The Week Ahead: Calm before the Storm

The present is a fleeting moment between the past and the future.  The economic news stream in the week ahead is light.  This will allow investors to contemplate last week's ECB announcements and adjust positions ahead of the critical events of the following week. These include the FOMC meeting, the launch of the TLTROs and the Scottish referendum.  

Draghi has once again demonstrated a boldness that surprised the market.  Recall his track record. He reversed Trichet's rate hikes almost immediately upon taking office.  He nearly single-handedly ended the existential crisis facing euro by aligning the ECB with the preservation of the monetary union.  He brandished what former US Treasury Secretary Paulson may have called a "big bazooka" (Outright Market Transactions), whose use has not been triggered, and may never be used.  He created a facility that lent cheap funds to member banks for three years, which helped drive down bond yields, and created the conditions that allowed financial institutions to return to the market.  

Facing lowflation, which aggravates debt servicing pressure, he led the ECB to do something that no other major central bank has done.  Namely charge banks for the privilege of leaving funds with the central bank. Even Japan, that wrestled with deflation for several years never took such a bold step.  

Now he is leading the ECB into a long-term asset purchase program that it seems clear the Bundesbank opposed.  The debate about whether it is tantamount to quantitative easing is nonsensical. Whatever one wants to call it, the ECB balance sheet is going to expand, and the composition will change.  Let's not forget the Federal Reserve never called its program QE.  It was credit easing.  

The fact of the matter is that the institutional arrangement and rules of engagement are different for the ECB, a central bank that has no Treasury to work with, a single bond market like Federal Reserve or the Bank of England.  That the ECB will buy asset-backed securities and covered bond is not so different from the Federal Reserve buying mortgage-backed securities.  The Bank of Japan buys a wider range of assets, including commercial paper, corporate bonds, ETFs and  REITS,

It is not clear how much the ECB's balance sheet will expand.  Draghi suggested one trillion euro, which would put it back near its peak.  In effect, last week, alongside the rate cuts, Draghi committed the ECB to an asset purchase program without providing much in the way of details. These will be announced in October, perhaps to give officials time to monitor the participation of the initial TLTRO facility.  

There are the usual naysayers.  Many think that EMU was flawed to begin with and whatever ails members can best be addressed by leaving the common currency.  They have consistently under-estimated Draghi's resolve.  In their economic determinism, they have under-appreciated the political commitment. Others argue it does not go far enough, though here too, the political constraints under which Draghi operates, is often not sufficiently appreciated.   The model is not the strong-leader variety seen at the Federal Reserve, the Bank of Japan and the Bank of England (the newest to independence, and least we forget former Governor King was outvoted more than once).  

The fact that Draghi has led the ECB over Germany and the Bundesbank's objections is noteworthy. It arguably strengthens the institution rather than weakening it.  On the other hand, it seems politically naive not to expect Germany to attempt to assert its will.  However, there does not seem to be much public resistance to the fact that starting next year, the Bundesbank will not be voting at every policy making meeting, for which there will be fewer.  

The question many investors are asking is whether the ECB's measures will work?  The answer depends on what one means by work.  The anticipation of the TLTRO and ABS purchases has already helped drive peripheral interest rates lower.  The cost of business borrowing in Spain and Italy has trended lower in recent months. There has been a preliminary improvement in the second derivative of bank lending.  The decline in the euro and base effects suggest inflation may soon bottom.  The core rate already appears to be stabilizing.  

What about the real economy?  High unemployment in many countries, including some core countries like France, depresses demand.  The French and Italian economies are particularly worrisome.  On the other hand, the contraction of the German economy in Q2 was a bit of a fluke in the sense that it most likely will not be repeated in Q3.  Last week's significant upside surprise from factory orders and industrial output will likely spilled over and help lift the region's aggregate figure that is due at the end of the week. 

Demand might not be amenable to monetary policy alone.  This is behind Draghi's call on governments to use the fiscal flexibility.  Although some officials in France and Italy saw it as an endorsement for their case for greater forbearance from the EU, in the context, Draghi seemed to be addressing the creditor countries. He specifically called on France and Italy to (finally) implement the much-needed structural reforms.  

