At sixes and sevens: A state of confusion and disorder, or of disagreement between parties. Derived in the 14th century from the game of dice, the meaning was to ‘carelessly risk one’s entire fortune’
After more than 6 years of extreme accommodation and monetary activism, a material recovery in global growth remains elusive. Against this backdrop, and a rising tide of criticism against the efficacy of central bank actions, G7 leaders meet in Ise-Shima, Japan.
Central bankers and markets have broadly reached the conclusion that monetary activism has reached its lower bound in most cases (or at least has reached the point of significantly diminished returns), aptly summed up by Angela Merkel’s remarks in Japan today that there is "hardly any leeway left for monetary policy” - Indeed, the market reaction to the initiation of negative rates in Japan, and the resultant higher JPY and lower equities, seems to endorse this sentiment.
On the Fiscal front, host nation Japan, with its government debt-to-GDP ratio of more than 230%, is (perhaps ironically) the most likely of G7 to add stimulus. At the other end of the scale, the UK and Germany are perhaps the most able, yet also most unwilling protagonists of further fiscal expansion. In the US, ‘lame duck’ President Obama is unlikely be able to pass any meaningful fiscal package with elections pending. Italy and France are bound by commitments to deficit reduction under the Stability and Growth Pact (SGP) - commitments that already stretch credibility due to their reliance on higher than likely growth forecasts.
"As a writer, you tend to use words to paper over structural cracks” Stephen Fry
What about structural reform, something that Mario Draghi has been urging until he is blue in the face for the past several years? It is unlikely that this G7 meeting will agree anything in this regard either.
Officially there will be little rhetoric about currency valuation outside of the standard pledges not to manipulate and that currencies should be allowed to float freely. However, with the US recently placing Japan, Germany and China (not present) on its watchlist for currency manipulation, it is likely that even unofficially, words that relate to currency may be chosen carefully. Behind the closed doors of their home nations, however, (silent) currency wars are very much alive.
"Status quo, you know, is latin for the mess we are in” Ronald Reagan
Currency markets are very much driven by three core issues at the current juncture. The first is the possibility of Brexit. The recent swing in the polls sharply in favour of the ‘Remain’ camp (one that we have highlighted the rationale for over recent weeks). As sentiment has swung back towards the UK maintaining the status quo, the currency has gained and implied volatilities have fallen back sharply. Whilst all of this seems fairly sensible, however, it is not likely to be as simple as that. Over the next few weeks, a narrowing of the ‘Remain’ lead is likely at some point and, thus, a lower GBP and higher baseline volatility by implication. While nerves have calmed on the political front, Brexit still has the capacity to disrupt currency markets, risk assets and even the US rate normalisation process.
The other two drivers, the USD and equity markets, are more closely linked. The macroeconomic backdrop over recent sessions has generated a strong bounce in equities and risk assets, together with rising US yields (at the front end at least). This combination should be very supportive for the USD at current levels, yet its progress has been very disappointing. One reason is that, while the front end of the US rate curve has risen, increased talk of US rate rises has had a far more muted impact at the long end. This lack of conviction, has worked against the USD, but in favour of equities. As long as the US data remains in the ‘Goldilocks’ zone (too hot for fear, too cold for rapid rate hikes), this muted activity in FX and maintained overvaluation in equities can be extended
It’s not over til the Fed lady sings?
"I don’t decide my politics based on the flavour of the month” Nandan Nilekani
With just 30 days left until the UK EU Referendum, you would be forgiven for sensing a certain degree of apathy in UK and GBP markets this week. The outward appearance of apathy, however, is likely masking a subdued, illiquid, consolidatory phase. Polls (and possibly more importantly, bookmakers odds) are clearly, if not entirely convincingly, in favour of ‘Remain’, and while that is ultimately the most likely outcome, we would expect at least a brief fightback from the ‘Leave’ camp, and a subsequent lurch lower in GBP and related risk assets at some point (probably closer to the Referendum date) over the next 30 days.
