By Neil Staines on 31/05/17 | Comment

"... don’t get hung up on zeros” Jack Welch

 

A hung Parliament was unlikely to have crossed the mind of Theresa May when she announced a surprise General Election on the 18th April with the polls skewed for a landslide majority. However, this morning a YouGov study for The Times suggests there is a real possibility that the current government will lose seats next Thursday. A surprisingly sharp turnaround.

 

However, our core view remains that the most likely outcome is still a conservative majority and a swift progression towards Brexit negotiations with the EU. On the data front strong money supply numbers, maintained consumer borrowing and better than expected consumer confidence in May, all argue against the prophecies of economic doom that continue to be aimed at the UK economy. We continue to echo the sentiment of Bank of England MPC member Michael Saunders that rising business investment, export and manufacturing gains will compensate for (and provide a healthy rebalancing to) any moderation in consumer activity, whether driven by higher inflation or not.

 

Amid the electioneering the topic of Brexit has been surprisingly subdued, however, Global ratings agency S&P stated in a report yesterday that "in the medium term, there is a real opening for UK business to develop closer trading relationships with faster growing non-EU economies. This will play to the UK’s strengths by focussing on faster-growing, technologically advanced, value-added manufacturing and services.”    

 

"Proverbs are short sentences drawn from long experiences” Miguel de Cervantes

 

The EUR has been drawn higher over recent weeks by a number of domestic factors {higher inflation around the Easter period, improved survey based activity data, removal of the threat of extreme political fragmentation in France,...}. However, we would argue that the core driver of a rising EUR has been the the narrowing yield spreads that have been driven by the concurrent reduction in US rate normalisation expectations and the rise in eurozone normalisation expectations.

 

Last week we discussed our view that the EUR, or at least "the extrapolation of positivity towards the EUR and eurozone interest rates, has likely extended too far”. In the near term, the EUR rally is being slowed down by the build-up of big long positions, the gap between how far the currency has gone and the move in relative yields, and the restraining rhetoric of ECB President Mario Draghi.

 

We have also mentioned in recent communications our view that the ECB’s inflation projections are vulnerable to a downward revision at the June meeting,  a prospect likely accentuated by the release of the bigger than expected pullback in the May headline inflation data to just 1.4% y/y - and, even more troubling, the drop in core inflation to just 0.9% y/y. In addition to measured inflation, inflation expectations - arguably a more important policy consideration at this stage of the recovery - have also turned back lower.

 

Furthermore, while the EUR bulls point to a reduction in the political risks to the eurozone and the EUR, the lack of agreement over Greek debt relief appears to threaten the calming political trend in the region, not to mention the focus that an Italian election would bring - particularly if the weekend suggestions of a September Italian election (to bring it in line with the timing of German elections) by former PM Matteo Renzi become a reality. The prospect of an Italian election, where there is perhaps the most mainstream anti euro parties in the region, as soon as September, in our view makes it very unlikely that the ECB would want to encourage a further extension of recent rises in the EUR and to a lesser degree interest rates.

 

"The cloud never comes from the quarter of the horizon from which we watch for it” Elizabeth Gaskell

 

Many commentators are now (after the 9% rally against the USD this year) calling for a move higher in EURUSD. We maintain the view that the EUR has likely extended too far. Furthermore, we hold the view that the USD has declined to a point at which it is likely undervalued in relation to its economic trajectory (Atlanta) and the likely implications going forward for real rates and relative rate spreads.

 

Quarterly growth in the US disappointed in at the start of the year, with Q1 growth at an annualised rate of 1.2% on its latest release. However, the most recent GDP tracker from the Atlanta Federal Reserve is currently running at 3.8% q/q annualised. Furthermore, with the markets having unwound the ‘Trump’ rally in the USD and US yield curve, we now view the risks to both yields and the USD as being skewed to the topside. That is without any inclusion of fiscal stimulus from the Trump administration, which likely accentuate the view.

 

The rest of this week, culminating in the US employment report for May is likely key to the underlying sentiment towards the USD in the near term - and by definition in nudging the balance of risks further in favour of a higher USD.



 

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