Highlights
- UK Inflation Report preview
- The RBA in wait and see mode
- Expecting something, but getting nothing from Draghi
- BOJ may follow Fed and ECB with no immediate action
- Fed inching closer to more easing
UK Inflation Report preview
The Bank of England kept interest rates and bond purchases on hold at its August meeting, which means that it did not release any statement alongside its policy decision. But we won’t have long to wait to hear from Mervin King as he presents the Bank’s third Inflation Report of the year this coming Wednesday.
The weakening UK economy, including a 0.7% decline in GDP in Q2 and a slump in the manufacturing sector PMI in July, suggests that the Bank will need to do more QE at some stage as the UK economy sinks even deeper into recession. The question now is: when can we expect that extra stimulus? We may get some clues on the timing of more stimuli from the Inflation report when the Bank will present its updated inflation and growth forecasts for the next two years.
The outlook included its last report in May was extremely gloomy, but this time the Bank is going to have to look though a very uncertain growth picture, clouded by the impact of the Jubilee Bank Holiday in Q2 and the Olympics in Q3, to try and decide when and how much more stimulus should be pumped back into the fragile UK economy. Consensus is for another bout of stimulus in November, when the last Inflation Report of the year is published. The Bank may choose to wait until then for a couple of reasons: 1, it would allow the effects of the recent QE boost to have an impact on the economy (QE feeds into the economy with a lag) and 2, it would also give the Eurozone authorities time to sort out the debt crisis, which is considered to be a major drag on the UK economy.
There are some signals to look out for in the Inflation Report that could give some guidance on future BOE policy action. We expect the growth forecast to be revised lower yet again for this year. The May inflation report suggested that growth in 2012 would skirt along the bottom, with the UK registering hardly any growth at all. This could be revised even lower especially after the decline in July’s PMI manufacturing data and a potential drop in activity caused by an exodus out of London during the Olympics. This may mean that the recession is more prolonged than the Bank expected in May. Then the Bank categorised the economic outlook as “unusually uncertain”, it will be interesting to see if it dampens its language further reflecting deterioration in the Bank’s expectations for growth in the coming quarters. If that happens then it would give a big hint that more asset purchases will be on the way.
Inflation is also a key driver of future action by the Bank. In its May report it said that the outlook for inflation “remains uncertain” and will be determined by the cost of commodities and also domestic cost pressures. Since May, Brent crude oil has started to creep higher again, which could keep the BOE on its guard, however, energy prices are not feeding through to higher wage costs, which could be enough for the BOE to loosen the reigns. Back in May it said that the risk of inflation being above or below target in the next two years was broadly balanced, however if it revises these risks higher then that would be another signal to suggest QE is waiting in the wings.
The pound has proven that it is fairly resilient to QE from the BOE, and GBPUSD is likely to be more impacted by overall market risk and the Eurozone sovereign debt crisis in particular. However, persistent weak growth and the prospect of a rate cut or more QE may make the pound an attractive funding currency especially against the higher yielding commodity currencies like the Aussie, the Kiwi and the Cad. GBPNZD could have further to decline if market sentiment does not take a massive dive lower post the ECB meeting last week. 1.9190 is a key support level then 1.90.UK CPI and wage data
Source: Forex.com
The RBA in wait and see mode
The RBA announces its policy decision on the 7th August, and the market expects the Bank to keep rates on hold at 3.5%. Since the Bank cut rates by 75 basis points in May and June, and one could argue that the external and domestic situation has stabilised in the recent weeks, this justifies a decision by the RBA to remain in wait-and-see mode, in our view.
There have been a couple of developments in the past few weeks that justify our decision to expect the RBA to remain on hold. The first was Q2 inflation. Consumer prices were a fairly mixed bag with the headline data slightly lower than expected, and the core data rising slightly. The trimmed mean inflation reading that is looked at by the RBA fell to 2% from 2.2% in Q1, but was stronger than the 1.9% expected. So although inflation has been trending lower, the lack of a major surprise to the downside means that it is unlikely to be a trigger for further policy accommodation from the RBA at this stage.
Other growth signals have surprised to the upside including Australia’s beleaguered retail sector. Retail sales for June were much stronger than expected, rising 1% vs. expectations of a 0.7% rise. This is the strongest monthly rate since March of this year. Part of the boost to retail sales was down to the Government Household Assistance programme, a variable cash bonus for householders from the government that was designed to try and boost spending and was introduced in May. The data suggests that this type of fiscal stimulus has worked, as retail sales were led higher by sales of clothing and footwear and also department store sales, which are sensitive to changes in disposable income (the UK’s George Osborne should take note).
Fiscal stimulus comes at a cost and this one was paid for by the carbon tax that came into effect on July 1st. Thus, energy prices may rise as a result of the tax, so the government cash bonus may not all be spent on the high street. Thus, there is a risk that retail sales could slow in the second half of this year.
Overall, the RBA is likely to strike a cautious tone in its statement. It is unlikely to cut rates unless the external environment deteriorates further. It may also make note of the slowdown in China and the impact it is having on the Australian economy. Exports of iron ore (where demand mainly comes from China) fell sharply in June.
Although the Aussie may look overvalued according to some technical indicators, in the current environment of low yields having an interest rate of 3.5% (in the US they 0.25%) makes the Aussie an attractive carry trade option. This could keep the Aussie well supported, especially against the GBP and EUR. Although GBPAUD has been falling since May there could be further downside. 1.4650 is a major support level, the lows from February this year, and then 1.45.
