8 january 2016 monthly economic update · monthly economic update january 2016 3 the negotiations...

Monthly Economic Update January 2016

1

Monthly Economic Update Not-so-sweet sixteen

2016 has started on a sour note. Once again turmoil in the financial markets

stems less from economic data than economic policy and politics. Tension in

the Middle East has so far pushed oil prices lower, while fresh moves from

Chinese policy-makers have again raised doubts about their ability to avert a

hard landing. So far growth in Europe has remained resilient, defying a long

list of political worries, headed by the risks to the EU from a potential ‘Brexit’.

Politics is also likely to become more of a polarising and destabilising force in

the US as we head towards the Presidential election at year-end.

The US economy was strong enough for the Federal Reserve to embark on the first rate

hike in more than nine years at its December meeting. But whilst the overall picture

remains reasonable, there are one of two emerging signs of potential concern and the

risks to the growth outlook are clearly skewed to the downside.

Following years of stimulative monetary policy, early warning signs may be indicated by a

slowing corporate profit backdrop, some signs of oversupply in residential housing, in

inventories and a weaker outlook for business investment. A downturn is not imminent,

but as time passes, these issues may increase the chances of a downturn if not reversed.

Defying adverse political and geopolitical shocks, the Eurozone recovery is proving to be

quite resilient. On top of terrorist threats, the refugee crisis and the rolling disputes over

Greek finances, there are new concerns about political gridlock in Spain. Yet so far there

has been little impact on economic sentiment. The ECB can therefore afford to wait-and-

see, although persistently low inflation might revive expectations of further easing.

In the UK, the debate about the EU referendum is heating up, as PM Cameron faces a

tough meeting in February to gain sufficient concessions to take back to the electorate.

Although the macro economy remains in good shape, Brexit fears are weighing on UK

asset prices and, we believe, will encourage the BoE to delay its first rate hike until 4Q16.

Japan’s election in July will set the tone for the year and the BoJ is unlikely to change its

stance before that takes place. Tapering may come up for discussion later this year,

despite the prospect of below-target inflation.

China’s annual Central Economic Work Conference in December emphasised “supply-

side structural reforms” but the investor-friendly message was overshadowed by worries

that the central bank was pursuing a policy of competitive devaluation. We do not believe

it is, but it will take action, not words, to persuade investors.

The moves in the 2/5/10yr fly provide an insight into the bond market sentiment towards

rates in the future. So far the message is that the rate hike risk in the US is being pared

back and the risk for further easing in the Eurozone is rising. The one trend that remains

in place is 2/10yr curve flattening, which if there were a significant shock and large-scale

risk-off, we would expect this to continue.

Bracing for the risks of a Chinese slowdown and higher US rates, EM and activity

currencies remain under heavy pressure. This should continue into early 2016, with

broad-based dollar strength causing a head-ache for the Fed. The surprise this year has

been the Brexit risk premium being built into GBP so early. That is unlikely to dissipate

before the 18/19 February EU summit.

FINANCIAL MARKETS RESEARCH

Global Economics

8 January 2016

Mark Cliffe Head of Global Markets Research

Rob Carnell

Tim Condon

James Knightley

James Smith

Chris Turner

Peter Vanden Houte

Padhraic Garvey

GDP growth (% YoY)

Source: Macrobond, ING

10Y bond yields (%)


FX


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Japan

Eurozone

US

Forecasts

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7

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00 02 04 06 08 10 12 14 16

US

Japan

Eurozone

Forecasts

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00 02 04 06 08 10 12 14 16EUR/USD (eop) USD/JPY (eop)

Forecasts


2

Eurozone: steady as she goes

If anything, one has to say that the Eurozone economy is showing resilience in the wake

of a number of adverse shocks. It would have been only logical for European consumers

to have been shaken after the terrorist attacks in Paris in November and the threat of new

attacks in other countries. However, consumer confidence actually rose in December for

the second consecutive month. Likewise, the PMI manufacturing indicator printed a

strong figure in December, with all forward-looking components heralding further growth

in the months to come. It seems that low interest rates, a relatively weak euro and

depressed energy prices continue to be a powerful cocktail supporting the recovery.

Both lending to households and non-financial corporates accelerated in November.

Though the absolute growth figures still remain low, the ECB’s expansionary monetary

policy apparently is starting to have an impact on credit markets. That bodes well for

investment growth in the coming quarters.

While the economic backdrop continues to improve (the OECD leading indicator is still

pointing to a growth acceleration in the Eurozone), political risks have not disappeared.

The Spanish economy is doing fine for the time being, with employment last year

registering the strongest increase since 2006, but politics have got very complicated. The

inability to form a regional coalition government in Catalonia is likely to lead to new

elections with the same risk present at the national level, where the formation of a

workable coalition proves to be very difficult after the general elections yielded an

unprecedented fragmentation of the political landscape.

Greece remains a longer term problem as reforms progress only slowly and the economy

remains weak. Pension reforms again prove to be a matter of dispute with the creditors.

The first review of the third bail-out programme has now been delayed until mid-January.

