Monetary policy has been a big factor driving asset markets in recent years. We expect this to continue in the second half of 2016. The economic outlook sketched out in parts 1 and 2 of the trilogy is not conducive to inflation. Admittedly, in the US, a labour market that is tightening further should generate some wage pressure (see exhibit 1 below) and thus some inflation. Core CPI inflation has already accelerated to 2.2%, while the core PCE deflator (the US Federal Reserve’s preferred inflation measure) has been more stable, at around 1.5%. Inflation and financial stability are arguments for a forward-looking Fed to gradually raise interest rates.
Exhibit 1: The US labour market is tightening and this is leading to some upward pressure on wages. This should feed through into a higher rate of inflation in the next six months.
Source: BNPP IP, Bloomberg as of 13/07/16
However, Fed policy is data-dependent as well as market-dependent. So changes in macroeconomic data and investor sentiment could easily change the outlook for interest rates. In May, the Fed had prepared the markets for a rate rise in June or July, but May's weak labour market report (published in early June) caused the Fed to back off, even though Fed-chair Yellen warned of reading too much into any one data point. It is possible that Brexit played a larger role in the Fed’s decision-making than it has admitted.
At the time of writing, markets are pricing in fairly low probabilities for a rate rise up to the November Federal Open Market Committee meeting. Indeed the priced-in probabilities are, in our view, probably too low for the Fed to make a move as it will not want to surprise the markets. We expect that for the Fed to act, it will require a probability of 40% or greater for a rate rise in December.
Exhibit 2: At the time of writing (mid-July 2016), financial markets are pricing in fairly low probabilities for a rate rise up to the November Federal Open Market Committee meeting (the graph shows the probability ascribed by financial markets (using the fed funds futures contracts) for rate hikes during the rest of 2016
Source: Bloomberg as of 13/07/16
Of course this could all change quickly if the data holds up. We think the Fed will focus particularly on the labour market. We expect job growth will hold up well enough for the Fed to raise rates this year, possibly as soon as September, although a delay to December is also feasible. With the US presidential election coming up this autumn, two rate hikes from the Fed between now and year end looks to us like an overly aggressive forecast.
While we think the impact of the Brexit vote on the global economy will be limited, we expect that it to have a greater effect on monetary policy. As mentioned above, Brexit may have led the Fed to delay its rate rise cycle. A rate cut in the UK in August looks like a certainty. In the eurozone, inflation is still precariously low and inflation expectations are hovering close to their record lows. They are, to paraphrase the ECB, on the brink of becoming unanchored. The ECB has just expanded its asset purchase programme to include corporate bonds, so it will likely be on hold for a while.
Nonetheless we think that low inflation, low inflation expectations, and a growth slowdown towards the end of the year will together prompt the ECB to announce further easing. Most likely in our view is an extension of the current asset purchase programme beyond March 2017. This could be accompanied by a relaxation of some of the limits the ECB has set for its asset purchases so as to be able to broaden the range of eligible bonds.
In Japan, we would have thought that the strength of the yen after the UK referendum was strong enough to trigger more monetary easing. The yen came close to 100 JPY per USD, undoing half of the depreciation since 2012 under ‘Abenomics’. The yen has rebounded slightly, but its recent strength will have a downward impact on inflation, which is already visible in import and wholesale prices. In our economic outlook for Japan we integrate the probability of some fiscal stimulus, although the size of any package is hard to predict at this time. A large fiscal stimulus could keep the Bank of Japan on the side lines, although that could have a profound impact on the yen. A positive surprise would be a combined monetary and fiscal push.
In emerging markets, monetary policy should show some divergence. We think that the Chinese authorities may be reluctant to ease further, given the financial imbalances in the economy. However, with growth moderating, some cuts in banks’ reserve requirements cannot be ruled out. South Korea and Indonesia could also ease further, while monetary policy may remain on hold in India due to a rate of inflation stubbornly above the central bank’s target. In Brazil, the economy and fiscal outlook are crying out for monetary easing, but sticky inflation and a new central bank governor in search of credibility will, in our view, delay the start of the easing cycle, possibly into 2017. [divider] [/divider]
This article was written on 19 July 2016 in Amsterdam
---This article is part of our recent ‘Investment outlook’ and ‘Economic outlook’ series. Here are the links to all the articles: Investment outlook for the rest of 2016: Europe Investment outlook for the rest of 2016: United States Investment outlook for the rest of 2016: Japan Investment outlook for the rest of 2016: Emerging Markets Economic outlook for the rest of 2016 – part 1 Economic outlook for the rest of 2016 – part 2 Economic outlook for the rest of 2016 – part 3