Investment Research — General Market Conditions
30 June 2017
Strategy
Central banks consider leaving the party
More and more central banks are beginning to discuss ‘when to leave the party’ by
removing easing biases and some are even talking about tightening. This has been
fuelled this week by what seems like a coordinated move by ECB President Mario Draghi
and Bank of England Governor Mark Carney, which sent yields on EUR and GBP higher.
It seems like both the ECB and BoE have joined the Fed in its faith in the Phillips Curve,
as Draghi argued that ‘deflationary forces have been replaced by reflationary ones’. This
is also the case in Scandinavia, as Norges Bank removed its rate cut probability entirely
last week (see Norges Bank Review: Cautiously hawkish – steeper FRA curve, limited NOK
upside, 22 June) and we think the Riksbank could follow suit at its upcoming meeting.
Interestingly, both Carney and Draghi argue that a constant monetary policy is
becoming more accommodative, as the economy continues to recover. Theoretically,
they are arguing that they think the so-called natural interest rate (also called ‘r star’ in
economic models) has increased, meaning that the current real interest rate gap (which
determines how easy monetary policy is in modern economic models) has widened. This
means that the central banks need to tighten in order to keep the policy stance unchanged.
However, as we argued as late as in last week’s strategy piece, the risk is that central
banks are too optimistic on inflation. It is not because the Phillips curve is dead but the
tightness of the labour market is not the only factor determining wage growth. While the
labour market continues to tighten, nominal wage growth has not moved much higher,
possibly due to second-round effects. When employees expect inflation to remain low, they
can live with low wage growth, as real wage growth may still be solid. Inflation
expectations are low, especially in the US and the euro area, and we think this is at least
due partly to central banks losing their credibility after having missed their inflation targets
for years. We still believe the ECB is too optimistic on its forecasts for wage growth and
core inflation, which explains why we still believe that the ECB will extend QE but most
likely lower the pace from EUR60bn to EUR40bn. Markets are now pricing in the first
10bp ECB rate hike for autumn next year, which is broadly ‘fair’, in our view.
Today’s key points
 Central banks are beginning to
discuss ‘when to leave the party’.
 Interestingly, both Mark Carney and
Mario Draghi argue that a constant
monetary policy is becoming more
accommodative as the economy
continues to recover.
 There is a risk that central banks
are too optimistic, as inflation
expectations remain low.
 Draghi let the stimulus exit genie out
of the bottle and we expect
EUR/USD to move higher in 12M.
Norges Bank has removed rate cut
probability entirely
Source: Norges Bank, Danske Bank
Low inflation expectations
Source: Bloomberg
Important disclosures and certifications are contained from page 3 of this report.
Senior Analyst
Mikael Olai Milhøj
+45 45 12 76 07
[email protected]
www.danskeresearch.com
Strategy
The Fed also seems very keen on continuing its hiking cycle despite low actual inflation.
At the latest meeting, Chair of the Fed Janet Yellen said repeatedly that the tighter labour
market will push up wage growth eventually and hence underlying inflationary pressure.
As the Fed seems to be focusing more on the unemployment rate and to some extent easy
financial conditions (driven by higher equity prices), we expect more details on the Fed’s
plan to shrink its balance sheet in September and another rate hike in December.
However, we still think there is a chance the Fed will be forced on pause due to low inflation
(expectations) and wage growth. See FOMC review: Hawkish Yellen ignores inflation and
weaker data, 15 June 2017.
Wage growth is low in the US despite
tighter labour market
The story is different for the BoE, as inflation is now close to 3% and the unemployment
rate at 4.3%. While our base case remains that it will stay on hold, as we are more
pessimistic on GDP growth and the wage growth outlook than the BoE, the probability of
a rate hike in the second half of the year (most likely in November) has increased. In any
case, the BoE has started tightening already by increasing the counter-cyclical capital buffer
to 0.5% (expected to be raised further to 1.0% in November) and we think the BoE will end
its Term Funding Scheme (effective from February 2018) at the August meeting.
Source: BLS
Much more one-sided trading in EUR/USD going forward
In our view, Draghi’s hawkish speech has let the stimulus exit genie out of the bottle.
See FX Strategy: ECB has let EUR/USD out the bottle, 29 June. Whether the ECB extends
QE or whether the first hike is postponed again should matter less for the big picture: Draghi
and co have now delivered the catalyst for the fundamental gravitational pull to kick in.
