Draghi’s Day

new ecb

  • It is all about the ECB meeting today
  • Norway’s and Sweden’s central banks held policy-making meetings; as expected, neither changed rates
  • A climax of some kind is likely in Spain today; Italy’s Senate will vote on electoral reform
  • Banco de Mexico announced it would increase its FX hedge auctions by $4 bln
  • Brazil cut rates 75 bp and Temer survived the lower house vote, as expected
  • Central Bank of Turkey is expected to keep rates steady; Turkey is becoming increasingly isolated; South Africa’s budget statement was beyond disappointing

The dollar is mostly firmer against the majors ahead of the ECB decision.  The yen and Aussie are outperforming, while sterling and the Scandies are underperforming.  EM currencies are mixed.  KRW and INR are outperforming, while ZAR and HUF are underperforming.  MSCI Asia Pacific was flat, with the Nikkei rising 0.2%.  MSCI EM is down 0.3%, with the Shanghai Composite rising 0.3%.  Euro Stoxx 600 is up 0.2% near midday, while S&P futures are pointing to a flat open.  The 10-year US yield is down 1 bp at 2.42%.  Commodity prices are mixed, with oil narrowly mixed, copper down 0.3%, and gold up 0.1%.

It is all about the ECB meeting today.  The market was hoping for more details last month, but Draghi pointed to today.  The broad issue is well known.  While growth has been strong, price pressures are still not, according to the ECB, on a durable path toward its “close but lower than 2%” target.  The ECB judges that substantial additional stimulus is needed.

It is currently buying 60 bln euros a month in assets, that consist of mostly sovereign bonds, but includes supras, corporates, and asset-backed securities.  At the same time, investors seem to accept that under the current self-imposed rules, which the ECB has modified in the past, there are about 300 bln euros in eligible securities that can be bought by the Eurosystem next year.

For the remainder of this year, the ECB is buying 60 bln euro (180 bln euros here in Q4) while the Fed’s balance sheet will decrease by $30 bln.  That divergence will continue to widen for the foreseeable future.  There appears to be a consensus that the ECB extends its purchases through the first nine months of 2018 at a pace half the current size.  That would allow the ECB to nearly exhaust its universe of acceptable assets.  During the first three quarters of 2018, the Fed’s balance sheet is projected to shrink by $270 bln.

Many observers are not convinced that the asset purchases are doing much good, but they recognize that stopping them would be potentially destabilizing.  The other important element, if not of greater importance, is what the asset purchases say about rising rates.  The ECB has been clear that like the Fed, it will not raise interest rates until after the asset purchases are complete.  The longer the asset purchases, the further out the first rate hike lies.  Last month, the consensus was for a six-month extension.

The ECB will likely seek to maintain as much flexibility as possible.  It is unlikely to call this tapering as it implies an endpoint, which the central bank does not want to suggest, even if we all know it is there.  The re-scaling of its operations is meant to adjust for the evolving economic and financial conditions.  Some details about the securities and maybe the composition of the assets it will buy may come in December.  Consistently, and as recently as last month, Draghi played down concerns about the scarcity of assets.

We suspect the short-term market is inclined to buy euros on as expected news.  Despite widening interest rate differentials in the dollar’s favor, the euro has been trading in a roughly $1.1720-$1.1880 trading range for more than the past two weeks.  Speculators in the futures market have a substantial gross and net long position.  The euro’s gains since Monday’s low (~$1.1725) appears to be some shorts who may have tried picking a top, covering ahead of the ECB meeting.

That said, we have not abandoned our expectation that last month’s dollar recovery marks the end of the slide that began with the defeat of the National Front in France in late April and concluded in early September.  A break above $1.1880-$1.1910 would call into question what we think is a medium-term bearish technical pattern.  Fundamentally, we think that the divergence meme is still the key driver over the longer term and we argue that the balance sheet and rate divergence have not peaked.  Indeed, the peak is still more than a year away.

Many have argued against this divergence emphasis.  Didn’t the Bank of Canada hike rates twice in Q3?  Isn’t that divergence?  We distinguish central banks engaged in a sustained monetary cycle (Federal Reserve) and central banks that have made a small tweak in policy.  Bank of Canada Governor Poloz’s comments reinforce our view that Canada is in the latter group.  We would put the BOE, which is poised to hike rates next week, in that same camp.  The Bank of Canada took policy rates back to where they were before the oil shock.  The Bank of England may take back the cut delivered after last year Brexit referendum.

