The downside risks to the GBP have grown profound and are increasingly being actualised. We looked for 1.20 as an appropriate target for GBP/USD post-Brexit. However, this is far too conservative in light of the growing signs that hard-Brexit is the central scenario and the recent uncertainty over reflationary policy, amid government criticism of Bank of England and signs of a less ambition fiscal stimulus to come in the November statement. The critical thing for the authorities to do is to allow the GBP slide to take its course. The memories of 1992 highlight how self-defeating it would be to focus policy on an exchange rate in contrary to the needs of the economy. A greater concern is the need to reverse the emerging negative correlation between GBP and Gilt yields. This will require the Bank of England to reiterate how its monetary policy framework is intact and to restore confidence in the durability of monetary easing. The slump in the probability of a November rate cut by the BOE to just 8.4% might provide a “lottery ticket” way of positioning for the BOE to make such a statement. However, the uncertainties over the government’s response to the GBP slump means that positioning for further GBP deprecation may, for now, be a cleaner trade than looking for a renewed downtrend in Gilt yields. Indeed, were the authorities to fail to quell speculation that the GBP could become more of a focus of policy, the surge in Gilt yields and associated risk of capital reflux from foreign investors, may only be beginning.
The Fed’s search for a reason to raise interest rates risks creating a policy error. There is no compelling reason for the Fed to hike, or to forego its battle-tested strategy of trying to manage asymmetric economic risks. Moreover, one consequence of a steady downtrend in the Fed’s neutral policy rate is that monetary tightening will bite far sooner than in previous cycles: a 25bp hike could be equivalent to a ~75bp hike pre-GFC. The market appears right to be sceptical about the Fed’s “targeted” rate hike trajectory. However, a lower neutral policy rate would provide resilience to the US yield curve in the event of a Fed hike since this trend is compressing the “equilibrium” term structure of yields. Indeed, this lower term structure helped limit the scale of the summer sell-off in US interest rates, a move we expect to continue to be retraced. We see value in positioning for lower 10yr US yields in both spot and forward space. One risk for the Fed is that while it agonises over how to appropriately conduct monetary policy in a world of a lowered neutral policy rate, by hiking prematurely it could exacerbate its dilemma by helping to maintain this very downtrend in the neutral rate.
The Bank of Japan delivered a new monetary regime following today’s policy meeting. Unfortunately, the switch to a yield and yield curve targeting framework will lessen the authorities’ ability to achieve their growth and inflation targets. The new regime is internally inconsistent, lacks a theoretical anchor and may compel an early tapering of QE. The new policy regime may provide a support to investors looking to buy-JGBs and receive JPY IRS in the 10-yr area of the curve as the BOJ tries to limit sell-offs and create a path to stable roll and carry returns. (The “old faithful” JPY IRS 7fwd 3yr is a “receive” into today’s policy decision.) However, in so doing the BOJ will slow the flow of liquidity into risk assets by allowing Japanese financial institutions to maintain their deflation-focussed portfolio mix. The new regime will also make it more difficult for the BOJ to prevent continued downside moves in USD/JPY over the coming months.
