12 October 2018
A test for the Fed

The combination of rising borrowing costs, trade tensions and geopolitical threats are stressing financial markets, but with US growth looking strong and inflation heading higher will the Federal Reserve ease back?

It wasn’t long ago when the big story in bond markets was the potential for an inverted yield curve. However, a 40 basis point rise in the 10-year Treasury yield over the past six weeks has put pay to that for now. The strong US growth and jobs story, combined with rising inflation has led the Federal Reserve to take a bolder position on the likely path for interest rates with officials clearly signalling a strong likelihood for four more rate rises over the next 15 months.

ECB: Auto pilot confirmed

The minutes of the ECB’s September meeting underline the Governing Council is very comfortable with the autopilot of a gradual quantitative easing tapering

Three main take-aways from the minutes

The just-released minutes of the European Central Bank’s September meeting give a good grasp of the discussion behind closed doors. Remember that the ECB had announced the expected and so-called anticipated reduction of monthly quantitative easing (QE) purchases from 30 billion euro to 15 billion euro, starting 1 October. 

For the rest, the forward guidance on an end of net asset purchases (end of this year) and interest rates (unchanged at least through the summer of 2019) had remained unchanged.

In the minutes, the following three issues stood out:

  • During the meeting, there had been an extensive discussion on the growth outlook and the potential impact from trade and emerging markets. As already illustrated by ECB president Mario Draghi’s comments at the press conference after the September meeting, the ECB had become a bit more cautious about potential risks to what is still regarded as a solid recovery. One member of the Governing Council even remarked that due to trade tensions and global risks, risks to activity could be characterised as being tilted to the downside.
  • The other important issue was the discussion on core inflation. Here, the ongoing discrepancy between low actual numbers and the ECB’s expectation of a pick-up still remain. It is obvious that the ECB still believes that supply-side constraints should translate into higher core inflation. However, the discussion also stressed that evidence of this materialising is still very scarce. There also seems to be some doubt within the ECB on whether higher wages would actually lead to higher inflation as an increase in labour productivity could mitigate any inflationary effect.
  • Finally, the word “vigorous” was missing in the minutes. Two weeks ago, Draghi’s comments at European Parliament about a “relatively vigorous” pick-up in underlying inflation in the coming years led to some excitement in financial markets. The fact that this wording is not in the minutes, as well as the fact that the ECB staff had actually lowered its core inflation projections for 2019 and 2020 at the September meeting, are in our view reason enough to believe that “vigorous” was one of the very rare slips of the tongue by the ECB president.

Little reason to doubt the ECB's auto pilot

Still, financial market participants keep on speculating about the timing of a first rate hike by the ECB. Every time, headline inflation picks up, or a hawkish member of the Governing Council makes a slightly misleading statement, market participants seem to get nervous. 

But, in our view, there is very little reason to doubt the ECB’s autopilot. The communication and the forward-guidance of the ECB since June has been very consistent and straightforward. The essence of the ECB’s strategy is a gradual end of the net asset purchases of QE by the end of the year and possibly a first rate in September or October next year. 

The only unanswered questions are for how long the ECB would be willing to continue reinvesting maturing assets, whether the ECB would first hike the deposit rate and then the refi rate or both together and what the size of the rate hike will be. 

However, it is currently far too early to answer these questions. Why should the ECB unnecessarily commit itself? As illustrated by the current market turmoil and doubts about the strength of the global economy, too much can happen between now and the end of summer 2019.

Brexit blog: Just how close is a deal?

Headlines suggest the EU and UK are getting closer to a deal – but finding the right words for the political declaration on a future trading relationship, that'll convince UK lawmakers to vote in favour of it, appears to be proving difficult

Finally, some progress on the Irish border issue

Over the past week or so, UK headlines have been dominated by reports that both sides are inching closer to a deal. But so far there have been mixed messages on exactly what could be agreed, and when it might happen. To get a better handle of what's going on, let's break it down into the two things that need to be resolved between the UK and EU.

