Five Questions Facing the Market

What is the outlook for Fed policy?

Can Japanese officials stabilize the bond market?

Is the ECB going to adopt a negative deposit rate?

What are the latest inflation readings?  

Is the soft landing still intact for China?

What is the outlook for Fed policy?   The dramatic market reaction notwithstanding, we think Bernanke and the FOMC minutes were clear.  To calls from some members to consider scaling back on the long-term asset purchases at next month's meeting, Bernanke essential said no, that it is too early, and he and the majority of the FOMC needed several more months of data to make that determination.  

And when that determination in made, we are talking about the pace of QE, not terminating it.   In addition, the Fed and some economists argue that the accommodation of QE lies in the stock of long-term assets that the central bank keeps off the market not so much with the flow of purchases.

It is true that QE will come to an end, which is partly why we thought references to QE-infinity were misplaced,(purposely?) confusing indeterminate with permanent.    Ceasing QE operations is a delicate process in which the Fed has been engaged in twice before.  The Fed's guidance suggests it will only adjust monetary on the basis of economic performance.  A slowing of QE and its eventual likely means the economy is stronger.  In addition, the faster than expected decline in the US budget deficit means that new net supply will also fall.

We continue to look for underlying US dollar strength.  Yet, to the extent that some of the dollar's recent gains are a reflection of a more hawkish reading of the Fed's stance than we think is really the case, we worry that the dollar is vulnerable to the disappointment.  Such a dollar pullback would provide medium term investors with a new opportunity to take on exposure.

Can Japanese Officials Stabilize the Bond Market?  There are high political and economic stakes at risk by both the volatility and direction of Japanese bond yields.   The BOJ continues to struggle to stabilize the market.  In addition to domestic source of volatility, officials have had to cope with a rising long-term global yields.  Over the past month, Japan's 10-year yield has risen 31 bp, the US 37 bp and Germany 25 bp and UK gilts 24 bp. 

The Abe government wants its cake and eat it too.  It wants to take credit for the economic recovery (and the fastest growing economy in the G7), demonstrate its commitment to ending deflation, and keep bond yields stable and low.  With earnings bolstered by the translation of foreign sales and income from foreign investment back into the weaker yen, corporations appear to be benefiting from Abenomics.  Yet they are not facilitating its agenda by raising wages and investment.

BOJ officials will again meet with Japanese bond dealers in yet another attempt to prevent its operations, in which it is buying 70% of the new issuance, from destabilizing the market.  After the last meeting, the BOJ made more frequent and smaller purchases.

The rise of Japanese interest rates changes the cost-benefit comparisons for institutional investors in buying foreign bonds.  The rise in JGB yields has spurred on insurance company to indicate it was going to increase its allocation domestically.   Japanese investors have sold about $95 bln worth of foreign stocks and bonds this year, while foreign investors have bought about $80 bln of Japanese shares.

Is the ECB going to Adopt a Negative Deposit Rate?   ECB President Draghi himself raised the possibility at the meeting earlier this month.    If the goal is to help revive lending, especially to small and medium sized business and improve the transmission mechanism of monetary policy, then we expect a serious analysis to highlight the risks and downplay the likely benefits.

That said, as ECB President Draghi has surprised many observers with his boldness--unwinding both to Trichet's rate hikes in his first two meetings--and ability to innovate--two LTROs and the OMT.   At the same time, OMT has worked by brandishing it not actually deploying it.   The dramatic success that moral suasion was not lost on Draghi.  We suggest the negative deposit rate is more like the OMT than the LTRO.   Because of the potential disruptive effects such a policy could have, we think the bar to it is high.  Unless there is a further material deterioration in conditions in the euro area, we do not expect the ECB to adopt a negative deposit rate.

There is asymmetrical risk around the euro.  It is more likely to sell-off sharply on a move to negative deposit rate than rally when the ECB, as we expect fails to signal a cut in the deposit rate next week.  Moreover, a refi rate cut is not the done deal many observers suggest.  As the new staff forecasts next week will likely show, most of the weakness see thus far was largely anticipated.  

What are the latest inflation readings?  Disinflationary forces have emerged in the first part of the year, while there continues to be pockets of deflation.  Earlier today Japan reported its corporate service price index for April, which fell for the first time in three months.  The headline rate fell 0.3%, for a -0.4% year-over-year reading; twice as large of a fall as the consensus expected.  The core rate fell 0.4%, also the first decline in three months.  The 0.7% year-over-year decline is the 11th consecutive decline.   

Japan will report CPI figures at the end of the week.    Sweden is also experiencing deflation as year-over-year CPI is negative.  Today it reported record low PPI of -5.3% year-over-year.  The 1.1% month-over-month decline compared with a consensus of -0.2%.    

Disinflation forces are strengthening in Germany.  It reported a 1.4% decline in April import prices.  This was more than 3 times larger than the market expected.  This warns of some downside risks to the CPI figures (the states begin reporting tomorrow).  

The euro area CPI estimate will be reported at the end of the week.  There are downside risks to the consensus 1.4% forecast (1.2% in March).  The US reports the Fed's favorite (but not only) inflation measure at the end of the week as well.  The core PCE deflator was up 1.1% on a year-over-year basis in March.  The small decline the consensus expects would put it into record low territory. 

Is the soft landing still intact for China?  The issue in China has morphed from what kind of landing to how soft of a landing.  Premier Li Keqiang acknowledged the serious challenges of achieving 7% growth over the next decade after a 10% pace over the previous decade.   It is not that the new government is more tolerant of weaker growth, but it actually wants a more sustainable pace, especially if it reflects a restructuring, especially in terms of moving away from industries with excess capacity.  An important speech over the weekend suggests the new government sees using more market pricing signals as a means to foster restructuring. 

China has become an increasing inefficient user of capital.  Every incremental unit of investment is generating less GDP growth.  That investment is increasingly debt financed.  Capital from offshore, some foreign, others from Chinese sources (see recent discussions of concealed capital flows in exports).   This explains the acceleration of reforms in the financial sector and the appreciating yuan.