Price action in the US dollar was far from straightforward this week, with the greenback actually strengthening against several partners in the wake of Wednesday’s Fed meeting ushering in a new era of dovish policy from the world’s most important central bank.
However, dollar weakness soon once again took hold, and the dollar is on track to close lower in a broad sense across the week. In this sense, the FOMC’s threefold commitment to keep rates at the lower bound until the labour market had reached capacity, and inflation was not only on target but likely to exceed it for some time seems to have squeezed markets into delivering another burst of marginal dollar weakness.
How much further the greenback can weaken remains to be seen…
Beyond a possible tweak in asset purchases the Fed is unlikely to expand easing further in the near future, and the sweeping change in the central bank’s reaction function has now largely been priced into US treasuries. Central banks will continue to weigh the implications of the Fed’s dovish turn and recent dollar weakness on domestic inflation outlooks, with a number of meetings this week across the globe from Scandinavia to New Zealand. Familiar themes will remain in focus in the US as the election campaign approaches its endgame, vaccine development continues globally, and Brexit limps towards a potentially explosive – or anticlimactic conclusion.
Negative rates will remain a topic of intense scrutiny for markets, particularly after last week’s Bank of England meeting minutes indicated that the central bank was further investigating their effectiveness as a policy tool. Fixed income markets duly upgraded their pricing of the probability that interest rates in the UK will be cut to negative, extending a trend that has been in place for months. The MPC’s two major concerns about the policy measure were negative sentiment effects – negative rates sound scary to many consumers, businesses, and investors – and transmission through the banking sector. Both measures will require further communications and research prior to implementation, neither of which is likely to be conducted in secrecy. The Reserve Bank of New Zealand has been more open about considering negative rates for longer than the BoE, while rates remain negative in Switzerland and have only recently risen back into positive territory in Sweden. All these central banks will meet next, as will counterparts in Norway and Mexico.
Bets on negative rates in UK and New Zealand mount
Monday 21st: It’s difficult to produce much these days without a semiconductor somewhere along the line, and South Korea is among the world’s leading exporters. As always, imports/exports data from the east-Asian powerhouse economy, released at 01:00 BST, will be viewed as a high-frequency bellwether for regional and global economic activity. The PBOC will update 1 and 5 year loan-prime rates at 02:30, with no changes likely given strong recent growth figures from the world’s second-largest economy. Much of the focus will be on its FX policies as the yuan continues to be set stronger on a daily basis. While a stronger yuan against the dollar isn’t anything new for markets, the fact authorities are allowing CNY strength on a trade weighted basis is a new dynamic for markets to digest. Japan will enjoy public holidays on Monday and Tuesday, offering USDJPY a chance for a pause after last week’s sharp gains by the Yen.
Tuesday 22nd: With its key regional peer in New Zealand increasingly eyeing negative rates, and the Bank of England similarly investigating the option, the RBA is in danger of becoming the most hawkish G10 central bank. While its policy settings may well be justified by the outlook for the Australian economy, and concerns about the “limits” of monetary policy that Governor Philip Lowe has repeatedly voiced, in practical terms this stance may cause unwelcome appreciation in the Aussie dollar. Deputy Governor Guy Debelle will speak on these topics at 01:30 BST, and may offer further information about the implications of the RBA’s last statement, which hinted that the Bank would “consider” further easing options. The Bank of England’s Andrew Bailey will follow at 08:30. Last week’s MPC minutes made it clear the BoE was investigating negative rates as a policy option – an uncontroversial thing for a major central bank to do. However, markets took the news as a license to price in a higher likelihood of the measure being implemented, with overnight index swaps reflecting expectations of about 15 basis points of cuts (to -0.05) by March 2021. Bailey may choose to skirt the issue entirely, or offer some color on exactly how the BoE’s thinking is changing. The Riksbank’s latest policy decision will also be released at 08:30, and is discussed below. CBI Industrial Order expectations will be released in the UK at 11:00, followed by eurozone consumer confidence and US home sales at 15:00.
Wednesday 23rd: The RBNZ will release a policy decision and its Monetary Policy Review at 03:00 BST. August’s meeting saw a QE expansion of $40 billion, and an increase in the issuance limit. Further policy moves are not likely at this meeting. Negative rates may receive some more formal attention, as may some type of funding support or conditional term lending measures. Later in the morning, flash purchasing managers indices will be released for France (08:15), Germany (08:30), the eurozone (09:00), UK (09:30), and US (14:45). The Norges Bank will announce its latest rate decision at 09:00, also discussed in detail below. In the afternoon Canada’s Parliamentary session resumes with a confidence vote and speech from the throne, while Jerome Powell will testify to the House Select Committee on the economic effects of covid-19. Given the FOMC’s comprehensive forward guidance and clear messaging from Powell, there are few possible further bits of information Powell could issue. Areas of interest may be possible commentary about more asset purchases or details of the averaging period for inflation the Fed intends to use.
