The Week Ahead: Central Banks in Focus

We suspect that the move in the capital markets that has dominated the first several weeks of the new year has been completed and a new phase has begun.   This is positive for equity markets in general.  Core bond yields rise.  We suspect the pressure on emerging markets will lessen.  This is likely to coincide with a pullback in the yen after a 3% gain since the start of the year.

There are no policy meetings for the major central banks this week, but they are the focus for investors in the week ahead.  

The new Chair of the Federal Reserve has not spoken about policy for three months.   Her silence will be broken with congressional testimony this week.    Yellen’s testimony may prove more interesting from a stylistic point of view rather than substance.   She has helped shape Fed policy and was on board with the tapering and forward guidance.  She cannot be expected to deviate from the Fed’s general economic assessment or the path Bernanke outlined in December.    The key message will be one of continuity not innovation.  

The wing of the Fed that was associated with the doves favors continued measured slowing of the long-term asset purchases.  The wing that is associated with the hawks advocates quickening the pace.  Yellen will resist the rearguard action of the hawks and she will likely have the macro economic developments on her side. 

That is to say that after accelerating in H2, the US economic activity is likely to moderating.   Three main forces are at work:  inventory-run down, inclement weather, and the rise in interest rates.    Last week’s trade figures warn that Q4 GDP is likely to be revised lower.  This week’s main economic report is January retail sales.   We already know that auto sales and chain store sales were softer. 

The Bank of England’s quarterly inflation report takes on extra significance this week.  Governor Carney has indicated that it will update the forward guidance that had not only listed certain knock-out considerations, but also identified the 7% unemployment level as a threshold for a review of monetary policy.   The media have been particularly hard on Carney, and many observers have claimed he is abandoning forward guidance (FG).  This does not ring true and seems to purposefully distorting FG. 

  

Yet, Carney and the BOE are not blameless.  Recall that the type of forward guidance Carney had adopted at the Bank of Canada was date-specific.  He had anticipated excess capacity (or output gap) would be closed a few quarters out and that the removal of accommodation would be necessary.    At the BOE, he anchored the forward guidance to data as did the Federal Reserve.  Both specifically cited the unemployment rate.    This is a mistake because the unemployment rate is regarded as a lagging indicator, has little to do with the overall economy, and more importantly, with inflation.   

Regardless of the unemployment rate, the labor market cannot be considered tight if wage growth remains weak.   Given its mandate, the Federal Reserve has a better justification for using the unemployment rate as a threshold.   The Fed has repeatedly signaled that rates will remain low until well after the unemployment rate falls below 6.5%.  

It is simply naïve to think that Carney will jettison forward guidance.  Central banks have long provided insight into their intentions.  Rarely has there been a pre-commitment, but there has often been guidance.  This guidance is all the more important in the current context as central banks want to assure households, investors and businesses are confident that officials will not pull away the punch bowl prematurely.  

The German Constitutional Court ruling before the weekend will keep the ECB in focus. Essentially, the Court indicated (in a 6-2 vote) that although it appears that the ECB's Outright Market Transaction (OMT) scheme overreached its authority, it referred the judgment for the first time to the European Court of Justice.  

The euro initially wobbled on the decision as many observers feared that the stability that the OMT pledge brought the EMU would be dashed.  The kind of conditions that the court suggested might be necessary to bring it into accord with its mandate would gut OMT and severely undermine Draghi's pledge in July 2012 to do whatever is necessary.   The German court suggested to be legitimate, the program should not reduce a country's debt, should be limited in scale and should not impact prices.  This is what most of the immediate analysis focused on.  

While offering its opinion, the German Constitutional Court recognized that it lacked the authority to judge the European Central Bank.  Only the European Court of Justice has the standing to rule whether the ECB had violated its mandate and if OMT was tantamount to monetizing national debt, which is expressly forbidden.   This is very important and did not seem fully appreciated by much of the near instant analysis.  

The European Union operates on the basis that treaties are primary law and is given precedence over national law.  By referring the case to the European Court of Justice, the German Constitutional Court formally recognized this principle.  The German court recognized its own limitations, and in so doing will, arguably, strengthen the supra-national effort.  

Under the normal timetable, the European Court of Justice could take 18 months to issue its ruling, though under fast-track provisions, a decision could be made this year.   The ECB and notably the German finance minister, have argued that OMT is not tantamount to monetizing debt and is therefore within the ECB's remit.    Draghi repeated this assessment less than 24 hours before the German court issued its finding.  

The German Court is expected to make its ruling on whether OMT violates the German constitution on March 18.   This will become an important date for the striking of euro options and forwards.  As OMT has not been activated, and most likely will not by then, the European Court of Justice is unlikely to issue its preliminary ruling, the German court may yet provide its more typical,"yes, but" formulation that allows greater integration provided German parliament retains an important role.  

The German Constitutional Court's raison d'etre is to protect the German sovereignty from encroachment.  The European Court of Justice is headquartered in Luxembourg and its purpose is to interpret EU law and ensure uniform application.   Many observers suspect that the European Court of Justice, which has one judge per EU member, will be considerably more sympathetic to OMT than the German Constitutional Court. 

While it is important for investors to monitor this important legal issue, it unlikely to alter market trends.  Specifically, the euro managed to rally a full cent from the lows seen on the knee-jerk drop spurred by the German court announcement.  

The debt of what are regarded as the most likely candidates of OMT (European periphery) still rallied after the announcement.  Of note the Spanish 2-year yield finished last week at new record lows.  Portugal is seeking to exit its aid program near mid-year.  We suspect some kind of form of a pre-cautionary line of credit is more likely than activating OMT.  We note that Portugal's 10-year yield finished last week within a couple basis points of 4-year lows, showing no stress from the German court ruling.  

Abenomics may be not be helped much, but it avoided a pitfall by the LDP victory weekend electoral contest for governor of Tokyo.  Even without the final results known,  challengers to Yoichi Masuzoe, a former health minister, conceded defeat.  The results were marred the low voter turn out that saw about 1 in 3 eligible voters go to the polls.  

Ironically, the 20%+ decline of the yen since the election was called that Abe would go on to win, has not produced a larger external surplus.  This point will be underscored by Monday's release of December's balance of payments.  It will likely extend the record deficit posted in November.  

The trade deficit itself is likely to be shy of a record.  The key to the record shortfall though is with the investment income balance.  This consists of various payments earned by Japanese investors, like royalties and licensing fees, but especially dividends and coupon payments.  As we have noted there is a large seasonal component here.  Simply put, the investment income balance typically deteriorates in Q4 and improves in Q1.   This suggests that Japan's balance of payments will likely bottom with the December report on Monday and improve as Q1 data is released.  

Lastly, we turn to China.  Talk of a China tapering is likely exaggerated.  Indeed, new yuan loans are expected to have grown more than two-fold in January over December and banks, rather than the shadow banking, likely accounted for the sequential increase in aggregate social financing. Consumer inflation will be reported toward the end of the week, and the consensus expects a 2.4% year-over-year rate, which would be the lowest since last May.  

More importantly for the emerging markets, which appeared to stabilize at the end of last week, China will report is January trade figures some time during the week ahead.  Exports and imports are expected to have slowed from December, perhaps distorted by the Lunar New Year, and this will result in a smaller trade surplus.