October 21 2015 is Back to The Future day, when Marty McFly arrived in his DeLorean. But it’s also an apt summary of developments in financial markets and central banking in recent weeks(although Groundhog Day is a strong alternative). Specifically, the past couple of weeks have been characterised by three main developments.
First, market concerns about China have dissipated somewhat following less disastrous than feared data (including this morning’s suspiciously close to 7% GDP release), an uptick in credit growth combined with announced fiscal easing measures and expectations of further monetary policy actions (sound familiar?). Second, US (and UK) rate hike expectations have continued to be pushed back as markets have focussed on dovish policymaker comments (downplaying more hawkish views) and have taken a glass half full view of macro data. Indeed, the market probability of a Fed rate rise now only exceeds 50% by March 2016. Third, expectations of further ECB easing which I have been advocating since early summer have become more consensus, with even market discussions/pricing of further deposit rate cuts (raising the bar for the ECB to again surprise, but then again in the Back to the Future world….).
Unsurprisingly, we’ve seen a combination equities bouncing a little, EM and commodity currencies recovering some of their post-Yuan float losses (oil prices also rose but have again retraced on excess supply concerns), government bonds rallying and both USD and GBP continuing to struggle (the difficulties of escaping the central bank peleton!). The ECB may well be most worried by this all, given their apparent focus on curtailing nascent EUR strength (EUR weakness has been a key element of PSPP transmission) given that headline inflation which they focus on has again fallen back into deflation territory and they seem to have finally acknowledged that inflation breakevens’ high sensitivity to oil price movements is . So Draghi this week seems likely to leave the door wide open to a December QE extension (alongside a downgrade to their overly-rosy inflation forecast, potentially echoing Nowotny’s 15 October surprisingly dovish comments. I wouldn’t completely rule out something more substantive this week, although that seems like a low-probability (less than 10%) scenario given that EUR isn’t surging upwards (unlike in May 2014).
But overall it seems to me that the market’s got a bit too carried away with pushing out expectations of FOMC and (perhaps especially) MPC tightenings. But predicting when such expectations can start being reversed (supporting USD and GBP) is a tough call in the current glass half full market environment, where participants markets are more receptive to dovish central bank comments (I discuss Lael Brainard’s nteresting speech below). A strong next US payrolls number seems like a necessary but not sufficient condition for the current dynamics to start shifting (upward revisions to recent weak data would be helpful and can’t be ruled out). But the likely reluctance of USD bulls to re-enter previously-crowded trades (which turned a bit sour) means the recent EM FX rally may well have further to run in the near-term. Obviously country-specific EM negatives can continue to weigh and a delayed Fed hike driven by a US data downturn (I’m less concerned about last week’s disappointign retail sales than the market seems to be) would also eventually spook EM currencies (weaker demand for their exports).
I personally think that the Fed should delay hiking into (early) 2016, to make sure that things aren’t going belly-up and actually start seeing some Phillips curve effects on wages and inflation (see here). Nevertheless the extremely low market-implied probability of a 2015 rate hike seems at risk given that in September 13 out of 17 FOMC members thought they’d act in 2015, they only delayed because they wanted to assess the China/EM situation and that seems to be turning the corner if you buy the data (I don’t really but FOMC may feel more obliged to do so), US demand indicators remain fairly strong and most of the FOMC seems to still believe in the Phillips curve (I’m more sceptical, although the UK example gives hope notwithstanding last week’s slightly disappointing data). But US data likely need to start performing pretty soon and FOMC members need to up their positive (China) comments for this to eventuate.
BoE rate hikes being priced in until 2017 looks pretty stretched given Carney’s continued insistence that the issue will come into focus around the turn of the year (with superficially dovish comments by new member Vlieghe offset by increased hawkishness by Forbes) with the lower rate expectations and GBP fallback mechanically pushing up the inflation projection in the November forecasting round. MPC have previously not been afraid to push back against market expectations they regard as too dovish (causing inflation forecast overshoots). Indeed Carney (unsuccessfully) attempted to do this in August (see here) so the risks seem skewed to him increasing the rhetoric a little next month (although MPC divisions seem to be growing while PMIs declining to EA levels and slightly disappointing wage and inflation data are counterviling forces).
Meanwhile I expect that small market expectations of BoJ action later this month will likely disappointed given Kuroda’s recent comments that inflation dynamics are as expected and that the current easing is having the intended effect on the economy together with an apparent focus on strong is on promising ‘shunto’ wage negotiations, low unemployment and hight corporate profits. So investors understandably wishing to avoid USD-based trades may find long JPY positions interesting. Specifically within G10 short EURJPY may well be attractive over the next couple of months given that: (i) the ECB is substantially less likely to disappoint dovish market expectations (I expect a 6-12 month PSPP extension to be announced in December as they revise their GDP and inflation forecasts lower, perhaps based upon an updated forecasting model); and (ii) both EUR and JPY are risk-off currencies, with the former reflecting the ECB’s negative rates policy, and hence would be roughly equally impacted by changes in market risk aversion around the next two FOMC decisions; (iii) EURJPY has moved rich relative to market rate expectations.
