Ebury: G3 forecast revision
The US Dollar (USD) rallied sharply against its major peers following the Federal Reserve’s monetary policy meeting in July. The currency rose to its strongest position in over two years following the meeting, despite the US central bank cutting interest rates for the first time in over a decade.
The Federal Reserve has embarked on a drastic U-turn in policy since its most recent interest rate hike in December. Amid heightened downside risks from growing US-China trade tensions, policymakers have shifted from signalling that additional hikes are on the way to cutting rates by 25 basis points back to the 2.00-2.25% range at its July meeting. Chair of the Federal Reserve Jerome Powell signalled that lower rates were a direct consequence of both weak domestic inflation and growing concerns among the committee regarding an escalation in the US-China trade conflict. Negotiations between the US and China over trade took a turn for the worse in May, with President Trump unexpectedly hiking the existing tariffs on $200 billion worth of Chinese goods from 10% to 25%.
While the G20 summit in Japan in late-June yielded a temporary ceasefire on additional tariffs and a promise of a resumption in trade talks, Trump slapped further 10% tariffs on an additional $300 billion worth of Chinese goods in early-August, set to take effect on 1st September. China appears to be ready to retaliate by stopping purchases of American agricultural products and allowing its currency to slide.
In line with our expectations, the FOMC voted in favour of lowering rates by 25 basis points back to a range of 2.00-2.25%, defying some of the market that were looking for a more aggressive 50 basis point rate reduction. The US dollar actually rose sharply across the board following the announcement as investors very much viewed the rate reduction as a ‘hawkish cut’. Firstly, the vote among FOMC members was not a unanimous one, with two members of the committee, Esther George and Eric Rosengren, dissenting in favour of unchanged rates. Powell’s comments in the accompanying press conference were also not as dovish as the market had anticipated. He voiced optimism over the strength of the US labour market, while also noting the recent improvement in retail sales data and general resilience shown by the domestic economy in the face of global uncertainty. Crucially, he also fell short of indicating that a full-blown easing cycle was on the way, instead claiming that the cut was merely a ‘mid-cycle adjustment’.
Increased appetite for cuts among the FOMC has a lot to do with the lack of inflationary pressure in the US economy. The main headline rate of US consumer price growth has been below the central bank’s 2% target in each of the past seven months. The Fed’s preferred inflation measure, the PCE index, also came in at just 1.4% in June, while the core PCE index is now at only 1.6%, both comfortably below target. We note, however, that the core measure of inflation that strips out volatile food and energy components has remained at or above the 2% target. A still relatively solid labour market performance, most notably robust earnings growth, could keep prices elevated this year.
As mentioned, the Fed has remained upbeat over the domestic economy, with its concerns largely focused on trade tensions. Much of the slowdown in the second quarter was driven by a sharp decline in business investment growth, although consumer spending picked up strongly from the beginning of the year. A good gauge of the recent undershooting in US economic data is Citigroup’s Economic Surprise Index, which has been deep in negative territory since mid-February. We do, however, think that there are no signs that an imminent recession or even a significant slowdown are on the cards. Year-on-year earnings growth has eased since increasing to a 10-year high in February, although still remains high by recent standards. The US economy also created a solid 164,000 net jobs in July. While the twelve month average is now back below the 200,000 level and at its lowest level since April 2018, we believe that we are far from the job creation levels that would warrant a sustained easing cycle.
Jerome Powell’s less-dovish-than-expected comments at the July meeting fell short of the market expectations, which had been pricing in another two interest rate cuts from the Fed later in the year. While Powell did not state that the move was a ‘one and done’ scenario, he did indicate that additional cuts would be data-dependent. His suggestion that ‘nothing in the US economy poses a major near term threat’ is an indication that we would need to see a deterioration in macroeconomic news in the coming months in order to once again force the Fed’s hand. Our relatively optimistic view on global trade means that while we think that Trump’s tariff announcement in August has renewed the possibility of another rate cut in September, we think that we would need to see a significant deterioration in global macroeconomic conditions in order to trigger an aggressive easing cycle.
Despite the above, we believe that the bar for Federal Reserve interest rate cuts is lower than that of the European Central Bank and indeed most other G10 central banks. In addition, the fact is that there is further room to cut there than in the Eurozone. This, in our view, should be supportive of our forecast for a broadly weaker US Dollar against most major currencies. We therefore maintain our call for a gradual upward move in EUR/USD. We do, however, revise lower the short term path for the pair in order to reflect the less-dovish-than-anticipated stance adopted by the FOMC at its latest meeting in July.
News headlines in the UK have continued to be dominated by Brexit developments in the past few months.
