Every now and then, it’s helpful to reassess what’s changed in the global economy and whether it warrants any changes to our broad macro calls. Given what we see as continued economic and monetary policy divergence, we are maintaining our strong dollar call.
There has been a lot of chatter and press lately about abnormally low volatility across most financial markets. To those of us who trade daily in these markets, this is stating the obvious. Looking at historical data, it’s clear that we are in a period of low volatility that’s resulted in very narrow trading ranges for most currencies.
Yet past experience tells us that this cannot last. Like a coiling spring, these markets will eventually uncoil and erupt in a period of heightened volatility. The proximate trigger is of course impossible to predict, as is the exact timing. Some believe that volatility is in a secular decline because of easy central bank policies worldwide. This sort of lazy analysis works until it doesn’t.
What will we see when volatility spikes? The dollar and other safe havens should benefit at the expense of so-called risk assets like EM. And it’s not just FX. Looking at equities, the VIX is the lowest since last October. What happened when the VIX reversed higher that month, rising from around 11% to peak above 36% in last December? The S&P 500 sank 20% over the course of Q4.
We’re not saying history will repeat itself, but as Mark Twain purportedly said, “it often rhymes.” Equity markets could become more vulnerable from a technical standpoint as record highs are approached. Yet we suspect any US equity market sell-off will be limited by a strong underlying US economy. The Q4 plunge was driven in large part by heightened US recession fears, and we believe those fears have been put to be for now.
GLOBAL ECONOMIC OUTLOOK
US: The biggest takeaway from recent US data is that the economy is far stronger than previously thought. The Atlanta Fed’s GDPNow model started off with an initial Q1 growth estimate on March 1 of 0.3% SAAR. It now stands at 2.4% SAAR. Elsewhere, the New York Fed’s Nowcast model is tracking 1.4% SAAR in Q1 and 2.0% SAAR in Q2. Both models should show even stronger growth after today’s March retail sales data.
Yet the Fed Funds futures strip continues to price in significant odds of a rate cut this year followed by another one next year. This implies high odds of a downturn and is at odds with what the US equity and bond markets are telling us. The S&P 500 is less than 2% from its record highs, while the US yield curve is no longer inverted. Quite simply put, these two key markets are signaling very low recession risk, while the Fed Funds futures market implies heightened risk.
Only time will tell but we remain constructive on the US economic outlook this year. We believe that the Fed Funds futures market will eventually fall into line. Indeed, we hold out some hope that the Fed may end up hiking this year after all. Some Fed officials believe the same thing, but it will all depend on the data.
Eurozone: Growth forecasts continue to be marked down. The Economy Ministry just cut its growth forecast for Germany this year to 0.5%. This is the most bearish official forecast yet and compares to Bundesbank (1.6%), IFO (0.6%), EC (1.1%), OECD (0.7%), and IMF (0.8%). Recent press reports suggest a “significant minority” at the ECB remain doubtful of the H2 recovery scenario that the bank is showing in its March projections. Some went so far as to cast doubt on the accuracy of its models. Today’s flash April eurozone PMI fell for the second month in a row, suggesting that the economy has not yet bottomed.
The ECB next meets June 6 and new staff projections will be released then. If data remain soft, we suspect the dovish ECB minority will grow and feed into an easier policy stance. In related news, reports suggest that ECB officials lack enthusiasm for any sort of interest rate tiering under the current negative rate framework. This is just a grim reminder that even if the ECB wants to add more stimulus, it simply lacks any strong policy levers to boost growth beyond a weaker euro.
UK: Brexit continues to weigh on the UK economy. The IMF just revised its UK growth forecasts down to 1.2% for 2019 and 1.4% for 2020. While the labor market remains firm, the Bank of England is facing the same conundrum that other central banks like the Fed and RBA are facing. That is, a strong labor market has yet to feed into wage and price pressures. To make matters worse, the BOE has Brexit hanging over its head.
For now, the BOE must take a wait and see approach during the Brexit extension until October 31. Next policy meeting is May 2, no change is expected then. The short sterling futures strip is pricing in the next 25 bp hike by mid-2020 and the one after that by end-2021. To us, it will all really depend on Brexit. If a soft Brexit with an extended transition period is the final outcome, then the BOE can proceed with its modest tightening cycle.
