The US economy has seen many “false starts” and the recovery remains low and frustrating. In order for the Fed to begin withdrawing monetary stimulus, it will need to see that the recovery is sustainable and that fiscal policy does not restrain it, says Simon Smith of FxPro.
In the interview below, Smith also discusses the timing of a negative deposit rate in the euro-zone, the chances of an EU exit by the UK and other topics moving currencies. Enjoy!
Simon has over seventeen years experience of macro forecasting and investment strategy research. Prior to joining FxPro in May 2010, Simon was a consultant with Thomson Reuters, having spent four years as Chief Economist at Weavering Capital. He has held economic and strategy positions with Standard & Poor’s, together with consultancy firms 4Cast and MMS International. Simon holds an MSc. in Economics from the University of London and a BSc. from Brunel University.
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Some renewed positive signs gave the impression that the Fed could begin winding down its QE programs. What does the Fed need to see in order to change course?
They need to see a combination of factors. The simple balance is between withdrawing stimulus too early and quickly so that bond markets (and other asset classes) take fright and keeping it in place too long, which risks stoking inflation and creates a longer and more difficult exit path, together with associated asset market bubbles. In practise, achieving this balance is far from simple, not least because it’s in part dependent on market sentiment and perceptions. These can change quickly and aggressively. The 1994 episode (when yields jumped 200bp on 10 year bonds within a year, nearly 400bp on 2 year bonds) is etched on the Fed’s distant memory. This is why they have talked for a long time about the exit strategy, what it is dependent upon and how it might be achieved. We know the broad parameters from recent Fed statements (unemployment rate of 6.5%, inflation projections close to target and inflation expectations well anchored). These remain the necessary conditions to keep stimulus in place, but beyond these, the Fed needs to be convinced that the recovery is sustainable and that fiscal policy is not going to restrain it and cause a reversal from the Fed. The past few years have had enough false starts and wrong steers from policy-makers. This time they need to be sure.
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The US recently reported higher tax revenue, and this could defer the debt ceiling issues. Is higher tax revenue a positive development, or does the delay of dealing with long term debt due to weigh on the dollar?
The primary issue is with spending and particular spending on entitlements. This is the time-bomb of which we can be fairly certain given current commitments and population demographics. Revenues can be pretty volatile month to month. I don’t think the debt issue is set to weigh on the dollar anytime soon. More important for the dollar will be the relative cyclical position of the US economy to its peers on the majors. Whilst budget issues are restraining the economy, they are doing so at a slower pace than initially feared.
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Do you see the ECB announcing a negative deposit rate in June? Would the euro suffer badly from such a move?
I think June is unlikely, more likely is July, possibly August. For now, the ECB has received some benefit (via a lower euro) from the more positive language towards the possibility of a negative deposit rate. In the meantime, the amount being deposited by banks overnight at the ECB (and currently being remunerated at zero percent) has been gradually falling. If this continues, then the ECB can introduce a negative deposit facility more as a carrot, rather than a stick. In other words, it’s not there to discourage banks that are already depositing there, more to incentivise those that are not doing so to continue to steer clear of it. The negative impact of such a move on the currency also diminishes if introduced in the middle of the year, because less well capitalised banks will be discouraged from keeping funds in the Eurozone.
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There are stronger voices in the UK support an EU-exit. Is there a real chance that this will happen or could this be seen as part of the negotiations with other EU countries?
In answering this, it’s not always easy to split the politics from the economics and I’m always keen to do so as much as possible (because no-one cares about my political views). The arrangements the EU has for dealing with those in the single currency and those that are not are pretty informal and sometimes not clear. So from a pratical viewpoint, it’s natural that the UK wants more clarity on the boundaries and if they are joined by others (Sweden, possibly Denmark) then they will have a stronger hand to play with. The current coalition government has stated that it will put a re-negotiated relationship with the EU that will be put up for a referendum, but only in the next parliament (which means most likely beyond 2015). I think the chances of leaving are fairly low in this scenario, provided that the re-negotiated deal assuages the concerns of the electorate.
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Japanese yields have risen despite the BOJ’s pledge to massive buying. What could be behind this? Can it have a negative effect on USD/JPY?
For now, the market is buying the reflation story. Market pricing of inflation on the 5 year horizon (breakeven inflation rates) have doubled since the start of the year, a near 1% increase in expected average inflation. Compare this to the US, where the same measure is marginally lower over the same period. Japanese companies have already seen a benefit from the weaker currency and there is already anecdotal evidence of wage increases in some areas. I would not see a negative effect on USD/JPY because we are so far away from contemplating an exit strategy from the BoJ.
Further reading: a previous interview with Smith: Gold prices can face another shake out
You can follow Smith on Twitter: @simonsmithy