Outlook 2017: Financial Markets
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- We are not convinced that Trump’s policy will give the US economy a sustainable boost nor that Europe can escape its structural problems
- Against the backdrop of subdued growth and inflation, we expect the recent rise in long-term interest rates to prove transitory, particularly in the eurozone
- Peripheral debt is likely to remain sensitive to upcoming political events in Europe
- The sharp rise in the dollar since early November looks overdone and we expect the rally to run out of steam in the months ahead, although the uncertain political situation in Europe should prevent a sharp rise in the euro
- We maintain our negative view on the Chinese renminbi
Is there still a way back?
Capital markets interest rates reached new historical lows during 2016, and the Chinese currency plummeted. The result of the British EU referendum was a surprise for many market participants, and led to a net deprecation of 18% of the British pound in the first nine months of the year.
Nonetheless, following an initial sell-off in equity markets, broad-based turbulence in financial markets remained largely absent. The main reason for this was the Fed’s cautiousness regarding its interest rate policy, while the ECB further fuelled investors’ search for yield with an expansion of its bond buying programme. The Bank of England cut rates and re-invigorated its purchase programme later in 2016. In other words, central bank easy policy settings once again acted as shock breakers.
This raises the question of whether there is actually a way back to normality for the financial markets, or whether the aftermath of the Brexit and Trump scenarios will ultimately lead to huge volatility. The international economy is still faltering and there is a high degree of political uncertainty. As radical scenarios become increasingly possible, there is an increasing risk that the financial markets will be disrupted.
If the central banks continue on their current path we will ultimately see even lower capital markets interest rates in 2017 than in 2016, while if there is a radical shift to extreme monetary policy measures such as ‘helicopter money’ or a worldwide budgetary stimulus we can expect interest rates to make a serious move to the upside. In the European context we tend to favour the first scenario, although an end to this is in sight. In the US, the election of Donald Trump makes the second scenario considerably more likely than previously was the case. This would however have all kinds of side-effects that could on balance have a negative impact on world growth and therefore for the development of interest rates.
Monetary policy has been eased drastically in all the large industrialised countries in recent years in an attempt to spark economic growth and raise the inflation rate towards the central banks’ target of 2%. Monetary policy in the EMU has now been loose to very loose for several years. Initially, the focus of the unconventional measures was very much on keeping the currency union together by buying government bonds issued by the weaker Member States that were facing unsustainably high interest rates and – from mid-2012 onwards – by warning that the ECB would do “whatever it takes”. Initially, this policy worked well and it is entirely to the ECB’s credit that the eurozone did not fall apart. But after the experiences in the US and Japan, it was somewhat surprising that the ECB decided to venture into the unknown territory of quantitative easing (QE) in 2015. After a tentative start with asset-backed securities at the end of 2014, in 2015 this policy took the form of large-scale purchases of bonds from central governments, international and government-related institutions (known as agencies), and has now been expanded to include regional government paper and corporate bonds in 2016. There has even been speculation that the ECB might purchase equities.
Reversing this policy is becoming increasingly difficult. This is partly because past policy measures are causing numerous side-effects (see Box 1), but also because its low effectiveness implies that it takes a long time before they can be unwound. The only channel through which it has been effective in the short term is exchange rates. A weaker currency helps exports and increases inflationary pressure through import prices. However, the problem with boosting economic growth by weakening one’s currency is that this is by definition a zero sum game. Any country that improves its competitive position in this way can only do so at the cost of its trading partners. And if they in turn ease policy further to weaken their exchange rates, at global level this policy can actually turn out be a negative sum game, as a result of the side-effects.
Box 1: Monetary policy, is the cure worse than the disease?
The low level of market interest rates we have seen in the past are not only the result of moderate growth and low inflation. Monetary policy measures in the form of ultra-low policy rates and quantitative easing are also responsible. And because these measures have all kinds of side-effects in the long term, this, in turn, makes it more difficult to normalise policy again (for a detailed account of this, see McGuire, 3 June 2016).
