- Reserve Bank of Australia’s more worried tone about the nation’s housing market have given the Australian dollar a bit of a kicking today.
- The dollar was down 0.2 per cent at $0.7715 in early European trade, but had dropped by as much as 0.4 per cent after the minutes from the RBA’s March meeting warned of a “build-up of risks associated with the housing market”, given a surge in investment borrowing and still-strong price gains in markets like Sydney and Melbourne.
- This is the first time in a while that we have seen the RBA refer to risks around the housing market in such an explicit manner.
- The yield on 10-year Australian bonds which move inversely to price, was down 1.5 basis points to 2.808 per cent.
Amid concerns that macroprudential measures introduced in 2015 are no longer working as effectively as they were last year, the federal government is expected to use its upcoming May budget to reveal a series of measures designed to boost affordability for actual home buyers and clamp down on those loading up on debt and buying multiple investment properties.
- Concerns about the housing market should eventually fade, but the dimming outlook for wage growth and inflation means the chances of future rate cuts are greater than markets anticipate.
- Solid economic growth in the December quarter meant Australia has gone 25.5 years without a recession. And while naysayers have long (and wrong) said it will all end in tears, the country is just six months short of surpassing the Netherlands’ record for years of consecutive growth.
Currency markets offer the perfect antidote to confident forecasters. The overwhelming consensus before Christmas was that the dollar was setting off on an early-1980s-style bull run, and investors should grab hold while they still could. The euro would fall to parity, and emerging markets needed to brace for turmoil as dollar debts would become harder to service.
Three months later, the dollar’s weaker, the euro (and the less-discussed yen) is up strongly, and emerging market stocks and currencies have leapt.
Understanding what went wrong with the forecasts is vital in pinning down what might happen next. But more important for the longer term are the Federal Reserve’s predictions of weak growth forevermore—and whether it is merely projecting the recent past into the indefinite future.
There were three major drivers of the dollar’s reversal. First and probably most important was that the dollar had become a crowded trade, with pretty much everyone believing it would carry on up. Bets on dollar futures had rarely been higher, and the consensus in favour of the dollar was strong.
Underlying this positive sentiment were two fundamental arguments, neither of which has so far worked out: Central bank divergence; and U.S. tax policy.
The Fed’s December increase marked the resumption of its interrupted rate cycle, while the central banks of Europe and Japan were stuck with hopeless economies and no inflation, and so wouldn’t raise interest rates in the foreseeable future. Investors were also convinced that the Republican-controlled House proposal for a border-adjusted tax would restrict imports while helping exports, giving a boost to the dollar.
As the year has worn on, all three forces behind the dollar’s reversal have come under pressure. The crowded positions have unwound somewhat, most obviously in speculative bets on dollar futures. Signs of inflation and faster growth have shifted the European Central Bank out of easing mode and talk of a European “taper” has begun. And the border-adjusted tax has been questioned by the White House and run into opposition from several Republican senators.
There have been only small shifts in economic forecasts, but they’ve been in the wrong direction for the dollar. The average prediction collated by Consensus Economics for U.S. growth has dropped from 2.3% to 2.2% in the past three months, while for Japan, the eurozone, U.K. and Canada, they have risen by 0.1 to 0.2 percentage points.
A bet on the dollar now could be based on the eurozone’s inability to raise rates much, if at all, without threatening the solvency of its weaker members. It could be based on Japan’s commitment to hold long-term rates at zero, ruling out an end to bond buying. It could even, less plausibly, be based on the border-adjusted tax being accepted by the Senate.
But for the long-term strong dollar bet, look to the Fed. The central bank is assuming the economy will experience a version of “secular stagnation”, popularized in recent years by former Treasury secretary Larry Summers. From this perspective, long-term growth will be weak, too much will be saved, and the “natural” interest rate will stay low. The dollar could still rise if the rest of the world is going to be even worse, but it’s hard to be truly bullish because the assumption of weak, long-run growth makes the Fed err on the side of lower rates.
At last week’s Fed meeting, policy makers held their long-run growth predictions for the economy at 1.6% to 2.2%, with a median forecast for long-run interest rates of 3%, equivalent to just 1% adjusted for inflation. Back in 2012, with the Lehman crash still fresh in the memory, the lowest Fed growth forecast was 2.2%, and the median expectation for long-run interest rates was above 4%.
