26 October 2018
G10 FX Week Ahead: Looking pretty bleak

The US economy looks to be hitting new heights, while Europe remains once again plagued by politics. Throw into the mix the strongest US wage growth figures since the global financial crisis - and it's hard to see the US dollar not remaining bid in the near-term. The only thing to caution is that much of this story is already priced into global FX markets

US growth keeps booming as consumers splash the cash

Another decent growth number will be welcome news for President Trump, but for markets, the bigger question is where the economy goes next. We see no reason to expect an imminent correction, although growth may begin to ease in 2019 as higher rates bite and fiscal tailwinds fade

At 3.5%, the latest US quarterly growth figure will be welcome news for President Trump, who appears keen to play up his administration's economic credentials to rally the Republican vote ahead of a challenging mid-term election in a couple of weeks’ time.

Unsurprisingly, it was another exceptionally strong quarter for the US consumer, where the combination of tax cuts, rising wages and a tight jobs market saw spending contribute 2.7% to the overall economic growth figure. Admittedly, the latest quarterly accounts were also given a sizable boost by inventories, which helped offset a particularly sharp correction in net exports.

But the big question for markets, particularly in light of the recent stock market movements, is whether this is ‘as good as it gets’ for US growth. Well, at this stage we don’t see any real reason to expect growth to fall sharply, particularly given that the fourth quarter is likely to be boosted by rebuilding and clean-up efforts following the recent hurricanes int he south-east.

That said, there is a risk that, as we move into 2019, growth begins to ease. Tighter financial conditions – driven by higher interest rates and the stronger dollar – may start to bite, while persistent trade uncertainties and fading fiscal tailwinds may also begin to restrain activity more noticeably. However, the strong underpinnings of the tight jobs market and the resulting positive impact on wage growth are likely to stay with us into next year, and we still expect a decent 2.4% growth reading for 2019.

With that in mind, we expect the Federal Reserve to push ahead with its tightening cycle, hiking in December and three more times in 2019.

The EU and Switzerland: Another arduous negotiation not going to plan

The EU and Switzerland have been trying to negotiate a new framework agreement for the last four years, but the complex negotiations haven't been going very well and the chances of reaching an agreement this year are now minimal. The market equivalence of the Swiss stock exchange is at stake

An opportunity to replace 120 agreements

The EU and Switzerland are currently negotiating a framework agreement to formalise their relations and replace 120 different treaties that exist at the moment. The Brexit negotiations have pushed the European Commission to increase pressure on Switzerland to sign an agreement and want the framework to be more restrictive than it is now so that Switzerland-EU relations aren't seen as an example for countries looking to leave (or leaving) the EU.

Currently, Switzerland has access to the European common market by allowing the free movement of persons. It can enter into its own trade agreements, as it did a year ago by negotiating a free trade agreement with China. In practice, it is estimated that more than 33% of current Swiss legislation comes from European law, but there is no agreement currently obliging Switzerland to transpose European rules into its law. 

The negotiations have been going on for four years, but haven't been moving very fast

A framework agreement would make the process more automatic by forcing Swiss rules to automatically change to align with European ones in areas such as legal development, supervision, interpretation and dispute settlement. In addition, an arbitration panel would settle disputes between the EU and Switzerland and the European Court of Justice would have a crucial role to play.

The negotiations have been going on for four years, but haven't been moving very fast. To make the Swiss to negotiate more quickly, the EU has put forth certain arguments on the table that can hardly be ignored by Switzerland. 

In December 2017, the EU decided to link the progress of the negotiations with the recognition of the Swiss stock markets rules that allow cross-border trading, but that recognition had only been extended for a year until the end of 2018. Therefore, it needs to be renewed again and the EU has already announced that it will only do so if it considers that progress in negotiations has been sufficient. 

The EU will only renew the agreement to recgnise Swiss bourse trading rules if it deems sufficient progress has been made  on the negotiations

This implies that in December 2018, without sufficient progress in the negotiations, European's access to the Swiss stock exchange and securities listed in Switzerland could be threatened. Without equivalence, Switzerland will probably apply the same measure to the EU and no longer recognise European stock exchanges. No need to say that this threat is extremely strong for a global stock market such as Switzerland. Without this access, the Swiss financial system would be in great difficulty, and the consequences for the Swiss economy would be significant.