Meanwhile, the IMF is still not on board and Prime Minister Tsipras even flirted with the

idea of leaving the IMF out (which would soften the supervision of the programme), but

this is not acceptable for Germany. In that regard, we still believe that some form of debt

relief is likely in the first half of the year, allowing the IMF to participate in the third bail-

out. That said, this is not likely to be a very smooth process.

Fig 1 Credit markets recover…

Fig 2 …but inflation continues to undershoot

Source: Thomson Reuters DataStream Source: Thomson Reuters DataStream

There are no general elections this year in the bigger member states (even though new

elections are a possibility in Spain), but Germany will see some regional elections in the

first half, testing the popularity of Chancellor Merkel. A lot of attention will be devoted to

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ECB inflation forecast for the year

HICP inflation

Eurozone recovery is

showing resilience…

…with ECB QE having a

positive impact in credit

markets

Political gridlock in Spain…

…. and more muddling

through in Greece


3

the negotiations with the UK in the run-up to the Brexit referendum later this year. The

February European Summit should be the crucial meeting, in which a compromise will

have to be reached on some of the British demands, to allow David Cameron to lead a

campaign in favour of EU membership.

Meanwhile, inflation remains extremely low. The HICP flash estimate showed a 0.2%

year-on-year-inflation rate, though core inflation remained at 0.9%. As core inflation has

been identified by the ECB staff as a better predictor of medium-term headline inflation

than headline inflation itself, the latest figures don’t give much of an indication that the

ECB will reach its objective anytime soon. What’s even more annoying for the ECB is the

fact that headline inflation will most probably remain below 1.0% throughout 2016 on the

back of lower oil prices. That will force the ECB staff to downgrade its inflation outlook for

2016 again (currently standing at 1.0%, while we forecast 0.5%), putting renewed

pressure on the ECB to act.

While we don’t exclude additional easing (Mario Draghi has emphasised on several

occasions the flexible nature of the QE programme), we don’t see any further rate cuts.

Only if the Eurozone recovery would show clear signs of faltering, the ECB is likely to

increase the monthly asset purchases, though this is not our base case for the time

being.

Peter Vanden Houte, Brussels

US: Reasons to be cautious With the Fed finally managing the so-called “lift-off” of rates in December 2015, it might

seem as if all the hard questions for the US have been answered. Growth is clearly

sufficiently strong, labour market slack sufficiently low, and inflation prospects sufficiently

good to allow for positive rates. The main questions would seem to be how fast will the

subsequent rate hikes be in 2016 and 2017, and where will fed funds eventually peak?

These are both fair questions. And ones we will return to. But the outlook is not as clear

as the initial assessment might seem, and could be muddied by political considerations

later this year. That said, unlike the Eurozone, which is defying political problems to grow,

the US political backdrop has not so far been a significant feature amid signs that

economic growth is probably losing, rather than gaining, momentum. Any political friction

to growth prospects is more likely to come as the election campaign hots up over the

coming year.

There have been a number of studies suggesting that the length of the business cycle

does not influence the likelihood of the next recession. That said, common sense

suggests otherwise. However, with only twelve peaks and troughs in the US business

cycle in the post-war period, we doubt that there are sufficient instances of downturns to

deliver a sensible statistically significant sample to test such a hypothesis rigorously.

Moreover, even if time itself is not the “cause” of downturns, time does provide the

opportunity for the excesses that eventually do deliver downturns. A number of these are

beginning to emerge in the current business cycle, which stretches from a trough in June

2009 according to the Conference Board, so is already more than six-and-a-half years

old. This current business cycle is already a year longer than the post-war business cycle

average, though the last three business cycles were longer, averaging 105 months.

The Fed finally lifted rates in

Dec-15, but what comes

next?

Politics is less of a

distraction in the US than in

the Eurozone, though that is

due to change

The US business cycle is at

least mid-cycle, and possibly

late-cycle…

A downturn seems more

probable than an

acceleration at this point

Crucial EU summit on the

Brexit question in February

Inflation continues to

undershoot…

…but no additional easing for

the time being


4

Fig 3 US Corporate profits stalling

Fig 4 Profit share of GDP

Source: Macrobond, ING Source: Macrobond

As well as the sheer longevity of this cycle, there are a number of warning signs we

should heed before taking the consensus benign growth view at face value. Our first

warning sign is that of corporate profitability. Rising profitability encourages higher

investment, rising employment, higher spending, stronger growth and so on. Falling

profitability does the opposite. Our focus here is not on reported earnings, which we

believe will probably be prone to exaggeration and accountancy “massages”, but to GDP,

that is, tax-based profit figures. Rather than erring on the positive side, we suspect that

these figures will tend to highlight bad news early, to limit tax liabilities.

The news here is not downright bad. But it does suggest that corporate profits are no

longer growing. And at a time when volume growth seems steady, but margins are likely

to be being squeezed by rising wages, this could be an early bellwether that future benign

growth is not all that assured. We have been trimming some of our investment figures this

month in response to this development, but we may have more work to do here.

