After a relative slow week following the announcement of the ECB's new initiatives and the US jobs data, the week ahead is chock full of key events. There are three in particular that can shape the larger investment climate. They are the FOMC meeting, the launch of the ECB's Targeted Long-Term Repo Operation (TLTRO), and the referendum on Scottish Independence.
I
The key issue around the FOMC meeting is the susceptibility of the forward guidance to change now that QE is drawing to a close. In particular, there are two elements that are being debated. First, in July, the FOMC statement cited the "significant under-utilization of the labor resources." Is this still a fair characteristic of the labor market? The statement was issued on July 30. There have been two monthly cycles of employment data. Taken as a whole, the data show continued improvement, though not acceleration. The labor market is healing, but it still does not appear to be in robust health.
Indeed, there is some risk that the pace of improvement slows. Non-farm payrolls peaked in April (304k) and have been down two consecutive months in July and August. While it is well-appreciated that August's initial estimate is often revised higher, what is less well recognized is that in six of the past nine years, jobs growth in September is lower than in August.
Weekly initial jobless claims put in their cyclical low (thus far) in mid-July. They have been gradually trending higher, and last week moved above the 26-week moving average for the first time since early May.
Since Yellen's discussion at Jackson Hole, more economists are talking about pent-up wage deflation. It is the idea that during the contraction, nominal wages did not fall as much as they "should" have to clear the market. The implication is that the lack of wage pressure now reflects that wages were too high previously. In turn, this means that the present lack of wage pressure should not be confused with the degree of tightness in the labor market.
At the same time, the fact that wages are sticky in both directions is consistent with a non-economic hypothesis about wages. Simply, even if crudely, put, wages reflect the relative power of the employee and employer. Despite the concern apparent heightened concern about the concentration of wealth and income and the framing of the of issue and debate by Picketty, it appears to have intensified in recent years. The social product (GDP) is growing slower, but the elites share has grown. This is clear from the continued divergence of wages and profits, and the increased wealth in absolute and relative terms since the end of the Great Financial Crisis.
The second part of the Fed's statement that will be closely watched is the reference that rates can remain low for a "considerable time" after QE ends. This has been a contentious issue for a number of regional Fed presidents. Many economists look for this to be dropped in the statement that will be released at the conclusion of the FOMC meeting on September 17. If it is dropped, the market will quickly conclude that a rate hike has indeed been brought forward. The idea would be a Q1 15 hike instead of mid-year. This would likely see an increase in short-term yields and a bearish flattening of the yield curve. It would likely spur a dollar advance.
Dropping or modifying this forward guidance is necessary for the gradual evolution of the economy and Fed policy. This is to suggest that there are a number of reasons why the FOMC would want to alter its language, and signaling a Q1 15 rate hike is not likely to be one of them. If "considerable period" is dropped, Yellen is likely to use her press conference to drive home this point.
A client survey conducted by a larger investment bank, and reported in the media, found that 30% expect "significant under-utilization" phrase to be dropping with the September statement. Another 26% expected it to be dropped in October. The "considerable time" phrase is expected to be dropped by 19% in September and 26% in October. The December meeting was picked by 44% of the respondents. This expectation seems to be more relaxed than market participants.
II
The ECB launches the TLTRO facility, and they key issue is the extent of the participation. The latest ECB rate cut that pushed the repo rate to 5 bp lowered the cost of borrowing from the TLTRO to 15 bp. The aggregate amount that can be borrowed is a function of the banks' loan book. Such calculations project a maximum borrowing of the first phase of the TLTRO (September and December) of about 400 bln euros.
The naive assumption is that banks will borrow 200 bln at each of the two opportunities. We suspect that the takedown on September 18 will likely be considerably less. Unlike the LTROs, we suspect that there may be a stigma attached to the TLTRO borrowings. The larger and healthier banks may see a beneficial result to not being seen eating again from the public trough. In addition, prudence suggests that even if one wanted/needed to participate, December might be a better opportunity. There is a small chance, though above zero that if the take down is small next week, the rules may be more favorably tweaked.
Some banks, especially it appears French and Italian banks, have been slower to pay back the LTRO funds. They may choose to replace the 1% older funding with the 15 bp of the TLTRO. We also note that there is no penalty for not using the TLTRO funds to boost lending to businesses and households, which is the facilities intent. Banks would have to repay the new funds after two years rather than four.
