Inflationary pressures build in G4 economies – Morgan Stanley

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Markets have yet to price in rising inflationary pressures driven by a revival of wage growth in G4 economies, say Morgan Stanley analysts, who add that an acceleration of price growth could have implications for bond yields, equities and, in turn, foreign exchange.

Morgan Stanley’s Hans Redeker, global head of FX strategy, and Gek Teng Khoo, an analyst, say inflation could soon join the list of factors driving currency movements – especially as they see the possibility of rising inflation being underpriced in the US, Europe, the UK and Japan.

“There are many factors driving FX at the moment. Given concerns about the soft growth data from [the] eurozone, China and trade tensions, growth is one factor we’re watching,” say Redeker and Khoo.

“Inflation is also another important factor… as there are signs of rising inflationary pressure, with wage growth rising throughout G4, but this is not priced by markets. A pick-up in inflation could thus have implications on bond yields, equities and thus FX,” they add.

The US bank, which topped FX Week’s one-month forecast rankings last week, has a bearish view on the dollar in the medium-term, as both the current account deficit and fiscal deficit of the US are rising, suggesting the economy will need to attract more foreign capital inflows to fund its spending.

“For this to happen, US assets need to look cheap or attractive, which can happen either via US yields rising or the dollar weakening, or a combination of both, pointing to downside in the greenback,” the analysts say.

Given concerns about the soft growth data from [the] eurozone, China and trade tensions, growth is one factor we’re watching

Hans Redeker & Gek Teng Khoo, Morgan Stanley

Redeker and Khoo point to the results of a survey on business conditions. The National Association for Business Economics reported that tax-reform efforts in the US had little impact on companies’ hiring and investment plans, suggesting the government’s fiscal stimulus package only provided a short-term boost to the economy.

“With the effect of fiscal stimulus expected to fade next year, this should cause the current optimism around US growth and the dollar to moderate,” the analysts say.

Corporate profit margins are also looking threatened, as both capital and wage costs are showing signs of rising, at the same time as support from the fiscal stimulus package fades, and trade tensions between the US and China show no signs of abating.

“A sell-off in US equities and widening of corporate credit spreads, causing a liquidation of these holdings, should weigh on the dollar, as foreigners have built up their dollar-denominated asset holdings, particularly in the US corporate bond market,” say Redeker and Khoo.

“We think the current dollar strength is unlikely to be sustainable and any near-term dollar upside should be limited,” they add.