Overnight we have the eagerly awaited monetary policy decisions of the Fed (daddy bear), the RBNZ (baby bear) and the BoJ (I guess that makes them mummy bear), all of whom judged that the current growth and inflation backdrop was neither too hot, nor too cold. All however, maintained their bearish currency preference (some more explicitly than others). We continue to believe that global monetary policy faces increasingly diminishing returns and that currency wars, while an ‘unspoken conflict’, are likely to become increasingly prominent.
"I’m not in this world to live up to your expectations” Bruce Lee
First up was the Fed and, with no expectations of policy action and no press conference, the focus centred on the statement. The key iterations were the removal of "Global and financial developments continue to pose risks”, and the addition of "continue to closely monitor inflation indicators and global economic and financial developments”. The statement also referred to growth in household spending as having "moderated”. While the Fed did not close the door to policy action in June, they by no means teed it up.
We have been (and remain) bullish on the US economy relative to its peers and market expectations, however, the monetary policy response function of the Fed is becoming more complex. Should the Fed take a further step towards monetary normalisation in June? Yes - as growth rebounds in Q2, inflation (price and wage) accelerates further, oil and commodity prices stabilise after the USD index retreated from its pinnacle - in our view, they should. However, does the fact that the UK’s Referendum on its EU membership comes one week after the FOMC meeting make that decision more complicated? Yes.
In the near term this likely puts pressure on the Fed ‘dots’ and their central expectation of two rate hikes this year. US rate expectations duly fell, with 2 year Treasury yields falling around 7bps (and 10 years dropping 10bps), putting the USD firmly on the back foot. US breakeven rates stayed firm, however, and the threat of US inflation later in the year remains high on our list of likely macro developments.
"You can’t base your life on other people’s expectations” Stevie Wonder
Second up was the RBNZ. Up until yesterday morning there had been little expectation of policy action. However, the very sharp drop in Australian inflation in Q1 (particularly with reference to the RBA April statement passage that read "low inflation would provide scope for easier policy”) had led to a sharp increase in expectations for further easing in both Australia and NZ. While the RBNZ kept its explicit easing bias, and stated that the "exchange rate remains higher than appropriate”, the inaction proved a disappointment and this particular currency war battle was lost.
"I want to top expectations. I want to blow you away” Quentin Tarantino
From a currency perspective, it was the BoJ, however, that were the biggest losers overnight. In January, despite the lack of a clear fall in economic activity or dip in inflation (or inflation expectations) Kuroda initiated negative interest rate policy (NIRP) in Japan. It is likely that his motivation was shock and awe (as has been the pillar of Arrow 1) and just as likely that it was intended to provide a further boost to corporate profitability that would encourage a wave of wage rises. The problem Kuroda now faces is that anything short of a bazooka will be met with disappointment.
Turning point of the Currency War
Phase one of the global currency war clearly favours those who have not already spent their bullets (or those where there is scope for credible further easing). On that basis we continue to expect the AUD and NZD have scope to fall further. The JPY, despite the likely increasing protestations of the BoJ, will surely struggle (particularly as our valuation metrics would suggest undervaluation of the JPY at current levels).
Phase two of the currency war is, however, likely more complicated and from our perspective flips the currency war on its head. In this scenario, those who have spent their bullets are in real trouble.
The trigger is when the IMF’s ‘new mediocre’ growth becomes an outright decline, or when inflation begins to take hold. At the moment, both the eurozone and Japan are suffering from low growth (through this low growth may well be above the current ‘potential growth’) and low inflation. Our fears for the progression of 2016 are higher inflation (starting in the US but ultimately spreading to global economy) and a reignition of eurozone debt and political fallout. In order to maintain its (troublingly high) debt-to GDP ratio, Italy needs a nominal growth rate of around 1.4%, Spain needs something like 3.4%.
