- The UK's struggle to keep its triple A credit rating
- Swiss inflation and the EUR/CHF peg
- Will Germany save the eurozone?
- Interpreting Bernanke: is more stimulus on the way?
- RBA, BOC expected to hold rates steady
The UK government is between a rock and a hard place: the economy is showing no signs of picking up speed in the third quarter. At best we may get 0% growth to take us out of a technical recession, but even that isn’t guaranteed as manufacturing and trade data weigh on the economic outlook. This puts pressure on the government to abandon its austerity drive and try to pump more stimuli into the economy and artificially boost growth.
Growth last quarter benefitted from flat levels of government spending, in contrast investment spending and household consumption both fell, so there is some merit to the argument that the government could help generate growth in the coming quarters if the Treasury loosened its purse strings. But that comes at a price – if the government abandons its fiscal austerity programme then the UK could lose its triple A credit rating, according to rating agency Fitch.
The rating agency said that there is limited room for the government to manoeuvre when it comes to stimulating economic growth and also trying to adjust the fiscal screws. As we have seen elsewhere, losing a triple A credit rating is not the end of the world, it hasn’t done much to hurt the US’s borrowing costs, but it could jeopardise the government’s credibility especially as the Chancellor has staked his reputation on the UK maintaining its rating.
While losing a notch or two on a credit rating may not hurt sterling, a political crisis most certainly would. Hence we will be watching the Prime Minister’s cabinet re-shuffle next week extremely closely. We expect Chancellor Osborne to keep his job, but as we move closer to his autumn statement in November life is not going to get any easier for occupant of Number 11 Downing Street.
Next week’s economic data releases from the UK including PMI data for the manufacturing and services sectors along with industrial production will be pivotal to assess the state of the economy as we move towards the last month of the third quarter. PMI data is expected to remain in the doldrums: with the manufacturing sector remaining stuck in contraction territory for the fourth consecutive month. The services sector is expected to remain above the 50-mark, but it is expected to fall.
The Bank of England is also announcing interest rates this week; however it is not expected to change interest rates or the size of its asset purchase programme. We believe the Bank will hold off taking more action until the November meeting to see how the July boost to QE along with the new Funding for Lending programme helps to boost growth over the coming months.
The fundamentals of the pound may be weak, but that doesn’t seem to get in the way of sterling. If the BOE remains on hold but the ECB takes steps to increase the size of its balance sheet at its meeting also on Thursday then we could see EUR/GBP come under some pressure. This cross has recovered in recent weeks, but a dovish ECB could see a test of 0.7900 – a key support level and the 50-day moving average – and potentially a move back to the 0.7850 zone.
Fig 1: UK government spending QoQ
Source: Forex.com
Swiss inflation and the EUR/CHF peg
The Swiss National Bank (SNB) is awash in FX reserves since enacting its 1.20 floor in EUR/CHF last August to limit upward pressure on the franc. It has seen FX reserves jump 50% in the four months to June to CHF 365 billion, which is about 60% of Swiss GDP in the second quarter of this year. The problem for the SNB is what to do with the euro it now owns and how to diversify its holdings to reduce its risk to the troubled single currency. It has said it is moving into commodity currencies like the aussie and the CAD, yet the aussie looks vulnerable as China’s economy slows and commodity prices continue to come off.
However, even while its peg becomes a bigger problem to deal with each month, the SNB is unlikely to end its policy any time soon. It continues to say that the peg is necessary to protect economic growth and also to help avoid deflation. Since Switzerland imports many goods and services, if the currency is strong it can lead to a fall in inflation. The economy is already in deflation – prices fell at a 0.7% annual rate in July.
The August data is released on Wednesday. It is expected to show that inflation picked up a bit on the month, but analysts still expect prices to decline on an annualised basis at 0.4%. The SNB could argue that without the peg deflation could be much worse, thus the latest inflation data could act as another justification for the Bank to keep the 1.20 floor in EUR/CHF in place.Will Germany save the eurozone?
As we ended last week the outcome of this Thursday’s ECB meeting remained up in the air. Reports that the head of the Bundesbank has reportedly threatened to resign in recent weeks on the back of negotiations for ECB policy action to try and stem the debt crisis added another twist to the outcome of the sovereign debt saga.