Opinions vary regarding the effectiveness of QE. According to ECB President Draghi, the policy has been a success and both growth and inflation are higher than they would have been without QE. But the relatively modest results are not proportionate to the scale of monetary stimulus used and the negative side-effects. Generally, we see the following problems:
- Low interest rates lead to a misallocation of capital (from capital-intensive to labour-intensive, from high return/high risk to low return and low risk projects); in the most favourable case this does increase employment, but not in the sectors that contribute to productivity growth.
- Low interest rates allow inefficient companies (and weak governments) to keep going and so are preventing ‘creative destruction’; the business dynamic in Europe, in the form of creation and breakdown of firms, has been relatively low as a consequence.
- Households tend to save more in a low interest rate environment (this may not be rational, but it is understandable on the basis of uncertainty or in an aim to maintain nominal wealth goals).
- Low market interest rates, via their impact on liability discounting, are also bad news for the funding ratios of pension funds and the earnings models of banks and insurers.
All this leads to low productivity growth and (due to low investment growth and greater supply of savings) to lower equilibrium interest rates. Low economic growth and inflation are then reasons for the central bank to double up on monetary stimulus. And this completes the circle.
The Fed in 2017
Although a year ago many analysts believed that the Fed’s policy interest rate would be raised several times in 2016, as the Fed itself had suggested, there has so far been only an interest rate increase in December 2015. There will probably be another hike in December 2016. We expect to see this scenario (of one rate hike) repeated in 2017, but this has become less certain after the outcome of the US election.
The still moderate growth of real wages and the global effects of the stronger dollar are obstacles to the Fed taking a more aggressive stance. Additionally, the rest of the world, and especially a number of the emerging markets, have become increasingly dependent on the dollar in the last six years. This also means that higher US interest rates and/or a stronger dollar will have a negative effect on the global economy and financial markets. This became all too obvious in the first two months of 2016 in the aftermath of the Fed’s interest rate hike in December 2015.
The most recent job figures suggest that employment continues to grow at a moderate rate, but also that the development of wages is still relatively modest. Moreover, the propensity to invest and productivity growth in the US are lagging, ultimately raising the question of how rapidly domestic wage and inflation pressures will actually show themselves.
There is still a considerable difference of opinion within the FOMC and the Fed will continue to act cautiously while things are still uncertain. Then we have the ‘Trump factor’, which involves increased uncertainty with respect to US trade policy as well as the possibility that the country will turn to a more expansionary fiscal policy. The bigger the budgetary stimulus, the faster the Fed will be able to raise its policy interest rate. However, if Trump unleashes a trade war and there is an increasing threat of a recession, the Fed will be forced to postpone further interest rate hikes or even, if there is a real threat of a recession, embark on a new round of quantitative easing. This could go either way.
We think that there is a considerable risk of a less liberal policy direction with respect to international trade, especially in the first half of 2017, whereby the negative effects of this on the world economy could outweigh the positive effects of a more expansionary fiscal policy. The Fed will most likely look beyond the short term, supply-driven effects on (import) inflation. However, the Republican-dominated Congress (both the Senate and the House of Representatives) will probably not give Trump everything he wants with respect to either fiscal policy or trade restrictions. Since the effects of the fiscal stimulus may only become visible in the course of 2018 and his trade and geopolitical policy could lead to much uncertainty in the rest of the world, the Fed will probably avoid any aggressive interest rate tightening.
The ECB has to keep going, but how long can it do so?
There does not appear to be much of an opportunity for the ECB to change its current policy. We expect to see an extension of the bond buying programme, which officially will end in March 2017, to at least September 2017. We expect an announcement on this as early as this month.
Nonetheless the perception is steadily growing that the marginal benefits of the current policy are declining and that further monetary easing in the form of QE will ultimately be of little use. This means that we will arrive at a crossroads at some point. One option is for the central bank to continue to stretch its mandate and look for ways of making its monetary policy more effective, for instance with the use of helicopter money. The level of resistance to this in Northern Europe will be such that there is only a small chance that the ECB will go in this direction. It is more likely that greater importance will be attached to fiscal policy. This is either because the establishment, forced to defend itself against the wave of populism, decides to loosen the fiscal reins, or it is because populist parties themselves gain power and change the beacons. A looser budgetary policy would allow the monetary authority to cautiously begin normalising its policy. The third option of muddling through looks like a dead end. In the short term however, this may be the most likely outcome.
