Updating the Divergent Monetary Policy Theme

The main thrust of our bullish US dollar outlook is the divergence in monetary policy trajectories. We do not think the divergence has peaked and anticipate it to persist through next year and into 2017.  

The main thrust of our bullish US dollar outlook is the divergence in monetary policy trajectories. We do not think the divergence has peaked and anticipate it to persist through next year and into 2017.  

Since the Federal Reserve finished QE3, the divergence has been driven by easing of policy by the European Central Bank and the Bank of Japan, and a broad number of high and medium income countries, including China. We expect the Fed to participate in the divergence by raising rates.  It has been particularly challenging this year to time the Fed’s lift-off, but the vast majority of Fed officials still anticipate it taking place this year. Of course, some doubt this, and a few Fed officials prefer to wait until next year, but fund managers, corporate treasurers, pension managers and debt managers recognize the risks of a move this year.  In addition, investment is just as much about risk management as it is about securities analysis. 

We thought it helpful to frame this week’s discussion about the macro-developments in terms of the divergence meme.  On balance, we expect the developments in the week ahead to strengthen the theme.  Barring a surprise, which is always possible, the key US economic data is expected to show that labor market slack continues to be absorbed, the core PCE deflator may tick up, and the consumer is still healthy in terms of real consumption and new auto sales.  

No fewer than eight Fed officials have speaking engagements in the week ahead.   Aside from Chicago Fed’s Evans, we would be surprised if any of the speakers disagreed in tone or substance from Yellen’s remarks from last week.  

On the other hand, the Eurozone’s preliminary read of September CPI may ease back to zero from 0.1% while the manufacturing PMI softened.  The ECB staff cut its growth and inflation forecasts earlier this month.   While ECB officials have indicated that it is still monitoring developments to understand if the flexibility of its asset purchases is necessary.  Evidence needs to accumulate, and that evidence is largely in the form of economic data.   The economic reports paint a picture of a region that is expanding by a little more than 1% annualized pace with no price pressures. The growth is too slow and inflation too low to allow the region to grow from under its debt burden.

Before the weekend, Japan reported that August core inflation (excludes fresh food) slipped back into deflation for the first time since April 2013.  The government downgraded its economic assessment last week.  The Tankan Survey this week is expected to show minor deterioration in sentiment among the longer companies, and a somewhat more worrisome slowing in capital expenditure intentions.  

If there is one thing missing from a compelling case of further measures by the BOJ, it is an apparent lack of will. Governor Kuroda has consistently found a silver lining in the cloud of economic and price developments.  He pragmatically does not limit his assessment to the targeted core measure.  Instead, he has referred to price pressures being significantly stronger if energy prices were excluded. 

It is not clear that what an increase in the monetary base of say JPY90 trillion a year will accomplish that JPY80 trillion has failed to do to, namely core consumer prices.  Nevertheless, many expect the BOJ to announce expanding is asset purchases, not just altering the composition for operational reasons, next month.  The Tankan survey will not stand in its way if that is what it wants to do.

Sweden has responded forcefully to the threat of deflation by buying government bonds and posting a negative deposit rate.  Its economic activity remains impressive with a 3% year-over-year expansion in H1.  The manufacturing PMI this week is expected to increase from 53.2 to 54.0, which would match the 12-month average. 

In contrast, Norway’s challenge is weak economic activity, not deflation.  That was what was behind last week’s rate cut that surprised many.  The manufacturing PMI has been below the 50 boom/bust level since April.  The risk lies to the downside of the Bloomberg consensus 44.0 reading (from 43.3).  The Norges Bank signaled an easing bias.  It may take a few months to act on it, but unless the data turns around, that is the most likely scenario. 

The Bank of England is also wrestling with the timing of its own lift-off.  The same logic that says the Fed may have missed its best opportunity to hike when it stood pat in June suggests the BOE missed its best opportunity as well.  Although the Q2 GDP revisions are not expected to be material, the UK economy does appear to have slowed in Q3.  The UK expanded average 3% growth in H2 14, and 2.75% growth in H1 15, it is set to slow toward 2.3% in the second half.  There is no pricing power, inflation, to speak of, and the wage pressure appears, at least partly, to reflect a shift in the composition of employment. 

