"Silence is better than unmeaning words” Pythagoras
Against the deafening silence of the Brexit progress in Europe, last night offered financial markets an alternate topic - the prospects for US monetary policy against the current domestic and global economic trajectory. As it turned out the Fed provided not just an alternate topic, but an alternate view.
Going into the meeting last night financial markets were sanguine about the prospects for any further policy or guidance change from the Fed - recent economic data have been mixed, but set against a backdrop of rising equity markets and a loosening of financial conditions. Minutes from the January FOMC meeting indicated that there had been substantive discussions about the intentions for the balance sheet rolloff and recent rhetoric from Chair Powell made clear that there would be an announcement of new details on the balance sheet "reasonably soon”.
The statement (and accompanying economic projections - or dots), however, could be considered the fourth consecutive dovish pivot from the Fed - this time centered around the assertion that "economic growth has slowed”. The Fed announced that the monthly Treasury roll off would be halved to $15B in May, and tapered thereafter to end in September, and signalled no rate hikes this year and one next year (down from one and one). Further, the negative narrative highlighted expectations of slower household spending and business investment and an upwardly revised unemployment rate at the end of the year.
"From now on, I’ll connect the dots my own way” Bill Watterson
From our perspective it is not clear that the Fed intentionally lurched further in a dovish direction. Rather, we see that there is clearly a conflict in the communication, where the overall narrative remains that the Fed "expect the economy to grow at a solid pace in 2019”, but where concern over global growth warrants a stance that is more accommodative.
While the Fed also suggest that it may be some time before the outlook calls for a policy change - the Fed still see the next move as a tightening while the markets increasingly see it as a loosening of policy - there are two significant implications that we draw from yesterday’s decision from the Fed. The first, from a currency perspective, the knee jerk market reaction to sell the USD on a more dovish Fed is from our perspective the wrong conclusion. Against a backdrop of low currency volatility and a global economic backdrop that is being dragged lower by China and (likely by extension) the eurozone, we would expect EUR to continue to underperform the USD, as EUR remains the likely funding currency of choice for international investors and the US continues to offer significant yield.
Secondly, we feel that this further dovish pivot from the Fed has implications for equity markets and risk assets. We are of the opinion that the Fed has pushed as hard on the accommodative policy rhetoric as is possible in the near term, and that either one of two future outcomes is likely. Either the data on the US economy really does disappoint, which undermines current equity valuations, or the data is not as weak as the Fed and some recent prints suggest, and thus the market has to begin to reprice rate hikes - again undermining equity valuations. While we are more sympathetic to the second scenario, it is also worth considering the current extended level of equity market valuation and the potentially negative technical backdrop that we see currently building.
The Final Countdown?
"Don’t expect to build up the weak by pulling down the strong” Calvin Coolidge
Last week, we discussed the renewed dovishness of the ECB, as Mario Draghi delivered what is likely to be viewed in retrospect as his parting gift to the eurozone economy. The extension of the current system of targeted loan provision (even if on less generous terms) and the commitment to keep interest rates at their current ‘boundary pushing’ level was driven by a sharper, more protracted than feared slowdown in the eurozone growth trajectory - led by Germany. Further, market consensus appears firmly in the camp that a bounce back in the Chinese economy through a natural resilience and the targeted policy stimulus of the PBOC (not to mention a successful resolution to the Sino-US trade spat) will bring about a bounce in the global export dynamic, and thus in the economy. We are less convinced.
Indeed, we are more of the opinion that the Chinese economic slowdown is in fact a more protracted and intentional tempering, and that Beijing is not likely to ride to the rescue of the widening eurozone / US growth gap at any time soon. Added to the continued rate premia, we maintain our view that the risks to the EUR are firmly to the downside vs. the USD.
"There cannot be a crisis next week, my schedule is already full” Henry Kissinger
In the UK, it has been another eventful week. Last Friday we suggested that there likely needed "to be some concessions between the EU and the UK to enable the Attorney General to amend his legal opinion of the indefinite nature of the backstop” in relation to the PM’s pledge to seek legally binding changes to the agreements. As the weekend progressed, however, press commentary in relation to discussions (let alone legally binding changes) were curiously absent - at least until late on Monday evening when it emerged that there had been some agreement to strengthen the commitment enabling the Attorney General to alter his opinion:
"I now consider that the legally binding provisions of the Joint Instrument and the content of the Unilateral Declaration reduce the risk that the United Kingdom could be indefinitely and involuntarily detained within the Protocol’s provisions at least in so far as that situation had been brought about by the bad faith or want of best endeavours of the EU...However, the legal risk remains unchanged that if through no such demonstrable failure of either party, but simply because of intractable differences, that situation does arise, the United Kingdom would have, at least while the fundamental circumstances remained the same no internationally lawful means of exiting the Protocol’s arrangements, save by agreement."
