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Last week, despite being shortened by the bank holiday, was a fascinating one. The leaking of details of the dinner at Downing Street attended by Jean-Claude Juncker 10 days ago, after which the EC President described the PM as “living in another galaxy”, eventually provoked a robust response from Theresa May, in which she accused Brussels of attempting to affect the result of the general election. Judging by the results of the local elections, in which the Tories made spectacular gains at the expense of Labour and an - almost literally – annihilated Ukip, interventions from Brussels may, indeed, affect the General Election but probably not in the way intended by leaker-in-chief, Martin Selmayr.
Undeterred, Juncker was at it again later in the week, calling Brexit a ”tragedy” and delivering a speech in Florence in French, explaining that ”slowly but surely English is losing importance”. All this open acrimony might have been expected to weigh heavily on sterling, but the pound has been ‘well-bid’ for a while now, as bearish speculators have been gradually ground down by the virtually unrelenting good news on the UK economy. Indeed, only very recently have weaker retail sales figures threatened to spoil the party, pointing as they do to the likelihood that consumers are being squeezed as inflation threatens to overtake wages.
Furthermore, while it is true that the Q1 GDP numbers disappointed at just 0.3% quarter on quarter, last week’s PMI numbers were very strong and suggest a Q2 GDP reading of 0.5% or 0.6%. Even the stronger-than-expected US non-farm payroll numbers on Friday (+211k versus a consensus of +185k), failed to halt the pound’s rise against the dollar and GBP/USD currently trades at 1.2970. Against the euro, sterling fared less well, the single currency being strongly supported as markets began to judge (correctly, as it turned out) that Macron was a shoo-in for French President. Interestingly, this morning, the euro, having opened stronger, has sold off. Perhaps the markets are fretting about En Marche!’s chances in the parliamentary elections in June. It is more likely, however, that with the threat of Le Pen now gone, hedge funds are putting carry trades back on, borrowing euros and investing in higher yielding currencies.
The dollar’s relative weakness last week was interesting. Granted, there was a short squeeze in GBP/USD and reappraisal of French politics. In the background, however, the commodity markets were having one of their periodic panics. Oil crashed back below $50, while copper and, particularly, iron ore sold off sharply. Indeed the iron ore price has dropped over 47% since the beginning of March – with almost a third of that move taking place since last Tuesday. Ordinarily, during a broad sell-off in commodities, the dollar tends to strengthen, but this is not what happened last week.
There are two possible explanations for this: either the long dollar trade remains crowded, even after substantial unwinding, i.e. there are still plenty of potential sellers of dollars out there; or the FX market, focusing on last Friday’s non-farm payroll numbers, has been slow to react to the chaos in the commodity markets. If this is the case, we are likely to experience a period of ‘catch-up’ this week – particularly since expectations are now 80% for a Fed rate hike on 14 June.
The fly in the ointment is China, or more particularly, the Chinese authorities’ control of credit and the shadow banking sector. Shadow banks are financial firms which perform some of the functions of true banks but with much less regulation and, typically, much more leverage. This can be useful when economic stimulus is required, as the more nimble shadow banks are able to extend more credit – and at a faster rate – than their slower-moving, fully regulated competitors.
However, the Chinese shadow banking sector has grown rapidly in recent years and, in the absence of full regulation and with eye-watering leverage ratios, is now judged to be a potential source of financial instability. The authorities have been tightening monetary policy since the middle of last year but are now also acting to correct what has come to be seen as an excessively generous credit regime. This has led to, amongst other things, sharp increases in deposits required for residential mortgages, and the commodity markets are worried that a dramatic slowdown in Chinese construction will massively reduce global demand for steel. This comes just after Chinese steel production reached an all-time high of almost 72 million tonnes in March, creating the perfect storm of a fall in demand, combined with a ramping of supply – hence the collapse in the price of iron ore.
Clearly, if China is about to start exporting deflation again, the consequences will be felt in the West. This will probably please Mark Carney as a tempering of inflationary pressures will vindicate his position of keeping rates as low as possible for as long as possible. In Europe, Mario Draghi will doubtless feel similarly smug, having reassured the markets at the ECB press conference last month that he expected interest rates to "remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases” which end in December 2017. A global commodity rout is just the ticket when justifying such policy largesse.
In the US, however, policy is more nuanced. The market expects a rate hike next month, and a month ago the Fed declared its intention to start reducing the $4.5 trillion of QE assets on its balance sheet as early as this year. Doubtless the Fed will do this by gradually reducing the amount of maturing bonds that get reinvested but ex Fed Chairman, Ben Bernanke, has argued that the Fed should have a buffer in terms of a higher Fed funds rate before starting to reduce its balance sheet.
The reason is that ceasing to reinvest a proportion of maturing bonds – and destroying the cash so created – is not only a tightening in itself but also something of an unknown. Before embarking on such a plan, therefore, it would be better to have some room to meaningfully cut the funds rate, just in case things went wrong and long-term rates spiked. How much of a buffer would be required is debatable but it is unlikely the Fed would feel comfortable about reducing the asset reinvestment programme with the funds rate below 2%. That looks like a stretch this year, particularly if recent commodity price action does, indeed, portend a serious Chinese slowdown and revival of global deflationary forces.
This week sees the BoE Quarterly Inflation Report on Wednesday which will provide further insight into how the MPC proposes to ‘look through’ rising inflation (China notwithstanding) in the short term. Later in the week we shall see March industrial production figures for the UK (Thursday, expected +2% y/y) and the eurozone (Friday, expected +2.3%). Friday also sees US inflation data for April, where CPI is expected to have risen to 2.3% y/y.
All views expressed here are the author’s own and are based on information and data available at the time of writing.
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