Shape of the Investment Climate
he economic data due out in what for many will be a holiday-shortened week is unlikely to change macro-economic picture:
• Even though the US economy is strengthening after a dismal first quarter, the peak in the Fed’s balance sheet is still the better part of six months out, and the first rate hike is more than a year away.
• China, the world’s second largest economy, has slowed, though the focus is just as much on the financial sector, where the yuan has weakened and financial conditions have tightened.
• The world’s third largest economy, Japan has instituted a retail sales tax, just as data shows that industrial production and household spending have turned down. Although first quarter growth likely accelerated from the 0.2% quarter-over quarter pace seen in Q3 and Q4 13, the economy may contract in Q2.
• The euro area economy has graduated from contraction to faint growth, but growth remains, as ECB President Draghi say, “weak, fragile and uneven.” Eonia is elevated, and there seems to be a strengthening consensus that more central bank action is required.
As the yield on 10-year US Treasuries recorded their biggest decline in a month and US 30-year yields fell to their lowest level since last July, investors learned that weekly initial jobless claims made new cyclical lows. Subdued price prices and inflation expectations (e.g., 5-year/5-year forward breakeven is just below 2.4%, more than 35 bp below the five-year average). Meanwhile, the US S&P 500 suffered its largest drop since 2012. This week’s data is likely to show the even without much use of credit cards (revolving credit), the household consumption (retail sales account for about 40% of consumption) is recovering after a soft start to the year. Industrial output also likely strengthened. Prices (CPI) are subdued. Housing starts are expected to jump back after some weather induced weakness.
Yellen’s speech to the NY Economics Club will be scrutinized for policy clues, but we suspect the pendulum of sentiment has swung nearly as far as it will. Interest rates approaching important low levels, like 2.6% on the US 10-year, 30 bp on the US 2-year yield (assuming one 25 bp rate hike in 2015, we estimate fair value as no lower than 40 bp) and near 90 bp implied yield on the December 2015 Eurodollar futures contract. The S&P 500 is approaching an important retracement target just below 1800.
At the IMF gathering over the weekend, ECB President Draghi gave the strongest signal to date that the central bank is indeed preparing new unconventional measures to arrest the slide in inflation. He was quoted in the media confirming that the euro’s strength “requires further monetary stimulus.” However, while many observers have advocated quantitative easing, reports suggest that as Bundesbank President Weidmann and Bank of Finland’s Governor Liikanen may be speaking for an emerging consensus that if the problem is the euro’s strength is a major force depressing prices, then the most effective policy is a cut in interest rates rather than QE.
There does seem to be truth in IMF head Lagarde’s undiplomatic claim before the weekend that is was just a matter of time before the ECB takes unorthodox steps. Whatever the ECB is going to do is at least a month and a half away. Although officials play down the significance of any one CPI report, the preliminary April reading, due out at the end of the month, is understood to be critical. The ECB is counting the Easter-effect being unwound in April that will boost CPI from 0.5%, the lowest level in more than four years. This was thought to be necessary to give Draghi and others time to build a consensus for action in June, when the staff unveils new inflation forecasts (it has consistently erred in seeing more inflation that actually has materialized).
The incredible success of the Greek bond auction has many observers scratching their heads. The economy is 25% small than before the crisis and its debt is closer to 170% of GDP (from 120% on the eve of the crisis), yet some investors, reportedly a third of whom were hedge funds and a full 90% were non-domestic investors) seemingly could not get enough of the paper with a 4.95% coupon. We suspect there is a logic to this and not simply naive and over-the-top speculation as many pundits have intimated.
The reasoning is at least three-fold: First, the cost of servicing the country’s debt, which is largely in official hands, is likely to come from easing the conditions through officials reducing the interest rate and extending the maturities, making it easier to service the modest amount of debt in private hands. Second, the diminished risk of Greece dropping out of EMU means that the redenomination risk has all but evaporated. Third, although the bond auction was successful beyond belief, it is unlikely to be repeated often as the private sector funds are still relatively expensive compared with the official sector
China’s financial conditions are tightening, though this week’s data is expected to show that officials are still struggling to slow down lending. Last week China failed to sell the full amount of 1-year paper it offered. Only CNY20.7 bln of the note was bought compared to the CNY28 bln that was offered. The rate was nearly 25 bp higher than expected at 3.63%, and yields were closer to 3.32% for paper with the same residual maturity. The 7-day repo rate, which reflects interbank liquidity jumped 75 bp last week to 3.75%, despite the PBOC conducting its first liquidity injection via repos since January. Corporate tax payments have aggravated the existing pressure and speculation of a rate hike here in Q2 continues to be picked up by the media.
Tensions in Ukraine are escalating. Forces sympathetic to Russia, if Russia is to be believed that it is not their personnel , have taken over a couple of cities in the eastern part of Ukraine and have incited unrest in more. Even before this, the US and Europe were threatening more sanction as Russian forces remain amassed on the Ukraine border. The position and weapons of those forces (including surface to air missiles, according to reports) is leading NATO to conclude that Putin is seeking the full occupation of Ukraine. Separately, before the weekend Putin’s letter to European officials warning that Ukraine’s failure to pay for its oil and gas risks cut-offs and pre-payment requirements for further supplies. This got Europe’s attention of course, but there is a contractual dispute. Putin says that Gazprom is owed about $35.4 bln for past subsidies ($17 bln) and fines ($18.4 bln) under a take-or-pay scheme.
We conclude by identifying three additional events this week that investors should note: First, the UK’s data is likely to show that the labor market continues to heal and the unemployment rate may slip to 7.0%, the previous threshold in the BOE’s forward guidance. Earnings growth is expected to improve, but the CPI should eased, perhaps falling to 1.5%, which would be the lowest since the beginning of Q4 2009. Second, the Bank of Canada is not about to change rates at this week’s meeting, but it may recognize that the economy is likely to recover in Q2 from a poor Q1, helped by a stronger US economy and that this may help put a floor under prices. Finally, New Zealand reports Q2 CPI figures midweek and barring unexpected weakness, the Reserve Bank of New Zealand appears poised to hike rates on April 24 in Wellington.
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