There is (still) no such thing as a free lunch
- Policy easing now firmly in the region of diminishing returns
- NZD spikes in the face of explicit RBNZ desire for weaker kiwi
- There remain 'a number of upside risks' for sterling
By Neil Staines
“The only reason the stock market is where it is is because you get free money” – Donald Trump
Last night, the Reserve Bank of New Zealand cut interest rates 25 basis points to 2.00%. In doing so, it stated that its “projections indicate further easing will be required”. Despite both this and governor Graeme Wheeler's stating that “we want to see the currency fall” (it's difficult to imagine a more explicit statement), the initial reaction in the FX markets was one of disappointment. NZD rallied 1.8% to a one-year high.
The fact that market expectations of a 25 bps rate cut from the RBNZ were more than fully priced in (implying a minority expectation of a bigger cut) and the statement that the RBNZ has “limited influence on the exchange rate” caused an initial market reaction that is a clear example of the maxim, "there is no such thing as a free lunch".
At least there isn't in FX markets...
If we widen our attentions to the broader financial markets, there are other areas where the desire for a free lunch is becoming an increasing risk.
“Always turn a negative situation into a positive situation” — Michael Jordan
Following last week’s decision from the Bank of England to reactivate bond buying and cut interest rates (among other things), the front end of the UK Gilt curve has turned negative. Aside from the technical debate over the supply of bonds at the ultra-long end of the curve (the traditional domain of the pension funds, whose ability to match long-dated assets and liabilities is increasingly complex), the BoE will continue to buoy bond prices (thus capping interest rates) anchoring the front end below zero.
This is the alternative and conceptually confusing reality where the BoE are paid to borrow.
In the short term, the yield shift is a negative factor for GBP. In previous rounds of QE, however, the low point in GBP has been the point at which the BoE begins its purchases of bonds.
Taking a slightly more medium-term view, there are a number of upside risks to GBP and the UK that are likely to present themselves over coming months, much of which derive their impetus from government, not central bank action.
Firstly, any sign of a strategy, or ultimate goals or opportunities that the government sees as a function of Brexit negotiations would go a long way to removing some of the current uncertainty, and thus encouraging business investment (NIESR see business investment as the big drag on post-Brexit UK growth, from minus 3.75% in 2016, to minus 2.0% in 2017).
Secondly, the current backdrop argues strongly for the UK government to attend to pension deficits, a growing output gap, weak productivity, and outdated or undersupplied infrastructure. The long-term fiscal expansion to deal with these issues would likely be GBP-positive.
The treasury's autumn statement will be our first taster of how aggressive the government can be in tackling these shortcomings, and thus to what extent fiscal policy can "gazump" monetary policy as the core impetus for the direction of GBP.
“The chief danger in life is that you make too many precautions” — Alfred Adler
If we take a wider look at the global economy, there is a distinct theme that has become dominant. One of yield hunting, with a near-blatant disregard for the associated risks. At the press conference following the RBNZ rate cut last night, Wheeler stated that he did “not want to join in a race to the bottom”.
Other central banks, willingly or not, are fully paid-up members.
In essence, in a world where there is no sign of monetary tightening, and worryingly, where there is little progress in structural reform, ever-lower yield curves mean ever-higher (forward-discounted) equity yield valuations and an ever more distant search for yield.
In a global economy where US growth is strong enough to maintain confidence but weak enough to prevent wage or price inflation, global equity markets remain the winner by default.
Until they don’t.
This hunt for yield applies equally to emerging markets, which have seen substantial gains over the past three to six months. Our view remains, however, that there is no such thing as a free lunch and from where we are sitting that applies to equities, to EM and more broadly to global risk assets – where the word ‘risk’ seems to have been marginalised in favour of what little yield remains.
— Edited by Michael McKenna
Neil Staines is head of trading at The ECU Group