Markets will always struggle to efficiently price assets in the approach to a binary event where the two outcomes have significantly opposing implications, particularly if the perceived probability of a particular outcome is liable to change (polls, sentiment). In this instance, however, there is also a third (after the correct market price given an in or an out vote) equally interesting dynamic, which is the current slowdown in the UK economy, and whether this is a function of Brexit uncertainty or an unrelated economic slump.
"Not sure why some UK data has been softer” BoE Kristin Forbes
Last week, MPC member Gertjan Vlieghe highlighted his concern over the recent decline in UK economic activity and suggested that the "UK may need more stimulus if growth does not improve”, suggesting that rate cuts and more QE were "on the table if the outlook worsens”.
From a currency perspective, this is very significant. GBPUSD has had one of the most consistent relationships between a currency pair and relative rate differentials over recent years, and if we overlay the current uncertainty of UK interest rate normalisation (even ignoring the potential Brexit implications) onto the current hawkish revival at the Fed (though admittedly from non-voters), it is rational to expect the interest rate differential between the US and UK to widen further in favour of the US. 2 year GBP rates are now over 20bps lower than US rates, something we haven’t seen since 2006.
In the event of a ‘Remain’ vote in 30 days time, there will undoubtedly be a relief rally in GBP, as hedges and (downside protection) derivative structures are unwound, but the relief rally also extends to the rest of the world, including the US. In the UK, however, it will take time for policymakers to gauge the transiency of the current slowdown. Rate differentials, and thus GBPUSD, becomes vulnerable against this backdrop.
"There is not enough union in the European Union” Jean Claude Juncker
Irrespective of the outcome of the UK EU Referendum, the EU and the eurozone have their own problems. While the recent data backdrop for the eurozone has been almost encouraging, it is likely (as has been strenuously reiterated by ECB President Mario Draghi) that the recent recovery is cyclical. Structural inadequacies remain.
Forecasts from the Bundesbank and domestic institutions suggest that the pace of German economic activity will decline in the second half of 2016. We expect that this pattern will be mirrored across the eurozone. Once the distraction of the Brexit debate passes, we expect the EUR to come under increasing pressure as the resumption of US normalisation highlights the inadequacies of eurozone reform on future growth potential.
"You cannot build sustainable growth on a pile of debt” Jens Weidmann
"Never sell the bear’s skin before one has killed the beast” Jean de la Fontaine
Earlier in the week, we highlighted our view that the global macroeconomic backdrop, and thus the dominant financial market themes, are currently a function of two things: the prospects of US monetary normalisation, and the pace of the Chinese slowdown (as well as economic ‘shock’ risks related to the recent rapid corporate credit expansion) . Last night, ratings agency Moody’s released a report in which they lowered growth forecasts for the US this year and reemphasised the risks of a China slowdown to both US and global growth prospects.
If we take look at equities and risk assets against the current backdrop, we are likely in a situation that we will call the goldilocks antithesis. While the US is not ‘too hot’, and China is not ‘too cold’, then Equities are ‘just right’. From our perspective, however, it is increasingly likely that the bear (market for equities) is just around the corner.
Last night, the minutes from the April FOMC meeting kicked the legs out from under a complacently dovish market. The broad economic data in the US has more clearly stabilised over recent weeks after the (now almost expected) Q1 weakness and, in conjunction with the stabilisation in Chinese economic activity, led the Fed to note that "global risks have diminished since March” and that most officials saw a June hike as "likely, if the economy warranted”.
The Fed’s forward guidance has stated for a number of years now that monetary policy is data dependent. We would argue, however, that against the complicated global backdrop, the Fed are predominantly equity and China dependent. While we firmly believe that the Fed should raise rates in June, it is likely that the voting members are more dovish than the wider board of Fed governors (as perhaps highlighted by the hawkish testimony of Williams and Lockhart on Tuesday - both non-voters). Furthermore, it is possible that the references to "continued downside risks to the outlook” including "Brexit and China currency risks”, that "need close monitoring” are sentiments from voting members that may well lead to a dovish disappointment in June.
