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Equilibrium, Terminal, and the Dollar Cycle Turning Point - Global Exchanges

FICC Podcasts Podcasts September 13, 2022
FICC Podcasts Podcasts September 13, 2022

 

In this week's episode, we discuss potential terminal rates for this cycle for G10 central banks and how they may differ from long-run equilibrium rates and what they may mean for foreign exchange. We also explore how the euro might react to a sudden peace in the Ukraine War.


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

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Greg Anderson:
Hi, welcome to episode 51 of Global Exchanges, a podcast about foreign exchange markets and related issues. In this week's episode, my cohost Stephen Gallo and I discuss potential terminal rates for this cycle for G10 central banks and how they may differ from long run equilibrium rates and what that may mean for foreign exchange. We also explore how the Euro might react to a sudden piece in the Ukraine war. The title of this episode is equilibrium, terminal and the dollar cycle turning point.

Stephen Gallo:
Hi, I'm Stephen Gallo, a London based FX strategist. Welcome to Global Exchanges, presented by BMO Capital Markets.

Greg Anderson:
Hi, I'm Greg Anderson, a New York based FX strategist. I'm Stephen's co-host.

Stephen Gallo:
In each weekly podcast like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets like commodities.

Greg Anderson:
We strive to make this show as interactive as possible. So don't hesitate to reach out by going to bmocm.com/globalexchanges. Thanks for joining us.

Stephen Gallo:
Okay. It's the 13th of September 2022. Thanks for tuning into this week's Global Exchanges episode. For background, I think Greg let's start as we often do by looking at the current position of the broad dollar, where we usually do that in BBDXY terms. Up 3.6% in Q3, which has about two weeks left in it. So, I guess, unless something dramatic happens here in the next couple of weeks, we're probably going to lock in another quarterly gain for the dollar as we head into the final stretch of the year.

Stephen Gallo:
Before I hand over to you, Greg, for the first question, I just want to point out the fact that if the BBDXY closes at or around its current level 1,305 in change, we will have a solid bullish engulfing candle on the daily chart. And it's important to point out that we can blame that on a much hotter than expected core CPI inflation print for the month of August from the United States.

Stephen Gallo:
I do need to point out though that our economics team were basically bang on the money with their above consensus call for the month over month. And definitely the result shocked the market. It didn't shock BMO economics. But that leads me to my first couple of questions for you, Greg, how much of this dollar rally do you think is just a squeeze, opportunistic shorts getting squeezed out, and how much of it is related to the market, the rates market and the FX market, now coming to terms with the fact that the Fed's terminal rate could well be higher than previously anticipated?

Greg Anderson:
Stephen, it's funny that you mention a squeeze, because normally when an asset price has been trending higher for 15 months, like the US dollar has, the market is long, and the only squeeze that you can get is a move lower. But the stylized facts of this US dollar rally is that leverage funds took profit and quit positioning for more upside in the dollar several months ago. So now they've got the FOMO, so to speak. And in some cases we may have money managers with models that told them to be long the US dollar to participate in this up trend, but they overrode their models because they thought the dollar was top. And now they're underperforming those models so badly that they may get squeezed into buying the dollar here. I think that, that is probably part of today's story.

Greg Anderson:
The other half of today's story is the dramatic rise in expectations for next week's Fed rate hike and for next year's Fed terminal rate. We now have about 80 basis points worth of rate hikes priced into the Fed funds future curve and presumably the greenback. We also now have a peak rate of 4.29% in the curve for the March 22nd FOMC. We basically added 25 basis points onto the March FOMC as a result of today's CPI print. The Fed fund's futures curve sloped downward a bit after March 22nd. But if we can believe FOMC speakers who have talked about this ad nauseam over the last six to eight weeks, they say they're going to reach the terminal rate and hold it. I don't think it's crazy for the market to assume that today's CPI print just lifted the Fed's terminal rate by 25 basis points.

