"The smaller the pond, the more belligerent the fish” Craig Brown
With Q3 GDP in the UK and the US dominating market sentiment and focus, today we take a closer look at the data and outline our views of the monetary (and to a lesser extent fiscal) policy risks. From where we stand those ‘risks’ are coming from different directions depending on which side of the ‘pond’ you sit.
Recently we have been discussing our view that the UK (and thus GBP) is suffering from what we consider undue, or excessive negativity. Indeed, earlier this week we suggested that our growing opinion is that the current UK monetary policy settings are the bottom of the accommodation cycle - we no longer expect a rate cut or any further extension to QE purchases from the Bank of England.
"As for our majority… one is enough” Benjamin Disraeli
This morning’s better than expected (advance) Q3 GDP is something of a case in point in that regard, as rates markets have now all but priced out the probability of a further rate cut and even began (albeit tentatively) to price a resumption of monetary tightening in the second half of 2017 . In fact the good news does not stop there. Recent substantial declines in GBP have significantly improved the UK current account deficit (as discussed in a recent NBER paper co-authored by Kristin Forbes).
If, as we suspect, UK monetary policy is at its floor, a positive proactive Autumn Statement from Chancellor Hammond could be a real game changer for the outlook for the UK. That is not to mention the positive implications of a more proactive, business friendly Brexit negotiation path. It is likely that the Bank of England maintain a cautionary tone on Super Thursday next week, however, it is increasingly likely that the economic projections are revised higher and economic stability concerns lowered.
"I would never die for my beliefs because I might be wrong” Bertrand Russell
Following on from yesterday’s better than expected US economic data, the markets are currently pricing in around a 70% probability of a 25bp rate rise from the Fed by the end of the year. In fact, it is likely that tomorrow’s advance Q3 GDP estimate for the US, barring any downside surprise, would make a December rate rise all but nailed on.
While we are firmly of the view that this (in our view overdue) rate rise is a positive development for both the US and global economies, it is perhaps at this stage worth taking a glance in the other direction. By this of course we are not suggesting that the Fed may cut rates, however, we do feel that there some risks to the outlook that, if realised, are significant enough to derail Fed (current) intentions of monetary normalisation.
Firstly (and most obviously), any shocks to confidence or financial markets as a function of the US Presidential election would give the Fed little time to gauge the duration and depth of impact before making their rate decision in December. In this regard, we would argue that the Presidential election polls likely underestimate just how close the outcome may be and as such under-price volatility.
Secondly (and something we have been cautioning about for some time), the risk of a significant decline in equity markets between now and the end of the year is a much higher probability event than is currently priced by markets. A significant decline in equity prices is likely to invoke caution from the Fed (as it did at the start of 2016 where there was a notable dovish pivot as a function of equity declines).
Lastly, and with perhaps the most far reaching connotations, is the risk of economic derailment in China. In the past, we have written about the encouraging, proactive, structural economic strategies of the Chinese authorities. Economic plans (and supporting fiscal and monetary policy) had been built to facilitate and accommodate the economy’s arrival at future (economic and social) milestones. Not (as we have been critical of), adjusting policy to fix past issues or current crises - as has been the theme in the eurozone for example. However, more recently it is clear that Chinese economic policy has been far more short termist in its outlook - for example positively encouraging the latest aggressive cycle of credit-driven expansion (despite global concerns over the level Chinese corporate debt levels and leverage), and as discussed in the press yesterday, encouraging companies to redouble coal production - reversing previous policy initiatives.
"Every dogma has its day” Anthony Burgess
"You pray for rain, you gotta deal with the mud…” Denzel Washington
Front page press this morning is the revelation that after seven years of negotiations the landmark EU-Canada trade deal (CETA - Comprehensive Economic and Trade Agreement) was thrown into chaos as the socialist Belgian region of Wallonia rejected the deal. While some commentators have been quick to suggest that this bodes ill for prospects of a swift UK exit deal, it could be argued that the UK has a clear advantage over the (intensely diverse) EU in its own, post Brexit bilateral trade negotiations.
On that note, the Wolfgang Munchau article in yesterday’s FT (Britain and Europe share an interest in an amicable split) highlighted some very interesting points. While much of the press and common opinion is that the rest of the EU will want to ‘make us pay’ for leaving the EU club, the reality is that a retaliatory hardball strategy by the remaining EU members would likely be just as painful, if not more so, for the EU.
For example, "Germany is not only exporting more goods to the UK, which we knew; it also has a surplus in services, including finance, according to the Federal Statistics Office. UK services exports to Germany were €24bn in 2015, while the UK imported services of €41bn from Germany. If a hard Brexit were to force the UK and the EU to impose quotas on traded goods and to suspend trade in most services, Germany would be harder hit than the UK.”