There are a few other notable developments today.  First, Norway’s and Sweden’s central banks held policy-making meetings.  As expected, neither changed rates.  The Riksbank showed no signs of exit despite firm prices and a strong economy.  The Norges Bank is also discussing institutional restructuring, like splitting off the wealth fund, and there is a recommendation from a panel established for these purposes to set up a separate monetary policy committee.  It seems that post-crisis, the work of many central banks has increased.  Norway may move toward a model more like the Bank of England.

Second, a climax of some kind is likely in Spain today.  Catalonia’s Puigdemont will speak to the regional parliament and may formally proclaim independence.  There had seemed to be a way out by holding new regional elections.  However, this did not seem to forestall Prime Minister Rajoy’s push to invoke Article 155.  It is now before the Senate, which is expected to vote on it over the next couple of days.

We have argued that with the businesses, the army, and several opposition parties siding with Madrid, the threat of secession is low.  The political theater may continue, but investors are looking through it.  The Spanish premium over Germany is almost back to where it was before the (illegal) referendum on Oct 1.  The Dow Jones Stoxx 600 is off 0.5% over the past five sessions, while Spain’s market is off 0.60%.

Third, and also in Europe, Italy’s Senate will vote on electoral reform today.  It will likely pass over the objections of some small parties who might not be represented in the new parliament unless they form a coalition.  The Five-Star Movement is opposed for the same reason.  Also, while the focus is on the ECB, and the next Fed Chair (which can be announced anytime), Italy will shortly name a new central bank governor.  Visco’s term is up at the end of the month.  Although it had seemed that he would likely be reappointed, it has become politicized and he seems to be taking the fall for legacy issues more than what happened under his watch.

In the US, weekly initial jobless claims (which fell to new cyclical lows last week) may bounce back when reported today.  The early call for next week’s non-farm payroll is over 300k, partly the bounce back from storms.  The September trade balance and retail inventories will be the last pieces for economists to mull ahead of tomorrow’s first look at Q4 GDP.

Banco de Mexico announced it would increase its FX hedge auctions by $4 bln.  USD/MXN dropped sharply on this news.  However, we don’t think the bank is trying to protect any particular level in the midst of a broad-based EM FX selloff, but instead is merely acting to prevent excessive MXN underperformance.  This was a rare sliver of good news in EM, however, and has helped USD/MXN stabilize.

Late last night, COPOM cut rates 75 bp to 7.5%, as expected, and signaled a further reduction in the pace of easing.  We think COPOM is on track for one more 50 bp cut to 7.0% in December before it ends the easing cycle.  The lower house vote on whether to advance the corruption charges against President Temer went 251-233 in favor of Temer, with 25 absent and 2 abstentions.  This was worse than the 263 votes Temer received for similar charges back in August, and suggests he is losing support for structural reforms.  Brazil reports September current account, FDI, and central government budget data.

Yesterday, press reports suggested that Germany is working to cut funding for Turkish banks.  Tighter restrictions are being pushed not only on state-owned German banks, but also on the multilateral EBRD.  Last week, Chancellor Merkel said she will seek to curtail pre-accession EU funding for Turkey.  The news comes on top of unverified reports that the US is investigating several Turkish banks for dealings with Iran.  Turkey is becoming increasingly isolated even as it becomes more dependent on hot money flows.

Central Bank of Turkey is expected to keep rates steady.  Inflation was 11.2% y/y in September, well above the 3-7% target range.  While the central bank will be under great pressure not to tighten any further, we think that recent lira weakness raises the possibility of a hawkish surprise today.  If not, we expect further erosion of confidence in the nation’s institutions.

The rand continues to outperform.  The surprise in yesterday’s budget speech was not that the fiscal situation is deteriorating.  Rather, it was the fact that Finance Minister Gigaba offered no solutions to this deterioration.  Instead of offering some concrete steps to contain the budget deficit, Gigaba outlined a program of heavier borrowing.  With the debt/GDP ratio forecast to rise to near 60%, we think this will be the trigger for downgrades next month.  Ejection from WGBI is only a matter of time, it seems.