ECU's Investment Blog
"Low inflation threatens the European project” - French PM, Manuel Valls
Much of the economic debate this week has been centred around the relative dovishness of Draghi at Jackson Hole and what this means for policy at next week’s ECB meeting. It was the tweaking of the wording of the speech (away from the text posted on the ECB website) to incorporate an acknowledgement of a significant slip in ‘medium term inflation expectations’ that drove market positioning.
"Over the month of August financial markets have indicated that inflation expectations exhibited significant declines at all horizons. The 5year/5year swap rate declined by 15 basis points to just below 2% - this is the metric that we usually use for defining medium term inflation. The Governing Council will acknowledge these developments and within its mandate will use all the available instruments needed to ensure price stability over the medium term." - Draghi (Jackson Hole speech)
Draghi, utilises the concept of medium term inflation expectations (and their anchoring) as a key pillar of the monthly ECB policy meeting statement: A concept which is utilised to demonstrate that the ECB are attaining their mandate of price stability across the Eurozone. If therefore there is evidence to suggest that medium term inflation expectations (and thus price stability) have become, or are in the process of de-anchoring, then the policy implications are significant.
Newton’s Third Law of … Economic and Political Traction?
The prospect of action at next Thursday’s policy meeting was pooh-poohed by comments released yesterday afternoon citing ECB sources. The comments were, however, very vague and uninformative - "New ECB action next week unlikely, but outcome much depends on August inflation data.” The August inflation data is scheduled for release on Friday (expected at just 0.3% y/y), so we don’t have long to wait. In essence, however, the debate over whether or not action comes at Thursday’s meeting remains an issue for timing rather than direction. It is clear that the eurozone economy is losing economic (and political) traction and that the direction and momentum of monetary policy is, in the near term equal and opposite to that of the US and UK.
"Never put off until tomorrow what you can do the day after tomorrow” - Mark Twain
Amid disappointing employment data in Germany this morning (and sharply weaker annual retail sales in Italy), the economic backdrop continues to disappoint across the Eurozone. In many respects, however, it is the political backdrop that is deteriorating faster. In this regard France is once again at the forefront. The new French government continues to push back against deficit reduction targets as the PM, Manuel Valls urges the ECB to go further in fighting dis-inflation and continues to protest the level of the EUR, as he (increasingly audibly) argues that the "pace of deficit reduction can be debated” amid a backdrop of stagnation.
We continue to expect the positive risk backdrop to be supported by the slow hawkish transition of the Fed and, as the US economy continues to outperform, the macroeconomic and monetary policy differentiation continues to support the USD vs. EUR. Today that focus will be on the Jobless claims and the revision to the Q2 GDP, which recorded a much higher than expected 4.0% annualised on its preliminary release. Tomorrow brings the Fed’s preferred measure of inflation (the PCE), where further stabilisation will add to pressure on the Fed to remove the ‘considerable time’ language of its forward guidance as the economy approaches escape velocity, perhaps as soon as the September meeting.
Och Aye the ‘No’?
In the UK, the Scottish referendum debate is becoming increasingly audible (Angela Merkel commented last night that she "expects the Scots to reject independence”). There is increasing evidence from options markets of a pick-up in volatility around the timing of the vote as the market assesses the appropriate risks associated with the vote. As we move into September, and move past the ECB policy decision on the 4th we expect the impact on GBP (and perhaps more specifically, GBP volatility) to become more acute. While our views align with those of Ms Merkel, September may bring GBP back to the fore, potentially for all the wrong reasons.
First law of holes: If you find yourself in one, stop digging!
As the weekend’s proceedings at Jackson Hole got up to ‘full steam’ the financial market week was drawing to a close. As a result the respective testimonies of Fed Chair Yellen and ECB President Draghi had a minimal impact. Following a brief period of reflection, however, the bank holiday thinned start to this week began with a correction in the underlying level of EUR vs. USD as a function of the respective monetary policy bias of Yellen and Draghi. We have been suggesting for a long time now that we are heading into a more acute period of economic and monetary divergence between the US (and UK) and the Eurozone. This weekend’s activity is, we believe, indicative of the risks and trajectory of economies and currencies alike as we move into Q4.
