EUR 2016 Outlook – Forget About Parity
By Kathy Lien, Managing Director of BKAsset Management
Six years after the financial crisis and the European Central Bank is still struggling to turn around their economy.
As recently as December, they increased stimulus in a desperate attempt to revive growth and drive inflation higher. This illustrates how deeply entrenched the slowdown is and how poor of a job Eurozone policymakers have done this past year. In the third quarter, the Eurozone economy expanded by a mere 0.3%. During this same period the U.S. economy grew 2%. Inflation is low around the world but the approximately 10% slide in EUR/USD combined with the full scale QE program launched in early 2015 should have been more effective in boosting inflation, which ran at a 0.2% annualized pace in November – well short of the central bank’s 2% target.
2016 brings more challenges for the Eurozone economy.
While the ECB is comfortable with the current level of monetary policy they will need to extend bond purchases beyond September 2016. September is only a soft target and we can’t see a scenario where growth or inflation will improve enough 9 months forward to warrant a reduction in stimulus. Also, if inflation and growth do not make significant upside progress, the ECB may need to expand the program in the coming year. The ECB’s decision to provide additional stimulus in December reflected their sense of urgency and their overall concern about the economy. Their efforts are paying off as there have been signs of recovery in the Germany but meaningful risks lie ahead. The prospect of further weakness in emerging markets, particularly China, unstable geopolitical situations in the Middle East and Russia, high unemployment, stagnant wages are just some of the problems posing downside risks for the Eurozone in 2016. Countries in the region will benefit from the new round of stimulus, weaker euro and low oil prices but the benefits will be slow to come. France and Italy have not made much progress in terms of growth and while Spain is doing well it is only the fourth largest economy in the region. The fiscal position of most Eurozone nations is also very weak with only a handful producing a budget surplus in the past 3 years. The largest sector, financials will suffer from negative deposit rates. Debt levels are high and major progress towards reducing that burden is not expected over the next 12 months.
British Pound and the Defining Issues for 2016
By Kathy Lien, Managing Director for BK Asset Management
2016 will be a defining year for the British pound – a year when politics will overshadow economics.
Considering that sterling ended the year near 7 month lows against the U.S. dollar, some of our readers may find it surprising that the U.K. was one of the best performing G10 economies. However according to the latest figures for the third quarter, the U.K. economy grew at an annualized pace of 2.1% which matches the pace of U.S. growth. In contrast the Eurozone and Japanese grew 1.6%, Australia expanded 2.5% and Canada contracted by 0.2%. There’s also very little debate that the Bank of England will be the next major central bank to raise interest rates. Yet sterling benefited from none of this and instead weakened versus the euro, Japanese Yen, U.S. and New Zealand dollars over the past 6 months. Part of the underperformance was driven by U.S. dollar strength but slow U.K. wage growth, mixed data and cautious policymakers has the market looking for rates to rise in 2017 and not 2016.
We believe the market is underestimating the Bank of England and the U.K. economy because 2016 should be a year of strong growth.
Consumer spending is the backbone of the economy and sales surged in the month of November. While wage growth slowed, labour force participation rates remain near their highest levels in 20 years and service sector activity is accelerating according to the latest reports. As the labor market tightens and inflation bottoms out, wages should rise as well. Slow Chinese and Eurozone growth poses a risk to the economy and the manufacturing sector but the U.K. is still expected to be one of the fastest growing G10 economies in 2016.
From the perspective of growth alone, the Bank of England should raise interest rates in the first half of the year. However there are 2 primary issues holding the central bank back – low commodity prices and the risk of Brexit. Oil prices could remain low for a large part of the year and as of November consumer prices are running at a 0.1% annualized pace, which is far short of the central bank’s forecast. Considering that the Federal Reserve raised rates with yoy inflation at 0.5%, the BoE may not need to see CPI above 1% before tightening monetary policy but they could be reluctant to do so until there is greater clarity on Britain’s position within Europe.
The greatest risk that the U.K. economy and the British pound faces in 2016 is Brexit.
In today’s Financial Times, there is an op-ed article by David Walker, the CEO of the Peter G. Peterson Foundation pondering the possibility of the U.S. losing its prized AAA credit rating. The paper focuses on a warning that was issued by rating agency Moody’s months ago. Moody’s has not issued a new warning, yet Walker and in turn, the FT has decided to re-inject uncertainty into the financial markets by resurrecting this fear. What has prompted this article is most likely the recent comments about the insolvency of the Social Security and Medicare systems. According to the trustees for the systems, the Social Security trust fund could be depleted by 2037 while Medicare could be insolvent by 2017. These dates of insolvency have been pushed up as the weak labor market reduces contributions. The Obama Administration has pressed the importance of gaining control of the growth in Medicare costs and their desire to tackle Social Security insolvency once health care reform is passed.
According to Walker, if the health care reforms strains finances further or if the federal government fails to monitor spending, tax or budget control, rating agencies could strip the U.S. of its credit rating.
Is Losing AAA Rating that Big of a Deal?