Bank of Russia confirms it’s in ‘standby’ mode

Bank of Russia fully confirmed our expectations by keeping the key rate at 7.5% and maintaining a cautious tone. The upcoming decisions are likely to be 'hold' - unless there are external shocks and/or local gasoline price growth fails to be addressed

CBR decision and reasoning in line with expectations

The Bank of Russia's decision to keep the key rate unchanged at 7.5% was in line with the consensus and our expectations. The reasoning behind the decision also doesn't surprise:

  • CPI is on track to accelerate from the current 3.5% year-on-year toward 3.8-4.2% YoY by year-end 2018 and 5.0-5.5% by year-end 2019 as a result of rouble depreciation pass-through and the upcoming VAT hike
  • Households' 12-month expectations somewhat improved in October (i.e. remaining near 10%, though no specific figure was provided)
  • GDP growth expectations from 2018-19F remain unchanged at around 1.5-1.7%
  • Financial markets have calmed since the September decision to put FX purchases on hold and raise the key rate by 25 basis points

Upcoming decisions likely to be between 'hold' and 'hike'

There was also no change in the assessment of the inflationary risks, which is also in line with our expectations. That highlights the uncertainties faced by the monetary authorities in the near- to mid-term. For now, we expect the key rate will remain unchanged until the end of next year under the assumption that the CPI will stay within the central bank (CBR) guidelines (including a temporary spike to 5.5-6.0% YoY in 1H18). At the same time, we acknowledge that the risks to our view on the CPI and key rate are tilted upwards.

  • The most obvious risk is external, which was directly mentioned in the CBR communique - including continued capital outflows from emerging markets and Russia-specific foreign policy risks. Remember that since April there were some RUB550 billion capital outflows from the state bond market (OFZ) and RUB8/USD depreciation - mostly on the back of global emerging market outflows. Still, non-residents hold around RUB1.8 trillion of OFZ, and we doubt that further tightening in sanctions has already been priced in.
  • The less obvious risk - the one CBR didn't mention - is the growing uncertainty regarding the local gasoline price growth. After a stable May-September, gasoline prices are back to 0.1% week-on-week growth since October. According to the media, the upcoming increase in excise tax and the overall tax changes in the oil industry may trigger an increase in the local gasoline prices by around 10%. The direct impact of such a spike on the CPI could be 0.4 percentage points (based on the gasoline's weight in the CPI basket). However, the secondary effects could amplify the potential deterioration in the inflationary trend. For now, it remains unclear whether the government will prevent this growth via budgetary or other means.

Our base-case scenario is unchanged 7.5% key rate in the upcoming meetings, but the risks to this view are tilted upwards.

Malaysia 2019 Budget Preview – A derailed fiscal consolidation

Sweeping policy changes under the Malaysian government’s drive to improve people's standard of living and drive out political corruption have strained public finances. We expect this to push the fiscal deficit above 3% and keep it there through 2019

Long-term inclusive growth, sustained development

The Mid-term Review of the 11th Malaysia Plan 2016-2020 (11MP) unveiled by Prime Minister Mahathir earlier this month (18 October) sets a clear tone for the upcoming Federal Budget for 2019 – a derailed fiscal consolidation. The first budget of the Pakatan Harapan [Alliance of Hope] coalition government will be presented to the parliament by Finance Minister Lim Guan Eng on Friday next week, 2 November.

As per the 11MP review, the fiscal policy by the new administration will be driven by objectives of an ‘inclusive growth and sustained development’. As tighter fiscal stance and risk from global trade tension slam the breaks on the economy, the government has downgraded GDP growth target for the remaining plan period, 2018-2020, by half a percentage point, from 5-6% in the original plan to 4.5-5.5%. The target for inflation is also revised slightly from 2.5-3% to 2-3%. And, contrary to the earlier target of a balanced budget by 2020, the fiscal deficit is now projected at 3% of GDP over the plan period.

Notwithstanding its drive to rein in high public debt the focus remains on continued fiscal consolidation. Yet the year 2018 will see the trend of steadily falling fiscal deficit underway since 2009 coming to an end; the deficit hit a record 6.7% of GDP in 2009 and has more than halved to 3% by 2007 (see below). The initial budget for 2018 under the previous administration had projected a further fall in the deficit to 2.8% this year. That's not going to materialise.

