The Interesting Week Ahead

Under more normal circumstances, next week would be among the most important of the weeks of the year.  The three largest central banks in the G7 meet, namely the Federal Reserve, the European Central Bank, and the Bank of Japan.  In addition, the first estimate of the US and EMU Q1 GDP will be released.  Other economic reports, including US auto sales and eurozone's preliminary CPI estimate, are also typically closely watched by economists and investors.

However, these are most certainly not normal circumstances. The central banks have not waited for scheduled meetings to adjust policy during the pandemic.  The Federal Reserve is at the effective zero-bound and shows little interest in adopting negative rates.  The ECB and the BOJ already have negative rates, and neither seems to be in a hurry to go deeper into negative territory.  Yet given precipitous drop in oil prices and the relative strength of the yen (it has spent a little more than a week since March 1 below its 100-day moving average found near JPY108.85 now), the risk is that Japan gets knocked back into deflation, i.e., outright contraction in CPI. 

The Fed's efforts to stabilize the capital markets have made great strides.   The VIX, for example, has been halved from its peak.  Around 40%, it is still more than twice what it was in early January.  The volatility of the Treasury market has been more than halved from its peak.  Around 70% MOVE is high but not unreasonably so.  The 200-day moving average at the end of last year was about 61%.  US dollar LIBOR has also eased.  The benchmark three-month dollar LIBOR slipped below 100 bp for the first time since March 16. This drove the spread between LIBOR and OIS narrowed to its lowest level in over a month.  After peaking late March near 138 bp, it is now near 90 bp.  Before the disruption, it did not trade north of 40 bp since early 2019. 

The ECB appears to be having a more difficult time.  First, the three-month Euribor premium over OIS rose from around 5-7 bp in most of February to 30 bp in April and is just below there now.  Euribor was around minus 40 bp in mid-February and fell to almost minus 50 bp as the markets priced in a rate cut by the ECB.  However, as it became clear the ECB was not going to cut rates, Euribor began rising.   It also reflected the reluctance to lend on an unsecured basis, and some banks might be running thin on collateral for operations with the ECB.  There are also some technical issues behind the elevation, including a low proportion of actual transactions, and nearly half of the contributors come from outside of the core countries.   Last week, three-month Euribor reached almost minus 15 bp before easing ahead of the weekend.  

The ECB has eased its collateral rules, including last week's decisions to remove (until September 2021) the investment-grade rating threshold for collateral.  Provided that the entity (corporation or sovereign) had an investment-grade rating by at least one of the main rating agencies (including DBRS) as of April 7, the ECB will accept it as collateral for loans.  The move is seen to help address the current challenge as well as mitigate the impact of potential rating downgrades on the availability of collateral. 

Although the ECB was prepared to accept as below investment-grade collateral, it was still reluctant to buy below it as part of its asset purchase programs, unlike the Federal Reserve.  The Fed previously indicated its willingness to purchase corporate bonds that lost their investment-grade rating since the announcement of its corporate bond-buying facility.  It gave itself the authority to buy high-yielding bond ETFs if the valuation was within specific parameters of net asset value.  To be sure, the ECB has made allowances and is buying Greek bonds (which are below investment grade) and kept the door open to doing so more broadly in the future, if needed.  

Second, the ECB is struggling to prevent greater divergence of interest rates.  Since it announced the Pandemic Emergency Purchase Program on March 18, the premiums the periphery offers over Germany have narrowed a little, and it has been erratic at best. The transmission of the ECB monetary policy is being stymied as reflected in the steepness of the coupon curves on the periphery, and the slowness of the collective response at both the eurozone and EU levels.   

The Bank of Japan meets on April 27.  The key challenge it faces is not about the price of money, but the access to it.   The BOJ may unveil a new initiative to support bank lending.  A local press report suggested that the BOJ is considering removing the self-imposed limit on its bond purchases.  This would be more about signaling intentions than a material change.  Over the last few years, as yield curve control has supplemented the bond purchases, the BOJ has consistently undershot its JPY80 trillion target.  Consider that the Fed has announced unlimited Treasury purchases and has gradually reduced the amount from $75 bln a day to $50 bln for all of next week.

