Central Banks: Behind the Curve

Central Banks: Behind the Curve

Stephen Smith and Brian Giuliano discuss current central bank policies and how they could have a big impact on markets in the year to come – and beyond.


Brian Giuliano: In Europe, the European Central Bank (ECB) is seen by some as following rather than leading. Growth in the broader European economy is quite strong. Many economic data points are sitting at multi-year, if not multi-decade highs. Consumer confidence is up, business investment has ticked higher – money is finally being put to work. Yet real interest rates across much of the region are in negative territory. A ten-year German Bund yields an amazingly low 40 basis points, for example.

Much of this price action has to do with the ECB and its aggressive quantitative easing program–which will remain in place for much of 2018.  If European growth remains solid, what happens to fixed income and currency markets once the ECB realizes just how far behind the curve they've become?

Stephen Smith: The ECB may not believe that they're really far behind the curve. Part of what's going on is after the great financial crisis, U.S. banks were recapitalized with $308 billion worth of equity. The ECB, because of its disjointed nature, was never really in agreement that they'd ever be able to recapitalize the banks. So, for example, in September 2017, 22% of the loans in Italy were still non-performing.

The ECB is now quantitatively easing because they want to get the economy up – and they've been extraordinarily successful, no matter how you look at it. You can almost use the word “boom” for Europe. Eastern European countries are clearly in boom mode. But the ECB also saw what happened when Sweden, Norway, and New Zealand raised interest rates – how it slowed the economy – and they don't want to take a chance on that happening in the rest of Europe.                             

As a result, the ECB is going to be late to the tightening cycle because they want to make sure the current economic success is self-sustaining. But if there’s another year of growth like this one, labor markets are going to be priced better, inflation's going to be stronger – and I believe that the ECB's will be forced to raise rates because of macroeconomic conditions.

Brian Giuliano: You mentioned Italy and the issue of non-performing loan issue. Let’s shift gears to politics in Italy. Elections are in a couple of months and populism is on the move. Is a negative election outcome in Italy enough to derail momentum in Europe?

Stephen Smith: No. Nothing positive has been delivered economically from the political class in terms of addressing Italy’s structural issues. So though the election will take place, it won’t take place in a vacuum. If you look around Europe, you see structural reforms in Spain, in Portugal, and in France. All of which is a heck of a lot better than not doing anything. So instead of there being a cloud over Italy, the country could in fact come out of the election to actually do something that's positive. They don't need to do something radical; they just need to do something positive. So the way this might play out is for overall European growth to continue, and for Italy to do something – possibly something marginal, but something in the right direction.

Brian Giuliano: Let's shift gears to the U.S. economy. The Fed is tightening – yields at the front end of the curve are moving higher. Incredibly, the back end of the curve had remained anchored – at least until the most recent couple of weeks.  But it now seems like yields want to push higher. Growth is solid, confidence is coming back. Is inflation in the pipeline?

Stephen Smith: Let's look at import inflation. Import inflation was running at minus 2% to 3% for a number of years. It got to zero in 2016. Last year, import inflation numbers were running at about 2%. Oil prices are no longer $27 a barrel, they now have a six handle on them.

In every single Fed district – all 12 of them – the biggest concern is a shortage of labor. And yet, there's no labor inflation, which has been a conundrum for the Philips Curve class.

Our job is to try to figure out what the economic data will be six to nine months from now. I think the U.S, -- now with the tax cut in place – is on an extraordinarily sound footing. The demand for labor will continue to increase and the dollar will continue to gradually work lower – best described as gradualism, rather than a crash.

I think import prices will continue to rise, and we're going to reach an inflection point with wages where shortages will develop and people will see wage increases. And that, in turn, will be the catalyst for the Fed. I think probabilities of that happening are relatively high.

Let's look at the data: If you continue to add just 175,000 jobs a month for one year, the unemployment rate in the United States would reach 3.5% or lower. But I find it hard to believe that unemployment could fall to 3.5% in a vacuum, with no wage inflation. That’s why I think there's a higher probability of wages starting to move with a three handle rather than two handle.

We also think that’s the reason one-year, two-year and five-year rates have broken out, with ten-year rates on the verge of a breakout as well. We believe it's going to cascade down the yield curve. At some point in the next three to six months, the long end's going to break, just like the front end of the curve did – because of wage inflation.

Brian Giuliano: You mentioned tax reform and the U.S. dollar. In essence, your outlook for 2018 is for a continuing decline in the currency, but not for an all-out crash. But a strong argument could be made that tax cuts could supercharge growth prospects in the economy, leading to more dollar appreciation rather than a decline. For about 12 to 18 months, the dollar has seemed to be in a depreciating trend. So help me get an understanding of how you’ve formulated your view on the dollar.

Stephen Smith: We’ve been dollar-bearish for two years. The dollar had been as strong as it was at the peak of tech mania in 1999 to 2000. The dollar has actually sold off slightly in a benign way over the last 12 to 18 months.

Let's look at some data points. Remember when Germany was the “sick man of Europe”? That was followed by five years of reconstruction in the early part of this decade. The dollar was actually declining during that period. We've done historical studies on this issue. Five of the six times that the U.S. raised interest rates, the dollar actually declined. There’s a widely-held perception that the dollar moves on interest rate differentials. Sometimes that’s true – and sometimes it's not.

We've also been thinking about the fact that we are nine and a half years into a recovery. What generally happens over time is that the rate of change tends to slow – because the economy starts to operate at full capacity. We might get a quarter or two early on, with the recent tax cuts, where you get maybe 3% growth for four quarters running.

But we believe the reality is that the rate will fade back to the 2%, 2.5% range. More importantly, with the output gaps where they are, relative GDP growth could be stronger in Europe, stronger in the emerging markets than it is in the U.S. And therefore, I think that there will be a tendency for the dollar to weaken. And that's the story that we're sticking with.

Brian Giuliano: Thanks, Steve

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