The long and noisy road toward normal monetary policy
In the week the European Central Bank outlined its plans to wind down stimulus, Stephen Gallo of the Bank of Montreal joins Michael Hunter to tune into the signals hidden in the noise.
Presented by Michael Hunter and produced by Fiona Symon
For some time, FX traders have been playing a guessing game it has not been clear when and how the European Central Bank will go about reducing its economic stimulus spending as it takes the first steps on the road towards normalised monetary policy. Now we know.
I'm Michael Hunter and this is Hard Currency, the FT's weekly tour of the world's biggest and most liquid market. Joining me to assess news of the ECB's plans to half its monthly bond buying budget to $30 billion euros from January is Stephen Gallo, European head of FX strategy at the Bank of Montreal. Sir, you are, of course, very welcome. What did you make of Mario Draghi announcement and the knock the euro took afterwards?
I think in terms of the price action, really, it's just noise. The bigger picture here, the really important picture, is that the ECB is really the only sort of glue holding the entire eurozone project together. It's certainly not the politics, so it must be the ECB. The key points that came out of the press conference from Draghi were that the ECB will continue buying outright for another nine months, they'll be involved in the bond markets for a very long time through the reinvestment programme, rates aren't going up anytime soon, loose for long. That was the key message that came out of President Draghi's mouth.
So dovish again from the ECB.
Reassurance, is what I think, because the move in the euro, you noted it went down, it's just noise in the bigger picture. It's reassurances from Draghi that the ECB is going to be there backstopping the bond market. But let me just be clear.
The situation in the eurozone, this is not the same thing as, like, you trying to train your kid how to ride a bicycle without training wheels. At some point, it just becomes self-sustaining and the kid goes off on his or her own. This is very different.
This is like trying to resist gravity. Eventually, at some point, gravity is going to win. And gravity, in this sense, is fundamentals and market forces. When the ECB finally does step away from the bond markets, gravity will take over as long as there is no increased political cohesion in the block.
So I think the message from Draghi was very clear, reassurances the ECB isn't going anywhere fast. As the dollar weakens over the course of the next 12 months, we think the euro will appreciate. But it's going to appreciate reluctantly because of these political tensions and other fundamental factors bubbling underneath the surface.
So you don't think that move we saw in the euro under $1.1730 is the beginning of the end of the euro's rally against the dollar? That's not what you're saying?
Well, it plays into another very important theme at the moment, which is the uncertainty regarding the new Fed chair. And so the dollar is relatively firm because of that. And so, therefore, it's difficult for the euro to rally significantly or sustainably right now anyway. But in the bigger picture, no, it's just noise. We think that the dollar will continue to weaken over the course of the next 12 months. And that will drag euro dollar higher. And, of course, also, as well, as we get through to 2018, the markets will be pricing in more normalisation of ECB policy, which will also be supportive for the euro.
OK, so let's look then the identity of the next chairperson of the Federal Reserve. The dollar was watching that speculation. We saw earlier in the week that Stanford University's John Taylor was emerging as a major candidate for the job. Now he's known for advocating a stricter rules-based approach to monetary policy. He's also been linked with the Vice Chair post which remains vacant after the retirement of Stanley Fischer. Janet Yellen's term expires in 2018. Generally, how much more of this do we have hanging over the dollar do you think?
Quite a bit probably, for another week or two at least. The market narrative, I think, is very different from reality. The market narrative at the moment, now that it seems that Yellen is out of the race, is that Powell will be on the more dovish end of the spectrum, Warsh will be on the more hawkish end of the spectrum, and Taylor will be somewhere in the middle. That's the market narrative.
So if we get a Taylor or a Warsh result, a nomination for either of those two individuals, yields in the US and the US dollar will take off. They'll go higher. The reality, though, is that in 2018, because the Fed has so well telegraphed quantitative tightening, there aren't going to be any major changes for that process. The Fed is basically on autopilot. And also as well, the Fed is, to a degree, a slave to market forces. It works both ways, of course. But any Fed chairman or chairperson that tries to rush the process of normalisation is going to run up to some very-- run up into some very aggressive market forces.