In the US, our view that economic momentum is stronger than consensus and the USD continues to be undervalued remains unchanged. The testimony from Janet Yellen, brought nothing in the way of policy announcement, but a great deal in terms of the progression of economic variables and their impact on monetary policy going forward. The view of Yellen as unwavering uber-dove, is being replaced by one where the development of the economic data is key to the timing and pace of monetary normalisation.
The acceptance that employment levels are approaching target and that labour market slack gauges need to become "more nuanced”, along with acceptance from the Fed that deflation risks have diminished continue to provide a positive backdrop for (front end) US interest rates (The longer end remains more a function of the uncertainty surrounding the ‘new’ medium term equilibrium level of interest rates), and allied with the improving growth backdrop, supportive for the USD.
"The tone from most when it comes to Europe is best described as worrying” Luc Coene
Over the bank holiday weekend in the UK, it was not just the South East of England upon which the rain fell – the clouds also darkened over the Eurozone and once again, it was France at the forefront of concerns. While the Jackson Hole testimony of Janet Yellen could be described as a transition between dove and hawk, that of Draghi was resolutely further towards the dovish end of the monetary bias spectrum, suggesting that the ECB "stand ready to adjust our policy stance further.”
Triangular Dichotomy… Tri-chotomy
In the Eurozone, as monetary policy explores the possibilities beyond the lower bound in interest rates, there is a growing triangular dichotomy. This tri-chotomy highlights the interconnected issues facing the Eurozone: debt (deficit) reduction, growth and political risk.
On one side of the triangle, is the need for fiscal prudence and responsibility. The recent decline of Eurozone bond yields, following the announcement of OMT and more recently lower interest rates and the possibility of QE has reduced government financing costs and should have enabled further structural reform and debt / deficit reduction. However, despite rising pressure from the German contingent for Eurozone nations to maintain (or regain in many cases) the pace of deficit reduction agreed and laid out in the Eurozone deficit reduction targets, progress has been minimal at best.
On the second side of the triangle and in some respects viewed as the counter argument to deficit (debt) reduction is the quest for growth. With Contraction across many of the Eurozone nations in Q2, and overall a very feeble showing for H1, growth is arguably the biggest threat to the Eurozone. Over the weekend Michel Sapin said that "the euro area risks spiralling contraction”. Adding insult to injury, the lack of growth combined with non-existent inflation, means that debt and deficits are more likely to rise in the near term than fall.
On the third side of the triangle and inherently linking the other two sides, is the political landscape. This weekend’s debacle in France, where the third government in two years (and the second in 5 months) was hurriedly put in place yesterday after the left wing ‘anti austerity, pro-growth’ revolt of (Ex) Economy Minister Arnaud Montebourg. While Draghi urged better use of fiscal flexibility within EU rules and Germany argues that ‘growth friendly consolidation is not a contradiction’ the Political boiling over in France is not likely the last we will hear on this debate. Political parties and political ideals are only valid while they have the support of the people.
From our viewpoint this particular triangle continues to point downwards for the EUR!
In addition, Draghi also stated at the weekend that the ECB will "acknowledge the change in [market-based] inflation expectations”, that have been lowered over recent weeks, pointing to the potential for further ECB accommodation going forward and from an interest rate perspective, the Jackson Hole impact was to see a sharp widening of the EURUSD 2 year interest rate differential to new cyclical wides in further support of the USD over the EUR.
"The Humble are in danger when those in power disagree” - Phaedrus
In our most recent postings, we have maintained our view that both the UK economic recovery and the imminent (Q4) monetary normalisation remains on course. Last week and earlier this week, we also discussed the risk that the market had overreacted to the recent weakness in wage growth. We argued that the likelihood of at least one dissenting vote from the MPC in the August BoE meeting was being roundly ignored by the market and that any such dissent would likely counter the near term dovish GBP sentiment.
