Of excitement and regret
It is with decidedly mixed emotions that I report that Event Horizon Research will be tenderly and proverbially, covered in bubble wrap and placed in storage. EHR will no longer provide economic and market analysis, advice and strategy – either in written or verbal form. I would to thank our clients and readers. It has been a wonderfully enjoyable ride.
The reason for shuttering EHR is that I have decided to return to the buy-side. As excited as I am about the position I will accept and the organisation I will be joining, I still feel sadness at closing EHR. On one level, when you pour your energy into building a venture from the ground-up you come to think of your creation as somehow, organic. A second, and much more prosaic reason for my maudlin mood is the realisation that the balance of probabilities suggest that in my new institution, I will no longer have the option of deciding to work in my underpants.
Fig 1. A form of work attire that is unlikely to be maintained
A third source of poignancy is that I will not be able to update the analytical narratives I had been building.
The UK budget confirmed the conclusions we reached during last year’s autumn statement – that UK fiscal policy will remain far too tight to offset the building economic risks of Brexit. Austerity remains a policy leitmotif of the Conservative government. Even Chancellor Hammond’s talk of 1.1% of GDP “fiscal headroom” to support the economy after Brexit is likely to prove illusory given that it rests on assumptions of a soft Brexit and no subsequent fiscal payments to the EU. The risks to UK economic growth are skewed to the downside over the coming 24-months and the Bank of England will remain the only source of offsetting counter-cyclical policy stimulus. We still see the next move from the Bank to be a further monetary easing, despite the high levels of headline inflation. We also stick to our core views: Gilt yields have yet to see their cycle low, and GBP/USD remains a sell towards 1.05.
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.
The USD has not reacted well to the early days of a Trump Presidency. Hopes for a pivot to the political centre have receded into the rear view mirror as Trump has started enacting his policy pledges. As controversial as these policies have been, the nature of the implementation process has been an additional source of concern: a lack of planning, coordination and prioritisation has inflated concerns that Trump and his team are not ready for administrative Prime Time. However, to adapt a sporting phrase – when looking at the longer-term impact of Trump on the USD and US assets one has to try and follow the ball rather than just the man. We still believe that Trump’s economic policies have the potential to create a sugar rush period of stronger economic growth in the US and lay the foundation for a USD overshoot. This does not mean that the experiment with Trumponomics is likely to end well. His policies are expected to ultimately exacerbate the slow burning growth and income crisis that laid the foundations for his election victory. Trump rode a populist wave but he is no populist. This feeds into our view that the US interest rate market is reaching levels where investors can look to buy-USTs/ receive IRS. Nonetheless, over the coming months the current correction lower in the USD is likely to provide a compelling buying opportunity, particularly against the currencies of Asia ex-Japan where Trump poses a substantial threat to the region’s already struggling growth model. Meanwhile, his policy platform and his administration’s decision-making process both reinforce our view that the global markets have moved to a new and higher volatility regime.
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
Many of the key concerns over the outlook for UK economic policy have been eased over the past week. Concerns over Bank of England independence and of the possibility of monetary policy being focussed on the GBP or imported inflation have all eased. The conditions have been laid for a breaking of the recent negative correlation between GBP weakness and Gilt yields. However, concerns have grown that the government will prove insufficiently ambitious with respect to fiscal expansion, which adds to our concern that the BoE is over-stating the outlook for economic growth into 2017. Further monetary expansion into H1 2017 appears likely. While there are some significant potential pot-holes for the global economy to traverse, most notably the forthcoming US Presidential election, it is time to start looking for opportunities to scale into long-Gilt position by building-up DV01 to the target level into weakness. From a medium-term perspective Gilt yields have yet to reach their cycle low.
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
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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.
A fragile world economy that faces an ever more daunting battle to combat deflation and where there is a growing concern that traditional reflationary policy levers are reaching their effective limits, could have done without another event shock. And yet that is exactly what it has received as the UK voted for Brexit. To make it worse, the subsequent political unravelling in the UK had created the impression that the country is rudderless as it seeks to navigate through the dangerous path the electorate has chosen. The PM has resigned and remains as a care-taker, the main opposition party is in turmoil with a leader at best luke-warm to Europe and whose consistently weak performance has sparked internecine warfare in the party, while it has become clear that the Brexit leaders do not have a plan of implementation or are even aware of the full implications of Brexit. The market turmoil appears fully justified. That said, for international markets the Brexit impact is likely to be more akin to the December-February market rout – painful, deep but finite. Brexit is not the trigger point to ”The Big One”, the financial crisis we fear is coming. However, for the UK – unless reason prevails and Article 50 is not triggered – the outlook is bleak. GBP has enormous downside potential, while Gilts may become Bund-like in that they are viewed as collateral rather than yield instruments. 10-yr Gilts could trade flat to a lowered policy rate.