The next area for possible concern is housing. At this stage, this is not about a price

correction, though that cannot be ruled out. Housing affordability does not seem

particularly stretched yet, thanks to low interest rates. But what does seem to be looking

a bit excessive, is new home construction, with excess unsold inventory now close to

average levels, and that average itself is elevated by pre-crisis excesses, and therefore

represents a figure that is already above what could be considered “sustainable”.

Like the profits figures, these are far from smoking guns. Construction could comfortably

continue at current rates and housing inventories could keep accruing for some time

before we would need to consider this a problem in the making. But the beginnings of

excesses are there, and tell us that we should at the least be cautious. We have trimmed

some of our residential construction figures this month. Again, we may have to do more.

Business inventories are one of the hardest parts of the GDP data to forecast accurately,

but historically, when manufacturing was a more important part of the business cycle,

inventory corrections were the catalyst for benign slowdowns, and re-stocking the cause

of the subsequent recovery. Right now, inventory growth seems high relative to GDP

growth, or to shipments. We think we may be due an inventory correction before too long

too. Whilst likely to be short-lived, these inventory corrections can cause substantial

deviations from the prevailing growth rate whilst the adjustment is made. Although we

think the risks of an inventory correction are growing, we have not yet made a more

substantial change from our existing forecast for some modest decline in the future pace

of inventory-build. We may have to do so before too long.

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Domestic non-financial, lhs, 4Qchange

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Domestic nonfin profits as %GDP

% GDP index

Slowing corporate

profitability is a serious

warning sign…

…though it is not yet a dire

threat

Residential housing is also

due a more moderate phase

of growth…

…though we are far from

bubble territory

Inventories have the power to

flip the economy into a

recession, though likely only

a technical one


5

Fig 5 New Homes supply picking up

Fig 6 Manufacturing inventories high relative to

shipments

Source: Macrobond Source: Macrobond

Another likely source of slower growth is consumer spending. So far, we have made no

further downward revisions to our anticipation for some slowdown in consumer spending

in 2016. The current forecast stems from smaller windfall gains from declining oil and

gasoline prices in 2016 compared with 2015. There is some argument for an offsetting

boost from wages growth, but to this, we have to balance a likely slowdown in

employment growth this year with the unemployment rate already at 5.0%, and bearing in

mind what we said earlier about profit growth. Our expectation for consumer spending

growth closer to 2.5% than 3.5% could still be on the high side. Though it is admittedly

hard at this point to see it falling into recession territory, unless some of the other risks

highlighted above materialise, in which case, this becomes rather likely.

Taken together, these risks do warrant a much more cautious Fed, in line with market

pricing rather than the Fed’s own guidance, with perhaps no more than 50bp of further

tightening this year. We continue to forecast growth of a similar amount to 2016 in 2017,

and a further 50bp of tightening then. But despite the research suggesting the irrelevance

of time as an indicator of looming recessions, our conviction about the 2017 numbers and

forecasts of modest growth beyond then, is on a rapidly diminishing slope.

Rob Carnell, London

UK: Risking it all? The outlook for 2016 looks very much like the start of 2015 did for the UK economy with

home-grown political concerns and external economic risks the main threats to what is a

respectable domestic growth story. Last year it was the ongoing Eurozone crisis and the

UK's own general election. This year it is broader softness in the global economy and the

UK's referendum on ongoing European Union membership.

In terms of domestic economic fundamentals, the combination of weakness in external

demand and sterling's relative strength have clearly hampered the manufacturing sector,

while the plunge in energy prices has exacerbated the decline in investment and output of

the UK's offshore oil and gas industry. Trade has consequently become more of a drag

on growth in recent quarters, but rising real household incomes and strong employment

growth have meant consumer spending has provided a strong base while investment

spending (outside of oil and gas) has held up well and government spending has not

been as much of a drag as we had expected. Indeed, after a very disappointing 0.4%

QoQ growth rate recorded in 3Q15, we look for a decent 0.6% rebound in 4Q15.

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Consumer spending is

unlikely to buck the trend if

other parts of the economy

soften

All of which should keep the

Fed’s approach to policy a

very cautious one

Domestic politics and

external economic risks are

the main threats to growth in

2016

Weakness in manufacturing

and trade have been offset by

strong consumer spending

We expect 0.6% growth in the

fourth quarter


6

Fig 7 Unemployment Rates

Fig 8 CPI and Wage inflation

Source: Bloomberg Source: Macrobond

The start of 2016 also looks encouraging with very strong employment growth (207k in

the three months to October), suggesting that the corporate sector remains upbeat, which

should also translate into ongoing healthy consumer sentiment. Sterling has weakened

and with stronger European activity numbers starting to come through, we are hopeful

that we may see some slightly better manufacturing numbers in the months ahead.

However, Asian-led global growth jitters could derail this prognosis, primarily through a

slowdown in key European partners' growth given the UK's relatively limited direct trade

with the Far East.

Our main worry though is the UK's EU referendum, which we think we will be held this

year rather than in 2017. The UK has already sent a list of demands, which has been met

with a fairly frosty response from EU officials so far. They include efforts to improve

competitiveness, exempting Britain from "ever-closer union" and bolstering national

parliaments, along with protection of the single market for the UK and other non-

Eurozone countries. However, the most contentious issue is the UK wanting to restrict EU

migrants' rights to in-work benefits, which many EU member states have clear

reservations over.

