"All human excellence is but comparative” Samuel Richardson
In our last post, we discussed the likely evolution of US monetary policy (or at least the evolution of market expectations of US monetary policy) following the rate rise on the 26th September. The Fed raised rates by 25bps to a new target range of 2.00% - 2.25% and removed their reference to "accommodative” policy, while continuing to highlight further strength in the labour market and economic activity, albeit amid relatively subdued inflation and inflation expectations.
At the time, there was a clear commentator bias towards the view that the removal of the term "rates remain accommodative” was indicative of a Fed approaching its terminal rate. However, we disagreed, suggesting that the economic summary (consumer spending and business investment are "expanding briskly”) and the explicit suggestion that that there would be little "aggregate impact” from trade tariff escalation imply that the bar for the Fed to pause is high.
With the domestic situation strong (and likely sustainable for several quarters at the very least) and the impact of a trade spat played down, the popular arguments for a Fed pause come from emerging market stresses as a function of higher US rates and or a correction in US equity markets. The former was played down by Powell at the September press conference - "we understand the Fed effects on the world” - and the latter was addressed last night in a speech by San Francisco Fed governor Daly, who stated her view that a correction in the stock market is "not necessarily a worrisome thing”. Stock market, or EM wobbles, may have caused a Fed pause under the guidance of Janet Yellen. Under Powell, we continue to view the risks to US rates as up, not down.
Furthermore, with growth at above 4%, almost double the potential growth rate, and with record low unemployment, rising oil prices, and the continued positive implications of the pro-cyclical fiscal stimulus, our view remains, that the biggest risk for the remainder of the year is an acceleration in inflation. If this view is correct, then US rates and the USD can rise significantly further.
This evening will provide an important reference point for US monetary policy. Last week, the IMF published their world Economic Outlook (WEO) update, in which a key point was that the period of synchronous economic growth, or global growth convergence, was anomalous, and that divergence is likely in the near future. Further, the ECB minutes from the September policy meeting painted a less rosy picture than that at the time of the statement / press conference. The minutes highlighted a less optimistic view on both growth and inflation, where growth risks are likely biased to the downside (not balanced, as the statement suggested) and that domestic inflationary pressures are likely to move higher "gradually” (not "relatively vigorously”, as Draghi stated in the press conference). Fed minutes this evening that offer no deviation from the strong growth, continued rate hikes mantra likely reinforce the IMF ‘divergent growth’ forecast, and highlight the prospect of US, and USD, outperformance.
"And still I’m here, to try and figure it out” Figure It Out, Royal Blood
"Bad news is a headline, gradual improvement is not” Bill Gates
In what was a quiet start to the week, there was little in terms of market price action - broadly flat global equities, bonds and the USD - and despite the near certainty of market expectation for a 25bp hike from the Fed, there was relatively little expectation of anything else from a policy perspective. In part, this had come from the Fed’s now engrained ‘gradual’ normalisation mantra and in part from the fact that there had been two prominent calls for the Fed statement / inference (following the ‘done deal’ 25bp hike): one for an indication of an acceleration of the pace of monetary tightening; the other for a removal of the term ‘accommodative’ in the statement, indicative of the increasing proximity to the neutral level of interest rates - and by extension, the end of the tightening cycle. We are significantly more sympathetic to the former.
Ultimately, the Fed raised rates by 25bps to a new target range of 2.00% - 2.25% and removed their reference to "accommodative” policy. At the same time, the statement highlighted the acknowledgement of further strength in the labour market and economic activity (the forecast for economic growth in 2018 was raised from 2.8% to 3.1%), yet continued signs of ‘at target’ but nonetheless contained inflation and inflation expectations.
The Summary of Economic Projections from the Fed also gave us revisions to the ‘dots’ (member expectations for future rate moves) that highlighted greater consensus around a 25bp hike in December, and another three similar hikes in 2019, essentially giving a median estimate of the terminal level of US rates at 3.375%.
