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Has the starting gun been fired?

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22 nd November 2016
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The recent increase in interest rate expectations has led many to suggest that we are witnessing the end of a three-decade bond bull market. Whilst we think the normalisation of monetary policy is long overdue and therefore welcomed, we don’t expect a smooth transition.
 
President-elect Trump has promised a significant fiscal easing program in the US, driven by increased infrastructure spending and large tax cuts. However, talk of regime change and a new order might prove to be overzealous as Trump’s ambitions are scrutinised and ultimately curtailed by Congress. With some analysts calculating a $12tn difference between Trump’s election policies and those of his supposedly fellow Republican paymasters in Congress, Trump’s self-confessed deal-making skills will be put to the severest of tests. However, with negotiations between both parties already in progress, one would expect a compromise to be achieved which will contain a major boost to fiscal expenditure.
 
Increased fiscal measures will coincide with the long-promised normalisation of rates, with a 0.25% increase in December along with ‘promises’ of further increases in 2017. This would be a prudent, if overdue measure, with the US economy going from strength to strength and inflation expectations quickly intensifying. Furthermore, with the US policy becoming increasingly inward looking, previous influences that have delayed the normalisation move, such as concerns over China’s economy and Brexit, are unlikely to be paid much heed in the future.  Janet Yellen will have to demonstrate less dilatory leadership in the future, particularly following the criticism directed at her by the President- The dollar continues to strengthen, hitting lows of 1.0569 and 1.2302 last Friday against the euro and sterling respectively, as global monetary policy appears to be diverging. We expect the strength of the dollar to continue, which will ironically hamper the manufacturing revival that swept Trump to power. This may in turn force Trump’s hand in acting upon the all too popular protectionist rhetoric that we have become accustomed to hearing from him. Moves to undermine if not abandon free trade agreements such as TPP and NAFTA will be drastic and to everyone’s disadvantage  However, since the US is the least dependent on trade of all developed economies, a breakdown in international trade will support the greenback. Amidst all the concern over Trump tearing up trade agreements, it would appear that the UK need have no worries. Evidently, according to the Liam Fox club of totally deluded Brexiteers, the regard in which Trump holds the UK means that he can hardly wait to agree a special trade deal just with us.
 
The prospect of higher Fed rates has also seen an increase in interest rate expectations on this side of the pond with the five-year swap rate rising to 0.90%, representing the complete reversal of the post-referendum rally. While this early reversal was in large part down to the economy proving to be more resilient than analysts had predicted, the more recent increases are attributable to increasing inflation expectations – at long last! Whilst the BoE has talked of looking through imported inflation, which seems counterintuitive given they did not do the same for imported deflation, there is a growing realisation that the BoE’s hand may eventually be forced, particularly if the currency continues to depreciate as we are seen to pursue a hard Brexit.
 
For all the positive soundbites regarding Brexit over the last few months, this week represents a crucial week for the British government, and the market will not take kindly to any half-baked efforts. May has kicked the week off with a speech to business leaders at the CBI annual conference against a backdrop of hardening battle lines within her own party. Sixty Conservative MPs have signed a letter demanding that the UK leave the single market and the custom union. This timely act will not have been lost on attendees, the majority of whom are seeking reassurances of the polar opposite.
 
This will be followed by the long-awaited Autumn Statement on Wednesday. With the UK all out of monetary policy tricks (or at least one would hope) it falls to Philip Hammond to loosen the fiscal straps and counter the economic fallout from a collapse in corporate investment. A commitment to infrastructure spending, most likely for ‘shovel ready’ projects rather than anything too ambitious, is regarded as a certainty. However, with deteriorating public finances, as is likely to be reaffirmed by the public finance figures released on Tuesday morning, Hammond is also going to be limited in his ability to offer significant incentives to support and drive business investment - and secretive deals with the likes of Nissan don’t count as such! Whilst the proof will be in the pudding, leaks over the weekend suggest a less than impressive start for our new Chancellor. At a minimum, the Government must distance itself from the political point-scoring that both sides of the Brexit debate are likely to take following his speech. We expect the latest set of OBR predictions, to be released on Wednesday in conjunction with the Autumn Statement, on the health of the UK economy, a near impossible and potentially politicised take, to come under the most criticism.
 
The eurozone has also seen its interest rate expectations increase over the course of the last week. One would be mistaken for reading this as a sign of confidence: it is simply the result of expected fiscal easing in the US. In fact, the US-German yield gap has reached a 27-year high with 10-year differential at over 2.00%. This is driven by diverging monetary policy. Whilst the Fed is anticipated to undertake the normalisation of rates, Draghi is expected to announce a further extension of QE in December. The current flat yield curve in the eurozone is a reflection that the economic recovery is reliant upon loose monetary policy, and there will be a lack of fiscal spending by governments. However, with the Italian referendum being imminent and the elections in France and Germany next year already making the headlines on a regular basis, there are greater concerns afoot and we expect these to dominate the headlines in 2017.
 
All views expressed here are the author’s own and are based on information available at the time of writing.

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