by Dean Popplewell, Director of Currency Analysis and Research, MarketPulse
More than five years after the onset of the Great Recession, consistent global growth remains elusive, prompting central banks to stick with artificially low interest rates while pumping an unprecedented infusion of cash into the financial system.
As they search for new ways to stimulate liquidity to augment the stimulus measures they’ve enacted, central bank policymakers must also fight deflation, and as expected, these are the themes that will continue to dominate the European Central Bank’s (ECB) train of thought as it has at the Bank of Japan (BoJ). Many foreign exchange (forex) participants and analysts are anticipating fiscal policy to be less of an impediment to U.S. growth in 2014. If so, it should allow the Federal Reserve to carefully navigate away from making asset purchases and reduce its massive $85-billion-a-month bond-buying program.
In 2013, the forex asset class managed to loiter within a contrived trading range policed by various central bank policies that, at times, led to a drop in both currency volume and volatility for painfully long stretches. The post-Lehman Brothers storm has now been replaced by a calmer period that continues to lack a badly-needed injection of global corporate investment to help spur growth (think Japanese Prime Minister Shinzo Abe’s third arrow problems, high unemployment in the Eurozone, and tentative U.S. growth).
There is great expectation that any rebound in the developed market will be led by the U.S. and Europe. Next year, the U.S. is expected to reduce the fiscal drag (increased taxes and spending seizures) that the American economy has endured in the last few years. Hopefully, this will lead to a consensus of a real growth rate of approximately +3%. That’s a far better prospect than what’s unfolding across the Atlantic. Recent hard and soft European data would suggest a more muted and gradual recovery for the 17-member single currency bloc. In Japan where Abenomics reigns, additional monetary easing, and stimulus from Abe’s third arrow (read: privately financed projects), should be capable of compensating the fiscal tightening (sales tax) Tokyo will initiate. That ought to lead to quicker growth for Japan. In general, any stabilisation in developed markets will eventually aid emerging markets, as increased demand in developed economies will soften the blow to any export deficits felt in the emerging world.
If this is what unfolds, it would be somewhat safe to assume that any improvement within the U.S., Eurozone, and Japan will complement the stabilisation of China’s economy, and it should support emerging market growth next year. However, even if the cyclical outlook for emerging economies growth is pegged to improve, structural weakness is likely to persist. As a result, the spread between emerging and developed markets will probably narrow. Regarding China’s “reform package”, the focus is on how quickly China might allow productivity to rebound, as well as how it alters the orientation of growth. By any measure, China is faring best as it adjusts policy to confront the changing global outlook. The market expects steady growth to be maintained between +7.5% and +8%.
Speaking in Tongues
Monetary policy will continue to deliver effective stimulus everywhere, but the urgency is required more so in Japan and Europe. It is widely expected that Japan’s prime minister will implement new quantitative measures in 2014, while the threat of deflation may pressure the ECB to introduce negative interest rates for the first time in its tenure. The Fed is expected to begin tapering while keeping short-term interest rates low for the foreseeable future. Any central bank policy divergences will provide investment opportunities in equities, forex, and to a certain extent, in fixed-income. Central banks must continue to improve communication with the market and speak with plain language. As witnessed on a few occasions in 2013, incoherent dialogue leads to market risk.
The global market outlook for 2014 will most likely be comprised of three main themes:
- Modest growth;
- Continued low inflation;
- Weakening potential.
Meanwhile, the Organisation for Economic Cooperation and Development (OECD) anticipates and/or recommends:
- Revised 2013 and 2014 global growth projections (2.7% and 3.6% versus 3.1% and 4%);
- A frustratingly vulnerable global recovery more than five years after the Lehman Brothers collapse;
- Despite the Eurozone exiting a recession, the ECB should be looking at policies to further reduce interest rates;
- That the Fed should keep its accommodative stance intact rather than considering the beginning of tapering.
The upside risks remain centred on capital investment – a global problem in 2013, where many corporations were long “cash” and repeatedly caught behind the investment curve.
Looking Ahead
Central banks’ monetary policies are expected to remain highly simulative and somewhat innovative in 2014. The Fed (soon-to-be under new leadership) will provide stronger forward guidance and it will reduce its monthly asset-purchase programme. Other central banks will have to adapt to any move the Fed makes. With global rates remaining “lower for longer”, it would suggest more market opportunities in other asset classes like equities. However, investors have yet to experience how a Fed taper will play out.
The Fed requires the “terrible twos” to be constant before tapering will be seriously considered:
- U.S. growth more than +2%;
- Inflation greater than +2%;
- Nonfarm payrolls to print employment numbers in the +200k’s.
The forex market is under the impression that any notion of Fed tapering is data-dependent. This may not be wholly accurate. Reading between the “transparent” lines, it’s been suggested that U.S. policymakers are increasingly keen to pullback on liquidity and reduce the Fed’s monthly bond-buying program, with or without any noticeable improvement on the jobs front. If one digs deeper, it becomes obvious that the Fed is already discussing “concerns about the efficacy or costs of future asset purchases.” The main hurdle for the Fed to overcome has to do with communicating its intentions concisely. The steepness of the U.S. Treasury yield curve suggests that it so far has succeeded in getting its message across clearly to investors – front rates remain low, while the long-end has backed up. The Fed is required to partake in a fine balancing act – too much tightening too fast could cause an unsightly global domino effect.
