The broad interpretative framework we developed since late 2014,
one that centers the de-synchronization of the major economies,
will retain its usefulness into the New Year and beyond. The first
phase of divergence was characterized by the Federal Reserve
standing pat after winding down their open-ended asset purchase
operations (QE3+), while many central banks from high-income
countries, including the eurozone, Japan, China, Canada, Australia,
New Zealand, Sweden, and Norway, eased policy.
Laying the Groundwork for 2016
With the Federal Reserve's rate hike at the end of 2015, a new
phase of divergence is at hand. It will be characterized by both
Fed becoming less accommodative, while other central banks maintain
or extend current easing policies. Some central banks may have
reached the end of their easing cycles, but it is possible that the
door is not completely closed.
We expect the Obama dollar rally to continue in 2016. The
premium one earns on U.S. rates will continue to attract capital
flows. Because of the wide, and widening interest rate
differentials, one is paid to be long dollars. This has powerful
implications for hedging. Dollar-based investors are
to hedge exposure (receivables) in euros, Swiss franc, and Japanese
yen for example.
Our assessment of indicative market prices suggests that the
divergence meme, as much as it has been discussed, it has not been
discounted. By the time the ECB met in early December when it cut
the deposit rate 10 bp to
30 bp and expand its program by six months (through March 2017),
the premium the U.S. offered over Germany for two-year borrowing
had increased to nearly 140 bp. It was around 85 bp when the euro
bottomed in March 2015.
The Fed funds futures strip suggests that the participants are
skeptical about a second Fed rate hike in Q1 16. The Federal
Reserve's dot plots suggest a majority of Fed officials think it
would be appropriate. Several large investment houses, and Fitch,
the rating agency, forecast a hike every quarter.
We recognize that the market is a great discounting mechanism.
Arguably it has no rival for its ruthless ability to aggregate vast
quantities of information. We have found it helpful in navigating
the markets to appreciate that events can be anticipated and
discounted. Buying rumors, selling facts is standard fare in the
capital markets. However, conceptually, we think that the widening
interest rate differentials cannot be fully discounted. The
interest rate differentials, including the slopes of yield curves,
provide powerful incentives driving new flows, influencing
investment, hedging and liquidity decisions.
The pace of monetary policy normalization will depend on
economic data, Fed expectations, and broad financial
There are several factors that make this cycle unique and
arguably, even more, challenging than would normally be the
case, including the new policy tools used by the Fed, and lower
The Fed's balance sheet is in play as an estimated $220bln
in Treasuries are set to mature next year.
The pace that monetary policy can be normalized will be a
function of the economic data in absolute terms and about Fed
expectations. At the same time, the broad financial conditions,
which include the dollar's exchange rate and financial markets,
will also be taken into account. We expect the pace of job growth
to moderate, but without a marked increase in the participation
rate, it may still be sufficient to absorb slack in the labor
market. This means that the unemployment (and underemployment) will
likely decline. The fall in energy prices may help check headline
inflation. Core measures are likely to increase on the back of
higher rents and medical services.
Presidential election years without an incumbent running have
tended to be associated with a small decline in equity prices. We
do not see the election as having much impact on the trajectory of
Fed policy. At most, the Fed may want to avoid action at the 2
November 2016 FOMC meeting, which does not include updated economic
forecasts, nor is it followed by a press conference.
There are several factors that make this cycle unique and
arguably, even more, challenging than would normally be the case.
Lower nominal GDP means that interest rates will be below levels
that prevailed in previous cycles. The Federal Reserve has new
tools, like interest on excess reserves and scaled-up reverse repos
that have not been
Unlike past cycles, the Federal Reserve has set a target range
for Fed funds rather than a fixed point target. It is not clear
where Fed funds will trade relative to its range. We have argued
that to maximize the effectiveness of its new tools, the Fed may
want to provide sufficient liquidity to keep the effective Fed
funds rate (weighted average) somewhat below the mid-point of the
range. That would also help officials drive home the point that
rate increases will be gradual.
