G4 forecast revision - September 2016

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Federal Reserve edges towards December interest rate hike

Financial markets are focusing again on the monetary policy directions of the major central banks around the world.

Federal Reserve Chair Janet Yellen has continued to strike a fairly hawkish tone, opening up the possibility of more than one interest rate hike by the Fed before the year is out. Speaking at the central bank’s heavily scrutinised annual Jackson Hole conference in Wyoming in the last week of August, Yellen explicitly stated that the case for higher interest rates in the US had strengthened.

However, the most recent US labour report since Yellen’s Jackson Hole appearance was fairly subdued with a slightly disappointing 151,000 jobs created in August, much lower than the previous two months figures both of which exceeded 270,000 (Figure 1). Average earnings growth also slowed, while unemployment remained unchanged for the third straight month.


Figure 1: US Nonfarm Payrolls (2010 – 2016)

Source: Thomson Reuters Datastream Date: 13/09/2016

We think that this weaker-than-expected payrolls number rules out the possibility of a second post-financial crisis interest rate hike in the US in September, although we still expect rates to be raised at the FOMC’s December meeting and every quarter thereafter in 2017. The delay in higher rates in the US means that we push out our call for EUR/USD parity back into the first quarter of next year.

Meanwhile in Europe, expectations for additional monetary policy action from the European Central Bank have increased since the Brexit vote, given the complete lack of inflationary pressure in the Eurozone. The Governing Council kept its monetary policy unchanged in September, although we expect to see at least an extension in its asset purchasing programme at its December meeting.

In the UK, the Pound has stabilised since the Bank of England cut its main interest rate for the first time in nearly a decade in August. The latest PMI’s have all picked up following a dire performance in July, suggesting that the negative effects on the UK economy from the Brexit vote may prove less significant than first feared. We think that calls for another sharp decline in Sterling are unfounded and expect a further stabilisation around the 1.30-1.35 levels against the US Dollar.

The Japanese Yen has also remained at very strong levels in the past few months, having broken back below the physiological level of 100 to the US Dollar in August following an apparent reluctance of the Bank of Japan to ramp up its monetary stimulus measures. The Bank of Japan disappointed the markets again in August by announcing only a very modest increase in its equity purchasing policy while keeping its main QE programme and interest rate unchanged.

Despite the recent soft performance in the US Dollar, we think the continued divergence in the monetary policy stances between that of the Fed and most other G10 central banks, namely the ECB and the BoJ, should ensure the Dollar recommences its upward trend against most major currencies. However, the likelihood of a later-than-anticipated interest rate hike by the Federal Reserve means we push back our timetable for US Dollar appreciation.

 

UK Pound (GBP)

Sterling has stabilised around the 1.30-1.35 range against the US Dollar since suffering its worst ever one-day performance and falling to its weakest position in three decades following the surprise Brexit vote in June. The currency has rebounded since mid-August despite the decision taken by the Bank of England to cut its benchmark interest rate for the first time since 2009.

The Bank of England voted unanimously at its August meeting to cut rates by 25 basis points to a fresh record low 0.25%, while also increasing its quantitative easing programme by £60 billion to £435 billion. Moreover, the central bank will now buy up to £10 billion of corporate debt, while launching a new ‘Term Funding Scheme’ of up to £100 billion in order to ensure commercial banks pass on the full rate cut to their borrowers.

The decision to launch a raft of new stimulus measures followed a string of fairly dire business activity PMI’s for July which suggested that the shock Brexit vote had put the UK economy on course to enter into its first recession in seven years. Service sector growth slumped by its most on record, while manufacturing activity suffered its worst month since February 2013.

However, fears of an outright recession in Britain this year have begun to abate following an impressive rebound in economic activity in August. The services PMI, of which accounts for around 80% of overall economic output, rose sharply to 52.9 from 47.4, back above the key level of 50 that denotes expansion. Manufacturing activity also experienced its joint largest month-on-month increase in the survey’s 25 year history, surging to a ten month high 53.3 from 48.3 (Figure 2).


Figure 2: UK Purchasing Managers’ Indexes (2014 – 2016)

 

Source: Thomson Reuters Datastream Date: 13/09/2016

Consumers in the UK also appeared to have shrugged off uncertainty created in the immediate aftermath of the Brexit vote. Retail sales growth surged by 1.4% on a month previous and by 5.9% year-on-year in July, marking its largest yearly expansion since September last year (Figure 3). Consumer confidence also picked up again in August having fallen to its lowest level since late-2013 following the referendum result.

Figure 3: UK Retail Sales (2010 - 2016)

 

Source: Thomson Reuters Datastream Date: 13/09/2016

We think that the UK economy will avoid falling into a technical recession this year, although we still expect near static growth in the third quarter of the year in line with the projections made by the Bank of England during its August inflation report.

Despite this apparent rebound in activity, Governor of the Bank of England Mark Carney reiterated in September that the BoE stands ready to take whatever action needed in order to support the UK economy. We remain of the opinion that further easing measures could be on the way should economic data in the next few months take another turn for the worse.

