March Economic Update: In like a lion, out like a lamb?

The Federal Reserve has adopted a more cautious approach to monetary policy since the start of the year. Trade tensions, the turmoil in equity markets and tighter financial conditions are cited as 'cross-currents' that are creating uncertainty, and in an environment of low inflation, the Fed can afford to be 'patient'.

However, these tensions appear to be easing. Borrowing costs have fallen back, equities have recovered all their losses, and there are positive signs regarding a potential US-China trade deal. With the jobs market roaring ahead, higher pay and rising inflation pressures mean that there is a strong case for a summer interest rate rise. This remains at odds with financial markets, which are pricing in a prolonged pause with an eventual rate cut in 2021.

Sentiment indicators have begun to stabilise in the eurozone having continuously declined since the start of 2018. However, any rebound looks to remain muted as a trade war with the US and a chaotic Brexit remain significant risks, keeping uncertainty high. What’s more, core inflation has fallen back below 1%, nipping any expectation of monetary tightening in the bud. In fact, the ECB has now extended its forward guidance of stable rates up to the end of 2019 and has also announced a new series of TLTROs to avoid a tightening in credit conditions.

The UK Prime Minister faces an uphill struggle to get her deal approved by Parliament, despite hints that her opponents may be shifting their position. That means an extension to the Article 50 negotiating period now looks inevitable, but if this delay is kept relatively short, the threat of ‘no deal’ will remain. That will keep the pressure on the economy, further reducing the chances of a rate hike this year.

China’s government has provided a set of targets for 2019. Almost everything was as expected, especially the new GDP growth target. The government is relying a lot more on fiscal stimulus rather than monetary easing. A repeat of previous guidance on the exchange rate mechanism may mean the yuan will continue to follow the dollar index.

The 10-year German yield at a mere c.20 basis points bears no reflection on the Germany economy. So how can we make sense of this? To keep it plain and simple, it is a measure of fear. That fear is a combination of two elements. First, there is the ‘macro’ fear that the current slowdown could become more severe. But by far the most significant element is an existential fear about the European project itself, and not enough attention is being paid to this. The EU elections in May could prove pivotal.

In FX, we continue to look for further USD outperformance vs the low yielding G10 currencies in coming months. The Fed will deliver a hike, while the likes of ECB or BoJ will remain dovish /neutral. The duration of the Article 50 extension will matter for GBP price action, with longer extension being more positive for GBP than shorter. In the CEE FX space, our top pick remains HUF.