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Is Powell a Maverick? - Global Exchanges

FICC Podcasts 09 août 2022
FICC Podcasts 09 août 2022


Disponible en anglais seulement

In this week's episode, we discuss an analogy of the situation facing the Fed Chair Powell and other central bankers, along with FX market implications.


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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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Disponible en anglais seulement

Greg Anderson:                Hi, welcome to Episode 48 of Global Exchanges, a podcast about foreign exchange markets and related issues. In this week's episode, my co-host Stephen Gallo and I discuss an analogy of the situation facing Fed Chair Powell and other central bankers along with FX market implications. The title of this episode is, Is Powell a Maverick?

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 9th of August 2022. Thanks for listening to Global Exchanges. Greg, let's kick things off. As you and I have talked about in the recent past, we're at an interesting juncture here in FX markets. So first of all, the calendar is approaching mid-August and many of us who are working, we're sitting, waiting for what will probably be a busy autumn season. And it's already been an up and down Q3, right? We had a pop hire in the broad dollar in early Q3, but since then it has been bleeding lower, and it feels like many investors are eager to call that early Q3 pop the high for the cycle and the dollar. But we've also seen it up and down in the economic data releases. State side, we had two quarters of negative, real GDP growth, two consecutive quarters.

                                                But last Friday's jobs report for the month of July showed a very strong labor market. In the Euro area slightly in contrast, we've had a number of really weak economic surveys and other data prints the labor market probably has a bit more slack in it than in North America. But the second quarter from a GDP growth perspective was decent in the euro area.

Greg Anderson:                So from this side of the pond, we've been hearing about extreme summer heat in Europe. Any comments there?

Stephen Gallo:                  As a noteworthy topic, Greg, I think this summer has definitely given people a real sense that we are truly in a cycle of higher average temperatures across Europe. England and Wales specifically have basically had the driest January, July stretch since the mid-1970s in terms of rainfall. My other anecdote just briefly would be that although the '75, '76 drought was more severe than what we're currently facing so far, we have seen new highs in terms of temperature in the current period. So in a nutshell it's real.

Greg Anderson:                Hey, Stephen, I don't want to make light of what sounds like a very serious situation, but I've got to ask something more on a personal level. Have you had a chance to cool off in the movie theater by taking in this summer's top selling movie Top Gun: Maverick?

Stephen Gallo:                  I haven't Greg. But it's not a bad idea given this heat. At the same time, I suspect higher energy costs will be forcing cinemas to increase their ticket fees if that hasn't happened already.

Greg Anderson:                Yep. It was the most expensive movie I've ever paid for. Without dropping too many spoilers that ruins it for you and any of our listeners who haven't seen the movie yet, let me just take you to the climatic scene near the end of the film. At that point, the old guy Navy pilot Maverick, and that's his call sign or nickname. He's trying to land an old fighter jet from the 1970s on an aircraft carrier. And conditions are really difficult with clouds causing bad visibility and vicious crosswinds and so forth. It's a really suspenseful moment. I'll point out Maverick isn't at an advantage relative to younger pilots because he's old enough to have flown this type of aircraft before. But it's still a really tough task because the plane is so different from anything that he has flown for many years.

                                                And then the conditions are so tough. So now the analogy. With the supply shocks that we've seen over the past two years, we've got an economic situation that's straight out of the '70's, just like that F14 that Maverick tries to land in the movie. And we've got financial markets full of young pilots who have only flown 21st century aircraft in 21st century conditions. Central bankers tend to be more senior like Maverick. So we do have people like Chair Powell or Madame Lagarde, who can maybe land a '70's airplane, but still the conditions are tough. Expanding just a bit further on the analogy. We've also got strange economic data like the contrast between payrolls and GDP that you mentioned, Stephen.

                                                I'd think of that as akin to clouds that make visibility poor for a pilot. And then we've got all these geopolitical crosswinds, like the Ukraine war, and now the Taiwan situation et cetera, plus the updrafts and the downdrafts from the pandemic haven't entirely subsided. And of course the aircraft carrier is bobbing up and down in the waves on the ocean. So look without spoiling the movie any further, there's the analogy and the reason for our title. As market participants at this point, we're just like the crewman sitting on the deck of the aircraft carrier as spectators basically, wondering if Powell is going to be able to land this plane, i.e., finish the tightening cycle without causing a recession that crashes into the ocean.

Stephen Gallo:                  It's a poignant comparison, Greg. And I think going back to what I mentioned earlier, the weather aspects of the current environment in the UK, they simply amaze me. So we've got similar economic conditions to take your line of thinking. We've got similar economic conditions, but also similar weather phenomena to what was experienced in the 1970s. So let me ask you Greg, about how far out so to speak from the carrier is Powell right now and what does the glide slope look like for the Fed?

Greg Anderson:                Great questions. So I think Powell is about halfway into his approach, but he's still a few minutes out, which I would roughly translate to three to six months before he either touches down on the carrier deck or crashes into the ocean. And I would say that the conditions have forced him to take a much steeper approach angle than his normal. But thus far his glide slope it seems to be okay. When Powell first steepened the approach with the first 75 basis point rate hike in June, markets freaked out about that just a little bit. And so we had a four week period where the Bloomberg dollar index rallied about 5%, but now it sort of seems like the crosswinds have abated a bit. So for example, oil has backed off 15% to 20%. And with that equity and currency markets have given Powell a little higher probability of achieving the proverbial soft landing. Look, this situation seems to be more about the conditions than pilot skill actually. So I think we're going to pass through several months where we just sit and watch the weather and wait.

Stephen Gallo:                  Right, Greg. So what we're basically saying, I think, and what you're saying is that conditions are very fluid by both recent and historical standards. And even though it's within Powell's ability to fine tune monetary policy settings for a soft landing, there are plenty of factors beyond his control which could still throw the plane off course. I mean, basically pilots tend to hope for the best, but always, always plan for the worst. Is that about right? I mean, I don't want to overdramatize things, but to me that feels right. And notice, I mean, I'm using the word fuels here instead of citing specific data or evidence. I think a lot of this situation for both investors in the FX market, and the Fed and Powell is about fueling our way forward, right?

Greg Anderson:                That sounds right, Stephen. This is a fly by feel situation for Powell, and I think it's also an observed by feel situation for us. The only thing that I would maybe add further to the analogy is that I don't think that Powell can pull up and take a second approach if some gust of wind comes up right before he's supposed to touch down. Either he lands the plane and we all celebrate, or he drops it into the drink and we all mourn. It just seems like a really binary situation.

Stephen Gallo:                  All right, Greg. So let's talk about the asset class specifically now FX. What happens to the dollar if he lands the plane? What happens to the dollar if he crashes into the ocean?

Greg Anderson:                In the case of the USD, it's a bit counterintuitive maybe, but with the real trade weighted dollar already about 15% above its long run average due in large part to extreme uncertainty, I would say that if Powell lands the plane, then I think the U.S. dollar relaxes lower. And that's just a move in the direction of mean reversion. And it corresponds with recovering global equity prices, lifting equity linked currencies in particular, but also probably lifting some really depressed currencies. And there are a lot of them like Euro, KIWI, some of the [inaudible 00:10:38] maybe even yen and so forth. So, now Stephen let me switch it over to you. ECB President Lagarde has got her own plane to land. Is her job easier or harder than Powell's? And what happens to the Euro if she crashes into the drink?

Stephen Gallo:                  Yeah, Greg, I think this is an important transition. I want to just briefly mention the FX side of the equation first and then go into the details. I think the main thrust of my argument as it has been, would continue to be that on their own, the major European currencies are not really in a position to drive the dollar lower, not what their current economic geopolitical and underlying flows pictures. Yes, of course there are positive event risks out there. In other words, positive shocks that could happen. But for now it still looks as if the real movement has to come from the dollar component of the exchange rates in question. And when that happens by default, some of those fundamentals for the European currencies will heal. Not all of them, some of them, but the main movement has to come from the dollar. So when we turn to the Euro and really Europe in general, it seems to me that the ingredients are there for elevated inflation pressures to remain stickier, maybe stagflation conditions to persist for longer, if you like that terminology.

                                                It's true that the food and energy price aspects of the backdrop in Europe is one of the most important elements of this story. And there tends to be more volatility in those prices than in underlying inflation. I don't think that necessarily means that high inflation or high inflation expectations can't become embedded. I think they can still become embedded. Secondly, there's potentially going to be even more pressure on governments in Europe, in the Euro area to step in to support economies through various means because of the war and the economic situation in general.

                                                And that could complicate things immensely for the European Central Bank. Maybe it already has Greg. We know that the Euro area is not fiscally integrated, and that fact is constraining the ECBs pace or ability to tighten policy. I guess the way to look at this is that if inflation pressure's cool on their own, for some reason, which could happen, the ECB might just get lucky enough. But if they don't, I think you have to draw the conclusion for now that the probability of a hard landing in Europe is higher than it is in North America, and that the ECB has a much more difficult task to complete.

Greg Anderson:                Okay. So let me ask you about another pilot in this plot. This one is a bit younger than both Powell and Lagarde, but is a renowned student of history. So maybe he can fly a really old plane. What about Andrew Bailey, Governor of the Bank of England? Is the task of landing the plane on the aircraft carrier deck easier or harder for him than it is for Powell and Lagarde? And what happens to the Pound if he crashes into the sea?

Stephen Gallo:                  Well, let me give you my angle on Sterling and the Bank of England, Greg. The base case is for the BOE to deliver a bit more tightening in terms of rate hikes and balance sheet reduction this year. The August policy announcement in my view may have been one indication that the bank is running out of wiggle room because of the added hit to the economy from tightening, and the fact that the UK is probably even a more interest rate sensitive than the U.S. economy. So I think the Pound is in a very tough spot if the BOE can't slow inflation down. And it's also in a very tough spot if the BOE tries to slow inflation too much.

                                                So a lot of things have to go just right for the BOE is basically what I'm saying. And when I think about the August policy announcement and the monetary policy report, what I think the bank has resorted to now is lifting or elevating its recession rhetoric in order to attack the risks or alleviate the risks of a wage price spiral rather than to go at attacking those risks purely through tighter monetary policy. And this risk of a wage price spiral and the issue of firms not being able to recruit staff in different parts of the country.

                                                It came up a number of times, not only in the press conference following the policy announcement, but also in the interviews that Andrew Bailey did post press conference. I mean, in a nutshell, it's not a horrible thing to be going into a growth slowdown with a tight layer market, but you run the risk of a harder landing further down the line if inflation becomes embedded and you end up in a wage price spiral. And I think that's one of the things Andrew Bailey most fears, a wage price spiral.

Greg Anderson:                So Stephen, as we wind to a conclusion here, I want to come back to the FX scenario analysis one more time. I said that we're three to six months away probably from knowing whether the Feds landing is a successful, soft landing or a crash landing into the sea. And I said that a soft landing would most likely bring a gentle relaxation lower in the U.S. dollar. I didn't mention it, but I will add now my view that a crash landing by the Fed will lead to another 5% or so higher in the U.S. dollar and then a sharp move lower after the fed is forced to cut. So a crash landing means high FX volatility and a U.S. dollar that spikes and then crashes. Stephen, can you please summarize what happens to the Euro and Pound respectively in the soft landing and crash landing scenarios?

Stephen Gallo:                  I think Greg if it becomes certain that the major European economies are going to have a hard landing, then we will run into new cycle lows in both Euro dollar and cable, which would probably equate to 95, 97 in Euro dollar on a first order move, 115 in cable. To summarize where we currently are with a month to three month Euro dollar in cable outlooks, we've basically just been suggesting that the risk of a hard landing is there, but it's not materially above 50% at this stage. But we acknowledge that a lot of the ingredients are probably there, just a question of whether or not they unite in the wrong way, if you want to put it that way.

                                                So it's not the base case, but it's a risk. And quite simply, if Europe avoids a hard landing on the flip side, then the major European currencies have probably seen their lows for the cycle versus the dollar. One complicating factor for this picture. I'll just add though, Greg, which is that a hard landing for the U.S. economy is arguably very bad for the dollar medium term, but it's probably a bigger, short-term negative for the major European currencies in the world economy in the short-term if it happens. So to frame this in the Top Gun context, if Maverick crashes the plane and causes a hard landing, then all the planes are going to crash.

Greg Anderson:                Well said. And I think we've probably pushed this analogy as far as we can. So it's a pretty good spot to wrap up for this week.

Stephen Gallo:                  Fair point, Greg. Let's wrap things up here. Thanks for listening everyone. Until next time.

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.

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Greg Anderson Chef mondial, Stratégie de change
Stephen Gallo Chef de la stratégie de change pour l’Europe

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