The Fed's balance sheet is also in play in a way it was not in
past cycles. An estimated $220 bln of U.S. Treasuries the Fed owns
may mature in 2016. It cannot be expected to allow the full amount
to roll-off, but maybe around mid-year, the Fed may begin exploring
this tool. Letting some fraction mature and/or refrain from
reinvesting interest payments would be seen as providing a
Immigration challenge may be more concerning than
The U.K.'s EU membership could occur in the second quarter;
the risk of rejection may lead to an underperformance of
sterling and U.K. assets.
We continue to expect that the Bank of England will be the
next major central bank to hike rates.
The immigration/refugee challenge may reach existential
proportions. In some ways, it is more fundamental than Greece,
which preoccupied investors at the start of 2015. As we have seen
in the debt crisis, EU officials are pushing for new collective
powers that erode national sovereignty. The goal is enhanced
ability to protect the external borders, even over the objection of
national officials. The politically salient agenda of immigration,
terrorism, high levels of unemployment, economic insecurity, and
sovereignty, plays into the hands of demagogues.
It is not clear when the U.K. will hold a referendum on its
membership in the EU. Many expect it late in the second quarter of
2016. The U.K. has long seen its interest extended in joining
Continental initiatives. Membership gave an opportunity to shape
directions and outcomes. The expansion of the EU eastward has
provided the U.K. new support for some of its positions.
If the U.K. does opt to exit, we would expect sterling and UK
assets, in general, to be marked down, and potentially sharply
(depending on what had been discounted). However, in the end, we
expect that the UK will remain in the EU.
The Bank of England is widely perceived to be the second of the
G7 central banks to hike rates after the Federal Reserve. A hike in
late-H2 seems a reasonable time frame as 2015 draws to a close.
However, wage growth, one of the few arguments favoring a hike, has
already lost the upward momentum, and there are other signs that
the UK economy may be slowing. The risk seems to be toward a later
rather than a sooner BOE lift-off.
Easing monetary policy in December takes the ECB out of the
picture in Q1 16. But if there is little improvement in inflation
prospects nearer midyear, and if the euro remains resilient and oil
heavy, then the doves may push for more action. Unlike previously,
though it did not prove to be the case, Draghi did not indicate
that the -30 bp deposit rate exhausts interest rate policy. Fiscal
policy also looks to be less restrictive in 2016 than it has looked
to be the case until late 2015.
s China transitions to a services and consumption focused
economy, officials recognize the need for more flexible prices
The close link between the yuan and the dollar injects an
unwanted tightening impulse in the rising dollar environment
that we anticipate.
There is a significant change in the market now that China
is experiencing capital outflows, yet China should not use this
as a pretense to devalue, and then re-link to the dollar when
the greenback's cycle turns.
The world's second-largest economy is engaged in a multi-faceted
transition. Partly driven by its desires of its political elite,
and in part driven by competitive pressures, China is moving up the
value-added production chain: It is shifting from manufacturing to
services, and investment (debt) to consumption.
To facilitate this transformation, Chinese officials seem to
recognize the need for more flexible prices for money. This
necessitated the liberalization of money market rates and greater
flexibility of its monetary policy. This in turn requires the
loosening of the link between the yuan and the dollar.
This is wholly desirable and necessary. The divergence theme is
not only about Europe and Japan, but China too. The cyclical
pressures in China will likely prompt further easing from the PBOC.
The close link between the yuan and the dollar injects an unwanted
tightening impulse in the rising dollar environment that we
The yuan depreciated by 3.87% against the U.S. dollar in the
year through mid-December. A decline of a similar magnitude (4%-5%)
in 2016 would not be surprising. It would still likely translate
into some appreciation on a trade-weighted basis.
