Federal Reserve: Committed to Hawkish Policy?

Federal Reserve: Committed to Hawkish Policy? 

The Federal Reserve is expected to take its first steps towards normalizing monetary policy in the middle of 2015, with the market anticipating a rate rise sometime in June or July. 

The US is in a position of cyclical leadership with the economy doing well, particularly the jobs market, and the US managing to buck the global disinflation trend. 

The US created over 300,000 jobs in November, but more important to Fed policy was the 0.4% rise in hourly earnings for November, which was the largest monthly rise since October 2011. The expected rate rise from the Fed has been one of the major factors behind dollar strength in 2014. The greenback has outperformed all of the major currencies and all of the emerging market currencies bar the Indian rupee (INR) and the Hong Kong dollar (HKD). Due to the divergent monetary policy paths between the Fed and other major central banks, the dollar is in a good position to continue to outperform in 2015, at least for the first half of the year. In the first few months of 2015 we think that the focus will shift towards what the Fed will do after the first rate hike. Right now the market is looking for two further hikes for the rest of the year, which has been supported by the economic data; however, the bigger risk in our view is that the Fed is not as hawkish as some expect. The Fed may have adopted a hawkish tone at its October meeting, but it could change its tune if the economic data starts to deteriorate or if the US catches the disinflation bug from the steep drop in oil prices. The other major risk to the Fed outlook is the dollar. So far the Fed has been remarkably tolerant of a strengthening greenback while other major central banks have been happy to see their currencies depreciate, including the Bank of Japan and the ECB. If the strong dollar trend continues in the first half of next year, the Fed may decide that it no longer wants to lose the race to the bottom. If the Fed starts to talk down the prospect of multiple rate hikes next year then we could see a sharp reversal in the dollar, and some respite for emerging market currencies that have fallen sharply against the greenback including the Brazilian real, South African rand and Russian ruble. While we expect the dollar to reign supreme in Q1 2015, its performance for the second half of the year could be tricky depending on the Fed’s tolerance of dollar strength. FX markets could face another year trying to parse Fed statements to see if Fed members are happy with the level of the buck. Thus, 2015 could be a year of two halves for the Fed: the first half could be about making the long-awaited rate hike, while the second half could be a more cautious Fed who tempers its rate-hike talk to limit dollar upside. Eurozone: To QE or Not To QE, That Is the Question… Big things are expected of the European Central Bank in 2015. After the Fed ended its quantitative easing program in October, the market has been waiting for the ECB, along with the BOJ, to take its place by providing the global financial system with Fed-style liquidity. But while the BOJ have been willing to step into the Fed’s shoes by announcing a second round of QE late last year, the same may not be true for the ECB. The ECB held steady at its December meeting; however, ECB President Draghi has sounded more supportive about the prospect of further easing and potential QE in recent weeks. As we move into 2015 we continue to think that the bar to QE remains high. According to German press reports after the December ECB meeting, three members of the ECB’s six-strong executive board refused to sign off Mr. Draghgi’s statement. Considering there is still a legal challenge outstanding on the ECB’s OMT program, don’t expect the opposition to QE to soften by the time of the first ECB meeting of 2015 on January 22nd. 