We suspect that a compromise is probable that will give the UK the ability to temporarily

restrict new arrivals – the UK has experienced an influx of more than 1 million Eastern

Europeans in addition to several hundred thousand people from "old EU" member states

since 2001. For example, there are suggestions that Poland's resistance, which has been

very strong, could soften if the UK offers support to defence initiatives. As such we

believe David Cameron will have enough of a "deal" that he believes he can sell to the

electorate and back the "Yes" campaign for the UK remaining in the EU.

At the moment the UK electorate is split 50-50 on whether to stay or to leave, but there

are around 20% of people who are undecided. However, given half of all the UK's foreign

trade is with the EU, which is clearly important for jobs, we suspect that the UK will

narrowly vote for the status quo, helped by the backing of the majority of business

leaders, trades unions and political elder statesmen and women.

Nonetheless, the uncertainty generated by the vote is likely to hurt sentiment and

spending of both households and corporates. As such, we expect an economic "soft

patch" in the 3-6 months leading up to the vote, which we suspect will be held between

late 2Q and early 4Q16.

With consumer price inflation set to remain low in 1H16 given the ongoing softness in

commodity prices and the fact that wage growth hasn't accelerated as quickly as we had

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2007 2008 2009 2010 2011 2012 2013 2014 2015

US UK Eurozone-1

0

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01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

CPI

Average weekly earnings ex bonuses

(YoY%)

Sterling weakness and

stronger Eurozone activity

may boost manufacturing…

… but Asian-led growth

concerns could derail this

prognosis

The main risk is the EU

referendum, likely to be held

in 2016

The UK electorate is

currently fairly split on

whether to stay or leave

Commodity price weakness

will keep a lid on inflation,

giving the BoE room to keep

policy loose

We suspect that a

compromise is probable

Uncertainty leading up to the

vote is likely to hurt

sentiment


7

suspected, the Bank of England has room to leave monetary policy extremely loose until

the economic uncertainty subsides. As such, we believe that the first rate rise will come in

November, but the prospect of a decent "relief" economic bounce-back after the

referendum means a steady rate rise programme through 2017.

James Knightley, London

China – Supply-side structural reform are the new buzzwords The Politburo released a statement at the conclusion of the December Central Economic

Work Conference (CEWC) saying, “Promoting supply-side structural reforms will be

important as it means China can adapt to and guide the ‘new normal’.” It also identified

five economic tasks for 2016: elimination of excess industrial capacity, destocking,

deleveraging, reducing business costs and improving weak links.

The statement says macro policy needs to be more accommodative to “keep economic

growth in a proper range” in the first year of the 13th Five-Year Plan. Tax cuts and a

higher fiscal deficit would make fiscal policy more forceful. Monetary policy needs to be

more flexible to facilitate structural reforms and lower business costs. We revise our

forecast of policy interest rates and now expect a cumulative 50bp of cuts, up from zero,

by mid-year.

Critics who identify industrial restructuring with the prompt closure of excess capacity may

be disappointed by the statement that mergers and acquisitions, rather than bankruptcy

and liquidation, would be the preferred approach to dealing with “zombie companies”.

However, the industrial restructuring debate frequently pits Anglo-Saxon restructuring,

where costs are recognised up front, against Japan-style restructuring, where

concessions and debt relief spread the costs over time. We see the authorities adopting

an in-between approach.

There are valid reasons for the authorities to eschew the Anglo-Saxon approach. For

one, the bankruptcy law is not fully worked out; guiding principles have yet to be

translated into regulations. There are practical difficulties related to the handling of

displaced workers, debt and legacy issues. Finally, in the current economic situation

there is a fear that bankruptcies will create economic instability.

The CEWC also identified reducing excess housing inventories as a major task for 2016.

The government is changing its affordable housing programme toward that end. The

Ministry of Housing and Urban-Rural Development announced in late December that the

government will not build public rental housing in 2016. Instead, it will buy unsold units

from the market for use as public rental housing. The programme is large: 6.9 million

homes were completed in the first 10 months of 2015. To put this figure in perspective,

the inventory of residential floor space was 441 million square metres in November, or

about 7.3 million 60-square-metre homes. Shantytown rebuilding, also part of the

affordable housing policy, could see a similar shift. The government renovated 5.8 million

units of shantytown housing in 2015.

Urbanisation policy, including hukou (residence permit) reform, is also directed at

eliminating excess housing stocks. 55% of Chinese, or 750 million people, live in urban

areas but only 36%, 490 million, have a local hukou. China held an urban city meeting for

the first time in 37 years in December and set as a target raising the share of urban

dwellers with a local hukou to 45% by 2020. This would require issuing roughly 20 million

hukous to migrant workers each year. The effectiveness of hukou reform for eliminating

The Central Economic Work

Conference

More accommodative macro

policy

M&A rather than bankruptcy

for zombie companies…

Reducing housing

inventories…

…including through hukou

reform.