Japan: The economy is already slipping ahead of the planned consumption tax hike in October. IMF just revised its Japan growth forecast down to 1.0% for 2019 and kept it steady at 0.5% for 2020. CPI rose only 0.2% y/y in February. March data out Friday is expected to accelerate modestly to 0.5% y/y, but this falls well short of the 2% target.
BOJ Governor Kuroda has made it clear that its stands ready to add stimulus. Our base case is that it waits until after the consumption tax hike to move. The central bank next meets April 26. No changes are expected then, but the BOJ will release its first forecasts for FY2021 ending March 2022. Press reports suggest the BOJ will show inflation remaining below target through FY2021, which implies that current stimulus will remain in place into FY2022 ending March 2023.
Dollar bloc: Canada has been the most aggressive major central bank outside of the Fed. It started the tightening cycle back in July 2017. It has hiked five times total to bring the policy rate up to 1.75% currently. Yet soft data in recent months has led the BOC to keep rates steady since October and to maintain a more dovish stance. Market does not fully price in the next 25 bp hike until mid-2020, but we suspect the BOC is done hiking.
The RBA is tilting more dovish. RBA minutes were released this week. The bank reportedly discussed rate cut scenarios but ultimately decided that there was “not a strong case” to ease near-term. This discussion of rate cuts is the first step towards moving to an easing bias soon. However, market calls for two cuts this year seem overdone. RBA next meets May 7, no change is expected then.
RBNZ has already moved to an easing bias. New Zealand just reported much weaker than expected CPI for Q1. At 1.5% y/y, headline inflation is well below the 2% target and the market is pricing in a rate cut before year-end.
Scandies: The Riksbank has hiked only one time back in December and so the policy rate remains negative at -0.25%. It has signaled that it intends to hike again in H2 2019 “provided that the economic outlook and inflation prospects are as expected.” At its February meeting, the Riksbank affirmed that it sees 50 bp of tightening in 2020 and another 50 bp in 2021. It next meets April 25 and there is a good chance that it signals a flatter rate path then. CPI rose 1.9% y/y in March, just below the 2% target. The Riksbank sees GDP growth of 1.3% this year, down from 2.5% in 2018.
Norges Bank started hiking with a 25 bp move back in September and followed it up with another 25 bp move to 1.0% this March. At that last meeting, it adjusted its rate path by signaling that it intends to hike again by June and again by year-end. However, it sees the rate peaking at 1.75%, suggesting only one more hike in 2020. CPI rose 2.9% y/y in March, above the 2% target. The Norges Bank sees GDP growth of 2.7% this year, up from 1.4% in 2018, due in large part to higher oil prices. As such, the Norges Bank feels confident that its rate path remains valid.
After briefly inverting last month, the US curve (3-month to 10-year) is back in positive territory. Given our more constructive outlook for the US economy, we believe that further bear steepening will be seen. While this implies further bond losses, higher long rates should be seen as dollar-positive. It’s also worth stressing again that the US economic outlook is equity-positive.
It’s clear from our survey of the global economy that monetary policy divergence is likely to continue this year. With the Fed on hold (and perhaps even tightening), most other major central banks are likely to be adding stimulus this year. That means the dollar is likely to become relatively more attractive than it already is against most currencies. The exceptions would appear to be the BOE and the Scandies, where modest tightening is likely to be seen.
And it’s not just the major central banks. In EM, some have already started the easing cycle (India) and many others are expected to cut rates soon (Indonesia, Philippines). Many that had been expected to start hiking rates are holding off (Colombia, Peru). Lastly, there are several that have already hiked but are likely to reverse course (Malaysia, Mexico, Russia) in the coming months. Bottom line is that we remain negative on EM FX in this environment.
As always, we caution that the game-changer for our bullish dollar call is the next US recession. When (not if) that happens, the Fed will not hesitate to cut rates quickly and aggressively. That is unlikely to be a 2019 story, however, and so we are maintaining our bullish dollar outlook through year-end.