Chinese Renminbi – Squaring the Circle

China’s exchange rate policy is one of many significant uncertainties or “known-unknowns” for 2017 (as it arguably was in 2016 and prior years).

The market’s focus is still very much on the rise in USD-CNY but Chinese policy-makers are keen to emphasise the importance of the Renminbi’s performance against a basket of currencies – the CNY Nominal Effective Exchange Rate (NEER). This comes as no surprise.

The monthly pace of CNY NEER appreciation or depreciation has rarely exceeded 3% in the past seven years, suggesting that policy-makers have sought to control the Renminbi’s rate of change.

Large (and well documented) capital outflows from China have been the main source of Renminbi pressure but China’s current account surplus-to-GDP ratio has also edged lower to around 2.5% due to a rising deficit in the services balance. This perhaps dents the argument that the Renminbi is still materially undervalued.

Moreover, despite the Renminbi’s gain in competitiveness in the past year, China’s trade surplus has somewhat counter-intuitively shrunk, not increased. This may be due to price effects outweighing demand-effects (for exports) and still strong credit-fuelled Chinese imports.

In response to quarterly capital outflows of between $100bn and $200bn since late 2015, the PBoC intervened in the FX market to the tune of about $280bn in January-November.

This strong commitment likely reflects the perceived economic and geopolitical benefits of limiting the Renminbi’s depreciation.

Near-term, I think the PBoC may continue to see some value in a broadly stable Renminbi or only very modest CNY NEER depreciation. If capital outflows re-accelerate this would likely require the introduction of further capital controls and aggressive FX intervention. This is certainly an option in the short-run.

If capital outflows stabilise or recede, the PBoC may be able to slow or even stop FX intervention. This is not a totally unfeasible scenario if global yields stabilise and a slightly stronger CNY attracts capital back into China or if capital controls take greater effect.

In the more unlikely scenario whereby China experiences capital inflows, which last happened in Q1 2014, I would expect the PBoC to have limited appetite for rapid and/or sustained Renminbi appreciation and instead use this opportunity to rebuild FX reserves.
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Paradox of Acute Uncertainty and Strong Consensus Views

There appears to be a quasi-universal belief that 2017 will be characterised by acute uncertainty, with the list of difficult-to-predict economic and political variables growing exponentially in recent months.

These include the paths which Donald Trump will tread in the US and Theresa May in the UK, the Fed’s reaction function, the future of the eurozone and EU with European elections looming, the perennial question of China’s exchange rate policy and outlook for oil prices.

And yet, there is already it would seem a set of strong consensus views about the direction which economic variables and financial markets will follow in 2017.

US reflationary policies are expected to rule, boosting already decent US economic growth, inflation and US equities, in turn forcing the Fed to adopt a far more hawkish stance than in 2015-2016 and pushing US yields and dollar higher.

At the same time, President-elect Trump’s penchant for protectionism, alongside a strong dollar and higher US yields, are seen as major headwinds for indebted emerging economies reliant on trade and by implication for emerging currencies, bonds and equities. These seemingly include the Mexican Peso and Chinese Renminbi.

Moreover, the consensus forecast is that at the very least EUR/USD will fall below parity, having got close in December.

The perception of acute uncertainty is not totally incompatible with seemingly well-anchored forecasts but they do make uncomfortable bed-fellows.

Some of the uncertainties which have gained prominence can be put to rest, for now at least. At the same time, some of the sure-fire trades currently advocated may struggle to stand the test of time, in my view.

Marine Le Pen is very unlikely to become the next French President, the Italian banking sector will not be allowed to implode and the euro may end the year on a strong note.

Emerging market currencies have showed greater poise in the past few weeks, with a number of central banks showing both the appetite and the room to support their currencies. This should be borne in mind. Read more

EM currencies, Fed, French elections and UK reflation “lite”

Rising US yields, stronger dollar, FX outflows from emerging markets into US equities, President Trump’s still uncertain policies regarding global trade and country-specific concerns continue to weigh on EM currencies.

But the pace of depreciation in EM currencies has abated, with a number of central banks hiking their policy rate and likely intervening in the FX market. China is manipulating its currency but perhaps not the way that US President Trump thinks.

