The days ahead are historic. By all reckoning, Merkel will be German
Chancellor for a fourth consecutive term. Many observers expect the
election to usher in a new era of German-French coordination to continue the
European project post-Brexit and in the aftermath of the Great Financial
Crisis.
A reanimated European project is also informed by a
sense that America may be a less reliable partner, and a strong Europe is
needed to secure the gains of multilateral institutions and the rule of law.
Although Kohl
also served four terms as Chancellor, and oversaw the reunification of Germany,
Merkel plays a critical role in shaping Europe.
New Zealand holds elections
at end the of next week as well. While the German contest does not appear close and the odds
on the most likely scenario are a return of the Grand Coalition, in New Zealand, the
center-right's decade-long rule is being seriously challenged by a resurgent
Labour Party.
The New Zealand dollar fell
by around 5.7% in August. The
pullback was twice as deep and lasted twice as long the as the correction in
the Australian dollar. However, ahead of the election, the technical tone
is constructive, and before the weekend, the Australian dollar posted a
downside reversal pattern against the New Zealand dollar. The Aussie
closed below its 20-day moving average against the Kiwi for the first time in
two months. The Kiwi is technically positioned to outperform the Aussie
by 3%-5% in the period ahead.
At the end of the week, UK
Prime Minister May is expected to deliver one of her most important speeches
about Brexit.
Expectations are so high that the next round of UK-EU negotiations was postponed to give May this opportunity. She is expected to present a vision of
the post-Brexit relationship between the UK and Europe. It will be grist
for op-eds, but will do little to push negotiations forward, which are still
stuck on the terms of the separation. UK officials seem to resist the
notion of sequencing on which the EU negotiators insist.
Neither sterling nor UK
asset markets are being driven by Brexit. Sterling rallied nearly 3% last week
to brings its gains here in September to 5.1%, the best in the world. The
main driver was surprisingly hawkish MPC minutes. There have been several times
over Carney's tenure as Governor that the BOE has sent such a signal to
the market. It has not delivered, but of course, this time, like every
time could be different.
Here in Q3, the Bank of
Canada has taken back the two rate cuts it delivered in 2015. It provided accommodation to help
the economy through a transition. It judged that the economy no longer
needed that accommodation and removed it. The Bank of England cut rates as part
of its precautionary measures after last year's referendum. It is not
unreasonable to judge that that accommodation is not required.
Alternatively, Carney can do
what he has successfully done before: Show a pragmatic flexibility and
trust the data. It
is not unreasonable to expect last year's currency depreciation to have nearly
run its course, and for price pressures to peak shortly. The market will
likely be particularly sensitive to the UK's high frequency data in the coming
weeks, as the BOE is perceived to be as well.
Three major central banks
meet in the week ahead: Norges
Bank, Norway's central bank, the Bank of Japan, and the Federal Reserve.
Soft inflation data last week underscore the Norges Bank is on hold. The
Bank of Japan is also not expected to change policy. The BOJ does not
need to buy JPY80 trillion of JGBs a year to keep the 10-year yields in a 10 bp
band around zero. Some see this as evidence of stealth tapering. We
are not convinced that this is the best way to understand what the BOJ is
doing, but we recognize the BOJ has been reluctant to formally acknowledge
this by scaling back its announced target.
In any event, the FOMC
meeting will be historic. We
have been suggesting since June that the Federal Reserve would announce the
beginning of its balance sheet reduction at the September meeting.
Although the BOJ had been engaged in preliminary forms of quantitative easing,
the Federal Reserve codified it, elaborated on it early in the Great Financial
Crisis. Although there were several rounds, it did cease, despite the
mocking by the skeptical that, once begun, it would be impossible to stop, as in
QE-infinity.
The Fed has not only stopped,
but it is in a position to begin to generally unwind some of it. The unprecedented nature of what is
about to happen seems to be under appreciated by many investors. Of course,
other central banks will not simply follow it, they will elaborate and modify
according to idiosyncratic factors, pre-existing conditions, and institutional
arrangements. However, the Fed's conduct will be part of the information
set they will have that the Fed does not.
