Market Insights

Politics v Economics

The battle between these two ancient disciplines is hotting up. Well, I say ancient, it’s hardly Latin v Greek, but in terms of what is driving the market there’s certainly a face off emerging between old-school central-bank economics and fresh-eyed-newcomer politics. Viz.:

Central banks are taking away the punchbowl

…it’s just they’re trying to do it very very quietly, so as not to disrupt the party too much.

  • The ECB have already tied themselves into explicatory knots as they battle a stronger currency, telling us that it’s OK as long as its caused by ‘exogenous’ factors, because then its impact of bearing down on inflation can kinda be ignored.
  • Then last night we have the Deputy Governor of the Bank of Canada telling us that “each decision is a live decision” but also that “as the Canadian dollar is strengthening, we’re certainly watching that closely and we’ll be taking that into account pretty strongly in making our decisions“.
  • And the RBA Minutes revealed again that while they’re happy with good jobs growth, and aware that super-low rates may contribute to excessive household debt, a strong AUD ‘was weighing on domestic growth and contributing to subdued inflationary pressure. A further appreciation of the Australian dollar would be expected to result in a slower pick-up in growth and inflation’.
  • Meanwhile Mark Carney lived up to his politician reputation with his speech last night, where he attempted to refine last week’s hawkish comments from his BOE. He appears to have taken a leaf out of the ECB’s songbook, by attempting to re-frame the argument using economic terminology. Rather than ‘exogenous’, he gropes instead for the trendy concept of “r*”, or ‘the natural rate of interest’ arguing that ‘The case for a modest monetary tightening is reinforced by the possibility that global r* may be rising, meaning that monetary policy has to move in order to stand still‘. This is classic Carney, using the language of the doves to turn hawkish… hey, we’ve got to raise rates otherwise they won’t stay low, yeah? All else being equal?

Thanks guys. Deliberate obfuscation is never helpful, even though you think you’re doing it so as not to frighten the market’s horses into another taper tantrum. Falling over yourselves not to worry people just means there’s not enough clear information for those people to make decisions. Hence both GBP and CAD sold off after those comments, only to rebound hours later. The long-term upshot is understood though: interest rates are turning.

  • The Fed could put the kibosh on this in their meeting tomorrow, of course. Just how worried are they about inflation? Did last week’s stronger than expected reading give them an opportunity to exhale? Or are they just marking time while Trump appoints their new leader (and around half of the rest of the Governing Board)?

Politicians are preparing for a punch-up

….or at least they are doing so more openly.

  • The power vacuum since Theresa May’s shock election miscalculation is now blowing up into open warfare. The only surprise is why it took so long. She is Leader of the country in name alone, fatally wounded but propped up by a team of warring puppet-masters who are merely biding their time before plunging their knives into one another to emerge as her successor. This Caesarian tragedy has only just begun. Ken Clarke popped up this morning as the wise narrator, with a telling off for Boris Johnson’s weekend article on his vision for Brexit: ‘Sounding off personally in this way is totally unhelpful and he shouldn’t exploit the fact she hasn’t got a majority in Parliament. He knows perfectly well that normally the foreign secretary would be sacked for doing that’. And while the Tory Party squabbles, the clock ticks down. The next round of Brexit negotiations with the EU has been pushed back, due to ‘Britain’s political calendar’, or rather, we are heading into the Conservative Party Conference, they’re all back from the summer recess, and now they’ve got to decide on a common direction. This, 6 months after Article 50 was triggered, and 3 round of ‘negotiations’ have already taken place. Forgive Blondemoney’s scepticism that this isn’t going anything other than badly.
  • –> The upshot is that, despite the about-turn from the BOE, the politics of Brexit and its potential impact on the currency is about to get ugly. Could it be a sign of a top in GBP/USD that HSBC have just thrown in the towel on their forecast of it heading to 1.2000?
  • On the other side of the globe, Japan’s Prime Minister is looking to shake things up by potentially calling a snap election. This news has been greeted with a fresh round of Yen selling, with an expectation of a renewed focus on Abenomics, which was basically a policy of depreciating their currency, but making it look nice by describing the use of Arrows. Or something. It would indeed be a good opportunity for Abe to call the election now, with the opposition on their knees, and before a new party can be formed by Tokyo Governor Koike after his recent shock win in Tokyo. And the North Korea missile launches have seen approval for the PM rebound. Oh that pacifist constitution could be ripped up very soon indeed.
  • –> It’s all very well that the market thinks “more Abe” means “more Abenomics” means “more selling of the Yen”. But what if his priorities have changed? What if there’s a reassessment of what Abenomics actually achieved? What if Kuroda doesn’t get reappointed as BOJ Governor when his term ends next April?
  • And then in the US, just as Trump had to turn to the Democrats to get the debt ceiling raised, he also says his “ears are open” to find the “right conditions” to stay in the Paris Climate Agreement. The Republicans fire back with a leak that they’re open to putting together a $1.5trillion tax cut which may not have to be exactly revenue neutral. In other words, all sides are becoming clear on the new reality. Consensus has to be brokered for each grouping to gain power – including DJT himself.
  • –> Does this break the deadlock in the US and mean that reflationary policies are back on the agenda? Or is the realisation dawning on DJT only very slowly?

