Parsing Divergence: Focus Shifts from Fed to ECB

The last two weeks have been about the US.  First,
it was Jackson Hole. The leadership of the Federal Reserve, Yellen,
Dudley and Fischer sang from the same songbook.
They all signaled that the time was approaching to take another step in the
normalization of monetary policy, without specifying precisely when.  
Then it was the US employment report, which
Fischer had specifically
identified as important. 
After the July
employment data in early August, the US 2-year yield was at 72.2 bp.
  It finished last week at 78.6 bp.  It was down six basis points on the week, with the decline mostly the result of the disappointing manufacturing ISM earlier in the week. The yield closed fractionally higher after the August
employment report before the week the weekend.  
The September
Fed funds futures implied a yield of 41
bp after the July jobs data, and after
everything was said and done, it implied
a 41.5 bp at the end of last week. 
 The net change after the August jobs
report was a quarter of a basis point or
the spread between the bid and offer.   By our calculation, the implied
41.5 bp yield is the same as a 22% chance of a rate hike later this month.
Bloomberg’s WIRP, which has become a widely cited benchmark, puts the odds at 32%.
The CME, where
the Fed funds futures trade, offers its calculation here.
  Its estimate is close to ours, and
it puts the odds of a rate hike at 21%.  Reasonable people may have
different ideas on where Fed funds will average after the hike.  They have
been averaging 40 bp since late-June, but before then, they often were below
the midpoint of the 25-50 bp range.
 We made the unbiased assumption
that Fed funds would average the midpoint of the new 50-75 bp range or 62.5 bp.
The US economy
is poised to snap a three-quarter period of sub-2% growth.  
The NY Fed’s GDP tracker was flat at 2.8%.
 The Atlanta Fed’s tracker is at 3.5%,  little changed from its first
estimate for Q3 on August 3 of 3.6%.  It was taken down to 3.2% after the
construction spending and manufacturing ISM, but marked higher after the trade
figures before the weekend that pointed to a smaller drag from net exports.
The most
important takeaway is that the
composition of growth is changing this quarter. 
 Consumption will pullback after its second strongest
quarter since the crisis.  It looks as if government and investment will
improve over the second quarter.  The wild card is inventories. It is difficult to have much confidence with the
limited data that is currently available, but it looks like the inventory
headwind may still be there, even if diminished.  
Four central banks
from high income countries meet next week:
 The Reserve Bank of Australia,
the Bank of Canada, Sweden’s Riksbank and the European Central Bank.  The
first three will likely come and go with little fanfare.  
It is well known that the RBA would prefer a
weaker currency, but it not prepared to do much about it.
  Even at a record low, the cash rate
remains well above other countries’ equivalent.  It is Stevens last
meeting before his deputy Lowe succeeds him.   The Bank of Canada cannot
be happy with the 1.6% annualized contraction in Q2, but it will look past the
short-run disruptions.  June growth exceed expectations.  

With a minus 50 bp repo rate and a minus 1.25% deposit rate, and a bond
buying program, Sweden’s Riksbank, the oldest central bank in the world, should be
counted as among the most aggressive of central banks presently.  Its
economy was grew 3.1% year-over-year in
Q2. Deflation has ended, and the CPI is
rising gradually.  It enjoys a large current account surplus.  There is no pressure for fresh action.  
That leaves the
meeting is significant.  Staff forecasts will be updated.  Two things
are patently clear.  The economy does not have much forward momentum.
 Price pressures remain disappointingly subdued.  Also, it is safe to assume that despite
Draghi’s please, the reform drive has stalled, or worse.  Nor is there
much prospect for fiscal stimulus.  Yes, the tragic earthquake in Italy
could see a bit more spending, and while it may be significant for the
rebuilding efforts, it is unlikely to be on a sufficient scale.  It is
small enough for to meet Brussels’ muster, it probably will not do much on the
national level, let alone the region.  
It comes down
to Germany, and it is a question of politics; of will, not means.
  Given the decline of Merkel’s
popularity, one might tempted to give credence to speculation that she is
considering offering a tax cut.  In some other countries, maybe, but seems
unlikely in a country where there is one word for both guilt and debt.  Moreover,
maybe it misreads German politics.
 Merkel faces two challenges, and
both are to her right.  
The most
important is with the Bavarian CSU.
  The strain between the two began
over Merkel’s acceptance of making efforts to keep Greece in EMU.  There
were some domestic policy differences, like minimum wage, but Merkel’s
immigration policy was the poisoned chalice.   The CSU may run their own candidate as Chancellor if the egos are
strong enough and if there was a reasonable chance of success.  The mandatory caveat is that Merkel’s rivals have
often underestimated her to their chagrin.  
Her other
challenge is with the AfD.
  Although the party has been wracked by internal discord and fissures,
the AfD, has struck a responsive chord with its anti-immigration rhetoric.
 Through a leadership change, it has morphed from an anti-EMU party to
anti-immigrant. It is likely to be a important
force in next year’s national elections.    It is possible hat the AfD edges past the CDU in the weekend’s Mecklenburg-Vorpommern state election, but in national polls, its support is around 12%.  
Merkel tacks to
the right with a greater emphasis on law-and-order issues, but this does not
seem sufficient to solidify her right flank. 
 These domestic challenges suggest
that Merkel will have to take a hardline
on European issues over the next year.   
So, we return
to the ECB.
   Over the last few months, the TLTRO II and corporate bond
purchase programs have been implemented,
but it is too early to evaluate the results. There does not seem to be a
consensus to do more, and, perhaps, the most that can be reasonably expected is to extend the asset purchase program
beyond of March 2017.  That is probably the path of least resistance, and
if not now, when?  Given the ECB’s modus operandi, the next window of
opportunity would be with updated staff forecasts in December.  
If the ECB does
not announce an extension of its QE, many market participants are likely to be
  They could express the
disappointment by selling bonds, and possibly other risk assets.  However,
Draghi could mitigate the backing up of rates by implying that procedurally,
the formal decision would be made later,
but there was a consensus of dissatisfaction.  
However, the
decision to extend the purchases is more complicated that it may appear. 
 An extension of the program will require the a
secondary and tertiary decision about the pending shorting, primarily in
Germany but experienced on the margins by several other sovereigns as well.
 There are several self-imposed rules that
could be altered.  The one
that has captured the most imaginations is the abandonment of the capital key.  The capital key, in effect, means
that ECB buys more bonds are larger countries than smaller countries. 
There could be
other decision-making rules.
  The fanciful one is that rather than
buy bonds proportionate to GDP, the ECB could buy bonds proportionate to the
size the debt market.  This would
favor, for example, Italy over Germany.  It would solve the shortage challenge but spur other issues.  The
capital key is an important decision-making
principle and many countries, 
There are other
ways to address the shortage issue. 
 The most straightforward
is to remove the interest rate floor on purchased securities.  Currently,
the floor is the deposit rate, minus 40 bp.  There is not a necessary
link between the yield the ECB receives for overnight deposits and what the
yield it pays when it buys a negative yielding bond.  In these operations
it is not borrowing short and lending long, which would make in fact link the
two rates.  
There is
appears to be little appetite to lower the deposit rate further, perhaps in
general, but it particularly now.
  And it could not be counted on as a
reliable way to address the scarcity issue, as yields can be driven lower
still.  It could become a little like the dog chasing its tail. The yields
fall below the ECB’s floor.  The floor is
lower.  Yields fall further.  So far, in this experiment, that
is what has happened.  Lather, rinse and repeat.  