So far, the policy line has been that the ECB will continue its loose monetary policy until we see a sustainable increase in inflation. Although inflation could reach 1.5% in the course of 2017, this rise will probably be only transitory. Underlying core inflation is still running at a mere 0.8% and wage development is still weak in most of the euro countries, apart from exceptions such as Germany. Even at the current rate of decline in unemployment, it could still take one or two years before the level of unemployment causes additional wage pressure (see De Groot, 2016). Of course, the ECB could say that, according to its projections, core and headline inflation will reach the desired level in 2018/19. However, this is a risky assumption, given the past years of overestimation of the inflation figures. Hence, continuing the current policy looks like the path of least resistance.
There are however increasing signs that the ECB is reaching the limits of its bond buying programme. We think that the ECB will stretch these limits by raising the amount of certain bonds it can buy (from 30% at this point) and that it will no longer take the deposit interest rate as the lower limit for the paper that it buys. This lower limit currently forces the ECB to buy long-dated paper and the liquidity situation in the market for this kind of paper has accordingly deteriorated (see Graham-Taylor, February 2016).
Ultimately however, this is not a permanent solution. We thus expect the ECB, perhaps as soon as December, to sketch the possible conditions and timing of a gradual unwinding of its purchase program in the future. However, it can only do so in earnest if it accepts that the programme is not working, or if it turns out that the program is working and underlying inflation has clearly improved, or if the eurozone countries embark on a strong and coordinated fiscal stimulus that in combination with structural reforms can raise long term growth. A Trumpian political reset in the eurozone could significantly accelerate such a process, but it could just as well push Europe towards disintegration, with all the consequences that this would entail.
Capital markets interest rates – lower again in 2017, but disintegration an even greater risk
We believe that the interest rate increase that has occurred since October is only temporary. Certainly in the eurozone, long-term interest rates could fall to their previous lows, or even lower, during 2017.
The fact that we live in exceptional times is evidenced by the level of capital markets interest rates. The 10-year yields on government bonds and swaps reached new historical lows in many countries in the course of 2016, and even went negative in a not inconsiderable number of countries. This is particularly remarkable because the central banks have actually been using all the tools at their disposal to stimulate the economy and thereby inflation. And this has clearly not been a success, since in that case we would have seen at least long-dated capital markets interest rates rise.
Is the rise in bond yields only temporary?
We have seen a sharp correction in the markets since the beginning of October. The rise in US and European long-term interest rates and in particular the steepening of yield curves we have seen is putting our sombre view to the test. The yield on 10-year German paper rose by nearly 30 basis points to 0.15% during October. Since Donald Trump’s election in the US, the rise in US yields (+40 bp for US Treasuries) has also pushed European yields higher (the German 10-year bond yield rose a further 15 bp to above 0.3%).
There were several reasons behind the rise in interest rates in October, one of which was speculation that we are on the verge of a normalisation of yield curves, driven by potential changes in the policy (framework) of the central banks. This speculation gained ground on 4 October, when Bloomberg reported that various ECB officials saw a gradual tapering of the bond buying programme as a serious option over time. Another factor was that, in a number of countries, the economic figures after the summer turned out to be better than expected. The clear rise in inflation – partly due to baseline effects – in the fourth quarter was not a surprise, but in combination with a 12% increase in oil prices in the first half of October this was enough to raise long term inflation forecasts in the markets as well.
