Overreaction Corrected, Fresh Look after US Jobs

With Japanese markets closed for a 4-day weekend, it was up to Europe to correct the overreaction to Draghi's comments yesterday. And correct they did, lifting the euro nearly a cent to almost $1.3140. Sterling was helped by a stronger than expected CIPS service PMI and approached $1.5560 after dipping below $1.5500 yesterday. 

The greenback is holding on to the lion's share of yesterday's gains, but the yen is largely sidelined. The Australian dollar has stabilized as well, despite increased speculation of a rate cut next week (OIS ~60% chance) after a dismal service sector report.

Of note, the Canadian dollar has been unable to participate in the foreign currency recovery today after Canada surprised by naming Poloz to replace Carney at the helm of the central bank starting next month. In his initial speech Poloz, coming more immediately from the Export Development Canada, emphasized exports to help promote a more vigorous recovery. The CAD1.0170-CAD1.0200 is the next important barrier for the US dollar.

The main event before the weekend is the US jobs report.  The consensus calls around 150k in private sector jobs.  This would be better than the first print for March of 95k, but still below the 3-month average of about 170k and the 6-month average of about 200k.  The report comes amid a slowing economy.  Pace of growth in the current quarter is expected to be around half of Q1.  

The drivers of the slowdown are two-fold.  First is the inventory cycle.  Despite the widespread use of just-in-time inventory practices, an inventory cycle is still very evident.  Inventories were replenished in Q1 and are set to slow.  The ISM showed inventory building fell to a 4-month low in April.  New orders slowed.  Manufacturing employment fell to a 5-month low.  

The second headwind on the US economy is the fiscal drag.  As it is now better appreciated, the fiscal multiplier is difficult to estimate. However, the impact is felt through a number of channels, including the payroll savings tax, the winding down of the wars, and in other government projects.  The March construction report showed the biggest decline in government projects in more than a decade.  

While we had recognized the economic case for an ECB rate cut, we thought the other larger considerations would tempt it to stay on the sidelines until next month.  The majority had expected a cut, but if the ECB was going to get the most of  the 25 bp cut in the refi rate, which is understood to be of limited economic impact, it had to jump up and down and make a big deal of it. 

And that is exactly what Draghi did by changing his tone about a potential cut in the deposit rate, which is now at zero.  He reiterated that the ECB is technically prepared and was "open minded" about it.  Officials today have downplayed an change in ECB policy or that the discussion of the deposit rate at yesterday's meeting covered new ground.   

No major central bank as adopted a negative deposit rate in several decades.  Even in the aggressive easing by the BOJ announced a month ago did not include a cut to even zero of its equivalent to the deposit rate--interest on reserves.  Nor has the Fed cut its interest on excess reserves.  We think a negative deposit rate would be more disruptive than helpful and can only be a policy of last resort. 

There was a news report suggesting that several ECB members, led by Constancio and Noyer, wanted to do more, with some talking about a 50 bp move.   This is a highly unusual leak and it strikes us that it was likely intentional.  Not as some have suggested to help drive down the euro, which had been neither strong nor weak near its 100-day moving average, but to reinforce the message that there is more the ECB can do.  

This is as important as a signaling device as Draghi's indication that full allotment at the refi operations will continue through at least the middle of next year.  Investors would react differently if it thought the ECB was truly at the end of its rope, that it had exhausted its policy options.