"Four legs (hikes) good, two legs (hikes) bad” George Orwell, Animal Farm
Last week we discussed the unspoken conflict of global central banks and the impact and implications of ‘currency wars’ on the global economic backdrop. The subsequent ECB meeting produced nothing new in terms of additional stimulus or, in many respects, additional information. Instead Draghi focussed on the broad improvements in eurozone financing conditions over the past 12 months and the fact that he expects the recovery to proceed despite continued global uncertainties and the downside risks to growth and inflation.
"Other things being equal, easing weakens own currency” Haruhiko Kuroda
Herein lies the problem. With weak growth, and near exhausted monetary artillery, it is likely that currency is becoming increasingly attractive as a (and perhaps the only) way to boost competitiveness, growth and ultimately inflation. However, the explicit agreement between G-20 central bankers and finance ministers not to manipulate currencies complicates matters. BoJ governor Kuroda stated recently that "other things being equal, easing weakens own currency”. The problem, as the ECB and BoJ are only too aware, is that one central bank is more equal than others.
"If the facts don’t fit the theory, change the facts” Albert Einstein
In January (and again in March), the Fed surprised us and the markets with their dovishness (among other things cutting their rate hike expectations for 2016 from 4 hikes to 2). Their implicit reference appeared above all to be a concern over global weakness and currency strength. The USD has declined notably. Most notably against the JPY. Indeed, despite the best efforts of the Bank of Japan, which now owns assets of more than 75% of its GDP and has negative rates, the JPY has appreciated by more than 10% since the BoJ launched its negative interest rate policy (NIRP).
From our viewpoint, the dominance of Fed policy is likely to continue and while the BoJ may introduce cheaper bank lending (perhaps even into negative rates), the impact on the JPY will likely be more of a function of the Fed than the BoJ
Back to reality?
Recent market movements have seen a drift higher in 10 year Treasury yields and the continuation of a sharp bounce in US 10 year inflation breakeven rates (1.66% from 1.20% in early Feb). Against this backdrop we find it increasingly difficult to expect the Fed to maintain its tendency to surprise on the dovish side of expectations (as has so far been the case in 2016). While a rate rise in April remains very unlikely, we would expect rhetoric to shape expectations towards a rate hike in June (other things being equal)
"The world is still looking for a post-crisis growth model” Raghuram Rajan
As the markets opened on Sunday night in the UK, the failure of oil producing nations to reach agreement (to freeze production and thus support prices) at the much heralded meeting in Doha caused abrupt price adjustments across a number of markets. Brent crude for example fell around 7% and equities and risk assets came under immediate pressure. However, as the Asian and subsequent European trading sessions progressed, fear subsided and the oil rebound (aided by a strike in Kuwait) gained momentum. Ultimately oil closed pretty flat on the day.
Volatility in the price of oil is by no means a new phenomenon and indeed an oil price of around $40 is by no means a drag on global growth (even if it has risen over 50% since mid February). However, as far as the broad financial markets are concerned the increased focus on the oil price has fostered surprisingly strong correlations with currencies and asset classes where there is no clear fundamental link to oil. This has added to the complexity and volatility of the current market backdrop as well as subtracting from liquidity.
Amid the ‘relief’ rally in oil, equities have plumbed new highs. Herein lies one of our major concerns.
Later on this week the focus of market attention will once again turn towards global monetary policy, firstly with the ECB (on Thursday) and then (on the 27th and 28th respectively) the Fed and the Bank of Japan. Central bank activism with very modest global growth trajectories create significant risks. The most significant risks from our perspective are an overvalued and artificially high equity market and the rising threat of currency wars.
"Currency war is a zero sum game… everybody loses” Guido Mantega, Brazil Finance Minister.