If the BOJ is to take fresh material action, observers have focused on it stepping up its purchases of corporate bonds and commercial paper.  The central bank will update its forecasts.  In January, it anticipated the economy would expand by a little less than 1% in the current fiscal year.  The IMF's new forecasts project a 5.2% contraction this calendar year after a 0.7% expansion in 2019. 

The FOMC two-day meeting concludes on April 29.  That morning, the first official estimate of Q1 GDP will be reported. The darkening of the outlook in recent weeks in a Reuters survey.  At the start of April, the median forecast was for a decline in output of 2.5% (annualized) and 20% in Q2.  However, the most recent survey found median estimates of -4.8% and -30%, respectively.

Despite the criticism levied against the Fed for encroaching the "free markets" or "buying everything" or facilitating "moral hazards," a Gallup Poll found that the confidence the Fed's Chair is the highest in 15 years, the most since Greenspan.  Those that had a "great deal" or a "fair amount" of confidence in Powell that he would do or recommend the right thing were greater the results for President Trump and Treasury Secretary Mnuchin.

Still, only the least imaginative among us would repeat earlier arguments about the Fed running out of ammunition.  Keep in mind the three levers that it controls or influence:  monetary policy proper (interest rates and its Treasury and mortgage-backed security purchases), market support efforts, on behalf of the US Treasury (nine special purpose vehicles), and regulatory/supervision.  The Fed has pulled all three levers, and each can be scaled.  The Fed can expand participation in existing programs like it recently did to include corporate bonds that lost their investment-grade rating since the crisis.

The Fed may consider including non-for-profits in its Main Street lending program.  It may also extend its local government bond-buying to include more municipalities.  The Fed is not bound by the FOMC schedule as it as aptly demonstrated. 

There may be a technical tweak in the reverse repo rate.  The issue is several key benchmarks, including the replacement for LIBOR, the secured overnight financing rate, and the general collateral rates are at a single basis point and this may be too close to zero for the Fed's comfort. In lieu of that, perhaps, the most important element of the FOMC meeting is Powell's press conference.  It is possible, and maybe likely, that the US economy bottoms before the next FOMC meeting on June 10.

The ECB meets on April 30.  ECB President Lagarde warned EU leaders that the eurozone GDP could contract as much as 15% this year and cautioned against taking too little action too late.  Her base case is a 9% drop in output, while IMF's new forecast projects a 7.5% contraction.  One initiative that may be under consideration is for the ECB to offer swap lines as the Federal Reserve has done.  In the analyses of the decade-ago crisis, some were critical that the ECB did not provide such lines to east and central European countries, for example. 

A Bloomberg poll found that one in four surveyed expect the ECB to announce it will boost its bond purchases, with many looking for a 250 bln euro increase.  The median forecast is for ECB to make a move after the summer and increase the purchases by another 500 bln euros.  We find ourselves more sympathetic with the majority here as the ECB has Pandemic Emergency Purchase Program is hardly six weeks old.  Moreover, we suspect that what is is buying could be more effectively executed.  For example, during a prior period of intervention, the BOJ is believed to have varied its orders to buy dollars.  Some were of the variety of "all or none"  or "fill or kill" orders that seemed to act as a force multiplier.   Also, much of the Eurosystem buying appears to be after the fact, defensively after the spreads had already widened.  

A few hours before Lagarde's press conference at the conclusion of the ECB meeting, the first estimate of Q1 GDP will be released, as will the preliminary April CPI figures.  The median forecast is for the euro area economy to have contracted by 3.5%, though the risk is for a greater slowdown.  France, Italy, and Spain report their national figures, and none is expected to have contracted by less than 4%.    

Deflation risk will be evident.  The euro's weakness is too mild to offset the deflationary drag from the contracting economy and drop in oil prices.  Headline CPI is expected to have risen by 0.1% in April, according to the median forecast in the Bloomberg survey.  Given the base effect, the year-over-year rate would fall to 0.1% from 0.7%.  The core rate is expected to ease from 1% to 0.7%. 

Disclaimer