Thursday 24th: The Swiss National Bank will announce its policy rate and release its latest Monetary Policy Assessment at 09:00 BST. With EURCHF now no longer threatening the 1.05 level, some pressure has been taken off the SNB. IFO will release survey data on the German economy at the same time. Weekly unemployment claims in the US will be released at 13:30 BST, after several consecutive weeks of remaining stuck at around 860,000. Testimony from Jerome Powell later in the afternoon on the CARES act is not likely to offer new information – the same can be said about another speech from Andrew Bailey at 15:00. Banxico will update Mexico’s official interest rate at 19:00, with a cut broadly expected.
Friday 25th: An uneventful day marked only by eurozone money supply figures at 09:00 BST, and durable goods orders in the US at 13:30. The former will of course show continued expansion in money supply, with loans to non-financial corporations remaining the key measure of transmission of ECB policies to the real economy. The Bank of England’s quarterly bulletin, a think-piece, will be released at midday. The bulletin is billed as exploring “ topics on monetary and financial stability and include[ing] regular commentary on market developments and UK monetary policy operations.” In this context, a leisurely read on the latest evidence on negative rates would make sense, but given the intense market attention, the topic may prove too controversial.
FISCAL FRAILTIES AND POLITICAL UNCERTAINTY WILL BE THE NARRATIVE FOR THE LOONIE NEXT WEEK
The Canadian dollar has already overcome two major tests in September. Last week, the loonie was shaken by the slide in oil prices and the latest assessment of the economic recovery by the Bank of Canada, while this week USDCAD faced up to the most dovish shift by the Federal Reserve in history as it outlined three major targets needing to be met prior to hiking interest rates. In response, the Canadian dollar has weakened only 0.89% this month, but its biggest challenge is arguably yet to come. After proroguing the parliamentary session on Tuesday 18th August, lawmakers are set to return on Wednesday 23rd September with the opening session headlined by a speech from the throne and a confidence vote in Trudeau’s administration. While the confidence vote is unlikely to result in Canadians heading to the polls for an immediate snap election, the speech from the throne will be closely monitored and could potentially induce further CAD volatility.
Loonie has already faced oil shock, BoC and Fed meetings, but now faces up next week’s political calendar
Trudeau is set to announce a bold new fiscal spending plan to kick start the economy and drive longer-term growth, but when will markets start to see fiscal consolidation?
Loose fiscal policy has been the main driver of the global economic recovery in the wake of the pandemic’s outbreak. With the government on track to record a budget deficit of around 16% of GDP for this fiscal year, the Trudeau administration hasn’t erred on conservative side with its fiscal response relative to G10 peers. However, rumblings from Canadian Bank executives and the latest warning by Fitch ratings at the end of last month brings the idea of fiscal consolidation back into question. There is a fine line for expansive fiscal policy being cyclically positive and structurally negative for financial markets. As Kevin Carmichael of the Financial Post recently noted, many investors will still harbour memories of the 1990’s when Canadian budget deficits were punished by bond markets.
Gross government debt-to-GDP is expected to rise above 120% by the end of the fiscal year, which Fitch ratings warns is “significantly higher than the ‘AA’ median”. The potential for another ratings downgrade by Fitch should fiscal anchors not be dropped by the Trudeau administration could spark bond vigilantes back into action in Canadian debt markets. While the solution of imposing deficit targets or even a debt ceiling is relatively simple in theory, in practice the execution of such policies is a fine art. The problem is the underlying dynamic that markets ultimately price their judgement of deficits with: the level of growth that is expected over that time frame. Simply committing to smaller budget deficits isn’t enough if economic growth isn’t there to progressively chip away at the overall debt pile. Generating economic growth in the current climate isn’t an easy feat either, especially with holes in Canada’s social safety net being exposed by the pandemic and investment into the oil industry left in a state of tatters, not to even mention the structural shifts currently underway in the economy due to the pandemic. Concerns do not end at the fiscal deficit – another issue is Canada’s inability to bring its current account back into surplus since the global financial crisis. The twin deficit problem highlights structural imbalances in Canada’s economy, which Trudeau aims to correct with the government’s bold new spending plan by looking at green investment, housing and a long-term overhaul of the employment insurance scheme. While on the surface this sounds conducive to longer-term growth, questions will center on the costs associated to such a plan.
