Macro Freestyle: Living with low volatility and high uncertainty
The desk argues that the current low volatility environment, coupled with high uncertainty surrounding macroeconomic factors, particularly the muted market response to the US government shutdown, presents both risks and opportunities for FX traders. Per the full note from Standard Chartered, this situation may lead to overlooked risks in G10 and emerging markets, especially if global growth weakens. The desk highlights that the US dollar could benefit from these dynamics, particularly as AI developments continue to evolve. With a consensus target of 1.075 for USD/EUR, the desk is positioned at the upper end of the current market spread, suggesting a bullish outlook amidst prevailing uncertainties.
What the desk is arguing
The desk frames this as a critical juncture where low volatility belies significant underlying risks, particularly in light of the US government shutdown. Standard Chartered's analysis indicates that financial markets are not fully pricing in the potential fallout from these macroeconomic uncertainties, which could lead to increased volatility in the future.
Supporting this view, the desk notes that the fiscal outlook for both G10 and EM economies remains precarious, especially if global growth falters. The muted market response to the shutdown may suggest complacency, which could be challenged by sudden shifts in sentiment or economic data releases.
Where it sits in our coverage
Our consensus target for USD/EUR stands at 1.075, with a range from 1.04 to 1.12. Notable firm targets include: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26) - citi: 1.12 (Mar26)
This view aligns with jpmorgan, which shares a similar bullish outlook, while bofa presents a more cautious stance at the lower end of the range. The desk's positioning suggests a belief that the USD may strengthen against the backdrop of global uncertainties.
How other firms see it
Firms like jpmorgan and citi are aligned with the desk's bullish outlook on the USD, reflecting a consensus that the dollar could appreciate in the face of global economic challenges. Conversely, bofa holds a contrary view, anticipating a weaker dollar trajectory.
Traders should keep an eye on the USD/EUR pair as it reflects broader market sentiment, particularly in relation to upcoming economic indicators and central bank communications that could influence volatility and risk sentiment.
What the calendar says
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stanchart
Hello, I'm Eric Robertson, Global Head of Research and Chief Strategist at Standard Chartered. And I'm Madhur Jha, Global Economist and Head of Thematic Research also here at Standard Chartered. Welcome to Macro Freestyle, our monthly podcast series where Madhur and I will identify and explore topics that are likely to be most impactful and relevant for financial markets and the global economy.
Welcome back to another episode of Macro Freestyle. We are recording this on October the 9th, and we will be discussing why, despite some fairly unfavorable developments recently, we seem to be living with low volatility. Eric, you have recently written about how markets still seem to be on a holiday, especially the bears, with limited reaction to the U.S. government shutdown and rising political tensions elsewhere.
How do you explain this? What a great way to start the discussion. There are a couple of interesting observations that I would make, the first of which is that if we look at risk indicators or volatility indicators in the market, you're absolutely right.
They are extremely low across the board, whether it's interest rate volatility, FX volatility, credit spreads, you name it. Everything we look at suggests a very low level of risk or risk premium. It feels like the level of uncertainty in the world, both from an economic and a political point of view, is still extremely high.
There's the U.S. government shutdown. There is political uncertainty in France. There is fiscal uncertainty in a number of developed economies, which has not gone away.
And yet markets don't seem to want to price that in or to grapple with those topics. And I guess another way of describing it is that the markets seem to believe that the base case is one of prices and assets staying in relatively narrow ranges. In other words, interest rate volatility will be low because perhaps the Federal Reserve is near the end of its interest rate cycle or the ECB is near the end of its interest rate cycle.
The problem is that the markets are assigning a very high probability to this low vol base case, but the tails on both the left side and the right side look extremely fat to us, which is a really fancy way of saying that the level of uncertainty looks significant. So for me, this is the disconnect that remains in place. And I think the U.S. government shutdown is just the latest example of a risk event or a development that should have put people on high alert but doesn't seem to have so far.
And Eric, what is your view on what's being underpriced here? What could really shake the markets out of their current complacency? Look, I think fiscal is an important one.
