The big buzz word at the moment is ‘normalisation’ – as in central banks trying to get back to good old-fashioned monetary policy. Fat chance! I’ll return to this fighting talk in a mo.

But in the meantime, where are we now in market terms? The repricing of monetary policy normalisation continued last week, with the G3 rates still heading north. Financials and dollar assets continued to outperform the Tech sectors, bond proxies and Gold. While concerned by stalling inflation progresses, central banks are cautiously preparing markets for an unwinding of quantitative easing. The latest Fed and ECB minutes were consistent with this change of tone. I think Graham Bishop, Investment Director at Heartwood Investment Management sums it up nicely when he questions “whether these rhetorical efforts represent the early stages of a coordinated global tightening programme remains open to debate. In any event, the pace of any tightening being considered is likely to be very gradual and should still leave financial conditions very accommodative. What is evolving, though, at least in the US and Europe, is that policymakers appear willing to overlook recent inflation disappointments, which they see as transitory, and instead are focused on the solidity of global growth. In their view, deflation risks have been defeated and the discussion now shifts to the adjustment of the current policy framework, which has been established for an emergency situation.”

Another great way of gauging what’s happening within monetary policy is to listen to the dispatches from the front line by London-based research firm Cross Border Capital. They’re constantly trawling through central bank data for big trends in global liquidity flows. Here’s a bunch of recent ‘summaries’:

Cross Border Dispatch 1: The Euro Undervalued?

“The Euro looks to be 10-15% undervalued, according to BIS real exchange rate data. Changing capital flows prompted by (1) improving economic data and (2) less dovish statements by European policy-makers are pushing back towards this equilibrium. In short, the Euro could be a key beneficiary of US dollar weakness over coming months. What is different in this report is the evidence we bring of the broadness of Eurozone economic recovery and the fact that the long-slated end to ECB QE may already have started.”

Cross Border Dispatch 2 : Watch out for? Saudi Arabia

Saudi Arabia now heads our country risk rankings. Its Composite Risk Index is flashing a major warning. At end-May 2017, the Saudi Risk Index hit a whopping 92.0 (‘normal’ range 0-100). Within the basket of factors, Forex Risk is especially high. Heightened forex risks have led the Authorities to sharply tighten domestic monetary conditions, which further compound problems.

Cross Border Dispatch 3: The US Federal reserve tightening?

[From 26th June] – Latest weekly data show aggregate major Central Bank balance sheet growth of 17.8% (or 24.9% measured in current US$). The downward trend led by the Fed has been punctuated by a pick-up in ECB and Bank of Japan liquidity provision.  Meanwhile the Bank of England continues to slow the pace of its injections.

The message seems clear. Normalisation is on its way.

What might happen next? According to Bishop at Heartswood” policy risk is rising. Balance sheet reduction in the US, tapering in Europe and further targeted tightening measures in China could all impact market liquidity and sentiment, despite overall financial conditions still remaining accommodative. These potential outcomes also come at a time when the growth momentum appears to be softening in the US and UK, albeit at the margin. By implication, in the future, the onus would fall to governments to support growth as central banks step back from financial markets. It remains early days and for now, at least, economic fundamentals continue to support risk asset markets. Nonetheless, more policy uncertainty is likely to add to market volatility and higher bond yields to reflect a less dovish posture taken by many central banks. “

My own take is as follows.

  • Normalisation will mean a maximum interest rate of 2.5% before panic sets in and rates are dragged lower again. Any attempt to push rates back up to normal long-term levels will be defeated by massive disinflationary pressure son the global economy
  • The ECB will absolutely avoid strangling the putative Eurozone recovery. What no one wants is another example of the Bundesbank throttling any recovery in favour of continued austerity
  • Governments around the world will be pushed into austerity containment i.e attempting to unwind austerity measures. The populists on both the left and the right will demand action.
  • All the current hype about unwinding globalisation and slowing down technology is complete hype and baloney. The policy makers stand no chance of doing anything other than controlling the worst side effects. The pressures affecting labour rates (technology and weak trade unions) will show no sign of abating.
  • Inflation will not increase substantially. The disinflationary pressures are so huge and unending that any hope of sustaining core rates above 3% are doomed to failure.
  • As central banks try desperately (and unsuccessfully) to wind back their balance sheets – largely using rhetoric and nothing else – national government’s will become much more active. Both developments risk major volatility as policy makers try and find a balance.
  • China is key. If the “communist” superpower can push on with stoking up growth, everyone will be happy. But at some point, this credit-fuelled binge must finish – and the painful restructuring stuff starts to happen. The next shock will come from China and Asia.