A rate hike for Christmas

Transcription

1 December 215 A rate hike for Christmas A December interest rate hike isn t fully priced-in by markets and as such there is upside potential for the USD if the FOMC delivers on its repeated warnings that rates will go up before year-end. But the greenback may struggle next year. If, as we expect, inflation remains tame and growth slows, the Fed will be forced to quickly move back to the sidelines, something that will weigh on the currency. The IMF s recent decision to include the yuan in its Special Drawing Rights could also take some steam out of the USD. The European Central Bank s decision to increase monetary stimulus in December isn t surprising given the dull economic outlook for the zone and continuing threats of deflation. While we expect EURUSD to be under pressure over the near term due to diverging monetary policies in the US and Europe, the common currency could stabilize or even appreciate somewhat in 216 as the Fed takes a pause. This year is one to forget for holders of the Canadian dollar. The 215 average for USDCAD is about 1.28 (i.e. 78 US cents for a C$) or 15 weaker than last year, the worst annual loss in over four decades. After that rout, things can only get better in our view. Besides an expected Fed-induced weakening of the USD, the loonie could also benefit from commodities which arguably have more upside than downside following this year s collapse. The C$ could also benefit from investment inflows if foreigners manage to see through the barrage of negative news on Canada, and make the most of a rare opportunity to snap up Canadian assets at a discount. We continue to expect USDCAD to come close to the lower end of the trading range in 216. Stéfane Marion/Krishen Rangasamy NBF Currency Outlook* Current 216Q1 216Q2 216Q3 216Q 217Q1 -Dec-15 USDCAD US cents per CAD EURUSD USDJPY AUDUSD GBPUSD USDCNY AUDCAD * forecasts for end of period Source: NBF Economics and Strategy

2 Fed set for December hike The Fed may well make history on December the 16 th with a first rate hike in almost a decade. And that despite a still-large output gap and non-existent inflationary pressures. So why is the Fed in a hurry to hike? The Fed can support its decision to hike by pointing to much-reduced slack in the labour market with November s gains for non-farm payrolls, the US has created an average of roughly 2K jobs/month this year. But more importantly, the Fed knows its credibility is on the line. Having warned markets for months that it will raise the fed funds rate before yearend, the Fed now finds itself with one last opportunity, i.e. the December meeting, to save face. Considering a 25bp increase in the fed funds rate in December is not fully priced in by markets, the USD has room to run over the near term. Surging dollar has room to run over the short term Trade-weighted US dollar Surging dollar NBF Economics and Strategy (data via Bloomberg).7 Current target.2 The FOMC will also provide updated projections at its December meeting. It will likely lower its forecasts for the path of interest rates through 218 after staff research confirmed that the natural interest rate is now much lower than in the past. But don t expect this to hurt the USD significantly because markets are already pricing in far fewer hikes than what the Fed is currently expecting over the forecast horizon. So, all in all, there s a decent chance December s meeting could be positive for the USD with greenback momentum likely extending to early next year. That s not to say USD appreciation will extend through the whole of 216. Note that past tightening cycles have generally not been favourable for the USD given the resulting deceleration in growth. We expect 216 US GDP growth to soften to around 2.3 not just because of the tighter monetary policy. Besides the continuing drag exerted by the strong dollar on the economy, consumption and housing are likely to Market expectations for Fed funds rate can appreciate further if Fed hikes 25bps in December Target after Dec215? Dec215 Jan216 Mar216 Apr216 Jun216 moderate in synch with a softer labour market because this year s employment surge won t be replicated. The moderation in growth may get the Fed to exercise restraint, something that s likely to weigh on the greenback. USD hasn t done well during tightening cycles USD index vs. short-term interest rates Index USD (R) 116? Fed funds rate (L) 2-yr yields (L)? NBF Economics and Strategy (data via Datastream) Yuan included in SDR It s now official. Starting October 1 st 216, China s yuan will become part of the IMF s Special Drawing Rights (SDR). The yuan s weighting in the SDR basket has been set at To make way for the yuan, the weightings of the two European currencies, i.e. the euro and the British pound, were adjusted down significantly while the weights of the yen and USD were trimmed marginally. The international agency adjusted its weightings in line with a new formula based on the value of the issuers exports, the amount of reserves denominated in the respective currencies that were held by other members of the IMF, foreign exchange turnover, and international bank liabilities and international debt securities denominated in the respective currencies. World: Yuan has third largest weight in SDR basket Weights in new SDR basket Before yuan inclusion After yuan inclusion USD Euro Yuan Yen Sterling NBF Economics and Strategy (data via IMF) 2

