Around the world, the process of normalization is running its course.  The Fed is the most obvious example and has been the leader in this process.  One by one, other central banks have followed the Fed in removing extraordinary stimulus.  This process is expected to continue into 2019.

The FOMC just delivered the eighth rate hike of its tightening cycle, moving the Fed Funds target range to 2.25-2.50%.  It left its “dot plot” steady, which points to another hike in December, followed by three in 2019 and one in 2020.  Growth and inflation forecasts were tweaked.  As of this writing, the market has priced in a nearly 75% chance of a December hike, and has fully priced in two more hikes in 2019. 

Meanwhile, the ECB is sticking to its forward guidance.  That means it will taper its purchases in Q4, halt its purchases at year-end and start hiking rates after next summer.  However, ECB officials have been stressing that the pace of tightening will be modest and very much data-dependent.  They also have not given guidance on when the balance sheet would start shrinking.

To its credit, the Fed has provided the ECB with a pitch-perfect blueprint on how to exit unconventional policies with limited market turmoil.  Recall that the Fed first tapered its asset purchases, then ended them altogether in October 2014.  The proceeds of any maturing securities were reinvested to keep the size of the Fed’s balance sheet steady.  Only after rate hikes began did the Fed start shrinking its balance sheet.

Benoît Cœuré, member of the Executive Board of the European Central Bank (ECB), prefers not to set an expected rate path, favoring instead the identification of the economic conditions needed for rate hikes.  Peter Praet, also an Executive Board member and the chief economist of the ECB, similarly prefers some sort of verbal forward guidance.  Both want to prevent market turmoil and both favor modest adjustments.  At the other end of the spectrum is Austrian central bank governor Ewald Nowotny, who wants to normalize policy more quickly than what’s currently planned.  ECB President Draghi clearly prefers the more cautious approach. 

There continues to be much speculation about who will replace Draghi when his term ends in November 2019.   Cœuré, Praet and Nowotny are often mentioned, but other possibilities include

Bundesbank President Jens Weidmann and Banque de France Governor François Villeroy de Galhau.  Press reports suggest that having a German fill the top spot at the ECB is no longer a priority for Chancellor Angela Merkel, as she focuses instead on getting a German to lead the European Commission.

Italy has thrown a spanner in the works.  The populist government led by the Five Star and League coalition has proposed a 2019 budget that seeks to follow through on their campaign spending promises.  The draft budget deficit is seen at -2.4% of GDP, higher than what Finance Minister Tria wanted.  That Tria caved to the populists is not a good sign going forward.  Italy must submit its draft budget to the European Commission for approval by mid-October, and critical comments from the Eurogroup finance ministers already suggest conflicts ahead.

The Bank of England (BOE) will remain on its cautious tightening cycle, which amounts to roughly one hike per year.  It last hiked rates in August.  That was only the second hike in this cycle and comes after the first hike in November 2017.  Recent signs of strength in the UK economy have boosted the implied yields in the longer-dated short sterling contracts.  A third hike has been fully priced in by March 2019, and a fourth by December 2019.

Yet offsetting this more hawkish BOE outlook is continued Brexit uncertainty.  As of this writing, the Irish border issue remains a sticking point.  Prime Minister May’s so-called “Chequers plan” was resoundingly rejected by the EU, and there does not appear to be a plan B.  Add to this a potential Tory leadership challenge to May as well as risks of snap elections, and one can understand why political risks are trumping the BOE with regards to sterling.

The Bank of Japan (BOJ) has signaled QE will continue in the foreseeable future.  There have been several tweaks to its unconventional policies, but the BOJ has pushed back against any market perceptions of “stealth tapering.”  Recently, the BOJ lowered its purchase range for securities with maturities longer than 25 years to between JPY10-100 bln for each operation in October, down from JPY50-150 bln in September.  It kept the indicative buying ranges for all other maturities unchanged.  Under its Yield Curve Control (YCC) policy, the BOJ seems to be encouraging a slightly steeper curve.  As a result, yields at the long end have moved higher and this will be welcomed by Japanese insurers.

Other major central banks have tightened, albeit modestly.  Norway’s Norges Bank recently started  a tightening cycle with a 25 bp hike, but the rate path that it signaled was fairly modest.  The Bank of Canada (BOC) has been the most aggressive, hiking rates four times from 0.5% to 1.5% currently.  It is widely expected to hike another 25 bp to 1.75% at its October 24 meeting.  Now that NAFTA uncertainty has ended, we think the BOC has even more confidence in its policy path.

