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What does US data mean for QE3?
Economic data released this week showed a deteriorating outlook in the US economic recovery. 2Q GDP growth was revised lower to a surprising 1.3% from the prior 1.7% estimate, durable goods orders saw the largest decline since January 2009, the September Chicago PMI fell below the pivotal 50 level for the first time since 2009, and personal income grew a mere 0.1% in August. U.S. treasury yields have fallen with the 10-year yield back below the 100-day SMA.
It is becoming more apparent that recent action taken by the Fed was indeed warranted, but how much QE will the Fed do and for how long? The FOMC indicated that “highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens”. Fed members such as Chicago Fed President Evans have indicated that he would prefer QE to continue until the unemployment rate falls below 7% or inflation rises above 3%. This suggests that the Fed may be printing dollars for the next two years, given the most recent economic projections. At the current pace, that would be about 1 trillion in new purchases.
The size, pace, and composition of purchases could be altered down the road and economic data will dictate market expectations for QE3. While economic data comes in weak, specifically labor data, US interest rate expectations are likely to remain low and the dollar could continue to decline as markets factor in more dollars being printed by the Fed. Technically, the dollar index looks to be consolidating in what appears to be a bear flag pattern below broken channel support which suggests the potential for a further decline.
Economic data next week includes key labor reports such as the ADP employment change and the September nonfarm payrolls (NFP) and unemployment rate. As monetary policy takes time to work its way into the economy, it is unlikely that we will see the benefits of the recent round of easing in next week’s releases. Furthermore, with heightened uncertainty over the looming fiscal cliff, employers may be reluctant to increase hiring which has been a factor in subdued job growth. Weaker labor data could put renewed pressure on the dollar as the Fed acts to promote sustained improvement in labor market conditions.
Waiting for the ECB
This week is busy for economic data and also central bank meetings. The European Central Bank (ECB) meets on Thursday amid a backdrop of deteriorating economic data, rising inflation pressures and also rising Spanish bond yields. At its last meeting the Bank announced its Outright Monetary Purchases programme, a sovereign bond-buying programme that has yet to be triggered. Spain is the leading contender for the OMT, yet it needs to apply for a bailout or a line of credit with enhanced conditionality before the ECB will start buying Madrid’s debt. Spain’s 2013 budget announced last week was seen by some as paving the way for Spain to accept a bailout, yet the Budget continues to leave the timing of an application of funds ambiguous.
The detail of the budgets for Spain and France, both released last week, were roughly in line with expectations. Spain will save EU40bn, and fiscal consolidation will be split between spending and taxes 60-40 respectively. France has adopted the tax heavy approach, leaving UK PM David Cameron ready to “roll out the red carpet” for French business people who are expected to flock to London after Hollande’s government announced a 75% temporary tax rate on earnings of more than EU1 million per year. However, these populist measures were fully expected, what the market was under-whelmed by was some over-optimistic fiscal consolidation and growth forecasts. Spain’s 2013 deficit target of 4.5% looks unrealistic and the growth forecast of -0.5% for next year look optimistic at best. France is also planning to bring down its deficit to 3% of GDP next year. The markets are sceptical as the intention is to do this mostly through tax rises, which could dampen growth and weigh on tax take. Overall, the Spanish budget was more “market friendly” than France’s. However, Spanish bond yields have risen by 25 basis points since the sharp decline after the last ECB meeting. French bonds are still being treated like a safe haven, but its public finances remain on a very precarious path.
The structural issues facing some Eurozone members are coming to the forefront as we start a new quarter. Not only do France and Spain have huge economic adjustments to enact in the next 12 months, but Portugal also announced that its budget deficit will be 5% of GDP this year and its debt-to-GDP ratio will be a whopping 120%, according to its statistics institute. This is not expected to start falling until 2014. A debt-to-GDP ratio of 100% is considered the limit for a healthy economy, which highlights the challenges that Lisbon faces in the coming years. Since Portugal’s bailout funds run out next year when it is expected to return to the capital markets, this data suggests that it could be in-line for another bailout and its return to public financing could take a long time. This weighed heavily on the markets at the close of the European session on Friday, knocking EURUSD off its recent highs, and causing the cross to dip below its 200-day moving average at 1.2840. A weekly close below this level would be an extremely bearish development for this cross and suggests there could be further downside towards 1.2750 then even 1.25 in the medium-term.
The ECB will have a sense of the growth picture for the currency bloc when it meets on Thursday. The September PMI surveys are released this week and they are expected to show that growth remains at 3-year lows. There is a risk that this data could disappoint after economic confidence data for September, considered a safe haven, declined more than expected. This index is considered a lead indicator, which does not bode well for September PMI readings. However, in contrast to falling growth, inflation in the currency bloc is rising, and the September estimate rose to 2.7% up from 2.6% in August. There is a powerful hawkish element on the ECB in the form of the German central bank the Bundesbank. It seems to have no patience for rising cost pressures, thus it is likely to resist any calls for a rate cut at this week’s meeting and we expect no change. The OMT programme has already been announced seemingly without consideration for rising inflation. But if prices continue to rise then we may see more caution around bond purchases if the OMT is ever triggered.