Some have
suggested raising the cap or issuer limit from the current 33%.
  While this is a bit arbitrary (what
is the difference between say 33% and 45%?), there is an underlying money and
risk management issue.  The point is that neither lifting the issuer limit
or cutting the deposit rate deeper into negative territory have limited
potential to be scaled.  

The Bank of
England does not meet next week, but the MPC will meet the following week on
September 15. 
 The recent string of data suggest
that the Brexit decision was a shock to the economy.  The July data, like
the industrial output, manufacturing production and construction that will be reported
next week will reflect that shock.
However, the news
has been superseded. 
 The August manufacturing and construction PMIs that were reported last week were better than
expected.  The combination of no immediate policy changes, including
triggering Article 50 and the divorce proceedings, and the decline in sterling
and the fall in interest rates may be underpinning British resiliency.
 Because of the structure of the UK economy, and especially the high
proportion of household debt (mortgages) are at variable rates, the fall in rates can be passed through relatively quickly.
 It has a one-off impact, as does the decline in sterling.  
The August
service PMI will be reported on Monday (while the US markets will be closed for Labor Day).
  The depreciation of sterling will
have less impact on the service sector. Although the service sector is the
largest part of the UK economy, we suspect that it has to be a significant
disappointment to boost expectations for a rate cut at the MPC meeting in the
middle of the month.  

If May is not going to trigger Article 50 until next
early next year, at the soonest, and the BOE is on the sideline, then there is
not reason why the Brexit decision needs to be the dominant driver of sterling
over the next, say, couple of months.
 That said, May indicated that the government will outline is broad plans for the post-exit relationship with the EU.  Brexit Minister Davis will present this to parliament.  It may ease speculation in some quarters that due to the complexity of the issue, or the second thoughts by some, the Brexit was not really going to happen.  

If the yen’s
strength is the most counter-intuitive development this year, then the market’s
insensitivity to Chinese developments may be among the most welcome development. 
  The moves that were so disruptive in August 2015 and
January this year have continued, but global markets have become decoupled.
  Recent data have suggested the economy is stabilizing, and the capital
outflows have slowed.  

There are two reports in the coming days that could
have impact outside of China.
 The first is the inflation measures. Deflation in producer prices is slowing, and the CPI appears stable.
 The year-over-year rate has averaged 1.9% in the May through July period,
the same as over the past 12 months.   The fall in grain prices warns of
the risk of easier price pressures. While easing of price pressures may give the PBOC scope to ease monetary policy, officials seem in no hurry to do so.  

The other
report that may impact investors is China’s trade balance. 
 China is the largest trading partner for many
countries in Asia.   Its demand for many commodities is understood to impact prices.  China’s trade surplus
appears to have begun growing again.  It has averaged $45.9 bln through
July, according to Chinese figures, which is nearly three billion more than the
average during the first seven months last year.  The August surplus is
expected to be near $58.3.   It would be the second consecutive month
above $50 bln, for the first time since December 2015 and January 2016.  
The US trade figures for July were largely overshadowed by the employment
except for
economists trying to estimate Q3 GDP. 
 However, there was one nugget that
is suggestive of coming trade tensions between the US and China.  In July,
the US recorded an overall deficit of $39.5 bln. The US-China deficit was $30.3
bln.   We suspect that regardless of the outcome of the US election, among
the most important economic issues is how China’s surplus capacity will be
absorbed.  To the extent that China tries to export it, the more intense
the clash.  The excess capacity in the steel industry was highlighted in the draft of the G20 statement.  


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