No surprises from the central bank of Turkey

Turkey's central bank kept the policy rate unchanged at 24% while pointing out the upside risks to the inflation outlook, ongoing strength in external demand and the slowdown in economic activity

Policy rate flat at 24%

At today's meeting, the central bank of Turkey kept the policy rate unchanged at 24%, in line with the Bloomberg median consensus and our call. This is following the sharp adjustment last month and with the recent lira strength on the back of Pastor Brunson’s release and subsequent signals from the US on lifting some sanctions. 

Markets first reacted negatively, and the lira moved to above 5.70 against the dollar, though later recovered towards 5.62s.

As we wrote before the meeting, the current recovery process of the lira could reduce some repercussions that we have witnessed since the beginning of this year including the declining FX pass through on inflation, given the high correlation between the lira's performance and core inflation. Secondly, the improving financial stability with a better operating environment for Turkish corporates that have a substantial short FX position. 

That would be a relief factor for the central bank along with improvements in the geopolitical picture that will likely support the capital flow outlook, despite continuing fundamental macroeconomic challenges, such as inflationary pressures.

Minor changes in the statement

In the statement, the central bank's growth assessment was broadly unchanged, pointing to the “slowdown in economic activity continues”, with an addition in the October statement that it is “partly due to tighter financial conditions”.

But, most importantly, the Bank remained vocal about price stability risks by, once again, reiterating price increases showing “generalised patterns across sub-sectors, reflecting the movements in exchange rates”. They also acknowledged upside risks in the inflation outlook despite “weaker domestic demand conditions will partially mitigate the deterioration”. 

Accordingly, it maintained a hawkish bias, keeping the main policy guidance in the statement unchanged. So, while highlighting the determination to tighten further, if needed, the bank will continue to monitor the lagged impact of recent monetary policy decisions and the contribution of fiscal policy to rebalancing process in addition to inflation expectations, pricing behaviour and other factors affecting inflation.

Despite the deteriorating inflation outlook with a surge in forward-looking expectations and fall in the ex-post real rate to the negative territory again, the central bank remained quiet.

This is probably because of rapid improvement in financial stability risks, the ongoing impact of recent financial volatility on the growth outlook, and expectations about the impact of the 10% price cut campaign on the inflation trend.

ECB: Not sexy but highly effective

The ECB remains determined to continue its chosen path to bring net QE to an end in December

No change today

No changes from the ECB and President Mario Draghi. As expected the European Central Bank sticks to its autopilot to bring net QE purchases to an end in December. It didn't deviate from its earlier language and looks highly determined to continue with its strategy, chosen in June.

Norges Bank stays on track for a Q1 hike next year

No change from the Norwegian central bank; gradual tightening path confirmed

Having raised the policy rate in September, little was expected from the Norges Bank today. And as usual, the central executive board delivered on expectations. Today’s statement indicates an unchanged policy stance, repeating the guidance that the next hike will most likely come in the first quarter of 2019, which we interpret as the March meeting, given the NB’s preference to move policy at meetings where they have new forecasts and a press conference.

The key assessment from policy statement indicates that:

“The Executive Board's assessment of the outlook and balance of risks imply a gradual increase in the key policy rate. Economic growth has been a little lower and inflation somewhat higher than projected, but the outlook and the balance of risks do not appear to have changed substantially since the September Report.”

With little news in today’s communication, the krone and short-term rates are largely unchanged.

So long as the Norwegian economy stays on track, and the rest of the world doesn’t fall off a cliff, we expect the NB will follow through on the Q1 hike. 

The key question remains what could cause them to shift from the current plan to raise rates on average twice per year. We continue to see the risks as skewed towards the upside, with the possibility of two hikes in the second half of 2019 in addition to the Q1 hike. But the recent sharp drop in the oil price and indications that the Eurozone and Sweden (key trading partners for Norway) are slowing down have reduced the chance of a more aggressive tightening path.

Bank of Canada hikes and hawkish tone suggests more to come

The central bank of Canada raised rates by 25bp today, but the question now is what will their 2019 tightening path look like? Downside risks linger, but unless they escalate, we see two more hikes coming next year

As widely expected, the Bank of Canada hiked the policy rate by 25 basis points bringing it to 1.75%. Although we expected to see a more dovish tone given the poor September CPI print of 2.2% year on year -considerably undershooting the 2.6% YoY consensus, the BoC remained upbeat with the view that the limited spare capacity in the economy will continue to put pressure on prices. This is why it looks set to continue on its tightening path.

