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Normalisation is coming so plan ahead

Normalisation is coming so plan ahead
October 17, 2014
Normalisation is coming so plan ahead

As holiday makers in the eurozone will have noted this summer, the single currency has been on the slide, losing over 6 per cent of its value against sterling since early April and almost 10 per cent against the US dollar since the end of May. In foreign exchange markets where currency traders make their money by betting on minuscule movements in cross rates, the weakness of the euro has been eye-catching. It is also understandable once you consider the key factor influencing it: a move to normalisation of monetary policy in the US.

 

Fed watch

As has been known by market watchers for some time, the six-year money printing experiment known as quantitative easing (QE) comes to end this month when the US central bank makes its final $15bn (£9.3bn) of asset purchases. In this period, the US Federal Reserve has increased the size of its balance sheet more than fivefold from $800bn in the autumn of 2008 to over $4.3 trillion. By driving down yields on US Treasuries and mortgage-backed securities through these asset purchase programmes, the actions of the Federal Reserve has been the one single factor that has driven down yields on a range of other financial assets, too. It has also created the excess liquidity and low-cost borrowing environment that has powered bull runs in bond and equity markets across the globe.

However, with the unemployment rate in the US dipping below 6 per cent for the first time since 2008, and making headway towards the 5.5 per cent level which some members of the rate setting Federal Open Market Committee (FOMC) believe represents full employment, the time is approaching when the FOMC will start a monetary tightening cycle. It's also one that will see the Fed funds rate rise from its record low target range of zero to 0.25 per cent.

Guidance from the US central bank is that the Fed funds rate will only increase after a "considerable time" has elapsed following the end of QE3 this month. This is unlikely to change when the FOMC has its next meeting on 28 and 29 October. Based on the futures market, current market expectations are that the first move in the Fed funds rate will be the middle of next year and the rate will end 2015 at 0.75 per cent, rising to 1.8 per cent by the end of 2016.

Of course, the US will have to maintain its strong economic recovery for tightening on this scale to actually happen. The Fed's estimate is for GDP growth of 2.8 per cent in 2015, albeit down from the 3.25 per cent forecast the central bank was predicting last year. The International Monetary Fund is more bullish, predicting GDP growth of 3.1 per cent next year.

Economic growth of that magnitude, coupled with a further contraction in unemployment to around 5.5 per cent by next summer, implies greater pressure on wage inflation as excess capacity is removed from the labour market. Inflation expectations in relation to the central bank's 2 per cent target rate would then become the key factor in the timing of the first rate move.

Admittedly, it is not a slam dunk case that the Federal Reserve will raise rates as markets are predicting. Indeed, minutes released from the FOMC's September meeting last week clearly highlighted that some members of the committee are worried that the recent appreciation of the US dollar, coupled with weak inflation and economic growth in the eurozone, and risks to global economic growth, could impact external trade and dampen US growth. Investors interpreted this as a signal that rates will stay lower for longer, causing an easing of US Treasury yields. That said, bond market investors still expect a rate move next year, which is why two-year US Treasury bond yields have tightened 12 basis points to 0.45 per cent since the end of May.

 

Global currency flows

Unsurprisingly, as investors adjust to an end to QE in the US, moves in the US bond markets have led to significant shifts across major currency markets. In fact, the US dollar index hit a four-year high earlier this month, having appreciated almost 9 per cent since July. The dollar index is made up of six currencies with the following weightings: euro (57.6 per cent); Japanese yen (13.6 per cent); sterling (11.9 per cent); Canadian dollar (9.1 per cent); Swedish krona (4.2 per cent); and Swiss franc (3.6 per cent).

This sharp appreciation of the greenback not only reflects general euro weakness for reasons I will discuss below, but also that of the yen. That's because both the European Central Bank (ECB) and the Bank of Japan are pursuing lax monetary policies, in stark contrast to a move to normalisation of rates in the US. Earlier this month the Bank of Japan pledged to increase its monetary base at an annual pace of 60 trillion yen to 70 trillion yen ($643bn) in line with a zero-interest rate policy aimed at reviving an economy that contracted at its fastest rate for five years in the second quarter following an increase in sales tax.

In the circumstances, the relative strength of the US dollar simply reflects global capital flows from low-yielding currencies in countries operating ultra-easy monetary policy to one offering greater potential for better returns as the Federal Reserve moves to tighten monetary policy. This also explains why sterling has been relatively stronger against the greenback than the euro as the UK is also close to entering a tightening cycle. For example, the two-year gilt has risen by 25 basis points to 0.75 per cent since February with consensus of a first rate hike in the first half of 2015. By contrast the two-year German bund yield has gone in the opposite direction and is actually trading on a negative yield of minus 0.07 per cent, meaning that you would actually lose money buying the paper.

Irrespective of the precise timing of when interest rates are raised next year in both the UK and US, the relative strength the US dollar, and to a lesser extent sterling, is likely to be a feature in the coming months given the divergence of these countries' economic and monetary policies compared with the struggling eurozone and Japan.