There were also technical reasons for the yield curve to steepen, especially in Europe and most particularly for German government paper and in fact already since the British EU referendum. The figure below shows that the interest rate spread between the German yield curve and the OIS (overnight indexed swap) curve widened between the beginning of July and the end of October by around 30 bp for longer maturities, but not for shorter maturities. The OIS curve is the ‘purest’ curve for interest rate expectations, while the German curve also reflects the relative scarcity of this paper. The steepening of the German yield curve compared to the OIS curve could reflect speculation that the ECB is planning to abandon its deposit floor. This would allow the ECB to purchase shorter maturities and would reduce the downward pressure on yields at the long end of the curve. Since we expect the ECB to abandon its deposit floor, this effect could intensify somewhat in the course of December.
The rise in long-term interest rates received a further (strong) boost after the election result in the US, which mainly sparked speculation that American under Trump would reflate, either with a fiscal stimulus or higher import prices as a result of trade barriers. Long term inflation forecasts in the US have risen sharply (by nearly 30 bp) to above the levels seen in mid-2015. This movement also led to a further increase in the yields on European paper.
At the time of writing, it is difficult to ignore this market dynamic entirely, also because the inflation figures in many countries will rise to some extent due to a lower comparison base (the comparison base will be the lowest in January 2017, because oil prices reached a 12-year low in January 2016). Speculation on the effects of Trump’s policy is so far mainly based on scanty information, but has led us to believe that we could see higher long-term interest rates in the near future, especially in the US.
Fundamentally, little has changed
Nevertheless, our view is that fundamentally little has changed. Regarding US interest rates, we are not convinced that Trump’s policy decisions will deliver a sustainable boost to the economy. His plans would appear more likely to increase income inequality rather than reduce it. This could even prevent a substantial pay increase for the middle class rather than boost income levels. Congress will probably curb Trump’s budgetary ambitions and his plans to raise trade barriers. Nonetheless, his plans could do serious damage to global growth (especially in emerging markets), and could have negative effects on commodity prices. Potential geopolitical tensions finally mean that both US and German government paper will continue to enjoy a degree of safe haven status. This is why our forecast for US 10-year bond yields at the end of 2017 is well below the current level. But a decline to historical lows now looks to be a long way off, and we have to admit that the uncertainties have increased significantly.
In a way, the situation in Europe is more clear-cut, in our view. Economic growth is still structurally subdued, as is underlying inflation. Wage growth in the eurozone in the second quarter of 2016 was at its lowest level since the early 1990s. This is also a sign that we are far from ‘full’ use of labour capacity in the euro area. A permanent steepening of the yield curve can only occur if there is a sustainable increase in inflation forecasts, which is unlikely while there is no convincing rise in wage inflation. The weakness of world trade growth, the fragile recovery in several heavily battered emerging economies and the shift from the political middle ground to the extremes in various countries also mean a situation of continuing uncertainty. Europe will see little benefit from Trump’s budgetary plans, while it will feel the negative effects of his international policy.
Therefore it is still plausible that German 10-year yields and the highly correlated swap rates could reach or even go below the previous low of 0.25% for the 10-year swap by the end of 2017.
Peripheral paper more sensitive to political developments
The political risks in the European context, as described in Box 2, are certainly important factors for peripheral government bonds. In terms of spread levels, there appears to be a clear structural floor for peripheral bonds vis-à-vis Germany. For Spanish and Italian paper this ‘floor’ is around 100bp. This level will be broken only if the eurozone actually moves to a mutualisation of government debt. This would appear to be a long way off given the current European political constellation.
Of the southern Member States, Spain put in a relatively good performance last year, supported by the favourable development of the economy and the formation of a minority government under PM Rajoy in October. Portugal and Italy have turned out to be more vulnerable to negative sentiment. This mainly has political component, which has been strengthened by both the British EU referendum and the election of Trump.
From a tactical point of view, we may see political developments leading to large spikes in peripheral risk spreads with some regularity in the remainder of this year and in 2017. Portugal’s vulnerable position, with its high debt, low growth and only one investment grade rating from credit agency DBRS, is particularly notable. The anti-austerity stance of the new Portuguese government has so far not led to insurmountable tensions with the European Commission and the country’s EU partners, but the country continues to operate on the edge. In Italy, negative sentiment is stoked mainly by structurally low economic growth and the problems in the banking sector (which are only being addressed on a case by case basis). A ‘no’ vote in Prime Minister Renzi’s constitutional referendum on 4 December could lead to political instability, and possibly to early elections.