“All these years they’ve had these bullish views and they’ve had to downgrade,” says Stephen Jen, co-founder of Eurizon SLJ Capital. “Now just as the world economy seems to be gaining traction they are moving the other way.”
Put another way, the Fed’s economists may have fallen into the classic psychological trap of recency bias, putting too much weight on the postcrisis period. The history of secular stagnation suggests the Fed’s far from the first to assume the good times are gone forever.
The term secular stagnation was coined by Alvin Hansen in 1938, on basically the same grounds as the idea is pushed today: weak productivity and population growth. He was badly wrong, as the surge in postwar technology and baby boom soon demonstrated. Patrizio Pagano and Massimo Sbracia at the Bank of Italy showed that such a mistake has usually been made when growth has been weak, with the same concerns raised in the world-wide depression of the 1870s, in the stagflation of the 1970s and again as the 1980s boom came to an end.
I don’t know if machine learning, biotechnology, robotics or even virtual reality will be the breakthrough that leads to faster growth in future. Maybe all of them will, maybe none of them. But I’m certain that it’s a mistake to put too much confidence in any long-term predictions of productivity or demographic change—and that it won’t take many good quarters of rising growth and inflation to see the Fed start revising up its expectations.
After protracted parliamentary debate, the bill authorising the prime minister to invoke Article 50, the legal basis for leaving the European Union, finally became law this week. Late on March 13th the House of Commons rejected two amendments that had been proposed by the Lords. As expected, the upper house then backed down. The government had been hinting broadly that the letter triggering Article 50 would be sent to Brussels immediately. On March 14th Mrs May duly hailed the bill’s passage into law as “a defining moment for our whole country”.
But then came anticlimax: Downing Street said the invocation of Article 50 would actually happen only in the week of March 27th. Before then, Mrs May plans to visit Scotland, Wales and Northern Ireland. All being well, she will still fulfil the promise she made last October of starting the Brexit process by the end of March.
A delay of two weeks in a negotiation due to last two years may sound trivial. Yet a plan in Brussels to hold a special EU summit on April 6th to discuss Mrs May’s letter had to be hastily junked. The meeting will now take place in early May, losing almost four weeks out of what is already an extremely tight timetable.
So why did Mrs May pull back at the last minute? After all, there was never going to be a perfect moment to invoke Article 50. Doing so just before the Dutch election on March 15th might have bolstered the far-right anti-EU party of Geert Wilders. Acting too close to the 60th anniversary celebration of the Treaty of Rome on March 25th might have seemed provocative. French and, later, German elections also loom in the near future.
The truth seems to be that Mrs May’s plans were upset by Scotland’s first minister, Nicola Sturgeon, who chose to announce on March 13th that her government would ask for a second independence referendum. She cited Brexit as the “material change” to justify this demand. And she attacked Mrs May for choosing to pursue a hard Brexit that will take Britain out of the EU’s single market, when a majority of Scots had voted to stay in the EU last June.
The reality is that Brexit is unwelcome not just to Ms Sturgeon but to all of Britain’s European partners. Even as they hold their 60th birthday party—which Mrs May will not attend—they know that the club is in deep trouble, not least because so many countries besides Britain have seen an upsurge of populist anti-EU parties. To most other EU countries, indeed, Brexit is just one more ingredient in a cocktail of often more pressing problems that afflict them.
In this context, indeed, some may take quiet satisfaction from seeing the Scots ruin Mrs May’s plan to trigger Article 50. A few may even see the rising risk of a break-up of the United Kingdom as suitable punishment for Brexiteers. Yet nobody will much enjoy the Article 50 negotiations when they eventually start.
At the same time few are convinced by Mrs May’s repeated mantra that no deal is better than a bad deal, which they see as just an attempt to bolster Britain’s weak bargaining position. On March 15th David Davis, the Brexit secretary, admitted to the Commons Brexit committee that since the referendum the government had made no forecasts of the economic consequences of leaving the EU without a deal and reverting to trade under World Trade Organisation rules. That makes it even harder to see how Mrs May can justify her claim.