…for good reasons


8

excess supply will vary by area but, in the aggregate, the inventory of residential floor

space would be cleared if 6% of the new urban hukou recipients bought a home.

Financial markets were roiled in the first week of 2016 by large daily depreciations of the

CNY fixing rate. As occurred following last year’s ‘811’ devaluation, investors worried that

the PBOC was depreciating the CNY for policy purposes. We blame such fears for

widening the USDCNH premium to spot USDCNY to a record 2.14% on Wednesday

(Figure 9).

We believe moves in the CNY fixing rate should be interpreted through what they imply

for the CNY NEER, which was released by the China Foreign Exchange Trade System in

mid-December. The CNY NEER bounced following the 811 devaluation and by the end of

October had appreciated nearly 4% (Figure 10). The PBOC began depreciating the fixing

rate in November and by the first week of January it was back at its post-811 low.

When the PBOC says it is capable of keeping the yuan “basically stable at a reasonable

equilibrium level” we think it is referring to the CNY NEER. We also believe the post-811

index level is salient. We do not believe policy aims to reverse the 2014 CNY NEER

appreciation, which, other things constant, would mean a 10% CNY depreciation against

the USD. We expect the PBOC to intervene in USDCNY to support the CNY NEER.

Thereafter, a basket peg exchange rate system implies that when the USD appreciates

against major currencies it will tend to appreciate against the CNY. ING sees 2016 as a

year of two halves for the USD/Majors, appreciating in the first half and depreciating in

the second. We now forecast USDCNY rising to 6.72 by mid-2016 then retracing to 6.60

by year-end.

Fig 9 China: USDCNH premium to spot USDCNY (%)

Fig 10 China: CNY NEER (31 Dec 2014 = 100)*

Source: Bloomberg, ING Bank *Calculated using the CFETS basket of 13 currencies and 2015 trade weights.

Source: Bloomberg, ING Bank

Tim Condon, Singapore

Japan: A year of two halves

For Japan, 2016 will be a year characterised by the Upper House election due to take

place in July. Judging by recent comments, amending the country’s pacifist constitution is

one of Prime Minister Abe’s top priorities. If he is to succeed in doing so, the law requires

the ruling coalition to hold at least two-thirds of each house. Although his party, the LDP,

and his coalition partner Komeito currently hold such a majority in the lower house, they

will need to secure 29 additional seats out of a possible 121 up for election this year

(Figure 11), or 70% of the vote. To help generate the necessary support, PM Abe has

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811

The Upper House election

will be the major theme this

year

PM Abe needs a large victory

to secure enough seats to

stage a referendum on the

constitution

CNY jitters

Revised USDCNY forecast

The CNY NEER


9

announced additional spending for election-sensitive areas such as industries affected by

TPP and low-income pensioners (who have been particularly affected by high food price

inflation). Moreover, he recently announced that all food will be exempt from the

consumption tax hike due to take place in April 2017.

This all has important implications for the Bank of Japan. Prior to the election at least,

politicians will remain wary about triggering further Yen weakness to avoid hurting

consumers and also to discourage foreign firms from taking over domestic companies at

a relatively cheap cost. It is also widely anticipated that PM Abe will formally announce

the end of deflation in Japan ahead of the election, and indeed stated only this week that

the country is “just one step” away. It is therefore likely that the BoJ will take a back seat

until the election and we do not any significant change in stance before then.

Fig 11 Upper House: Breakdown by political party

Fig 12 Tax hike: Evidence from 2014 retail sales

* 29 additional seats needed for coalition to hold two-thirds of seats

Source: The National Diet of Japan

Source: Macrobond

Later in the year though, the environment will become more challenging for the BoJ. At its

most recent meeting, technical adjustments were made to QQE which are designed to

extend the lifetime of the policy beyond 2016. However, it is likely that concerns

surrounding the longevity of QQE will resurface again later this year, at which point the

BoJ will have to start seriously considering tapering purchases.

This will come at a difficult time, with the consumption tax hike in April 2017 set to be a

significant headwind for the economy. Despite the exclusion of food, evidence from 2014

suggests the front-loading effect is more apparent for durable items (Figure 12). Thus, we

expect to again see a large degree of frontloading in the first quarter, with ensuing

weakness afterwards, albeit to a lesser extent than in 2014. More crucially though, we

believe inflation is unlikely to reach the 2% target, even if oil rebounds significantly. With

this in mind, balancing a need to keep monetary conditions accommodative whilst

introducing tapering will ultimately be a tricky manoeuvre.

James Smith, London

48

65

9

11

41

17

23

28

0% 20% 40% 60% 80% 100%

LDP Kōmeitō DPJ Other Opposition

Mandate Expires in 2019

50%

Mandate Expires in 2016 29 Additional seats needed*

-40% -30% -20% -10% 0% 10% 20% 30%

Motor Vehicles

Food & Beverages

Fuel

Fabrics, Apparel& Accessories

Others

General Merchandise

Machinery & Equipment

April 2014 (Post)

March 2014 (Pre)

MoM% Change

Data seasonally adjusted by ING

Despite recent adjustments,

concerns about the long-term

feasibility of QQE will likely

resurface

The consumption tax hike

and below-target inflation will

make tapering difficult

The BoJ is unlikely to change

its stance prior to the

election


10

FX: Policy preferences & politics

The New Year starts with some familiar themes in FX markets; namely the extent of the

Chinese slowdown, its implications for PBOC FX policy and the continued rout in the

commodity sector. Those currencies most exposed to these themes have under-

performed – and look likely to continuing doing so through the first half of the year. Once

again we highlight FX exposure to these key themes through our FX Macro Vulnerability

Scorecard below.