Canada’s government finances will be a focal point for investors as debt skyrockets and the current account is yet to recover
It is well known that a free lunch doesn’t exist, despite central banks now generating a large discount. The fact Trudeau leads a minority government could bring greater fiscal accountability for markets, but the likely path of the budget’s progression hinges on the support of the NDP, whose political support could equally result in a larger bill. Should the bond markets’ tolerance for financing the government’s deficit start to show signs of wavering, not only will the Bank of Canada be forced to step up its QE programme in order to mitigate the repercussions, but the loonie will likely start to also price this credit risk. On the flip side, should the new fiscal plan announced during the speech from the throne show signs of fiscal consolidation and prudence, the loonie will likely feel the effects of the economic current recovery receiving an adrenaline shot.
Snap election likely to be avoided this time around, but with another confidence vote scheduled to take place after the budget is announced, political risk will continue to loom large
After a cabinet retreat in Ottawa ahead of parliament reconvening next week, Prime Minister Trudeau outlined his preference to avoid a snap election in the coming months. With Covid cases rising as we head into the winter months, the risks of Trudeau falling short at Wednesday’s confidence vote are seemingly dissipating. Despite this, the level of political risk remains heightened. The resumption of Parliament also means select committees will resume their investigation into links between Prime Minister and former Finance Minister Bill Morneau with WE charity. The scandal was ultimately the driving force behind Morneau’s resignation and the findings by the select committee could cause further political havoc.
As if that wasn’t enough, questions around the government’s finances will cause further political uncertainty later on in the year.
While Trudeau is likely to pass Wednesday’s confidence test, he will need to build bridges with opposition parties for when the fiscal update is due later on in the year, which is also subject to a confidence vote…
This vote will be a riskier one for the government as votes will be cast on proposed economic policies as opposed to next week’s vote, which will likely focus on the administration’s handling of the pandemic. With all of these dynamics in play along and the new Conservative Party leader Erin O’Toole yet to cut his teeth at the helm of the largest opposition party, political uncertainty is likely to remain a factor for Canadian markets until year-end.
BIG WEEK FOR SCANDNAVIAN CENTRAL BANKS
Now that central bank week has ended for the Fed, BoE, SARB, and CBR, all focus now turns to the Scandis. The central banks in Norway and Sweden look set to keep interest rates on hold.
The Norges Bank has cut its key interest rate to a record low of zero since May, down from 1.5% before the pandemic, to fight the economic downturn from the pandemic. With Norway’s giant sovereign wealth fund allowing for ample cyclical fiscal support for the economy, the Norges Bank has the luxury of being away from the front line of economic stimulus. Norway’s core inflation accelerated to 3.7% in August, up from 3.5% in July, while inflation (excluding energy prices) jumped to 1.7% from 1.3% in July.
The Norwegian krone’s weakness explains a big part of the jump in the core inflation rate – imported consumer goods prices surged by 4.6%, well above the total core inflation figure of 3.7%.
The high inflation may add reasons for the Norges Bank to slightly revise its rate path upward next week, but it should also flag the long-lasting downside risks from the virus. Policy makers from the NB have noted the recent jump in the inflation, but acknowledged its temporary nature as both the strengthening NOK and prospects for low wage growth suggest inflation will moderate. The Norges Bank already flagged higher rates from the end of 2022 during its July meeting as Norway is experiencing a less severe shock than most other economies, indicating that the country will probably not go into negative rates or quantitative easing going forward.
The latest data from Sweden shows that its economy may be headed to a faster recovery than the Riksbank’s expectations. The central bank expected headline inflation to increase by 0.3% in August, but the figure saw a surge to 0.7% instead, following a jump in energy costs. The core inflation rate, which excludes energy, eased to 1.41%, down from 1.51% in July. Unlike most other central banks, the Riksbank has not touched its interest rate policy since the start of the pandemic. The Riksbank implemented a negative rate policy from 2015 to 2019 and moved back to zero before the start of the pandemic, leaving no room for the central bank to join the global cutting spree. Instead, the Riksbank launched a SEK 300bn asset purchase programme in March and extended it to 500bn in its July meeting. As the asset purchase programme has expanded very recently and also runs until the end of June 2021, and Sweden’s recovery is progressing faster than expected by the Riksbank, we foresee no change in monetary policy in the upcoming meeting.
Policy curve for the Norges Bank shows a higher implied rate in the near future since the improved forecasts in the July meeting
Ranko Berich, Head of Market Analysis
Simon Harvey, FX Market Analyst
Ima Sammani, FX Market Analyst