China: any number you want as long as it’s close to 7%
Recent Chinese data have been less disastrous than many in the market feared and the Chinese authorities seem to be rising to the task of supporting the economy (even if it likely exacerbates economy’s high-debt problem) – a hard-landing looks less likely than it did a few weeks ago, although markets undoubtedly also overreacted to the August PBOC yuan float decision (see here).
Specifically, manufacturing PMIs seem to have stabilised, albeit at sub-50 levels, FX reserve outflows have slowed and total social financing has picked up. It’s not all been positive, with import weakness has continued (-20.4% yoy!) with negative short-term impacts on commodity currencies like AUD. Today’s Q3 GDP data were, as usual, reported suspiciously quickly (less than three weeks after the end of the quarter!) and their close proximity to the 7% target (6.9% beating market expectations of 6.8%) raise obvious questions about their veracity. Such concerns are amplified by the strength of the services sector component (+8.6%) despite the recent steep Chinese equity price falls and financial services reportedly driving services growth earlier in year. So I’m not completely buying the good news story of the economy successfully and relatively seamlessly rebalancing away from investment/exports and towards consumption (which reportedly contributed 4pp of the 6.9% growth). And the more traditional drivers of Chinese growth fixed asset investment and industrial output were weak by Chinese standards (10.8% and 5.8% respectively).
But much of the improved market tone about China (which hasn’t yet gone so far as optimism) reflects announced fiscal measures and expectations of further monetary policy easing (give how seriously the authorities seem to be taking the situation). On the former, the government has announced some major rail infrastructure projects, cut first time mortgage downpayments to 25% and small car taxes to 5% and has contributed to the pickup in credit growth.
Discord amongst the Fed Governors
Market expectations of the Fed delaying hiking until 2016 in part reflect the very unusual situation of two of the five Governors on the FOMC (Lael Brainard and Daniel Tarullo) openly disagreeing with the Yellen and Fisher by identifying themselves as in the “wait until 2016” group (alongside Chicago Fed’s Evans and Minneapolis Fed’s Kocherlakota). While Yellen key ally Bill Dudley played down the apparent Fed discord (the “Fed has a clear, defined strategy”) markets seem to be listening to the doves more than the FOMC majority.
Brainard’s 12 October articulation articulation of her case for “watching and waiting to see if the risks to the outlook diminish”, was particularly interesting and dovish. Her bottom line that “the classic Phillips curve influence of resource utilisation on inflation is, at best, very weak at the moment…the fact that wages have not accelerated is significant” accords with my arguments in previous POSTS that a delay of a few months would be sensible. Downside risks also mean that the recovery needs to be carefully nurtured and they make risk management arguments for a delayed hike more relevant. She also argues that the tightening of financial conditions are equivalent to a couple of rate rises – and have been driven by USD’s rise, where she outlines adverse impacts on inflation and GDP. And broad channels of China impacts need to be considered (not just bilateral trade links). Tarullo also worries about the Phillips cure and that the natural rate of unemployment having fallen, arguing that he wouldn’t support a 2015 rate hike without “tangible evidence” of inflation and wages increasing. But he seemed more open to switching his view depending on the date in the next couple of months: “I want to hasten to add that that is an outlook that changes based on developments in the economy.”
On the other side Bullard (2016 voter) thinks that the “orthodox case” for a 2015 liftoff is clear given that the Fed has met its goals (it’s all about cumulative progress) but policy nevertheless remains at emergency settings. And the gradual pace of rate rises mean that policy wouldn’t be tight – it would provide plenty of insurance against any remaining risks to the U.S. economy, and simultaneously mitigate against the it will mitigate against the dangers of maintaining extreme policy settings. He also shot down the arguments to delay provided by continuing low inflation, low global interest rates and foreign developments. On the latter, foreign (China) policymakers’ responses means that the Fed doesn’t also need to react and he also reckons that EM countries are prepared for Fed liftoff. This echoes Fischer’s comments that foreign officials are telling FOMC to ‘just do it’ on liftoff, who also stated that “We do not currently anticipate that the effects of these recent developments on the U.S. economy will prove to be large enough to have a significant effect on the path for policy”.