In the 6-months since we first undertook a detailed analysis of the Saudi Arabian economy, little has happened to change our conviction that the 30-year old USD/SAR peg is inconsistent with a world where the price of oil is increasingly inelastic to the policies of OPEC. Despite the recent pick-up in oil prices, Saudi Arabia is still faced with the challenge of a widening current account deficit and declining FX reserves, while the need to limit the hit to GDP of lower oil revenues has resulted in a 21.6% of GDP budget deficit. Some optimism has been generated by the government’s plan to fund a Sovereign Wealth Fund by selling part of Saudi Aramco. However, establishing a SWF aimed at generating non-oil income may in part be inconsistent with the SAR-peg in the current climate: the much mooted sale of a 5% stake in Aramco over the next 18 months would likely generate funds that are equivalent to the decline in Saudi FX reserves over the past 12 months. Long-USD/SAR positions in the FX forwards continue to be attractive, as a larger risk premium needs to be attached to the SAR-peg, while the carry cost of such a position continues to represent a small price for adding convexity to an investor’s portfolio
The Bank of England has more than made up for it’s surprise inaction last month as today’s policy announcement met our expectations for both a rate cut and the resumption of Quantitative Easing. While the GBP60bn expansion of QE was less than the GBP100bn we were expecting, the BOE over-delivered in other areas: it signposted a likely move to a near-ZIRP policy this year; it unveiled a new scheme to help the transmission of the policy rate cut to the real economy in a manner which will also ease the burden of lower interest rates on bank earnings; it announced a GBP10bn purchase scheme for corporate bonds. Following today’s announcements many of our existing market forecasts might appear conservative. While we still expect GBP/USD to head below 1.20, our 25bp target for 10y Gilt yields appears too high. Indeed, with Gilts expected to be increasing viewed as collateral rather than yield instruments over the coming quarters, the downside for Gilt yields is substantial. Our target for the GBP IRS 10fwd 10yr of 1.0% also looks conservative with 0.75% appearing more likely. However, from an economic growth perspective today’s announcements can only have a muted impact in offsetting what we expect to be a 3% Brexit effect on UK GDP growth. The baton now must pass to the government where we believe a 2% of GDP fiscal stimulus is urgently required.
The compelling economic challenge in most major economies is for an improved coordination of policy across reflationary levers, so that policy-makers can tackle the slow burning global growth crisis. The extreme degree of policy coordination – Helicopter money – may be a desired end-state for many economies. There is of course a dark side to such a policy of “inflationary” deficit financing. Emerging markets are replete with examples of central banks under-writing fiscal spending in a manner that has spurred economic dislocation and undermined investment returns. The damage these policies have reaped on various emerging markets stems from the fact that, unlike candidates for helicopter money, many emerging market central banks have monetised fiscal debt at a time when there is no zero bound problem for monetary policy and when the key economic challenges are not insufficient demand and downside risks to inflation. Argentina provides a prime example of the problems of inappropriate inflationary deficit financing. A decade of populist rule left the new President with a legacy of unsustainable budget deficits, high inflation, weak economic growth and an unpredictable regulatory regime. In contrast to many key leading economies, Argentina’s challenge is to disentangle monetary and fiscal policy and thereby return to economic orthodoxy. Reining in the budget deficit is a critical success criterion for the government’s stabilisation plan. While the government faces a daunting economic challenge, the market has expressed confidence in President Macri by maintaining long positions in the country’s Eurobond debt. By contrast, following a maxi-devaluation, sentiment in the ARS remains weak. However, we think that the risk premia on the ARS priced into the FX forward curve is too high since a tight monetary policy and a more stable ARS could be crucial components of a stabilisation plan over the next 12-months. We see value in establishing short-USD/ARS positions, which can potentially bring to investor portfolios a high return trade that is uncorrelated to prevailing market beta.
The ARS risk premium priced into the FX forward curve seems to high: opportunity to short-USD/ARS
One positive side effect of the UK vote for Brexit appears to be a policy shift away from austerity towards an embrace of reflationary fiscal policy. This has the potential to meaningfully change the UK’s economic growth outlook. Moreover, the expected UK policy shift is part of an evolving global theme whereby more policy-makers are starting to address one of the key factors behind the slow-burning global growth crisis – a lack of policy coordination between reflationary levers. The US presidential candidates each propose a more activist fiscal policy, Canada’s government is enacting its election pledge of fiscal stimulus, while Japan may soon combine fresh fiscal stimulus with QQE3 and potentially the “Hail Mary” opinion of Helicopter money. These are encouraging signs, and may offer some hope that the world economy may not reach the deflationary end-state that appears to be it’s current destination. However, optimism needs to be tempered. Any fiscal easing in the UK will be aimed at avoiding recession rather than accelerating recovery, and may fall far short of the 2% of GDP we feel is required over the next 12 months. The UK policy change reduces severe left-tail risk with respect to the GBP rather than comprising a bullish scenario: GBP/USD is still expected to move below 1.20. Globally, with a few exceptions, progress towards sufficiently aggressive and broad-based policy reflation remains patchy, and geographic coordination remains poor as policy-makers still address multi-lateral problems with bi-lateral solutions. Nonetheless, that more policy-makers are embracing more economically optimal policy options can only be a positive trend for global growth. In terms of Japan, which is closer to the point of radical policy coordination and where policy mis-steps of the past 12 months require bold action from the government and Bank of Japan, we see value in owning deep out of the money upside in USD/JPY while CAD/JPY could be an interesting play on relative policy dynamics. Meanwhile, stay receved JPY IRS.