Merkel reiterated her support for Jens Weidmann, the head of the Bundesbank, suggesting rumours of his resignation were not just smoke without fire. The last thing the ECB needs is a change of personnel at the top, so if this story develops it could cause some adverse reaction in euro-based assets.
But while HR issues in Germany’s central bank are worth investors keeping an eye on, what traders want to know is will the ECB embark on more bond purchases this week? On Friday ECB member Coeure said that the ECB is studying ways of intervening in the short-term bond market based on “strict conditionality and the EFSF/ ESM programme.”
The market has been prepped to expect some bond-buying programme announcement from the ECB at this week’s meeting and if it doesn’t deliver then the Bank will be accused of misleading the markets. However, ECB members like Coeure have been extremely clear: there will be no bond purchases if Spain does not apply for formal aid from the EFSF/ESM. Right now that seems unlikely especially since Spain’s prime minister delayed seeking official financial help last week even though more autonomous regions of the Iberian nation continue to tap the country’s own EU18bn bailout fund.
Thus, the markets could be left wanting yet again by an ECB who continues to do too little too late. While Draghi may want to help keep the currency bloc together by using its financial firepower to try and protect the bond markets of Spain and Italy, it may not be able to do so without the full support of the German Bundesbank and also before the German Constitutional Court rules on the legality of the ESM long-term rescue fund for the currency bloc, the ruling is due on 12th September.
The problem facing the ECB was reflected in Friday’s economic data releases: inflation was stronger - rising to 2.6% in August up from 2.4% in July, while unemployment reached a new record high of 11.3% in July. How does the ECB help countries like Spain re-build their wrecked economies when inflation hawks like the Bundesbank remain resistant to anything that smacks of government financing? This is the real problem that needs to be solved, the question is will it be solved by next Thursday?
The ECB meeting is the chief focus this week after the Fed governor didn’t give too much away regarding the Federal Reserve’s next move during his speech at Jackson Hole in the US on Friday. He sounds concerned about the economy and listed the options the Bank has at its disposal, however he didn’t answer the two questions the markets wanted answering: 1, what type of action the Fed will take and 2, when it will take it. But while there is still the prospect of more QE from the Fed, the markets are running out patience with the ECB and eurozone officials.
Without Germany on board, the eurozone project is unlikely to survive, and if Berlin is not on board with the ECB at this week’s meeting then we may see a sharp sell-off in the single currency and other euro-based assets. Likewise, Spanish and Italian bond yields could start to move higher again.
Levels to watch out for: a positive message from ECB President Draghi on Thursday could see EUR/USD rise above 1.2630 towards 1.2750. However, any disappointment could cause a sell off. If the sell-off is sharp and aggressive we could even breach 1.2435 – the top of the daily Ichimoku cloud, below here is the end of the technical uptrend.
While the ECB press conference is the major even this week there are also some economic releases to watch out for including the August PMI data and the second reading of Q2 GDP, which is expected to remain unrevised at -0.4%. The PMI data is expected to remain mired deep in contractionary territory.
Likewise, retail sales are expected to decline in July relative to June suggesting that the eurozone could slip into a formal recession (two consecutive quarters of negative growth) in Q3. Spanish budget data and unemployment for August is also worth watching.
Fig 2: EUR/USD daily Ichimoku cloud chart
Source: Forex.com
Interpreting Bernanke: is more stimulus on the way?
The highly anticipated speech by Fed Chairman Ben Bernanke sent the US treasury yields and the dollar lower while giving a boost to equity markets. The combination of the market reaction indicated that participants are expecting more easing to come from the Fed at the next policy meeting. Comments from the Fed Chairman hinted at the need for further stimulus as he noted that the “economic situation is obviously far from satisfactory” and that “stagnation of the labor market in particular is a grave concern.”
The speech itself reviewed “Monetary Policy since the Onset of the Crisis” and in it, Bernanke defended the effectiveness of nontraditional policy approaches. He said that the impact of QE is “economically meaningful” and that is “provided significant help for the economy.” Bernanke said that he would not rule out further asset purchases and that the Fed will boost accommodation as needed for growth. This is in line with our expectations that all options remain on the table as data emerges.