UK Prime Minister May struck a deal with the European Union over a 585-page draft withdrawal agreement in late-November, but she was unable to force the deal through three separate parliament votes. While the margin of defeat for the third vote narrowed to 58 MPs, this was still far short of commanding a majority. The failure of Prime Minister Theresa May to force her Brexit withdrawal agreement through parliament has heightened concerns that the UK could be heading towards a ‘no deal’ Brexit come the delayed 31st October EU exit date. These concerns have sent Sterling sharply lower against its major peers since the beginning of May, with the Pound extending its losses to around eight-and-a-half percent versus the US Dollar in the past five months alone. This, combined with soft domestic data and increasing bets on Bank of England rate cuts explain why the UK currency is currently trading around its weakest position in trade-weighted terms since October 2016.
UK Prime Minister May struck a deal with the European Union over a 585-page draft withdrawal agreement in late-November, but she was unable to force the deal through three separate parliament votes. While the margin of defeat for the third vote narrowed to 58 MPs, this was still far short of commanding a majority.
The key sticking point to Brexit has been the inclusion of the so-called Northern Irish ‘backstop’ in the withdrawal agreement. The backstop, a failsafe mechanism that ensures the avoidance of a hard border between Northern Ireland and the Republic of Ireland after Brexit, essentially ties the UK into the customs union for an indefinite period of time. This is something that the hard Brexiteers within the House of Commons have been firmly opposed to. The reality of a Johnson-led Tory Party has unnerved investors and contributed to much of the recent weakness in the Pound. Johnson has appeared the least concerned of all the Tory leadership candidates regarding the possibility of a ‘no deal’ Brexit and has been the most vocal in the view that the UK will leave the European Union on 31st October come what may.
Heightened ‘no deal’ concerns have been reflected in the latest bookmaker odds, which are now placing more than a 40% implied probability on the UK leaving the EU without a deal in place, up from around 16% a matter of weeks ago. While the House of Commons has voted in favour of rejecting a ‘no deal’ outright, it is worth noting that this amendment is not legally binding and the possibility of the UK leaving the EU without a deal in place at the end of October remains.
We’re beginning to see the uncertainty over Brexit filter its way through to generally weaker UK consumer and business activity. The UK economy expanded at a decent pace of 0.5% quarter-on-quarter in the first three months of the year, but the latest indicators of economic activity ensure that growth is all but certain to have slowed in the second quarter. Recent PMI prints have been particularly soft and are all now around or below the level of 50 that separates expansion from contraction. The composite PMI, which represents a weighted average of activity of the UK’s services, manufacturing and construction sectors, came in at 49.7 in June, the first time it has fallen into contractionary territory since the immediate aftermath of the EU referendum in July 2016. The Bank of England is now forecasting the economy to post flat growth in the second quarter, a downward revision from the previous 0.2% estimate.
With domestic activity slowing and the Brexit saga dragging on longer than expected, market pricing has shifted from penciling in tighter Bank of England policy commencing in early-2020 to pricing in interest rate cuts. At its most recent meeting in August, the BoE once again reaffirmed its wait-and-see stance, although it did revise lower its growth forecasts. Governor Mark Carney has stated that the perceived likelihood of a ‘no deal’ has increased, while noting heightened downside risks to growth. It also reiterated its view that easing is possible should a Brexit deal fail to be agreed.
It is worth noting that UK inflation has also declined in the past twelve months. Core inflation came in at 1.8% in June, just above its lowest level since January 2017 and now comfortably below the central bank’s 2% target.
We do stress, however, that the UK labour market remains a bright spot and could encourage the BoE to reaffirm its view that ‘gradual’ and ‘limited’ interest rate hikes are required over the forecast horizon, provided we get a Brexit deal in the interim. The rate of UK unemployment has fallen again, declining to a fresh four decade low 3.8% in the three months to April. Earnings growth has also accelerated again to back around a decade high above 3% and in real terms is currently just above 1%.
This is a very healthy level by recent standards and may provide support to UK growth should it filter its way through to an improvement in domestic consumer activity.
We think that Sterling will continue to be driven almost entirely by Brexit developments throughout the remainder of 2019. While we acknowledge that the risk of a ‘no deal’ has undoubtedly increased in recent weeks, we remain bullish on the Pound. Our base case scenario remains for an agreement to be forced through the House of Commons at some point before the 31st October exit date. It is clear that there remains little appetite for a ‘no deal’ among the majority of the House of Commons and indeed the EU. We are, however, increasingly of the view that this may require the calling of a general election in order to break the impasse. That being said, we think that the path of least resistance for Sterling in the coming weeks is lower. Each day that passes without positive Brexit news edges the UK closer to an acrimonious ‘no deal’ exit from the European Union, widely regarded as the worst case scenario for both the UK economy and the Pound. Under such a scenario we would expect to see a sell-off in Sterling of anywhere between 5-10% from current levels versus the US Dollar. By contrast, any scenario that avoids a ‘no deal’ would, in our view, send the Pound sharply higher and ensure that Sterling ends the year as one of the best performing currencies in the G10. We do, however, revise lower our GBP forecasts across the board to reflect the delayed timetable for a Brexit agreement.