The BOJ’s soon to be majority ownership of the JGB market blurs the line between QQE and helicopter money
Within a slowing global economy that is replete with potential event shocks, the Eurozone stands apart from other major economies in terms of its lack of policy flexibility. Monetary policy has to remain the dominant source of reflation, with the diminishing multiplier effect this entails, while fiscal policy remains overly tight and regulatory policy comprises a notable tightening of monetary conditions. To make matters worse, Germany comprises a “deflation engine” at the heart of the Eurozone. This is an unstable equilibrium with respect to the medium-term durability of the Euro. More immediately a lack of policy flexibility comes at a time when some key inflation measures in Europe are flashing deflation warnings while concerns are building with respect to the banking sector solvency of some Eurozone countries, most notably Italy. The negative interest rate and QE policies of the ECB complicate translating these risks into investment themes given that they seek to suppress credit and risk premium in financial asset. However, the current structural and cyclical forces in Europe reinforce the value in core bond markets despite the ticker-shock of low/ negative yields: Bunds, for instance, should continue to trade more as collateral instruments with an embedded FX option rather than yield products. There is also value emerging in trades that fade the ECB action with respect to select non-core sovereign bond markets, with the proviso that trades need to be structured appropriately: a BTP curve steepener, or short BTPs and long Bunds or USTs in the 10-yr area offer value. Meanwhile, Eurostoxx are expected to persist their marked under-performance of US equities while high yield and financial credit spreads appear increasingly vulnerable, particularly as they lie outside the ambit of ECB QE. Finally, an increasingly structural outflow of capital is expected to establish a medium-term trend of EUR weakness.
EUR 5fwd 5yr inflation swap: warning lights and wailing klaxons regarding the prospect for price stability.
In the post-Brexit political turmoil that has engulfed the UK, the Bank of England is providing some required adult supervision. It’s early diagnosis of the economic impact of the Brexit vote allied to it’s policy response – talk of monetary easing, and the Financial Policy Committee’s easing of financial conditions via the regulatory channel – are necessary and welcome. However, a theme of the post-crisis global economy is that monetary policy should not bear the brunt of reflationary policies due to diminished money multipliers. Fiscal policy needs to be more active. Unfortunately, the government’s talk of corporate tax cuts will do little to address the looming problem of insufficient aggregate demand and of the risk that UK consumers copy their US counter-parts and increase their savings rates. A policy response that is uncoordinated across reflationary levers implies continued downside for the GBP, which we expect to depreciate to below 1.20 vs. the USD. Meanwhile GBP interest rate markets have continued reason for strength. We continue to see the 10yr Gilt yield moving flat to a lowered (0.25%) policy rate, and over the coming months see receiving the GBP IRS 10fwd 10yr becoming a higher beta play on the GBP yield curve.
The policymaker response to the slow burning growth crisis of the global economy remains uncoordinated across geographies and reflationary levers. It is a path that leads to mounting non-linear risks for global markets and growth. The global economy needs a more effective and coordinated policy response, one that can raise aggregate demand but also prevent some of the increasingly persistent, cyclical restraints to economic growth becoming structural. While there are growing signs that some key countries may switch to more effective reflationary policies, in all too many cases the political barrier to appropriate policy remains high, and may first require a period of pronounced market and economic dislocation which could mean a pyrrhic victory for investor portfolios positioned for a switch to reflation. However, short-of a sufficiently bold policy reflation, there are a number of policies which could meaningfully improve cyclical and secular global growth and which may face a lower political barrier to implementation. Some of these are already emerging onto the global policy agenda, and have the potential to provide a much needed upside risk to growth and market performance.
US worker productivity – An example of how insufficient and misdirected reflationary policies can lad to a cyclical restraint to growth becoming a structural one
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