So the most important decision in 2015 has come and gone with a 0.25% rise in US interest rates and we now need to work out exactly what this means for the road ahead, or at the very least as far into the first half of 2016 as it’s possible to see.
Monetary & Economic Divergence
We have previously discussed the idea of monetary policy divergence as a key feature of 2016. Indeed we have already had a taste of how the market can react when monetary policy doesn’t meet its expectations, when the ECB underwhelmed in early December.
Markets reacted to an interest rate cut and increase in QE as if Mario Draghi had chosen to raise rates and tighten his QE plans. The lesson there is that is that historical market relationships will not always hold true in exceptional circumstances and that the ‘rush for the exit in a crowed trade’ is always an ugly affair . The initial reaction to the Feds decision has been much more positive.
Of course central bank policy is to large extent determined by economic circumstances and performance. The chart below plots the Citigroup Economic Surprise indices for a number of leading economies, regions and groups.
These indices plot the differentials in economic data releases, whether positive or negative, in a given economy, from their forecast levels. For example the dark green line ,that rises sharply on the right hand side of the chart, plots Japan’s economic surprises (the recent sharp upward revision to Q3 GDP would have been among the drivers here).
In essence an upward trend and a read above zero in these indices could be considered positive for an economy / currency. With the caveat that if something appears to be too good to be true (for example the aforementioned revision to Japans Q3 GDP) then that may well be the case. Though if the uptrend in surprises continues, then it could actually represent an inflection or turning point in the fortunes of an economy.
Here is the quandary then, as the USA begins to tighten its monetary belt, we could be forgiven for thinking that the US economy would have been ‘surprising to the upside’, but in fact it hasn’t been.
The Surprise Index for the USA, represented by the dark blue line in the chart above, rallied into October and November but failed to move above zero in both instances and has subsequently ‘sold off’. It now rests well inside negative territory. Yes of course we have had some big beats on data points such as Nonfarm Payrolls, but on balance there have been more negatives than positives in the final quarter of 2015, as far as US economic data is concerned. To justify further Fed action in early 2016 I think we will need to see this barometer swing the other way.
You could argue that the fault lies not with the US economy but in analysts’ forecasts. I.E. they (analysts) have been overly optimistic in their forecasts, setting the bar too high allowing the data to undershoot. But when you look at the wide dispersion of forecasts on key data points it’s hard to tar them all with the same brush. Though of course analysts are susceptible to crowd behaviour and herding just like anyone else.
On a brighter note there has been an upturn in the data emanating from the both the G10 and the Eurozone (the grey and yellow lines above respectively) though those aggregated regional readings don’t tell us the whole story. For which, we need to dig down into the data from individual member states.
Limits to what monetary policy can achieve
Unconventional monetary policy has probably saved much of the global economy from an even tougher time in the aftermath of the global financial crisis and great recession that followed. But history will have to judge if its implementation was an overall success. We will need to see QE unwound before that can happen. That process is now at least partially underway in the US.
Though as we know things are moving along a different path and at a different speed in Japan, the Eurozone, China and the Emerging Markets. Loose Monetary Policy has provided a safety net over the last six or seven years but there are limits to what it can achieve, without being accompanied by structural changes. We have seen some of these in America but not yet in Europe and Japan. There has also been collateral damage along the way, as a strong US currency, in plentiful supply helped depress commodity prices and put pressure on Emerging Markets. Many of whom have also borrowed substantial sums in US dollars and who now face the prospect of a rising cost of debt servicing.
Looking forward with confidence?
As we approach the start of 2016 I want to be able to look forward with confidence. However I find myself subject to the same nagging & recurring doubts and I can’t shake off the feeling that we are nearer to the top of an economic cycle than the bottom, therefore the risk remains to the downside. Notwithstanding the post Fed bounce in major equity markets.
It would be nice to receive an economic surprise as a Christmas present and to find that Fed has acted wisely and for the benefit of all. However charts such as the one below, from Yardeni research, have the power to keep me up at night. True correlation and causation are not always reciprocal and some the items in the commodity basket (red line) may be more appropriate to a previous age. Nonetheless it would be negative indeed should the blue line, which tracks global export values, follow the red commodity price index line and move sharply lower.
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