BoE’s Weale’s come off…
The release of the August minutes yesterday duly announced the dissenting votes of McCafferty and Weale, who both voted in favour of an immediate 25bp rate hike. In many respects, this signals the start of the Monetary policy debate in earnest. Our central expectations remain that economic strength in Q3 (which we expect to at least match the Q1 and Q2 growth pace of 0.8% q/q), coupled with gradually rising wage pressures (as unemployment continues to decline) and, the desire for the path of gradual rate rises, warrant a UK rate rise in Q4 2014.
Our relative hawkishness is further supported by recent evidence that suggests that the second half of 2014 will be (potentially significantly) stronger than was expected as recently as May. This theme was explicit in the minutes and while the BoE forecast for 2014 was raised to 3.5% from 3.4% (as well as revising expectations of a slowdown in H2, to a maintained pace of growth throughout H1 and H2), we see scope for somewhere closer to 4.0% for the year as a whole. In addition to this, the Confederation of British Industry (CBI) released its latest survey yesterday which highlighted 29% of respondents reporting stronger orders than usual. Further confounding expectations of a growth slowdown in H2, 42% of industrial businesses expect output growth in the quarter ahead.
Outliers or advance party?
The market reaction to the split MPC vote was minimal, as many chose to classify Mssrs Weale and McCafferty as outliers and not merely the advance (hawkish) party. The minutes stated that "Consumer spending, household and business investment were all anticipated to make positive contributions to growth throughout the forecast period” and, from our perspective, these contributions warrant a Q4 rate hike as we progress to a normalisation of UK rates.
Bank staff will also be conducting further analysis regarding the evolution of labour supply over the coming months (as they try to further understand the sharp dichotomy between concurrent job gains and wage weakness), the findings of which could also be key to confirming or disputing a rate hike in Q4.
Fed on the Turn?
From our perspective, the minutes of the July FOMC meeting constitute a further hawkish progression from the Fed. Statements such as "Many Fed officials said job gains might bring a rate rise sooner” and "Participants saw the job market noticeably closer to normal”, were clear signs that the bias at the Fed is turning. To draw an analogy, with the size of the Fed balance sheet and the sensitivity of international markets to the Fed normalisation process, the ‘turn’ may be as gradual as that of the QE2. Nonetheless, it is a turn.
While some may continue to argue about the level of ‘economic slack’ in the economy, overall we continue to see strength and depth. We thus maintain our (very) long held view that the first rate hike in the US comes in Q1 2015 – earlier than market consensus. We will have to wait for next week for any significant input from a data perspective, but rising US yields (particularly as they are led by the front end of the curve) continue to support USD gains in the near term. The annual Central Bankers’ meeting at Jackson Hole gets underway tomorrow, and while it is unlikely that it is the stage for new policy revelation, it would be foolish not to pay heed to the possibility.
"A change of rhythm is needed” Pierre Moscovici
In Europe, the situation is becoming more complicated on many levels. This morning’s German PMI data highlighted a more moderate slowdown in August than the market had expected. However, the Eurozone-wide measure highlighted a more pronounced deterioration pointing to more acute deterioration in the periphery. Throughout H1, the PMI data has been a poor barometer for GDP growth in the Eurozone, as thay have maintained the trajectory of expansion, while the official GDP figures have fallen into stagnation (or worse!). On this basis, it is worth paying attention to the consumer and economic sentiment data, which is more closely correlated to GDP.
The other rising concern in the Eurozone is the growing political tension. France remains the main ‘anti- austerity’ protagonist, as continued economic stagnation raises the volume of the calls for delays in the deficit cutting targets. Pierre Moscovici commented overnight that the "weak EU growth justifies deficit flexibility”, and government spokesman Le Foll said yesterday that France wants "Eurozone crisis taken into account”, citing low inflation and weak growth. As Germany become increasingly frustrated with the resistance to austerity and lack of progress on structural reform, the situation in France shows little sign of improving. It is generally accepted that France needs an annual GDP rate of around +1.5% per annum in order to create new jobs. With no growth in H1 this year and an official forecast of "no more than 1.0%” in 2015, French unemployment is likely to continue to rise well into next year. The French dissent has potentially only just started!