3 The IMF s acceptance of the yuan in the SDR will help China in integrating further with global financial markets, something that is of crucial importance in rebalancing its economy. Without access to foreign capital to finance a more generous social safety net, China would struggle in its objective to boost consumption. China is about to become a larger issuer in global bond markets recall that in November the People s Bank of China proceeded with Beijing s firstever debt offering in international markets which was reportedly oversubscribed. Following this success, China s finance ministry is now preparing to issue longer-term renminbi bonds in London. All told, a slow tightening campaign by the Fed coupled with better increased issuance of (and demand for) Chinese debt in global markets could help boost the yuan and hence limit USD upside in 216. ECB increases stimulus While the Fed aims to tighten policy, the European Central Bank is going the other way. At its December meeting, the ECB cut the interest rate on its deposit facility by another 1 basis points to -.3. The central bank also decided to extend its QE program to at least March 217 (was initially expected to end in September 216) and to reinvest principal payments to keep the balance sheet sizable. New staff projections showed little change to real GDP forecasts but they also showed lower inflation forecasts. The ECB had little choice other than act. Growth remains soft as evidenced by the meagre 1.2 annualized increase in real GDP in the third quarter. And despite the Q3 gains, output remains below levels reached more than seven years ago. And with such anaemic growth rates, the threat of deflation isn t going away. The annual inflation rate was just.1 in November according to the Eurostat s preliminary estimate. Even the annual core inflation rate was only.9 in the month, highlighting the economy s challenges in generating inflation. While the ECB s loose policies are aimed at keeping the euro soft, we may see some stabilization for EURUSD if, as we expect, the Fed s upcoming tightening cycle ends up being short. As such, we expect the common currency to appreciate somewhat in the second half next year. Loonie has upside USD weakening would of course be good news for commodity prices and hence the Canadian dollar. The current negative correlation between monthly changes in the broad dollar index and the price of WTI remains one of the strongest ever seen. World: USD appreciation precipitated the oil price slump 15 US$/barrel (log scale) USD and price of oil (WTI) Index (log scale) USD (right) WTI (left) Current By our estimate, a 5 or so depreciation of the tradeweighted greenback next year coupled with a reduction of oil oversupply (the current assumption of the Energy Information Administration) could push WTI to $57 by the end of 216, which is well above the $5 currently forecast by the forward curve. In other words, there is potential for upside surprise. The loonie could also benefit from investment inflows if foreigners manage to see through the barrage of negative news on Canada, and make the most of a rare opportunity to snap up Canadian assets at a discount. There already seems to be favourable movements on that front with third quarter data showing net positive inflows from foreign direct investment for the first time in a year. That was made possible by the largest jump in inflows since 27 (courtesy of M&A activity), which more than offset Canadian direct investment abroad * Broad dollar index (26 currencies) NBF Economics and Strategy (data via Datastream) Canada: FDI inflows on the rise Sources of financing for current account deficit Foreign Direct Investment Other flows Portfolio flows CURRENT ACCOUNT DEFICIT 6 Current account deficit in Q3 was mostly financed by short-term other flows although 5 there were also net positive inflows from FDI - 21Q1 21Q2 21Q3 21Q 215Q1 215Q2 215Q Correlation of monthly changes in USD* and WTI 12-month moving correlation 52 8 NBF Economics and Strategy (data via Statistics Canada) Period average FDI-related inflows into Canada that were made possible by the largest jump in inflows since 27 - Q

