"It seems the brighter you are, the deeper the hole you get into” Tuesday Weld
Over recent weeks we have been discussing the progression and evolution of global monetary policy. As standard monetary policy approached its lower bound, many global central banks expanded stimulus through non-standard measures, some of which (such as quantitative easing, or QE) have been used so extensively over recent years that they would likely now be considered ‘standard’. Yet, in the quest for attaining the magical 2% inflation target, many global central banks have pushed the envelope even further through negative interest rates, corporate bond buying and even direct purchases of equities or ETF’s.
Taking a step back from the near term struggle for central banks to attain their respective inflation targets, we retain a high degree of skepticism about the efficacy of many ‘non-standard’ monetary policy tools. As we contemplate how the history books will reflect such monetary activism (not as highly as those involved may like, we fear), it is perhaps not surprising that global central bankers are taking time, amid continued persistent low growth and low inflation, to review their policy efficacy.
"What happens to the hole when the cheese is gone” Bertolt Brecht
Bank of Japan governor, Haruhiko Kuroda, explicitly ordered an "Assessment of policy effectiveness” to be completed by the next BoJ monetary policy meeting on the 21st September, and we would expect that a number of other global central banks are undertaking a similar exercise (publically or not). This year’s global central bankers ‘off-site’, at Jackson Hole, entitled "Designing Resilient Monetary Policy Frameworks for the Future”, will likely constitute a high level head scratching event over the current issues: low inflation and low growth, and perhaps most importantly, the possible change in their relationships and interactions.
In reality, however, the likelihood of any break away from traditional central bank inflation targeting any time soon is negligible. Instead the Jackson Hole weekend will be the focus of markets purely with the aim of gauging the near term policy inclinations of the array of attending central bankers - most notably Janet Yellen.
"A mouse never entrusts his life on just one hole” Plautus
Yellen speaks late Friday afternoon (BST), and amid a recent ebb back towards the hawkish end of the monetary spectrum, we would suggest that the risks are that Yellen leaves the door open for a September rate rise, with a narrative of the (albeit slow) progression in jobs and (albeit fairly pedestrian) growth. It is also likely that the broader market will be expecting the Fed to once more err on the side of caution while inflation refrains from troubling the 2% target. Thus the bar for a hawkish surprise in terms of near term action is likely quite low.
However, it is also likely that Janet Yellen conveys the message that the longer-term trajectory for interest rates is (once again) shallower than previously thought. Thus, even the prospect of a near term rate hike from the Fed could end up being USD negative and equity supportive if expectations for the equilibrium level of rates are dragged ever lower.
"In trying to scramble out of a hole, it sometimes digs deeper” Wellington Mara
In the UK, the efficacy of monetary policy is being tested more explicitly, as the BoE’s latest foray into asset purchases have not exactly gone according to plan. At its first attempt, the BoE’s reverse auction failed to buy the requisite amount of bonds. Yesterday, in its third open market operation, the BoE was forced to pay a premium on the debt, once more due to low supply, driving prices sharply higher likely unsettling an already nervous market.
The implications of the struggle for the BoE to enact its pre-announced monetary policy actions are not necessarily clear, as far as rates and GBP are concerned. Carney et. al., however, may well be hoping for a continuation of stronger than expected post-Brexit economic data as an excuse to abandon the latest round of QE.
With a very light data calendar, FX has been relatively quiet this week, however, with a number of speakers from the BoJ to the BoE, ECB and of course the Fed, we would expect that Friday, ahead of a bank holiday in the UK on Monday, will bring a sharp uptick in volatility.
"From the dark end of the street...” Van Morrison
According to a recent study by UK estate agent Haart, a pattern has emerged in the UK property market that struck an interesting chord with us this morning. The report suggest that the UK property market has become skewed by how people voted in the EU Referendum, highlighting that in areas that voted to Remain, the number of sales that have fallen through have jumped by 50%, whereas activity has picked up in those areas that voted Leave - "The reality is that we have a property market that is heavily driven by sentiment and it is the confident Leave voters who are currently keeping the market afloat” - Haart CEO.
If we take a step back from the regional UK property market there are some interesting connotations and possibly implications for the UK economy and global market sentiment that arise from this anecdote. Confidence is key. If policy makers could find a way to allay the Brexit fears of Remain voters, not just at the individual level but at the corporate and multinational level, then the UK will be in a very strong position. What is needed is a plan.