Elsewhere, Sweden’s Riksbank signaled that it is likely to start its tightening cycle in either December or February.  We favor December, as the underlying economy remains strong.  The Riksbank is concerned about the housing market, and so we suspect the tightening path will start off very modest.  Elsewhere, with the mainland Chinese economy slowing, we believe policymakers in Australia and New Zealand will maintain a dovish stance.  Consensus sees neither the Reserve Bank of Australia (RBA) nor the Reserve Bank of New Zealand (RBNZ) hiking rates until H2 2019. 

Most emerging market (EM) central banks have started tightening cycles.  Those that haven’t are likely to begin in 2019.  Just as ultra-low developed market (DM) rates allowed EM rates to fall sharply, so too should higher DM rates feed into rising EM rates.  As the developed world moves to a more normal state of affairs regarding monetary policy, so too should EM.

The People’s Bank of China (PBOC) is the major exception.  With the mainland economy slowing, the PBOC enacted another round of monetary and fiscal stimulus back in July.  It has pledged to keep liquidity ample.  In another special case, the Hong Kong Monetary Authority has been hiking rates in lockstep with the Fed because of the HKD peg.  Liquidity has tightened in Hong Kong money markets in recent weeks, lifting the HK dollar off the weak end of its trading band.

Currency Forecasts Q1 2018

Elsewhere in Asia, India, Indonesia and the Philippines are already in their respective tightening cycles.  Korea and Malaysia have each hiked only once, taking back the emergency cut in the wake of Brexit.  The Monetary Authority of Singapore tightened policy modestly in April by adjusting the slope of its S$NEER trading band.  Taiwan and Thailand have yet to hike rates and are unlikely to do so until well into 2019.

In EMEA, the Czech National Bank started a tightening cycle last summer and has continued hiking rates this year.  The Central Bank of Russia just started its tightening cycle, while Turkey is in the midst of a protracted tightening cycle.  The South African Reserve Bank delivered a hawkish hold in September, and the 4-3 vote with 3 dissents in favor of an immediate hike suggests the start of tightening will be seen sooner rather than later.  Israel is likely to hike in Q4, while Hungary has started to lay the groundwork for exiting unconventional policies.  In this region, Poland stands out for its ultra-dovish forward guidance of steady rates through 2020.

In Latin America, Argentina and Mexico have already tightened.  With inflation still high in both countries, neither is expected to ease anytime soon.  Brazil is likely to start hiking rates in October, while Chile is likely to in Q4. Both Colombia and Peru are likely to hike rates in Q1 2019.

Tighter global liquidity is one major headwind for global growth.  Another is ongoing trade tensions.  As of this writing, the US and China have announced several tit for tat rounds of tariffs.  Even more tariffs appear likely, and Chinese officials have said no talks will take place in the current environment of threats.  Because China is such a large part of the global supply chain, these tariffs will likely have spillover effects on the regional trading powerhouses like Korea, Taiwan and Singapore. 

To its credit, Chinese policymakers have stressed that they will not weaponize the yuan.  That is, they will not devalue the currency in order to regain competitiveness.   As such, we see the yuan trading in line with wider EM FX.   China will continue with its efforts to internationalize the yuan, albeit cautiously.  The most recent IMF COFER data show the yuan’s share of global reserves rising to a record high 1.84% of the total. 

For the most part, we see ongoing weakness remaining concentrated in the new “Fragile Five” countries of Argentina, Brazil, Russia, South Africa and Turkey.  All five have idiosyncratic risks that are likely to persist well into 2019.  Elsewhere, Mexico continues to bask in the recent rebranding of NAFTA into USMCA.  While the economic benefits are yet to be determined, USMCA takes the focus off Mexico and puts it squarely on China.

All in all, investors will continue to face a difficult global environment in Q4.  Economic and political uncertainty remain high.  Delivering a speech in Washington, D.C. on October 1, IMF Managing Director Christine Lagarde warned of growing downside risks to the global economy, pinning much of it on rising trade tensions. 

“Six months ago, I pointed to clouds of risk on the horizon.  Today, some of those risks have begun to materialize,” she said.

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