If the narrow ranges that have dominated are going to end in the week ahead, the impulses can come from four sources, it would seem. These are Federal Reserve Chair Yellen’s testimony to the Joint Economic Committee of Congress, the ECB meeting, Chinese economic data and the conflict in eastern Ukraine.
Each of these potential sources are important in their own right, but in terms of market impact, one stands out the most, and that is the ECB meeting. First, though let’s consider the other events.
Yellen’s testimony is a risk because investors are still getting used to her communication style, and arguably she is getting used to presenting as the Fed chief, though her resume in public service is extensive and impressive. However, the risk of her going off message before Congress seems marginal at best.
Her message is clear, and she has honed it since the mid-March gaffe. The economy is recovering, but the central bank remains unsatisfied with the progress in achieving its one of its three (not two mandates, as often suggested. Ironically and tellingly, many observers forget/ignore the mandate of financial stability): namely fully employment. And indeed, the April employment report again shows the divergence between the headline non-farm payroll growth and decline in the sharp decline in the unemployment rate and the broader measures that Yellen has cited, including, average earnings, part-time work and the participation rate.
The Federal Reserve is on course to continue its measured pace by which it is slowing its asset purchases. At $45 bln, a month in purchases over the next six weeks is will have returned to the pace that was initially announced when QE3+ launched. The first rate hike is still some time off, even though there are some hawks at the Fed that would favor any earlier move.
The fact that the US 10-year yield is so low (slipping below 2.60% at the end of last week) is one of the big surprises for asset managers this year. Such a low yield is not suggesting fears of a Federal Reserve that will let inflation get out of hand. While the Fed’s yield suppression policies are still operating, but it is buying few Treasuries and then when the yield was nearer 3%.
Next week is a heavy reporting week in China’s data reporting cycle. The data is unlikely to change observers’ minds. Officials continue to struggle to rein in credit expansion, which, while slowing, still appears to be fairly strong.
Export growth is expected to remain weak, which should help temper some of the criticism of the yuan’s weakness. Owing to China’s role in the global division of labor and the international supply chains, a relatively small amount of the costs of inputs for its exports are denominated in yuan. Therefore, a larger decline in the yuan is needed to boost overseas sales.
We note that China’s imports are also slowing. This will be a headwind for countries and companies that were anticipating increased exports to China. However, as we noted before given the growth of the Chinese economy, 7% growth now is likely to do more for the global economy that say 10% growth five years ago.
Meanwhile, the crisis in Ukraine is intensifying, and the eastern part of the country has become the front line of the conflict. It may be a single incident from becoming a civil war. As the German foreign minister put it recently, EU officials got too carried away by the opposition to the previous Russian-allied government (where the president had been elected largely due to the votes from east Ukraine) and did not give geopolitics its due (Really? Since Russia’s occupation of some areas in Georgia in 2008 and its use of both carrot and stick tactics to intimidate some of its neighbors, Germany and France still sold Russia military assets). Putin is taking full advantage of the opportunity created by this overreach by the EU.
Since the situation as not stabilized, a new round of sanctions by the US and the EU is likely. It has yet to be seen in the data, but many investors and officials are wary that that the sanctions will be a headwind to the fragile economic recovery in Europe. The manufacturing PMIs would more likely pick up weakening impulses from abroad, but corporate earnings, especially in the energy and auto sector may pick up some impact.
Separately, some anecdotal reports suggest capital outflows from Russia have accelerated. This may be an additional source of demand for euros, Swiss francs, British pounds, and some suggest Israeli shekels. There is also some concern that given the credit downgrades, banks with exposure to Russian government and corporate bonds, and especially French and Austrian banks, may be particularly vulnerable.
This is a nice segue into the ECB meeting. Most observers recognize that with the small uptick in the flash April CPI and the new staff forecasts not available until June that a move this week is unlikely. A stand pat ECB, however, even with the ongoing threats of more dramatic action, could see the euro push higher as the event risk passes.
New staff forecast for growth and inflation are important, but only for one set of ECB challenges, namely the threat of deflation. We expect the staff forecasts to continue to be consistent with other economists, including the team at the IMF, that indicate little chance of deflation in the euro area as a whole. The IMF’s forecasts point to Greece as the only member to experience deflation this year. The staff currently forecasts headline inflation in the euro area at 1.0% this year and 1.3% in 2015. There does not seem to be a compelling case to change these at this juncture.
Instead, and what many observers seem to be missing is that economic growth in the area is catching and the staff’s forecast of 1.2% growth may be in need of an upward revision. Policy makers and investors need to remain vigilant, but nearly three months into the Ukraine/Russia crisis and the economic knock on effect seems minor.
The transmission mechanism of the ECB’s monetary policy appears to be working again. Bond yields in the periphery have fallen dramatically, and Spanish and Italian ten-year yields are near record lows. Foreign participation in the debt sales have increased. There still is the problem of access to capital by small and medium businesses, but the ECB’s surveys suggest that there are understandable demand side constraints and, in any event, conditions are improving. Meanwhile, time is being bought to create the conditions to revive the asset-backed securities market that could be used to help facilitate credit extension to SMEs.
Taken together, these points do not seem to justify what we have called “nuclear options” of an unprecedented negative deposit rate, with unintended and unforeseeable consequences, or an asset purchase scheme. If more investors come to this view, it could prove to be euro positive.
At the same time, there are some challenges the ECB faces that do not necessarily depend on new staff forecasts. EONIA has become elevated and more volatile and this has effectively tightened some aspects of the financial conditions in a similar way that an increase in the effective Fed funds rate would. There are several steps the ECB could take and it may not necessarily wait for June.
The step that we have advocated is narrowing the rate corridor by cutting the 75 bp lending rate. A 25 bp would send the desired signal, while not sacrificing much control. Rarely have spikes in EONIA exceeded 50 bp, but as the balance sheet of the ECB falls and excess liquidity trends lower, it is possible that in the future that the upper end of the rate corridor is tested.
The ECB could deliver a small cut in the 25 bp repo rate. Even a 10-15 bp cut could weigh on EONIA, leaving aside the month end squeezes. To increase excess liquidity, the ECB could cut required reserves, like it announced in late 2011. It reduced required reserves to 1% from 2%. A case can be made now with the new bank capital requirements that required reserves have been superseded.
We think the likelihood of a new LTRO is slight because of the downside risks (the decline in interest rates makes is less attractive for banks, while the lack of broad participation would increase the stigma on those who would draw on it). In addition, a new LTRO would likely strengthen the linkages between banks and sovereigns, just as they are showing some signs of weakening as officials wanted.
The elevation of EONIA has been a significant obstacle to the ECB’s ability to sterilize the SMP purchases. It could formally stop its sterilization efforts. This would provide extra liquidity into the banking and thereby help to ease EONIA, at least for a period of 2-3 months, as the LTRO repayments slowly eat away at it.
The risk is that if the ECB does nothing and Draghi relies on his verbosity, simply getting past the event could be euro positive. While still shy of the dramatic unconventional options of negative deposit rates or asset purchases, the risk of more modest action by the ECB seems higher than many observers are suggesting. If not, the risks seem to be asymmetrically distributed to the euro’s upside.