Indeed, sterling has lost favor as the pendulum of market sentiment has swung away from an early BOE hike.  In fact, looking at the June 2016 short-sterling futures contracts, the hawkishness peaked in late June with an implied yield 113 bp.  On September 24, the implied yield made a new life-of-contract low (high in price) of 71 bp. 

Given the developments over the past couple of months, investors are particularly sensitive to developments in China.  In the week ahead, the official PMIs will be reported.  If the monetary and fiscal stimulus that China has deployed can be expected to help the large state-owned sector, then the official PMI may begin to stabilize before the Caixin measure, which tends to give more weight to smaller, private sector firms.

The Shanghai Composite has spent the past four weeks chopping along the trough after falling by around 45% from the mid-June high.  As it has moved broadly sideways, its impact on other markets appears to have lessened.  However, a break of the lower end of the range, around 2980, could have a new knock-on effect. 

China is very much part of the divergence story, which is one of the reasons it is succumbing to the pressure to loosen the link between the yuan and the dollar.  It was not ideology, or a new passion for markets, it was good, old pragmatism.  Linking the yuan so tightly to the dollar had become increasingly a headwind while the operational conditions for joining the SDR required some tweaking of its currency regime.  

We continue to believe the capital outflows from China are being exaggerated.  Some of the missing capital may reflect the reform measures that allow businesses greater control over their foreign exchange earnings.  Often the decline in China’s reserves is cited as if it were simply a quantity of money rather than the dollar valuation of some quantity.  More than half of the decline in China’s reserves over the past year can be accounted for by valuation swings.  

Nevertheless, the capital outflows that do exist, suggest that a further embrace of market forces could see the yuan lag further behind the dollar in the next leg up.  With soft non-food prices, there is still plenty of scope for the PBOC to ease further.  This includes the reserve requirements, which were a macro-prudential tool to siphon-off some of the hot money that had flowed into China previously. 

There are other issues, which will command attention.  First is the risk of a US government shutdown, if a clean temporary spending authorization bill is not passed by the end of the month.  House Speaker Boehner’s resignation as of the end of next month gives the Republican moderates an upper hand, albeit only for a few weeks.  The mid-December debt ceiling has more disruptive potential, and Boehner’s replacement may need to be bloodied by confronting the White House early in his tenure. 

Second, another “last” push for the Trans-Pacific Partnership (TPP) will take place this week (in Atlanta).  There are three major outstanding issues that remain divisive: dairy trade, auto manufacturing, and patent protection for pharmaceuticals.   Each passing month without an agreement pushes the issue deeper into the US national election.  Even if an agreement were reached in the coming days, which seems unlikely, Congressional support, even on the fast-track conditions, would not place for a few months.   It could split the Democratic Party.  A Biden campaign would, of course, be in favor while Clinton’s base would push her away from support, and Sanders is a clear critic. 

Third, Europe is being challenged by a number of crises simultaneously. Russia/Ukraine is simmering while a new front has been opened by Russia escalated support for Assad.  The refugee problem, primarily from Libya and Syria, where the US and European involvement has been strong is exposing new fissures in Europe and deepening pre-existing ones.  Greece has returned Syriza to power, and implementation of the agreement with the official creditors will likely be seen as a new phase of negotiations. To this list, add politics in the Iberian Peninsula.

Catalonia holds elections today (September 27).  Locally the election is being billed as a referendum on independence, and the head of Catalonia promises independence within 18 months if his coalition of secessionists’ wins.  Early indications suggest the turnout is heavy.  The secessionists will be fought tooth and nail by Madrid, which can count on the EU and other countries for support.    A tense period lies ahead, and this is before national elections that will be held before the end of the year.  

Portugal will hold national elections next month.  Regardless of the electoral outcomes, we anticipate that next year, the IMF will step up its pressure on both Spain and Portugal to take more measure to boost growth potential while reducing debt.

The takeaway is that the near-term developments will likely strengthen the divergent forces.  Barring a particularly poor employment report (and remember that the August series is often revised up), the Fed will be guiding market expectations to still expect a hike this year.  European, Japanese, and Norwegian data will add to pressure to ease further.  The failure to reach an agreement on TPP may be dollar and yen negative if everything else could be held constant, meaning that it could be overwhelmed by the usual market noise.  Europe is facing several challenges, and a new front may open as Catalonia likely pushes harder for independence. 

Divergence Drivers and the Dollar is republished with permission from Marc to Market