The recent US and China stabilisation had driven 2 year US Treasury yields up significantly over the past 2 weeks, yet going into last night’s release, markets were only pricing around a 10% probability of a June rate hike. That (market implied) probability is now at around 32%. We would expect this recalibration of interest rate expectations to dominate the proceedings in the near term. However, while the initial reaction in FX was one of USD strength across the board, we expect that the interest rate recalibration will ultimately weigh on equities and risk assets, and thus JPY and (to a lesser degree) CHF may start to outperform the USD.
"Win or lose we go shopping after the election” Imelda Marcos
This morning’s retail sales data in the UK are a reminder that the risks to the UK economy are not uniformly negative and that a resolution to the Brexit uncertainties will likely result in a sharp repricing of near term growth, inflation, interest rate and currency valuation expectations. Yesterday saw the release of another poll that gave the Remain camp a clear lead. While we would anticipate a lurch back towards ‘Leave’ in the polls over coming weeks, and volatility to pick up again (after the sell off this week - next week the 1 month date covers the event risk), it is clear that the risks to the UK economy and to GBP are not just to the downside.
"A man who stands for nothing will fall for anything” Malcolm X
Overall we continue to favour USD longs in FX, as higher US yields and a steady equity market favour broad outperformance. The USD index has now reversed all of April’s fall, moving marginally ahead of the rise in yields, yet market positioning has not likely caught up, suggesting the USD has further to go.
"Everyone is entitled to his own opinion but not his own facts” Daniel Moynihan
Last week, we suggested that the ‘threats’ from the UK government that Brexit would be bad for house prices and risk higher mortgage borrowing costs was likely "the winning blow in the Referendum campaign, as for much of the voting populace this is likely an unpalatable risk to take, no matter how attractive the long run alternative”. An overnight poll from the Telegraph/ORB suggesting a widening of the Remain lead (55% Remain vs. 40% Leave from 52% vs. 43% previously) highlights this interesting character trait of the broad UK voter: being told what they ‘ought’ to do by a US President brings resistance, threatening an Englishman’s ‘castle’, however, is a step too far.
All of this, however, does not mean that the debate, or indeed the heightened volatility surrounding GBP is over. In fact from here, any lurches towards the Brexit camp will have increasingly large impacts and connotations for financial markets. In the medium to long term our view remains clear, that the EU’s bureaucratic rigidity and inability to reform is a negative for those within and outside the union. Furthermore the debate over the UK’s relationship with the EU, and by extension the rest of the world, will not be settled by a ‘Remain’ vote in the Referendum.
"Truth is such a transient thing” Tracey Emin
The main event of the overnight session was the release of the minutes from the May RBA policy meeting. Against a complex, multidimensional risk backdrop, the RBA and AUD provide a perfect example of the transient nature of current market sentiment. One month ago, the consensus market view was that a rate cut from the RBA was unlikely. Following a downside inflation miss in the Q1 data, the RBA cut rates and the pricing of a further rate cut this year rose to 80%. Last night, the release of the May minutes highlighted that the decision to cut in May was more finely balanced than anticipated as members "discussed the merits.... [of] awaiting further information before acting", once more wrong-footing the market.
This lurching from one extreme to another has been increasingly common in financial markets in 2016, fuelled by lack of conviction, global uncertainty, poor (and in our view, often misleading) forward guidance from central bankers and, most significantly, a substantial reduction in market liquidity.
"The present is the only thing that has no end” Erwin Schrodinger
From our perspective, the key drivers of the global macroeconomic backdrop, and thus broad financial market direction, remain (i) the prospect of US normalisation and (ii) the pace of the slowdown in Chinese economic activity. At the current juncture, equities and risk assets have bounced as the global economy remains on the very narrow support of a stimulus-induced growth stabilisation in China and of US data, that remains strong enough to prevent panic and weak enough (at least for now) for the Fed to delay its path of normalisation.