During the onset of the global financial crisis, the monetary response from central banks, while uneven, was extraordinary from a historic perspective. The public intent of activist monetary policies such as zero interest rate policies (ZIRP) and Quantitative Easing (QE) were shock demand, business investment and economic activity back to life. (Negative interest rate policy NIRP is another concept altogether and one which in our view will likely be viewed historically as a mistake). The subliminal intent, however, was likely to boost equity markets and weaken the currency. 8 years on from the GFC, activist policies are still in place, and with conventional and unconventional monetary policies at or very near their limits, ‘currency wars’ (while remaining a concept that central bankers and treasury officials publicly deny) are very much alive.
"Everyone has his day but some days last longer than others” Winston Churchill
Bringing all of this together, heightened volatility in the oil market, the (temporary, spurious?) correlation of a number of currencies of non-oil producing countries and the tacit desire of a number of global central banks for a weaker currency has led to a very volatile, complex and confused FX market.
Despite the heightened volatility and uncertainty so far this year, our view that the USD should outperform through 2016 remains (despite the policy normalisation reticence of the Yellen Fed that emanated from the March meeting and subsequent press conferences). We are also increasingly of the opinion that the JPY will follow an upward trajectory, again (tacitly at least) largely against the will of its central bank.
Furthermore, despite the recent impressive rally in equities we are increasingly of the opinion that equity valuation levels are unsustainable. As markets become more accustomed to the concept that monetary stimulus is reaching (or has reached) its limits, equity valuations will likely be brought into question.
The Bank of Japan meeting on the 28th is likely a very important barometer in this regard. Expectations of further activist policy from Kuroda are growing and the Central Bank’s ability to continually satisfy the bulls is reaching its limits. We would view any rally in equities as a function of further Japanese accommodation as a selling opportunity and the exact opposite for the currency.
"There is plenty to worry about” Christine Lagarde
The IMF Spring meeting has emitted a constant stream of downbeat comments over recent sessions despite the fact that the economic data has shown signs of stabilisation globally over recent weeks. Following the global financial crisis, monetary policy makers, governments, global institutions (such as the IMF) and rating agencies were widely criticised for looking in the wrong direction (through rose tinted spectacles?) when the crisis hit. At the current juncture, all are in danger of being guilty of the exact opposite.
Furthermore, as fiscal monitors warn of a sharp increase in deficits and debt in emerging economies (as weaker growth and lower commodity prices weigh) and as deficits hit new highs, world government debt/GDP ratios rise. The IMF (and an increasing school of thought) are now calling for those that have fiscal space to use it stating that "monetary policy alone can not carry the growth burden”. The recommended near term solution is that those with fiscal space should borrow more, and the long term hope is more growth.
"Slow growth is a fact of life in the post-crisis world” Olivier Blanchard
From our perspective, this strategy generates a number of concerns, and one likely outcome.
Firstly, those economies that have fiscal space (for example Germany) are not so keen on the idea. Secondly, it is not clear either that the macroeconomic backdrop is fundamentally as bad as feared, OR, that ramping up global debt (arguably the root cause of the financial crisis) in order to stoke a recovery is the ideal strategy.
With much of the world stuck in low growth or recession and with two of the three biggest economic areas pursuing monetary activism of a form that is (in our view) not at all suited to the capital and or savings dynamics of their economies - savers and owners of capital (such as the eurozone and Japan) are punished by low or negative rates, whereas borrowers and spenders (such as the US) are beneficiaries. The likely outcome, in our view, is a (potentially significantly) higher USD.
Our frustrations about the dislocation between economic activity and official rhetoric was redoubled overnight as the broad Chinese data for March showed further signs of stabilisation. Despite rising concerns over corporate leverage ratios (presumably by all but the IMF?) the Chinese authorities appear to be in control of the growth transition. This is a global economic positive, even if Chinese service sector growth does nothing for the rest of the world.
"The EU is not just unreformed, it is unreformable” Nigel Lawson
Over recent sessions the Brexit debate has also hotted up. As the HM Government leaflet on ‘Why the Government believes that voting to remain in the European Union is the best decision for the UK’ lands on British doormats, the Bank of England increased their warnings of a "prolonged period of instability in the UK”.