In aggregate the UK would be most negatively affected; however "having an unsustainable external position is a rare benefit when you want to negotiate a trade deal”.
In this morning’s morning’s Telegraph Ambrose Evans-Pritchard mirrors this sentiment. He quotes Swedish Finance Minister warning that it would be a serious mistake to chastise Britain for leaving the EU, appealing instead for an amicable deal to minimise damage for both sides.
"Things turn out the best for people who make the best of the way things turn out” John Wooden
This morning’s German IFO survey rose in October, consistent with the recent upturn in eurozone PMI and industrial production data, after the summer slump. The PMI’s, at a 10 month high, are broadly consistent with quarterly GDP growth of 0.4%. However, it is interesting to note that despite the recent flow of better-than-expected eurozone economic data, the EUR remains under pressure. EUR weakness is likely just as much a function of USD strength at the current juncture, however, it may need 10 year US Treasury yields to break above 1.80% before the next leg lower (higher for the USD) can begin.
As the ECB run out of policy ammunition and into political constraints ahead of the German and French elections next year, we would anticipate continued pressure on the currency. If as we expect, Brexit negotiations become more conciliatory and pragmatic, then we would expect GBP to be a significant gainer against the EUR.
"The element of harmony is super important” Pharrell Williams
In the UK, yesterday’s CBI industrial trends survey for October saw business optimism surge on the quarter, with export volumes growth at its strongest level in 2.5 years. While the headline total orders index still points to near term fragilities, it is clear that much of the hysteria surrounding the near term collapse of the UK economy in the event of a vote to leave the EU was at best an exaggeration. CBI also said that UK competitiveness with the EU is at a record high.
Next Thursday (3rd November) really will be a ‘Super Thursday’ for the Bank of England, when we get the release of the Quarterly Inflation Report (and new economic projections), as well as rate decision and simultaneous meeting minutes. Our view is increasingly erring towards the current monetary policy settings being the bottom of the accommodation cycle in the UK. The first estimate of Q3 UK GDP on Thursday will be the next point to review this view.
"First rule of fight club is: You do not talk about fight club” Fight Club
Yesterday’s ECB meeting press conference was something of a disappointment. Those looking for inference or conjecture about the ECB’s future policy intentions were instead whipsawed by the bluff and double bluff of issues Draghi claimed the ECB had not discussed.
By way of a checklist, the ECB did not talk about (i) extensions to the QE programme, (ii) Tapering of QE, (iii) the intended QE horizon or (iv) the stock vs. flow issue of QE. Draghi’s inherent dovish message became lost.
The statement and thus the policy message was effectively unchanged from early September. Draghi praised the eurozone’s moderate (yet steady) economic growth with resilience to "global and political uncertainty” but continued to highlight the fact that "risks to the economic outlook [are] still tilted to the downside”. On the inflation front Draghi maintained the fact that the ECB see a "gradual rise in inflation” yet there are as yet "no signs of a convincing upward trend in core inflation”.
Despite the largely unchanged statement and the alleged lack of discussion points from the Governing Council (leading to an uncharacteristically short press conference), broad market consensus remains focussed on further monetary accommodation in December (likely in the form of an increase in asset purchases under the QE programme).
It could be argued that a possible reason for a non-committal Draghi performance was a function of internal disagreement about the need for further easing. The debate over the efficacy of monetary policy and the side effects of ultra low rates is an increasingly heated debate in both economic and political circles. Indeed, last night ex-BoJ board member Sayuri Shirai suggested that the new BoJ framework of "curve control” is in fact "a move toward tightening” and signals an "end of increasing quantity”
"One may miss the mark by aiming too high as too low” Thomas Fuller
As political pressure to redress the reliance on ever more accommodative monetary policy grows globally, yield curve volatility is rising. Draghi stated in the press conference that there current information (from a BoJ like review of monetary policy) is that "low or negative rates do not hinder the transmission of monetary policy”. Policy makers and politicians, however, will likely want to expand this form of review to look at the impact on consumer and business confidence and perhaps most significantly whether such low rates, with the promise of being maintained (under forward guidance) is in fact a root cause of weak business borrowing and investment.
Last night at the EU Summit, UK PM Theresa May confirmed that the UK would invoke Article 50 by the end of March. May was said to have told EU leaders that the UK is aiming for "minimal Brexit disruption”, disappointing Donald Tusk who said that "he still hopes that the Brexit decision will be reversed”. In an ironic parody to Draghi’s long list of things that were not discussed, the one thing that everyone wants to talk about at the EU Summit, "How will Brexit affect trade/migration/investment/relations?” was ‘off-limits’.
With a minimal data calendar to end the week, sentiment will likely drive positioning and activity into the week’s close. From our perspective, despite the better-than-expected earnings data (in the most part) from US corporates over recent days, we continue to see equity valuations as being overstretched at current levels and we continue to see real risk appetite as weaker than equity levels and current price action would suggest. M&A flows may suggest some further selling of GBPUSD, however, we would suggest that much of the requirement has likely already been done and would favour a higher GBP (and a higher JPY) in the near term.