At the press conference, Powell reinserted the "rates are accommodative” narrative, suggesting that its omission in the statement does not signal a change in the rate path, simply that this factor of the forward guidance lexicon has run its course. That said, I would imagine that the question "Are rates still accommodative?” now simply becomes a regular feature of the press conference Q&A.
From our perspective, there were some key inferences from the press conference and Q&A. Firstly, in his refreshingly straightforward, frank style, Powell was clear to point out the underlying strength of US economic activity and the Fed’s resultant favourable outlook. This is enhanced by the fact that consumer spending and business investment are "expanding briskly”. Secondly, Powell played down any negative prophecies from the current, escalating trade tensions / spat / war with China stating that "its hard to see much aggregate impact from tariffs”. Lastly, in the three months since the last Fed rate rise, there has been a period of acute stress in emerging markets, stress that may have caused previous Fed governors to waiver on their commitment to normalisation. Powell’s message in this regard was very clear, "we understand the Fed effects on the world”, highlighting his view of the importance of communication and transparency - not accommodation - implying the bar for the Fed to pause is high.
Our view remains, with growth at above 4%, almost double the potential growth rate, and with record low unemployment, rising oil prices, and the continued positive implications of the pro-cyclical fiscal stimulus, that the biggest risk for the remainder of the year is an acceleration in inflation. Ultimately, against the current backdrop we maintain our view that unless we see a sharp moderation in US growth, or a deceleration in US inflation, USD outperformance likely remains dominant. After all, despite the current growth and interest rate premium the "dollar has only partly recovered its decline of 2017”: Jerome Powell
"The problem with socialism is that eventually you run out of other people’s money” Margaret Thatcher
In his closing speech yesterday, Jeremy Corbyn, the leader of the UK opposition party promised higher wages, higher spending, the nationalisation of major industries (with cheaper services and higher wages for the workers), forced corporate equity carve outs for workers (undefined), boosting child care, aged care, adding 10,000 police officers and embarking on the biggest homebuilding programme ever. Spending plans well beyond the means of any realistic taxation plans.
Perhaps, Mr Corbyn should look at the impact on Italian borrowing costs from the suggestions (light by Corbyn’s standards) of the Italian coalition government, where 2 year borrowing costs went from around negative 0.30% (as a function of the negative ECB rate and QE programmes) to above 2.80%. After much backtracking and pledging to delay spending programmes (and respect the maastricht criteria of the EU) those costs moderated to around 0.75%. This morning, the debate has intensified once again as we approach the Budget announcement. Watch this space.
Next Blog on the 17th October.
"Unlike presidential administrations, problems rarely have terminal dates” Dwight D. Eisenhower
Over recent, sessions we have seen a significant rebound in risk appetite, equities and emerging markets and, despite the rally in US yields, a weaker USD. Regular readers will be well aware that this move is counter to our near term expectations. We have maintained the view that USD strength should result from a continued gradual path of monetary normalisation from the Fed - as continued growth momentum and significantly negative real yields leave the Fed already behind the curve. In the emerging market space, the combination of a managed China slowdown / deleveraging and intensifying Sino-US trade spat has had significant negative implications for a large number of economies. Those that have high external (USD) debt will also likely suffer the negative spiral of higher servicing costs, weaker investment and thus a weaker currency. In the G10 space, outperformance has likely been dominated by stable or widening growth and interest rate differentials.
From an idiosyncratic perspective, there have been two significant events that have exacerbated, if not driven, the case for a weaker USD over recent weeks. The first was likely the larger than expected rate rise from the Central Bank of Turkey (CBRT), which, despite intense pressure from President Erdogan to lower inflation, reasserted their independence and raised rates 625bps to 24.00%, in defense of the TRY. The rate rise calmed nerves and reduced fears of a further disorderly collapse of the TRY - halting, even reversing, the negative contagion across broader EM.