…only half way up
Over the weekend, BoE Governor Carney added to the ongoing UK rate hike timing uncertainty by stating that the BoE will not wait for rising wages to lift rates. This follows the dovish market response to last week’s Quarterly Inflation Report (QIR). In the press conference that followed the release of the QIR, Carney twice said "wages are not a threshold for policy" adding "I can't be clearer than that". It is possible, therefore, that the weekend’s utterances indicate a certain amount of frustration, or indeed were intended to ‘smooth’ expectations ahead of the possible revelation of a dissent (or more than one?) when the minutes of the August BoE meeting are released tomorrow.
Whatever the rationale, and while we have long been advocates of a Q4 rate hike in the UK, the recent rhetoric and data, which has seen short sterling futures and GBPUSD retrace all of the hawkish response to the Mansion House revelations, have only added to the uncertainty. Expectations for the first UK rate hike have indeed been marched to the top of the hill… and then marched down again.
This morning’s UK inflation data further disappointed the rate hawks as clothing prices dragged the headline index lower in July (after boosting the June data) as the timing of price cuts distorted the annual comparison. Despite the technicalities, however, lower price pressures reduce the urgency on the BoE to act and, despite the fact that we see the wage inflation data levels in July as the low point for the year (and subsequently rising into year end and beyond), we will likely now need some signs of further acceleration in growth and/or positive price developments to prompt a rate hike in 2014 (which remains our core view). All UK and GBP focussed eyes, however, now turn to the August BoE minutes and the (very real) possibility of one (or more) hawkish dissenter.
…when they were down, they were down
In the Eurozone, the economic backdrop is increasingly and more uniformly negative. Following the very disappointing Q2 GDP data from the region last week, yesterday’s Bundesbank Monthly Report clearly stated that the "German economic outlook has clouded” and that the "data cast doubt on German H2 rebound”. Today, the focus is on the UK and the US. However, the release of the flash estimates for August PMI surveys on Thursday, will likely be key to Eurozone sentiment and, from a technical perspective, a break below the 1.3333 level in EURUSD will likely trigger further selling.
In addition to the weak economic backdrop, the political backdrop within the Eurozone is becoming more fractious and increasingly negative. As Berlin heads for confrontation with the social democratic governments of Italy and France over Europe’s fiscal compact, Moody’s warned yesterday that France’s inability to reach deficit targets would prove a test of the eurozone’s ability to enforce fiscal rules. Mario Draghi’s ‘whatever it takes’ mantra was not likely meant to include political mediation for the ‘spat’ between the eurozone’s biggest members, the negative implications of which are not yet priced by the market.
Neither up, nor down
On Friday, (FOMC voting member) Dallas Fed President Richard Fisher, stated that the "market is trading too dovishly compared to the FOMC”, following up on his previous comments that he had not dissented due to the fact that the Fed were "moving in his direction”. This sentiment fits with our view that the US economy is, and will likely continue to be, stronger than consensus expectations and, as a result, US monetary normalisation will come sooner and ultimately tighten at a faster pace than is currently market expectation. In accordance with this view, and despite its recent frustrating progress, we continue to favour the USD on FX markets.
The US data calendar is fairly light this week, although focus will be on the release of the July FOMC meeting minutes on Wednesday and the testimony of Janet Yellen at the Jackson Hole conference on Friday. At Jackson Hole, the events are centred around the topic of "re-evaluating labor market dynamics this year” and it is likely that the sentiment and rhetoric reflect the same tone and verbiage as the recent Humphrey Hawkins testimony and July statement.
As the global economy grows at a very pedestrian pace, with global exports continually disappointing, the importance of gaining a share of that slower growth (and export market) becomes ever more important. In that environment, currency valuation is a key variable and (as we saw last night from the RBA, and recent protestations by the French) a weak USD will likely face increasing political resistance.
