Dollar Buying Dries Up, though Sterling Remains Exceptional

There has been no follow through US dollar buying after yesterday’s push that saw the euro fall to its lowest levels since early April and the yen ease to seven day lows. Sterling is the main exception, on the back of a disappointing employment report and dovish Quarterly Inflation Report.

The disappointing US retail sales data and the downward revision in estimates of Q1 GDP, with some economists shaving Q2 forecasts as well, coupled with more rhetoric about ECB easing in a couple weeks helped fuel purchases of risk assets. That said, European equity markets are seeing some profit-taking after yesterday’s gains had carried the FTSE to 15-year highs and the DAX to new closing highs for the year. The yen appears to have been largely dragged up by the dollar’s weaker tone and the easing of US interest rates.

The main economic news today has been the UK employment data. It was disappointing, and this saw sterling surrender its initial gains against the dollar that had lifted it $1.6875 from $1.6820 yesterday and pushed it through yesterday’s lows. To be sure, it is not that the employment data was weak. The claimant count fell 25.1k instead of 30k as the consensus expected, though the unemployment rate did tick down to 6.8% from 6.9%.

Given the BOE’s shift away from the unemployment threshold to its forward guidance, as did the US, these measures may be less important that wage growth, and here the UK employment report is truly disappointing. Average earnings, which are reported with an additional month lag, are for March. On a 3-month/3-month a year ago measure, earnings rose 1.7% rather than 2.1% as the Bloomberg consensus expected. The fact that the return to labor remains pitifully low speaks the slack in the labor market and will help to keep rates low for longer.

The BOE’s quarterly inflation report was a bit dovish than expected and this accelerated the profit-taking on sterling. The upward revisions to 2105 growth to 2.9% from 2.7% are a minor tweak. The clear message is that more economic slack can be absorbed before hiking rates. Many had expected a more convincing signal that rate hikes may be brought forward, though Carney thought to be resisting a push to hike rates before next May’s election. Carney’s refusal to capitulate has seen short sterling futures contracts rally strongly (March 2015 contract now implies an 92 bp yield vs 106 bp yesterday. We estimate that the market was pricing in 50 bp rate increase by the BOE over the next 12 months and that has been obviously scaled back.

The disappointing UK report, coming on the heels of the disappointing US retail sales report and more ECB voices fanning speculation of a multi-step easing move next month has seen bond markets rally strongly in Europe, while yesterday’s rally in US Treasuries is extended in the European morning.

ECB President Draghi had indicated as his press conference that there was unanimous support for unconventional action if needed in June. This, as well as other signs, suggested that the Bundesbank’s objections had softened. There are two important elements of the ECB’s potential action that is important in this context: when and what. Draghi underscored a move in June, and this has really been the case since April’s ECB meeting. The “when” is the easy part. The “what” remains more difficult. If there has been needed information, it is that the asset purchase scheme is somewhat less likely, and rate cuts are more likely.

However, even here, it is not clear that this means a negative deposit rate. There is scope, as we have argued, for a lending rate cut, which is the top of the ECB’s rate corridor. The repo rate can be cut further. Required reserves can be cut. SMP sterilization attempts could be suspended. A negative deposit rate could have potentially disruptive consequences for the very banks that the ECB is seeking to help and will soon have supervisory responsibilities.

Moreover, the knock-on effects on the government and business will be detrimental as banks will likely pass the negative rates. The local and federal governments deposit (taxpayer funds and borrowings) at banks from which they draw. Imagine a department that has tightened its belt under austerity and is allocated its annual budget, which get his with the negative deposit rate. It is like an additional tax.

Surely, the euro area is on the mend. Reasonable people may debate how far along the process it is. Yet consider that only the Cypriot economy is contracting. Only Greece is forecast to be in deflation this year. Growth in Q1 surpassed the US, we will have confirmed before the week is out and that does not even integrate the likelihood that the US economy actually contracted in Q1 (wait for the revision). Interest rates are considerably lower, adding to the virtuous cycle, reducing the sovereign’s debt servicing costs while strengthening bank balance sheets (the ECB’s SMP purchases, as controversial as they have turned out to be an excellent investment). Banks have been able to raise capital, and some have begun sell-off portfolios of bad loans.

If the conditions at the heart of the crisis, whether in 2008, 2009, 2010 or even 2011, did not elicit what we have dubbed nuclear options (negative deposit rates or QE), it is not clear why current conditions do. There is no evidence that the decline in inflation is having knock-on effects on households, whereby they defer purchases anticipating lower prices.

There has been some talk linking the euro and Australian dollar’s gains today to Asian central bank diversifying newly acquired dollars bought in intervention efforts to slow local currency gains. For example, some reports suggest that South Korea have become more aggressive, defending the KRW1020 level since the end of last week. We suspect that this may picked up by the Federal Reserve’s custody holdings that will be released tomorrow.

Japan will report Q1 GDP figures first thing in Tokyo on Thursday. An expansion of about 1.0% on the quarter is expected, from 0.2% in Q3 and Q4 13, as activity was boosted ahead of the sales tax increase. We do not expect a strong report to be much of a market mover, in the same way, we argue that even a downward revision to US Q1 GDP does not really matter. Events have made the data less relevant for opposite reasons. In the US, investors and economists are confident that the US economy is returning to trend growth in Q2, or even a bit faster (2.5%-3.0%). In Japan, after the strong Q1, the economy may contract in Q2.