And I say that because we know that there are significant fiscal risks across a number of major economies. We also know that governments are having virtually zero success at getting their fiscal issues under control. Now, it's important because in the economies that we're talking about, again, France, U.K., the U.S., these economies and their bond markets are major benchmarks for borrowing and lending around the world.
And if we were to see some sort of a fiscal shock play out in the bond markets, that to me is a potential threat to the level of benign pricing that we see in a number of markets. I mean, if we were to start to see really volatile bond auctions, for example, that's going to have an impact on not only bond prices, but credit spreads and equity markets. So the fiscal risk is underpriced, and you can see that in a variety of measures.
The other risk that I think is underpriced is on the interest rate side and specifically short-term interest rates. Now, the base case, yes, I agree. The ECB is probably at or near the end of its cycle.
Central banks in Asia, which have been easing monetary policy, look to be getting to the end of that cycle. And even in the U.S., where there's considerable debate about how much the Fed may or may not need to ease, the two sides of the range are still pretty narrow. People are talking about a range of something like 275 versus 3.5.
In the grand scheme of things, that's not really a big deal. But here's where I get interested, which is considering that all markets have this price as the base case outcome. It strikes me that that's where there is significant risk.
I mean, maybe the risk is that the Fed just doesn't need to ease much more than one or two more times, and we're left with a terminal Fed funds rate of 3.5%. Maybe the economic optimism with regards to Europe and Germany is misplaced, and the ECB has still got quite a bit of easing to do. Maybe the economic weakness in China is going to spread more aggressively to the rest of Asia.
When spreads are this tight, when rate expectations are this low, my antennae perk up and say, this doesn't look like the right sort of pricing for the base case scenario relative to the tails. I guess a question I have for you, Madhu, you have written extensively about fiscal risk and fiscal space for EM over the last five or six years. And I wondered if you could give us an update on how you see some of the fiscal risks that may or may not be developing in EM.
Currently, a lot of countries are enjoying narrowing spreads in the EM space as well as ample funding because we have seen a rate cutting cycle in the major economies as well as in these emerging markets themselves. So currently, these countries do have some fiscal space to support economies if there is a cyclical slowdown. But there are some key risks that are emerging from next year or in the medium term that we need to be cognizant of.
And I think the biggest one is that if you have major economies having fiscal concerns and that leads to elevated funding costs, then that really does impact emerging markets. And this is particularly important because you've got emerging markets that have seen a rise in their debt levels and also some weakening of your fiscal positions given a series of shocks, including COVID. And for most of these emerging markets right now, domestic spending is expected to grow at a much faster clip than domestic revenue, which means that that mismatch has to be funded externally.
So if you've got this situation where you need more of your funding to come from external sources and yet external funding is pricier, that does expose you to all the volatility that you could see in the bond markets, even in major economies. And so I think the focus for investors and clients and market participants is going to be what is happening in terms of the R minus G comparison or the comparison between the rate of growth of the economy, is that growing at a faster pace than the rate at which interest costs are going? That would be very much the crux.
And I think it's heartening to see that some of the economies that have very limited fiscal space in the EM world are now beginning to focus on things like structural reform, infrastructure spending and building up productive potential, which should then help alleviate some of these concerns on the fiscal side. But clearly, this is something that needs a lot more work. And those countries that are able to do more to build productive potential will see a lot more opportunity in terms of having fiscal space.
Maybe staying with opportunities, Eric, you have talked in the past a lot about the potential for US dollar outperformance. Can you explain why you are more bullish than perhaps market consensus? Yes, this is a topical question at the moment.
Now, we've continued to explore this from a handful of angles. And when you think about a major currency like the dollar, there's a handful of inputs that you have to think about. Number one is rate differentials.
That's pretty basic. Number two is the broad discussion of capital flows, whether it's portfolio flows or FDI, etc. And the third is what I would call structural developments that might enhance or detract from things like profitability and productivity, etc.