In conclusion…

The market has followed central bank meetings religiously for the past 10 years – after all, they’re the guys who brought the post-financial crisis madness to an end. They spoon fed us a calmer outlook. They mandated us to take risk, and compress volatility in the process. So it’s no surprise that all the focus is on them. Their unclear language can be frustrating, but at least we understand that they’re trying to turn the low rates supertanker around, even as they try to prevent an excessively speedy appreciation in their currency. Usual stuff then.

But the politics? No, that’s messy. One minute Trump can’t get anything done, the next he gets the debt ceiling raised. One minute the UK are progressing nicely through Brexit negotiations, the next their government is self-immolating. One minute Japan can’t reflate for love nor QQE money, the next its leader calls a snap election to reinvigorate his economic programme.

This back and forth is common in the political world, but entirely unclear to the financial world. In the battle of economics v politics, it’s 1-1 going into half time. Fresh oranges please!

Mr. Big is Back

Yes that’s right, the unreliable boyfriend is back. Just when you thought you’d got rid of him, there he is, waiting for you outside your flat with an overzealous bouquet of flowers, cigarettes and a bottle of vino. The first few times your heart leaps even though you know it shouldn’t; but by this stage you just sigh and wonder why he bothered. Did he really think the leather jacket and naughty smile would cut the mustard??

And so, before the metaphor entirely tires itself out, we turn once again to Mark Carney’s pronouncements on interest rates. There he is on Sky News warning the British Public that the possibility of a rise in rates has ‘increased’.  *wink*

I know, I know, we have heard this many times before. Most laughably in the summer, when one minute it was “now is not yet the time to begin that adjustment” of raising rates, then the next minute – or to be precise, 8 days later – it was “Some removal of monetary stimulus is likely to become necessary if the trade-off facing the MPC continues to lessen and the policy decision accordingly becomes more conventional“.

Sterling enjoyed a delightfully painful flip-flop as a result of those comments, but Blondemoney dealt the unreliable boyfriend a fair hand back then. He merely saw the way the wind was blowing for the MPC and was giving himself the flexibility to ensure he wasn’t in the minority when the eventual rate hike decision is taken.

The wind has been blowing even further in that direction since the August inflation report, as the MPC noted themselves in the Minutes yesterday:

‘the relatively limited news on demand had pointed, if anything, to a slightly stronger picture than anticipated in the August [Inflation] Report’

‘If anything, recent developments had suggested that the remaining spare capacity in the economy was being absorbed a little more rapidly than had been expected’.

Pretty optimistic stuff. Even in paragraph 32 of the Minutes, which outlines the argument for leaving policy unchanged, they comment on ‘some signs of growing momentum’: ‘in particular stronger employment data, signs of a pickup in the housing market, and a partial rebound in new car sales’. And that’s in the paragraph arguing for unchanged rates! Oh the little tinkers. It’s in that paragraph that they give their biggest hint of when the rate rise could come, concluding:

‘More generally, the Committee could undertake a full assessment of recent developments, and the data released over the next couple of months, in the context of its November forecast round.’

So – November is when they’re itching to go, and a 70% chance of a 25bp hike is now priced in following comments from dove Gertjan Vlieghe this morning that:

‘Until recently, I thought the appropriate response of monetary policy was to be patient, given modest growth and subdued underlying inflationary pressure. But the evolution of the data is increasingly suggesting that we are approaching the moment when Bank Rate may need to rise. If these data trends of reducing slack, rising pay pressure, strengthening household spending and robust global growth continue, the appropriate time for a rise in Bank Rate might be as early as in the coming months

A little bit more than 25bps is now fully priced by February next year. The reason for the disconnect in timing is partly because of that whole unreliable-boyfriend, lack-of-credibility thing, and also that yield curves have become so flat that hardly any central bank is expected to do anything ever. Never ever. Like, ever.

