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Commodity Rally and Central Bank Dovishness Running Hand in Hand, For Now

Dovish global central bank policy, led by
the US Federal Reserve, and a rise in the global price of energy, metals and
other commodities have been key drivers of the rally in global risk appetite since

Specifically, the US Dow Jones and S&P
500 are up about 14.8% and 13.1%, respectively, to multi-month highs. A
GDP-weighted basket of commodity currencies’ nominal effective exchange rates
(NEERs), comprising the Australian dollar, Brazilian real, Canadian dollar,
Norwegian krone, Russian rouble, South African rand and Malaysian ringgit, has
appreciated by a similar 13% according to my estimates.

Of course country-specific factors, such as
the political landscape and currency-valuations, have impacted individual
currencies’ pace of appreciation. For example, the high-yielding Brazilian real
NEER surged 11% between mid-January and mid-March, thanks to attractive
valuations and a narrowing current account deficit, but has since only eked out
a 1% gain as the uncertain political landscape has come into greater focus. But
the price increase in crude oil, iron ore, copper, zinc, gold, platinum, palm
oil and more recently gas and nickel has undeniably been a potent common factor
behind commodity currencies’ broad-based appreciation.

Back by Tepid Global Growth

The currencies of non-commodity emerging
market economies have perhaps unsurprisingly fared less well. A GDP-weighted
basket of NEERs compromising the Chinese remninbi, Indian rupee, Indonesian rupiah,
Korean won, Mexican peso, Philippines peso, Polish zloty, Singapore dollar,
Taiwan dollar, Thai baht and Turkish lira has depreciated 2% since mid-January.

Even if we exclude the heavily-weighted and
depreciating renminbi, this basket of currencies has appreciated only 1% and
been-flat-lining for the past month (note that I include the Mexican peso, as
manufactured goods account for roughly 85% of Mexico’s total exports, and the
Indonesian rupiah as the country’s exports are well diversified). In this
currency group, only the Korean won NEER, up 1.2% since mid-March, has managed
to post a gain greater than 1%.

This raises questions about this equity and
commodity-currency rally’s vulnerability in coming months to “known-unknowns”,
including Fed policy, commodity price developments, China’s structural
challenges, and the efficacy of central bank and government policies, and of
course to “unknown-unknowns”– the events which we simply cannot forecast.

After all, the global macro outlook remains
murky at best. PMI data for Q1 suggest that global GDP growth may have slowed
further from an estimated six-year-low of 2.8% year-on-year in Q4 2015. The IMF
recently revised down (again) its global growth forecast for 2016 to 3.2%, with
the risk remaining biased to the downside. Fed Chair Janet Yellen has also
repeatedly expressed clear concerns about the outlook for both the US and
global economy. Notably, the well-respected Monetary Authority of Singapore
(MAS) moved to a flat nominal effective exchange rate policy at its recent
semi-annual meeting – a policy setting not seen since the 2008 great financial
crisis and a clear reflection of MAS’ concerns about Singapore’s open economy
and by extension regional and global developments. 

Elephant in the Room

The market has all but priced out the
probability of the Fed hiking its policy rate at its 27 April meeting. While
the policy rate is virtually guaranteed to stay on hold next week, this pricing
does not allow for even a slightly less dovish statement by the Fed – which
remains a possibility in my view given the recent strength of global equities,
a weaker US dollar and a rebound in Chinese activity (more of that below).

Looking further ahead, the market is only
pricing in a 22% probability of a 25bp hike (or put differently 5.5bp of hikes)
at the Fed’s policy meeting on 15 June. Ironically, it is this very
conservative market pricing which in itself increases the probability of a Fed
hike by supporting the US economy and depressing the dollar (via low interest
rates) and by supporting global equities – something which Yellen has alluded

If the Fed does not hike rates in June and
pushes out a hike till much later this year or even 2017 this may well provide
further steam to the current risk-rally. But it would also be the first time
the Fed has hiked 25bp (from a very low starting point) and then stayed on hold
for a significant period of time – a clear signal that the Fed is looking
beyond decent US data and seeing something it does not like. This in itself
should give the market bulls pause for thought.

Up Long-Term Problems

The 64% rise in Brent crude oil prices
since the mid-January lows owes as much, if not more, to supply constraints (despite
the failure of OPEC countries failing to formally freeze global supply) and to global
risk sentiment than it does to stronger global demand. The OPEC meeting
scheduled for 2 June could take the steam out of oil prices if once again major
oil producers fail to agree on formal caps for oil production.

However, a recent pick-up in Chinese
economic activity – as measured by the up-tick in both the official and
unofficial measures of manufacturing PMIs to multi-month highs in March and
decent GDP growth of 6.7% year-on-year in Q1 – has been a significant driver of
other commodities’ prices. Chinese policy-makers have resorted to old-fashioned
policies of spurring state-owned bank lending to corporates and households,
with new CNY-denominated loans up 25% year-on-year in Q1. As a result fixed
investment growth rebounded to 10.7% year-on-year in Q1 from 10% in 2015,
retail sales growth inched up to 10.5% year-on-year in March from 10.2% in
January-February and property prices in large cities have rapidly escalated.

Unsurprisingly demand for steel, and its
core components, including iron ore and nickel, and other construction
materials (such as cement) and Chinese imports have risen in tandem, albeit
from a low-base. The dollar-value of Chinese imports, seasonally-adjusted,
jumped about 8% in March, with import volumes of iron ore up 6.5% year-on-year
in Q1. This is clearly benefiting the economies of major commodity exporters
such as Australia and appreciating their currencies in the absence of
significant central bank intervention.

China’s credit policy may be easing
short-term growth challenges but excessive lending is also exacerbating excess
manufacturing capacity, asset bubbles and non-performing loans as investments
struggle to yield returns commensurate with borrowing costs or worst fall in
value. While official data suggest that non-performing loans are still modest
at around 2% of total loans, the actual number is believed to be higher.

The government is planning to securitize
some of these bad-loans but the experience of other countries (notably in Latin
America) suggests this partial solution only buys time. At some point, chunks
of this distressed debt will likely need to be written off, with banks absorbing
at least part of the cost. The more unprofitable and highly-indebted
state-owned enterprises may need to close or merge with corporates boasting
stronger balance sheets. Tackling this problem head-on would strengthen the
Chinese economy’s long-term health but likely be a drag on growth near-term and
so the question remains as to when Chinese policy-makers will feel they are in
a position to act. Markets will have to keep a close eye on these developments,
even if on the surface the economy and the currency paint a more benign

Policies Unlikely to Provide Silver Bullet

Finally, much has been written about the
declining marginal returns from central banks’ increasingly loose monetary
policies (the Bank of Japan being the poster-child of misfiring central bank
policy) and the inability of either the US or Chinese economies to
single-handedly support global growth. The IMF has therefore repeated its call
for a strong and coordinated policy response from major governments, and the G7
summit on 26-27May could present such an opportunity for leaders to
present a united front and new initiatives.

Precedent, however, suggests that G7
meetings promise a lot but deliver little, while governments’ willingness and
ability to finance profitable and productivity-enhancing infrastructural
projects is debatable at best.

Olivier Desbarres


Colin Lambert

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