The second significant point was more subtle, but perhaps further reaching. At the ECB meeting last week, Mario Draghi noted that "domestic cost pressures [including wages] are strengthening and broadening”, projecting "significantly stronger core inflation” - despite current measures remaining generally muted. By extension, this positive (if still second order) progression of eurozone inflation - and thus rate expectations - contributes to the proposition that we may be entering a period of a more synchronous monetary and economic progression. The USD had likely benefited in large part from the very opposite for much of this year.
(Inflation) "Born in the USA” Bruce Springsteen
This theme is further accentuated by the concept that the US is approaching its terminal level of rates. This is where we diverge from current ebb of market participants towards a weaker USD. We are of the view that the Fed will continue to raise rates on a ‘gradual’ basis (broadly once per quarter) well beyond the current expectations of the market (approximately three and a half more 25bp rate rises). We also retain the view that the most significant risk for Q4 is likely higher (US-led) inflation. If this is to materialise, then the current debate about the proximity of terminal rates, r*, and even likely curve inversion will dissipate and the second order derivatives of the relative directions of monetary policy between the US and the rest of the world likely turn sharply back in favour of the USD.
In short, we are inclined to see the recent weakness of the USD as a pullback, not a change of direction.
"Will you have some tea, at the theatre with me?” The Who, Tea & Theatre
Earlier today the UK inflation release highlighted a sharp rebound in prices in August, driven by sea fares, clothing and theatre prices. Just going to show that the any uncertainties surrounding the Brexit negotiations are not yet deemed serious enough to reduce demand for the matinee performance of Julie at the National (poor budgie!). In many respects, however, the relative pricing power of the ‘recreation and culture’ section of the UK economy is an encouraging barometer for underlying momentum of the economy as a whole.
"We are now on the home stretch in Brexit talks” Michel Barnier
However, Brexit remains clearly the biggest issue for the UK economy at the current juncture. Or rather, from our perspective, the current uncertainty surrounding what Brexit will ultimately look like and also what the rules (and therefore opportunities) will be. Echoing M Barnier’s positive comments from last night, PM May suggested today that the "exit deal is virtually agreed” and ahead of this week’s ‘informal’ EU Summit in Salzburg, called for "goodwill and determination” in Brexit talks, urging the EU to get behind the UK’s offer of a "fair arrangement that will work for the EU economy as well as the UK’s”. May will deliver a presentation of her Chequers proposal at the opening dinner this evening, ahead of EU27 discussions tomorrow it is hoped will result in a more flexible mandate for M Barnier, as the continuous negotiations recommence.
We have a number of times now outlined our view that there will be a deal between the EU and the UK, and that it is likely to be the Chequers deal - albeit likely with some minor amendments / concessions. Last week we referred to the Chequers deal as a ‘slow Brexit’, a holding pattern, or a long term transition stage until politics and or technology catches up - sentiment that was alluded to by the environment secretary Michael Gove over the weekend, where he said that whilst Chequers is "the right deal for now”, a future prime minister would have the power to "alter the relationship” and elements of the agreement.
Mr Gove also offered some advice to the disunity within the Conservative Party during this week’s Panorama "Inside No 10: Deal or No Deal?” where he stated that the Chequers deal is not perfect, but that "you must never make perfect the enemy of the good”. Ultimately, if Theresa May brings a Chequers-based deal back to the House of Commons, as we expect, a deal under which, in essence, the UK leaves the EU, ends free movement, enables external trade deals and maintains trade with the EU, however imperfect, we find it hard to believe it would be voted down by sufficient MP’s so as to risk a cliff-edge no-deal outcome. The next two months, however, are key.
"The dominant feeling of the battlefield is loneliness” William Slim
While significant for the future of the UK economy and that of the EU and Europe, the Brexit ‘soap opera’ plays a minor role in determining global financial market sentiment at the current juncture. The dominant role is played by the US and China.