"Global private capital is not being encouraged to invest” Scott Morrison
From a monetary policy standpoint, the global ‘race to the bottom’ has likely had a significant impact on broad long term consumer confidence. By this we do not mean the traditional measures of investor and purchaser sentiment that have held up well over recent years, but the difficult to quantify negative impact on confidence of very weak pension growth, (almost) no return on savings and asset price distortion that arise as a function of the current global monetary policy activism.
Furthermore, as Australian Treasurer Scott Morrison suggested recently, "global private capital is not being encouraged to invest” in the current growth / inflation / yield environment - This perhaps argues that the huge global monetary stimulus is not doing what it is intended to do. This sentiment was echoed recently by Bill Gross, who said that "capitalism does not work at zero interest rates.”. It is perhaps not surprising therefore that many central banks (notably BoJ, Fed and RBNZ) appear to be conducting a thorough review of the efficacy and objectives of monetary policy against continued pedestrian economic activity at the current juncture.
"This is the strangest life I’ve ever known” Jim Morrison
Last night’s Federal Reserve minutes shed little new light on the progression of US monetary policy. On one hand there appears to be a growing minority that sees the US economy as being at or near the point at which a rate rise is warranted. However, several members wanted to "wait for more inflation confidence”, stressing that they saw "ample time to act if inflation rises”. That is likely the key point. Until there are clear signs of an uptick in price and or wage inflation, there is little conviction on the FOMC to raise rates. Markets are now pricing a 50% chance of a single rise in the Fed Funds target rate by January ‘17.
We have outlined the implications of this a number of times recently. We maintain the view that a US economy that is too cold for rate rises and too hot for recession fears generates a hunt for yield, diverting cash into equities and risk assets (including EM). This likely continues unless or until there is some evidence of inflationary pressure or rising inflation expectations.
"We can make this last forever” James Morrison, Please don’t Stop the Rain
Perhaps more worrying than the monetary situation in the US is the monetary situation in Japan. It was reported overnight in the WSJ that PM Abe’s economic advisor Honda, sees "more than a 50% possibility” of the BoJ taking ‘bold’ measures next month. The interview goes on to discuss an increase in the monetary base target to JPY 100 trillion per year indefinitely, stating that Japanese monetary policy "hasn’t been eased enough”.
"...To the bright side of the road”? Van Morrison
In the UK this morning, retail sales surged past expectations, accelerating to an annual growth rate of 5.9%. This comes in quick succession after the stronger than expected UK employment data for July, where employment hit an all time high and the dole queue shortened in the month after the Referendum. We will pick up on GBP again next week, suffice to say that our views remain unchanged from recent comments where we have been advocating GBP strength (particularly in the near term against the USD).
So far it seems that the negative economic claims of ‘project fear’ have failed to materialise in the UK. Yet. While we are acutely aware that heightened risks to business investment, trade and fiscal support remain in the medium term, we retain the view that confidence is key to the recovery, globally. We would also argue that the confidence argument is even more critical at zero interest rates. Outside of winning a record number Olympic gold medals, it may be difficult for government to formulate a policy of ‘confidence stimulus’. However, the first steps must be a plan, and a supportive fiscal platform from which to launch it.
"First law on holes - when you’re in one, stop digging” Dennis Healey
The last set of policy meeting minutes from the FOMC (released on the 27th July) painted a mixed macroeconomic picture of the US. They pointed out continued labour market improvements (and even some increase in labour utilisation) amid a moderate pace of economic expansion. Within that expansion, however, it was noted that household spending was growing strongly, but that business investment remained soft. In that regard, Friday’s weak retail sales print was a concerning development.
Despite the dissent from Kansas City Fed governor, Esther George, at the July FOMC meeting, the minutes continued to convey at best a modest medium term rise in inflation (and inflation compensation or expectations), amid diminished risks to the economic outlook. The threat of inflation, and thus higher US interest rates, continues to abate.
Last week we made the point that "in a world where there is no sign of monetary tightening, and worryingly, where there is little progress in structural reform, ever lower yield curves mean ever higher (forward discounted) equity yield valuations and an ever more distant search for yield.”