Perhaps because of the media's focus the subsequent conversation between Merkel and Draghi, many missed the Die Zelt story at the end of last week that reported a fiscal package to support the German economy is being cobbled together.  The measures include faster depreciation for capital expenditures to reduce taxes and spur investment, more public investment and the end of the tax on utility use.  It is not clear what will trigger the implementation of what Die Zelt referred to as "emergency measures."

Many observers also did not appear to recognize that Japan was moving down a similar path. Opinion has heavily favored the BOJ to expand what it has a called qualitative and quantitative easing.  BOJ Governor Kuroda has given no sign that this is something being contemplated.  

Monetary policy is doing its job.  Base money has exploded.  The yen has begun weakening again. Inflation, Kuroda says, is half way to its objective.  The immediate headwind to the Japanese economy was not monetary policy, but fiscal policy, in the form of the April 1 retail sales tax hike.   It seems only reasonable for a fiscal policy response, which is what we have advocated.  

Last week, Finance Minister Aso reportedly strongly hinted, for the first time, that the Abe government would submit a supplemental budget for the current fiscal year.  There were no details announced.  However, effecting psychology and arguably behavior, the retail sales tax is to be hiked in October 2015 from 8% to 10% (it was 5% at the start of the 2014).  We suspect that while anticipation of the first leg of the tax hike spurred consumption, the anticipation of the second leg will not. 

It is as if the Q1 14 economic jump reflected the two-part tax hike over the next 18-months. Whatever real gain in wages may be forthcoming, they will be eaten away by the retail sales tax.   Neither Kuroda nor Aso has suggested that the next year's tax hike should be forgone, though Abe has indicated an official decision will be made before the end of the year.    

The immediate challenge for the UK is not economics.  Last week's non-manufacturing PMI jumped, and although the economy has slowed in late Q2 and into Q3, it continues to operate at a level that puts it at the top of the high-income countries this year.  That said, there are some preliminary signs that the house prices may be peaking.   

The July industrial and construction output figures due out in the week ahead (Tuesday and Friday respectively) are unlikely have much impact.  The market's focus is on the Scottish Referendum on September 18.   The latest YouGov poll, published by the Sunday Times, shows the "yes" camp, which has experienced some momentum in recent weeks, has taken a narrow lead (51%-49%).  In order to do so, it overcame a 22-percentage point deficit.  It is the first poll that puts the independents ahead.  This will weigh on sterling when trading opens in Asia.   

Turning to the US, the disappointing jobs growth was duly shrugged off by investors.  It is historically subject to significant revisions, and as a signal of the overall economy, it is contrary to most of the other economic data.  The economy appears to be expanding at a little faster than a 3% pace here in Q3.  

There are two reports in the week ahead that will attract attention.  The JOLTS (Job Openings and Labor Turnover Survey) has taken on somewhat greater significance since Yellen has guided investors away from the unemployment rate and toward a broader range of metrics.  At the end of the week, the US will report retail sales.  A 0.4% headline is expected where the surge in auto sales is checked by the decline in gasoline prices.   The measure used for GDP calculations, excludes auto, gasoline and building materials rose 0.1% in July, and the consensus expects a 0.3%-0.4% rise in August.  

In terms of Fed policy, we do not attach much value on the string of high-frequency economic data. The Fed will conclude QE next month, and a rate hike is still more than six months out.   The immediate focus is on next week's FOMC statement and whether it will soften or drop references to a "considerable period" that rates will remain low.   This would not be surprising, but there need not be a sense of urgency, and this may be expressed by referring to the importance of amorphous "data."

The inability of the bond market to rally on the back of weakest job growth of the year is a potential signal that US yields may have bottomed.  This risk, in turn, may point to a consolidation or pullback in the US equity market.  The BOJ's ongoing operations and the ECB's measures more than offset the end of QE in terms of global liquidity.  In the current environment, liquidity is a key driver, and my continue to underpin asset prices, and risk-taking more generally.