Contents: Is more QE on the way? Is the ECB's big bazooka enough to save the Eurozone? Conventional vs. Unconventional - the ECB vs. the Riksbank Event risk in Europe next week Can the UK's labour market continue to surprise on the upside? RBNZ to hold
Is more QE on the way?
At last week's Jackson Hole symposium, Fed Chairman Ben Bernanke expressed his view that the economic situation remains "far from satisfactory" and specifically that "the rate of improvement in the labor market has been painfully slow". Furthermore, minutes from the most recent FOMC meeting indicated that the many members saw additional stimulus would likely be warranted "fairly soon" unless incoming data indicated a sustainable strengthening in the pace of recovery.
The release of the August employment report disappointed with a decline in job growth to 96K from the prior downwardly revised 141K (prev. 163K). This underscored the weakness in the recovery and reinforced views that the Fed will soon act to ease monetary policy. If the previous number that was thought to be 163K was unsatisfactory, then the August readings are clearly unacceptable. The details of the report show an unexpected decline in manufacturing payrolls of -15K (cons. +10K) and private payroll growth of 103K (cons. 142K). What may look like a bright spot in the report with a drop in the unemployment rate to 8.1% from 8.3% is actually representative of a decline in the work force. This is due to changing demographics and more importantly discouraged workers that are simply giving up.
Market action has indicated expectations of more accommodation from the Fed. Treasury yields have fallen, the dollar is significantly weaker, and equity markets remain buoyant in the face of disappointing labor data. With the strong comments made from Bernanke and many of his colleagues at the Fed, we anticipate easing from the FOMC at next week's meeting. Just what form of easing remains the key question and many participants are focusing on another round of asset purchases or QE3.
At the minimum, we expect the Fed to extend the forward guidance on interest rates into 2015. No action from the FOMC would hurt the Bernanke's credibility in light of his very dovish comments of late. QE3 is questionable however as the previous two rounds of quantitative easing have been unable to allow the Fed achieve levels of unemployment consistent with its mandate. We would expect that QE3 would have to be larger than previous rounds as asset purchases tend to have a diminishing impact. A new program that is open ended would allow the Fed to be noncommittal on the size and may impact markets positively. Such an aggressive program could weaken the USD significantly as the Fed expands its balance sheet, however the bank could follow the ECB in sterilizing purchases which would limit USD downside.
Technically, we see the potential for further USD weakness as key levels this week have been breached. The dollar index broke below long term bull channel support and the 200-day simple moving average (SMA), EUR/USD is above long term bear channel resistance, USD/CAD made new lows for 2012, and USD/JPY remains below its weekly cloud.
Figure 1: The dollar index broke a long term bull channel and 200-day SMA after the Aug. employment report
Is the ECB's big bazooka enough to save the Eurozone?
The ECB was the focus last week after confirming the details of its bond-buying plan, however now the market needs to figure out whether this is a real game changer and if the worst of the Eurozone crisis is behind us. We have had "big plans" from the ECB before: at the end of 2011 the ECB's LTRO programme of bank loans was launched to great fanfare, but by March the impact of the EU1 trillion of loans was already fading. So will the Outright Monetary Transactions (OMT - also affectionately called "On Merkel's Terms" on trading desks!) have a longer effect on peripheral bond markets than the LTRO?
Looking at the positives first, there are a couple of things to point out: 1, the purchases are unlimited, and 2, the ECB doesn't have special creditor status. In the event of a sovereign default on bonds purchased using the OMT programme the ECB will be in the same queue as the man on the street when it comes to getting paid back. Both of these things should make Europe's peripheral bond markets a more attractive investment choice. Added to that, there was some concern that the purchases will be "sterilised", however sterilization works differently in the Eurozone than it does elsewhere. While money will flow into the sovereign coffers of the most troubled economies, money will be taken out of the stronger economies like Germany, the Netherlands etc. So while there is no net increase on the ECB's balance sheet, there will be a boost to ECB funds going to countries like Spain, while they may be reduced in places like Germany. This has already been reflected in the sovereign bond markets, Spain's 10-year bond yields fell to 5.75% by the European close on Friday, while German 10-year yields are 30 basis points above their lows reached in July.
The other sticking point is that OMT will only be triggered when Spain or Italy apply for either a full sovereign bailout or a "precautionary" credit line. These will both come with conditions; however we do not know yet what the conditions will be. Likewise, we don't know if the conditions will be less onerous for a country who applies for a credit line vs. those who apply for full-blown sovereign bail outs. We still need to find out the detail, but the distinction regarding conditions could be a diplomatic nightmare for the ECB.
Going forward, the drop In Spanish bond yields proved that the OMT has "worked" before it has even been implemented. If yields can fall to 5% in the next few days and weeks then we could see EURUSD move towards 1.30. In the long-term we believe that the ECB has done two things to reduce the tail risk of a member making a disorderly exit. Firstly, it has taken care of banks' cash requirements by loosening collateral requirements so banks can get loans from the central bank even more easily. Secondly, it has targeted sovereign yields, but is only doing so if fiscal reform is implemented at the same time. Thus, although the euro looks very overbought in the short-term and we could see a pullback at the start of this week, the rally may well continue, especially if we get QE from the Fed on Thursday (see US section).