What is perhaps more interesting from our point of view however is the impact and implications of a Brexit for the remainder of the EU and indeed the eurozone. From our perspective this is a significant risk that is yet to be adequately priced by the markets.
Dutch Finance Minister and Eurogroup President Jeroen Dijsselbloem yesterday urged the UK to work on concerns inside the EU, concerns that he stated are widely shared within the EU. However, the fact that the EU, EC and IMF are still unable to find a way forward among themselves, let alone with Greece in the neverending Greek debt saga, leads us to agree with Mr Lawson.
"Benefits of unconventional policy are diminishing” Raghuram G Rajan, Bank of India Governor
Over recent weeks and months we have debated the efficacy of the increasingly activist and unconventional monetary policy approach of the world’s central banks. While the clear objectives of the central banks is to lower borrowing costs throughout the term structure of the yield curve, after such a long period of extreme monetary accommodation, market participants and commentators are increasingly (and nervously) questioning this approach.
We have also argued that the extreme monetary accommodation has disproportionately benefitted companies over consumers. This phenomenon has been most clear in Japan where policy has driven borrowing costs down, the currency down and equity valuations up, leading to record corporate profits. On the flip side the collapse in consumer activity as a result of the first sales tax rise (from 5% to 8%) highlights the continued fragility of the Japanese consumer.
In the US (and equivalently in the UK), low borrowing costs have also disproportionately benefitted corporates. Furthermore, the trend of equity buy-backs has synthetically boosted stock valuations, flattering corporate balance sheets but arguably adding to the fragility of the market in the medium term. While declines in unemployment have been dramatic, productivity has remained very low and the resultant slow wage growth has stunted the consumer recovery.
Whether the focus is on corporates, consumers, equities, currencies or even growth a an increasingly credible case can be made that that the benefits of unconventional policy are diminishing.
"Costs of unconventional policy are increasing” Raghuram G Rajan, Bank of India Governor
If the benefits are diminishing then it is natural to look at the costs or the risks associated with such extreme policies. From our point of view, the risks are rising.
We have argued over recent weeks that there is a negative feedback from monetary accommodation in terms of confidence. The Fed recently reduced their rate hike projections for this year from 4 in December, to just 2 rate hikes this year. Instead of efficiently pricing those two rate hikes into the US yield curve, the market immediately priced out almost all probability of any rate hikes at all in the US in 2016. This negative reinforcement is a growing risk.
Over recent days there has been a rise in rhetoric questioning the current monetary policy path and highlighting many potential pitfalls. Blackrock Chairman Larry Fink suggested over the weekend that the current yield curve (and thus low returns) have led to people cutting back on expenditure to save for retirement, thus reducing consumption. Furthermore, the raft of corporate buybacks, encouraged by the current yield curve, add little value to the economy in the long run and, from our viewpoint, add considerable risks.
Equities have remained remarkably buoyant this year, aided by the dovish shift from the core triumvirate of global central banks - Fed, ECB and BoJ. We now think that the risks to the downside have increased significantly. European stocks rose yesterday led by Italian banks, as plans to deal with their non-performing loans (currently around EUR 196B, or ~10% of GDP) boosted sentiment. However, as the US earnings season got underway yesterday with disappointing results from Alcoa, the near term risks to equity sentiment are likely increasing.
"If the shoe fits, it’s too expensive” Adrienne Gusoff
In FX, the very near term will likely be dominated by corrections in overcrowded trades (GBP and JPY are the obvious candidates). JPY is now up around 10% on a trade weighted basis since the BoJ announced its negative interest rate policy at the end of January. Futures data suggests that the speculative JPY longs are at their highest level since around 1992 and while in the very near term we feel that the JPY move is due a correction the implications of the JPY move are increasingly negative. Japan average corporate breakeven for USDJPY is 103 this year, thus the main beneficiary of Japanese monetary activism, Japanese corporates, are finding their margins narrowed (and potentially threatened).