Our view remains that, while the prospects of a dramatic acceleration of growth in the US is unlikely, an acceleration of (wages led) inflation is likely. Against this backdrop, it becomes increasingly difficult for the Fed to justify such emergency monetary policy settings and thus normalisation (reluctantly) continues.
Furthermore, the Chinese stimulus measures are very unlikely to be maintained indefinitely, and we would anticipate a renewed slowdown (amid continued capital flight pressure) over coming months. This does not bode well for commodities, commodity currencies and, in conjunction with our views on the resumption of US normalisation, is potentially the perfect storm for equities and risk assets.
In the near term volatility, illiquidity and a distinct lack of market conviction has continued to be supportive of equities and risk assets (and risk correlated currencies). In the medium term we do not view this as sustainable.
"The element of harmony is super important” Pharrell Williams
While the headlines from yesterday’s ‘Super Thursday’ concentrate on the (reluctant) admission (after persistent press badgering) that the effects of Brexit "could possibly include a technical recession”, there are a number of significant points from the Inflation Report and the press conference that deserve more attention.
The Inflation Report states clearly that the "unusually large” drags from food and energy prices are "expected to fade over the next year”. Furthermore, the committee judges that spare capacity is projected to be eliminated by early next year, thus, "increasing domestic cost pressures”. The committee also makes it clear that their inflation projections are conditioned on a path for Bank Rate implied by the markets (clearly distorted by expectations of Brexit implications) and continued membership of the EU (or excluding any Brexit induced inflation impact from currency devaluation).
In terms of growth, the BoE reiterated that activity growth slowed in Q1, and stated that they expect a "further deceleration” in Q2, amid "increasing signs that uncertainty associated with the EU Referendum has begun to weigh on activity”. At the same time, the committee noted a recovery in risk assets and emerging market capital flows, as well as a sharp rise in the price of oil.
The historic rule of thumb is that it takes around a year for the full impact of a change in monetary policy to be felt. With spare capacity and base effects imparting accelerating upside pressure on inflation well within that time period, we would argue that without the prospect of Brexit, the MPC is already behind the curve. Thus, in the event of a Remain vote, the MPC may have some catching up to do. More notably, if the MPC has some catching up to do on rates, then the market (which is priced significantly more dovishly than BoE rhetoric would suggest the Bank is) likely have even more (hawkish) catching up to do.
"Everyone is exposed to economic risks of some kind” George McGovern
From an FX point of view, this perspective becomes particularly relevant. When GBP came out of the ERM in 1992, it fell around 20%. Many have based expectations for the currency impact of Brexit at a similar magnitude. However, there are a number of important differences between two scenarios. Firstly, and likely most importantly, GBP’s ejection from the Exchange Rate Mechanism was a surprise (akin to the removal of the CHF peg in early 2015). Secondly, derivative markets were less sophisticated, less liquid and less understood then than they are today.
The EU Referendum was pre-announced months ago, giving markets, corporates and even governments time to contemplate the impact and implications and, where deemed necessary, hedge against the potential negative impact through today’s highly liquid, sophisticated derivative markets. In fact, a recent study suggests that ‘all companies’ have an average of 53.4% of their currency exposures hedged. For ‘top corporates’ (however determined), that number rises to 83.4%. This is not to mention the downside protection / speculation purchased by banks, financial institutions and speculators. EU referendum risk premium continues to rise.
Yesterday’s Inflation Report from the Bank of England states that "the relationship between macroeconomic and financial indicators and underlying economic momentum [is] harder to interpret at present”, and as a result they are "reacting more cautiously to data releases than would normally be the case”. Not surprising, given the backdrop of an unquantified probability of an unquantified shock to the broad macroeconomy.