The less dire than expected performance in the UK economy following the Brexit vote has so far provided decent support for Sterling, with a reversal in bearish Sterling positions causing the currency to recover to its strongest position since mid-July in September.

We continue to expect the Pound to remain mostly stable in its recent range, while slowly depreciating back towards to 1.30 level against the US Dollar as the Federal Reserve gradually hikes interest rates at the end of this year and throughout 2017. This should ensure a moderate appreciation versus the Euro.

 

 

GBP/USD

GBP/EUR

E-2016

1.33

1.30

Q1-2017

1.32

1.33

Q2-2017

1.31

1.35

Q3-2017

1.30

1.35

E-2017

1.30

1.37

E-2018

1.30

1.37

 

US Dollar (USD)

Expectations for the next interest rate hike by the Federal Reserve have been the key driving factor in financial markets ever since the initial Brexit shock dissipated, with the central bank in the US now edging closer to its first interest rate hike since December 2015.

Chair Janet Yellen made it clear that higher rates are on the horizon during her annual speech at the Jackson Hole conference at the end of August. Yellen claimed that the case for another hike had strengthened “in light of the continued solid performance of the labour market and our outlook for economic activity and inflation”.

However, the likelihood of multiple rate increases this year now looks slim following the release of a slightly underwhelming labour report released in the first week of September. The US economy added 151,000 jobs in August, less than the 180,000 consensus and significantly down on the previous two months which added a combined 546,000 jobs following upward revisions (Figure 1).

We think the US jobs market still remains in very good health despite this slightly weak report, with the three month average of job creation comfortably in excess of 200,000. The jobless rate remained unchanged for the third straight month at 4.9%, below the level that the Fed deems as the rate of full employment. Average earnings growth is also above its recent average despite dipping to 2.4% in August, and remains well above the level of inflation (Figure 4).


Figure 4: US Average Hourly Earnings (2010 – 2016)

 

Source: Thomson Reuters Datastream Date: 13/09/2016

The level of JOLTS job openings, a survey measuring the number job vacancies in the US, also surged to a record high in July (Figure 5), further pointing to an improvement in overall labour market conditions.


Figure 5: US JOLTS Job Openings (2006 – 2016)

 

Source: Thomson Reuters Datastream Date: 13/09/2016

The US housing market also appears to be recovering at a steady pace, albeit still remaining well below pre-recession levels. Housing starts are hovering around an eight year peak, while new home sales rose sharply by over 12% in July to highest level since 2007 (Figure 6).


Figure 6: US Housing Starts & New Home Sales (1990 – 2016)

Source: Thomson Reuters Datastream Date: 13/09/2016

The US Dollar also appears to be paying little attention to the Presidential Election in November, suggesting to us that the market never really priced in the possibility of a Donald Trump victory, which now looks increasingly unlikely.

While the chances of a September rate hike have begun to recede, we think that the still impressive labour market performance in the US should allow the Federal Reserve to hike interest rates by a further 25 basis points for the first time in a year at its December FOMC meeting. Financial markets are currently pricing in around a 60% chance of a hike before the year is out. Provided the labour market continues to hold up well in the face of higher rates, we expect to see additional hikes throughout 2017 on a quarterly basis in line with the Fed’s June dot plot (Figure 7).


Figure 7: Federal Reserve “Dot Plot” (June 2016)

Source: Thomson Reuters Datastream Date: 15/06/2016

Gradually increasing interest rates by the Federal Reserve should, in our view, recommence the US Dollar’s rally against almost every major currency, particularly so against both the Euro and the Japanese Yen. However, we push back our timetable for US Dollar appreciation given the delay in the Fed’s monetary tightening plans and now forecast parity in EUR/USD at some point in the first quarter of 2017.

 

 

EUR/USD

GBP/USD

E-2016

1.02

1.33

Q1-2017

0.99

1.32

Q2-2017

0.97

1.31

Q3-2017

0.96

1.30

E-2017

0.95

1.30

E-2018

0.95

1.30

 

Euro (EUR)

The Euro has held up relatively well of late despite heavy pressure from both the European Central Bank’s (ECB) ultra-loose monetary policy stance and the raft of political problems currently plaguing much of Europe.

The ECB has maintained its large scale quantitative easing programme at 80 billion Euros a month since March while keeping both its main refinancing and deposit rates unchanged at 0% and -0.4% respectively at its September meeting. There was, in fact, no change in the ECB’s statement from its previous meeting in July. The Governing Council surprised the market (and ourselves) by opting to not extend the timeframe of its asset purchasing programme beyond the existing March 2017 timeframe, although there remains scope for extension “if necessary”.

President Mario Draghi also failed to provide any clear hints that further stimulus could be in the pipeline. Draghi reiterated his view that the central bank’s existing policy stance was working effectively, instead blaming Brexit uncertainty for the recent sluggish growth in the Eurozone.