Stephen Gallo:
Right, Greg, that makes perfect sense. To be honest, the shock in FX markets today and also at the very front end was palpable given the data surprise. So with that out of the way, can you elaborate on the difference between the terminal rate for the Fed and what we often refer to as the equilibrium or natural rate of interest for the US economy, since you're the economist in the room, Greg? And just for the record, I'm talking here about the Fed funds rate in nominal terms. But correct me if I'm wrong, Greg, it's ultimately or usually the real Fed funds rate, which is usually defined long run equilibrium, right?

Greg Anderson:
So, Stephen, the Fed communicates "longer run projection" in its dot plot. And that figure doesn't tend to change much, although it did rise by 10 basis points in June from what was communicated in March. For June, the longer run was 2.50% nominal. And I'll point out that Fed uses this term longer run, I think because of criticisms of the whole idea of equilibrium. Equilibrium, I would argue, it mostly exists in the laboratory of economists' heads. But the real world economy rarely if ever, gets to equilibrium because it is so beset by shocks that take it from one extreme to another.

Greg Anderson:
So at any rate, the Fed had longer run "equilibrium" inflation at 2.0%. So you put it together, nominal rate 2.50, inflation, 2.0. The Fed is basically saying that it thinks that their longer run equilibrium real interest rate is about 50 basis points.

Greg Anderson:
So the other thing I'll point out from the June dots, and yes, we'll get a new set next week and it will almost surely show higher interest rates across the board, except for possibly this longer run dot. But at any rate, the June dots showed an end of 2023 nominal Fed funds rate of 3.8%. So basically, the FOMC was trying to communicate at that point that it intended to hike to a rate well above the "longer run equilibrium."

Greg Anderson:
In sense issuing those dots, the FOMC has tried to clean up its communication with all the speakers implying that the FOMC won't cut in 2023. So in other words, they want the market to pricing them holding their so-called terminal rate for an extended period of time. And I believe they're probably overselling that point, because they don't want the two year yield to invert to the overnight rate at this juncture. At least not now with inflation so hot. It would be way too soon for that. And moreover, that particular inversion might cause problems for some financial institutions.

Stephen Gallo:
So, Greg, do you think a four handle on the terminal rate for the Fed is appropriate or has the market priced it too far?

Greg Anderson:
Based on today's CPI number, I do think that a four is reasonable. Today, we've got the peak at 4.29%, as I mentioned. I'm more inclined to believe that the Fed would probably stop with a target corridor of 4.00 to 4.25. And so with the overnight rate in the middle of the quarter, that would put it at about 4.10 at the terminal rate.

Greg Anderson:
So I think maybe that 4.29 is a little bit rich, but I agree with the market that a four handle now sounds right. And it now appears that probably a majority of FOMC participants are likely to want a four handle on the terminal rate.

Greg Anderson:
So with that, I'm getting sick of the hot seat. So let me turn the table on you, Stephen. It's not just the Fed that is coming to grips with four handle for its terminal rate. Where is the OAS curve for the Bank of England's terminal rate? And do you think that is appropriate?

Stephen Gallo:
Firstly, Greg, the short answer to the more academic question is that I don't know where the long run equilibrium rate for the UK is. During the era of low inflation, I came across estimates for that rate, which were as low as -6%, if you can believe that, to estimates that were as high as +2.5% in real terms. But let's ignore the real rate and expected inflation for a moment and just concentrate on the nominal rate and current inflation, because those are the terms most of us think in.

Stephen Gallo:
I think with inflation in the UK likely to peak, close to 15% in this cycle, the BOE could probably easily argue that a four to 4.5% terminal rate, which is roughly what the OAS curve has priced in, would be restrictive. And if we go back to the theoretical real rate for a moment, the current UK five year break even rate is around 3.5%. So that adds some credibility to the view that a four handle would be a restrictive level for bank rate given where medium term market based inflation expectations are.

Stephen Gallo:
I would just point out two additional things, Greg. One is the debt issue, and one is a balance of payments issue. Even if the BOE pauses its hiking cycle with rates only mildly restrictive, the fact that domestic debt ratios for various sectors of the economy are where they are today does not mean a restrictive rate must cause the pound to appreciate sustainably, especially if the UK is undergoing a hard economic landing.

Stephen Gallo:
The one balance of payments angle I have is current account deficits, the size of the one the UK is currently shouldering, they may be more difficult to cover in this environment without a high interest rate profile. So that makes me think a higher terminal rate is appropriate. The question is what happens along the way as we try to get there.

Greg Anderson:
Stephen, I think your point about what happens along the way is a critical one, because with inflation so high in this cycle is a terminal rate's got probably very little to do with long run equilibrium. It's got a lot more to do with the point that central banks get to before they break things and have to stop hiking.

Greg Anderson:
So with that, let me read off what the Warp function in Bloomberg says about terminal rates in a few currencies. For the Fed in the US dollar, the peak of next year's OAS curve is presently at 4.29%, as previously mentioned. For the Bank of England and the pound, it's 4.42%, so half a hike higher. For the Eurozone and the ECB, it's 2.49%. For Australia and the RBA, it's 3.58%. And then lastly, for Canada and the Bank of Canada, it's 4.13%.

Greg Anderson:
So just to summarize, we've got four handles on the terminal rate for the dollar, for the pound and for the loony. And we got a three handle on the terminal rate for Aussie and a two handle on the terminal rate for Euro. Does this make sense?

Stephen Gallo:
Greg, for the Euro area, I assume with the degree of economic slack still apparent in parts of the periphery, the disparity in wage growth between parts of the north and parts of the south so far, and because of financial fragmentation risk, I suppose a two handle for the ECB's base rate makes sense. But, Greg, we just got to remember and remind listeners that we're talking about a currency union here without a fiscal or a political union. So who really knows? We do know based on past experience and evidence, which is important, that a one size fits all monetary policy for the Euro area hasn't really led to optimal results for the block. So really who knows?

Stephen Gallo:
For Sterling, Greg, I'm not sure a four handle will be a pleasant ride. For the currency or the UK economy, a four handle may be appropriate from the perspective of inflation and my balance of payments argument, which we touched on earlier, but that doesn't mean the UK economy can withstand a four handle. And you can probably see where I'm going here with this with my Sterling view. There haven't been many changes in that regard, but I'll park that issue for now.

Greg Anderson:
So for my currencies, I think it's appropriate that the Bank of Canada's terminal rate is on a four handle alongside the Fed's. I do think that in long run "equilibrium," Canada should probably have an overnight rate that is 25 to 50 basis points lower than the US'. And that's due to Canada's higher savings rate. But since equilibrium is mostly just a construct in economy's TEDs where the terminal rate is how far the central bank can get to without breaking things. I think the BOC and the Fed are about on equal footing in that regard.

Greg Anderson:
I also think the RBA could get to a four handle without breaking the Australian economy. But with as dovish as RBA governor, Lowe, has been throughout his tenure, I think the market is right to assume that he will stop with a terminal rate below the Fed's and probably on a three handle.

Stephen Gallo:
Greg, just switching gears for a moment and going back to my bear stance on Sterling, something I wanted to fit in here. I think it's interesting, if you'll pardon the pun, that some swap rate differentials, interest rate differentials, they've been moving in favor of cable in recent weeks, but the pound has continued to sag. So I can see this when I look at the two year sector, for instance, that rate differential went from -50 mid August against the pound to +25 about a week ago, while cable was in the midst of a fairly intense downdraft.

Stephen Gallo:
So I'm standing by my point for the time being that structural factors like the impact of the war in Ukraine, the balance of payments, fiscal risks and interest rate risks are causing the pound to diverge a bit from where UK relative rates are trading. And it's not like the UK and the US have vastly different terminal rate expectations in the market anyway, but yet you're still seeing some relative UK rates rising. And so I think we need to see a lot of those structural negatives turn to positives before we can truly say that the bottom in the pound Sterling is in for this cycle.

Greg Anderson:
So I gather you don't really think the bottom is in for the pound. I guess it looks to me like maybe there are more signs of a bottoming pattern in Euro dollar, but maybe I'm imagining things.

Greg Anderson:
I guess, where I wanted to go next, Stephen, we've had a lot of Ukraine war news over the past week that raises the prospect of an early end to that conflict. So here's my question. Suppose Russia were to pull its troop out of Ukraine over the next month, how high would Euro dollar bounce? 105, 110? And what probability would you attach to such a scenario?

Stephen Gallo:
Greg, I'm not 100% sure about cable or Euro dollar. I believe my tilt on the negative prospects for the UK economy are correct. And I would lean towards the bottom not being in just yet, but my conviction is moderate. It's not huge. And also let's not forget that developments in both currency pairs are going to be heavily dependent on what this winter brings in terms of weather, which is a complete wild card. I'm willing to bet you most meteorologists would've not predicted that we would've had a very inactive Atlantic hurricane season this year, but that's what we've gotten so far. So it's a wild card.

Stephen Gallo:
As for your questions on Ukraine, look, my view is that we will have reached a major pivot if Russia declares that it's intended objectives have been met and engages in a full withdrawal of its troops. If that happens and Russia pulls troops out over the next month, I would say immediately 105 in Euro dollar. And I'd give that scenario currently a probability of maybe 20 to 25%. Whereas it was perhaps in the 10 to 15% range, maybe even a bit lower, a week or so ago.

Stephen Gallo:
But then you mentioned 110. I think the path to 110 in Euro dollar will be a lot tougher. And I think why, a lot of the constraints on raw material supplies, input costs, issues, the costly renewables transition, all those issues are still going to be there. And I can't foresee Russian sanctions being dropped or its foreign exchange reserves unfrozen quickly or at all, as long as Putin remains in power.

Stephen Gallo:
Now, let me pin you down on the dollar, Greg, given what you asked me about cable and Euro dollar, are you ready to call a top in the big dollar yet?

Greg Anderson:
According to the Fed's broad real dollar index, dollar is at a high since 1986. So it's gone a bit further than I would've thought at the start of the year and even back in June, when we last published our quarterly. I don't rule out that last week's BBDXY high will prove to be the high for the whole cycle, but I guess I don't really think so. I'd be more convinced if we had experienced something that looked on the chart and felt in the marketplace, like a blow off top. But I don't think we've had a blow off top yet.

Greg Anderson:
So I'm going to stick with for now the mantra that the dollar is probably got one to 3% higher left to run over the next one to three months. I would say that this quick piece scenario that we've talked about for Ukraine, if that happened and we had the Euro dollar retracement up to 110 associated with it, then guess what? Exposed it would look like a blow off top for the dollar index. And then I would probably call the top. But I guess I'm with you, I don't give that scenario that much probability mass right now.

Greg Anderson:
So if we don't have that, we're instead left with a more central scenario of the Fed and other central banks, continuing to hike potential into H1 of next year, below trend global growth, ongoing economic and geopolitical uncertainty and risks. You know what? In that scenario, the US dollar top may not be in until the Fed stops hiking. And in that case, it's probably a gently rounding top for the dollar, as opposed to the blow off top that I am looking for.

Stephen Gallo:
That's a good way to loop in all the remaining details, Greg. I think we've done enough for one episode. So why don't we wrap up here? Thanks for sticking with us for those of you that are still out there. And until next time, bye for now.

Greg Anderson:
Thanks for listening to Global Exchanges. Listen to past episodes and find transcripts at bmocm.com/globalexchanges.

Stephen Gallo:
We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify, or your favorite podcast provider.

Greg Anderson:
This show and resources are supported by our team here at BMO, including the FICC macro strategy group and BMO's marketing team. This show is produced and edited by Puddle Creative.

Speaker 3:
The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.

Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy

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