The ECB meeting and the US jobs data are the two key events in the coming days. At the March meeting, the ECB failed to take fresh action. That broke the equilibrium that had kept the euro in a five cent trading range ($1.33-$1.38). Only now, amid dovish comments from ECB officials and a more hawkish Fed, accompanied by a thus far sustained rise in the Fed funds and Eurodollar futures strips, have managed to push the euro back into its former range.
The US employment data will be the first since the FOMC de-emphasized the unemployment rate itself in the forward guidance if offered, choosing instead to focus on a wider array of economic variables. Clearly, with the shifts in participation, the unemployment was always a flawed threshold, though useful up to a point.
The shift in the Fed's forward guidance may encourage a change in the market's focus. We suggest that average hourly earnings may be of greater importance than the market often attributes to it. At her press conference, in response to a question, Yellen played down the modest increase seen recently.
Average hourly earnings had risen by 0.4% in February and some observers have warned that this is a sign of a tightening in the labor market and the beginning of the long called for increase in inflation. However, average earnings seemed to have been inflated by the statistical consequence of the decline in hours. The decline in hours is likely distorted by the weather.
In any event, the year-over-year pace has been between 1.9% and 2.2% since November 2012. Even if it ticks up in this week's report, as last March's 0.1% gain drops out of the measure; the direction is sideways.
A strong report is likely to reinforce the rise in US short-term yields. It will test the idea that the dollar has become more data sensitive. At the same time, there is a presumption that the tapering will continue at the measured pace barring a significant economic shock.
In contrast, with weak money supply growth, a continued contraction in lending, an elevated EONIA (more than twice the effective Fed funds rate), and an economic recovery that remains, as Draghi says, weak, fragile and uneven, the ECB is under pressure to provide additional accommodation.
The tone of official comments has turned more dovish and the BBK appears to have eased its opposition to QE. However, the ECB still refuses to recognize risks of deflation and sees "light at the end of the tunnel" as the BBK's Dombret suggested last week.
There was a decline in short-term interest rates in response. Indeed, last week, the widening of the US premium over Germany on 2-year rates was more a result of the decline in Germany (6 bp) than the increase in the US (2 bp).
Surveys suggest an overwhelming majority do not expect the ECB to cut rates. Expectations could be adjusted after Monday's release of euro area March CPI. Soft German and Spanish figures before the weekend warn of further disinflationary forces. The year-over-year CPI is likely to slow to 0.6% after a February reading of 0.8%. This would be a third of the pace seen as recently as February 2013 and half the pace seen as recently as August 2013.
The euro's pullback appears more related to the loss of upside momentum as the $1.40 level was approached than pricing in a rate cut. In addition, the price action before the weekend warned that short-term European rates (Euribor futures and the German 2-year bond) may have bottomed.
The failure of the ECB to act may reinforce a cynicism among many observers that Europe got the benefits of OMT, though it has not been operationalized. Investors want to action. That may be a bit harsh, as the Draghi has surprised the market and in a more dovish direction several times. The ECB offered a facility, OMT, but no country has chosen to trigger it. That is not Draghi's fault. It was not a bluff.
While a stand pat policy, even if accompanied by dovish rhetoric, would likely see the euro's upside tested. Euro extremes are often marked by a double top or bottom. If $1.40 is tested and largely remains intact, it may boost confidence that a top of some import is in place. The reaction to a dovish surprise is a more difficult call. Of course, it partly is a function of precisely what is done. However, a relaxation of policy could spur more fund flows, especially into the periphery, which may be euro positive.
There are a number of other events that, while not having the systemic impact of the ECB meeting and the US employment data, may impact the investment climate.
First, China's PMIs will provide a fresh update of the world's second largest economy. The Chinese economy peaked in 2011, around the time the MSCI Emerging equities peaked. The bulk of the slowdown is behind it. Chinese officials are signaling a desire to stabilize growth. However, to be sure, the focus has shifted from the real economy to finance. Officials are trying to wring out some of the excesses, and this will help reduce excesses in the real economy.
Lending to industries that suffer from excess capacity is being slashed by 20% this year and again next year. The weakening of the yuan is forcing an unwind of some of the leveraged speculative positions. The apparent increase in corporate failures also re-introduces risk and at least begins to address the ubiquitous moral hazard problem.
The yuan spent last week consolidating the prior week's losses. The PBOC drained funds from the banking system and the 7-day repo rate has jumped, finishing last week at near 5.45% after pushing briefly through 6.0%. It was at 2.25% as recently as March 6.
Second, while the BOJ continues to buy about $75 bln worth of securities a month, the Japanese government is set to hike the retail sales tax to 8% from 5% on April 1. The anticipation of the tax may have helped boost Q1 GDP at the cost of Q2 activity. The economy's performance after the tax is key to the policy response (from the BOJ in terms of more monetary stimulus and from the government in terms of a supplemental budget). The tax will steal the limelight (and significance) from the Tankan report, which is likely to show softness in forward looking subcomponents.
Third, the UK monthly cycle of data begins with three PMIs. While the Japanese economy likely picked up in Q1 after the lackluster 0.2% pace in H2 13, the US economy slowed as in Q1, the UK economy appears to have maintained its momentum. The UK appears to have achieved this and generated less price pressures. UK gilts appear to be trading more in line with US Treasuries and less like a core European bond.
Sterling itself underperformed most of the month, but this ended last week. A move above $1.6660 could spur a re-test on the $1.6800 area. Euro has approached a trend line near GBP0.8235. A break of this signals a challenge on the February low near GBP0.8160.
Fourth, the Reserve Bank of Australia meets this week and is widely expected to leave the cash rate at 2.5%. Its displeasure with the strength of its currency has been duly noted, but has lost its sting The RBA will not change policy. Nor is it prepared to significantly step up intervention. That said; it is a bit stretched against the US dollar after a 1.8% rise last week.
Fifth, we note two highlights in emerging markets. Turkey held local elections on Sunday and they are being heralded as a referendum on Prime Minister Erdogan. The early results suggest the AKP is losing the mayor contests in Istanbul and Ankara. The opposition CHP is doing well in the preliminary results. The Turkish lira is trading on the firm side of a 7-week trading range against the dollar (~TRY2.17)
Brazil's central bank meets and is widely expected to hike the Selic rate by 25 bp to 11.00%. The real has strengthened following S&P's decision to cut the country's rating. The change to a stable outlook may have been more important. The real traded at 4-month highs against the dollar at the end of last week (~BRL2.25). It looks particularly stretched and closed both Thursday and Friday last week beyond two standard deviations from its 20-day moving average (Bollinger band).
