Of farewells, underpants and unfinished themes

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.

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Scotland – the economic and exchange rate backdrop for independence

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.

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The UK budget – hitting an economy when it’s down

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.

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The BOJ’s SNB moment? JGBs, USD/JPY and potential negative convexity

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.

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The USD surge: Tighter UK fiscal policy highlights diverging global policy settings

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

As for Generals, so for central bankers: USD/JPY and the BOJ’s pro-cyclical policy framework

As for generals, so for central bankers: sometimes, good fortune can be the most beneficial of virtues. The market reaction to Trump’s victory and his reflationary policy stance has meant that the Bank of Japan’s recently changed monetary framework has emerged as an accelerant to JPY weakness and has enhanced domestic monetary reflation expectations. The new yield curve-targeting framework is inherently pro-cyclical. With the BOJ’s yield cap set to accelerate JPY liquidity creation and widen the USD-JPY yield differential, USD/JPY is likely to remain a higher beta G10 component of the trend of broad-USD strength. The current uptrend in USD/JPY may have much further to run, with a return to the 120-levels likely over the coming months. However, high beta properties cut both ways. The pro-cyclicality of the new policy framework could accelerate JPY strength were global reflation hopes to fade or risk appetite diminish. This reflects how the BOJ’s policy framework essentially rewards Japanese financial institutions that adopt a traditional, deflation focussed and JGB heavy portfolio allocation. As such, while we see continued upside potential for USD/JPY over the coming months, investors could consider investing part of their profits of the short-JPY trade in downside protection. Meanwhile, on moves above 115 we would consider rotating USD-longs more fully towards the EUR or continued short-exposure to emerging market currencies, particular those in Asia.

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UK – the emergence of economic policy clarity

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.

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The Gilt sell-off, mounting UK economic risks and an inflation scare that rhymes

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.

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BOE’s need to allow the GBP slump to run its course and break the negative correlation to Gilt yields.

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.

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The falling neutral Fed Funds rate – a yield curve anchor and insulation against a Fed policy error

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.

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