As Geopolitical Risk Rises, US Political Risk Eases
Posted on April 12th, 2017
Geopolitical risk appears elevated after recent events in Syria, Tillerson en route to Russia, US warships en route to the Korean Peninsula, and reports of Chinese troops moving towards the North Korean border. These developments are providing support for JPY and gold, and keeping global asset markets on edge, trading in choppy ranges. However, rising geopolitical risk is helping revive confidence in the Trump administration and reduce political risk in the USA. The improvement in Trump administration performance may prove more durable and lift yields and help support the USD as geopolitical risk fades, reversing recent gains in JPY and gold. The USA labor data had no smoking gun on inflation, but revealed further tightening in the labor market and will keep the Fed on a path to gradually tighten rates and begin to dis-invest in Treasuries and Agency MBS later this year. Recent flattening in the US yield curve may also reverse if geopolitical risk recedes. Nerves over the French election are rising as the race for the first round tightens. EUR is languishing near recent lows. If Macron makes it to the second round on 23 April and Le Pen achieves little more than a quarter of the vote, EUR may start to recover. The probability of a Macron victory should rise in a head-to-head run-off with Le Pen.
US labor market tightens
US labor data still didn’t have a smoking gun on inflation, with wages growth and hours worked stable, but the market tightened further into levels that suggest wage growth may start to pick-up. As such, the Fed have to remain vigilant and send signals that policy accommodation is likely to continue to be removed gradually.
ADP and NFP diverge
The ADP employment report and the Government non-farm payrolls (NFP) report had moved closely together over the last year or so. However, the two reports diverged significantly in March. ADP rose 263.5K, NFP rose only 98K. ADP has exceeded NFP report for the last five months in a row. As such, the two reports are sending difference signals.
ADP suggests employment has accelerated since around October last year, rising at its fastest three-month moving average since 2014 (+252.5K) and the fastest six-month moving average since March-2016. NFP had the lowest six-month average since 2012 (+163K).
While still at levels that point to labor market tightening, NFP suggests that employment growth may be on a steady declining trend.
The NFP report is more comprehensive and more recognized by the market. Revisions to the two reports may tighten their recent relationship in coming months.
The slower growth in NFP may indicate some slowing in the economy, but it fits with the narrative that the labor market is tightening. Job growth is expected to slow as the excess supply of labor falls, reducing the capacity of employers to find suitable workers.
ISM non-manufacturing and manufacturing employment indicators diverge
The ISM surveys of employment sent mixed signals. The employment component rose sharply for manufacturing to a new high since 2011 at a strong level of 58.9 in March. The non-manufacturing employment index fell significantly to 51.6 in March, a low since August last year.
Perhaps this reflects the direction of the Trump administration to rejuvenate manufacturing in the USA. However, non-manufacturing represents a much larger proportion of the USA economy, and may be a better indicator of total employment trends.
Strong Household survey – tightening labor market
While NFP were significantly weaker than expected, the household survey that generates the unemployment rate was above expected. The household survey jobs rose 472K, a high since Feb-2016.
The unemployment rate (4.5%) fell to a low since May-2007, before the sub-prime crisis in the USA that led up to the 2008 global financial crisis. The U-6 under-employment rate fell to 8.9%, a low since December-2007.
The participation rate held steady at 63.0%, equal to the highs since Mar-2014. Participation has been in a downward trend for the last decade as baby-boomers move into retirement, so the recent gradual uptrend is a sign of labor market tightening drawing more workers back into the labor force.
The unemployment rate (4.5%) is below the FOMC’s median estimate of the neutral level (4.8%), already at the FOMC projection for the end of this year, and below the pre-crisis average from 1995 to 2007 of 5.0%
The U6 underemployment rate (8.9%) is just above the average from 1995 to 2007 (8.7%) that might be considered the neutral level.
Some evidence of slack
The participation rate probably fell more sharply than may be accounted for by demographic changes during the post global financial crisis period of slow recovery in the USA from the 2008/2009 Great Recession. As such, it could continue to rise or remain stable for some time yet.
The measure of part-time workers for economic reasons also suggests that there may be still some slack in the labor market. It fell in March to a low since mid-2008, but remains significantly above its pre-global financial crisis average from 1995 to 2007.
Wage growth rate stable at neutral rate with lower productivity
Wages growth trended higher in 2015 and 2016, but may have flattened out since around Q3 last year. Hourly earnings rose 2.7%y/y in March, steady at its three-month moving average.
With labor productivity running lower since the 2008 Global Financial Crisis, this might be the new neutral rate of wage growth, but it is below the 3 to 3.5% rate pre-Global Financial Crisis.
Fed disinvestment policy should steepen yield curve
Last week, the Fed suggested that they were aiming to begin the run-off in its holdings of US Treasuries and Agency MBS late this year, after one or two more rate hikes. The pace and extent of this disinvestment is expected to be fleshed out towards mid-year. The Fed minutes suggest it favors a gradual and smooth dis-investment.
Rates policy will continue to be favoured as the main lever for adjusting policy, although the Fed may decide to stop or even reverse the asset disinvestment should the inflation outlook deteriorate. As it begins the disinvestment, it may choose to raise rates more cautiously, at least initially, to assess the impact of the dis-investment. NY Fed President Dudley suggested there may be a short pause in rate hikes.
The prospect of disinvestment should tend to place some upward pressure on US yields, more so at the mid to longer end of the curve. Whereas the prospect of a more cautious Fed rate-hiking policy may hold down shorter term rates. The tendency should be for the US curve to steepen.
Rates policy might still be more influenced by the state of the economy and the inflation outlook, but, all things equal, the disinvestment process might lessen upward pressure on the USD (via less urgency to raise rates).
Nevertheless, curve steepening may tend to undermine currencies that are more influenced by the longer-term bond yields. This might include the JPY and higher yielding emerging market and commodity currencies; although there are no hard and fast rules on this.
To date, there has been no obvious steepening impact on the US yields curve, although US yields did firm late last week after the mixed US labor market report.
Globally, yield curves have flattened since mid-March. There may be a number of reasons for this.
Confidence in the Trump administration to deliver on growth orientated policies, including tax reform and infrastructure spending has faded, especially in the wake of the failed vote on the Healthcare bill.
The Fed built-up expectations for rate hikes in early-March, but then delivered a ‘dovish’ hike in mid-March, leaving its forecasts for growth, inflation and the rates path largely unchanged from their December projections.
Oil prices fell sharply in the first half of March, reducing inflation expectations. However, they have recovered significantly over the last two weeks.
Geopolitical risks have increased around developments in Syria and North Korea.
The approach of the French presidential election, dovish ECB comments, ongoing Brexit uncertainty.
Rising Geopolitical risk, falling USA political risk
However, the increase in geopolitical risk may turn out to reduce political risk in the USA. The Trump administration was receiving a lot of negative press ahead of the recent Syrian gas attack. It was under pressure from the failure of the healthcare bill, a steady stream of controversy surrounding the investigations into Russian interference in the election, Trump’s Twitter responses were descending into a tiresome pattern of deflection, spin, and attacks on the media, and media focus was turning towards White House infighting and instability.
The US missile attack on Syria, in response to a chemical weapons attack on Syrian people, has generated widespread support from the US Congress, media and internationally. Trump has navigated with relative calm his meeting with China’s President Xi. His Secretary of State, Tillerson, has appeared balanced and in command of tense international events, concerns over a strange chumminess with Russia have faded. Trump got his pick for the Supreme Court (Gorsuch) up, Steve Bannon was removed from the National Security Council.
The outlook for tax reform has been downgraded, but Trump’s economic team appears to be taking the lead and working on a plan to achieve broad Congressional appeal, having learned a lesson from the Healthcare bill failure. The involvement of respected administration figures, Mnuchin, Ross, and Cohn is likely to sustain market expectations of a successful overhaul of the tax code, even if it does take longer to happen.
While geopolitical risks appear elevated, news may quieten down and Trump may come out appearing more presidential with capable and respected team members displaying more influence. Confidence in his administration may lift and help boost US economic confidence and yields.
French election race tightens, EUR languishes
The first-round vote on Sunday 23 April is a wide field and expected to be a close race. The National Front’s Marine Le Pen (Nationalist, alt-right), the most dangerous candidate for the stability of the EUR, is ahead in the opinion polls with 24%. But the most supportive candidate for the EUR, Emmanuel Macron, leader of the En Marche! Movement (centrist) is just behind with 23%.
Not too far behind the two favourites are Francois Fillon (The Republicans – right) – 18.5% and the fast improving Jean-Luc Melenchon (Unsubmissive France – leftist) – 18.0%.
No candidate is likely to win a clear majority in the first round, sending this election to a final run-off between the top two candidates from the first round on 7 May.
Le Pen may win the first round, but she is a polarizing figure, and many of those that do not vote for her in the first round are expected to go to the alternative candidate.
As such, betting markets are favouring Macron as winning the second round. Nevertheless, from a peak of 70% probability of victory on 26-March, Macron has slipped back to 57%. Le Pen is given the second highest chance of victory, currently 26%, up from around 24% in late-March.
The uncertainty dragging on the EUR can be seen in the options market. One-month options now take into account both rounds of the election. One month vol has jumped to 12.5%, above 3mth historical vol of 7.2%. The one-month 25 delta risk reversal has fallen to -3.7% (a higher cost to protect against downside risk for the EUR).
The USD has struggled since mid-March as some of the confidence in the Trump administration has faded and the Fed has sent mixed messages. Some fall in global yields and higher geopolitical risk has supported JPY and Gold. However, the EUR has noticeably lagged its peers (JPY and gold) since 27 March (around the time confidence in a Macron victory peaked).
The French – German government bond yield spread that had been narrowing over the preceding month, started widening again since 27 March, consistent with the turn down in the EUR.
However, part of the fall in EUR can be accounted for by dovish rhetoric from key ECB council members and a lower than expected CPI inflation report in March.
Earlier in March, after the ECB meeting on the 9th and some stronger survey data, the EUR gained as the market focused on the prospects for reversing extraordinary policy easing in 2018. Several ECB members have emphasized in recent weeks that it is premature to change policy guidance.
The EUR may continue to be hemmed in ahead of the French election, with the threat of a deep fall in the unlikely but possible event of a Le Pen victory.
If Le Pen gains more than a third of the first round vote on 27 April, and Macron was to under-perform and slip into third spot in the first round, the EUR might build in more substantial risk and fall to new lows. However, if Macron were to make it to the final round, polling close to Le Pen in the first round, EUR might strengthen as he would be a clear favourite to win the second round.
Overall, the EUR has proven very stable over the last year, despite its negative rates policy. The market appears to be quite forward looking and willing to see upside for the EUR as the region’s economy gains momentum.
The first economic sentiment indicator for April (Sentix survey of investors) rose further to a high since 2007, consistent with the trend of other indicators.