Are improving fundamentals fuelling an imminent withdrawal of the Fed’s loose monetary policy? Whether the Fed begins to taper its asset purchases in December or in the first quarter of 2014 doesn’t matter all that much. Many in the market do not expect the various asset classes to perform as wildly as they had when the Fed first floated the idea back in May 2013. Regardless, equities remain the global investors’ asset of choice despite assurances that stock returns will not necessarily carry-over smoothly into 2014. Others believe that the “mighty” dollar is on edge and about to wake from a two-month slumber of tightly contained range trading. Improvement in U.S. growth and the orderly move higher in Treasury yields is sure to support the dollar. This is in stark contrast to what the forex market was exposed to during the summer of 2013’s emerging market flight. During that period, investors were wide-open to volatile spikes and the relentless selling of emerging economic assets, firm in the belief that the Fed was on the cusp of reducing its quantitative easing program. The USD should be highly favoured, especially against a dovish yen and Aussie next year.
On the other side of the planet, the jury remains out on Abenomics. Of the three arrows in Abe’s quiver – bold monetary easing, flexible fiscal policy, and a growth strategy aimed at bolstering the economy’s supply capacity – only the first arrow has hit the bull’s eye. Despite the yen underperforming across the board, and Tokyo distancing itself from any suggestion of currency manipulation, the market believes that another “arrow” aimed at devaluing the yen to an even greater degree will most likely need to be drawn and released in the first quarter of 2014 – if not sooner.
Eurozone Split Deepens
The Eurozone continues to rely on Germany to support whatever economic growth the region is producing. The German economy is expected to grow in the fourth quarter by as much as +0.5%. However, the Eurozone’s No. 2 and No. 3 economies’ outlook do not appear rosy: France and Italy are expected to continue to battle their own growth wars. The dismal composite data for both countries hints at further contraction in the current quarter. With divergence appearing within the core (Germany and France), and the periphery (Spain and Italy), there is certainly room for Draghi and the ECB to follow its surprise interest rate cut last month with further easing. Fixed-income traders believe there’s a case for the ECB to deal with the decline in excess liquidity, which is starting to “increase volatility in money markets.” There does remain a number of innovative options for ECB policymakers to tap, ranging from cutting the reserve requirement, to leaving the Securities Market Programme “partially or fully unsterilised.” The ECB should look at non-standard monetary measures to further bolster an economy suffering from record-high unemployment, bank deleveraging, and tight credit conditions (are negative deposit rates on the horizon?).
What about the EUR? There’s been no deficit of voices calling for it to be lower versus the greenback. Apart from the odd slip-up here and there, the EUR bear has mostly lost out in 2013. Will 2014 be different? Deflation is a real threat for the Eurozone, and with growth nearly non-existent, ECB policymakers may require “fresh” evidence of further economic deterioration before stepping into the easing policy fray. The divergence between euro/U.S. rates will see the single currency underperform outright and eventually head back toward its 2013 low of €1.2780.
Bank of England (BoE) Governor, Mark Carney, and other members on the BoE’s Monetary Policy Committee (MPC) are expected to remain highly accommodative for the foreseeable future but there are risks aplenty. Last November, the “Old Lady” cut its inflation expectation while insisting there is significant spare capacity to leverage. Much bigger news was the fact that the MPC expects the British unemployment rate to fall below +7% sooner-than-expected. England’s strengthening recovery over the second half of 2013 has shifted market expectations toward higher interest rates by the end of 2014. The +7% unemployment guide was originally touted as the BoE’s trigger point for tighter monetary policy. The BoE needs to remain accommodative, and communicating its position around an ever-shifting employment benchmark will be tricky. The market expects Carney’s forward-guidance threshold to be revised. With further divergence expected on mainland Europe, investors should anticipate the Scandies (the Norwegian krone and Swedish krona) to underperform against GBP.
China’s Uncertain Reform Blueprint
The world’s second-largest economy is faring best as it adjusts policy to confront the changing global outlook. China’s growth prospects will be less of a concern to the market in 2014. The reform package reportedly proposed by Communist Party General-Secretary, Xi Jinping, following the Third Plenary Session last November, will surely dominate most analysts’ thoughts next year. The success of the plan will be determined by how these policies will be executed. Now that the Chinese manufacturing sector has become somewhat unprofitable, it has led to less private investment – a global problem. Though the document focuses on improving China’s capacity to carry out economic and financial reforms, it remains light on details.
According to the OECD, China’s 2013 gross domestic product was 7.7%, and the OECD expects it to achieve 8.2% next year. While Chinese economic recovery of the last 12 months is subdued when compared to recent history, money and credit growth needs to be reined in. The OECD suggests Beijing should increase social benefits, financial liberalisation, and tax reform.
Nevertheless, China’s economy remains strong. What sets China apart is that it has been growing because of structural change as the government addresses its economic weakness quickly – a by-product of its political ideology. It will continue on its trajectory to become more of a middle-income country.
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