At the start of this year, the consensus financial market view was that the procyclical fiscal stimulus in the US would shift the focus back towards its burgeoning twin deficits, at the same time that the rest of the global economy, dragged along in the US slipstream, began their respective policies of monetary normalisation - thus it was a view ultimately of USD weakness. However, what happened was the opposite. The rest of the world saw their growth slow sharply back towards (or beyond in some cases) trend growth, and the US tax breaks drove substantial repatriation, capital investment and consumer spending (amid multi decade tightness of the labour market), and thus an acceleration of US growth. By extension, the widening growth differentials - and ultimately interest rate differentials - drove a stronger USD - particularly against those emerging market countries with high external (USD) debt
Over recent weeks, we have highlighted that we continue to favour the USD in FX markets, driven by two factors: (i) a Federal Reserve that remains firmly on its path towards gradual normalisation, as continued growth momentum and significantly negative real yields leave the Fed already behind the curve (ii) the slowdown in China, which, while in large part a function of domestic deleveraging policies, has had significant negative implications for a large number of EM economies. Those that have high external (USD) debt will also likely suffer the negative spiral of higher servicing costs, weaker investment and thus a weaker currency. Furthermore, higher US inflation is the process by which the impact of these two factors is accelerated.
"Going nowhere. Going nowhere”Therapy, Going Nowhere
"I’ve got me a whole months wages” Megadeth, Cold Sweat
Last week, we discussed the impact and implications of US monetary policy normalisation on global financial markets. The view was that, while there are many idiosyncratic concerns across emerging market (EM) and developed markets (DM), at the current juncture the dominant force on capital flows as well as market sentiment and pricing is the economic outperformance and resultant (rising) interest rate differentials favouring the US - and the USD. In this respect, the US employment report for August, released last Friday, is an important marker.
The data showed that payroll gains re-accelerated, after the modest slowdown in July, with the underlying unemployment rate unchanged at 3.9% (3.853%, to be more precise). While the unemployment rate and the further drop in the underemployment rate were flattered by a drop in the participation rate, the report was a further reinforcement of the strength of the US economy. Furthermore, we would argue that the jump in the average hourly earnings print to 2.9% (the level reached in the January report, and seen as a precursor to the February equity market wobbles) is a significant and positive development.
We have argued on many occasions that the biggest risk to financial markets in the second half of 2018 is inflation, particularly US inflation, and the implications for higher US rates and a potentially significantly higher USD. If this is the outcome for H2 2018, then the current emerging market woes are just the beginning. This week, we will witness the latest installment of the US consumer price index (CPI) series. Expectations are for a dip back to 2.8%, from 2.9% annual pace in July. We would not rule out a 3 handle.
"Alla sätt är bra utom de dåliga” Swedish Proverb
Translation: All methods are good except for the bad ones.
Last week, we also discussed the Swedish elections that took place this weekend. On Thursday, the Riksbank left rates unchanged at -0.50%, as expected, and despite highlighting the strength of Swedish economic activity and the fact that inflation is close to target, the Riksbank pushed back on interest rate rise expectations (again), from later this year to early next year. Ahead of what was expected to be a ‘hung-parliament’ following the weekend’s election, it is perhaps not surprising that the (independent) monetary policy committee played down the likelihood of a near term rate hike. However, with a near 4% current account surplus, strong budget surplus, good growth, robust inflation (even if stripped of energy) and what we see as an undervalued currency, we would argue that a rate rise should come, at the very least, at the near end of the December - February forecast, especially if, as we expect, there is a relatively swift and uncontroversial formation of government.
"The report of my death was an exaggeration” Mark Twain
Over the weekend, it also seems that there has been some progress in the UK and on Brexit. Among the commentariat, you may be forgiven for believing that the Prime Minister’s Chequers proposal was DoA. However, following the release of a transcript of the discussion on the topic of the Chequers deal, even Mr Barnier was reported to have asked reporters to show him where he had said that the Chequers deal was dead - as several high profile pieces have argued.
Furthermore, while there remains much popular criticism of the chequers plan, none of its critics have, thus far, offered an alternative plan. At least not one that deals comprehensively with the Northern Ireland issue. From our perspective, the Chequers deal is the most likely prospect for the UK - EU (interim) future relationship.