Oh but another curveball was thrown into that lack of curve pricing yesterday, with US inflation data beating expectations at almost 0.3% month-on-month. Maybe that December rate hike from the Fed might come after all? Either way, these are reminders that central banks are not flatlining.

Blondemoney knows from experience that when you’ve been let down and disappointed by Mr. Unreliable, it’s easy to believe he aint changed. But the whole corpus of the Bank of England is starting to sing from the same hymn sheet. When uber-dove Haldane flipped towards rate hikes in June, he noted:

‘“Provided the data are still on track, I do think that beginning the process of withdrawing some of the incremental stimulus provided last August would be prudent moving into the second half of the year”’

This argument to withdraw the ‘insurance’ cut post-Brexit vote was cited again in yesterday’s Minutes:

‘A withdrawal of part of the stimulus that the Committee had injected in August last year would help to moderate the inflation overshoot while leaving monetary policy very supportive.’

Just like the Bank of Canada, they’ve decided the time is right to remove the insurance policy, and they’re just going to go for it. And why not? There’s certainly a window of opportunity for the BOE to get it done before Brexit talks get complicated.

This time, it’s not just Mr Unreliable at your door, it’s him and his best mates turning up with banners, loudspeakers, a song, and a script to deliver a clear message of why This Time, He Means It. Are you gonna take him back in, girlfriend? For once, you should.

A little reminder

This morning provided a nice juxtaposition of news stories that deftly explains why we are where we are.

First up we have the fish-finger-loving, partial-to-a-glass-of-vino-or-ten, EU Commission President Juncker. He was giving his State of the EU address, and unsurprisingly called for an end to individual country vetoes, along with introducing a single European President, and every member state to be in the Euro and Schengen. ‘Ever Closer Union’ writ large indeed.

At the same time, the ONS released UK employment data. Yet again, unemployment fell, but yet again, wages remained stagnant. Real wages are now 3.2% below their peak in 2008 (h/t @Rupert_Seggins):

Oh, and what’s happened to asset prices since then? Up, a lot.

So those who own assets have become a lot richer. Those who own more assets, have become richer than those with less. Inequality between all segments is rising, even before we take into account that salaries are falling in real terms.

To put it bluntly, if you wanted to trade up from a one bed flat to a 3 bed starter home, even with two incomes and super-low interest rates, and banks falling over themselves to lend, it can’t be done. Stagnant wages alongside exponential asset growth have stymied people’s progress. Or at least, their perceived progress. Meanwhile “the rich”, “the elite”, “the 1%” appear unscathed. And worse, uninterested. Jean-Claude Juncker believes the answer to people’s concerns about the establishment, is to create a more powerful and isolated establishment. Or at least, that’s how his speech today could be conceived. If you were, say, a powerfully disenfranchised electorate looking for someone to blame.

Amongst Remainers, there has been and continues to be astonishment that people would vote for something that could be so economically crippling. After all, those real wages aren’t doing very well following the currency-depreciation-induced bout of inflation in the UK, induced by that whole Brexit vote. However, sometimes Turkeys do vote for Christmas, if they’re sick and tired of their current situation. As YouGov report, a majority of Leave voters consider economic damage to themselves or the country to be a “price worth paying” to leave the EU:

I know, you’re tired of this aren’t you? You roll your eyes at the loonies who voted to Leave, or who voted for Trump, or maybe even who voted for Macron, now that he’s spent 26,000 Euros on makeup as he smashes up the Unions. In any case, as a humble market investor, you think this is all a depressing sideshow. Your conundrum is how to get yield in such low volatile times. Here’s how compressed spreads are these days (h/t @BarbarianCap):

But it’s those pesky politics that make these spreads look so unsustainable. The People Have Spoken but goddammit they just Keep On Speaking. Juncker’s speech is a reminder that the anti-establishment mood will persist until The Establishment make some changes. And eventually they’ll be forced to. And in such ways that will make the future path of the economy look quite different from those of the past. Market-based spreads will need to reflect this risk premium at some stage.

Just a small reminder, though, as for now it’s carry on carrying mixed with a dash of stop-hunting (GBP being the current such target). Keep an eye on the AUD above 0.8000 – if that starts moving higher then we are in return to euphoria form, with stocks even higher, spreads even tighter, and the rest.