We no longer expect any material dip in the cross over the summer, and we have
upped our 1M and 3M forecasts to stand at 1.13 (previously 1.11 and 1.09, respectively)
as we see the cross in a range around this level in coming months. For the longer term, our
call remains unchanged and we still expect the cross to edge towards 1.18 in 12M. We have
upped our 6M forecast to 1.15 (previously 1.12) to reflect our belief that the higher ranges
are here to stay.
Draghi let EUR/USD out of the bottle
Source: Bloomberg
Financial market views
Asset class
Main factors
Equities
Our short-term trading opportunity stance (0-1 month): Sell on rallies
Our strategy stance (3-6M): Neutral on equities vs cash
After riding high on the T rump trade, we turned more cautious in early April. W e reiterate that position in this update, with a Neutral stance on equities. W e put most cyclical sectors
on Neutral or Underweight and many defensives on Overweight, and we reiterate this as well.
Bond market
German/Scandi yields – set to stay in recent range for now, higher on 12M horizon
European bond yields will be range trading over the summer and thus we do not expect the sell-off to continue. W e have a significant reinvestment need from redemptions in the
European government bond market during July and early August, which will lend support to the European government bond market. Furthermore, we do not expect inflation to rise
into the autumn, and even though GDP growth has surprised on the upside in a number of EU countries, we still expect the ECB to continue the QE into 2018 but at a slower pace.
EU curve – 2Y10Y set to steepen when long yields rise again
T he ECB is still keeping a tight leash on the short end of the curve and with 10Y yields stable, the curve should change little on a 3-6M horizon. Risk is skewed towards a steeper
curve earlier than we forecast.
US-euro spread set to widen marginally
T he Fed raised rates by 25bp as expected by the market and announced the initial steeps for a QT programme, where the balance sheet is being reduced at a very gradual pace.
Hence, the impact on the T reasury market is expected to be benign. Inflation and inflation expectations are falling in the US and the market is priced for very modest hiking pace. W e
see risk on the upside for the latter.
Peripheral spreads – tightening but still some factors to watch
Economic recovery, ECB stimuli, better fundamentals, particularly in Portugal and Spain and the French elections will lead to further tightening despite the recent strong move. T he
EU commision and the Italian Finance Minister have reached an agreement in princple on MPS, and thus a model for banking recapitalisation plans in Italy has been presented.
Furthermore. the risk of an early Italian election has also diminished. Hence, we are entering a summer with stable to tighter spreads between the core and periphery.
FX
EUR/USD – no more material dips expected, set to test new highs in H2
T he ECB has unlocked upside EUR/USD potential; we no longer look for any substantial downside in the cross. Range around 1.13 near term, but set to move towards 1.20 further out.
EUR/GBP – range-bound but risks tilted for GBP support
Sterling caught in undervalued territory during Brexit negotiations but rising risk of an earlier-than-expected BoE hike, which could provoke GBP strength.
USD/JPY – gradually higher longer term
BoJ sidelined in central bank exit talk should cap JPY upside for an extended period. T he Fed's and the ECB's eagerness to tighten is set to support EUR/JPY and USD/JPY near term.
EUR/SEK – range near term, then gradually lower
Gradually lower on fundamentals and valuation longer term but near-term SEK potential limited by the Riksbank.
EUR/NOK – range near term, then gradually lower
Headwinds near term due to global weakness and low oil prices but longer term NOK should rebound on valuation, growth and real-rate differentials normalising.
Commodities
Oil price – range-bound, downside risk
Downside pressure from bearish fundamentals and stronger USD. Approaching a natural floor where US producers are forced to scale back on future production increases
Metal prices – range-bound, downside risk
Underlying support from consolidation in mining industry, industrial cycle nearing a peak. Downside risk from slowdown in global growth.
Gold price – range-bound
T ug of war between geopolitical uncertainty and stronger USD.
Agriculturals – rising again
Dry weather creating supply concerns. Shrugging off negative impact of lower oil prices and higher USD.
Source: Danske Bank
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Strategy
Disclosures
This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske Bank’).
The author of the research report is Mikael Olai Milhøj, Senior Analyst.
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Report completed: 30 June 2017, 08:03 GMT
Report first disseminated: 30 June 2017, 13:10 GMT
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