Reasonable people can debate some of the details, but there was little doubt that last week's big event, the ECB's asset purchases, were widely anticipated. Nevertheless, what is striking is the repeated surprises by officials over the past several months.
Perhaps it began at the end of last October with the Bank of Japan's 5-4 vote to double down on what was already an unprecedented pace of expanding its balance sheet. The in November was OPEC's decision, not to reduce production to make room for increased US production and other non-OPEC producers. Also in November, the People's Bank of China unexpected cut its 1-year deposit rate, spurring an advance of nearly 40% in the Shanghai Composite in the following six weeks.
A few hours before the Swiss National Banks stunning decision to lift its cap on the franc, the Bank of India announced a rate cut in between policy meetings, catching the market off-guard. There have been other surprises by emerging market central banks in recent weeks, and all in the direction of easing policy.
There are no fewer than eight central bank meeting in the emerging markets in the week ahead (Thailand, Israel, Russia, Hungary, South Africa, Mexico, Colombia, and Malaysia). While the risk is the greatest that Thailand cuts rates, there is scope for surprise rate cuts. We suspect it is a question of time before Russia, South Africa, Malaysia, and Colombia cut rates.
The Bank of Canada had its own surprise for investors last week when it unexpected cuts its overnight cash rate to 75 bp from 1.0%. It was the first change in rates since the mini-tightening cycle in 2010.
These stand in stark contrast to the Federal Reserve. The Fed gave investors months to prepare for tapering of its asset purchases, and even waited a bit longer than many had expected. It then proceeded to taper. It did not let an unexpected contraction in Q1 14 GDP distract it. It did not let an acceleration of the pace of job growth distract it. Nor were some bouts of market volatility sufficient. It said what it was going to do. It then did it. This is one form of credibility.
The Federal Reserve concludes its two-day meeting on January 28. The statement is unlikely to change substantively since the last one in mid-December. Whatever negative impact is thought to be spurred by the dollar's appreciation (restrictive), it is more than offset by the decline in oil prices and interest rates.
The FOMC's forward guidance is evolving. It has shifted from a "considerable period" to being "patient" before raising rates. There is no need to change that now. The March meeting is a horse of a different color. If the forward guidance is not shifted in March, ideas, which we share, of lift-off taking place around mid-year will have to be reconsidered.
There have been two data points that seemed to work against the optimistic view that gets one to a Fed hike in a several months. Average hourly earnings fell, and retail sales (even when autos, gasoline, and building materials are excluded) were disappointing. Investors may have made too much of these reports, and the data end the end of next week that could help to correct the impression.
First, within the first official look at Q4 GDP (which is expected to be the third consecutive quarter of above 3% annualized growth), will be an estimate for consumption, of which retail sales account for about 40%. Consumption is expected to have posted its strongest quarterly growth in four years; rising by 4% after a 3.2% annualized increased in Q3.
Second, Q4 Employment Cost Index (ECI) will be reported. As the name implies, this index is a broader of the costs incurred to secure a labor force. It includes direct costs, like wages, but also indirect costs, like benefits and taxes. Employment costs rose by about 0.44% at a quarterly average rate in the 2009-2013 period. The pace has increased. In Q2 and Q3 it rose, employment costs rose 0.7%. The ECI is expected to have risen by 0.6% in Q4. When the ECI runs higher than CPI, it implies profit margins are declining.
With the ECB new bond buying program not being implemented until March, investors' attention will return to politics and economic data. Three notable data points will be provided: Spain's Q4 GDP, flash eurozone January CPI and money supply figures. Many observers highlight the improvement in Spain, and Q4 GDP is likely to match Q3's 0.5% pace. However, it has been insufficient to slow the meteoric rise of Pademos, which is kindred spirits of Greece's Syriza.
If the polls are correct, Syriza is going to win a plurality of the vote in Greece. It will be given 50 bonus seats in the 300-member parliament. It has three days to secure a majority. If this fails, New Democracy, the expected second largest party, will have three days to do the same. A third party will get an opportunity if it fails. If that too fails, new elections will be called. This is what happened in 2012.
