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MACROECONOMICS

What Will Drive the Markets in 2016

Four Drivers, Investment Climate, in 2016, Macroeconomics, fx trader, forex

11 Jan 2016

The broad interpretative framework we developed since late 2014, one that centers the de-synchronization of the major economies, will retain its usefulness into the New Year and beyond.  The first phase of divergence was characterized by the Federal Reserve standing pat after winding down its open-ended asset purchase operations (QE3+), while many central banks from high-income countries, including the Eurozone, Japan, China, Canada, Australia, New Zealand, Sweden, and Norway, eased policy.

Laying the Groundwork for 2016

With the Federal Reserve’s rate hike at the end of 2015, a new phase of divergence is at hand.  It will be characterized by both Fed becoming less accommodative while other central banks maintain or extend current easing policies.  Some central banks may have reached the end of their easing cycles, but it is possible that the door is not completely closed. 

We expect the Obama dollar rally to continue in 2016.  The premium one earns on US  rates will  continue to attract capital flows.  Because of the wide, and widening interest rate differentials, one is paid to be long dollars.  This has powerful implications for hedging.  Dollar-based investors are paid to hedge exposure (receivables) in euros, Swiss franc, and Japanese yen for example. 

Our assessment of indicative market prices suggests that the divergence meme, as much as it has been discussed, has not been discounted. By the time the ECB met in early December when it cut the deposit rate 10 bp to minus 30 bp and expanded its program by six months (through March 2017), the premium the US offered over Germany for two-year borrowing had increased to nearly 140 bp.  It was around 85 bp when the euro bottomed in March 2015.

The Fed funds futures strip suggests that the participants are skeptical about a second Fed rate hike in Q1 16.  The Federal Reserve’s dot-plots suggest a majority of Fed officials think it would be appropriate.  Several large investment houses, and Fitch, the rating agency, forecast a hike every quarter.

We recognize that the market is a great discounting mechanism.  Arguably it has no rival for its ruthless ability to aggregate vast quantities of information.   We have found it helpful in navigating the markets to appreciate that events can be anticipated and discounted.  Buying rumors, selling facts is standard fare in the capital markets.  However, conceptually, we think that the widening interest rate differentials cannot be fully discounted. The interest rate differentials, including the slopes of yield curves, provide powerful incentives driving new flows, influencing investment, hedging and liquidity decisions. 

Drivers for 2016

Federal Reserve

• The pace of monetary policy normalization will depend on economic data, Fed expectations, and broad financial conditions.

• There are several factors that make this cycle unique and arguably, even more, challenging than would normally be the case, including the new policy tools used by the Fed, and lower nominal GDP.

• The Fed’s balance sheet is in play as an estimated $220bln in Treasuries are set to mature next year.

The pace that monetary policy can be normalized will be a function of the economic data in absolute terms and about Fed expectations.  At the same time, the broad financial conditions, which include the dollar’s exchange rate and financial markets, will also be taken into account.  We expect the pace of job growth to moderate, but without a marked increase in the participation rate, it may still be sufficient to absorb slack in the labor market.  This means that the unemployment (and underemployment) will likely decline.  The fall in energy prices may help check headline inflation. Core measures are likely to increase on the back of higher rents and medical services.

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