Nor are the parliamentary manoeuvres over Brexit finished. This week it emerged that at least seven bills besides the planned “Great Repeal Bill” will be needed to give effect to Brexit. Mr Davis has also conceded that any deal negotiated under Article 50 would require parliamentary approval. And although Lord Bridges, a Brexit minister, said in the Lords that he found it hard to see how Parliament could hold a vote if there were no deal, even that could be open to question. Lord Hope has declared that the Supreme Court judgment which forced the government to bring forward the Article 50 bill may require further primary legislation before Brexit actually happens. And he should know—for he is a former Supreme Court justice.
- Federal Reserve officials this week signaled that the end is near in the difference between Australian and U.S. interest rates, which has been positive since 2001.
- As the Fed raised short-term rates by a quarter percentage point on Wednesday, it projected two more such increases in 2017: If it carries through, the upper end of the target range for U.S. rates will be 1.5% by the year’s end—where Australia’s benchmark rate is now.
- The closing U.S.-Australian rate gap is a standout example of a trend currently looming over foreign-exchange markets: the narrowing difference between U.S. and global interest rates. While the Fed is now in tightening mode, many central banks that have long had higher benchmark rates—such as those in Australia, India and Brazil—are on hold or cutting.
- Currency players often seek to profit from interest-rate gaps, known as the “carry,” by investing in stocks, bonds and currencies in countries with higher rates. Now, rising U.S. rates could trigger a reversal of such capital flows, which could prove destabilizing for countries that had benefited from the search for yield during the years when U.S. rates have been ultralow.
- Moves in the euro in 2014 show how changing interest-rate differentials can result in bad blood for currencies.
- The European Central Bank pushed its key interest rate negative in June 2014, while the Fed’s target range for its benchmark rate stayed between 0% and 0.25%.
- The gap between the two regions’ rates has since widened, as the U.S. has started tightening. The euro dropped 12% against the dollar in 2014, 10% in 2015 and 3.2% in 2016, according to Thomson Reuters data.
- Some investors are sanguine about the impact of narrowing interest-rate gaps, arguing that other factors can influence currencies. A rebound in commodity prices and solid economic data in China, a major trading partner, have brightened Australia’s outlook, helping propel the Aussie to a gain of 6.5% this year against the U.S. dollar.
- And even as the Fed pushes ahead with rate increases, the currencies of some countries could remain attractive as their interest rates remain much higher, investors and strategists say.
- They recommend owning high-yield darlings like the Indonesian rupiah and Indian rupee, where benchmark rates are 4.75% and 6.25%, respectively, providing a substantial buffer against rising U.S. rates.
- The Federal Reserve may be well set on its interest-rate raising course this year, but gains in the dollar could prove harder to come by.
- The key reason why the dollar’s gains are slowing: The U.S. is no longer the sole bright spot in the global economy.
- Sure, the world’s largest economy has recovered enough for the Fed to start normalizing interest rates after years of near-zero levels.
- But the eurozone is now growing faster than the U.S.
- In Japan, where officials have resorted to unorthodox measures in the past five years to stoke inflation, prices are finally rising slightly.
- Both the Bank of Japan and the European Central Bank left monetary policy unchanged at their latest meetings.
- In China, economic data has been solid so far this year.
- Dollar’s losses after the Fed raised overnight rates seems to contradict common economic wisdom, which dictates that as the U.S. raises rates before other major global central banks, the divergence should boost the dollar. Higher interest rates tend to boost the allure of a country’s assets, which in turn tends to attract capital.
- While that may yet prove true, the U.S. currency’s already sizable advance since 2012 may lead to diminishing future returns, some investors say.
- The ICE U.S. Dollar Index has risen each year since 2012. The bulk of the rally happened in 2014 and 2015, when the index advanced by 12.8% and 9.3%, respectively; in 2016, it gained 3.6%. More than half the index’s weight comes from the euro, followed by the Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc.
- The scene was different during the great dollar surge of 2014-2015. While the Fed had just started winding down its post-financial crisis bond-buying program, central banks in Japan and Europe were busy buying up government bonds to stimulate their persistently sluggish economies, keeping bond yields low globally.
- The yearslong move higher in the U.S. dollar has left it looking expensive. One gauge of a currency’s value is its real effective exchange rate, or REER, which measures a country’s exchange rate against several trading partners, adjusted for inflation.
