ECB Meeting and UK Election Key Drivers in Week Ahead

This week’s
two main events, the ECB meeting and
the UK national election have drawn
investors intentions in recent weeks.  
The ECB may take a baby step
on what promises several quarter exit
path from its extraordinary monetary policy.   

UK Prime Minister May’s call for a snap
election was seen as a strong move, taking advantage of the apparent weakness of her domestic rivals and
strengthen her hand in negotiations with the EU.  
At the same time
preventing an election that would have complicated the conclusion of the Brexit
negotiations. 
 May used the reaction to the US decision to pull out of the Paris Accord as an opportunity to put some distance between the UK and the German, French and Italian response. In recent weeks, the initial Tory lead has been whittled
away to the point that YouGov is projecting it will be 18 seats shy of a
majority.

In the UK the need for a coalition
government is often referred to as a hung parliament. 
 If the election does result in a
hung parliament, a coalition will be particularly tricky.  The tightening
of the polls is not so much driven by the loss of Tory support, despite some
seemingly electoral gaffes. Rather what appears to have happened is that the
Labour Party is increased its support primarily at the expense of the Liberal
Democrats and the UK Independent Party.   The Scottish Nationalist Party
may unexpectedly find itself in a position to shape Brexit, with knock-on
implications for a second referendum on independence (and staying in the EU).
The Lib-Dems may be reluctant to enter
into a new coalition with the Conservatives. 
 They were decimated in the last
election, and may not win sufficient seats to give a coalition a majority.
 The Tories had been loath to formally
enter a coalition with UKIP, but post-referendum, and given the
political realities, it may be reconsidered.
In foreign exchange market, the US
dollar’s weakness is masking political anxiety in sterling. 
However sterling has lost about 4.5%
against the euro in a slide over the past six consecutive weeks. It has fallen nearly 3% against the yen
in the ongoing four-week drop. On a trade-weighted basis, sterling fell
throughout May, losing 2.75%, before recovering a little last week.
 Volatility has increased (three-month implied) for the past three weeks,
and the skew in the risk reversal (puts and calls) has moved sharply in favor of puts.
The FTSE 100 reached new record highs
before the weekend. 
 There
seemed to be an interesting logic at work.  If the election outcome was
favorable than equity market would rally and the FTSE 100 would go for the
ride.  If the election outcome were
unfavorable, sterling would be sold and
this would cushion the downside of the FTSE 100 where foreign earnings are so
important.
Over the past year, generally speaking,
developments that favored what is arguably an ill-defined soft Brexit often was
seen as positive for sterling. 
 Developments that were seen
as tilting the odds in favor of a hard
Brexit were often sterling negative.
 Now that Article 50 has been triggered this may change.  
Ostensibly, formal negotiations will begin shortly after the election. Much of
the initiative now is in Brussels’ hands. Perceptions of a weak leader at
10 Downing Street may be harmful to the investment climate at precisely when
circumstances require more.
The economy slowed more than expected in
Q1 and did not appear to be
reaccelerating in Q2. 
Inflation
is expected to peak in the coming months when oil’s recovery and the impact
from sterling’s steep losses fade.   The Bank of England meets the middle of June again but is widely
understood to be on hold for a considerable period. The Brexit
negotiations are going to be fraught with tensions and harsh words, especially
in the beginning of this two-year process
for which the clock is already ticking.  The liberal global trading system
that has evolved over the last 70 years is being
challenged from within at the same time that terrorism is threatening from without.  A third terrorist strike in the UK this year took place on Saturday.   
If May’s call for an election in the first
place, which contravened the previous Tory government’s attempt to set fix
schedules for elections, was unexpected, the relative success of Labour, led by
Corbyn, is a complete and utter surprise. 
 A Labour-led coalition government
would like to scare many investors, and
the first instinct may be to sell-off UK assets if this became a distinct
possibility.
In contrast, most developments on the
Continent have gone rather swimmingly.
 The eurozone economy continues to expand at a solid and steady rate of about 0.4%  a quarter. The
political threat posted by the (among other things) anti-EMU
populist-nationalism has been turned back at every opportunity.  The
threat of an Italian banking crisis subsided. An index of Italian bank
share prices is up more than 10% year-to-date.   Italy seems to be moving
toward a precautionary recapitalization of Monte Paschi, and could also include
addressing Veneto banks as well.
Although Greece’s debt burden has not been lifted, the risk of another crisis seems
to have been put off until at least until toward the middle of next year when
the current aid package ends. 
 In the meantime,
Greece’s 10-year yield has fallen 100 bp this year already, and it has
practically all happened in the March and April.  Greek stocks have also
rallied strongly this year.  The 22% gain of the Athens’ Stock Exchange is
the most in Europe.
A combination of energy prices, the past
depreciation of the euro, and higher prices of some vegetable prices pushed up
headline and core inflation in the euro area. 
 It is acceptable for central banks
to look through some economic developments if the impact is thought to be
transitory This is what the Fed has repeatedly
done, and the Bank of England is doing it now, with inflation running a
bit hot.
Some of the creditor nations in the eurozone have never been wholly supportive of
many of the unorthodox measures, and seem to seek the earliest possible exit.
 
