One of the key issues hanging over the market since April when the policy signals pointed to a move by the ECB in early June was precisely what it would do. In recent days, it has become clearer that the ECB is more likely to cut rates than initiate an asset purchase program.
There are three interest rates the ECB could. The first is the lending rate, which stands at 75 bp and marks the top of its interest rate corridor. Usually in low or falling interest rate environment, the rate ceiling is of lesser importance. However, a lower lending rate, under current conditions, cold help reduce the volatility of overnight rates (EONIA).
The second rate it could cut is the re-finance. It is at 25 bp and under the current policy setting, the ECB is willing to provide as much funds at this rate as banks want, limited only by the acceptable collateral. A 10-15 bp cut seems to be the consensus view. The ECB also could extend the period for which is it willing to provide full allotment (unlimited funds). There have been some calls to reduce the refi rate to zero, but this seems to be an outside possibility. Even though EONIA has traded above the refi rate, a lower refi rate may still exert, albeit, limited downward pressure on overnight rates.
The third interest rate that the ECB could cut, and the most controversial is the deposit rate. It currently stands at zero, and there is much talk that the ECB could set it at -25 bp. This would, in effect, tax banks for leaving excess reserves at the ECB. The tax would hit banks with the most surplus funds that hardest and these of course are mostly from core countries, excluding France. Banks from peripheral Europe and France may account for 20% of the funds at the ECB. These banks typically are net borrowers and so lower rates would also likely benefit them the most.
There are secondary effects of a negative deposit rate that may overwhelm these primary effects. It is important to recognize that such a measure has not been implemented by a large economic area. Even at the worst of its deflationary phase, Japan never forced banks to pay for the privilege of leaving funds with it. Banks are likely to pass on the negative rates to customers, as some banks did when Denmark adopted a negative deposit rate. This may lead to a change in the way corporations and institutional investors manage their euro balances.
The prospects of a negative deposit rate may be a factor weighing on the euro. However, more importantly, the recognition that an asset purchase scheme is somewhat less likely, has helped encourage increasingly nervous investors in the peripheral European bond markets. As we have noted, IMF and EU officials have expressed concern about the sustainability of the peripheral bond rally and some institutional investors has been quoted by the press indicating some profit-taking had begun.
The flows leaving the periphery appear to be returning to core bonds. Last week, 10-year Treasury and bund yields fell 13-14 bp. Gilts, with the help of a dovish BOE's Quarterly Inflation Report and soft earnings growth data, outperformed with 17 bp decline in 10-year yields. In contrast, Italy's 10-year yield rose 9 bp, Portugal 16 and Greece 59 bp. Spain fared best, with only a 2 bp increase in the 10-year yield.
Funds also seemed to move into emerging markets. The MSCI Emerging Market Index (equity) rose 2.5% last week, easily outperforming the major indices. Emerging market bonds also rallied. Some investors are also moving into eastern and central Europe, including Poland and Hungary. HSCB will report its flash manufacturing PMI survey for China at midweek and some sign that the world's second largest economy is not slow further may also provide some support for emerging markets as an asset class.
Global monetary conditions will remain extremely accommodative. Soft US industrial output and manufacturing data on the heels of a disappointing retail sales report continues to discourage investors from taking too seriously St Louis Fed's call for a rate hike as early as Q1 15. Even now the Federal Reserve is buying more long-term assets than it was when it first announced QE3+ in September 2012. The rally in short-sterling futures suggests the BOE has been successful in pushing out interest rate hike expectations. The BOJ is the main exception. It is leaning against expectations that it will have to increase its $70 bln a month of asset purchases.
The economic data scheduled to be released in the coming days is unlikely to change the basic economic assessment and policy outlooks. The FOMC minutes will do nothing to change perceptions that those officials that are emphasizing the economic slack, particularly in the labor market, are in a majority over those who are emphasizing the risks of such extremely accommodative monetary policy. The stronger than expected housing starts reported last week, is likely the start of some more constructive housing data, including existing and new home sales reports this week.
We do not expect the minutes from the Reserve Bank of Australia or the Bank of England to be very revealing. The RBA is clearly on hold and prefers a weaker currency. The BOE's minutes have been trumped by the Quarterly Inflation Report. Next month's Financial Policy Committee meeting is more important in terms of macro-prudential efforts to address housing. This will reinforce the BOE's signal that it is in no hurry to raise rates.
Separately, it appears that UK consumer prices are stabilizing while retail sales should accelerate from the nearly flat (0.1%) rise in March. They will be reported Tuesday and Wednesday respectively.
The flash euro zone PMI will be reported on Thursday. It should not be surprising to see the PMI begin to move broadly sideways after the strong advance in recent quarters. That said, the real economy has not performed much different than the ECB expected. There is no evidence that the risk of deflation is sparking a downward spiral in demand as consumers postpone purchases in anticipation of lower prices.
Politics, rather than economics, may be the key talking points in the coming days, ahead of the EU Parliament election in the second half of the week, with results announced on May 25. Polls suggest that the anti-EU parties may draw as much as a quarter of the vote, with France's National Front and the UK's Independent Party doing particularly well, with implications for national campaigns. It appears to be a very close race between the center-right EPP and the center-left S&P.
The Ukraine presidential election will be held on May 25. That will likely begin a new phase in the crisis. Reports suggesting that non-uniformed combatants (Blackwater) maybe confronting non-uniformed Russian allied combatants in east Ukraine also appears to be mark a new phase. It continues to appear that the limited sanction regime is having a somewhat greater cooling off effect on Russia's financial and trade ties than it may have initially appeared.
Perhaps it is Putin's trip to China that may be the most suggestive of change. It might take Europe a few years to cut its dependency on Russian energy if it wanted. However, that is the direction that its strategic interest lie. Russia's actions, especially the annexation of Crimea and its continued bully behavior towards Georgia and Moldova, has alienated it from the Europe. It must turn to Asia. Chinese officials are well aware of this. They hold the whip hand. It is an opportunity to secure low energy prices on a long-term contract. That this can turn into a strategic relationship is unlikely, but it may serve Russia and China's interest independently to at least pretend this is possible.
For its part, China has adopted different tactics in Hong Kong, and Taiwan than Russia is on its borders. China would not accept Tibet, for example, of having a referendum on independence. It abstained in the UN Security Council vote to condemn Russia. To the extent the Russia's actions in Europe frustrate the US effort to implement its Asian pivot, China is unlikely to undercut it.
China has its own problems in securing its territorial claims. The regional hostility toward Japan and the nationalistic impulse of Prime Minister Abe win little general support. The Philippines dispute with China may be dismissed as a client state of the US. However, the confrontation with Vietnam has escalated over the weekend, leading China to evacuate some of its citizens. Unlike Japan and the Philippines, Vietnam does not enjoy a security treaty with the US, leaving it more vulnerable to Chinese reprisals.
Lastly, the electoral victory in India of the BJP and its allies is encouraging investors and fanning the hopes of reform. In the five sessions, through May 15, foreign investors bought $1 bln of Indian shares, almost 20% of what was bought since the start of the year. Last week, Indian shares rallied 5% about 50% of what they had risen up until then. The rupee was the strongest of the Asian currencies last week appreciating 2% against the dollar. Before last week, it had gained about 3% since the start of the year. We expect Modi to enjoy a honeymoon that will be good for investors and recommend global investors embrace potential near-term profit-taking as a new opportunity to participate.
