Fra BNP Paribas:
The Chinese year of the fire monkey is not starting off very hot in terms of risk appetite. At the time of writing, markets were pricing in 8% odds of a rate cut from the US Federal Reserve by November, the 10yr US Treasury hit its lowest level since August 2012, the yen moved to its strongest level against the dollar since October 2014 (up by more than 7% since 1 February) and the euro had spiked nearly 5% against the dollar in the last 10 days.
Global markets are decidedly risk-off, central-bank action looks uncoordinated and we see few signs of calm ahead. In this environment, despite its bias to hike, we see little chance that the Fed will be able to sneak in another rate hike this year and now expect no further action this year or next.
Similarly, we think central banks across the world will continue to adopt easier policies in response. The major force of tightening in global monetary conditions unleashed by the Fed started with the taper tantrum in May 2013. It pushed interest rates immediately higher and has fuelled a much stronger US dollar (the Fed’s broad dollar index peaked on 20 January with a nearly 35% appreciation since its trough in mid-2011).
While interest rates have come down sharply, USD strength has led to a sharp deceleration of global FX reserve growth and therefore of highpowered money growth. Markets appear to have lost some confidence in central banks’ ability to turn things around. Unconventional monetary policies work, in part, through asset prices, the expectations channel and the exchange rate.
These channels are impaired at the moment. In particular, the Bank of Japan’s failed attempt to weaken its currency has revealed the limits of deeper deposit-rate cuts against a backdrop of higher market volatility (which reduces the incentives to do carry trading) and the perceived cost that such a policy imposes to the banking system. What can halt what is happening in markets?
The key is monetary easing on a more global (coordinated) basis. The Fed shifting its stance on rate hikes is the key, first step. This would take pressure off the greenback and therefore reduce the squeeze on global high-powered money. But balance-sheet expansion elsewhere, rather than minor tinkering with rates, is also crucial. ‘Currency wars’ help no-one; a coordinated and non-competitive approach is needed. We have a global problem; we need a global solution.
The Fed has been reluctant to give up hope of a gradual adjustment in monetary policy that would restore its monetary firepower. We previously forecast a pause in our fed funds profile later this year that suggested markets and the economy would force the FOMC to halt its plans to normalise policy. Despite what looks set to be a solid economic performance in Q1, the market-led pause we were expecting appears to have come sooner than we expected.
Moreover, as we expect growth and employment to start to slow in H2 2016 and to continue throughout 2017, we see no compelling reason why the Fed would be able to continue to tighten policy this year or next. For the eurozone, the global risk-off mood has been exacerbated by a number of aggravating factors. For a start, economic data have weakened of late, challenging the consensus view that the economy would hold up well thanks to supportive domestic factors.
We have revised our forecasts for Q4 GDP and now expect it to have risen by just 0.2% q/q (from 0.3% previously). While marginal, this change is significant: at this pace, the economy is running at around its potential and the output gap is therefore no longer closing. This highlights the risk that low inflation will be even more persistent than initially feared.
The loss of confidence and downgrades to growth expectations have resulted in tighter monetary conditions via a stronger currency, higher credit and peripheral bond spreads and lower stock prices. If sustained, this would weigh further on European economies, highlighting the risk of a negative feedback loop.
Last but not least, rising support for mostly Eurosceptic populist/protest parties has altered the eurozone’s political landscape. These parties are becoming increasingly influential in both the national and the European debate, pushing against more integration. This might prevent an effective political response to potential adverse shocks. Market movements have been big and impactful Loss of confidence in central banks Global problem calls for global, coordinated action Fed tightening looks off the table for 2016-17 Eurozone inflation might stay low for even longer Risk of a negative feedback loop Shift in Europe’s political landscape
With inflation set to turn negative as early as in March and inflation expectations showing some signs of unanchoring, the ECB has no choice, in our view, but to step up both its rhetoric and its action over the next few weeks. We have been forecasting another package of measures at the next meeting on 10 March that will include a substantial increase in the scale of the assetpurchase programme, a step-up of the run-rate and a 10bp cut in the deposit rate. A 10bp deporate cut does not look like it is going to be enough, however.
The odds of a tiering system, including liquidity provisions and modifications to other aspects of the asset purchases, have risen markedly. In our view, even with a bigger package, these measures are unlikely to ignite a turnaround in the severely impaired market sentiment – a similar scenario to the response following the ECB’s easing in December 2015. Even before the change in our call on US policy, we thought a rate hike by the Bank of England was unlikely in 2016. A Fed on ‘perma-hold’ reinforces this view.
The BoE is unlikely to raise rates against a backdrop of an uncertain global environment, financial markets prone to bouts of tension and extended policy easing by the ECB. Moreover, UK growth looks set to come in below 2% in 2016, due to soft global demand, domestic fiscal tightening and concern over the outcome of the UK’s referendum on continued EU membership (both the UK and EU are pushing to have the referendum out of the way by late June or early July).
The Bank of Japan is in a tough spot, with the yen now much stronger than it was before the introduction of its negative policy rate. For the time being, the BoJ will probably want to assess how far negative rates are penetrating the market and their side effects. Barring exceptional circumstances, therefore, additional easing is unlikely at the next meeting in March. However, as markets are turbulent and pricing in virtually no prospect of Fed rate hikes this year, the yen should continue to face upward pressure.
While the degree of uncertainty is high and much depends on market developments, our base scenario now is that the BoJ will cut the interest paid on excess reserves by another 20bp in June this year. One possible obstacle for a further IOER cut might be international criticism of the BoJ’s ‘beggar thy neighbour’ strategy. But international policy coordination, while desirable, does not seem likely to come about, at least in the near future.
A halt in the Fed’s tightening cycle would come as welcome news to the Central Bank of Russia, which warned once again this week that it does not exclude policy tightening due to RUB weakness feeding into inflation. However, the oil-price trend remains the principal factor for the central bank’s decision-making process. We maintain our view that a rate hike this year is a less likely scenario, which would happen only if the RUB goes into an uncontrollable depreciation spiral due to speculative behaviour by market participants and/or the general population. Instead, we expect the central bank to keep rates higher for longer and use other instruments to alleviate RUB pressures: increase FX repo provisions, tighten RUB liquidity, exert more pressure on exporters to sell their FX revenue and potentially even engage in smallscale FX interventions.