As economic
conditions have evolved, the ECB collectively has modified its forward guidance
and is preparing to do so again on the same day as the UK goes to the polls.
  Specifically, the ECB is expected to modify its language on the outlook
for interest rates and its risk assessment.
The ECB has told investors that interest
rates will remain at present or lower levels if needed. 
It can drop the downside bias.  The
market has effectively done this already. The ECB would be validating
what the market has done.  The ECB has indicated that downside risks have
diminished, and the ones that exist stem from exogenous factors (maybe Brexit,
US trade policy, China’s economy).  It could say the risks are fairly
balanced, and it would be a small incremental change.

In fact, such expectations seem so widespread that if the ECB do not make these
changes, it may be seen as dovish, even though making these minor changes are
not exactly hawkish. 
 Draghi
has indicated that it is premature to talk about the exit strategy, and this
applied to the negative deposit rate as much as the asset purchases.  The
earliest the ECB will announce its intentions for next year is September.
 The ECB is expected to buy 30-40 bln euros of assets in the first part of
next year, down from 60 bln currently and 80 bln most of the last year and through Q1 17.
The ECB’s staff will update its forecasts.
 Growth forecasts may be revised a
little higher. 
What
would reinforce Draghi’s message that inflation is not yet on a sustained path
toward the target despite the recent elevated readings would be driven home if
the staff trimmed this year and/or next
year’s inflation forecast.   Medium-term averages of the euro have risen
around 5% since its March forecasts, and
a medium-term average of the Brent has fallen by about 5%.
Buy the rumor, sell the fact type of
activity could be seen in response to the ECB, but sentiment toward the euro
may not change unless US rate premium grows.
  The euro finished last week on its highs of the
year, within striking distance of $1.13, last seen in the early response to the
US election last November.  A potential trendline is drawn off the August 2015 high (~$1.1715), and May 2016 is
found near $1.1450 by the end of June.  (~$1.1615).
There is little technical or fundamental
reason to expect the euro to reverse lower in the week ahead. 
 The US economic data calendar is
light.  The non-manufacturing ISM, durable goods orders and consumer credit will not alter investors minds about the
trajectory of Fed policy.  Fed officials
enter their quiet period ahead of the next FOMC meeting so they will not be
able to try to shape the investors’ understanding of the recent news that
included the third successive decline in the core PCE deflator, weaker auto
sales (which may have knock-on effects on retail sales and future impact
manufacturing output), and a tepid employment report.
Not only will European events overshadow
US economic news, but so will the US politics.
  First, there are press reports
claiming to have identified President Trump’s first two appointments to the
Federal Reserve’s Board of Governors.  Rather
than commenting on the candidates themselves, we share a caveat.
 Investors may want to look past some partisan claims.  There are few
dissents from Governors in recent years.   It is difficult to tell based
on voting records which Governors were appointed
by a Republican President and which by Democrat Presidents.
As it turns out, Governor
Powell is currently the only Republican appointee.
  His voting record and demeanor suggest great continuity
if the speculation is true that he replaces Yellen as Chair early next year.
  That said, Volcker, Greenspan, and
Bernanke were each appointed by the President from one party and reappointed by
the President of the other party.
The second important US political
development is the testimony of former FBI Director Comey before the Senate
Intelligence Committee investigating the alleged involvement of Russia in last
year’s election. 
 It
is important for investors because the more protracted the imbroglio, the more investors may question the
Administration’s ability to legislate its economic program that had included
corporate tax cuts, and tax reform, deregulation and a large infrastructure
initiative. Ironically, a distracting political crisis would likely be bullish US bonds, on slower growth
and inflation ,and less demand for capital.  That decline in interest
rates may weaken the dollar while lending
support to equity prices.

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