Our favoured view at the current juncture remains EUR weakness, as the uncertainty over growth prospects increase and the chances of further stimulus (perhaps even full blown QE) increase. As we move through the traditional holiday month of August, we expect activity and trading volumes to pick up and EUR selling to increase as stronger US growth and the ‘risk’ backdrop (with US yields holding up) continue to support the USD.
"The road to success is always under construction” - Lily Tomlin
As we have noted many times over the past few months we are broadly ambivalent as to the fortunes of GBP against the USD in the current environment. As US growth rebounds and interest rate expectations begin to shift towards normalisation, exposing a clear divergence between US and Eurozone policy, there is a growing case for USD strength. Furthermore, we maintain the view that the USD remains broadly undervalued and as monetary divergence unfolds, we continue to favour GBP and USD vs. EUR (and to a lesser degree due to monetary inactivity and geopolitical risks, the JPY).
This morning, we have seen further evidence that the economic backdrop for the Eurozone is deteriorating with Germany’s Q2 GDP contracting 0.2% q/q matching the very poor Italian performance for Q2. France also disappointed expectations with a second consecutive quarter of stagnation – a performance which led the French Finance Minister Michel Sapin to declare that "France will not meet its deficit target this year”. German growth felt the pinch from the decline in global export activity as net exports detracted from growth in the quarter, which was further dented by the fall in construction spending that was seemingly brought forward into Q1 due to mild weather. Our sentiment is largely summed up by ECU Global Macro Team member, Kit Juckes, who said this morning:
"That just highlights Draghi’s problem. Too little growth to stop the debt snowball, a vicious cycle of fiscal austerity and lack of aggregate demand staying in place and dooming Europe to Japanification.”
The main focus yesterday was Bank of England Governor Carney and his delivery of the August Quarterly Inflation Report (QIR), preceded by yet another strong UK employment report. We have noted before that the base effects of delays in bonus payments last year have weighed on earnings growth figures, but beyond that the wage inflation / productivity puzzle continues to … puzzle. Despite the continued strength in what the BoE refers to as the ‘quantity measure’, or the nominal rise in employment, the weakness in wage growth (and ultimately its implications for the BoE mandate of inflation) dominated sentiment and price action.
Infamy, Infamy, they’ve all got it in for me!
Historically, GBP has been very sensitive to interest rate movements and relative yield differentials. With rates having been ‘on hold’ for such a long time at the effective zero bound, that sensitivity has been heightened. On that basis, the reaction of short sterling interest rate futures after yesterday’s QIR is significant. The boost in GBP (GBPUSD through 1.70) came after the (now infamous) June Mansion House speech where Carney indicated that a rate rise "could happen sooner than markets currently expect”. In delivering the August QIR yesterday, Governor Carney came under further criticism for the Bank’s forward guidance (alleged) inconsistencies and the heightened uncertainty with which Carney described the expected paths of wage growth and productivity, led markets to price a lower probability of a 2014 rate hike than was priced at the time of the "sooner than markets expect” rhetoric. This undermined GBP on foreign exchange markets.
Dissent in the ranks?
With the data calendar fairly light for the rest of the week, there is a risk that the decline in GBP extends in the short term. However, there was one comment from the QIR report which brought an extension of GBP’s decline, where we disagree with the markets’ interpretation. Carney stated that "Now is not the time for a rate increase”. Our viewpoint on this is that if there were a case for a rate hike now, then it would have been implemented last Thursday. That is not to say that a rate rise will not be deemed appropriate in Q4 Indeed, we still believe that there is a strong possibility of a hawkish dissent from last Thursday’s meeting when the minutes are released next week.
In short, the disappointing wage growth and the Governor’s disappointing lack of conviction have dented GBP in the near term. However, we maintain the view that on both economic and monetary differentiation, GBP should resume its outperformance against its Eurozone counterpart once this "healthy” short term market setback has run its course. Similarly, recent sessions have seen disappointing progress from the USD, however we mirror the sentiment of Carl Icahn who said recently "We can no longer simply depend on the Federal Reserve to keep filling the punch bowl” and while this was likely directed at the ‘Yellen put’ for equity (and asset) markets, we maintain that US monetary policy will turn hawkish, more rapidly than the markets currently expect.