And what's interesting is that each of these may be starting to turn back in favor of the dollar. And let me explain my thinking there. On the rate differential side, as I mentioned earlier, I do think the market is still overly optimistic about how much the Fed will cut rates.
The question is how much? Let's say with a terminal Fed funds rate expectation of 3%, maybe the right level is three and a half percent. Now, in the grand scheme of things, maybe that's not a big deal, but 50 basis points when you're talking about rate differentials could potentially be important, especially when we think about the U.S. versus Europe.
And I think there is a scenario where the economic optimism with regards to Europe gets called into question, either because fiscal in Germany is less pronounced than expected, or maybe the laggards of Europe exhibit a greater influence on the growth profile. But I certainly think using U.S. versus Europe as an example of the rate differential story, I'm of the opinion that rates will move further in the dollar's favor over the next six months. On the capital flow story, this gets interesting to me because there has been a fairly reallocation of capital back towards other DM economies and markets and other EM markets this year.
We've seen some of the best inflows to EM that we have in close to 10 years. And that diversification story is important. However, there are a couple of factors that suggest to me that maybe the inflow story to the U.S. could start to turn positive again.
The technology and the AI story, I think, is still going very, very strong. I think people are realizing that there are relatively few economies in the world that are really offering the kind of investment opportunities in that space that the U.S. has. There are others, of course, but the U.S. is certainly a dominant feature in that space.
The other point that I think is an important question but is so far unanswered is this question of productivity. Now, I know you and the team have just put out a report looking at U.S. productivity trends and you've asked, could we see an environment or a scenario where U.S. productivity starts to really outperform again? And what could that mean for capital flows?
And what could that mean for U.S. asset pricing? The fact that we're asking those questions and the fact that the negative narrative is already in the price suggests to me that on a risk-reward basis, the dollar has more room to run. Now, we've seen some dollar performance already.
The likes of Dollar Korea have had a nice run up. Euro-dollar is off the highs. Dollar-yen is starting to move a bit higher for a variety of reasons.
So it's early days, but I think there's a good story here, especially considering the bearish consensus on the dollar. I want to stick with this AI theme and the productivity theme, Madhur. You guys have published on this very recently, and I wondered if you could share some of your preliminary thoughts on how these AI developments that everybody is focused on, what are the practical implications in terms of traditional economic narratives?
This has become such a source of optimism for the global economy that this could be transformative enough that it will pull us out of this weak growth, high debt situation that we are currently envisaging for the foreseeable future. Our work suggests that so far, the impact of AI on productivity and growth potential has been fairly limited, and most of the benefit has been captured in terms of consumer well-being and consumer surplus. But as companies start to adopt more AI, we are likely to see more of an impact coming through in terms of productivity.
And I think countries are becoming a lot more aware of this. And that's why you see quite a few countries, including emerging markets, now try to introduce their own AI models, their own AI strategies. And it's really quite heartening to see countries like, say, Malaysia and India punching well above their GDP weight in terms of AI capabilities.
I think economies and the authorities are realizing that this could really be what changes the growth dynamics. Having said that, there is only one dominant player in the AI space, which is the U.S., and it leads everybody else by a wide margin. The only true challenger to the U.S. is China, which could catch up.
So in all of the data that we're looking at, whether it's investment trends or clusters or AI capabilities in terms of computing power or skill sets, these two countries really dominate, and the U.S. is far ahead of everyone else. And I think they want to maintain that position because clearly the U.S. realizes, and so does China, that this can have significant implications for the way the global economy looks in a few years, as well as how markets look in a few years. And so recently, both of these countries have introduced their own AI roadmaps just in the last couple of months.
So clearly the race for AI dominance is very much on. And I think there's a lot more recognition that this could really be what drives the next leg of transformation of the global economy. Let me ask you a follow-up question.
Everybody's focusing on the AI opportunity, but is it worth giving some consideration to some of the risks that could spill out of this, whether it's from a resource allocation point of view, commodity allocation point of view, concentration risk, et cetera? What do you think some of the risks are that we should at least be thinking about as we start to have these discussions? Absolutely.