Figure 2: German and Spanish 10-year bond yields
Source: Forex.com and Bloomberg
Conventional vs. Unconventional - the ECB vs. the Riksbank
Last week the Swedish Riksbank cut interest rates in a surprise move. The rate now stands at 1.25%, the second cut in two months. The central bank also lowered its expectation for rates next year to an average of 1.4% down from its previous estimate of 1.6%. The justification for the rate cut was down to the deterioration in the economy in the second half of this year. The unemployment rate has started to rise; mortgage lending has continued to decline and is at its lowest level since the mid-1990's. Consumer and business confidence levels are falling and service sector surveys have reversed the strength from earlier this year. Its exports, 70% of which go to the Eurozone, are also at risk as Europe's economic data remains weak. The central bank had been under pressure to cut rates to try and dampen upward pressure on the SEK, which had risen over 10% versus the euro this year. It has since lost a bit of strength but remains relatively high. The Riksbank has spoken out about the strength of the SEK in the past, and this rate cut will hopefully cap SEK gains for the medium term.
The action by the Riksbank was in sharp contrast to the ECB - the Riksbank stuck with conventional monetary policy, while the ECB is re-writing its rule book with one unconventional programme after another. However, after the ECB's downward revision to GDP for this year and next, it now expects this year's decline to be around -0.4% and next year's GDP range between -0.4% and 1.4%, could the Eurozone do with some conventional rate cuts from the ECB? The bond buying plan may have reduced credit growth, but it hasn't necessarily helped the economy as the OMT is helping to boost the euro, making the periphery's export markets less competitive. Thus, the ECB may want to follow the Riksbank's old school approach and consider cutting rates further down the line.
Figure 3: EURSEK
Source: Bloomberg and Forex.com
Event risk in Europe next week
The ECB may be out of the way, but there is still some event risk to be aware of and most of it emanates from the Northern bloc of fiscally "strong" countries. The first is the German Constitutional Court ruling on the 12th, which will rule on the legality of the Eurozone bailout funds. A recent poll by news agency Reuters found that 20 top lawmakers in Germany believe the court will rule the ESM legal, however, if there is a surprise ruling then the euro could sell off sharply. Since the Bundesbank was the lone dissenter on the ECB last week, watch out for any signs of further bailout fatigue from Berlin.
Elsewhere, Holland holds a general election also on 12th September. The latest opinion polls suggest that the Liberal pro-euro party will win, although maybe not by a large enough margin to avoid forming a coalition. The problem is the anti-euro socialist party, which has been gaining more attention of late and seeing its voter base rise. It is anti-euro and also against cutting the fiscal deficit. If you see the fiscally "responsible" Northern Bloc nations start to dissent when it comes to public finance reform then it could be harder to force tough conditions to bailout terms in the periphery. This is another risk that could de-rail the euro-based risk rally in the coming months.
Can the UK's labour market continue to surprise on the upside?
The UK labour market has been the one bright spot in the UK's economy. It created 201,000 jobs in Q2, which was the largest quarterly increase in two years. This has helped to keep the unemployment rate stable even though the economy has nose- dived into its first double-dip recession for 30 years. There are many people in the market who doubt whether this can last and there have been some signs that job growth could be cooling. The service and manufacturing PMI's for August show a slight deterioration in the employment component of these indices. And a recent KPMG/ REC jobs report found that job placements had declined in July. Hence jobless claims, released on Wednesday, may have increased last month. The ILO unemployment rate for July is expected to remain at 8%.
The pound has benefited strongly from the weaker dollar on the back of QE expectations. This helped to push GBPUSD above 1.60 on Friday and opens the way for a move back to 1.62. However, pound strength has not been broad based. EURGBP continues to rise and GBPAUD has also fallen as markets' risk appetite picks up with a vengeance. Thus, any weakness in the labour market figures on Wednesday could cause another leg higher for EURGBP above 0.80 and then potentially to 0.8150 - the highs from June - in the near term.
Figure 4: UK labour market and YoY GDP
Source: Forex.com and Bloomberg
RBNZ to hold
The Reserve Bank of New Zealand (RBNZ) will meet on Wednesday, September 12 and we expect the Bank to keep policy rates on hold at 2.50%. As such, the tone of the statement is likely to drive price action. We think that there is the potential for the Bank to take a more dovish stance as uncertainties remain high and the NZD stays elevated. The outlook for New Zealand's trading partners' remains downbeat as external conditions continue to be weak. A sharp slowdown in China, likely recession in the Eurozone, and weak PMI's across the globe indicating continued contraction is likely to keep economic activity subdued.
Domestically, the unemployment rate ticked higher to 6.8% amid a declining participation rate, card spending has declined, as has housing prices. Inflation is at the lower end of the Bank's target range but is expected to settle near the mid-point of that range in the medium term.
NZD/USD is currently trading above the 0.81 figure, close to the levels at the RBNZ's April meeting in which the Bank said that, "should the exchange rate remain strong... the Bank would need to reassess the outlook for monetary policy". Following this statement in April, the kiwi plunged and we would expect that a mention of NZD strength may result in near term softness for the currency.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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