Our point on currency, however, is that the risks are not singularly biased to the downside. In the event of a vote for Brexit, financial market participants from all contributory angles have (albeit to varying degrees) hedging or participating strategies in place - these should damp the downside reaction to a certain degree (though downside risks likely still prevail). In the eventuality of a Remain vote, growth, interest rate and GBP forecasts, expectations and pricing will likely all be marked significantly higher.
In short, the upside risks for GBP are far closer in magnitude to the downside risks than are currently priced by the markets.
"I do not shop casually” George Vecsey
"Get your facts first, then you can distort them as you please” Mark Twain
At the beginning of what is a very quiet week from an economic data perspective, the likely drivers of financial markets are few and far between. US nominal yields continue to drift lower amid a US data backdrop that brings little resolution to the great US normalisation debate. At the same time, however, US breakeven rates have also fallen, providing a relatively stable trend for real US yields and, therefore, the USD. Thus, attention will likely shift elsewhere for impetus.
With the Japanese back from the Golden Week holidays, official rhetoric (verbal intervention) has been stepped up. Japanese officials have played down their recent inclusion in the US Treasury’s currency manipulator ‘watch list’, in order to convince the markets of the seriousness of their intent. While we think it unlikely that the MoF will intervene in the currency in the short term, there renewed ‘threat’ has so far been enough to drive short-end Japanese rates to record lows (3m TIBOR at -6bps) and the JPY back from the abyss.
An Englishman’s home is his castle
In the UK, the developments are increasingly interesting. The threats from the government that Brexit would be bad for house prices and risk higher mortgage borrowing costs is likely the winning blow in the Referendum campaign, as for much of the voting populace this is likely an unpalatable risk to take, no matter how attractive the long run alternative. In the medium to long term our view remains clear, that the EU’s bureaucratic rigidity and inability to reform is a negative for those within and outside the union. Furthermore the debate over the UK’s relationship with the EU, and by extension the rest of the world, will not be settled by a ‘Remain’ vote in the Referendum.
In the near term, the macroeconomic backdrop for the UK has deteriorated somewhat since the 2015. The Remain camp are all too quick to point to Brexit as the root cause of the decline, however, the slowdown across Europe is perhaps even more troubling.
"If you were right, I’d agree with you” Robin Williams
In the eurozone, it appears that yesterday’s Euro area Finance Ministers meeting to discuss Greece has finally paved the way for Greek debt forgiveness, following the passage of the controversial Greek pension reforms. (Yesterday the WSJ ran a story suggesting that without debt relief, the data suggests that Greek Debt/GDP would be at 258.3% by 2060). This is particularly interesting as this outcome could only be obtained by a U-turn from Germany and is now "expected to allow the IMF to participate in the programme” [Ministers].
Industrial production data from the Netherlands, France and Germany this morning highlight the increasingly concerning economic environment in the eurozone. While the EUR is unlikely to make much downside in the near term, the case for building a structural short in EUR on any rallies from here is growing, with the summer months looking increasingly vulnerable for the region.
"How much easier it is to be critical than to be correct” Benjamin Disraeli
Over the next weeks and months, the most critical developments for the path of global prosperity likely come from the US and from China. Further signs that the Chinese growth trajectory is levelling off (albeit at a significantly lower level) should breathe relief into much of the global economy. Linked with a continuation of US domestic strength (despite the political uncertainties ahead in 2016), US policy normalisation is also likely a positive development for the global economy. Subterraneously and subliminally the global currency war will continue at the forefront of policymakers minds. Weak spots in regional or domestic growth trajectories will only reinforce it. This adds a further level of complexity to FX markets for the foreseeable future.
A quiet data calendar, particularly from a US viewpoint, for the rest of the week suggests a period where position reduction may dominate direction; in that regard, GBP shorts and JPY longs are vulnerable (though the latter has already unwound a significant amount since last week’s JPY highs). AUD may also be vulnerable to a bullish correction, despite the very poor performance from iron ore over recent sessions.