Firstly, there's the so-called Irish backstop, where discussions are beginning to get very technical. We dived into this in more detail last week, but ITV's Robert Peston reports that the EU could be prepared to accept British demands for an all-UK customs union to be built into the Irish backstop solution. In exchange, the UK would need to accept that regulatory checks could arise between Northern Ireland and the British mainland if they leave the single market in future.

Some reports indicate this could be settled in time for the EU Council meeting next week, but as ever the challenge is 'wording' it in such a way that will convince MPs to vote in favour of the agreement. That's where the second part of the agreement comes in - the political declaration on future trade - and this is where there seems to be more disagreement on the way forward.

US Treasury FX Report Preview: From trade war to currency war?

The US Treasury is set to release its FX report anytime now. While no major US trading partner meets the technical criteria to be labelled a currency manipulator, there are risks the US administration finds a loophole. Should the US opt to take the trade war into the currency arena, a market positioned long US dollar may quickly bail on the greenback

No 'major trading partner' of the US currently meets all of Congress's 'currency manipulator' criteria

Despite speculation that the FX report could be released this week, the general consensus is that it will likely be out next week after Treasury Secretary Steve Mnuchin returns from the IMF meetings. Here are some of our quick thoughts:

  • Currently, no major currency meets all three criteria to be labelled a currency manipulator based on the ‘formula’ (as President Trump referred to it) outlined in the 2015 Trade Act. But Thailand and Switzerland are the closest to being labelled a currency manipulator.
  • Thailand hasn’t ever been part of the assessment – but could well be considered a ‘major US trading partner’ in this report given the net bilateral goods deficit is greater than $20 billion based on the US census data. Our economists in Asia argue that this figure is debatable – with the official Thai data putting the bilateral deficit at around $12 billion. If it is included in the assessment – then we note that it ticks the other two boxes (material current account surplus and one-sided FX intervention) and the Treasury will have no choice but to label Thailand a 'currency manipulator'. However, besides making an example of Thailand – we think there's no geopolitical reason to bring a small country like Thailand into the current US administration's clampdown on global trade imbalances. Hence, we put a trivial risk on Thailand being labelled a currency manipulator. 
  • Switzerland’s bilateral goods trade with the US doesn’t quite meet the $20 billion deficit threshold – currently a $16 billion deficit – which basically saves it for now. 
  • So our base case is that the US Treasury retains the same monitoring list: China, Japan, Korea, Germany, Switzerland and India. 
Italy: Temporary fiscal push next year but what then?

The stated unwillingness to resume the structural adjustment path and very optimistic growth assumptions raise doubts about debt/GDP developments. A more conciliatory post-2019 and a constructive debate on the contents of the budget might yet limit the market concerns

NADEF marks a break with the past

The update to the Economic and Financial Document (NADEF), published last Friday, with a one-week delay, has shed some light on the policy stance of the 5SM/League government. For obvious political reasons the new 5SM/League government had to mark a break with the past, and the NADEF was the first available official vehicle. As we know, it had a complicated formation, which left observers hostage to volatile and not always reliable sources of information.

Have emerging markets reached an inflection point?

This was one of the many questions we asked the attendees of the Emerging Markets Traders Association meetings in Hong Kong and Singapore. Although there was some divergence in responses - both panels were cautious after the recent sell-off

A poor outlook for emerging markets

The Emerging Markets Traders Association (EMTA) meetings in Singapore and Hong Kong took place against the backdrop of the escalating trade war, emerging market sell-off and contagion, Chinese central bank policy action and Indian central bank policy inaction this year. 

The event was hosted by ING, and there was plenty to talk about, not least, where last year's panel went wrong. Last year the panel had agreed that although an inflection point for emerging markets was near, it wasn't imminent. Clearly, that inflection point has now been reached, so we asked whether it had further to go, or whether the more battered parts of emerging markets were starting to look good value? 