It quickly became clear that while the legally binding changes were an improvement, they were unlikely to be enough to overcome the 230 vote deficit from the Meaningful Vote’s first iteration. It wasn’t. It did, however, reduce that deficit to 149. This reduction and the fact that there were some notable new backers (such as David Davis, and Sir Graham Brady) meant that the PM’s deal, though in need of significant medical attention, was not dead.
As laid out last week, failure to secure a majority for the ‘deal’ meant a contingent (and amendable) vote on No-Deal would take place. Amid much confusion over the whipping arrangements by the Conservative Party, ‘No-Deal’ was defeated - while the motion was not binding, it was a clear demonstration of the will of the House.
Finally, yesterday came the vote on an extension. Like the ‘No-Deal’ vote previously, the wording of the question is important. The government’s motion stated that - If the House of Commons has approved a Brexit deal by 20 March, then it will seek a short technical extension to end-June. If, however, MPs have not approved a Brexit deal by 20 March then the motion states that a longer extension is likely to be required and, with it, the UK would have to hold EU elections.
Yesterday turned out to be a strong day for Theresa May. All wrecking amendments to the vote (a second referendum, a series of indicative votes, and a pause and rethink) were defeated and the question was passed unamended. This is important for two reasons. Firstly it means that the PM and government retain control of the next stage of the process and secondly, the PM’s deal will come back again - potentially with some modest additions (a unilateral declaration?).
"Learn from yesterday, live for today” Albert Einstein
For many months, we have held the view that May’s deal is the most likely outcome. Despite the volatility and uncertainty, we retain this view. We also retain the view from last week that "there has been a significant reduction in the probability of a no-deal scenario”. In fact, the only other credible route for the UK to take is no-Brexit. Next week - the return of the Meaningful Vote, the EU Summit and, on the 25th March, a debate on next steps should the situation remain unresolved - will be key.
From a currency perspective, our views also remain unchanged. In fact, last week saw the negative tail risks for GBP diminish further and the upside potential for GBP, most significantly against the EUR, become less restrained.
Six months is both a very short and a very long time in financial markets. For both ECB President Draghi and UK PM May the next six months will bring their reign to a close - Mario Draghi’s more definitively after the September policy meeting; Theresa May’s likely sometime after the Withdrawal Agreement has been completed or in the unlikely event of a no-deal Brexit. For both, in very different ways, the next six months will also likely define their terms.
"Cos at the boards is the man they call the Mario” Sure Shot, Beastie Boys
This week, it was the turn of Mario Draghi to take centre stage, as the ECB President delivered the decision of the Governing Council and outlined their latest economic forecasts. Going into the meeting, markets were broadly expecting a discussion of further (targeted) loans to the banking sector, to replace those set to run-off in September but not, by consensus, expecting their announcement. However, given the disappointing global growth dynamic, and particularly the global export dynamic, that has dragged the manufacturing sector (if not the economy as a whole) into recession in Italy and Germany, markets were also expecting a downgrade to the ECB growth forecasts.
The announcement of a new series of targeted longer-term loans and an extension to the ECB’s forward guidance (extending the pledge to keep rates on hold from "at least through the Summer of 2019” to "at least through 2019”) was clearly more dovish than the markets expected ex-ante. Furthermore, the current fragility of the region was clearly highlighted by the sharp cuts to the growth forecast for 2019 (from 1.7% to just 1.1%) - The ECB also cut its inflation forecasts at the policy relevant horizon, 2021 to 1.6%, from 1.8%, thus warranting the extended forward guidance pledge.
From our perspective, this was only a small part of the story. Indeed, the comments overnight that many Governing Council members thought that the growth revisions had not gone far enough and the specific reference to the surprise at the pace of deterioration in Germany that had sparked the ECB into action are key. Furthermore, while the official line from the ECB for the past six months has been that the slowdown is temporary, the FOMC’s Brainard last night described it as seeming "more persistent”. We are increasingly in the latter camp.