So, again, rather like that chunky move we saw in the euro around the ECB press conference, it was down by as much as 1% against the dollar, you described that earlier as noise. Some of these themes around the identity of the next Fed chairperson is also looking a bit like noise?
Like noise and the broader theme for the dollar, we see the dollar heading lower over the next 12 months driven by fundamental factors. I won't get into those at the moment. But the bottom line is that once the market moves to pricing more closely what the Fed has telegraphed what it starts, the dollar stands to lose some of its gains.
Do you think that there is going to be a trend for buying the dips, moving around the volatility on some of these moves have been quite whippy over the last few weeks as this longer-term pattern, perhaps, takes a little bit longer to emerge? Is this a time for some whipsaw trading around these major powers?
Quite possibly, although I would say at the moment that the market is taking the Fed uncertainty for the most part in its stride. It's waiting patiently. It's almost become ingrained in traders' heads which way to trade rates and the dollar when we get a Taylor result, for example, or if we get a Powell result or a Warsh result.
So we're just waiting. We're waiting patiently. And there will be some noise, as I say, around that announcement. But once we get through it, the broad, fundamental picture for the dollar over the next 12 months is-- is negative.
It's going to be driven lower by a 3% to 5% per year twin deficit downdraft-- wider fiscal deficit, slightly water current account deficit, higher commodity prices because of solid global growth. These factors in the past have always played into a weaker dollar vis a vis dollar smile theory. And they will again, in our opinion.
So whoever chairs the Fed has got a lengthy watch list ahead of them for the rest of 2017 and into 2018. Now on our watch list, as we move toward the end of the programme, the Bank of England is expected to raise rates for the first time in a decade next week. That would reverse the quarter point cut it made in immediate reaction to the Brexit vote. Obviously, that means the BOE is a little bit further down the road toward normalising monetary policy than its nearest neighbour over in Frankfurt. How seriously are you taking this kind of stuff around the pound?
Not so much anymore. I would say probably the move is 70% to 75% priced in for November. So actually, there is more downside risk for the pound in November if they decide not to go. Our view is that they will go. They'll hike 25. They'll pitch it as an attempt to shore up financial stability risks and complement the earlier macroprudential tightening, head off inflation risk from diminished spare capacity, and so on.
But really, the Bank of England hiking rates 25 basis points next month is like breaking a window and then repairing the window. They cut in 2016 after the referendum. They misread the economy. The economy proved to be stronger than they thought. But they cut, and now they're simply reversing that cut.
It's not-- in the grand scheme of things, probably what you're getting here from the BOE is just playing into the Sintra doctrine that came out of the ECB conference in Sintra over the summer where central banks took steps to warn markets that things were getting more towards normal over the coming 6 to 12 months. Outside of that, I don't think it really means very much.
The BOE will probably want the flexibility of keeping another rate hike alive, it provides some support to sterling, you know, weak pound causes them complications, it causes the economy complications. But in reality, when they hike in November, they probably won't touch rates again until at least the end of next year at the earliest.
Gradual, gradual, a gradual, path towards normal monetary policy or normalised monetary policy. Just a brief bod at the pound being at $1.30, at that kind of a level. I know you have some pretty pronounced thoughts about those kind of levels of sterling. Could you put those in a nutshell for us?
Dips in sterling, for the time being, for the next two to three months, I think should be bought because, largely speaking, if you look at what came out of the EU summit, to me the tone looked fairly conciliatory, Merkel's tone in particular. I don't think, as we go over the course of the next two to three months, there is a chance for a major sell off in the pound as those talks move forward.
As we get towards the summer, if there's no progress though, the risks of a downside move in the pound will increase measurably, I would say. But for the next two, three months or so, you look to buy dips in sterling and cable. Anything below 130 is a buying opportunity in our opinion. And in euro sterling, anything at or above the 90 mark would be a selling opportunity in euro sterling for the next two to three months.
OK, and with that, that's all we have time for. Our thanks to Stephen Gallo from the Bank of Montreal for being our guide. Hard Currency will be back next week with Roger Blitz. Until then, you can keep up with all the news and comments on FX at ft.com/markets and at Fast FT.