"Don’t lower your expectations to meet your performance” Ralph Marston
Weakness in US retail sales in July (contraction in 8 of 13 major retail categories) had already led to the market lower the probability (implied by the OIS yield curve) of a rate hike in 2016 to below 50%. The release of an academic paper by Fed governor Williams suggesting a broad reassessment of monetary policy in an era of low rates - or more specifically suggesting a higher inflation target - is a further lurch to the dovish end of the monetary spectrum from the Fed, and from our perspective is of significant near-term concern for the USD.
Despite economic outperformance against its G-10 peers, the search for yield amid the Fed’s "diminished” near term risks to the economic outlook will put pressure on the continued positional bias of long USD. This can be further undermined by falling rate expectations and and concerns over the US consumer (and policy intentions: is a 4% inflation target stretching the definition of price stability?)
While the next instalment of FOMC minutes arrives this Wednesday, the revelations in Fed thinking from Williams likely mean that the importance of the (retrospective) August FOMC minutes has been gazumped by the (forward looking) implications for policy from the Jackson Hole summit, and Janet Yellen’s testimony on the 26th of this month.
"If you find a path with no obstacles, it probably doesn’t lead anywhere” Frank A. Clark
This morning we have seen higher than expected inflation data in the UK (on rising input costs as GBP drop fuels prices) and GBP has duly appreciated. Against a backdrop of a paradigm shift lower in the equilibrium level of GBP, imported inflation is expected and thus, as the Bank of England have forewarned, is of significantly reduced direct impact on the UK rate path. Despite that, a higher than expected figure will still likely weigh against the prospect of further monetary accommodation (in part at least), a theme that may be exacerbated by UK retail sales on Thursday, if our expectations of outperformance are confirmed.
With GBP positioning at record short levels, and adding in the negative US interest rate connotations of the Williams paper, we see potential for GBPUSD to rise in the near term. A weaker than expected inflation print in the US this afternoon will likely add to any momentum. Watch this space.
"The only reason the stock market is where it is is because you get free money” Donald Trump
Last night, the Reserve Bank of New Zealand (RBNZ) cut interest rates 25bps to 2.00%. In doing so, they stated that their "projections indicate further easing will be required”. Despite this, and the explicit statement from Governor Wheeler that "we want to see the currency fall” (difficult to imagine a more explicit currency view), the initial reaction in the FX markets was one of disappointment. NZD rallied 1.8% to a 1 year high.
The fact that market expectation of a 25bp rate cut from the RBNZ was more than fully priced in (implying a minority expectation of a bigger cut) and the statement that they (the RBNZ) have "limited influence on the exchange rate” caused an initial market reaction that is a clear example of the maxim, ‘there is no such thing as a free lunch’. At least not in FX markets.
If we widen our attentions to the broader financial markets, there are other areas where this maxim is becoming an increasing risk.
"Always turn a negative situation into a positive situation” Michael Jordan
Following last week’s decision from the BoE to reactivate bond buying and cut interest rates (among other things), the front end of the UK Gilt curve has turned negative. Aside from the technical debate over the supply of bonds at the ultra-long end of the curve (the traditional domain of the pension funds - whose ability to match long dated assets and liabilities is increasingly complex), the Bank of England will continue to buoy Bond prices (thus capping interest rates) anchoring the front end below zero. This is the alternative and conceptually confusing reality where the BoE are paid to borrow.
In the short term, the yield shift is a negative factor for GBP, however, in previous rounds of QE, the low point in GBP has been the point at which the BoE begins its purchases of bonds.
Taking a slightly more medium term view, there are a number of upside risks to GBP and the UK that are likely to present themselves over coming months, much of which derive their impetus from government, not central bank action. Firstly, any sign of a strategy, or ultimate goals or opportunities that the Government see as a function of Brexit negotiations would go a long way to removing some of the current uncertainty, and thus encouraging business investment (NIESR see business investment as the big drag on post-Brexit UK growth; -3.75% in 2016, -2.0% in 2017).
Secondly, the current backdrop argues strongly for UK government to attend to pension deficits, a growing output gap, weak productivity and outdated or undersupplied infrastructure. The long-term fiscal expansion to deal with these issues would likely be GBP positive. The Autumn Statement will be our first taster of how aggressive the government can be in tackling these shortcomings, and thus to what extent fiscal policy can gazump monetary policy as the core impetus for the direction of GBP.