This could lead to a widening of the EM-DM gap. EMs have been trying to catch up very quickly to the DM world, and they've managed to reduce the income gap by growing much faster. But clearly at this point of time, developed markets are leading, especially the U.S. is leading in terms of AI investments and AI innovation.
And that means that many emerging markets, with the key exception of China, could be left behind. And so that reverses almost that catch-up that was happening. So this is a really key risk.
Now, many emerging markets have grown over the last 70-odd years by integrating into global supply chains, by having export supply chains. What does this imply for those economies that have large populations that need to be taken away from agriculture towards, say, manufacturing or services? Does this disrupt the whole supply chain story?
This can be quite energy intensive. So it is not looking very good for countries that are energy importers and don't really have access to that kind of energy. So there are risks.
But at the same time, I think we are beginning to realize the possible opportunities. The release of DeepSeek that caused quite a lot of volatility in the equity markets a few months ago suggests that, OK, if you have cost-efficient ways of including and adopting AI, then maybe the spread will be much faster. I think one of the great opportunities is that we haven't yet seen a lot of this reflected in FX and fixed income markets.
We've seen some impact on equity markets, given the bullishness of AI stocks and how that's leading equity markets. But we haven't really seen the impact in FX and fixed income. And that really reflects the lack of tangible evidence of productivity gains.
But as companies start to adopt both in the EM and the DM space, you should see those productivity gains start to materialize. And again, I think here, the US exceptionism story might become a lot more entrenched. And that will support the positive US dollar story as well.
So there are areas of opportunity. Well, of course, we have to be cognizant of the risks and the need for regulations to make sure that this is not too disruptive for the global economy. Erik, staying with the US and coming back to a more short-term outlook, how do you see the shutdown situation playing out?
And how do you, in particular, see the Fed reacting to the possibility of a prolonged shutdown? I mean, the absence of official data has to be an issue, right? 100%. Look, I go back to the way the Fed often communicates when there's a temporary shock or event risk, which is that they try to look through the short-term economic impact.
The problem with regards to a shutdown is there's a very important dividing line between a short-term event and something that's more sustained. And where that dividing line is, especially in terms of the Fed's reaction function, is impossible to pinpoint. For markets, there's the fact that a lot of economic data now is not being released because of the federal shutdown.
And so investors, corporations, et cetera, are flying blind to some degree. A more sustained shutdown is going to have an impact on spending because paychecks are not being made. Government contractors are not being paid.
Federal funding for infrastructure projects, et cetera, around the country get put on hold. So the longer the shutdown persists, obviously, the greater potential economic impact. And happening at a time when I think there are already some questions about the resilience of the U.S. economy is obviously hardly ideal.
In terms of how it plays out, my assumption is that this will get resolved over the course of the next few weeks. My understanding is that there are some very important discussions going on that are bringing the issues of healthcare cost, healthcare allocation, et cetera, and some of the other key issues being addressed and hopefully resolved. And so I think if we're making an assumption that this is resolved or at least dealt with by the middle of October or the third week of October, the Fed probably doesn't need to respond.
But if we think that this is going to persist through to the end of the year, then I think the growth impact is not negligible. And I suspect the Fed will need to start to incorporate that into at least its short-term observations. Now, its short-term observation may be that the Fed funds rate is at the appropriate level right now.
And if it's at the appropriate level, then maybe they decide that they don't need to do anything. But I think if the Fed's inclination is to cut rates at the next meeting or the next two meetings, I think the government shutdown, assuming it's protracted, is going to push them over the edge to easing monetary policy to support the economy. Thanks, Eric.
That's all we have time for today. Thanks so much, everyone, for listening in and hope to see you next time. Thanks, Madhu.
Great discussion as always and looking forward to our next discussion in a month's time. Thank you for listening to Macro Freestyle, our monthly podcast series on all things macro. Please do join us again for next month's edition.
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