Although the market – especially since Trump – does not appear to be unperturbed, the likelihood that the eurosceptics will gain control in Italy in 2017 still looks to be limited. Furthermore, the ECB’s bond buying programme, which will continue in 2017, forms a safeguard against excessive spikes in risk premiums. Actually, these spikes could offer investors a good opportunity to re-enter this market. But the tail risk has increased, and it should be clear that if Europe begins to slide towards a scenario of disintegration, the safeguard provided by the ECB will no longer be a given and spikes in risk aversion will permanently affect peripheral spreads.
Box 2: Three risks for the financial markets leading to disintegration
A global economy that is muddling through, years of extreme monetary policy and the rise of populist parties present various risks for the financial markets. The dissolution of established institutions is no longer an unimaginable scenario. Broadly speaking, we see three risk factors for the financial markets:
- Political turbulence leading to economic disintegration,
- The bursting of bubbles, and
- Less efficiently functioning markets as a result of insufficient market liquidity
The result of the British EU referendum, the election of Trump and the rise of anti-establishment and anti-EU parties in Europe cannot, in our view, be seen as unconnected events. They are the result of growing resistance against free trade and globalisation (mostly because those who have lost out from these developments have not been adequately compensated). Labour has had the worst end of the deal for decades, and the global labour income share in GDP has been in a declining trend since the mid-1980s. Monetary policy in the past years has, arguably, made (wealth) inequality worse.
After the election of Trump, in the US we see uncertainty with respect to the size of the upcoming fiscal stimulus and the potential effects of trade restrictions. But in the European context, this means an increased risk of disintegration of the EU and/or the eurozone if the Member States fail to address the root causes of the problems. A scenario of an EU exit by one or more Member States could manifest very differently in comparison to the sovereign debt crisis of 2010-2012 (see De Groot, 2016).
The markets are already seriously disrupted as a result of the extensive amount of monetary stimulus that has been used. There is what could be called a bubble in the bond markets and if central bank policy is the only factor that drives investor behaviour, this could be a risk to financial stability, even without excessive lending. The fact that the valuations of financial instruments, at the very least, seem high in comparison to the fundamentals means of course that if the central banks move too quickly towards the exit these valuations will be severely pressured, with all the consequences that this would entail. Stopping loose monetary policy will involve severe shocks. The Fed has already experienced this, first when it wanted to end QE and again when it wanted to raise interest rates.
But if the central banks continue to purchase government paper ‘as usual’ (as is the case in Japan and the eurozone), the risk also increases that market liquidity in this paper will continue to dry up. This could lead to a lack of high quality collateral, with market prices becoming more volatile and more sensitive to small changes in supply and demand (for a detailed analysis, see Graham-Taylor, 2016).
 In a press conference in October, President Draghi dismissed the bubble scenario because in the ECB’s view bubbles are usually identified with periods of high asset prices and rapid growth in monetary aggregates (lending).
EUR/USD: choosing the lesser of two evils?
Despite the recent optimism post-Trump, we are not convinced that the dollar will strengthen further in 2017. On balance, we actually expect the dollar to weaken against the yen and the euro over time.
At the beginning of October the dollar looked as though it was going to be one of the weakest G10 currencies after the British pound. This perception, however, changed completely due to encouraging figures on the US economy and the election result, after which the dollar gained strongly in value.
Inflation expectations and interest rates also rose, and in principle these are factors for a stronger dollar. But as we have already argued, we are not convinced that there will be a fundamental recovery. Under Trump, the US may well undergo a stronger budgetary stimulus, but the effects of a less liberal trade policy on world trade and domestic inflation are downside risks for the dollar.