 

The future is a foreign country: they do things differently there

What the ECB and the Fed wouldn’t give to have the UK’s inflation eh? Core CPI came in at a joyful above-target 2.7%. The cost of raw materials went up to 7.6% in the year to August from last month’s reading of 6.2%. Just in case there was any doubt as to what was driving it (clue: the Great British Pound), here’s a chart showing the marked upswing since that Brexit vote came upon us:

So, it’s pretty simple for Mario and Janet. If you want to hit your inflation target, engender an unexpected vote on the future trading power of your nation. Janet’s lucky, she got an unexpected vote on her political leader, but it took the market a while to catch up to his prospects of reform and thus re-rate the currency accordingly. Oh, how those central bankers must laugh (here they are at Jackson Hole):

But then poor Janet, because despite the significant loosening in US financial conditions this year, there still isn’t much inflation. Maybe that will improve on Thursday, right? When we find out the latest US inflation data? Small fly in the ointment – the next couple of months inflation data is going to be very messed up by pesky natural disasters. The hurricanes, as dreadful as they are, will ultimately prove reflationary, what with the rebuild and supply shortages. But they’re also going to confuse the hell out of the data. Here’s what happened to inflation readings after Hurricane Katrina:

That means it’s going to be very hard to tell what the underlying inflation rate is for the economy, absent these temporary shocks. Markets have to try to price the future regardless, and they’re doing a jolly good show of it too. Here’s the latest outlook for what’s priced into interest rates:

Not a lot, basically. The most excitement over the next 12 months lies in Canada, where a full 50bps of hikes is priced. That’s two whole rate hikes people! Wooohooo! I hope you’re screaming because this rollercoaster is going fast. More notable is one hike from the Bank of England in that time. Although that would only take back the post-Brexit vote August 2016 insurance cut. Not exactly what Kristin Forbes had in mind for her parting speech upon leaving the BOE this summer, where she warned:

‘Many of the factors that have justified keeping interest rates at emergency levels over the past few years have become less potent, and sterling’s depreciation has fundamentally shifted underlying inflation dynamics in a way that makes it more pressing to begin this voyage soon

The majority of the BOE are (yet?) to agree with her. The rise in inflation should be ‘looked through’. Just as it was when it was running at 5% following the financial crisis. (Is there much use in a target if it is either completely missed or completely ignored??) Even if the BOE were to start to pay attention, and start a hiking cycle, would that be good or bad for the economy? No wonder longer term rates remain low.

Somewhat surprisingly, the ECB’s Coeure quoted work by Forbes in his speech yesterday about the pass through effects of the currency onto inflation. Forbes uses a lower currency to argue for rate hikes; while Coeure uses “exogenous factors” to argue that a higher currency can be compatible with rate hikes. Here’s his chart of what’s driven the appreciation in the Euro:

He explains:

‘there are three forces, of roughly equal strength, that help to explain the euro’s marked appreciation in recent months: improved euro area growth prospects, an exogenous component and a tightening in the relative monetary policy stance vis-à-vis the United States.’

In other words, it’s OK for the Euro to rally due to higher domestic growth, as that allows European companies to pass on the higher costs to the consumer and preserve their margins. It’s also OK if it’s exogenous because they can’t do anything about that. And they can’t do anything about US interest rates so that’s basically exogenous too. So, it’s all OK.

He goes on to wax lyrical about the joys of a flat interest rate curve, suggesting that this also means it’s OK for the currency to appreciate, because long-term monetary policy is still loose.

So the stage is set for the ECB. Any time they get a bit edgy about the appreciation in the Euro, they can shout that it’s NOT EXOGENOUS and it should fall accordingly, as the market pares back expectations of the taper. If they’re fine with the currency rising, say it’s exogenous, and let it fly.

In summary, we have central bankers approaching inflation and the exchange rate in whatever way they like, to make the argument for the monetary policy path they’ve already chosen to take. It’s no wonder so little is priced into those curves. The market knows as much as the central bankers do. Not much, basically. We like to think we understand the future. But it is truly the unknown country.

Throw into the mix that Janet Yellen may only have four more meetings left as Fed Chair, and all bets are off. Although… overnight we heard that Ivanka Trump met with Janet in the summer, just before her father went on to say Yellen was still in the running and told the WSJ  ‘I like her. I like her demeanor. I think she’s done a good job…I’d like to see rates stay low. She’s historically been a low-interest-rate person‘.

If Janet Yellen doesn’t want the poisoned chalice then could it be #IvankaForFedChair?