The downward trend witnessed in the Euro at the beginning of the year has recommenced itself since the end of June.
While expectations for Federal Reserve interest rate cuts have increased, the European Central Bank has also continued to strike a dovish tone, with President Mario Draghi suggesting that additional policy easing may be on the cards in the Eurozone at some point later in 2019. ECB dovishness, combined with a string of generally soft domestic economic data, sent EUR/USD back towards the 1.10 level in late-July. The pair is currently trading around 2.5% lower year-to-date.
ECB President Mario Draghi caught the market off-guard during his 17th June speech in Sintra, Portugal. Draghi stated that ‘lingering’ downside risks were strengthening the case for ECB policy action, claiming that ‘additional stimulus will be required’ should the outlook for the Euro Area economy fail to improve. This message was reiterated at the bank’s July meeting, in which the bank give its clearest indication yet that it was willing and able to ease policy as soon as its September meeting.
Regarding its future policy moves, the bank’s statement noted that ‘the Governing Council expects the key ECB interest rates to remain at their present or lower levels at least through the first half of 2020.’ The addition of the word ‘lower’ to the bank’s previous statement in June marks a significant change in forward guidance that suggests that the bank is ready to follow suit with the Federal Reserve in easing policy at its next meeting. Draghi also suggested that in addition to modifying interest rates, the reintroduction of its quantitative easing programme could be on the cards. The ECB is said to be examining options ‘such as the design of a tiered system for reserve remuneration, and options for the size and composition of potential new net asset purchases.’
Mario Draghi also struck a dovish tone during the bank’s press conference, voicing heightened concerns over the outlook for the Euro Area economy. He stated that significant stimulus was still necessary, while noting that recent data pointed to ‘somewhat weaker growth’ in the second and third quarters. Draghi also claimed that the chances of a rebound in activity in H2 were now lower, highlighting the recent downturn in manufacturing data and growing external downside risks, namely protectionism and the possibility of a hard Brexit.
Draghi’s comments suggest that the central bank is more concerned about global trade uncertainties than the market had previously anticipated. The shift to a more dovish stance has also followed another period of generally weaker-than-expected economic data out of the Eurozone. We have long reiterated that the ECB will maintain an accommodative policy stance so long as Eurozone inflation remains well short of the central bank’s ‘close to, but below 2%’ target.
Headline inflation came in at just 1.1% year-on-year in July, its lowest level since late-2016. The critical core inflation measure, the main economic data print the central bank looks at when deciding on monetary policy, has also remained stuck well short of target, coming in at just 0.9%. This measure has hovered around the 1% mark every month for the past five years and has, as of yet, not shown any signs of an uptrend towards the bank’s target. A robust labour market should begin to filter its way to higher inflation, although this has taken much longer than the central bank (and us) initially anticipated.
The Eurozone’s economy has also slowed in the past year, which has helped increase speculation that ECB rate-setters will consider adopting an even more accommodative policy stance in the coming months. Growth in the second quarter of the year came in at just 0.2% QoQ and 1.1% on a year previous, its slowest pace since 2013.
The crucial composite PMI has risen off five-year lows from earlier in the year, driven by a pick up in services. The manufacturing index has been on a sharp downward trajectory ever since the beginning of 2018 and has now been below the level of 50 denoting contraction for six months. Industrial production has also posted positive month-on-month growth on only two occasions since September 2018, although this measure did increase by a solid 0.9% month-on-month in May.
We think that the inclusion of the phrase ‘lower levels’ with regards to future interest rates in the ECB’s statement is significant and paves the way for fresh stimulus at the central bank’s next meeting in September, when updated economic projections will be released. This, we believe, will include a 10 basis point rate reduction and could potentially entail a resumption in the ECB’s asset purchasing programme. Following Mario Draghi’s dovish speech in July, financial markets are now placing a 100% implied probability of an interest rate cut from the ECB in September, a sharp increase on the approximate 20% that it was pricing in back in mid-May. Policymakers in the Eurozone are clearly concerned about growing downside risks to the outlook and the failure of the Euro Area economy to generate inflationary pressure.
Despite the heightened probability of lower rates from the ECB, we still believe that the likely path for EUR/USD this year is higher. With interest rates in the Eurozone already at or below zero, the Federal Reserve has much more room to lower rates than its European counterpart. This, we believe, should provide decent support for the common currency during the remainder of 2019. We therefore maintain our forecasts for a gradual appreciation in EUR/USD back towards the 1.18 level by the end of next year. In this regard, the fact that the Euro is now trading higher than before the Federal Reserve’s ‘hawkish cut’ and a raft of negative economic news in the Eurozone is significant.