Core inflation is the key variable for policy decisions, and despite the slight dip in September, the three main measures still averaged the BoC’s 2% target. As long as core data floats around this level, we expect further tightening in 2019. We predict two hikes in 1Q19 and 3Q19, taking the policy rate towards the lower end of the BoC's estimate of the nominal neutral rate (2.5%-3.5%, based on at-target inflation). 

If lingering downside risks subside, then a third hike next year isn't entirely out of question, particularly, if we see a pick-up in wage pressures on the back of labour shortages, as was hinted at in the latest BoC Business Outlook Survey.

Riksbank still in wait-and-see mode

No change from the Riksbank leaves the timing of the first interest rate increase uncertain. We continue to see a February hike as somewhat more likely than a move in December

The Riksbank left both the policy rate and the forecast for interest rates unchanged today. The policy statement is also broadly similar to September, indicating that the policy rate “will be raised by 0.25 percentage points either in December or February”. Two monetary policy committee members are now voting for an immediate rate hike (Martin Floden joining Henry Ohlsson in the hawkish dissenter’s camp).

The forecasts for GDP have been revised down following the statistics office’s major revision to the Q2 GDP figure, and now indicates somewhat weaker momentum in the Swedish economy. Unemployment has also been revised up following weaker employment growth figures.

Set against that, the inflation forecast is largely unchanged, and the statement is somewhat more optimistic that underlying price pressure is consistent with inflation remaining around the 2% target.

In our view, a December or February hike looks like a genuine 50-50 decision at this point and probably comes down to the data between now and the December meeting

In effect, the economic situation has reversed from the first half of this year, when GDP growth was very strong, but inflation looked anaemic. Now, price pressure look reasonably solid, at least in the near term, but growth is clearly slowing down. Similarly, global risks have shifted towards the downside and increasingly look like a factor that could nudge the inherently cautious Riksbank governors towards (an even more) gradual tightening path.

The fact that there is no indication that a December hike has become more likely, which to some extent had been expected after the strong September inflation reading, means today’s stance is very marginally more dovish than anticipated. As a result, the krona has weakened slightly, and near-term forward rates have shifted down a touch.

In our view, a December or February hike looks like a genuine 50-50 decision at this point and probably comes down to the data between now and the December meeting. 

We still see the Riksbank's forecast for GDP as somewhat on the optimistic side. Combined with further turbulence on global markets,  this suggests to us that the cautious majority on the Riksbank board are likely to push the first rate hike into February, but it is a close call.

Our October guide to global central banks

Everything you need to know about central bank policy around the world

Federal Reserve: Look for slightly more modest rate rises in 2019

While the Federal Reserve no longer views monetary policy as “accommodative” it certainly can’t be described as “restrictive”. Growth is strong, the unemployment rate is at a 50-year low and inflation is at or above the Fed’s 2% target on all the key measures. The ongoing support from massive tax cuts and mounting evidence of rising wage pressures suggest there is little reason to expect any meaningful slowdown in economic growth in the near term.

As such, the Fed suggests that the most likely course of action is a further rate hike in December taking it to a total of four 25bp interest rate rises in 2018. President Trump may not like it, but the Federal Reserve will continue to assert its independence and make policy fit the economic circumstances.

Economic activity will likely moderate in 2019 as the fiscal stimulus fades and the lagged effects of a strengthening dollar and higher interest rates dampen growth. There are also risks for growth in the form of trade protectionism and emerging market struggles, while the recent equity market wobble highlights an additional potential threat. As such, we look for a more modest set of interest rate rises in 2019 – we forecast three hikes that will be spread out over the first three quarters of 2019.

Reading time around 18 minutes

In case you missed it: A flurry of central bank meetings

Most central banks with meetings this week chose to keep rates on hold this and the ECB President Draghi put on a brave face on the outlook and the autopilot path, but make sense of all central banker's next moves with our exhaustive guide. Plus, the US reaches new heights and another political impasse on the hands of the EU - and no it isn't Brexit

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