Standing up for central bankers

Blondemoney is no blind central bank groupie, despite the eccentrically detailed focus on their pronouncements. In “Beyond Inflation Targeting“, the BM editorial begins:

Global imbalances, bankers’ bonuses, light-touch regulation: all have been blamed for causing the banking crisis and ensuing recession. But one potential villain lurks in the background, hidden behind technical jargon and protected by tradition: the central banker. We all know that the build-up of risk in the system precipitated an almighty bust, but let’s not forget who controls the key determinant of the price of risk: the central bank through its monetary policy

Written in 2009, that paper argues the central bank obsession with hitting inflation target mandates helped to precipitate the financial crisis. Eight years later, and we have had the ECB turn to negative interest rates and QE to stave off lowflation. Except now, of course, without stoking another bubble-bursting crisis. So it’s time to stand up for Mario Draghi, applauding his attempt to reverse Alice in Wonderland monetary policy even as the inflation target prize might be scuppered.

That’s why on Thursday he didn’t blink in the face of an appreciating Euro. It’s the price to pay to return to some normality. There is talk of a policy error. There is the undoubted instability that it will cause. But really, there aren’t many options left open to him. Domestic money flows out of the eurozone are coming back home as growth returns and yields fall on foreign assets; the Euro was going up anyway.

Let’s not feel too sorry for him, however, as his apparently irrational approach is going to throw up some unhelpful market movement.

The ECB may not appear too concerned about the level of the Euro but they are darn well concerned about the pace of its appreciation. The key phrase is “financial conditions”, which he mentioned four times in his press conference:

This autumn we will decide on the calibration of our policy instruments beyond the end of the year, taking into account the expected path of inflation and the financial conditions needed for a sustained return of inflation rates towards levels that are below, but close to, 2%.

In other words, if the Euro rallies too far too fast, that will tighten financial conditions, so they won’t tighten policy so quickly. So, a higher Euro means lower Bund yields, which is quite nice for the ECB, as it means they can taper into a rising market. It’s not so nice for investors, because it becomes a cat-and-mouse game. The rise from 1.0500-1.1500 was a repricing that ECB QE was coming to an end; 1.1500-1.1800 was a repricing of the Fed as inflation headed lower; this last spurt higher in the Euro was a reprice of ECB apathy towards the currency. The ECB are now OK with a higher Euro, but not too much too fast. That means a very jagged future path for the currency: up two steps, back down one or even two or three.

It means correlations will become unstable. Bund yields and the Euro won’t rise together, they’ll oppose one another, as they have in the past 6 weeks. But that may not hold, either, because at some stage higher inflation could come back and mean a faster taper ahead. Last night we found out that Chinese PPI inflation, a key indicator for global CPI, beat expectations, turning higher for the first time in 3 months.

Positioning has certainly shifted significantly over the summer. This chart from Citi shows that shorts in the USD have been increasing for both hedge funds and real money – but there has been a big divergence in the Euro, where the typically longer term money has been buying it as hedge funds sold it:

The risk now is that the short-term money decides to be the bull to Draghi’s red rag. You don’t care about a higher Euro hey Mario? OK, we’ll give it to you… only for him to pop up with a few shouts of “calibration”, “financial conditions”, and “endogenous”, which would smack the Euro back down again.

N.B. Endogenous is also one of his faves – apparently it’s OK to ignore a higher currency if it comes from endogenous factors. If they were exogenous, that would mean a higher pass through effect onto inflation, meaning a higher euro would make the ECB less likely to hit their inflation target. But as BNPP’s Chief Market Economist Paul Mortimer-Lee has pointed out, the higher Euro hasn’t done much at all to the 5y5y inflation swap:

There is always volatility around turning points. For the Bank of Canada, they had decided to take back their insurance rate cuts and just get it over with. They must have been aware that would strengthen the currency, but decided it was a price worth paying to rip off the plaster and get it done. And in any case, why is a stronger currency so bad? If you want to tighten, then a stronger currency gets some of that done for you. The last few years of the currency wars, designed to prop up ailing growth, are not so relevant any more.

So yes, let’s stand up for central bankers. Even as they are deliberately throwing a hand grenade of volatility into the market. We started this year thinking Trump reflation plus Le Pen might take EUR/USD to parity. Right now we are approaching the peak of the exact opposite view: Trump can’t get anything done plus Eurozone reflation. These final few big figures higher in EUR/USD might be the last, and the most volatile.

Have a good week ahead folks!!