There appears to be many considerations going into the ECB's ABS program, which Draghi committed to without providing any substantive details. The stronger the participation in the TLTRO, it would favor more restrictive ABS/covered bond "modalities." Draghi seemed to suggest that ECB wanted its balance sheet to return to it high water mark, which requires about more than one trillion euros, to allow for the continued repayment of the LTRO.
Strong participation in the TLTRO could see the euro trade higher and could underpin European peripheral bonds. Anticipation that banks will seek to minimize maturity mismatches may be a factor behind that rally in 2-year bond prices that have driven the yield of many eurozone members below zero. Weak participation will likely see yields bounce back.
Separately, the Swiss National Bank also meets on September 18. The euro was threatening the CHF1.20 floor the SNB had set when official comments indicated that it would not rule of the adoption of negative interest rates. The euro moved further away from the floor, which seems to reduce the risk of negative rates this week. The SNB successfully got the market to do the heavy lifting with inexpensive verbal intervention. Nevertheless, given that deflation forces continue to grip the Swiss economy, and the pressure on the euro has strengthened, the risk of negative Swiss rates still seems like a potent and credible threat. We note that the EuroSwiss futures contracts (3-month CHF interest rates) imply negative rates for the next two years.
III
The Scottish Referendum was hardly more than a minor risk event on most investors’ radar screens until a single poll showed the independents with a slight lead. Sterling fell sharply. Indeed, it gapped lower, and although sterling finished the week near its highs, the gap was not closed. The economic shock that a “yes” vote would have is thought to hurt cut UK growth and postpone the first BOE rate hike.
To be sure, if Scotland votes for independence, it will not take place immediately. To the contrary, the next eighteen months will featured intense negotiations over various economic issues such as debt, currency regime, oil ownership, as well as political issues like the placement of the UK Trident nuclear submarines based on Scotland’s west coast. The UK is scheduled to hold national elections next May. Should a Scotland that will be independent in a year later vote in the UK elections?
We suspect the negative immediate impact on the UK economy is exaggerated, and the 12-cent decline in sterling since mid-July provides some stimulus. A “yes” vote would send sterling down further. We do not see why this would delay a BOE rate hike that we have been consistently expecting in Q1 2015. If anything sterling depreciation boosts the risks of inflation that two MPC members already anticipate (hence their dissents in July favoring an immediate rate hike), and makes it more likely others would join them.
Much ink has been spilled on the impact of independence on Scotland. The kind of currency regime would it have has been particularly heated. This hardly matters for international investors. And independent Scotland, even if it preserves its territorial integrity (Shetland and Orkney, which would ostensibly have claims on much of the North Sea oil, could chose not to be part of an independent Scotland by either staying with the UK or forming their own country. The voting results from this region will also be important to monitor) would not have many attractive investment opportunities. It would be another small, likely indebted, weak country who will have to go through an ascension process to join the EU.
Some observers argue that a Scotland that uses sterling or adopts the euro, would not be truly independent. While we recognize that having its own currency would be one expression of (monetary) sovereignty, we think there is a romantic notion of sovereignty in much of the discussions, and that many do not appreciate that extent the extent to which a small country next to a large country, or bloc, have real limits on their sovereignty whether or not they have their own currency.
Is not Germany and France sovereign, even though they do not have the euro printing press? Sovereign Denmark chose not to join EMU, but it kept its currency in a tight band against the euro. Its monetary policy has one goal: maintain the tight currency link. Switzerland jealously guards its sovereignty, refusing to join the EU, EMU and NATO. Yet, it has put a cap in place on the Swiss franc against the euro. Cannot a sovereign voluntarily limit its own degrees of freedom and still be sovereign?
Mexico and Canada are sovereign. They have their own currencies and both have explored some degrees of freedom from US monetary policy. However, these are very limited, and the fact of the matter is that when the US, which absorbs the bulk of their exports, sneezes they still catch cold. The vast majority of Mexico’s banking assets are at foreign banks.
A small “no” victory, which seems like the most likely outcome, will prevent the sentiment to return fully to status quo ante. Many will play up parallels to Quebec,which for a period independence was a recurring threat. However, the terms of this referendum, allowing a simple majority to carry the day, with sixteen-year-olds eligible to vote, while Scots living outside of Scotland cannot, is unlikely to be repeated. The additional devolution promised by the major parties in London may also absorb some of the angst.
On a victory for the unionist “no” vote, we expect sterling to bounce toward $1.65-$1.66. This is likely to be supported by a rise short-term UK rates, as the market belatedly gives greater heed to BOE Governor Carney’s comments from last week, suggesting Q1 rate hike expectations were appropriate. The sharp rise in sterling’s implied volatility would also likely ease.
