The global trade theme continues to dominate the financial markets. In the major battle, that between China and the US, both sides are digging in their heels. This is starting to slow global growth. Yesterday’s announcement by Trump that he would impose tariffs on imports from Mexico will only exacerbate the situation by increasing uncertainty.

The market is starting to signal recession. Yield curves have been flatting in the major industrial countries; the US and Canada curves are already inverted (as is Japan, perennially, but that’s a different story) and the others are getting there slowly but surely. 

World trade is shrinking on a year-on-year basis, and with it the outlook for manufacturing in the developed world is turning down.

The decline in trade seems to be hitting the Eurozone harder than the US – the US and EU manufacturing PMIs were at about the same level last summer, before all the trouble started, but since then the EU version has fallen much further than the US version has.

That’s probably because of Germany’s reliance on foreign trade. German manufacturing foreign orders have fallen very sharply and are now down nearly 10% yoy, the biggest fall since the 2011 Eurozone crisis.

Continued economic outperformance by the US is likely to support the dollar going forward, leading to a lower EUR/USD. Over the longer term, EUR/USD tends to track the relative performance of EU vs US industrial production.

Furthermore, if growth begins to flag, the US can do more about it than most other countries. Rates in the EU and Japan are already at some of the lowest levels in recorded human history. The markets are discounting further easing by the Fed, which should provide support to the US economy if global growth does turn down.

Of course, lower short-term rates could weaken the dollar as well, if they make US bonds less attractive than foreign bonds. But at some point the limits to EU easing will set in and EU growth is likely to stall, unless of course Germany has a sudden change of heart with regards to fiscal policy – not likely any time soon, unfortunately.

This is why I think we are in for a period of sustained US strength, notwithstanding the fact that the US is perhaps the source of the problems facing the global trading regime. It’s sort of like what happened during the Global Financial Crisis of 2008/09 – even though it was caused by the collapse of the US housing market, the dollar managed to strengthen across the board.

 

Coming week:  ECB, RBA,  NFP

A week of acronyms coming up!

The European Central Bank (ECB) Governing Council meeting will be the big event of the week. Not that anyone expects them to change rates, heaven forbid. The odds of a rate cut sometime this year are increasing, but are still seen as less than 50%.  Rather, investors will want to get a sense of how concerned the Council members are about the slowdown in growth and the fall in inflation.

Inflation expectations have been trending lower in the EU. That’s sure to worry the Council members.

Growth in bank lending has accelerated slightly in recent months, but still is nothing compared to the 8% yoy growth rate that prevailed before the Global Financial Crisis. This may also call for some further loosening of monetary policy.

The new ECB staff forecasts will be another point of interest. Other central banks have expressed concern about the impact of the US-China trade war on growth. It’s likely that those concerns will manifest themselves in a slightly lower growth forecast for the EU. However, I would expect the inflation forecasts to remain the same for political reasons more than economic. 

While no one expects them to move rates, I expect them to signal that further easing is possible if necessary. There are several tools under consideration.

At the last press conference (April 10th), ECB President Draghi signaled that they might consider a “tiering” system for deposit rates at this meeting. The ECB’s deposit rate is currently negative (i.e., banks have to pay to deposit money with the ECB). Under a tiered system, the Bank would charge less or even pay interest on deposits up to a certain level. The reason is that negative interest rates are not necessarily having the intended effect. The negative deposit rate is supposed to dissuade banks from depositing money with the central bank and encourage them to make loans instead. But if there is no demand for loans, they wind up depositing the money anyway, which costs them money and makes them less profitable. There is some concern that less profitable banks are less able to take risks on borrowers, although the ECB’s own research has shown that this is not the case – banks that are subject to negative rates do tend to make more loans, they find.* ECB is also likely to consider the pricing of its new targeted long-term refinancing operation (TLTRO).

Draghi also once again stressed the willingness of the ECB to use “all instruments” if necessary to get inflation back up, including cutting the deposit rate further. The EU CPI figures will be out on Tuesday, so he will be able to discuss the latest data.

In short, while no one expects them to move rates, there are various ways in which they can signal their determination to “do whatever is necessary” to get inflation back up. They may well tinker with the statement accordingly. More dovish forward guidance is likely to be negative for the euro.

The other major central bank meeting is the Reserve Bank of Australia (RBA), which meets on Tuesday. They’re the only central bank I know of that meets 11 times a year. Frankly it gets boring, given that they haven’t changed rates since August 2016. This time however it’s likely to be different:  the market is pricing in an 87% likelihood of a rate cut.

Note in this graph the sharp jump on April 24th of expectations of two rate cuts this year and the plunge in expectations of no rate cut.

That’s the day that the March consumer price index (CPI) data came out, showing inflation trending even further below the RBA’s target range. After that, the only question is, would they cut once this year or twice?

RBA Gov. Lowe basically confirmed the market’s expectations last week when he said in a speech that “we will consider the case for lower interest rates” at this meeting. As Lowe explained it, the RBA has changed its mind about how low unemployment can get before inflation starts rising. Apparently they had thought that the nonaccelerating inflation rate of unemployment (NAIRU) was around 5%, but now they think it’s even lower. That means they’ll have to get the unemployment rate down further if they want to see inflation back in their target range. 

The question then is whether the next rate cut after that will depend on the data, as central banks often say, or will they just repeat the last phrase from the May statement that “the Board will be paying close attention to developments in the labour market at its upcoming meetings.” The use of “meetings” in the plural implies that as long as the unemployment rate is above their new NAIRU level and inflation is below target, they see no problem in cutting rates further. Thus the market may start to discount a rate cut at the July meeting too, which would be negative for AUD.

Finally, this being the first week in June, we have the ever-fascinating US nonfarm payrolls (NFP). I think the NFP is much less important than it used to be, because with the Fed on hold (or “patient,” as they would say), the hurdle for any change in policy is much higher than it used to be. At this point it would take an extraordinary series of NFPs to get them to hike again, while we would have to see several consecutive months of a decline in jobs for them to consider cutting. Against that background, a wide range of numbers has the same outcome for the markets, namely nothing.

That’s exactly what the market is looking for yet again, The NFP is forecast to be 198k, not far off the six-month average of 208k. Average hourly earnings are forecast to rise by 3.2% yoy, as they have three out of the previous four months. These would be quite status quo figures that would confirm the wisdom of the FOMC’s “patient” stance and have no implications for monetary policy either way. That should be neutral for the dollar.

Other important indicators out during the week:  on Monday we get the rest of the manufacturing PMIs around the world, including the final versions for Europe and the US. These will give us a better grasp on how global growth is developing. Fed Chair Powell makes some brief welcoming remarks at a Fed conference on Wednesday, and Thursday both Bank of Japan Gov. Kuroda and Bank of England Gov. Carney speak at an Institute of International Finance meeting in Tokyo.

*Working Paper Series #2283:  Negative interest rates, excess liquidity and retail deposits: banks’ reaction to unconventional monetary policy in the euro area https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2283~2ccc074964.en.pdf?95f071e362a63d1017bf9ca55d065375 


Today’s market data

 

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Marshall Gittler

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