Fischer also reiterated the September hold was motivated by the need to assess the China/EM situation. So if China is indeed turning the corner (and FOMC may well be more obliged to treat the data at face value than I am) then a 2015 fed rate rise becomes more likely (as long as it doesn’t overly tighten US financial conditions further). Markets don’t seem to have yet started to focus on that dynamic – they’re in a goldilocks scenario of Chinese growth being neither too hot nor too cold – but may start doing so if FOMC members start talking up the Chinese economic improvement.
Markets have also taken a bit of a glass half empty view on US data. For example, USD fell to a 2-month low on US retail sales rising by 0.1% in September versus market expectations of a 0.2% rise (i.e. a 0.1pp miss). While it would obviously be a worrying sign should consumption really be slowing, given that it’s been the main driver of recent US GDP growth, I’d caution against overinterpreting one months data, especially when the underlying consumption drivers remain apparently strong (e.g. a consumer confidence bounceback, strong auto sales) notwithstanding stagnating wages. Industrial production has fallen (month on month) in eight of the past nine months of 2015 data, although its only 0.7% down on its end-2014 level since the one month of positive growth (July) reported a chunky 0.8% rise. The picture is also better for manufacturing output, with output down in “only” five of the months in 2015 and output up 0.3% since end-2014. Indeed, US manufacturing output momentum is actually the strongest in the G4 (despite the USD appreciation). The market reaction to the stronger than expected US (core) CPI inflation, downplaying somewhat fears of Chinese PPI deflation would pull it down, also produced only a limited reaction (perhaps because markets are waiting to see the more influential core PCE deflator update – I’m not holding my breath for a strong number).
As discussed above, overall I think that the Fed should delay hiking until (early) 2016 but suspect that markets are under-pricing the likelihood of a 2015 Fed hike eventuating (given the overall body of Fed comments). And interestingly the FT today reported that 65% of the investment bank economists they surveyed are still backing a 2015 hike (down from 90% before the September FOMC), with 85% of those expecting a 2015 liftoff expecting two rate hikes by June 2016. So as I discussed here the moment of bond market reckoning may have only been delayed.
MPC and GBP: the US mini me?
The MPC (and GBP) have in recent months been viewed by markets as the Fed’s (and USD’s) mini-me – which is unsurprising given that both are at the front of the (slowing) central bank peleton and that the UK is a more open economy. But, as discussed above, market pricing of the first MPC rate hike not being until 2017 seems excessively dovish and vulnerable to an eventual repricing, albeit with the catch being that it’s difficult to predict when this will occur. My own take is that August 2016 BoE rate hike seems like a reasonable base case given the apparently-solid dynamics of the UK economy (albeit slowing a little recently) and the desire of UK policymakers to avoid having to eventually raise rates sharply (given still-high household debt llevels) by getting behind the curve. And as mentioned above the risks seem a little skewed to MPC leaning a but against very dovish market pricing when they reveal their November Inflation Report.
As I anticipated the MPC minutes were incrementally dovish (noting an “easing in the pace of activity” and discussing potentially greater labour market spare capacity and potentially shorter monetary policy transmission lags) but it wan’t all one-way traffic (“there had so far been few signs of a material effect on business and consumer confidence in the advanced economies” of the China/EM slowdown). But overall there quite a lot of treading water ahead of the November IR (not yet pushing back against very dovish market rate expectations before they’d crunched the numbers, as I anticipated).
Governor Carney quickly followed up with a repeat of his relatively hawkish stance (no unreliable boyfriend again yet!) that “policy comes into sharper relief around the turn of the year”. The extra soundbites were that “the rules haven’t changed….you can achieve your inflation target even in the face of some very large external forces” and that the Fed’ decision was “not decisive” for the MPC. Markets apparently again didn’t pay much heed to Carney, instead apparently alighting more on superficially dovish comments from new MPC member Vlieghe. But his concerns about downside risks from the global environment and view that inflation prospects were not strong enough to call for an immediate rate rise are pretty mainstream. Ditto his views that the next rate move is more likely to be up than down and that it’s “likely that the neutral rate is very, very low right now and that it is only rising very gradually over time”. His concerns about GBP strength in a weak global situation were more notable, although GBP is arguably strong precisely because most of the rest of the world is weak relative to the UK. Alongside that, MPC member Shafik argued that pre-emptive MPC tightening (to guard against debt worries) could be counterproductive.
But MPC member Forbes provided a more hawkish counterpoint, supporting Carney by arguing that the EM “doom and gloom” was exaggerated the slowdown, and the recent turbulence had not changed her expectation that the next move in interest rates would be up and would come “sooner rather than later”. That relatively upbeat take onclusion was in part motivated by the UK having low exposure to China and emerging markets, as Carney has also been stressing, and argued that greater EM links could actually close the UK trade deficit (relevant given the Chinese trip to London). But as the Fed’s Brainard noted last week (see above) non-trade channels such as asset price movements and banking sector exposures can also clearly matter.