With the market having almost fully priced in a December Fed hike, it will focus on FOMC members’ likely further downward revision to their forecasts for the appropriate policy rate.

Commentators are making a number of assumptions about next year’s French presidential elections and the potential impact on the euro. Some seem reasonable, others less so.

The first assumption is that Fillon will beat Juppé in the second round run-off of the Republican primaries on 27th November. This is indeed the most likely outcome.

The second assumption, which I agree with, is that no presidential candidate will clear the 50% threshold required in the first round of the elections on 23 April to become President.

The third assumption, now seemingly hard-baked, is that no Socialist candidate stands even a remote chance of making it to the second round of the presidential elections on 7th May 2017. I would argue that it is too early to write off that possibility.

The fourth assumption, which I believe is still far-fetched, is that Front National leader Marine Le Pen could win the second round to become President, which in turn would precipitate France’s exit from the EU and pressure the euro.

UK markets’ mixed reaction to Wednesday’s Autumn budget was in line with my expectations of higher yields and stronger Sterling.

Chancellor Hammond’s modestly stimulative package reflects the realities and uncertainties which the UK economy has faced since the June referendum. This is still the over-riding theme markets will have to deal with in the near and potentially long-term.

Hammond had one hand behind his back and a moving target to hit. He has backloaded spending to 2018-19 and beyond with a focus on infrastructural projects to boost languishing UK productivity. Read more

Sterling: The lady’s not for turning (yet!)

There are multiple factors behind Sterling’s collapse in the past fortnight to decade lows and the question remains whether these factors will reverse any time soon.

At the top of the pyramid of causes for Sterling’s demise, in my view, is not the UK’s large current account deficit or Bank of England (BoE) policy but the stance on EU membership which Prime Minister Theresa May has adopted.

So while Sterling’s greater competitiveness may eventually drive FX inflows into the UK and help Sterling to recover, financial markets and investors are likely to continue to take their cue from the British government near-term.

Simply put, if Theresa May continues down of the path of “Hard Brexit”, however ill-defined, Sterling is likely to remain under pressure.

However, history shows that while EU leaders have a tendency to drag their feet over key issues, they are able and willing to eventually find some kind of compromise.

Moreover, Theresa May will be subject to the will of her own Conservative Party – which on the whole supports membership of the UK or at least a softer form of exit from the EU – and of the people.

While the BoE would prefer a more stable currency and lower yields, there is probably little than it can (or should) do near-term beyond trying to reassure markets, investors and households. Read more

Federal Reserve – the Father Christmas of central banks

Thursday’s Fed policy meeting contained few major surprises, even if the divide amongst FOMC members has received much attention.

The bottom line is that 14 out of the 17 FOMC members, and at a minimum 7 of the 10 voting members, estimate that at least one 25bp rate hike before year-end would be appropriate.

Should the Fed hike in December – currently my core scenario – this almost unprecedented glacial pace of hikes would be in line with my January forecast of only 1-2 hikes in 2016.

The Fed’s accompanying statement and Yellen’s press conference were, if anything, reasonably upbeat. There were no direct allusions to the dollar, property, equity and bond markets or to global factors, with some justification (for now at least).

The Fed’s two main concerns are squarely centred on sub-target inflation and areas of weakness in the labour market.

It will thus be paying particular attention (and so should markets) to evidence of slack in the US labour market, with the unemployment rate becoming a less useful measure per se of labour market strength and potential wage/price pressures, in my view.

The Fed is clearly giving weight to the historically low neutral Fed funds rate. Even so FOMC members may have to further tone down their 2017-2018 estimates of the appropriate policy rate in relation to realistic (if still a little optimistic) economic forecasts.

Financial markets’ reaction has so far been mostly text-book: a jump in market pricing for a December hike to 16bp, a bull-flattening of the US yield curve, a slightly weaker dollar, a rally in EM and commodity currencies and stronger global equities.

But now comes the hard part. Volatility in Fed fund futures is likely to remain fluid in coming weeks, with financial markets increasingly sensitive to key US data, particularly on inflation and labour markets, speeches by FOMC members and presidential opinion polls.