But is losing the AAA rating that big of a deal? Yes. A credit rating reflects the risk of default. Therefore a lower credit rating means that a country is at greater risk of defaulting on their debt. Some global funds are mandated to invest only in AAA debt and therefore if the U.S. loses its AAA rating, we could see a massive outflow of foreign investment. Also, a credit rating downgrade is the perfect excuse to push through an alternative reserve currency to replace the dollar because it would strip the confidence of sovereign funds like China that have been buying dollars to prop up the U.S. economy. Yes, investors will still buy U.S. Treasuries, but their purchases will be less. It could also have a spillover effect on corporate debt and will raise the cost of borrowing for the U.S. government.
How Real is the Risk?
Now with the risk in mind, I think that ratings agencies talk a good game but they will problems following through. The consequences of downgrading U.S. sovereign debt is huge both politically and economically. Therefore Moody’s or any rating agency for that matter may be reluctant to the first to pull the trigger. Downgrading the U.S. is very different from downgrading Ireland. Based upon how the rating agencies have handled the credit derivatives bubble, chances are they will be behind the curve once again.
With that in mind, U.S. finances are deteriorating significantly, raising the concern of Asian nations. However if President Obama is successful at turning around the U.S. economy, America will be well equipped to meet its debt obligations.
For the first time since August 2007, the Federal Reserve is not expected to change interest rates. With the fed funds rate now set to a target range of 0 to 0.25 percent, the Federal Reserve has maxed out on their most conventional monetary policy tool. Although they still have different ways of adding liquidity to the financial system and stimulating the economy, what was once the second most market moving event risk for the foreign exchange market could become a non-event. Going forward, traders may have the same disregard for FOMC rate decisions as they do for Bank of Japan meetings. The only way for Wednesday’s FOMC rate decision to hurt the dollar would be if the central bank announces that they will be purchasing long term US Treasuries in size or if they add more ingredients to their alphabet soup of new programs. There is nothing to support the dollar on the upside as the Fed is not expected to start talking about raising interest rates.
FOMC Decisions Could Become a Non-Event for the US Dollar
The last time that the Federal Reserve drew an end to a major easing cycle was in 2003 when they took interest rates to 1 percent from a high of 6.5 percent in 2000. At that time, interest rates hit the lowest level in more than 40 years. The last rate cut that the Federal Reserve made during that easing cycle was in June 2003. The following charts illustrate how the EUR/USD traded following the next 2 interest rate decisions at which interest rates were left unchanged at 1 percent. In August of 2003, the EUR/USD fell 30 pips in the hour following the rate decision and by the open of the European trading session it was down a total of 80 pips. The move was very gradual and happened over the course of many hours, which is unlike the type of volatility seen after recent FOMC rate decisions. The same indifference to the FOMC rate decision happened in September 2003 as well. The EUR/USD fell less than 20 pips in the hour following the rate decision and proceeded to fall another 30 pips over the next 8 hours.
See charts and continue reading on FX360.com
The US dollar is selling off aggressively ahead of Friday’s non-farm payrolls report on the fear that for the second month in a row, job losses may have topped 500k. The recent moves in the currency and equity markets suggest that everyone expects a very weak labor market report. Although the consensus forecast is -520k, the whisper number is closer to -650k to -700k. Sentiment is strongly skewed in one direction which can be dangerous considering the fact that some of the leading indicators for non-farm payrolls call for a rebound. The Non-farm payrolls report is the most market moving release for the currency market and it should live up to its volatility inducing reputation.
Why Non-Farm Payrolls Could Rebound in December
For many Americans, 2008 has been a year unlike any other. Companies across the nation have been forced to tighten their belts and move into survival mode, accelerating layoffs towards the end of the year. With the December numbers, more than 2 million Americans will have lost their jobs in 2008. In fact, jobs were cut every single month last year. Although everyone expects very weak job growth, there is reason to believe that we may see a rebound in non-farm payrolls. First, the employment component of Service sector ISM, which is one of the most reliable leading indicators for non-farm payrolls improved in December along with the University of Michigan Consumer Confidence Index. Since the US is a service based economy, the slower pace of job losses in the ISM report suggests that we could see a rebound in non-farm payrolls.
In addition, every single time that we have seen non-farm payrolls fall by more than 500k, there is a steep rebound the following month. In the past 50 years, we have had 3 cases where more than half a million jobs were lost in one month and in every single one of those cases, NFPs rebounded close to 50 percent. The improvement in service sector ISM suggests that the rebound could be seen again in December.
12 Consecutive Months of Negative Non-Farm Payrolls
With that in mind however, non-farm payrolls will still be weak and the unemployment rate will rise as all of the leading indicators for non-farm payrolls point to more job losses. The main reason why the whisper number is around -650k to -700k is because private sector payroll provider ADP reported that 693,000 jobs were cut last month. Given that non-farm payrolls came out worse than the ADP report every single month last year, this has led some people to believe that job losses in December could have been the largest in 5 decades. Unemployment rolls are also continuing to grow with the 4 week average of jobless claims and continuing claims at 26 year highs. Layoffs have risen 274.5% while online job ads have declined. Despite the rebound in the employment component of service sector PMI, the index remains in contractionary territory while the record low hit by the Conference Board’s report of consumer confidence offsets the improvement in the University of Michigan data.
Here’s how the 10 leading indicators for non-farm payrolls stack up for December: