why markets are still underestimating the fed · economic and financial analysis $21 billion*...

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Follow us@ING_Economics17 November 2017

Why markets are still underestimating the FedOur answers to this month’s big questions

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Economic and Financial Analysis

Our top sixthemes this

month


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What the 19th congress could mean for China

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#3

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#6

Shaking up the Fed: What vacancies and voter rotations mean for rates

What’s in store for oil and petro-currencies in 2018

Will the Italian election end in a hung parliament?

Global Economics and Strategy Team

November 2017

The latest on the Eurozone economy

NAFTA: What now for the “worst trade deal ever”?



Economic and Financial Analysis 2

There are a series of Fed vacancies that still need filling

Powell hired, but what about the other Fed vacancies?

Jerome PowellChair nominee

V

Vice ChairMid-2018 Vacancy*

Board of Governors

V VV

Brainard Quarles

Janet YellenCurrent chair

William DudleyOutgoing NYFed President

Stan FischerEx. Vice Chair

Outgoing

Regional Presidents (2018 voters)

V

NY Fed* Cleveland RichmondAtlantaS. Francisco

V = Vacancy

Markets may have shrugged off the upcoming change at the top of the Fed, but they remain complacent about the risks of faster rate rises next year

Assuming Chair Yellen steps down in February, that will leave 4 out of 7 Fed Board positions vacant.

With Trump facing mid-terms next year, it is unlikely he’ll want to see clear hawks appointed that could threaten his 3% growth target.

Until Trump has made his decisions and the full 2018 voter mix becomes clear, it is perhaps not surprising that markets continue to treat the Fed's latest "dot diagram" cautiously.

*William Dudley is currently filling in as Fed Vice Chair, meaning the First Vice President of the NY Fed is currently the alternate member.

Image sources: Federal Reserve, Shutterstock


One hike priced in. We expect two, and the risk is more rather than less

Markets are still underestimating the Fed’s 2018 plans

Neel KashkariMinneapolis Fed

Charles EvansChicago Fed

Loretta MesterCleveland Fed

John WilliamsSan Francisco Fed

Two doves out

Two hawks in

Annual regional Fed voter rotation

The combination of upside risks to growth and mounting inflationary pressures, as well as a hawkish rotation in the make-up of Fed voters, suggests that markets are too cautious in only pricing in one hike next year.

As part of the annual Fed voter rotation, two of the most dovish members will be replaced by two hawks – John Williams and Loretta Mester

Williams is in favour of three hikes next year, and Mester has hinted she'd like the Fed to go 'a little stronger‘ even than that.

Until Trump gets new governors onto the Fed board, this means the group of voters will be both smaller and more hawkish, faced with an economy that is performing well and that may have more fuel thrown on the fire with tax cuts.

We're expecting a December rate hike, and these various factors mean there is upside risk to our call for two further rate rises next year.

Image source: Federal Reserve


NAFTA: What now for the “worst trade deal ever”?

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90 92 94 96 98 00 02 04 06 08 10 12 14 16

$ B

illio

ns

Mexico

Canada

US trade balance with Canada and Mexico ($bn)President Trump threatened to rip-up NAFTA arguing the US has not benefitted – jobs have been lost and the US’ trade deficit has ballooned.

Negotiations need to be completed swiftly (aim of 1Q 2018) – Mexican election in July, US mid-terms next November

Up for debate are rules of origin changes, 5Y sunset clause, “Buy American” government procurement, national minimum content rules

Will Mexico & Canada reluctantly agree to a watered down version of Trump’s original demands?

National pride may give way to economic pragmatism as the US demands “some candy”

Image source: Shutterstock


$21billion*

Exports to Canadaof US GDP 1.4%

Exports to Mexicoof US GDP1.2%

$525billion*

$545billion*

of Canadian GDP

Exports to US17%

of Mexican GDP

Exports to US29%

$1090 billion

2016

$265billion

1992

*Bilateral trade

Mexico looks most vulnerable from a NAFTA collapse

US-Canada trade could revert to 1988 Canada-US Free Trade Agreement. That would preserves tariff free trade, but still implications in terms of rules of origin and minimum content for products

Canada-Mexico free trade could continue, but Mexico-US trade may have to go to WTO rules

Total NAFTA trilateral trade

Source: Macrobond


What the 19th congress could mean for China

2018-2020

• Build a middle-income class

• Coordinate economic growth with education, talent, innovation, the rural economy, regional growth and environmental sustainability.

• Avoid systemic risks

The blueprint

• Deleveraging in the corporate & financial sectors to continue, in turn pushing up interest rates

• Anti-corruption will continue

• This would likely lead to changes in the management of State Owned Enterprises (SOEs)

What we expect

2020-2035

• Increase technological ability, aiming to become one of the most innovative countries

• Raise the proportion of middle class citizens

• Narrow the difference between urban and rural development

• Improve environmental sustainability

The blueprint

• Household robots would be more common

• But we worry there would be overcapacity in the technology sectors

What we expect

2035-2050

• Establish a modern society

• Become an influential country in terms of economic power and role on the international stage

The blueprint

• To be an influential country, the Yuan would have been internationalised with few capital controls. Before then, interest rates would to become market driven.

What we expect


The blueprint could be achieved earlier than 2050, but there are hurdles

But we see three risks to China’s blueprint

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2

3

Hurdle 1: A build up of central and local government debts

Technology needs more infrastructure investments but the preparation stage requires the government to spend a lot of money. This will put pressure on gross government debt.

Hurdle 2: Narrowing the wide urban-rural living standards gapGiven the gap between urban and rural livings standards is already wide, this will be a challenge.

Incomes are rising slightly faster in rural areas (8.7% vs. 8.3% in urban centres), but the level of urban disposable income is still 2.8 times that of rural. Likewise, consumption is 2.3x higher, albeit as with incomes, spending is growing more rapidly in rural areas (8.6% annual growth vs. 6.2%).

Hurdle 3: Beware of trade and geopolitical conflictsOther countries would feel the threat in terms of economy size, development of technology, and beefing up military power.


Closing the gap in the Eurozone

8

The Eurozone economy continues to surprise positively and is showing few signs of coming to an abrupt halt, even with some of the political risks on the horizon.

This means that the output gap could be closed sooner than expected, decreasing the need for stimulus in most Eurozone economies.

-1.5

-1

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1.5

2

2.5

Eurozone output gaps

2017 2018 2019

European Commission Estimates

Source: European Commission


As ECB starts to taper, inflation is still a headache

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With the Eurozone economy performing well, the ECB has announced it will start to gradually taper asset purchases from January by reducing monthly asset purchases to €30 billion, until September 2018.

But inflation is still low and any pick-up from here is going to be very gradual. That’s why European Central Bank (ECB) President Draghi was at pains to stress that the road to ‘tapering’ of its bond purchases will be a dovish one.

0.0

0.5

1.0

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2.0

2017 2018 2019

ECB staff projections for core inflation

March projections June projections Sept projections

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500

1000

1500

2000

2500

3000

3500

4000

4500

5000

19

98

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00

20

02

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20

05

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06

20

08

20

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20

11

20

13

20

14

20

16

20

17

Bill

ion

s

Total ECB assets

Source: ECB, Macrobond


Luigi di Maio(Five Star Movement)

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The countdown to the Italian election is on…

Italian general election

ING expects the election in

March 2018

Key players and possible coalitions

Matteo Renzi(Democratic Party)

Angelino Alfano(Popular Alternative)

Nicola Frantoianni (?)(Italian Left)

Roberto Speranza (?)(Democrats and Progressives)

Matteo Salvini(Northern League)

Silvio Berlusconi(Forza Italia)

Giorgia Meloni(Brothers of Italy)

Hung Parliament?Based on current opinion polls, none of the coalitions may be able to form a government in isolation, therefore the real game will start right after the election.

The recent regional vote in Sicily, won by the centre-right candidate, showed how relevant coalitions can be in the Italian framework. Making them consistent at the national level will likely prove a difficult exercise on all fronts

The new electoral law, which will apply to both branches of the Italian parliament, foresees a mixed system. Two-thirds of the seats will be allotted using a proportional system, and a third with a first-past-the-post system, with blocked lists.

Based on the latest opinion polls, the Italian political spectrum remains divided into three groups of similar size. As the new law does not include a majority premium, barring substantial opinion shifts, none of the three groups seem to be in a position to win a majority in the parliament.

Image source: Shutterstock


Bank of England to tread carefully in 2018

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We don’t rule out a hike next year – but there are a lot of “ifs” in the Bank’s outlook…

Global growth stays

strong

Investment & trade offset

consumer drag

Wage growth & domestic

inflation pressures

build

The Bank of England’s rate hike ingredients

The Bank of England has signalled it is prepared to hike twice more – including one increase in 2018

But there are a lot of “ifs”, not least all the Brexit hurdles to overcome if it is to be as “smooth” as BoE hopes

We’re less confident wage growth & domestically-generated inflation will rise as fast as the Bank hopes. Growth looks set to remain sluggish too.

We don’t rule out a 2018 hike – but it isn’t guaranteed


We have revised our ICE Brent forecast for 4Q17 to $57 per barrel and for 2018 to $51 per barrel.

Crude oil: What’s in store for 2018?

Geopolitical risk, positive economic data, and expectations of an extension to the OPEC production cut have seen ICE Brent trade above US$60/bbl for the first time since 2015.

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Non-OPEC supply will continue to rise despite a slowdown in rig activity. That’s particularly true in the US, which is set to see its highest level on record. In 2018, we see the US increasing its market share in Asia.

IEA expects that growth in oil demand will slow over 2018 to 1.3MMbbls/d. This number is key for the oil market, as it is less than the 1.4MMbbls/d of non-OPEC supply growth forecasted for the year.

OPEC will extend their production cut deal to the end of 2018, however the risk is that the longer the deal continues, the more likely compliance starts to slip.

We are bearish on crude into 2018 on the view that:

The oil market should return to a small surplus over 2018 at US$51/bbl. The key risk to the view is a worsening of the current geopolitical environment.

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Fiscal breakeven oil price (US$/bbl)

2017

2018

2017 ICE Brent YTD average


Petro-currencies lose their mojo

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Investors seem to doubt the sustainability of crude’s rally

A problem for petro-currencies?

The correlation between petro-currencies and crude has dropped markedly over the last twelve months.

NOK, in particular, has lagged. This may owe to general fatigue with Scandi currencies where both the SEK and NOK are frequently seen as under-valued.

So what next for petro-currencies?

If crude turns lower it would spell trouble for the CAD and RUB where markets are aggressively pricing future rate hikes.

If crude doesn’t turn lower the market could start to re-price Norges bank tightening cycle.

What about oil importers?

If crude prices stayed bid or pushed higher, we think vulnerable currencies worth highlighting are India and Turkey (struggled to rein in its current account deficit).

Source: ING, Macrobond

Source: ING, Macrobond


Who’s next in line to tighten monetary policy?