 

 

Eurozone economic and currency weakness

Whereas the US has a healthy core inflation rate of 1.7 per cent, and the UK's consumer price index is 1.5 per cent - albeit these rates are below the 2 per cent target rates for both central banks - the eurozone is battling major deflationary pressures. In fact, the core inflation rate in the region fell to a five-year low of 0.3 per cent in September, down from 0.4 per cent the previous month.

Moreover, with little respite in sight for falling commodity prices, partly reflecting the sharp economic slowdown in resource hungry China and a softening of global growth expectations, and eurozone demand being undermined by an unemployment rate for the 18 member countries stubbornly around 11.5 per cent, almost double the 5.9 per cent rate for both the UK and US, then the risk of the region heading towards deflation has increased markedly. This is important because a permanent deflationary environment will make it impossible for heavily indebted countries, still nursing sizeable budget deficits, to reduce their debt burdens. In fact, debt-to-GDP ratios would continue to spiral beyond the point of no return.

Weakness in the labour markets, low inflation and high unemployment is hardly 'new' news to the economists at the ECB. However, when taken alongside data that shows that the core economies of Germany and Italy contracted in the second quarter, and France stagnated, the IMF now predicts there is a 40 per cent chance the region will enter recession and a 30 per cent chance it will slide into deflation. Ultimately, it's this unpalatable economic backdrop that has forced the ECB to belatedly take action this month by announcing new measures to purchase private asset-backed securities (ABS) and covered bonds, and potentially those retained by banks that created them.

With the IMF predicting the UK economy will grow by 2.7 per cent in 2015, and employment at record levels, then there is reason to expect sterling strength against the euro as rates tighten here

Unfortunately, investors are not buying into this QE-lite monetary easing programme, which falls short of what is ultimately needed: a full-blown QE programme employing the ECB's massive balance sheet to purchase government bonds of member states. But that is not what is being offered by the ECB, nor by its German members who vehemently oppose the central bank launching a bond bazooka at the markets. That spells bad news for the eurozone economy and the euro in particular, which is why yields on 10-year German bunds are at a record low of 0.88 per cent, around 140 basis points lower than the rate on US 10-year Treasury bonds.

And it's the divergence of the eurozone and US economies that is likely to underpin the US dollar rally for some time yet. Furthermore, with the IMF predicting the UK economy will grow by 2.7 per cent in 2015, and employment at record levels, then there is reason to expect sterling strength against the euro as rates tighten here.

 

The tightening cycle

So with a move to normalise monetary policy looking nailed on in the US next year, and economists predicting the next move in UK interest rates could be as early as the spring of 2015, then it's only sensible to prepare for rising bond yields in these countries as monetary policy is tightened.

It's worth noting that the interest rate upcycle in the US could be more intense than in the UK for a number of reasons. Firstly, the US economy and its banks have emerged from the 2008-09 recession and financial crisis in far better shape than those of the UK. Secondly, the country is less reliant on exports (accounting for only 13 per cent of GDP), whereas around a third of the UK's GDP is export trade of which a half is to the stagnating eurozone. This leaves the UK economy more exposed to woes on the continent than the US, which is a relatively closed economy.

Thirdly, the US imports around 20 per cent more than it exports, so dollar strength acts as a strong boost to real domestic purchasing power for consumers and enhances profit margins for businesses that sell domestically but use foreign-made inputs. These factors should not only underpin the US recovery, but could also lead to dollar strength against the pound even though the UK will be tightening rates at the same time. This will have an impact on equity markets.

 

Impact on equity markets

The fact that equity markets on both sides of the Atlantic have been weak recently is in part down to the Federal Reserve taking away the punch bowl that helped drive the bull market. When both QE1 and QE2 ended in the US, equity markets subsequently corrected for a period of four to five weeks as investors adjusted to the new environment. But they eventually do as a look at previous US interest rate upcycles shows that on no occasion was the first rate hike followed by a deep market sell-off, albeit there has been increased volatility in the immediate aftermath of it.

In other words, investors come to terms with the change in monetary policy well before it actually happens, which is exactly the process we are seeing right now. It's also worth noting that the average gain in the US market has been 6.5 per cent in the six months after the first rate hike, according to strategists at Charles Stanley Stockbrokers. That's worth noting given the high correlation between movements in the UK and US stock markets.

In terms of the impact on equities, as monetary policy is normalised expect a steepening of the yield curve. Historically, this has led to outperformance of cyclical sectors as investors rotate holdings into companies most exposed to the economic growth forecast.

On a company-specific level, it's reasonable to expect the relative US dollar strength to benefit UK companies with significant overseas dollar-denominated earnings once these are translated back into sterling. In this environment it's best to focus on companies with high operational leverage and low financial gearing because rising bond yields will penalise companies with high financial leverage. Technology stocks fit the bill here and as strategists at Charles Stanley rightly point out, the sector is also likely to be a major beneficiary of rising capital expenditure. Another sector set to benefit from rising base rates should be the insurers.

Clearly, there is execution risk to any normalisation of rates in the UK and US. Central bankers are all too aware of this. But what is in no doubt is that normalisation is coming. It's time to plan ahead for that event.

 

■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'