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

Asian currencies sticking to script

Despite the volatility in financial markets, Non-Japan Asia (NJA) currencies continue to behave broadly in line with historical patterns. Specifically, a basket of NJA currencies (excluding the renminbi) which was appreciating at about 3% month-on-month versus the USD dollar is now weakening in month-on-month terms, as largely predicted (see Figure 1). The pattern is similar when NJA currencies are measured against trading partner currencies. Read more

Global growth – Down but not out

While equity and commodity markets have recovered, it is an almost consensus view that already tepid global economic growth in H2 2015 likely weakened furthered in Q3 and shows few signs of recovering near-term,

Governments, lacking in both leadership and fiscal-reflation headroom, have passed the buck to central banks struggling to hit multiple growth, inflation and financial stability targets.

However, talk of global recession let alone economic collapse is somewhat overdone and I reiterate my long-held view that the global growth story is a cause for concern, not panic (17 December 2014).

Global GDP growth has been mediocre but pretty stable in the past three years at around 2.4 and 3.2%, according to respectively World Bank and IMF estimates, so perhaps it is the expectation of a return to pre-2008 growth rates which is unfounded.

International institutions have revised down their global GDP growth forecasts for 2015 but history suggests that the IMF’s 2015 forecast of 3.1% growth may prove a tad too pessimistic.

The focus on China’s ill-defined “hard-landing” and “true” growth rate has obscured the fact that growth in US, still the world’s largest economy, is back to its long-term average. 

Finally, while policy-makers are running out of tools to spur their economies, a number of emerging market central banks, including in China and India, still have room to cut policy rates further.

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Deflation, what deflation?

Four themes have hogged the headlines this year – Greece, China, the Fed and linking these three topics…the risk of deflation and associated damage to the global economy.

At the risk of over-simplifying a complex picture, what is striking is that global headline and core inflation have actually been pretty well behaved (see Figure 1). Further analysis shows that headline and core inflation have evolved in reasonably narrow ranges since early 2013 in the world’s largest developed economies as well as China and Mexico. The fact these inflation data series are a little boring is in itself noteworthy given that central banks typically favour low and stable inflation. Read more

Conservatives win landslide victory in UK Elections

After months of half truths, hollow promises, claims of greatness, veiled threats and televised showdowns, it’s finally over.  No, I’m not referring to the overhyped but ultimately disappointing Mayweather vs Pacquaio “fight-of-the-decade”, but the far more unexpected outcome of the UK general election. The ruling Conservative Party has comprehensively won the battle and war for the hearts – or at least the minds – of UK voters.

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