4 but there are still vulnerabilities That said, not all is rosy for the C$. While we re encouraged by the improvement in FDI, short-term flows still remain the primary source of financing for Canada s current account deficit. Those are relatively unstable flows which have potential to quickly reverse, meaning the Canadian dollar is vulnerable to a change in foreign investor sentiment. Foreign investors also seem to find Canada s securities less alluring these days. For the first time since 28, net quarterly foreign investment in Canadian securities was negative in Q3. The net outflows in that quarter were driven by money market instruments and equities which more than offset inflows into bonds. But even the inflows into bonds weren t necessarily a ringing endorsement of Canada given the bulk of the Q3 investment was in foreign currency-denominated bonds. Canada less alluring to foreign investors Net foreign inflows into Canadian securities Divestment from Canadian equities and money market instruments led to first quarterly foreign outflow since 28 Q NBF Economics and Strategy (data via Statistics Canada) C$ bonds US$ bonds Other currency bonds TOTAL BONDS 5 while the bulk of foreign investment into bonds were mostly in foreign currency 3 denominated securities -1 21Q1 21Q2 21Q3 21Q 215Q1 215Q2 215Q3 So, foreigners are still somewhat apprehensive about Canada, perhaps due to concerns about the economy s ability to overcome headwinds generated by the oil shock. The Bank of Canada s persistently dovish tone isn t helping win the confidence of foreign investors either. 2 1 Net foreign inflows into Canadian bonds But there s no denying that, outside the energy sector, the Canadian economy is improving. The continuing decline in oil & gas production (which was largely responsible for September s output slump) didn t prevent GDP from bouncing back in the third quarter with growth of 2.3 annualized. That, together with upward revisions to the first half of the year, puts Canada on track to grow about 1.2 this year, a touch higher than what the BoC had estimated back in October. Also positive is the apparent stabilization in energy prices and spreads which should provide relief to producers in the resources sector and reduce pressure on public coffers because government revenues depend on nominal GDP which in turn depends on prices. Canada: Energy prices seem to be stabilizing Index Bank of Canada energy price index and WCS-WTI spread BoC energy price index (L) Stabilization of energy prices and spreads Spread (R) US$/barrel -8 Q est. NBF Economics and Strategy (data via Bank of Canada, Datastream) All told, while acknowledging near-term pressures on the loonie to depreciate due to unfavourable terms of trade and the start of the Fed s tightening cycle, we expect the currency to make a comeback by mid-216 thanks to better oil prices, the erosion of yield disadvantage (as the Fed takes a pause) and more generally due to an improving economy which should all give foreigners more confidence about investing in Canada. We continue to expect USDCAD to come close to the lower end of the trading range in Quarterly price changes for WTI and WCS oil WTI spread C$ WCS in C$ mean less pain for producers in Q 1Q 15Q1 15Q2 15Q3 15Q est. In December, the central bank left monetary policy unchanged but warned about major uncertainties ahead: The economy continues to undergo a complex and lengthy adjustment to the decline in Canada s terms of trade. The BoC gave itself a pat on the back by saying that monetary policy stimulus and the depreciated Canadian dollar have helped in the economy s adjustment. With trade as the major driver of growth, we expect the Bank of Canada to maintain the dovish rhetoric as to keep the loonie grounded.

5 Annex Euro Japanese yen British pound Canadian dollar Australian dollar Chinese yuan NBF Economics and Strategy (data via Datastream) 5

6 ECONOMICS AND STRATEGY Montreal Office Toronto Office Stéfane Marion Marc Pinsonneault Warren Lovely Chief Economist & Strategist Senior Economist MD, Public Sector Research and Strategy Paul André Pinsonnault Senior Fixed Income Economist Krishen Rangasamy Senior Economist Matthieu Arseneau Senior Economist Angelo Katsoras Geopolitical Associate Analyst General: National Bank Financial Markets is a business undertaken by National Bank Financial Inc. ( NBF ), an indirect wholly owned subsidiary of National Bank of Canada, and a division of National Bank of Canada. This research has been produced by NBF. National Bank of Canada is a public company listed on Canadian stock exchanges. The particulars contained herein were obtained from sources which we believe to be reliable but are not guaranteed by us and may be incomplete. 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