Deflationary Forces Strengthen

The month and week are winding down, and what a month and week it has been. The three key events were all about Europe. The SNB's unexpected decision to lift the cap on the franc. The ECB's decision to proceed with a sovereign bond buying program was less a surprise but just as momentous if not more so. Syriza's victory in Greece is already changing the political landscape.

Negative nominal rates, unthinkable eighteen months ago, have become more common. And if zero is not the bottom of nominal interest rates, how low can rates go? The SNB has its target rate at -0.75%. Look at what else has happened. Italy sold 10-Year bonds this week at record low yields. Ireland yesterday auctioned Tbills at zero interest rates. German yields are negative through 5-Year and the 30-Year bond yield today is just above 1%. When assessing the cost of its aid to the periphery, shouldn't we deduct the interest rate savings?

As more senior European officials meet with the new Greek government two things are becoming more apparent. First, the government is not taking unilateral action. Second, it does have a different perspective and interests that it will express and have to be accommodated to some extent. For example, new sanctions on Russia require unanimity. At first it appeared that Greece was going to block new sanctions. A compromise was worked out.

Today there is talk of extending the current "extension" of the existing assistance programs as long as six months (through August). We have suggested a small extension was possible. It was not the cynical "pretend and extend" but it was a practical solution. Six months seem too long though for both sides-the Greek government as well as the official creditors. That said Greek bonds are extending yesterday's recovery.

There were three inflation reports today. First Japan, where the BOJ is expanding its balance sheet by 1.4% of GDP a month, reported that inflation continues to move in the wrong direction. The BOJ's target, core inflation, which excludes food but not energy, adjusted for the sales tax increase last April slipped to 0.5% from 0.7% and this is the third month below 1%.

Second, Spain reported its harmonized CPI at -1.5% in January from -1.1% in December. This follows yesterday's news that German CPI fell to -0.5% from +0.1% in December. Third, both of these reports fed into the EMU flash CPI of -0.6%. The consensus had expected a -0.5% reading after -0.2% in December. The core rate, which had been steady at 0.7% throughout Q4 2014 fell to 0.5%.

One fear of falling prices is that it may hamper consumption as households defer purchases. However, this is not what is happening in Europe. Yesterday Spain reported retail sales surged in December to a 6.5% year-over-year pace from a 1.9% in November. France today reported consumer spending jumped 1.5% in December, more than offsetting the downward revision in November from 0.4% to 0.2%. German retail sales rose 0.2% in December after a revised 0.9% in November.

Japan is a different story. Overall household spending fell 3.4% year-over-year. The consensus was a 2.3% decline after a 2.5% fall in November. The story here seems to be less one of deflation and more of the ripple effect of the sales tax increase.

Separately, eurozone unemployment fell to 11.4% in December from 11.5%. Italy surprised with a fall to 12.9% from 13.3%. Japan unemployment unexpectedly slipped to 3.4% from 3.5% and the job-to-applicant ratio rose to 1.15 from 1.12. Labor market slack or there lack thereof has not been a useful guide to wage pressure.

Denmark is using both of its tools to maintain the narrow band against the euro. It cut interest rates for the third time in ten days yesterday. Its key rate is now at -0.5%. It has also intervened, with estimated ranging from 5-8 bln euros this week. Under ERM II, it is to committed to keeping the DKK in a 2.25% band against the euro, but in practice has adopted a 1% band. Under ERM, both sides, the strong and weak currency have an obligation to defend the bands. Unlike the SNB's franc cap, the Danish regime is supported by the ECB. The question arises, will the ECB act to defend the euro against the rising Danish krone? Since it has not exercised inter-margin intervention at the 1% band, will it be there if the 2.25% band it tested?

Meanwhile, the euro has rallied strongly against the Swiss franc this week. After the Greek election, the euro tested CHF0.98. Today it resurfaced CHF1.05. The market suspects SNB intervention. This reaffirms our understanding that the lifting of the franc was a tactical decision and did not signal a free-float or the end of the SNB's balance sheet expansion.

There are three features in the remaining part of the last session in January. First, the second and third rounds of the Italian president selection process. A two-third majority is still needed until the fourth round tomorrow when a simple majority is needed. The ballots are secret. If Renzi's candidate, Mattarella does not win in the fourth or fifth round over the weekend, it will be seen as a sign that he has lost control of his party. Renzi has risked breaking with Berlusconi with whom he formed a pact to push a reform agenda in order to strengthen his support within the PD. He clearly picked a candidate that would antagonize Berlusconi. Renzi appears to be betting that losing confidence of his party is more serious than a break with Berlusconi that could be repaired, after all, Alfano who helped bring Berlusconi down and formed his own party is now back supporting Berlusconi's candidate.

Second, the US reports Q4 GDP and the Employment Cost Index. The former, expected to be around 3%, is likely to have been lifted by an increase in consumption, which should offset the weakness in the December retail sales report. Similarly a 0.6% rise in the ECI should help offset the weakness in hourly earnings. A weaker than expected report could have noticeable impact on Fed expectations for a mid-year lift-off. In addition, the University of Michigan's consumer confidence survey, and especially the long-term inflation expectations will be watched closely. The FOMC appears to be putting more weight on it than the market-based measures of inflation expectations that have fallen sharply.

Third, Baker-Hughes reports the US oil and gas rig counts later today. This week has seen a large number of oil companies report earnings. Refineries have generally done better and large oil companies with refineries have fared better than the pure producers. The large international operators have reported a marked decline in North American revenues compared with other regions. The declining rig count in the US is important, but should not be confused with a decline in output.