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.
In our recently released strategy note (The Gilt sell-off, mounting UK economic risks and an inflation scare that rhymes) we outlined that the upsurge in UK break-even inflation rates to over 3% had over-stated the likely path of UK inflation. Admittedly, the slump in the GBP will drive import prices higher and could see the Bank of England’s (BOE) 2% inflation target overshot by over 1% within 12-18 months. However, the laggardly nature of wage growth and growing downside risks to the economy will mean this poses more of a threat to household disposable incomes and hence private consumption more than it will spark a second round inflation effect. A steep disinflation if not deflation will follow the import price shock.
Chart 1. The UK CPI-RPI wedge is cyclical
One rejoinder to the view that BE spreads have overshot is that the reference rate for UK Linkers is the RPI rather than the CPI. Due to numerous computational and compositional weaknesses, the RPI substantially overstates the level of inflation as determined by the more robust CPI. This “inflation wedge” currently sees the RPI 104bp above the 1.0% Y/Y rise in the CPI and over the past 5 years has averaged 71bp, which has been the medium-term differential. BOE analysis suggests that the wedge could rise to 1.4pp over the long-term. This questions whether UK BE inflation rates have actually overshot since a 3% RPI may be consistent with a CPI of 2% or lower.
This is a viable criticism. However, there is a strong cyclical component to the UK inflation wedge. One of the reasons why the RPI tends to be higher than the CPI is that it includes measures of housing price trends and mortgage payments. Both of these measures tend to move lower into a UK economic downturn. Chart 1 demonstrated how the CPI wedge turned steeply negative in 2008-2009 when the UK economy went into a deep recession, and then reasserted a positive differential as the recovery matured. Given our growing concerns with respect to the UK economic outlook, we would expect the cyclicality of the inflation wedge to narrow the differential between the CPi and the RPI. Hence, we feel confident in believing that UK BE spreads have over-short the likely path of inflation.
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 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.