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Dovish Tide Amongst Central Banks Poses Challenges

1R9GB7Hh0sr4rPGUWWLIbPQDYjO1bRlZlLbVfFgrMonetary policy, in developed markets at least, increasingly seems a case of words speaking louder than actions. At its policy meeting on 26 January, the European Central Bank delivered nothing but its commitment to deliver on its mandate of 2% inflation and a possible adjustment to its policies in March has been sufficient to cut two-year German yields 3bp to a new multi-year low of -48bp and the EUR/USD cross has remained firmly anchored around 1.09.

The Bank of Japan at its meeting on 29 January cut its policy rate, but the small-print reveals that the BOJ’s new negative policy rate will only be applied to additional funds left with the central bank, not to all outstanding balances. The initial 2.5% collapse in the yen versus the USD and slump in Japanese yields indicate that the market bought the impressive policy headline with few reservations and paid scant attention to the details, although price action in the past 48 hours suggests markets have better digested the modalities of this new policy.  

Major central banks’ dovish actions and/or promises, alongside weak macro data and ultra-low commodity prices have given markets an undeniably dovish colouring. The two-year interest rate for the US, Eurozone, Japan and UK now averages about 12bp, down an impressive 20bp year-to-date. Equity markets, in the doldrums since the turn of the year, have struggled to string together the semblance of a rally, but are showing a tad more resilience for now at least.

Rates cut talk premature

Unsurprisingly perhaps, the rates market which has long priced out any Bank of England hikes, is now pricing only 16bp of Federal Reserve rate hikes this year – or only a 60% probability of a 25bp hike. To put this in perspective, the market only five weeks ago was pricing over 50bp of hikes by end-2016. 

The US economy may be in better shape than some of its OECD counterparts, but recent data have helped torpedo the likelihood of the Fed hiking four times this year as FOMC members on average currently expect. US GDP growth, while held back by likely temporary factors, slowed sharply in Q4 2015 to 0.7% qoq annualised and manufacturing ISM remained stuck well below 50 for the fourth consecutive month in January.

This is likely to be reflected in the Fed’s new economic projections “dot chart” to be published alongside its policy rate decision on 16 March. In any case, for market participants the question has shifted to whether, rather than how much, the Fed will hike.

It still seems premature to think that Fed rate cuts, let alone further quantitative easing, are imminent. In the past 25 years there is no precedent for the Fed hiking rates once after a long hiatus only to cut rates a few months later and only once has the Fed cut rates when non-farm payrolls were robust. Despite monthly payrolls averaging 230,000 in June-August 1998, the Fed cut rates three times in succession in September-November 1998. But this was at the peak of the Russia crisis and by end-1999 the Fed had fully reversed these cuts. Other rate cutting cycles have been associated with significant deteriorations in non-farm payrolls and on three out of four occasions with job losses – in mid-1990 to mid-1991, in 2001 and in 2008-2009.

PBoC eyes policy rate cut

Non-farm payrolls have averaged 284,000 in the past three months and the unemployment rate has fallen to a seven-and-a-half year low of 5.0%. That is not to say that a reasonably robust US labour market precludes Fed rate cuts, as the 1998 crisis showed. After all, the labour participation rate remains low by historical standards at only 62.6% and wage growth has slowed to 4.5% year-on-year. But the hurdle for the Fed to cut rates is seemingly pretty high when domestic job creation is strong. With this in mind, Friday’s release of January non-farm payrolls (and any revisions to back-data) is particularly important. Analysts forecast a figure of +190,000, down from +292,000 in December 2015.

Incidentally, this labour market situation is not unique to the US, with the UK and NZ also experiencing strong employment growth alongside soft wage growth, the unifying theme being that these economies can currently generate either more jobs or much higher wages, not both.

Emerging market central banks will not want to fight this dovish tide, with the People’s Bank of China (PBoC) likely to eye a policy rate cut after the early-February Chinese New Year. The PBoC last cut its policy rate on 23 October and its lesser known standing lending facility on 19 November, but clear signs of weakening growth have kept further cuts on the cards. But central banks of commodity-exporting economies including Brazil, Russia and South Africa are in a greater bind. While they would like to cut rates to support growth dwindling in the face of weak commodity prices, they realistically cannot as their currencies are already under pressure and inflation is running high. South Africa is a point in hand, with the South African Reserve Bank having to go the other way and hike rates 50bp at its policy meeting on 28 January.

Complicated currency outlook

The implications for currencies are not straightforward. While the price of all bonds and stocks can theoretically fall simultaneously, by definition not all currencies can depreciate at the same time (or appreciate for that matter). There will be winners and losers and picking those out is certainly more challenging when so many central banks are implicitly, if not explicitly, pursuing policies to weaken their currencies (I intentionally avoid the term “currency wars” so often misunderstood and misused).

Indeed, we are seeing major currencies treading water. The US dollar trade weighted index (TWI), which has been on the ascendancy since summer 2014, has traded in a narrow range in the past three weeks, according to my estimates. Similarly, the CNY TWI – which many have forecast to collapse – is down only 2.5% since its all-time high in mid-October and broadly unchanged since the renminbi’s token devaluation versus the dollar last August. The BoJ has admittedly succeeded in arresting the yen’s six-month rally, for now at least. 

Central banks are clearly aware of the limitations of exchange rate policy and are seemingly taking out insurance should monetary policy fail to lift inflation. Central banks, including the Reserve Bank of New Zealand this week, have been reminding us that they have little impact on volatile energy and commodity prices and can therefore only really influence core, rather than headline inflation. And admittedly, global core inflation has been broadly stable around 2.2% in recent years, rising slowly in recent months in both the US and UK. Even if it can be (partly) rationalised, markets are unlikely to accept lying down this shifting of the goal posts. The risk remains firmly tilted towards rates markets and central banks egging each other on in a dovish direction, but the major currencies may need a little more convincing to move forcefully in either direction. 

Olivier Desbarres


Galen Stops

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