Assuming that the Fed pursues a very cautious tightening path in 2017 as well, we think that the rally in the dollar will lose momentum as early as the end of 2016. We expect to see the EUR/USD rate at around 1.08 in the coming months, with slightly higher levels of around 1.10 in 2017. Our cautious view is mainly due to the uncertainty regarding the policy decisions of President Trump and their ultimate effects on the global economy. A strong rally in the euro also does not seem likely, given the continuing loose policy by the ECB, the upcoming elections in the Netherlands, France and Germany and the Italian constitutional referendum.
British pound: the negative effects of Brexit still have the upper hand
The British pound has had its most volatile year in 2016 since the market turbulence in 2008. The decline in the pound has even exceeded that seen during the ERM crisis in 1992. Between the end of 2015 and the end of October 2016, the pound has fallen by 17% against the dollar and around 18% against the euro.
Although the British economic figures after the summer were better than expected and although it will take at least two years before Brexit actually happens, we still see the British pound as vulnerable on both political and economic grounds. The speech by Prime Minister May in October suggested that the British government was prepared to make economic concessions in order to obtain greater freedom with respect to immigration and legislation. The EU on the other hand has taken a clear line: there will be no compromise on the four freedoms (free movement of people, goods, services and capital). Even now that the UK parliament will have some part to play in the process after the Supreme Court ruling, it looks as though a ‘soft’ Brexit will be difficult to achieve.
Without full access to the common market and without Passporting rights for financial institutions, readiness to invest in the UK both from within and from abroad will come under pressure. The fact that the economy, and mainly industry and the export sector, is still doing well at the moment is mainly due to the weak pound and the fact that the UK still has full access to the internal market. But this is temporary, and higher inflation will ultimately have an effect on domestic consumption.
Although Bank of England Governor Carney warned in October that the Bank also has limits when it comes to tolerating inflation, we expect that it will look beyond this supply-driven rise in inflation. Given the high levels of the government deficit and the current account deficit, the British pound is more likely to fall further than rally in 2017. We expect to see a level of around 0.91 for EUR/GBP by the end of next year.
Renminbi: still just as negative
We still remain as negative as before on the Chinese renminbi, despite the heavy depreciation that has already occurred in recent years. We think that a level of 7.60 for USD/CNY towards the end of 2017 is entirely possible (against the current level of 6.90).
Although growth has apparently stabilised in China and there are signs of reflation, this is mainly due to a huge credit-driven boost to consumption by the Chinese government and a housing market that once again seems to be in a bubble condition. Both these situations are clearly unsustainable and we are already seeing the Chinese government taking macro-prudential measures to slow the housing market and lending (this time by targeting mainly high-risk investment products).
This means that if things go wrong and the bubble bursts, the Chinese currency will suffer a hard fall. But if the government has to intervene with a rescue action, the additional money and debt creation that this will entail will cause the currency to decline further. These are the extreme scenarios. In the ‘business as usual’ scenario, there will also continue to be downward pressure on the currency because capital is mostly looking to leave the country due a lack of domestic investment opportunities and because foreign investors are still reluctant to invest in China. This scenario was the reason for our forecast of a depreciation of the renminbi in 2015-2016.
Trump’s election victory in the US is just another reason in our view to see the currency as weak and could mean the target we have set will be reached earlier than we expect.
The Outlook 2017 is a publication of RaboResearch of Rabobank and a co-production with Financial Markets Research. The date of completion is the 28th of November 2016.
The views presented in this publication are based on data from sources we consider to be reliable. Among others, these include Macrobond. These data have been carefully incorporated into our analyses. The economic growth forecasts and scenarios are generated from the NiGEM global econometric structure models.
The use of this publication in whole or in part is permitted only if accompanied by an acknowledgement of the source. RaboResearch accepts, however, no liability whatsoever should the data or prognoses presented in this publication contain any errors.
Abbreviations for sources: CBS: Statistics Netherlands, OECD: Organisation for Economic Co-operation and Development, CPB: Economic Policy Analysis Netherlands, IMF: International Monetary Fund, ECB: European Central Bank, Fed: Federal Reserve.
© 2016 - Coöperatieve Rabobank U.A., Nederland