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.
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.
A climate of low yields and expansive central bank balance sheets has naturally complicated the pursuit of trades that can generate an expected annual return of ~20%. For this reason, we have been banging the proverbial drum regarding the opportunity for investors to be short-USD/ARS. This trade is a direct beneficiary of the Argentinian government implementing – outside the auspices of the IMF – a classic stabilisation plan, one that requires monetary policy to be tightened such that it stabilises and strengthens an exchange rate following the ending of an unsustainable FX peg. The long history of EM financial crisis suggests that when a country implements this policy framework and as long as there is sufficient political will to absorb the hit to economic growth – which there is in Argentina – then investors can harvest the outsized risk premia that is usually embedded in FX forward curves. They can also often expect capital gains from currency appreciation. The market’s scepticism towards the ARS is fading and the currency is experiencing growing investor focus. While the subsequent appreciation of the ARS and leftward shift in the USD/ARS NDF curve has reduced the attractiveness of entry positions, a short-USD/ARS position still has the potential to deliver 15-20% returns over the coming 12 months.
USD/ARS spot and forward curve
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.
Between mince pies, frenetic excursions for last minute presents, and family rows, the Christmas period can see noteworthy news slip past the gaze of many investors. One such development may have occurred in Argentina where USD/ARS has spiked over the past fortnight in response to the resignation of the country’s Finance Minister, Alfonso Prat-Gay, who was the most public face of Argentina’s attempt to return to the path of economic orthodoxy. The natural concern is that president Macri’s decision to ask for Prat-Gay’s resignation heralds a return to populism. Our preference for a short-USD/ARS position rests on the assumption that the Argentinian government will implement a well thumbed and battle-tested economic stabilisation plan, a central pillar of which is a tight monetary policy aimed at stabilising the ARS and limiting second round inflation effects of the December 2015 maxi-devaluation. However, while Prat-Gay was a critical visible face of the reform era, the broad-based support for orthodox economic policies in Macri’s administration is expected to ensure policy continuity. In fact, Prat-Gay’s departure may increase the likelihood of tight monetary policy being sustained. The ARS sell-off appears overdone, and the rightward shift in the FX forward curve provides an appealing opportunity to establish short-USD positions, and thereby place a non-correlated trade into an investment portfolio.
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: 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.
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.