A caveat to our theory that the ECB will not embark on QE would kick in if inflation falls below 0% in December. If this happens then we could see the ECB take some action, but we doubt that the ECB will fill the Fed’s shoes when it comes to QE, or even match Draghi’s pledge to boost the ECB balance sheet by EUR 1 trillion. Draghi talked about this six months ago and said a larger balance sheet was needed to ward off deflation fears. But since then nothing has happened and the ECB’s balance sheet has shrunk by EUR 100 billion. But will an ECB QE program actually work? Unfortunately for the ECB, the answer isn’t as clear as it may hope. The two most recent large-scale versions of QE were the US version (QE3) and the Japanese version (QQE); one has been a resounding success so far, the other not so much. As the US enjoys accelerated job growth, healthy GDP growth and inflation on the lower end of acceptability, Japan has experienced a worsening economy and still too low inflation despite the enormous size of stimulus in terms of the size of their economy. What Europe needs to find is at least some semblance of what the Fed has done with its version of QE. However, you will notice that there is a “3” next to the Fed’s QE which means that this was the third time around for the world’s most influential central bank, so getting it right isn’t easy. The easiest outcome for Mario Draghi would be a large take-up of its longer-term refinancing operations (known asTLTRO). Back in September the Bank only managed to attract bids to the value of EUR 82.6 billion for its cheap loans. The market will be looking for take-up around the EUR 150 billion mark at future auctions. If this happens then QE may not be deemed necessary, which could save Draghi a fight with his German colleagues. Apart from QE, the ECB could have more pressing problems to deal with in 2015. Greece is expected to have a general election sometime in spring, which could see a win for the anti-euro SYRIZA party. This may widen sovereign credit spreads, and could make it hard for Greece to remain in the currency bloc if its new government does not adhere to the strict terms of its 2010 bailout. The impact on the EUR is likely to be negative. Widening sovereign spreads combined with QE could trigger another leg lower to below 1.20 vs. the USD. However, even though deflation fears and Greek political risks could prove toxic for the EUR, bears need to be careful. Firstly, the EUR has already had a sharp fall vs. the USD. Secondly, the market is already short the EUR which leaves the single currency at risk of a reversal. Lastly, as we mention above, the Fed may not be comfortable with dollar strength and could adjust its policy towards the middle of 2015 to limit upside in the greenback. Overall, the outlook is negative for the EUR, albeit with a potential slowdown in the pace of depreciation in the second half of 2015. Japan: Sowing the Seeds of Hyperinflation Do a quick Google search on “Japan” and “hyperinflation” and you’ll likely come across a litany of articles and prophecies declaring that The Land of the Rising Sun has already pulled a Wile E. Coyote; namely that they’ve already run off the inflationary cliff, but we’re just waiting for them to realize it and plummet to the earth. Granted, some of those doomsayers were saying the same thing back in 2010 or 2013 or probably even before then if you dig deep enough. The problem for these prognosticators is that it hasn’t come to fruition despite all the warning signs blinking red across the board. In fact, for years Japan has been adding to situations that historically help trigger a hyper inflationary event.

One of the most frequently quoted metrics for determining the future fate of Japanese inflation is their debt-to-GDPratio, or gross government debt as a percentage of GDP. In this category, Japan is at the top of the world at 237.92%, and they really shouldn’t want to be there. The list of nations that are actually doing BETTER than Japan in this category is a who’s who of economic strife: Zimbabwe, Greece, Portugal, Italy, Iceland, Ireland, and Lebanon, just to name a few. In its defense, Japan does have plans to try to lower that debt-to-GDP burden as a consequence of Prime Minister Shinzo Abe’s economic stimulus program (lovingly dubbed “Abenomics”), but it hasn’t gone according to plan so far. In an effort to bring budgets closer to actual revenue there was a consumption tax hike back on April 1st 2014 (that wasn’t an April Fool’s joke), which was supposed to be followed by another hike in 2015 that has now been delayed for 18 months due to a struggling economy. In addition, the Bank of Japan has increased Quantitative Easing in an effort to get interest rates so low that Japanese investors stop buying Japanese Government Bonds. Past hyperinflationary episodes were largely caused by an increase in money supply to help pay off debts, the most well-known being the Weimar Republic in Germany in the 1920s. In an effort to bring Germany out of recession and pay off reparation debts from WWI, the German Papiermark was devalued by 50% in 1919 which kicked off the inflationary episode economists love to reference. Eventually, the Papiermark was replaced by the Rentenmark at a conversion of 1 trillion to 1 in 1923, which is utterly ridiculous when you think about it. However, it wasn’t just debt that helped trigger hyperinflation; there was also political uncertainty and overall loss of confidence as the Great Depression was felt especially hard in Germany. While Japan hasn’t outright devalued their currency in one fell swoop like Germany did back in 1919, they have devalued it by over 50% in the last two years as the USD/JPY has risen from sub 80 to over 120 at the time of this writing. In addition, the Bank of Japan has pledged to add to their already large QE (15% of GDP per annum) by double if the economy doesn’t start to recover, which would take that already burdensome debt-to-GDP ratio even higher. When Germany started experiencing hyperinflation, their debt-to-GDP ratio was just under 300%. Also Japanese politics are in flux as Abe has called for new elections and Japanese consumer confidence has declined in the latter half of 2014. When perceived as a whole, it appears that Japan has sown all the necessary seeds to bring about hyperinflation in the struggling state. However, once again, these seeds have been sown for many years now as doomsayers have been keen to point out. So will 2015 be the year that Japan finally falls down the rabbit hole? Whether hyperinflation is the ultimate result or not, it appears that the JPY might be losing even more value as the hyperinflationary seeds continue to germinate. Bank of England: Shifting to a Dovish Stance The last weeks of 2014 saw a sharp reduction in expectations around the timing of the first rate hike from the Bank of England. In the middle of 2014 the market had expected the BOE to hike rates at the end of Q1 2015; however, after a sharp fall in inflation and a deterioration in the UK’s growth outlook, expectations for the first rate hike have been pushed back to August 2015. This recalibration of rate expectations for the UK has been reflected in the pound, which has fallen more than 3% versus the USD since the start of the fourth quarter. The outlook remains bleak for the pound as we start the new year on the back of falling inflation expectations and monetary policy divergence with the Federal Reserve in the US. Falling inflation is a big risk for the pound this year, as the BOE may find it tough to hike interest rates if prices continue to fall. The Bank of England’s 12-month inflation expectations survey for November saw expectations fall to their lowest level since February 2010 (see the chart below). This is problematic for the Bank as maintaining price stability is its only mandate, yet inflation is falling sharply and could drop below 1% early next year. 