When it comes to the FX Majors, we note that EUR/USD has not suffered the kind of

short squeeze witnessed last August (to 1.16) when China was reforming its daily fixings

and the CNY was weakening sharply. Positioning cannot be blamed. Currently

speculators have larger short EUR positions today than they did back in August.

Instead we think the relatively subdued reaction of EUR/USD owes to the fact that the

Fed, after all, did tighten in December and down-played Chinese concerns. By tightening

the Fed has positioned itself as one of the very few central banks in the developed world

that is prepared to accept a stronger currency. With another Fed hike expected in 1H16 –

and the ECB more likely to cut than raise its inflation forecasts – we continue to see a six-

month window where EUR/USD can trade as low as 0.98.

Fig 13 ING FX Macro Vulnerability Scorecard

Source: ING

One area of surprise this year is the performance of GBP. We had expected a Brexit-

related risk premium to be built into GBP around the timing of the referendum – most

likely in the summer. In fact that risk premium is already emerging in GBP – which is now

trading some 2% weaker than financial fair value models suggest.

However that 2% risk premium looks unlikely to narrow until greater clarity emerges at the

European Council meeting of 18/19 February. Should PM Cameron not be able to secure

concessions, particularly on the in-work benefits for EU migrants, opinion polls could shift

cleanly towards an EU exit and easily knock another 2-3% off GBP.

Currently EUR/GBP is trading at the upper end of a 0.70 to 0.75 trading range and a top-

side break could easily catch investors and ourselves off-guard.

Chris Turner, London

-5

-4

-3

-2

-1

0

1

2

3

4

5

BRL COP ZAR KRW AUD MYR NZD CLP MXN RUB TWD SGD CAD NOK TRY IDR INR PHP THB SEK GBP JPY PLN HUF EUR CHF CZK

Sensitivity to Risk

Sensitivity to Oil Prices

China Trade Share

Sensitivity to Fed rate hike

ING Macro Vulnerability Score

ING FX Macro Vulnerability Scorecard

Higher value indicates greater relative sensitivity to short-term macro risks (ie, China weakness and a risk-off inducing Fed tightening cycle)

EUR/USD has not suffered

the kind of short squeeze

witnessed last August

One area of surprise this

year is the performance of

GBP

That 2% Brexit risk premium

looks unlikely to narrow until

greater clarity emerges at the

European Council meeting of

18/19 February


11

Rates: Long end comfort helped

by 5yr richening

The drift lower in core rates since the beginning of the year has more to do with growth

uncertainty in emerging markets than coincident macro circumstances in the US and

Eurozone. Uncertainty on the prognosis for China is front and centre as a driver, but

vulnerabilities can be identified in many other emerging markets such as Brazil, Russia,

Turkey and South Africa, while Asia is being caught between the dual negatives of a

China outflow theme and the risk for higher funding rates via Fed policy. As a

consequence of this a flight into core product has been the parallel theme to the risk-off

mood that has dominated through the early days of 2016.

So what does this mean for rates and curves? The obvious impact effect has been lower

yields right along both the Treasury curve and most Eurozone curves and close

derivatives (eg, Euro denominated high rated names across Central Europe). The curve

effect has largely been biased towards flattening (2/10yr segment), which correlates with

a lower risk for a medium-term inflation build, as back end rates have fallen by more than

front end rates. It is tough for front end rates to go anywhere too fast though, as front end

US is being bullied by a rate hike ambition while front end Eurozone is either in deep

negative territory or at exceptional lows for lower rated (but investment grade) product.

One measure that we like to look at is the positioning of the 5yr on the curve, as

summarised on the 2/5/10yr fly (which we calculate as short the wings and long the

belly). A cheap 5yr valuation (ie, pick-up versus the wings) typically correlates with a

bearish prognosis for rates. We find this is in play on the US curve (Figure 14), as the

curve structure is consistent with a rate hike outlook. That said, it is the movement in the

fly that is interesting, as the past week has seen the 5yr become less cheap to the curve

(in gross terms the fly has moved from 22bp to 10bp). The 5yr is still cheap, but not as

cheap as it was, and this correlates with a discount for less rate hikes going forward.