Should Clinton win the US elections, US data improve and the Fed hike in December, I would expect the dollar to end the year stronger, EM currencies and global equities to struggle to hold onto post-US election gains and major currencies to underperform.

The more problematic scenario for the Fed (and its credibility) is one whereby Donald Trump wins and/or US economic activity slows down.  

This would likely cause a sharp sell-off in global equities while safe-haven assets (e.g. gold, Swiss Franc) would outperform the dollar and in particular EM currencies. Moreover, these moves could struggle to reverse even if the Fed decided to pause in December. Read more

Global Central Bank Easing Nearing Important Inflexion Point

Recent comments from the Fed, ECB and BoJ have rattled financial markets after a summer of relatively low volatility.

The correction in financial markets has so far been relatively modest, particularly for equities and the dollar. But the questions remain where global monetary policy goes from here, the implications for asset valuations and ultimately whether elevated global risk appetite will correct more forcefully.

My core view is that eight years of ultra-low (and in some cases negative) central bank policy rates and expansive bond-buying programs have helped stabilise global growth and inflation, albeit at low levels.

At the same time, the costs of ultra-loose monetary policy, including asset price bubbles, distortions in bond markets, pressure on the banking sector and even rising inequality, may be starting to outweigh the benefits.

Therefore, major central banks, with the exception of the BoJ, may refrain from loosening monetary policy further near-term.

I would certainly expect central bank policy rate cuts to become increasingly less frequent than in the past and the ECB and BoE to keep the modalities of their current QE programs broadly unchanged for now.

At the very least, the world’s most influential central bankers may going forward tweak a discourse which has in recent years largely focused on doing “whatever it takes”.

To be clear, the risk near-term remains biased towards more central bank monetary policy easing. Bar the Fed and possibly a handful of EM central banks still fighting weak currencies and high inflation, no major central bank is likely to hike policy rates or tighten monetary policy this year, in my view. That’s a story for 2017, at the earliest.

But if we have indeed reached an inflection point in global central bank monetary policy, if anything financial markets will become more sensitive to any downturns in still tepid global growth and inflation and to the negative side-effects of loose monetary policy.

In this context higher volatility is likely to prevail and global risk appetite may struggle to forcefully regain traction for now. Read more

US Economy Not at Full Employment

Markets, which tend to focus on US non-farm payrolls and the unemployment rate, may be relying on an incomplete and arguably inaccurate picture of the US labour market which fails to fully take into account a still sizeable pool of available workers.

Job creation has been robust in recent years, but the working age population has also increased while the share of full-time employees remains modest. As a result, the ratio of the working-age population employed in full-time jobs, currently 48.7%, remains well below its historical average.

Importantly this ratio tends to lead the growth rate in private sector employees’ hourly earnings and points to earnings growth only rising modestly in coming months from around 2.4% year-on-year.

The policy implication, all other things being equal, is that the Federal Reserve may not have to worry near-term about a tight labour market boosting pay-packets and in turn wage-led inflation. With US GDP growth having collapsed in Q1, global growth having slowed further to around 2.6% year-on-year and global PMI and Chinese trade data showing little bounce in April, the Fed’s decision to keep rates on hold so far this year is at least defendable.

My core scenario of one or two Fed rate hikes this year remains feasible but my expectation that the Fed would pull the trigger in June will likely be proven wrong. The Fed fund futures market has all but discounted a mid-year hike, currently pricing in a probability of only 8% for a 25bp hike, versus 23% back on 26 April. Read more

What to expect in 2016 – same, same, but worse

Trading on Fear

It is clear that markets so far this year are trading on sentiment, more specifically fear, with hard-data playing second fiddle. Or more accurately, price action suggests that markets are focusing on disappointing December numbers (e.g. US ISM) or even reasonably uneventful data (Chinese manufacturing PMI) and ignoring strong data such as U.S non-farm payrolls, Chinese services PMI and exports (see Figure 1).  The hit-and-miss approach of Chinese policy-makers to stabilise equity markets (and ultimately growth) have done little to restore confidence. I nevertheless flag in Figure 37 some of the key data and events to focus on this year. Read more

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