While political uncertainty will likely remain elevated in Greece for most of the week ahead, Italy's political drama unfolds. A new president must be picked. Beginning Thursday, and limited to two rounds a day (in some kind of bizarre reminder of the Italy's poor economic performance) a new president will be picked. The first three rounds require a 2/3 majority. Starting with the fourth round a simple majority is sufficient. The first three rounds are about posturing. The real drama lies in the backroom deals between allies and rivals.
The January flash CPI report will give a taste of the challenge of the ECB's efforts to put prices back on track to reach its target of near, but below 2% on the headline rate. By simply deciding that its target is really the core rate, some pressure would be alleviated. Egos and inertia more that economic rationality lies behind the reluctance. Deflation is likely to have intensified. January CPU is expected to have fallen to -0.5% from -0.2% in December. The core rate is expected to be unchanged at 0.7%; low but not deflation. The ECB model projects its asset purchases will push CPI up by 0.4% this year and 0.3% next.
Meanwhile, the financial conditions in the euro are were improving before the new asset purchase program was announced. The recent bank lending survey showed an increased in demand from businesses and households. The M3 growth is expected to have accelerated to a 3.5% year-over-year pace in December. It has risen steadily since bottoming in April 2014 below 1%. Credit extension also likely improved. On the margins, this may encourage participation in the TLTRO.
The UK reports its first estimate of Q4 GDP. It is expected to have slowed from 0.7% to 0.6%. The average quarterly growth over the last seven quarters has been 0.6%. Although the two dissenting hawks on the MPC capitulated, Governor Carney has indicated that the central bank will look past the one-effect of the decline in oil prices on inflation. Sterling's weakness against the US dollar, where it fell below $1.50 last week for the first time since July 2013 is being offset on a trade-weighted basis by sterling's rise against the euro, where it is at seven-year highs.
Japan reports a slew of data. Even though, the yen seems more sensitive to the equity markets than the data there are three points to consider. First, despite the unprecedented pace of the expansion of the BOJ's balance sheet, price pressures continue to ease. When the sales tax increase drops out of the base, it will be even more evident that there is a poor correlation between a central bank's balance sheet and consumer prices.
Second, despite a tight labor market (3.5% unemployment rate and 1.12 job-to-applicant ratio), wage growth is poor, and household consumption is weak. Overall household consumption likely finished last year 2.3% lower than December 2013.
Third, the combination of a weaker yen, the drop in oil prices and US economic growth above trend will improve Japan's trade balance. The December deficit is expected to narrow to JPY735 bln form JPY893 bln in November. The seasonally adjusted figures show similar improvement. Merchandise exports are expected to have risen by 11.2% year-over-year, which would be the strongest in 2014. Foreign demand may also have help spur the expected 1.2% increase in December industrial output.
Last week's MOF data showed Japanese investors bought a record amount of foreign shares. There was a spike up in JGB bond yields. The combination of the two may reflect the ongoing diversification of Japanese pension funds and the reform of GPIF. For their part, foreign investors have sold Japanese bonds for four consecutive weeks; a streak not seen in a year. Foreign investors have also pared their holdings of Japanese shares for the fourth week in the past five.
Monetary policy in Australia and New Zealand is set to change. The Reserve Bank of New Zealand meets. It will likely signal that its mini-tightening cycle has ended. It is too early to reasonable anticipate a rate hike, but we suspect that is the direction of the next move.
For its part, Australia reports Q4 CPI figures. The year-over-year pace is expected to fall to 1.8% from 2.3%. This would be the lowest since the middle of 2012. Some observers have played up the correlation between New Zealand's CPI, which was reported on January 20 at -0.2% on the quarter and 0.8% year-over-year. Our correlation work on level and change over the past five years points to a 0.4-0.5 correlation. In any event, a soft inflation report in Australia will likely encourage speculation of an RBA rate cut as early as next month.
Lastly, we note that the message coming from the earnings reports of the world's three largest international energy service companies, Schlumberger, Haliburton, and Baker-Hughes was nearly identical. Contracts are falling faster in North America than in other regions. Schlumberger reported a 25-30% decline in North American customer spending compared with 10-15% in the rest of the world. Haliburton reported a 25-30% decline in the US. Baker-Hughes data show a 15% drop in US oil rigs since October 2014. It says Saudi Arabia has shut down a single rig over the same period.
As the earnings reporting season continues, Royal Dutch Shell and ConocoPhillips will report earnings. Investors will be keen to for more information on capital expenditure plans and hedging strategies.