Draghi’s language on growth was clearly and intentionally more dovish, stating that "weakening data points to sizeable moderation in growth” and "we are maintaining our growth assessment to the downside… and let me tell you, this is the first time the ECB has introduced new easing measures and moved the balance of risks to the downside”. The reason we use the term intentionally more dovish is that we believe that the language at the press conference was intended to augment the impact of the easing measures, stressing that the "new measures are adding accommodation”. With interest rates already negative (threatening bank profitability), QE up against the existing country limits (threatening to amount to fiscal transfers), and forward guidance now testing the limits of incremental impact, the ECB has one workable channel it can effectively utilise for the transmission of monetary policy: the currency. From our viewpoint, Draghi’s press conference yesterday, while in reality was of little incremental impact, was aimed at giving the region a competitive currency boost, under the camouflage of monetary policy.
What’s more, given the current market positioning, the delicate balance of risk assets and the growing concern over the global growth dynamic, he may very well get his way.
"Should I stay or should I go?” The Clash
Speaking of getting your way, however, thus far the same cannot be said of Theresa May. Ahead of next week’s crucial vote (and subsequent contingent alternates), there likely need to be some concessions between the EU and the UK to enable the Attorney General to amend his legal view of the indefinite nature of the backstop. In our mind, the debate has moved beyond any form of end-date, or unilateral exit mechanism, towards a bilateral arbitration mechanism and or a strengthening of the criteria around the negotiation of a Free Trade Agreement. This is a very big weekend for both Theresa May and Michel Barnier. History will likely not be kind to either should the withdrawal agreement fall apart at this late stage.
That is not to say however, that the fortunes of GBP are indeterminately linked to the prospects of the weekend’s negotiations. From our perspective, there has been a significant reduction in the probability of a no-deal scenario (the Commons vote on no-deal is highly unlikely to pass - thus leaving extension the only prospect if the WA fails). And the fact that an extension - particularly a long one - increases the ultimate likelihood of remaining in the EU, it is far from clear that this is GBP negative. On the other hand, if the WA passes and the EUR (as we expect) remains under pressure, the EURGBP could trade below 0.8000.
This afternoon’s US employment report was something of an anomaly. The headline employment print was surprisingly weak, at just 20k, however all other aspects, the unemployment rate, household survey employment gains, participation and wage growth were all strong. The knee jerk reaction in credit, equity and emerging markets was negative, but overall we remain more positive about the US and the USD.
"let’s waste time…” Chasing cars, Snow Patrol
Last night’s release of the January Fed minutes was complicated by the fact that Washington snow storms prevented journalists from gaining their usual embargoed access to the report ahead of its official release. This meant that the salient points were drip fed onto the newswires as the report was read and digested real-time. Of course, this doesn’t change the facts but it feels very apt for the matrix of global and idiosyncratic (even weather) factors that appear complicating financial markets at the current juncture.
The minutes themselves were also less than straight forward. The clear dovish pivot from the Fed that sprung from the depths of the stock market at the end of 2018 still remains clear, with the emergence of a clear anticipation of a review or cessation of the balance sheet roll-off later in 2019 – Fed staff provided options for ending that balance sheet runoff as "almost all FOMC wanted to announce runoff end before too long.
However, there also remain some members of the committee that anticipate further rate hikes in 2019 should the "economy remain on track”. This is key from our perspective. While the monetary posturing of the Fed has lurched firmly in a dovish direction, the data hasn’t. In fact, the Fed economic narrative remains robust: "Fed officials see continued sustained expansion… strong labour market, inflation near target… recent household data have been strong”. The concern from the Fed is, we believe, twofold. Firstly, the sharp fall in equities and risk assets into the year-end 2018 (accompanied by widening credit spreads and sharply higher volatility) brought about a tightening of financial conditions that appeared to alarm the Fed. Secondly, this tightening of financial conditions happened at a time where the realisation of the extent of the slowdown in the global export dynamic was most pronounced. The combination of these two factors, we believe, drove the sharp and unexpected dovish pivot from the Fed.
Since the low point of the US stock market – broadly in line with the pinnacle of the dovish Fed pivots – US equities have rallied almost 20%, credit spreads have narrowed and volatility has reduced. Indeed, financial conditions have eased significantly. The Fed has, however, remained at the dovish end of its recent pivots. Thus, at least while the stark lack of global inflationary pressure continues, the issue holding back the Fed is global trade – and its implications for those economies most heavily reliant on global export markets.
In the near term we are of the view that the macroeconomic data continues to paint a quite painful picture of declining activity – this morning’s very weak manufacturing (PMI) data from Germany (47.6), and by extension the eurozone (49.2) – is a case in point. However, towards the middle of 2019 we expect a stabilisation in the Chinese economy (talk of further targeted stimulus measures from the PBOC were announced this morning) and by extension a stabilisation in the global export dynamic. It is also our view that the second half of 2019 will bring a resurgence of inflation, led by the US, as tight labour markets and a more stable China (global slack). Under this scenario the current monetary settings of the Fed will begin to look too loose quite quickly.