Costa’s Last Stand?
"One day the house of cards will collapse” prof. Otmar Issing
With all the politicking and positioning going on on both sides of the Brexit debate it is interesting to hear the views and comments of one of the founding architects of monetary union and the first chief economist at the ECB prof. Otmar Issing. Ahead of this week’s ECB meeting prof. Issing expressed his view that the "European Central Bank is becoming dangerously over-extended and that the whole euro project is unworkable in its current form.” He also stated that "the euro has been betrayed by politics that has degenerated into a fiscal free-for-all” and that the EU itself is a "House of Cards...The moral hazard is overwhelming”.
"Friends make the worst enemies” Frank Underwood, House of Cards
Herein lies a distinct issue for the UK in its Brexit negotiations, provided at some point the government can come up with a coordinated strategy - there is a distinct lack of unity and consensus from within the EU.
Broad market focus will fall back on the eurozone this week with the ECB meeting on Thursday. Recent weeks have seen a re-emergence of EUR short positioning, a lower EUR and a steeper European yield curve. In isolation, these two events are rarely correlated. The bond market moves likely have more to do with rising rate and inflation expectations in the US, and the curve targeting in Japan, than an expectation of tapering, inflation or higher yields in the eurozone. In that regard we would expect Mario Draghi to reaffirm, if not extend the expected duration of asset purchases under the current round of QE later in the week.
"Democracy is so overrated” Frank Underwood, House of Cards
We have discussed, on many occasions over recent months, our view that monetary policy is (or has) reached its useful limits globally and that markets, forecasters and policymakers will increasingly shift their attentions to national governments in the search for ‘growth friendly’ fiscal loosening. On both sides of the Atlantic at the moment there are also rising signs of potential government intervention in monetary policy - further confusing the policy debate.
Stanley Fischer continued to debate the non-linearity of monetary policy at, or close to, the lower bound yesterday evening stating that "operating close to zero may undermine confidence” (a factor that, potentially more importantly, also applies to central bankers in relation to financial stability). Fischer also expressed his view that expansionary fiscal policy (and waning investor caution) could lift the natural rate. This is a concept that we would agree with - confidence is the key and higher rates bring benefits as well as restrictions.
"Proximity to power deludes some into thinking they wield it” Frank Underwood
On the fiscal side, the UK Autumn Statement on the 23rd of November is likely the key barometer of how the establishment view the need for fiscal policy to pick up the baton. Chancellor Hammond will almost certainly abandon the 2020 date for a balanced budget, yet it remains unclear how bold the ‘genuine’ fiscal easing measures will be, beyond the automatic effects of a lower GDP forecast on the Budget, and the higher gilt yields on interest servicing costs which tighten policy by default.
This brings us fairly neatly on to GBP. The decline in the pound since the ‘Leave’ vote in the UK’s EU Referendum has been sharp and significant. The magnitude of the decline however, is now beyond that which would be expected to compensate for the negative implications (under the ‘hard’ Brexit economic projections by both the Treasury and the IMF) on GDP growth, productivity and yield differentials. Our long term fair value models retain GBP valuations significantly higher than they are today. With sentiment, positioning and perhaps most significantly political uncertainty extended to the downside, we are clear in in our opinion that the risks to GBP are increasingly to the topside.
"There is but one rule: Hunt or be hunted” Frank Underwood
Yesterday’s bond market bear rally was halted by further weakness in the Empire State manufacturing index and while this highly volatile series by no means constitutes a US economic prosperity bellwether, it does serve as a reminder that Janet Yellen may well be considering letting the US economy run hot, but it has to get there first.
"If you follow the trend, you will always be right behind it” Lindsey Haun
Last night, the market's’ primary focus of attention shifted away from the GBP, the UK and Brexit - at least temporarily. The release of the minutes from the September 21st FOMC meeting in Washington brought US Fed Funds Rate normalisation, interest rate differentials and equity valuations back to the fore.
The key strapline from the September statement, the fact that the rate decision in September was (for several) a "close call”, echoed through the minutes. While many members reiterated that they saw "few signs of inflation pressure” and many viewed "some labour market slack remaining”, the Fed officially noted that a "reasonable argument could be made” for a rate hike. Effectively, this leaves us in a situation where there is likely not enough urgency to hike just before the Presidential elections (and its possible market and international response) and that ceteris paribus (as economists would caveat - or with other conditions remaining the same) the Fed will take another baby step to rate normalisation in December.