If inflation continues to miss the BOE’s 2% target rate then we would expect some more dovish talk from the MPC. While we don’t think that they will boost policy action to try and stem the disinflationary trend, we do think that they will be happy to push back market rate expectations until late 2015. From a currency perspective this is pound negative, but economic fundamentals may also weigh on the pound next year. The UK’s current account deficit is still a large 5.17% of GDP; this compares with a deficit of 2.25% of GDP in the US and a 2.41% surplus in the Eurozone. We think that the market will be less forgiving of the UK’s economic imbalances, especially as the other major economies have made large improvements. Added to this, political risk is back to the fore with the General Election in May (see our election preview for more). The pound’s performance next year could be somewhere in the middle between the US dollar and the Euro. We think it will continue to fall versus the USD due to political risk, a deteriorating growth outlook and divergent monetary policy paths for the Fed and the BOE, while it may continue to rise versus the EUR, especially if the ECB embarks on QE at some stage this year.  

Australia and New Zealand Continue to Head in Different Directions It’s going to be a very important year for Australia and New Zealand. Both economies face many trials in the year ahead, but New Zealand may emerge as the victor in the Trans-Tasman battle for growth. In Australia during 2013-14 a strong property market showed potential to spur economic growth in the broader economy, but the rest of the economy failed to respond and activity at the ground level remains restrained. This is set against a backdrop of retreating mining investment and falling key commodity prices, which doesn’t bode well for Australia’s all-important resources sector. It’s not all doom and gloom Down Under, however. There is some hope that a falling exchange rate and accommodative monetary policy will carry the economy through 2015. Since September 2014 the Australian dollar has taken a mauling, with AUDUSD down over 10% at the time of writing (this report was written in early December). The onus is on policymakers to help support the economy and foster sustainable economic growth. Further monetary policy loosening by the RBA next year should keep the economy from stalling, but GDP growth may fall to around 2.5% in 2015. This assumes the exchange rate remains in the low 0.8000’s and commodity prices don’t fall off another cliff. In NZ, the economy is much better situated to deal with threats to growth originating from falling commodity prices and even lackluster global commodity demand. NZ is heavily reliant on certain commodity exports, particularly dairy products. However, NZ has other avenues of growth to fall back on. Rebuilding efforts in Canterbury, a generally solid construction market and strong net immigration are expected to augment domestic demand in 2015. These reliable sources will provide a solid platform for growth this year. At the same time, the economy is dealing very efficiently with high levels of growth. In other words, it can sustain a high growth rate without booming inflation, which in turn gives the RBNZ more room to keep monetary policy at a more accommodate level for longer. The differing economic conditions and tolerances between Australia and NZ are expected to widen the interest-rate gap between the two nations. In Australia, the threat of a strong housing market is always going to be in the back of the RBA’s mind, but it can use macro-prudential tools to limit price pressures in the housing market. This will free up the RBA to use traditional monetary policy to support the broader economy. As such, we expect the RBA will cut the official cash rate next year. We believe that the RBA may hike rates twice next year, which would bring the cash rate to 2.00% by the end of 2015. Across the Tasman, the RBNZ is expected to begin tightening monetary policy next year, but not until Q3 or Q4. Easing price pressures in the housing market and only mild inflationary forces in the rest of the economy, largely due to falling commodity prices, mean that the RBNZ can maintain looser monetary policy for longer than would be possible if inflationary pressures were stronger. We see the RBNZ raising the cash rate to 3.75% late in the third quarter or early in Q4 2015.