"We are the Judean Peoples Front” Monty Python, Life of Brian
So, in the US it is monetary policy and the geopolitical aspects of the enduring trade negotiations that dominate market sentiment and positioning. In the UK, it remains firmly the politics. After the resignation of 7 (now 8) Labour Party lawmakers and subsequently 3 Conservative MP’s the Independent group of MP’s now match the parliamentary seats of the Liberal Democrats. However, it is a recent poll of voting intentions that raised eyebrows suggesting that the group – who are not a new party, nor do they have wholly uniform views (outside of all wanting a second referendum) – could attract 14% of the vote. Moreover, it also suggests that the biggest loser from this political fragmentation has been the Labour Party.
Outside of the near term political shenanigans the Brexit negotiations continue. The suggestion from Brussels yesterday that any alterations to the agreements would have to pass through the UK Parliament before the EU 27 would be asked to ratify them is perhaps a sign that there is some progress in train. The suggestion From the UK Chancellor that the government could put a revise deal to the House of Commons (reportedly one that the use of a ‘parallel declaration’ or ‘interpretive instrument’ to repackage the Backstop) as soon as next week is also suggestive of this theme. GBP remains significantly undervalued under our valuation methodology and as the market continues to price an increased risk of a no deal scenario, we maintain the view that its likelihood remains low.
"Anyone who isn’t confused really does not understand the situation” Edward R. Murrow
There have been two dominant drivers of the macro backdrop over recent months - Fed policy and the global economic slowdown - which have provided a complex backdrop for financial markets. From our perspective, these two factors offer not just conflicting directional arguments, but also temporal ones - cyclical and tactical. In FX terms, this is creating uncertainty and distortion for the direction of the USD and this looks set to continue. Indeed, looking more closely, the path for risk assets and the USD is perhaps even more complex.
Firstly, (at the current level of the Fed Funds rate - near although still below in our opinion the neutral or equilibrium rate) the Fed’s dovish pivot and particularly the pace at which the Fed have gone from further gradual increases to a rate pause, and then to apparently considering raising the pace or duration of the balance sheet rolloff, has heightened volatility. Furthermore, it has also heightened the gamma or the rate of change of directional expectation of interest rates - effectively, the sensitivity of rate expectations to the underlying dynamic. Therefore, as the data evolves (a process even further confused by the delay to the release of a large amount of high frequency data as a function of the shutdown) we expect the impact on US rate expectations is likely to lead to continued high USD volatility.
Recent communications from Fed speakers suggests that there has been an expansion of their definition of ‘data dependence’ to encapsulate the impact on financial conditions from equities and risk assets. This is an interesting development. It is clear that the decline in equity markets into year-end was responsible for the change in reaction function of the Fed and ultimately the dovish pivot. Perhaps more significant to us is how this reaction function evolves not only now that equity and credit markets have provided a significant amount of easing of financial conditions, but also if we have additional strength indicated from the economic data, not to mention the resurgence of inflation - something that we expect, but that policymakers seem to have dismissed as a prospect.
Moving on to the second factor, the global economic slowdown, we are also likely at or near the point of maximum sensitivity. We have discussed on many occasions here the fragilities in the global export dynamic - likely directly as a result of the China slowdown - that has been so notable in Q4 in Germany, Japan, South Korea and other export dependent economies. Furthermore, we have also noted that the China slowdown, which has been evident for around a full year now, is driven predominantly by the domestic de-risking and deleveraging process (reform) and not clearly, as many commentators allude, as a function of the Sino-US trade spat. In part, due to the fact that the ‘intentional’ China slowdown has been going on for so long, and the fact that Chinese targeted stimulus measures are being implemented (and can be stepped up), we see potential for stability in China in the near term.
Tying all of this together - at least for the USD - we expect the near term backdrop to see USD weakness, as a more positive backdrop for equities and risk assets, as stabilisation in China, reduces any safe haven flows towards the USD, and as the Fed ‘pause’ delays the reaction function from stronger US economic data to the reality of tighter monetary policy in the US. From our viewpoint, while this is a tactical consideration, it can see the USD undermined and risk assets supported in the near term. This backdrop will likely also be extended by the risk positive implications of a resolution to the Sino-US trade spat, and even a Brexit deal. The cyclical considerations likely evolve once Fed policy resumes its tightening bias and would be accelerated by the emergence of inflation (significantly more likely than markets and policymakers expect). From our viewpoint this is a more dominant theme when it emerges - not for now.