The main macro focus of the day will be the publication of the IMF’s updated global economic forecasts in which we expect the aggregate global growth forecast to be revised down to the "new mediocre” level of around 3.0%, from 3.6% in October.
"Being cautious does not mean standing still” Dallas Fed, Richard Kaplan
Last night’s (much awaited) FOMC minutes told us very little we didn’t already know. Front end US yields are pretty much exactly where they were before the release, equities and the USD (ex USDJPY) are also broadly similar. Earlier this week we questioned whether the FOMC was increasingly divided between doves and hawks, whether there was a growing risk that the Fed normalisation trajectory will accelerate in H2 2016 and whether equities and risk assets were increasingly vulnerable. Our views remain. Yes. Yes. Yes.
The minutes showed that even though the US jobs market continues to perform strongly and inflation and inflation expectations (albeit less pronouncedly) are rising, the "sharp, though temporary deterioration in global financial conditions” phrase continues to define Fed policy reticence. Beyond the hawkish minority such as Esther George who said that "postponing rate hikes could undermine the Fed’s goals”, support for a move in April seems limited.
Some commentators (including voting member James Bullard) are arguing that the Fed caution is based on the view that they would rather risk an overshoot on inflation rather than (even a modest) undershoot in inflation or economic growth at this stage - James Bullard suggested yesterday that 2.2% is better than 1.5%. From my perspective however this misses a really important point - the impact of Fed confidence on business and consumer confidence. The Fed were instrumental in introducing ‘forward guidance’ to the global policy makers lexicon. They are now running dangerously close to allowing it to work against them as hesitation infers caution infers concern.
We have made our views on the Fed’s ‘data dependence’ clear. From our perspective the cumulative employment gains and recent acceleration in wage and core inflation rates justify a gradual normalisation of US policy. However, current market pricing suggests around a 20% chance of a rate rise in June, and only a 50% chance of a rate hike by November. Even with a heightened possibility (and broad array) of negative shocks in the global economy, we continue to anticipate that the path of US rate rises and the USD is currently understated by the markets.
This market interpretation and the subliminal (or liminal) message from the Fed and other policy makers is creating (in some cases significant) dislocations within and between asset classes. Recent correlations across financial markets highlight the uncertainty and split opinion of the future trajectory of the economic recovery, interest rate normalisations and risk assets. However, from our perspective, this dislocation offers opportunity
Over the past month USDJPY and S&P (historically highly correlated as a barometer of risk aversion) have gone in opposite directions. Instead of suggesting that this correlation has broken, we err towards JPY being a leading indicator for equities and risk assets. The extreme fiscal and monetary accommodation in Japan has seemingly stopped working it’s JPY weakness magic. We feel it is not long before the same becomes apparent in equities and risk assets.
"Europe is facing a number of challenges simultaneously” Vitor Constancio
In the eurozone, ECB vice President Vitor Constancio was on the wires this morning highlighting the risks of second round effects (negative headline rates contaminating core readings) and thus justifying the "comprehensive set of measures” announced at the March meeting to combat the threat to prices and growth.
As he highlighted the fact that Europe is currently facing a number of challenges simultaneously, came the release of the news that Dutch voters had (by a margin of almost two-to-one) rejected a free trade treaty between the European Union and Ukraine. The vote (which is non-binding) highlights the extent of anti-EU sentiment in one of the bloc’s founding members, and likely weighs in on the Brexit debate.
Furthermore, as retail PMI data from the region yesterday point out accelerating activity in Germany and accelerating decline in France and Italy, it was interesting to note German Finance Minister Wolfgang Schaeuble’s acknowledgement of the growing discontent over the ‘one-size-fits-all’ policy construct of the EU.
"Standing in the middle of the road is very dangerous; you get knocked down by traffic from both sides” Margaret Thatcher
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