- The dollar’s REER is currently higher than both its five- and 10-year averages, according to the Bank for International Settlements. While currencies can trade above and below their long-run valuations for extended periods, it underscores the extent of the dollar’s rally.
- Meanwhile, the real effective exchange rates for both the euro and yen are below their five- and 10-year averages, suggesting they are cheap.
- For sure, there are other factors that could push the dollar higher this year.
- Changes to U.S. tax policy, especially any that provide incentives for companies to bring the cash they have stashed abroad back into the U.S., could yet be a game changer for the dollar. If U.S. companies repatriate those earnings, the resulting flow of money could boost the dollar regardless of the economic outlook. President Donald Trump has talked about lowering the corporate tax rate, and his Treasury Secretary Steven Mnuchin has laid out plans to overhaul the tax code by August.
- How have investors reacted to Brexit?
- Investors have struggled to make sense of the politics and economics of Brexit ever since the referendum.
- A large devaluation in the early post-referendum days prompted gloomy predictions for the pound.
- At times, the government’s Brexit policy, particularly its confusing communication strategy, left investors flummoxed and so more inclined to be bearish on sterling.
- But the economy’s resilience and Theresa May’s more coherent Lancaster House speech on Brexit in mid-January have kept sterling above $1.20 since that threshold was tested in January.
- Meanwhile, the government’s legal difficulties, which at one stage cast doubt on its Brexit timetable, have been largely forgotten as it has steered its Article 50 bill through parliament.
- What will happen to sterling when Article 50 is triggered?
- It has long been regarded as likely to be a significant market-moving event but forex analysts now expect the moment itself to have only a modest impact on sterling.
- Investors are no longer in denial about Brexit, and have been pricing in the reality of the coming divorce.
- Still, Article 50’s trigger will not go unnoticed by investors. Even though it is a sure-fire event, further weakness may ensue, possibly involving a test of the January low.
- More significant may be the EU’s response in the days after the announcement, and what it says about the negotiations process.
- How is sterling shaping up as the negotiations begin?
- Sterling is considered cheap, given the underlying health of the UK economy, now forecast to grow 2 per cent this year.
- While that is a buying opportunity to some, a series of factors are also assuming greater importance to investors than the Article 50 trigger. These include the increasing burden of sterling’s decline on corporate Britain, the risk of Brexit on inward investment, the relationship between Mrs May and other EU leaders in the run-up to official negotiations and the French presidential election. There is also the prospect of US interest rate rises to consider.
- So sterling is heading for what value?
- The problem for investors is how to judge the progress of what will be two years of Brexit negotiations. Which is why several strategists are reluctant to forecast anything significantly at variance with the pound’s current value during at least the remainder of 2017.
- More likely is that sterling’s direction will be influenced by developments in other countries. For example, there is scope for the pound to weaken against the euro in the coming months, if the eurozone economy continues to strengthen, Marine Le Pen loses the French presidential election and the European Central Bank becomes less dovish.
- The pound experienced a week of volatile swings.
- A pattern likely to be repeated several times throughout the third quarter as Brexitweighs on the economy and prompts further easing from the Bank of England.
- While above the Monday trough of $1.3118, its lowest level in 31 years, currency analysts are united in the belief that the pound is heading lower in the coming weeks.
- Sterling’s renewed fall in the wake of Thursday’s speech by Mark Carney, in which the Bank of England governor delivered an uncompromising assessment of Brexit’s impact on the economy and signposted monetary easing, graphically illustrated how any rallies are liable to be snuffed out every time negative data or commentary emerges.
- Key to how far sterling falls is the post-Brexit shape of the UK economy and its relations with trading partners, particularly Europe.
- If Brexit looks to be smelling like the UK remaining in [the EU] in all but name, there’s little chance that sterling would get to $1.25.
- The flipside was the hawkish tone of Tory leadership frontrunner Theresa May on immigration which pointed to problems for the UK in maintaining access to the single market should she become prime minister. That looks a lot more like a hard Brexit, and that’s more negative for sterling.
- The two key dates on the horizon are the BoE’s monthly policy meeting on July 14, which Mr Carney signalled may decide to cut interest rates, and September 9, when the new leader of the ruling Conservative party is named.