We expect the ECB to continue to stress that the OMT is its most aggressive action yet, and it won’t be enacting any new measures to try and stabilize the currency bloc. It may also stress that it won’t start buying bonds until the country in question has applied for a bailout and is on an economic reform programme approved by the EU and IMF. It will be interesting to see what Draghi says about Spain’s budget and whether its latest efforts at economic reform are enough to activate the OMT and get the ECB acting as a lender of last resort. We think there is a 40-50% chance that this may happen as early as this week, but Madrid is likely to want assurances it won’t have to accept extra austerity if the ECB does buy its debt, which could delay the start of the programme for some time yet.
Overall, the bias could be to the downside for the euro next week as fundamental and technical data continue to undermine the single currency. We believe that 1.25 will remain well supported as the ECB’s OMT programme has removed the tail risk that the currency bloc could collapse. Spanish bank stress test results and also the conclusion of rating agency Moody’s latest review of Spain’s sovereign credit rating will also be digested by the markets early next week.
Eurozone economic confidence and manufacturing PMI
Source: Bloomberg and Forex.com
Will the UK’s growth bounce be maintained?
The key focus this week will be on the UK PMI surveys for September. In August these surveys made a surprise jump higher and all eyes will be on whether they can sustain these gains at the end of the third quarter. The market expects the manufacturing sector survey to remain in contraction territory at 49.0, however, it expects the services sector survey, which is more important for the UK economy, to retreat slightly to 53.0 from 53.7 in August, but this is still some of the highest levels since May and suggests that the economy could have bounced back in 3Q after an upward revision to 2Q’s GDP figure to -0.4% from the initial reading of -0.5%.
Recent data has been fairly mixed with stronger industrial production and employment data, and weak retail sales for August. Thus, it is fairly hard to predict the PMI’s this month. In the past the pound has benefited from positive economic surprises and we could see GBPUSD rally on the back of good PMI readings, especially if US economic data continues to support QE3. However, 1.63 – the high from the last 12 months - is going to be a tough level to breach and so far the bulls have been unable to push it above here. In an environment of elevated Eurozone stress we could see the dollar attract some safe haven demand this week, which could weigh on GBPUSD. Support lies at 1.6110 then 1.6050 and 1.5980.
The perils of being a safe haven also became clear last week when the UK recorded its largest ever current account deficit at nearly 6% of GDP or GBP20.8bn in 2Q. This measures the UK’s investment income – the proceeds from UK investments abroad minus foreign investments in the UK, the trade balance and also cash transfers. Usually the UK has a fairly flat current account, which is good because we have a fairly wide trade deficit. Thus, this latest news is another bash to our public finances. The decline may have been down to the UK being heavily invested in overseas equities, which were hit by volatile markets in the second quarter. At the same time a strong pound eroded the value of income made abroad especially in the Eurozone. The other reason is that since the onset of the sovereign debt crisis UK Gilts have been treated like a safe haven and attracted buying interest. So as the value of our investments fell, the value of foreign-owned Gilts rose. We will have to see if this will reverse after the strong performance of equity markets in 3Q.
The Bank of England also meets next week, but no change to asset purchases or rates is expected, as we wait for the BOE to conclude its latest round of asset purchases next month.
GBPUSD: daily chart, 1.63 is a tough resistance level
RBA may not be ready to cut rates
The Reserve Bank of Australia (RBA) will meet on Tuesday and while interest rate expectations have declined recently, we expect the Bank to remain on hold but deliver a dovish statement. RBA minutes from the September meeting noted that “the current assessment of the inflation outlook continued to provide scope to adjust policy in response to any significant deterioration in the outlook for growth”. This suggests an easing bias however in our view despite somewhat softer growth, the Bank is likely to pause for now and continue to monitor incoming data.
Since the last policy meeting, data has shown that GDP growth slowed to 0.6% q/q in 2Q from the prior 1.4%, the trade deficit has widened to -556M in July from -227M, and home loans have fallen. The unemployment rate unexpectedly fell to 5.1% in August from 5.2%; however this was a result of a drop in the participation rate to by 0.2% to 65.0%. The Bank has noted recently that the domestic economy appeared to be growing around trend pace and effects of earlier rate cuts are still working their way through the economy.
Weak Chinese economic activity and falling commodity prices have also increased RBA rate cut expectations. At the same time expectations of stimulus from China is growing. As China is Australia’s largest trading partner, easing by the People’s Bank of China (PBoC) would be supportive for the Australian economy. As monetary policy conditions have eased across the globe, this may reduce some of the immediate external risks to the RBA’s outlook.
Action taken by other central banks around the world have seen tail risks recede which have given a boost to the AUD as a high beta currency. Minutes of the last RBA meeting noted that, “members discussed the possibility that the high level of the exchange rate was weighing more heavily on the economy than might be expected”. AUD/USD is only marginally higher than at the September 4 policy meeting, but this is still likely to be a concern for the Bank.
Interest rate expectations since late August have dropped for overnight rates 3-months out. The 3-month Australian overnight indexed swap (OIS) has fallen from a high of 3.453% on August 30 to 3.135% this week (see Figure below). We anticipate that the RBA will cut interest rates later this year, but we expect that the cuts will not be delivered at next week’s meeting. AUD/USD upside is likely to remain limited with a medium term double top above the 1.06 figure as key resistance. A break below the 200-day simple moving average (SMA) may see a decline towards the 100-day SMA as the next downside support.
Lower Australian interest rate expectations may weigh on the AUD
Source: Bloomberg, FOREX.com
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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