Fig 14 US Treasury long belly on 2/5/10yr fly

Fig 15 Bund long belly on 2/5/10yr fly

Source: ING Estimates, Bloomberg Source: ING Estimates, Bloomberg

On the Eurozone curve something similar is in play (Figure 15). The important nuance

here is the 5yr trades exceptionally rich to the curve (pick-up into the wings), which fits

with the view that pressure remains for a further easing in rates. QE has had an impact

here too, as it has manufactured a very flat 2/5yr segment as players are forced out of the

ultra-front end along the 2/5yr segment in order to achieve a positive yield. In the past

week the 5yr has richened further, and this is a reflection of the wider pressures in play

0

5

10

15

20

25

30

35

40

45

50

Ja

n 1

5

Mar

15

May 1

5

Ju

l 15

Sep

15

No

v 1

5

Ja

n 1

6

bp%

5yr More Cheap

5yr Less Cheap-50

-45

-40

-35

-30

-25

-20

-15

-10

-5

0

Ja

n 1

5

Mar

15

May 1

5

Ju

l 15

Sep

15

No

v 1

5

Ja

n 1

6

bp

5yr Less Rich

5yr More Rich

The 5yr is rich on the

Eurozone curve, and has

become even richer of late

We also find that the 5yr has

richened on the curve…

although note that the 5yr

remains cheap to the curve in

the US on rate hikes

Core yield curve have shifted

down and flatter as a

consequence

The main driver at the

moment is uncertainty, with

China creating the

convenient catalyst towards

risk-off


12

and associated flows into core product (in gross terms the Bund fly has moved from

-35bp to -42bp).

What does all this mean? The moves in the 2/5/10yr fly are often independent of the level

/ change of rates or the curve and so provides an independent insight to bond market

sentiment towards rates in the future. So far the message is that the rate hike risk in the

US is being pared back and the risk for further easing in the Eurozone is rising. That said,

the moves are not yet at a magnitude that would suggest a radical change in sentiment.

The US curve is still quite steep, and thus continues to discount an uplift in front end rates

in the forwards, and by implication multi-hikes from the Fed. Also, we have not moved out

of prior trading ranges for the fly (Figure 14 and Figure 15).

The one trend that remains in place is 2/10yr curve flattening (the 10/30yr curve has in

fact been steepening). The nuance in recent days is that it is flattening from the 10yr

(2/10yr). If there were to be a significant shock and large-scale risk-off we would expect

the flattening process to continue. Against this backdrop we remain comfortable on the

ultra-long end of the US curve as we see rates capped at 3%. The back end of Eurozone

curve also offers a relative safe haven with positive total return optionality. There is no

change to our structural view here, which centres on medium-term US rate hikes and

uplifts in headline inflation, but the tactical view has become more comfortable on getting

long carry, not in the classic sense though as it is carry into the 30yr for returns.

Padhraic Garvey

The richer 5yr is consistent

with a lower rate hike

expectation in the US…

… but trading ranges have

not been breached as of yet

We remain comfortable in

flatteners, and we like 30yr

exposures, especially in the

US where we see rates

capped at 3%


13

Fig 16 ING global forecasts

2014 2015F 2016F 2017F

1Q 2Q 3Q 4Q FY 1Q 2Q 3Q 4Q FY 1Q 2Q 3Q 4Q FY 1Q 2Q 3Q 4Q FY

United States

GDP (% QoQ, ann) -2.1 4.6 5.0 2.2 2.4 0.6 3.9 2.1 2.7 2.5 2.1 2.5 2.3 1.9 2.4 2.4 2.4 2.1 2.2 2.3

CPI headline (% YoY) 1.4 2.1 1.8 1.1 1.8 -0.1 0.0 0.1 0.5 0.2 1.6 1.5 1.6 1.8 1.7 2.2 2.2 2.2 2.2 2.2

Federal funds (%, eop)1 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.25 0.25 0.50 0.50 0.75 0.75 1.00 1.00 1.25

Fed monthly average asset

purchase total

65.0 45.0 25.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

3-month interest rate (%, eop) 0.30 0.20 0.20 0.20 0.27 0.28 0.33 0.61 0.60 0.80 0.85 1.05 1.10 1.30 1.35 1.55

10-year interest rate (%, eop) 2.71 2.53 2.49 2.17 1.90 2.35 2.03 2.27 2.30 2.50 2.50 2.60 2.60 2.70 2.70 2.80

Fiscal balance (% of GDP) Fiscal Year 2014/15 -2.8 Fiscal Year 2015/16 -2.7 Fiscal Year 2016/7 -2.4 Fiscal Year 2017/18 -2.3

Fiscal thrust (% of GDP) 0.0 0.2 0.2 0.0

Debt held by public (% of GDP) 74.1 74.2 73.8 73.2

Gross public debt/GDP (%) 102.4 102.6 102.2 101.8

Eurozone

GDP (% QoQ, ann) 0.9 0.2 1.2 1.5 0.9 2.2 1.6 1.2 1.4 1.5 1.6 1.7 1.7 1.8 1.6 1.7 1.8 1.8 1.9 1.8

CPI headline (% YoY) 0.7 0.6 0.4 0.2 0.5 -0.3 0.2 0.1 0.2 0.1 0.4 0.2 0.5 0.8 0.5 1.3 1.7 1.8 1.9 1.5

Refi minimum bid rate (%, eop) 0.25 0.15 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05

3-month interest rate (%, eop) 0.28 0.21 0.08 0.08 0.02 -0.01 -0.04 -0.14 -0.17 -0.18 -0.18 -0.17 -0.13 -0.10 -0.05 -0.01