From our perspective, however, this is a very important caveat. No sooner had the minutes been delivered, than lower US (and global) bond yields, sharply weaker Chinese trade data (posting the first y/y fall in exports ex- the New Year holiday distorted months for a long time), and a significant drop in US equities complicated the backdrop. The near term macroeconomic progression of China will likely become the dominant protagonist in the case for a December US rate hike, though all three are likely to be key in global market and consumer sentiment.
The trend in Chinese exports remains weak, at the same time non-financial company debt burdens are increasingly troublesome. This development is likely captured in the Fed minutes under the comment "officials still saw important downside risks abroad” and further negative developments here will likely be enough to halt the Fed once more.
A tightening labour (labor) market is the main argument for raising rates in the US, even as rising participation has halted the decline in the unemployment rate itself. Wage growth is (slowly) trending higher, but even among those favouring a rate hike at this stage, none are suggesting that the pace of hikes picks up to any significant degree.
With oil prices back below $50, there may be room for some of the recent US curve steepening to be unwound and if (as we would anticipate) equity markets accelerate to the downside, then we would favour the JPY to regain some of its recent lost ground in FX. As far as equities and USDJPY are concerned the phrase caveat emptor is likely just - particularly if (as we fear) Q3 earnings season in the US disappoints.
"Not all those who wander are lost” J. R. R. Tolkien
With little on the data calendar to distract markets today, it is likely that GBP regains prominence as a focal point for the expression of negative sentiment. Earlier in the week we discussed our views that the negative sentiment towards GBP was becoming overdone, stating our view that in the long run "the UK economy will be stronger, more flexible and progressive outside the regulatory confines (and lack of direction) that defines the EU”. We have also argued that it is very unlikely that the pain of divorce from the EU will be felt only on the UK side, and that in that regard GBP is beginning to offer value against the EUR.
The data calendar so far this week has been sparse and with the assistance of a US bond market closure for the Columbus Day Holiday yesterday, activity across financial markets has so far been relatively light. With little data, what market ebbs and flows there have been, have been driven by geopolitics.
"They all laughed at Christopher Columbus…” Frank Sinatra
The OECD declared yesterday that the UK will grow at a stable but slower pace for the foreseeable future, as a result of uncertainty over its future relationship with the European Union. A far cry from the "sharp, sudden and dramatic slowdown in the UK economy” that the organisation had forecast before the Referendum vote in June.
The current government stance has given the impression of a bias towards a so called ‘hard Brexit’, one which would likely cede access to the ‘single market’ and revert to trading under WTO rules, in order to impose restrictions on immigration. The prospect of which has been a significant driver of GBP selling over recent sessions.
A leaked government report warning cabinet ministers that the Treasury could lose up to GBP 66 billion a year in tax revenues under a hard Brexit, has only exacerbated the move this morning. Some commentators have referred to this report as an extension of ‘Project Fear’ or the last stand of the Remainers. In the long run, we are of the view that the UK economy will be stronger, more flexible and progressive outside the regulatory confines (and lack of direction) of the EU. However, in the near term, uncertainty is causing some to propose that the UK is going to sail off the edge of the world!
"We are calling more loudly for growth boosting actions” Christine Lagarde
In the eurozone, the bounceback in manufacturing activity and industrial production in Germany and Italy, has done little to aid the EUR, which is trading at its lowest level in over 2 months. Some eurozone officials appear from their comments to be more interested in almost tantrum like threats to the UK over Brexit negotiations. The Luxembourg Prime Minister commented over the weekend that "closing EU borders for a day would teach the UK a lesson”. We would argue that the eurozone should focus less on teaching the UK a lesson, and far more on learning from the lessons of previous mistakes. Meanwhile, Mario Draghi continues to urge national governments to "do reforms” while the "very substantial monetary support” is in place.
As far as the UK is concerned, we have some sympathy for the heightened sensitivity of GBP to the heightened uncertainties surrounding the future trade and market access negotiations. However, GBP has fallen more than 35% against the EUR in a little over a year. During that period the UK has outperformed in terms of growth and inflation metrics, and going forward we fail to see how a Brexit, irrespective of how ‘hard’ it may be, could be singularly negative for just one side of the trading argument. Particularly as the UK is the predominant buyer in the relationship. In short, as negative GBP sentiment appears to have reached fever pitch, we now suggest that there is increasing value in owning GBP vs. EUR.
"Said I was reaching for the moon” Frank Sinatra
Amid the dearth of economic data, markets will maintain an intense focus on the US for signs of a resumption of monetary normalisation in December (or even, though much less likely, November). In this regard, it is interesting to note the comments of Chicago Fed Governor Charles Evans (widely regarded as being at the dovish end of the Fed spectrum) overnight, who suggested that Fed policy may be changing soon and that "one Fed move is not that big of a deal either way”. His sentiment was, however, tempered in the longer term, as he maintained that the risks to inflation were to the downside and that the Fed should peg rate hikes to inflation progress.