With geopolitical concerns having ebbed over recent days, the market’s attention will likely turn back towards the macroeconomic backdrop this week. The data flow this week, while modest, will likely continue to highlight the economic divergence between the UK (and in terms of second tier data, the US) and the Eurozone (and, while distorted by the increase in sales tax on consumption, Japan). After a long period of global economic underperformance, global zero interest rate policy and global QE, economic and monetary divergence among major economies will likely see a marked pick up in volatility. This is just the beginning.
If Germany sneezes, will the rest of Europe catch a cold?
In years gone by the phrase ‘if the US sneezes, the rest of the world catches a cold’ was analogous with the fact that the US, as the world’s biggest consumer and financial market, was a critical input in deriving the fortunes of the rest of the global economy. Over recent months, if not longer, it has been Germany that has been the last bastion of economic growth for the Eurozone economy. First quarter GDP growth in Germany was flattered by base effects and unusually warm weather and, at 0.8%, likely boosted the EUR. However, the resultant base effects and hangover from the early expenditure of Q1, means that Q2 is likely to be considerably less impressive. We have stated previously the considerable fall in German exports to Ukraine and, more importantly, Russia in the first five months of this year. Taking this all into account Q2 GDP will likely be negative in Germany. Going forward, the further negative impact of sanctions and embargoes on trade, mean that Q3 could be significantly worse.
So, with Italy back in recession, France teetering on the edge and the possibility that Germany tips into negative growth in Q2, the macroeconomic backdrop continues to favour EUR weakness. Perhaps more pertinently, this backdrop continues to favour monetary accommodation (and even further easing from the ECB) at a time where we feel the UK and US are closer to the rate hiking cycle than centrally expected. In our view, this continues to favour GBP and USD vs. EUR.
In Japan, the GDP data is expected to contract sharply – by as much as 7% at an annualized rate – which reflects an unwind of a strong first quarter, as well as the effect of an increase in the consumer tax to 8% from 5% in April. So far, the BoJ has maintained its existing policy, which has created concern in the financial markets that Abenomics might be running out of steam.
At a recent Treasury Select Committee hearing Mark Carney was referred to as an "unreliable boyfriend”, a criticism of his dovish forward guidance (later amended when the unemployment rate reached 7% significantly earlier than expected), then followed more recently by hawkish criticism of market expectations for the timing of the first rate hike. As we move towards a period of greater economic and monetary divergence, greater emphasis will be placed on the reliability of global (boyfriends – girlfriends in relation to Janet Yellen) central bank heads.
In the UK, all eyes will be back on Carney and the Bank of England Inflation report forecasts tomorrow. Recent sentiment towards the UK recovery and thus GBP has moderated over recent weeks, with GBPUSD down over 2.5% from the highs, however, from our perspective; there is more fuel in the tank for the UK recovery and for GBP over the coming months.
With UK unemployment continuing to fall and with the suggestion the MPC’s Ben Broadbent that the risks to Q3 growth forecasts are to the topside, we maintain our view that the first UK rate hike will come in Q4. Indeed, we would suggest the possibility of an acceleration of the decline in the unemployment rate this month, looking for 6.3% on the headline rate. Furthermore, anecdotal evidence from graduate employers suggests that July saw a sharper annual rise in wages for new starters (+20% y/y) and, while base effects are likely to continue to mute wage growth data in the very short term, we expect wage pressures to build from here into year end.
This morning’s ZEW is a stark reminder of the serious economic ramifications of the tensions in Ukraine / Russia and the fragility of both sentiment and economic recovery in the Eurozone (even in what is presumed to be the strongest). Any further improvements in the UK (or US) data, or hawkish rhetoric from here, will likely have increasingly negative implications for the EUR.