Fiscal thrust (% of GDP) -0.2 0.1 0.2 0.1


Japan

GDP (% QoQ, ann) 4.5 -7.6 -1.1 1.3 -0.1 4.4 -0.5 1.0 0.7 0.7 0.8 1.4 1.4 1.9 1.0 4.7 -6.1 -0.4 1.3 0.6

CPI headline (% YoY)2 1.6 3.6 3.3 2.7 2.7 2.3 0.5 0.2 0.2 0.8 0.3 0.2 0.7 1.2 0.6 1.5 2.5 2.4 2.3 2.2

BoJ o/n call rate (%, eop) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

BoJ asset purchase total 213 227 249 270 290 310 330 350 370 390 410 430 450 470 485 500




Fiscal thrust (% of GDP) 0.4 -0.8 0.0 0.0


China

GDP (% YoY) 7.4 7.5 7.3 7.3 7.4 7.0 7.0 6.9 6.9 7.0 6.7 6.6 6.5 6.3 6.5 6.7 6.6 6.4 6.4 6.5

CPI headline (% YoY) 2.3 2.2 2.0 1.5 2.0 1.2 1.4 1.7 1.5 1.5 1.5 1.4 1.6 1.5 1.5 1.5 1.3 1.4 1.7 1.5

PBOC 1yr deposit rate (% eop) 3.00 3.00 3.00 2.75 2.50 2.00 1.75 1.50 1.25 1.00 1.00 1.00 1.00 1.00 1.00 1.00

PBOC 1yr best lending rate (% eop) 6.00 6.00 6.00 5.60 5.35 4.85 4.60 4.35 4.10 3.85 3.85 3.85 3.85 3.85 3.85 3.85

7-day repo rate (% eop) 4.19 4.07 2.91 5.07 3.80 3.30 2.39 2.49 2.25 2.00 2.00 2.00 2.00 2.00 2.00 2.00

10-year T-bond yield (%, eop) 4.54 4.09 4.07 3.62 3.60 3.62 3.27 2.86 2.75 2.50 2.50 2.50 3.30 3.40 3.50 3.60

Fiscal balance (% of GDP) Fiscal Year 2014/15 -2.0 Fiscal Year 2015/16 -3.5 Fiscal Year 2016/17 -3.2 -3.0

Fiscal thrust (% of GDP) n/a n/a n/a n/a

Public debt (% GDP), incl. local

govt.

56.6 60.2 60.0 60.0

UK

GDP (% QoQ, ann) 3.6 3.4 2.5 2.5 2.9 1.5 2.2 1.8 2.7 2.2 2.9 2.4 1.6 3.0 2.4 3.0 2.6 2.9 2.7 2.7

CPI headline (% YoY) 1.7 1.7 1.5 0.9 1.5 0.1 0.0 0.0 0.0 0.0 0.7 1.0 1.4 2.3 1.4 2.8 3.1 3.2 2.9 3.0

BoE official bank rate (%, eop) 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.75 1.00 1.25 1.50 1.75

BoE Quantitative Easing (£bn) 375 375 375 375 375 375 375 375 375 375 375 375 375 375 375 375




Fiscal thrust (% of GDP) -0.9 -0.9 -1.5 -0.7


EUR/USD (eop) 1.38 1.36 1.26 1.21 1.05 1.10 1.12 1.09 1.02 0.98 1.05 1.10 1.12 1.15 1.18 1.20

USD/JPY (eop) 103 102 109 120 120 123 120 120 121 123 123 120 118 117 116 115

USD/CNY (eop) 6.21 6.20 6.14 6.21 6.20 6.20 6.36 6.52 6.67 6.72 6.66 6.60 6.57 6.55 6.53 6.50

EUR/GBP (eop) 0.83 0.80 0.78 0.78 0.71 0.71 0.74 0.74 0.72 0.74 0.76 0.76 0.76 0.77 0.78 0.80

Oil (US$/bbl, pa) 108 110 103 77 55 64 51 45 35 40 50 55 60 60 65 65

1Lower level of 25bp range

2Includes effect of April 2014 and 2017 consumption tax increases

Source: ING forecasts


14

Disclosures Appendix This publication has been prepared by ING (being the commercial banking business of ING Bank N.V. and certain subsidiary

companies) solely for information purposes. It is not investment advice or an offer or solicitation to purchase or sell any

financial instrument. Reasonable care has been taken to ensure that this publication is not untrue or misleading when

published, but ING does not represent that it is accurate or complete. The information contained herein is subject to change

without notice. ING does not accept any liability for any direct, indirect or consequential loss arising from any use of this

publication. This publication is not intended as advice as to the appropriateness, or not, of taking any particular action. The

distribution of this publication may be restricted by law or regulation in different jurisdictions and persons into whose

possession this publication comes should inform themselves about, and observe, such restrictions. Copyright and database

rights protection exists in this publication. All rights are reserved. ING Bank N.V. is incorporated with limited liability in the

Netherlands and is authorised by the Dutch Central Bank.

8 january 2016 monthly economic update · monthly economic update january 2016 3 the negotiations...

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