Ahead of the next FOMC meeting in September, the August employment report will be released which may contain revisions to July’s figures. This will provide a clearer picture of labor market trends, which we believe is key to Fed’s decision. While it appears that the Fed is inching closer to more stimulus and is ready to act fairly soon as indicated in the last FOMC meeting minutes, we feel that the monthly labor report (due Friday) as well as the September ECB meeting (Thursday) will be key in determining Fed policy.
Bernanke indicated a number of headwinds including the low levels of housing activity, fiscal policy uncertainty, and financial market stresses as a result of the EU crisis. As such, we view the European policy response as a factor in the consideration of Fed policy.
For now, as it seems the Fed is leaning towards providing more accommodation and markets price in the likelihood of additional stimulus, the dollar may see further gains. These gains may be limited as technically, the dollar is approaching significant support. The key level in the Dollar Index comes in around the 200-day simple moving average (SMA) which also happens to be where year-long channel support comes in around 80.70 (see Fig 3).
A break below here is needed to indicate further dollar weakness. To the upside, the 100-day SMA is the key pivot and a break above here is needed to signal the potential for dollar strength.
Fig 3: Dollar Index remains in a long-term bullish channel
Source: Bloomberg
RBA, BOC expected to hold rates steady
On Tuesday, September 4, the Reserve Bank of Australia (RBA) will meet to announce monetary policy and we expect the bank to keep rates on hold at 3.50%. The tone of the statement is likely to drive price action in the Aussie and we feel that the bank may acknowledge uncertainties in Europe, the Chinese slowdown, relatively firm domestic growth, and high exchange rate.
Taken together, it is likely that the bank will reiterate that policy is currently appropriate and keep a neutral stance. The Australian dollar has remained relatively firm as a result of the country’s strong fiscal position which has attracted reserve diversification from various central banks.
Domestic growth has been close to trend, inflation remains at the low end of the Bank’s target range, and labor growth persisted with the addition of 14k jobs in July. Furthermore, the unemployment rate fell to 5.2% from 5.3%, however this occurred alongside a decrease in the participation rate to 65.2% from 65.3%. The housing market has cooled with a -17.3% m/m decline in building approvals and a drop of -5.6% in new home sales in July.
External uncertainties remain high and while progress in Europe looks to be on the horizon with potential bond buys by the ECB and more talk of a banking union, there is scope for disappointment as plans have not been put into action. China’s slowdown appears to be ongoing with PMI readings falling to November lows. This contrasts with the RBA’s view from its last rate meeting in which the Bank noted that “China’s growth has moderated to a more sustainable pace, but does not appear to be slowing further.”
Slowing growth in China has resulted in reduced demand for Australia’s resources and has seen prices of key exports, such as iron ore, fall sharply. While this is likely to put downward pressure on the Australian economy moving forward, we do not expect the RBA to react to near-term commodity price fluctuations at the upcoming meeting.
The Bank of Canada (BOC) will meet on Wednesday, September 5, to make its rate announcement and we are looking for the bank to maintain its overnight target rate at 1.00%. As recent as last week, BOC Governor Mark Carney reiterated his stance that higher rates “may become appropriate” as the economic expansion continues to accelerate. GDP figures released on Friday showed a monthly increase of 0.2% in June which was higher than expected and y/y growth of 2.4% (cons. 2.2%). Furthermore, the Ivey PMI reading jumped to 62.8 in July from the prior 49.0, which indicates a shift to expansion.
The trade deficit widened to -1.81B in June on increasing machine imports and, retail sales were soft in June with a monthly decline of -0.4%. Carney acknowledged the weaker data, but did not seemed overly concerned as he indicated that the expansion may be curbed by “short-term special factors.” The governor went on to say that the data “bears watching,” however maintained his hawkish stance.
We expect the statement to uphold the relatively hawkish bias of the BOC and therefore we continue to expect the Canadian dollar to outperform the commodity currencies. Though external conditions remain fragile and uncertainties high, growth in Canada is anticipated to be driven largely by domestic factors.
Fig 4: Canada monthly GDP growth accelerated in June
Source: Bloomberg, Forex.com
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