Will the central banks really risk tightening monetary policy?


Over the last couple of weeks, the market has switched its attention from political uncertainty across the globe to the prospect of tighter monetary policy from some of the World’s major central banks. Policy makers from the Federal Reserve, Bank of Canada, Bank of England and now the European Central Bank have indicated that the time to start raising rates and withdrawing the stimulus measures employed over the past nine years is fast approaching.

 

The leader of the pack has been Janet Yellen, head of the Federal Reserve, who first hiked the Fed Funds rate back in December 2015, and has since followed by with a further three 25 basis point increases (December ’16, March ’17 and June ’17). According to the Fed’s dot plot chart (which sets out the committee’s expectations for where the path of the Fed Fund’s rate) policy makers expect to raise rates once more this year. 

 

Capture1

 

Nevertheless, markets seem less certain and are currently pricing in a 58% chance of a rate hike by December 2017. The primary source of uncertainty is the outlook for inflation. The Fed has a dual mandate of maintaining price stability around 2% and ensuring steady economic growth, however, the committee’s preferred measure (the core PCE price index) had inflation running at 1.4% in June (down from 1.7% in May) while the core consumer price index rose 1.7% in May, down from 2.2% in February. This is despite unemployment being at its lowest level since 2001 (the theory being that a tighter labour market should drive up wages which should then fuel inflation).

 

Based on the Fed’s brief, there appears little reason for the committee having to raise rates again in the months ahead. That of course assumes conventional wisdom and ignores a third factor – namely a desire to normalise monetary policy to provide sufficient ammunition to stave off the next economic downturn.

 

For now, we’ll stick with the dual mandate and hence we continue to feel that there is a growing risk that expectations of additional rate hikes may be overhyped. Even if the Fed does follow its implied path in the short term, we question whether this will continue longer term with another four rate hikes penciled in for 2018 based on the fact that we expect growth to become increasingly fragile and we envisage inflation remaining subdued. This is reflected in the 5 year, 5 year USD inflation swap rate (see chart below) which suggests that inflation expectations are declining again after a sharp rise following Trump’s victory last year.

 

Capture2

 

What does this mean for the dollar?

Most (if not all) commentators would agree that one of the primary reasons why the dollar has outperformed so many of its peers over the past twelve months has been expectations of tighter monetary policy at a time when other central banks remained accommodative. However, we are now seeing this phenomenon challenged on two fronts:

 

  1. The Fed is unlikely (in our opinion) to continue hiking rates at the pace implied in the minutes from its meeting in June.
  2. Growing expectations of tighter policy from the likes of the ECB, BoE and BoC, make their respective currencies more appealing from a yield perspective, especially given that they remain ‘cheap’ on most valuation metrics. Looking at the chart above showing inflation expectations, the UK is expected to endure far higher inflation (implying a greater need for tighter policy).

 

As such, we remain moderately bearish on the dollar in the months ahead against both the pound and the euro (see our forecasts on pages 3 and 5. Against the CAD, we are more bullish, primarily because we expect the Bank of Canada’s ability to raise rates to be limited amid the risk of real estate bubbles bursting and the negative impact this could have on the wider Canadian economy (but more about this to follow in another edition).

 

Author: Marc Cogliatti



 

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