Despite the lack of any immediate action, we think that the stream of poor economic news out of the Eurozone of late means that at the very least an extension in the timeframe of purchases beyond March 2017 is now looking increasingly likely. We expect the QE program to be extended by at least six months no later than the December meeting.

Economic growth in the Eurozone remains very soft, with GDP growing by a fairly dour 0.3% in the second quarter of the year following a 0.5% expansion in the first three months of 2016. The latest business activity PMI’s have also all declined so far in 2016, with the composite index falling to its lowest level in a year-and-a-half in August (Figure 8). The ECB acknowledged as much by announcing a very minor downgrade to its growth forecasts for 2017 to 1.6% from 1.7%.


Figure 8: Eurozone Purchasing Managers’ Indexes (PMI’s) (2013 – 2016)

Source: Thomson Reuters Datastream Date: 13/09/2016

Inflation in the Eurozone has also failed to show the meaningful turnaround that the ECB would have hoped for, having now shown little or negative growth in every month for almost two years. The ECB nudged their 2016 inflation forecast lower from 1.3% to 1.2% in September, although even this looks optimistic given consumer price growth registered a meagre 0.2% in August (Figure 9).

Figure 9: Eurozone Inflation Rate (2009 – 2016)

Source: Thomson Reuters Datastream Date: 13/09/2016

The stability of the Eurozone’s political landscape is also looking increasingly shaky, particularly following the Brexit vote. Spain now faces its third general election in a year after the conservative People’s Party failed to form a new government in the summer, while concerns are brewing again in Greece that the country is not making sufficient progress to meet the conditions of its third bailout. Italy also faces its own referendum in October on a number of widespread political reforms, while its banking system is currently plagued by a plethora of bad loans.

We think that the escalating political problems in the Eurozone and the soon to be growing monetary easing stance from the European Central Bank should recommence the Euro’s downward path against almost every major currency. This will be particularly so against the US Dollar which we expect the single currency to reach parity with at some point in the first three months of next year.

 

 

EUR/USD

EUR/GBP

E-2016

1.02

0.77

Q1-2017

0.99

0.75

Q2-2017

0.97

0.74

Q3-2017

0.96

0.74

E-2017

0.95

0.73

E-2018

0.95

0.73

 

Japanese Yen (JPY)

The Japanese Yen has continued to show remarkable resilience in the third quarter of the year, having so far in 2016 strengthened sharply against almost every currency in the world. The Yen has comfortably been the best performing G10 currency this year, rallying in excess of 17% against the US Dollar (Figure 10) amid growing uncertainty in financial markets and the Bank of Japan’s reluctance to ramp up its existing quantitative easing programme.


Figure 10: USD/JPY (January ’16 – September ‘16)

Source: Thomson Reuters Datastream Date: 13/09/2016

At the Bank of Japan’s latest meeting in July, the central bank disappointed investors, announcing just a small tweak to its monetary policy. The main interest rate and QE programme were left unchanged, while increasing its exchange-traded fund purchases to an annual pace of 6 trillion Yen, up from its previous pace of 3.3 trillion Yen.

A number of senior officials in Japan, including Prime Minister Shinzo Abe, have suggested that the country won’t hesitate to increase stimulus if needed. BoJ Deputy Governor Hiroshi Nakaso claimed in early-September that the central bank would not rule out deepening negative interest rates or introducing other measures in order to achieve its inflation target.

The lack of any meaningful additional easing measures from the Bank of Japan comes as a bit of a surprise given the complete lack of inflationary pressure in the Japanese economy. Headline inflation has nosedived so far this year, having now been in negative territory for each of the past five months. Consumer prices fell by 0.4% in July (Figure 11), with the idea of the central bank reaching its 2% inflation target any time soon looking increasingly notional.


Figure 11: Japan Inflation Rate (2010 – 2016)

Source: Thomson Reuters Datastream Date: 13/09/2016

Economic growth for the second quarter was revised upwards slightly, although still remains weak with the economy growing by just 0.7% annualised in the three months to June. A strong Yen and weak demand from abroad has hurt exports and lowered capital spending. Exports fell for the tenth straight month in July having fallen by 14% on a year previous, its largest annual decline since the financial crisis.

We think the bleak economic outlook in Japan heaps further pressure on the BoJ to act when it conducts its comprehensive assessment later this month. We don’t think the Bank of Japan can afford to disappoint markets again and expect to see some form of rate cut coupled with measures to protect commercial bank profitability when policymakers next convene at their 20-21 September meeting.

Given the delay in the timetable of additional easing from the Bank of Japan and the subsequent resilience shown by the Yen, we lower our short term forecasts for JPY. However, we still forecast a depreciation of the currency from current levels against the US Dollar and a much more gradual one versus the Euro.

 

 

USD/JPY

EUR/JPY

GBP/JPY

E-2016

109

111

145

Q1-2017

113

112

149

Q2-2017

118

114

155

Q3-2017

119

114

155

E-2017

120

114

156

E-2018

120

114

156

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