14

ECB

Fed

BoE

BoJ

BoC

RBA

RBNZ

Riksbank

Norgesbank

Nov 2017

Dec 17

Q

Sept 17Balance sheet unwind starts

2017 2018

Rate hike QQE/balance sheet change

June 18 Dec 18

3Q181Q18

2Q18 4Q18

1Q18 4Q18

3Q18

Dec 18

ING policy rate forecasts

Q

Jan 18Tapering begins

Q

Sept 18End of current QE extension

Q

Oct 17Tapering announced


Our global forecasts

EUR/USD EUR/GBP

USD/JPY Oil (Brent Crude)

1M: 0.88 3M: 0.88 6M: 0.88 12M: 0.861M: 1.17 3M: 1.20 6M: 1.22 12M: 1.27

All data sourced from Bloomberg/ING forecasts

1M: 114 3M: 114 6M: 114 12M: 115 4Q17: 57 1Q18: 50 2Q18: 50 4Q18: 52

1.00

1.10

1.20

1.30

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1.50

Jul 11 Jul 12 Jul 13 Jul 14 Jul 15 Jul 16 Jul 17 Jul 18

INGConsensusForwardsEUR/USD

0.65

0.7

0.75

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0.85

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0.95

13 14 15 16 17 18

INGForwardsConsensusEUR/GBP

70

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130

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ING

Forwards

Consensus

USD/JPY

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140

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ING

Consensus

Brent Oil


Our global forecasts2017F 2018F

Q1 Q2 Q3 Q4 FY Q1 Q2 Q3 Q4 FY

United States

GDP (% QoQ, ann) 1.2 3.1 3.0 2.8 2.2 2.6 2.5 2.6 2.7 2.7

CPI headline (% YoY) 2.5 1.9 2.0 2.4 2.2 2.3 2.4 2.6 2.3 2.4

Federal funds (%, eop, lower bound) 0.75 1.00 1.00 1.25 1.25 1.50 1.50 1.75

3-month interest rate (%, eop) 1.15 1.30 1.33 1.56 1.57 1.87 1.91 2.08

Eurozone

GDP (% QoQ, ann) 2.2 2.6 2.4 2.2 2.3 1.8 1.7 1.8 1.8 2.0

CPI headline (% YoY) 1.8 1.5 1.4 1.3 1.5 1.2 1.4 1.4 1.5 1.4

Refi minimum bid rate (%, eop) 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

3-month interest rate (%, eop) -0.33 -0.33 -0.33 -0.33 -0.33 -0.33 -0.33 -0.33

Japan

GDP (% QoQ, ann) 1.1 2.5 0.9 2.6 1.5 1.5 0.8 1.3 0.0 1.4

CPI headline (% YoY) 0.2 0.4 0.6 0.2 0.4 0.7 0.5 0.7 0.8 0.7

Excess reserve rate (%) 0.0 0.0 0.0 0.0 0.00 0.0 0.0 0.0 0.0 0.0

3-month interest rate (%, eop) 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05

China

GDP (% YoY) 6.9 6.9 6.8 6.7 6.8 6.7 6.6 6.7 6.7 6.7

CPI headline (% YoY) 1.4 1.4 1.6 1.5 1.5 1.5 1.5 1.6 1.7 1.6

PBOC 7-day reverse repo rate (% eop) 2.45 2.45 2.45 2.45 2.45 2.45 2.55 2.55 2.65 2.65

UK

GDP (% QoQ, ann) 1.0 1.2 1.6 1.1 1.5 1.1 1.6 2.1 1.8 1.4

CPI headline (% YoY) 2.1 2.7 2.8 3.0 2.7 2.7 2.3 2.3 2.4 2.4

BoE official bank rate (%, eop) 0.25 0.25 0.25 0.50 0.50 0.50 0.50 0.50 0.50 0.50

BoE Quantitative Easing (£bn) 445 445 445 445 445 445 445 445 445 445

3-month interest rate (%, eop) 0.35 0.35 0.35 0.60 0.60 0.60 0.60 0.60 0.60 0.60

Economic and Financial Analysis17

“USD: Making everyone (else) great again!”

“What we really think of the Bank of England’s rate decision”

“Confused by Yellen’s direction? You’re not alone”

“When caution’s not enough for the euro”

“Brexit battle continues as talks enter round two”

“Normalisation will be a long, uncomfortable journey”

“G10 FX: Careless Central Bank Whispers”

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