The Brexit decision was always likely to create a renewed threat to the political union of the UK, and sure enough Scotland has called for a renewed referendum on independence. The economic argument for Scottish independence remains weak. Scotland’s fiscal position, combined with it’s ambition to rejoin the EU, would ensure years of painful economic austerity. Moreover, Scotland’s weak external liquidity position and the UK’s opposition to the country retaining the GBP means that the most realistic options for a future monetary anchor would be a currency board or, and far more appropriately, a floating exchange rate. Both options come with macro-economic costs. However, while economic arguments held sway over the Scottish electorate during the 2014 referendum, Brexit has weakened their impact: the UK government is embarking on an aggressive, multi-year policy of fiscal austerity, meaning that the choice facing Scottish voters would be to choose their path of fiscal restraint; Brexit means that Scottish independence could mean a path into the EU or EEA; the coalition of political parties that would fight against Scottish independence would be far more fragmented than in 2014. As the UK government moves towards a hard Brexit, the pressure for a second independence referendum is unlikely to dinimish, and will represent yet another factor that weakens the multi-year outlook for the GBP.
As the BOJ steps up its rinban operations to defend its yield cap, it is demonstrating the unusual pro-cyclciality of it’s monetary framework: during times of improving growth expectations and rising yeilds the pace of BOJ liquidity creation is biased to increase, and vice versa. The failure of the era of Abenomics to end Japan’s multi-decade experience of deflation argues in favour of the BOJ defending it’s yield cap. As such, with a lag domestic investors could start to allocate more funds to JGBs and there is the potential for the JPY IRS 7fwd 3yr (the pivot point of the curve and our favoured way of expressing bullish views on JPY interest rates) to rally 25-30bp over the coming 3-6 months. However, we cannot recommend such a trade with any degree of conviction. Our bias is to seek trades with a positively convex return profile, but being received JPY interest rates essentially makes investors “short” the potential for a possible BOJ regime shift in policy formation. While we feel this is unlikely, Japan’s long history of policy mis-steps and the experience of the SNB and its decision to break its FX floor, both provide reason for caution. We have greater comfort in expressing a short-JPY FX view, particularly against the USD. While USD/JPY is clearly correlated to the JGB trade, there are some independent dynamics that could argue for the recent correction lower in USD/JPY running its course and reversing.
Hopes have been building that the ineffective global policy response to the slow-burning global growth crisis would be transformed, that belatedly policy would be coordinated across reflationary levers and there would be reduced reliance on monetary easing. The election victory of Donald Trump embodied this hope given his commitment to a fiscal stimulus. However, while the expected combination of looser fiscal policy, tighter monetary policy and faster growth in the US into 2017 has underpinned a surge in the USD, hopes for a broader global reflation are likely to be disappointed. Outside of the US, much of the G10 remains overly reliant on monetary stimulus. The latest example was the UK and the government’s Autumn Statement, or mini budget. We believe that the coming Brexit-related downside risk to growth requires a 2% of GDP fiscal stimulus, to augment the Bank of England’s August policy ease. In contrast, the government announced a tightening of fiscal policy over the coming 5 years and austerity remains it’s political leitmotif. This adds downside risk to UK economic growth and to the GBP which we still expect to hear towards parity vs. the USD, while Gilts could be poised for a recovery. More broadly, the increasingly divergent policy mix of the US compared to other G10 economies is likely to help spur further USD appreciation against major currencies into 2017. It will also maintain a trend of weakening emerging market currencies. Continue reading
It has happened. The continued failure of global policy makers to address the compelling economic challenge of our age – the slow burning global growth and income crisis – has spurred the US electorate to embrace the anti-systemic. Much of the world will wait to see if president elect Trump pivots towards the centre in terms of his economic, social and trade policies. As we wait, we can consider what would happen if President Trump was not bluffing, if he enacts his full economic agenda. While this is unlikely, it provides a possible limiting extreme in terms of the potential economic and market impact of a trump Presidency.
Some implications leap out. A fiscal expansion that could dwarf the Bush tax cuts – a package amounting to a USD5.8trn expansion in Federal debt – would provide a sugar-rush leap to economic growth. The switch to fiscal reflation would enable the Fed to enact it’s desire to tighten policy, and could reverse the multi-year downtrend in the neutral Fed Funds rate. The consequence is highly negative for USTs. Meanwhile, President Trump’s stated desire to weaken the USD could be initially undermined by policies to encourage a repatriation of overseas liquidity and by a policy outlook for much looser fiscal and somewhat tighter monetary policy. Trump’s projectionist leanings could also spark crisis among key emerging markets, with China being particularly vulnerable, as Beijing may be pressured into implementing deflationary policies at a time when its highly levered economy was struggling with a structural slowdown. Into the initial period of “Trumponomics”, US risk assets could defy conventional wisdom and perform well into the expected flurry of activity in Trump’s first 100 days, especially in relation to overseas markets.
However, from a longer- timeframe, optimism in the immediate US economic and market response to untrammelled Trump policies could be fleeting and represent a pyrrhic achievement. Undiluted Trump policies would represent an accelerated withdrawal of the world economy from 40 years of globalisation and liberalisation, which has so supported economic and financial market growth. The significance of this regime shift could not be over-stated. Actual and potential global growth would continue to fall, as would the alarming decline in global productivity growth. This would be an economic story that may not end well. Hence, hope for the policy pivot and if not, enjoy the sugar-rush phase of growth which may not last
The continued negative correlation between GBP weakness and Gilt yields is a threat to the UK economy as it at least in part negates the expansionary effect of BOE monetary easing and indeed of GBP weakness. It may also lessen the ambition of the UK government to initiate a much-needed fiscal stimulus. This is concerning since the UK economy is particularly ill equipped to withstand the Brexit shock. Households – the core driver of the post-GFC economic recovery – face the shock with a weakened balance sheet: nominal wage growth remains weak, and rising inflation will squeeze disposable incomes; households have rapidly increased leverage in recent years; flow of funds data shows UK households to be dis-saving at a rate last seen on the eve of the GFC.
In terms of the drivers of Gilt weakness, the variable we are least worried about is the concern over inflation. While higher import process will see the CPI exceed the BOE’s 2% inflation target, insufficient wage growth will mean this poses more of a threat to growth than to medium-term inflation. This is a story of FX and commodity price shock to headline inflation that we have seen play-out many times in G10 economies over the past decade. Now is no different. BE inflation spreads have already widened to the point where they significantly over-state the likely path of inflation. Similarly, concerns about the impact of a foreign investor flight from Gilts may prove over-stated. However, while we have maintained our bullish medium-term forecasts for Gilts, any near-term appetite to fade the rise in nominal yields is tempered by an understanding of how it may take some time for the market to recognise that the current inflation scare is over-stated and also by the emerging signs that the government may persist in its recent criticism of the BOE’s loose monetary policy. The latter poses a particular threat to the Gilt market, and ultimately the GBP and UK economy, if it reinforces the increasingly common – and persistently incorrect – viewpoint that the UK requires tighter monetary policy.
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