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Are Markets Headed for a Nasty Shock?

When assessing which large tail risk events are likely to take place in 2017, speakers at Profit & Loss’ Forex Network London emphasised that there are other risk factors being overlooked that might have a greater impact on financial markets.

“Like last year, the tail risks this year are quite high compared to normal,” said Colin Harte, strategist and senior portfolio manger at BNP Paribas Investment Partners. “There are some quite material risks that – if they come to pass – could have a significant impact on markets.”

He noted, however, that many of the expected tail risk events from 2016 were less dramatic than expected in the end: sterling took an obvious hit after the Brexit result, but soon became range-bound again, while the Trump election victory actually led to a rally in the equity markets.

“The big risks are probably the ones that are going to be less well-flagged. The Italian banking system could be one with the potential to cause problems,” said Harte. “Another one is that the market is still underestimating the risk of protectionism, and specifically how that protectionism could lead to a major spat between the US and China.”

Harte pointed out that the US political system means that President Trump can’t dictate fiscal policy, it has to go through Congress, meaning that he could end up with something that looks more like a conventional Republican package. 

In contrast, the one area where Trump has a lot of executive authority is trade, because he can issue tariffs and name a country as a currency manipulator.

“If [Trump] gets frustrated on healthcare and he doesn’t get the fiscal package that he wants, there’s a risk that he will choose to go the protectionist option, and I think the market is really under-appreciating that risk at the moment,” said Harte.

Meanwhile, Jan Randolph, director of sovereign risk at IHS Market, warned that the expansive monetary policy employed by central banks in recent years has made it harder to see potential bubbles emerging in financial markets.

“We’ve found it relatively easy for central banks to put their big fat foot in the financial markets to take over the functions of commercial banks who, for reasons of balance sheet, can’t or don’t want to fulfill those functions any more, but I think that it’s going to be more problematic for them to take their big fat foot out of these financial markets,” he said.

“This could be a concern due to the fact that, because of the money that has been flooded into these markets, everything has been smothered in terms of relative pricing of risk, and as that big fat foot comes out, we don’t know exactly what we’ve done in terms of creating bubbles,” he added.

Richard Cochinos, head of G10 strategy at Citi, pointed out that very low cross-market volatility, combined with the removal of this backstop from central banks, which has effectively been in place for the best part of eight years now, could set the scene for a surprise in financial markets.

“Markets love to linearly interpolate forward and we’ve come out of very successful improvements in the growth outlook of most major economies and there’s a general underlying assumption that’s going to continue in Q2, Q3 and throughout all of 2017. 

“That re-pricing lower, as well as the dominant flows to emerging markets that are at a higher beta and are higher yielding assets, is something that is a huge risk. It’s difficult to point towards a specific trigger, it’s the unknown unknowns that will catch the market by surprise, but the signs are there. Ultimately, there’s this broad assumption of this continued growth outlook being quite positive, as well as relatively low volatility in markets, which is a sign that there is some complacency,” he said.

Focusing specifically on where he expects to see big currency moves this year, Cochinos pointed to central bank policies in Japan and Switzerland as potential drivers within the G10 markets.

“I do see the BoJ policy and the SNB policy as unsustainable over the medium-term framework, and so in those environments yen strength and likely Swiss franc strength are going to be two key components. It’s difficult for me to time this precisely, but we’re moving in a macro environment where those policies will probably have to shift this year and those will both have currency impacts,” he said.

Looking away from G10, Harte pointed to the renminbi as one currency that could present a significant challenge to market participants.

“The renminbi has basically outlived the current exchange rate regime, but political pressures in the short-term are compelling [Chinese authorities] to keep it in place,” he said.

According to Harte, the logical move – from an economic standpoint – would be to widen the bands within which the RMB can trade or let it float freely. The problem this would create though, he said, is that it would make the RMB materially weaker, which is unlikely to go down well with the US Treasury or the Trump administration because it would make Chinese exports far cheaper. 

Harte added: “I think that’s where the bigger tensions are going to be and that’s a bigger shock potentially for markets, because it has a knock-on effect for Asia and other economies and it could be a catalyst that provokes quite an aggressive trade response from the US.”

Meanwhile, Randolph picked the commodity currencies as interesting ones to keep an eye on in 2017. Specifically, he pointed out that there is a big disparity between how different countries react to a downturn in commodity or energy prices, and that this is often reflected in their currencies.

“Some countries are very good at what the IMF euphemistically calls “external adjustments” in the face of an oil price fall.  They let their currency fall, imports can fall on the back of falling exports and it protects their foreign exchange reserves. 

“These are remedial policy measures, and some countries like Russia and Brazil have been here before and they know what to do, they have relatively independent central banks, they’re now coming out of this external adjustment, they’ve refigured and reviewed their budgets, and as they come out of it, their currencies are beginning to move up again,” he said.

In contrast, Randolph added, countries that have experience with these “external adjustments” don’t necessarily know how to respond and their currencies are therefore less likely to strengthen at the same pace.

He concluded: “We’re seeing a situation where commodity markets have moved off the floor, but then they tend to get ahead of themselves and so we often get a relapse situation. But then interesting enough, “Trumpflation” – the idea of a Trump fiscal stimulus – has actually benefited the emerging markets, because obviously, there is a lot of raw materials involved in that and so it has benefitted a lot of the emerging market currencies, as well as what’s happening at a policy level in terms of external adjustment.”

Galen Stops

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