The apparent greater market focus on dovish MPC comments appears explained by UK wages and inflation both having (small) nagative surprises. The small average weekly earnings slowdown (with private sector regular pay growth falling to 3.2% from 3.4% three months ago) grabbed headlines because it was not predicted by any of the Bloomberg-surveyed economists and hence provoked discussions of whether that was “as good as it gets” for UK wages (whose impact on inflation will in anycase be offset by apparently-improving UK productivity). But UK pay growth remains a shining light in comparison with the US or EA situation: the UK seems like one of the few places where the Phillips curve effect is apparent (while UK consumer confidence remains a relative strongpoint see here). But employment growth was again relatively strong and vacancy levels remain near record levels, if also slightly softer. So MPC will likely not yet be judging that the labour market has definitively turned based on these data, although the minutes did discuss potentially greater labour market slack. But the BoE agents will be tellling the MPC that recruitment dificulties are runnign at record levels (with over half of firms reporting difficulties). And indeed, firms told the BoE agents that they were planning on raising starting salaries to try and address their recuruitment difficulties.
The fallback of headline inflation back into negative territory was a little disappointing but will not have completely suprises MPC, who have previously been clear that they will look through near-term moves (which they can do nothing about) and have repeatedly said that they expect a sharp pickup in the next few months (on base effects). The disappointment that core inflation didn’t pickp is a bit larger. Moreover, the tendency for core CPI disappointments to be associated with GBP appreciations has continued – another reason why MPC will have been glad to have seen some respite in GBP’s rise (unlike the ECB’s increasing concern about the EUR’s nascent rise).
ECB: continued concerns about EUR strength, likely to act in December
While the lack of new staff forecasts means that ECB fireworks shouldn’t be expected next week, it will be interesting whether Draghi echoes Couere’s 12 October message that “it is certainly our duty to be prepared to cope with all kinds of contingencies” and/or Nowotny’s 15 October surprisingly dovish statement that “One has to say that we’re clearly missing our target…it is quite obvious that in the current economic situation additional sets of instruments are necessary“. While he noted on 11 October he noted that PSPP had “met and even surpassed our initial expectations” that seemed aimed at maintaining confidence that the ECB has remaining ammunition in an environment where investors are increasingly questioning the efficacy of QE policies and he reiterated that inflation hasn’t moved up as quickly as expected and that the ECB stands ready to act. But it will also be interesting to hear Draghi’s views on the potential adverse macro impacts of the the VW crisis (see here, this week’s PMI data should give us a taste of the scale of the effects): reports of auto price discounting aren’t that helpful in overcoming the EA’s deflationary tendencies.
But with the ECB concerned about nascent EUR strength (see here) and EURUSD remaining stubbornly close to 1.14, given increasingly dovish Fed market views, Draghi will likely not want to disappoint dovish market expectations. So he will likely leave the door wide open to acting in December. That said, the chart below illustrates that the ECB could have been even more worried if the EUR’s previous inverse correlation with equity prices had persisted – in which case EURUSD would have been closer to 1.20 (ceteris paribus). But the ECB’s September monetary policy account revealed that the ECB was starting to get more concerned about the continued close correlation between EA inflation breakevens and oil prices which I have been banging on about in recent months – recognising it as a potential sign of inflation expectations becomming de-anchored.
My expectation remains that the ECB will likely announced a 6-12 month PSPP expansion at their December meeting, when the inflation and growth forecasts seem likely to be lowered to more plausible levels (see here). Indeed, this could conceivably come alongside potential improvements to the ECB forecasting model to address it’s relatively poor forecasting record which ECB Vice President Constancio’s Jackson Hole paper hinted at.
But given the now near-universal consensus that the ECB will act in December (a Bloomberg poll todays shows 81% of surveyed economists expecting further action, up from 68% last month, although only 56% think that it will happen in 2015), if Draghi et al want to stem the nascent euro appreciation (which they are partly responsible for by making it a funding currency see here) it seems increasingly likely to have to again suprise on the dovish side (the Fed delaying liftoff into 2015 has ambiguous impacts on EUR). But it seems like the bar for such dovish suprises is rising: market expectations of further ECB (deposit) rate cuts have been growing, which is something that Draghi has explicitly previously ruled out (so there may be credibility concerns about a U-turn). They have managed to surprise in the past when push came to shove. And with EA inflation headline inflation, which the ECB tend to focus on, back in negative territory and credit and growth dynamics remaining fragile the ECB will appreciate that the stakes are high. I wouldn’t completely ruke out a surprise action this week, although that’s probably a less than 10% chance and would likely require EURUSD rising closer towards 1.20 to prompt it (which it doesn’t seem to be doing).