The Fed has made clear how
and at what pace its balance sheet will shrink. It will simply not recycle the
full amount of maturing bonds and MBS in its portfolio. It seeks to put
the program on near automatic pilot; not to be influenced by the vagaries of
the economic data or the proximity to its goals. The pace will begin slowly at
$10 bln a month ($6 bln Treasuries and $4 bln MBS). The pace will increase by
$10 bln a month every quarter until reaching the $50 bln a month. We
suspect in the initial period the market impact will be minor, but as the terminal
velocity of $ 150 bln per quarter is approached, the risk of
disruption seems to be greater.
Admittedly there are a
number of moving parts and imponderables, like the Treasury's issuing schedule,
fiscal policy, global development, and the regulatory treatment of Treasury
assets for financial institutions. Tax considerations and investment strategies that have led
to vast amounts of cash on corporate balance sheets (a recent Financial Times
report found that 30 US companies had accumulated a combined portfolio of cash
and financial assets worth more than $1.2 trillion) are also important factors
in trying to anticipate the impact of the shrinking of the central bank's
balance sheet.
The Fed's main tool for
monetary policy will remain the Fed funds target (range). A September rate hike has long been
ruled out by investors, with guidance by the Fed officials.
Investors ought not expect any clues for the December FOMC meeting, the
next one that is followed by a press conference. Shaping expectations for the
December meeting can wait until at the November 1 meeting.
However, through its new
forecasts (represented in the dot plot), the Federal Reserve will be providing
important information. For
the first time, it will be providing forecasts for 2020. What is the
importance of Fed forecasts, one may wonder, given that the forecasts are often
wrong as much if not more than market economists? It is through the
forecasts that investors will have a better idea of the terminal rate for Fed
funds that the current Fed members have.
The reference to current
members is a reminder that the Board of Governors is about to have a major
makeover. With Fischer stepping down next month, and Quarles likely to
join by the November meeting, there are still four appointments that have to
be made, including the Chair. In our calculus, we see the reappointment of Yellen as the
path of least resistance. It does not appear to be particularly salient to
the President's base. Some argue that Trump wants low interest rates and his
appointments will reflect this. It may be difficult to find people with the
requisite skills and experience that would have raised rates much slower than
Yellen. Also, some of the more rule-based approaches, like the Taylor
Rule, would imply higher rather than lower rates.
The FOMC statement itself
will likely recognize the distortions in the high frequency data due to the
intense storms in Texas, Florida and South Carolina. The pre-weekend double whammy of
disappointing retail sales and industrial output may already reflect some early
signs of the weather disruption. The Fed's chief task is not so much
predicting the future, but trying to steer monetary policy through the changing
business cycle and structural evolution of the economy. The severe storm makes
the Fed's task focusing on the economic signals more difficult.
Despite downgrades in Q3 GDP
forecasts (NY Fed GDP tracker to 1.34% from 2.06% the previous week, and Atlanta
Fed to 2.2% from 3.0%), the underlying economic trend has not changed. It is growing slightly faster than
what economists estimate is trend growth. Therein lies the problem.
Trend growth has slowed, and monetary policy can do very little to boost trend
growth.
Our argument that the odds
of a December rate hike are greater than many others is not because we see higher
inflation or faster growth. Our
view, spurred by comments in Fed speeches and FOMC minutes, is that the easing
of financial conditions in the face of the Fed's considered judgment that the
economy requires less accommodation, is significant. Just as investors are aware of the
Fed's reaction function, so too are Fed officials aware of investors' reaction
function. Its institutional credibility is being challenged in a way
vaguely similar to what Greenspan called a "conundrum" in 2005.
Given our collective experience, financial stability is central.
Disclaimer
FOMC Highlights Big Week
Reviewed by Marc Chandler
on
September 16, 2017
Rating: