20 Sep 2018
Mark McDonnell, Macro Analyst for the Henley Fixed Interest team looks at the hiking cycles within G10 countries and highlights Norway, Sweden, Australia and Canada as countries that are most likely to disappoint. Most of these countries are stuck between 'a rock and hard place' – caught between the monetary policy of their larger trading partner and high levels of private sector debt.
Analysis of G10 hiking cycles and 5-year forward rates – that is the market’s expected 1-year rate in five years' time - provides some interesting results. It shows what’s priced in in terms of countries' respective hiking cycles. Theoretically, these economies could disappoint – especially when they have sizable debt loads. The countries that seem most likely to disappoint include Norway, Sweden, Australia and Canada. There are direct lessons between this analysis and the value in rates markets. The analysis is less relevant for foreign currency as this is determined by the hiking cycle over a shorter time of period, amongst other factors.
Figure 1 shows the gap between each country’s current policy rate and 5-year forward rate (calculated using the market pricing of the 1-year forward rate in 5-years' time).
Figure 1: G10 policy rate and market priced long-term equilibrium rate
Figure 2 shows the markets' pricing of the 5-year forward rate. New Zealand, the US and Canada, respectively, have the highest rates.
Figure 3 Shows the number of hikes priced in between now and in five-years' time. The economies with the most hikes priced are Sweden and Norway.
The analysis is then complemented by plotting 5-year forward rates and hiking cycles against private sector debt. Countries towards the top right-hand quadrant are those most likely to disappoint. When 5-year rates are plotted against private sector debt, countries most likely to disappoint are Norway, Canada and Australia. When hikes cycles are plotted against private sector debt, countries most likely to disappoint are Norway and Sweden.
The analysis in interesting as it highlights the dilemma these countries face. Take, for example, the Scandinavian economies. The economies of Sweden and Norway are stronger than their main trading partner, the eurozone. This is reflected by the higher 5-year forward rate and longer hiking cycle. At the same time, both economies have high levels of private sector indebtedness – partly a consequence of keeping policy too loose in the past and rapid house price growth. These economies face the difficult choice of: 1) waiting for some clarity as to what the ECB will do; or 2) using the strong growth backdrop to hike now and build up a buffer for the future. Option 1 risks exacerbating the private sector debt problem and option 2 risks unwanted FX strength and an inflation undershoot.
With strong links to US policy, Canada faces a different problem. With the tailwind of fiscal stimulus, the US economy appears to on a better footing than Canada. And with the Fed in hiking mode, the Bank of Canada (BoC) has already hiked four times. Although this helps the BoC build up a buffer for the next downturn, if they continue to hike one-to-one with the Fed it's only a matter of time before higher debt servicing costs impact the private sector. At the very least, both the Riksbank (Sweden) and the Norgesbank (Norway) will be looking to learn lessons from Canada's hiking cycle - should they finally get round to raising interest rates.
Mark McDonnell is Macro Analyst for the Henley Fixed Interest team at Invesco Perpetual.
All data is as at 31.08.2018 and sourced from Invesco Perpetual unless otherwise stated.
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