"The chief danger in life is that you make too many precautions” Alfred Adler
If we take a wider look at the global economy, there is a distinct theme that has become dominant. One of yield hunting, with a near blatant disregard for the associated risks. At the press conference following the RBNZ rate cut last night, Governor Wheeler stated that he did "not want to join in a race to the bottom”. Other central banks, willingly or not, are fully paid up members.
In essence, in a world where there is no sign of monetary tightening, and worryingly, where there is little progress in structural reform, ever lower yield curves mean ever higher (forward discounted) equity yield valuations and an ever more distant search for yield. In a global economy where US growth is strong enough to maintain confidence but weak enough to prevent wage or price inflation, global equity markets remain the winner by default. Until they don’t.
"You and I travel by road or rail, but economists travel by infrastructure”
This week got off to the kind of start where you would be forgiven for thinking that a large proportion of the market was on holiday (or watching the Olympics). The relative calm in financial markets, however, perhaps gives us an opportunity to reflect on the global macroeconomic backdrop and the possible opportunities for the rest of 2016 and beyond.
As monetary policy reaches the end of its impactful cycle, the baton for growth inducing policies has been clearly passed to governments and to fiscal policies. With around two thirds of G-20 nations planning fiscal loosening, it is possible, if not probable, that the next global boom is in infrastructure.
"Keep your face to the sunshine and you can’t see a shadow” Hellen Keller
Without doubt the UK qualifies for its own section in this thought process. Renewed monetary accommodation from the BoE has seen real yield differentials and pretty much all relative rate differentials plumb new lows, resulting in renewed downward pressure on GBP. However, while policy makers warn of the impending economic deterioration of post-Brexit UK, it is worth noting that much of this policy maker negativity is a function of what can only be described as preliminary confidence surveys at a sectoral level.
Ian McCafferty (until recently considered one of the MPC hawks) suggested in a Times article today that if the UK economy slows "in line with initial survey signals, I believe more easing is likely to be required”. However, with so much of the negative growth expectations based on extrapolating short term hits to consumer and business confidence, we would emphasise the risk that confidence can return as quickly as it dropped. Last night’s BRC retail sales data for July is a case in point, highlighting that it only takes a little sunshine to boost retail activity sharply above expectations.
"You were the sale of the century” Sleeper, Sale of the Century
This morning’s UK data is arguably less relevant in assessing the post-Brexit UK as the data was for June. However, we would argue that the weakness in both manufacturing production and more broadly in net trade would have been significantly impacted by expectations. For example, having been warned by the Bank of England and just about every commentator on the planet that a ‘Leave’ vote would bring a substantial decline in GBP, it would not be surprising to hear that foreign companies (at least those with some pricing power or flexibility) decided to delay non-essential UK purchases (even at the margin) on the basis that there may be a significant discount for doing so. If this was the case then we might expect that there will be a significant rebound in the purchase of (exchange rate driven) discounted UK goods and services over coming months. We shall see.
We retain our view that the UK (consumer and business) is more resilient than the market is pricing in, and while we have clearly pointed out the negative implications for GBP in the near term, we retain a view of renewed UK and GBP outperformance going forward. We are increasingly close to the trigger point, which must come in the form of economic good news relative to expectations.
"To call this a recovery is an insult to recoveries” Mitch McConnell
Another significant driver of global financial markets is the continued debate over Fed policy. Friday’s US employment report for July highlighted further strength in the depth of the labour market recovery. Perversely, the much bigger than expected jump in payroll gains, as well as the lack of acceleration in wage growth, led some Fed members to the dovish conclusion that there is more labour market slack than they had expected - thus the equilibrium rate of unemployment is lower, along with the urgency to hike. However, the market increased the probability of a September rate hike to around 30%. We retain a positive view on US growth, rate expectations and the USD, despite the stubborn dovishness from (at least part of) the Fed.
The rest of the week is unlikely to spring into action and we would expect activity to remain fairly light. Against that backdrop, the commentary from the RBNZ tonight, that accompanies what is generally accepted to be a 25bp rate cut, is important for the progression of monetary policy in NZ, and likely relevant to Australia. As credit risks and overcapacity continue to drive a lower CNY and increased exporting of deflation, we would anticipate that countries with substantial reliance on trade may become increasingly vulnerable. Particularly if, as we would expect in Australia, further rate cut expectations begin to rise again.
"It WAS the best of times, it was the worst of times” Charles Dickens
This time last year, things were very different for the UK. George Osborne was proudly asserting Britain as one of (if not the) the best performing major economies in the world, Mark Carney was nudging the markets towards the prospect of a rate rise, Cameron was yet to announce the date of the EU Referendum and Leicester City were 5000-1 to win the Premier League title.
Yesterday, Mark Carney delivered his ‘Super Thursday’ press conference and along with it, the new reality. The November ‘15 Quarterly Inflation Report (QIR) from the Bank of England had pointed to an enviable level of growth, from a global context, at broadly 2.5% in 2016, 2017 and 2018. Since then successive QIR’s have brought successive downward revisions to UK growth forecasts. Yesterday saw an acceleration of that theme - the biggest growth downgrade ever in the history of the Inflation Report.
In essence, the BoE now forecast a drop in annual growth to around 0.8% in 2017 - a fall that brings with it a heightened probability of a technical recession along the way. Furthermore, as a function of a lower GBP, the BoE also raised their expectations for inflation. This combination is likely to lead directly to an increase use of the word ‘stagflation’ in the financial and economic press.
"This is not mission difficult Mr Hunt, it’s mission impossible. Difficult should be a walk in the park” Anthony Hopkins
In light of (and to a certain degree justified by) their weaker economic projections, the Bank of England responded with an aggressive array of easing measures, as it stated that the adjustments as a function of leaving the EU "may prove difficult”. Carney stated that the stimulus was appropriate, given the scale of the shock.
The Bank of England cut interest rates 25bps to 0.25% with the explicit additional statement that, should the data progress as they expect, the rate will be cut to "near zero” by year-end (though Carney was equally explicit in stating that the lower bound for interest rates is above zero and that there will be no contemplation of negative rates in the UK, let alone ‘Helicopter Money’ which Carney referred to as a "flight of fancy”)
The Bank also reopened its Asset Purchase Fund, with a QE expansion of GBP 60 billion and as much as GBP 10 billion in corporate bond purchases. Furthermore, the Bank opened a Term Funding Scheme (TFS) that acts to facilitate the transmission of monetary easing, through increasing the availability of funds for banks (and thus lending), while at the same time negating any reduction in net interest margins - thus reducing the effective lower bound to "near zero”.
"Every chemical reaction has a transition state” Derek H. R. Barton
Here is where, if we may, we would put the UK’s monetary position in the context of global monetary policy. Carney stated clearly that "the biggest UK economic issues are structural” and that "monetary policy can only help with the adjustment”. It is "appropriate [for monetary policy] to be the first responder to a shock” (Carney), however, now we feel that it is the turn of fiscal policy and more significantly supply side reform, to do the heavy lifting.
Carney’s GBP 170 billion shot in the arm of the UK economy, lower interest rates and the promise to do more if required mark an important transition from our perspective, one which is taking place across the globe. The BoJ have (wittingly or not) given the market the impression that they have run out of ammunition, conviction or ideas (or all three) for ever further monetary easing, and the snap back in JGB yields (sharply higher) is a gentle reminder that the exit from such extreme monetary activism is a far from simple exercise. From here the Abe government seem acutely aware that they now have an increased role to play. However, it seems that the much awaited ‘Abe fiscal stimulus’ equates to a relatively small fiscal impulse.
Down under, the RBNZ are likely the only major central bank with credible room for conventional (or indeed otherwise) monetary policy easing (maybe even three 25bp cuts this year). Though it is arguable that the RBA are also in this camp, yesterday’s monetary policy report suggested that further easing is less likely. We would expect AUD to outperform against NZD going forward.
"Even if you fall on your face, you are still moving forward” Victor Kiam
We wrote earlier in the week that "it is likely that we get a significant monetary easing from the Bank of England this week” and that "this likely provides a medium term buying opportunity for GBP”. We stand by that view.
There will be many twists and turns in sentiment towards the UK economy as plans and strategy for the post-Brexit UK evolve. The Chancellor stated yesterday (in full knowledge of the measures about to be taken by the BoE) that he was "prepared to take any necessary steps to support the economy and promote confidence”. We retain our medium term positive view on the prospects of the UK, and in line with those MPC members who dissented on the QE expansion, we would argue at this stage that recent "surveys may overstate the economy’s weakness”.