Our general economic outlook for the rest of 2018 is for continued growth with low, but rising inflation worldwide. In this scenario, we expect major developed market central banks to gradually reduce the still-extraordinary level of liquidity in financial markets.
A sudden rise in inflation is, in our view, the principal risk
The main risk to this benign and constructive base case, however, is an unexpected acceleration in inflation that causes bond yields to spike higher in the US. Bond and equity markets worldwide still look expensive to us, although less so since a recent correction from January's peak. Nevertheless, overvaluation is a potential risk to our scenario.
And the risk of a trade war cannot be dismissed
Another risk which cannot be dismissed relates to the Trump administration’s tariff threats on trade with China and other countries. While this may culminate in a wider trade war in which major economies retaliate, we are still at the phase of threats and posturing and it will likely be time before any actual action is taken. A serious trade war is not our base case yet, but these disputes are serious and need monitoring. What follows here are our expectations for various regions and currencies.
Prospects for the US dollar
In the first quarter of 2018, we saw US and global economic growth slow slightly from relatively high levels (by recent standards), but there is now a divergence between the US – where economic activity is holding up better and inflation is continuing to rise – and Europe and Japan, where inflation remains quite disappointing.
Expectations are now for three or four interest-rate increases by the US Federal Reserve in 2018 as key Fed governors appear more confident about both GDP growth and rising inflation.
New Fed chair Jerome Powell, working with newly appointed New York Fed president John Williams and vice-chair Richard Clarida, is likely to forge a monetary policy not very different than the one set up under his predecessor Janet Yellen. This welcome continuity, together with a generally robust world economy, should contain the possibility of major policy errors and help extend the current long growth expansion.
The US dollar weakened sharply in January before stabilising over the rest of the first quarter of 2018. Since mid-April, the US dollar index has rallied by 3.5% (see Exhibit 1 below showing changes in the DXY between 14/05/2016 and 14/05/2018) as 10-year US Treasury yields approached and broke above the psychologically important 3% level.Exhibit 1: A rally in the US dollar index (DXY) in April 2018 Source: BNP Paribas Asset Management, Bloomberg as of 14/05/2018
Valuations of the US dollar have recently recouped with interest-rate differentials
The recoupling of the dollar with interest-rate differentials after a long period of a lack of correlation was notable and impulsive.
The upward surge in April of US Treasury yields and renewed traction on the US dollar were also consistent with the fact that in the first quarter, both actual and prospective US GDP growth and inflation data diverged from GDP growth and inflation surprises in Europe and Japan.
Should these divergences continue, the DXY could rise back to its November 2017 peak (i.e. about 3.5% higher than where it ended April) when the anticipation of US tax cuts boosted economic activity and dollar sentiment.
Over the last three years, total returns of US Treasuries have been below the rate of US inflation
US Treasury total returns have underperformed US inflation for three consecutive years - a first since 1981. Yields may need to rise significantly to ensure positive real returns to investors who will soon have to bid on a lot of new supply thanks to bigger US budget deficits. This could happen as a spike, regardless of how slowly and gradually the Fed raises interest rates.
One historical spike of note was when the Fed last went into an easing mode in the summer of 2003, when over a six-week period 10-year Treasury yields shot up by 132bp (from 3.12% on 13 June 2003 to 4.44% on 29 July 2003 and ultimately 4.6% by 3 September 2003), before correcting lower (see Exhibit 2).Exhibit 2: A historical spike of note in US-Treasury yields - in the summer of 2003 Source: FactSet, BNP Paribas Asset Management, as of 04/05/2018
We could conceivably see a smaller spike should it become obvious that US growth is not slowing and that inflation will indeed rise, along with more Treasury supply.
A spike in US bond yields would probably be positive for the US dollar
Whereas the ‘boiling the frog’ approach by the Fed, gradual yield increases in Treasuries and continued global growth would generally be negative for the US dollar, a spike in yields would probably be positive in the short term, even if the Fed is not aggressive — especially as other central banks and regions remain sluggish and highly accommodative.
The dollar index rallied by 7.5% over the summer of 2003 before resuming a long decline to the end of 2004 as global growth picked up. Similarly, the dollar could resume its decline longer term as the ECB and Bank of Japan move closer to policy tightening and global growth picks up.
Are there still bond vigilantes out there? Or are the US and global economies too weak to sustain a spike in US rates?
Prospects for the euro
President Mario Draghi has indicated that the ECB may need to delay announcing further plans for ending its quantitative easing (QE) programme until July or perhaps even beyond.
Such a dovish setback contrasts with expectations for the Fed to steadily tighten policy, coupled with the contrast between US and European data and the continued pull from US rate differentials, gives the euro room to weaken in the near term.
Longer-term, we expect a stronger euro
As the ECB’s exit from QE starts to develop later in 2018, we expect the euro to strengthen.
The Swedish krone remains relatively cheap and should fare better than the euro over a longer time frame.
The British pound may not do as well as the euro as negotiations over Brexit are likely to continue to cloud the outlook for most of 2018.
We are neutral on the Swiss franc as it has nearly reached the artificial floor level of 1.20 euro/CHF that broke in January 2015.
Outlook for the Japanese yen
The Bank of Japan (BOJ) is expected to begin gradually raising the target of 0% yields on 10-year JGBs as its plan for exiting QE takes shape for 2019.
Inflation in Japan, however, remains far from the bank’s 2% target and the latest data shows another significant setback.
Given that the Japanese yen remains quite undervalued (by 20% or more), we would expect it to stay in a wide range of between 105 and 112 per US dollar in the near term and strengthen longer-term toward 100JPY/USD, or even further, as the BOJ starts to modify its policy of pegging 10-year JGB yields near to zero, i.e., applying a yield curve control (YCC) policy.
Yen to remain a safe haven
This adjustment to YCC is now expected to come later in 2018 or perhaps only in 2019. The yen will likely continue to perform best during periods of risk aversion in global markets (e.g., when there are fears of a trade war), and poorly in periods where investors are looking for higher-yielding investments and retain their risk appetite.
President Abe’s decline in popularity also plays into the possibility of a stronger yen as any changes in leadership in the government or the BOJ could accelerate the BOJ’s exit from the unpopular negative interest-rate environment.
Outlook for emerging market (EM) currencies
With US dollar strength and US long-term yields breaching major thresholds of 3% or higher, we have generally turned more negative on EM currencies in the near term.
As mentioned above, a further spike in US yields is possible given the resilience of the US economy and inflation, and in the face of a large supply of Treasuries due to the growing US deficit and the Fed’s reduction of its balance sheet.
EM currencies should stabilise and recover when US yields top out and global growth picks up again. This may not happen until later in 2018.Other posts on this topic