We suspect that without being in a clear uptrend against the
dollar (and Hong Kong dollar), the extent of the yuan's
internationalization may slow. We have suggested that part of what
was happening was the conversion of China's trade with its Special
Administrative Region (Hong Kong) and that this exaggerated the
extent of the yuan's use outside of China. Cyclical factors,
including the carry trade that favored the yuan, may have also
exaggerated how much internationalization of the yuan was actually
In any event, a country with a large current account surplus
would be expected to export its savings. For many years, China also
experienced capital inflows. The currency was not allowed to
appreciate as much as these forces would have suggested
Now China is experiencing capital outflows. That is a
significant factor that has changed. U.S. officials have long
harangued Chinese officials to operationalize their declaratory
policies of letting market mechanisms drive the exchange rate. U.S.
officials have argued against the practices that led Chinese
officials to hold so many (over $1 trillion) Treasuries.
It may be well and good that China now sees these actions are no
longer in its self-interest and ceases. However, and here is where
the long-game comes in, China should not use this as a pretense to
devalue, and then re-link to the dollar when the greenback's cycle
turns. In the short-run, however, if the yuan appears to be more
market driven and the market takes it a bit lower, we do not
anticipate loud voices of objections. That said, the election year
in the U.S. means that a greater news cycle risks.
Commodities and Emerging Markets:
The price of energy has far-reaching economic impact.
A Although there is the risk of a weather shock or a
geopolitical disruption in supply, the base case is for oil
output to increase over demand in the first half of 2016.
Many emerging market economies have been hit be a painful
negative terms of trade shock: the price of their products are
falling faster than imports and global investors are pulling
We anticipate that the turn of the calendar will not alleviate
the pressure that has bedeviled commodity producers and many
emerging market economies. The slow, mostly domestic driven
activity of the high income countries, and notably the transition
in China, dampens demand growth.
High fixed cost producers discover powerful incentives to
produce at a loss even if it weighs on prices further. When prices
are high, countries do not recognize the incentives to diversify
away from their reliance on commodities. When prices are low, they
cannot afford to, and this is how the cycle plays out, again.
The rising commodity prices in the 2005-2008 period provided,
with some lag, producers incentives to boost output. Similarly, the
drop in prices will, with some lag, force a rationalization of
supply through failures, combinations that destroy inefficient
capacity, and spur productivity-enhancing, capital-saving
The price of energy has far-reaching economic impact. Petrol and
natural gas products are a key cost of agribusiness, including
fertilizers and pesticides. It is important in manufacturing and
transportation. The decline in gasoline prices has helped boost
consumers' purchasing power in the US, Europe, and Japan. The drop
in energy prices provided economic support in some sectors, even as
it weakened energy sector earnings, slashed investment, and
undermined share performance. Benchmarks that exclude the energy
sector are being developed and will likely to begin to be adopted
The decline in non-OPEC output in the coming months, half of
which may come from the U.S., will likely be offset by increased
Iranian and Libyan output. By its reckoning, OPEC output in
November was about 900k barrels a day more than it estimates 2016
demand for its product.
Although there is the risk of a weather shock or a geopolitical
disruption in supply, the base case is for oil output to increase
over demand in the first half of 2016. Inventory levels may grow
relative to seasonal averages. Downward pressure is likely to
continue. The charts warn that the price of light sweet crude oil
could drop into the $20-$30 a barrel region. This could force a
more rapid industry restructuring and make for a different OPEC
meeting a year from now.
Many emerging market economies have been hit by painful negative
terms of trade shock. The price of their products (commodities) has
fallen faster than what is typically imported (manufactured goods
and capital equipment). At the same time, global investors
generally appear to be pulling funds from the emerging markets as
an asset class. Additional pressure is coming from the unwinding of
the currency mismatch that many emerging market countries and
companies took on by borrowing cheap dollars in the past.
These are significant economic challenges. Even with strong,
decisive and responsive leadership, the waters are difficult to
navigate. Weak, ineffective, or incompetent and corrupt leadership
exacerbate the economic challenges. It accelerates capital flight
and aggravates both inflation and recession, which in turn leaves
officials choices among poor alternatives. Investors watch
macroeconomic indicators closely. We are noting that especially in
the current environment, political considerations also warrant
6 Reasons Why The Markets Discount The FOMC's Rate
Forecasts For 2016