The consensus was that EM still has a place, but needs careful differentiation - a blanket tracking approach was unlikely to deliver superior performance

There was some divergence in terms of the Singapore and the Hong Kong panel, with Singapore more open to the idea that EM assets were nearing (but hadn't yet reached) good value, but the Hong Kong panel was more reluctant to call a buying opportunity just yet. 

The panelists discussed whether there was a place for EM in portfolios, given that the S&P 500 had returned better returns for lower risk profiles since the Lehman crash. The consensus was that EM still has a place, but needs careful differentiation - a blanket tracking approach was unlikely to deliver superior performance. Another observation was that recent market weakness had reflected more a lack of buying, than any substantial fund outflows. This has been a somewhat orderly re-pricing rather than a wholesale rejection of the EM universe. 

The biggest negative shock that could make for an even bleaker outlook would be an acceleration in US inflation, coupled with a slowdown in the US and/or Chinese growth 

The audiences in both settings were still negative, with 38% more votes by the audience in Singapore for a further sell-off over the coming 12- months than for a rally (see chart below) and a 40% margin in Hong Kong favouring more selling. 

The biggest negative shock that could make for an even bleaker outlook would be an acceleration in US inflation, coupled with a slowdown in the US and/or Chinese growth. That was seen as combining all the most negative components that would result in a much more aggressive EM sell-off, dashing hopes for a rally.

Germany: Warning - political landslide in Bavaria ahead

Sunday’s regional elections in Bavaria could become an important milestone, either imminently or in the future

Since the start of the new government in March this year, German politics have been hijacked by the forthcoming regional elections in Bavaria. In a bid to defend its absolute majority in Bavaria, the CSU (the sister party and coalition partner of Angela Merkel’s CDU) has been openly criticising Merkel, starting several inner-coalition conflicts which almost led to a collapse of the government. In June, the CSU and CDU clashed bitterly over the issue of whether or not German police should be allowed to turn back refugees at the German-Austrian border, even forcing Chancellor Merkel to convene a special European Summit. For much of September, both parties were in an almost permanent fight over the fate of the head of the domestic intelligence service. When Bavarians go to the polls this Sunday, many observers hope that political tensions in Berlin will ease. They could be wrong.

Switzerland: The sun is shining but clouds loom

Low core inflation, high GDP growth, a super cautious central bank and arduous negotiations with the EU: the Swiss economy is doing well but uncertainty is growing

Super strong growth in the first half

The Swiss economy is doing really well. It grew at a fast pace in the first half, with GDP growth reaching 1% and 0.7% quarter-on-quarter in the first and the second quarters, respectively, thanks to a robust foreign demand. The Swiss economy has recorded a QoQ growth rate of more than 0.7% for five straight quarters, something that has not happened since the beginning of 2015 when the exchange rate floor against the euro was abolished. The main driver of growth in 2Q18 was manufacturing (+1.5% QoQ), which benefited from robust foreign demand and the depreciation of the Swiss franc. Note, however, that part of this growth (0.2 percentage points) is somewhat artificial due to license income generated by the marketing of major international sports associations based in Switzerland. The World Cup and the Winter Olympic Games both took place in 2018, which had an impact on GDP data. With no sporting events planned for 2019, however, this effect will disappear. 

World trade: from boom to bust

Trade growth looks set to almost halve in 2018 to 2.6% and could drop to 1.3% in 2019, the lowest level since the trade collapse of 2009. The current trade conflict is one of the reasons, but there’s more going on

2018: Protectionism kicks in slowly

The global economy is flourishing. ING expects 3.9% GDP growth for 2018, significantly higher than 2017. But this positive development has failed to translate into an acceleration of trade growth. On the contrary, the average monthly growth rate for world trade in the first half of this year has been just 0.07%, a fifth of the average monthly rate in 2017.

Reading time around 13 minutes

In case you missed it: A war of words

After the shakeout in equity markets, next week should be all about the choice of words with currency manipulation threats looming for China, a somewhat vague political statement that sets the vision for the trading relationship between the UK and the EU and hopefully a softening of the heated spat between Italy and Brussels over the three-year budget plan

In this bundle