"A compromise is an agreement where both parties get what neither of them wanted”
Lastly, while we expect very little from the UK this week, we have a couple of thoughts. The press over the weekend and this week has been full of criticism and condemnation for Theresa May’s attempts to get a compromise deal through Parliament that balances those who desire a clean break Brexit and those who are just trying to prevent it from happening. However, we remain more positive on proceedings and expect there to be sufficient concessions on the backstop to get the Withdrawal Agreement through Parliament.
However, there are two important caveats to this. Firstly, we would expect that concessions will only be made by the EU if they ensure the passage of Bill through Parliament - in that regard, the backing of any amendment this week that indicates a deal with a replacement to the current form of the backstop is critical. Secondly, it is also likely that any such concessions may come as late as the March 21st EU Summit - just days before the UK leaves - in part to prevent the prospect of further UK demands.
On that basis, and the fact that we continue to view GBP as significantly undervalued we view Theresa May’s appeal to "Hold our Nerve” likely applies equally to holders of GBP and Members of Parliament.
"Constant refutation with myself” Walking Contradiction, Green Day
The global macroeconomic backdrop is becoming increasingly complex, as conflicting cyclical and tactical factors clash. On a cyclical basis, there has been a continuation of the decline in global economic activity (led by China and by extension the global export oriented economies, most notably Germany and S. Korea) but a maintained, if not widened, growth differential in favour of the US - a negative risk, strong USD backdrop. On a tactical basis, the recent (2nd iteration) dovish Fed pivot and the prospects for a resolution to the Sino/US trade negotiations provide the opposite outcome potential - a positive risk, weak USD backdrop. With very little on the data calendar for release next week (and resolution to the trade talks unlikely) this state of confusion may be set to continue. One key focal point next week however will be the return of the Withdrawal Bill voting (and amendments) to Parliament - or at the very least the debate.
Having followed a 2 day visit to Northern Ireland with a trip to Mssrs Juncker and Tusk, there seems to have been no change to the Brexit situation. However, looking a little closer there are a couple of points to note. Firstly, while the May / Juncker / Tusk meeting was bookended by strong and defiant (if conflicting) statements from both sides, the resultant impact was a reopening of talks (but not the WA - at this stage at least). This should be viewed as a marginal positive. Secondly, this morning there has been a notable shift in the stance of the Labour party, who have reinvigorated the prospect of a second referendum and have offered more clarity around the party Brexit plan - a customs union commitment consistent with the Norway type model that had lost support and momentum in Parliament. This move is likely a function of Labour seemingly slipping further behind in the polls, but it is nonetheless significant as it likely gives Parliament a (much) softer back-up plan, should the prospect of no-deal get uncomfortably high - however, suboptimal it might be!
"Judge not lest ye be judged yourself” Holier than Thou, Metallica
BoE Governor Carney was asked in yesterday’s Quarterly Inflation Report Q&A, whether he agreed with the recent comments of Donald Tusk. His response was that he was very surprised by the comments but that if one were to be theological about it that those who judge others will also be judged themselves. A thought that was likely a fitting heading for the meeting itself.
The BoE statement that accompanied the unchanged verdict highlighted a cut in the 2019 growth forecast (from 1.7% to 1.2% and from 1.7% to 1.5% in 2020) as the uncertainties of the Brexit negotiations had increased.
Commentary from Carney, however, was more positive, as he stated the view that current UK domestic fundamentals are sound, financial stability risks are subdued and that continued tight labour markets are driving higher real income growth. This, along with any progress on Brexit, provide upside risks to the UK economic narrative.
Many of the questions were clearly aimed at trying to cajole Governor Carney into statements of gloom (or worse) about the progress of Brexit and or the concept itself. Instead, Mr Carney’s ripostes turned cajoling around and instead made a clear point of the message that the Bank of England wished to give to their readers/viewers. That message was, in essence, that the labour market remains very strong, financial sector stable, households are doing very well (currently enjoying the biggest annual rise in real incomes since the referendum vote at +2.5% y/y). BUT that uncertainty is having a damaging effect on business investment (though not business hiring) and that business are not yet prepared for a no deal/no transition Brexit.
Essentially, and dramatically simplified, the message was that the Bank think that in the long term the economy will retain a strong upward trajectory. We are just not sure how far away that is, and what the path to get there will be. From our perspective, and likely with a significantly shorter time lag, this mirrors our view for GBP.