Source: Forex.comExpecting something, but getting nothing from Draghi
The markets’ initial reaction to the ECB meeting on Thursday has been one of disappointment. There was no big bazooka from ECB President Draghi. Instead he called for governments to stand ready to “activate the EFSF/ESM in the bond markets when exceptional financial market circumstances and risks to financial stability exist”. He also said that the ECB, within its mandate, could “undertake outright open market operations” of a size “adequate enough to meet its objective”. Thus, Draghi has said that there could be official buying of Spanish and Italian bonds by the EFSF/ ESM and the ECB but only if the situation gets out of control. So does that mean that bond yields need to rise above the 7%/ 8% mark before the ECB will act?
Draghi’s press conference had a much more muted tone relative to his remarks in London last week where he passionately said the Eurozone was here to stay and that the ECB would do all in its “mandate” to ensure the euro survives. It appears that Draghi’s comments in London meant that the Bank won’t protect the Eurozone right now; instead the ECB will avert disaster only when the euro looks like it is under severe attack. Draghi may have referenced the ECB’s mandate many times during his speech in London, but he must have known that the markets are jumping on the back of central bank comments even more so than they are on fundamentals, so he should have been more careful if he wanted to avoid a “disappointing” market reaction after his press conference.
This meeting has dealt a blow to Draghi’s credibility, and the mixed market reaction shows that the ECB’s communication skills may need some work. EURUSD bounced around 230 pips during the press conference, and Spanish 10-year bond yields surged 35 basis points to a whisker below 7%. Money flooded out of risky assets and into the safe havens like German Bunds and Treasury bonds. The Spanish Ibex index collapsed 7% during Draghi’s comments and Europe’s banking sector declined by a hefty 4%.
Since central banks hold the key to whether markets rally or sell off, the lack of ECB action at Thursday’s meeting could be self-fulfilling. If it causes investors to panic and Spanish and Italian bond yields to rise sharply, it may eventually force the ECB to re-activate its bond buying programme sooner rather than later.
So what is next for the Eurozone? It’s quite hard to tell. The ECB seems to have been dictated by the German Bundesbank. The head of the Bundesbank said in comments during an interview in late June that the ECB can’t over-step its mandate and also that it can do less than some governments’ think it is capable of. He added that the German central bank was the largest in the Eurozone and thus had a bigger say than others, presumably Greece or other bailed out nations. If the ECB doesn’t act then it is up to the governments of Europe to resolve this crisis and that does not seem likely, at least not in the near-term. This leaves markets without an anchor until the next EU summit in October.
Until then we expect markets to meander lower, unless there is a sharp decline in the credit worthiness of Spain or Italy. EURUSD seems to have lost control of the 1.23 handle on the back of the ECB meeting, which leaves 1.20 in view. However, a decline below the June 2010 lows may not be as likely as some think, because the markets will expect central banks to react if volatility gets out of control. This leaves the markets without any clear direction for the next few weeks, which could limit the downside in euro-based assets.
The euro is likely to remain an attractive funding currency, so rather than looking at EURUSD, a short EURSEK position could profit in this environment. Although this cross is already at record lows, there could be further momentum to the downside as Europe’s authorities and now its central bank do nothing to ease credit risk in the region, which is currency negative. Also, the relative growth potential between Sweden and the Eurozone remains wide, with Sweden getting off to a good start in Q3with a positive jump in its PMI manufacturing survey for July after a strong second quarter. A move lower to 8.2 and then potentially to 8.0 could be possible in the absence of official support to draw a line under Europe’s sovereign debt crisis.Spanish 10-year bond yields remain close to the 7% line in the sand
Source: Bloomberg. Please note that this is not a product we offer at Forex.comBOJ may follow Fed and ECB with no immediate action
The Bank of Japan will hold a 2-day meeting next week and will announce policy at the conclusion of the meeting on Thursday August 9. Japanese officials have been under increasing pressure to stem yen strength and move towards its inflation target with the International Monetary Fund (IMF) recently calling on the BOJ to easy policy further.
Options available to the Bank are to expand its asset purchases, extend the maturity of its purchases, change the type of securities it buys to include private assets, or change the language of its 1% inflation target. Despite all of the options available to the Bank, we expect the BOJ to follow in the footsteps of the Fed and the ECB in providing no immediate actions but reiterating its commitment to provide more accommodation as needed.
At the last policy meeting, the BOJ expanded the size of its asset purchases by ¥5T and recent comments by the Governor Shirakawa indicate that the Bank will continue pursuing “powerful” monetary easing until the 1% inflation goal is in sight. As we have previously noted, the BOJ’s perception of “powerful” easing at times differs from the market’s view. With external uncertainties high and a recent increase in its asset purchases, it is likely the BOJ will hold off for now on further measures.
The JPY is likely to remain attractive as a haven. Investors around the globe have been searching for safety and yield, and with many government bonds offering negative yield, the little yield that Japanese bonds offer present a better alternative. Furthermore, the long term trend of JPY appreciation boosts the appeal to foreigners who wish to hold yen. As we have seen in the past, actions taken by Japanese officials, whether it is intervention or monetary easing, has had little impact on reversing the broader trend of yen strength. Intervention tends to be utilized more in times of high yen volatility, and we note that current JPY volatility is significantly less than at the previous periods of intervention. As such, we remain bullish on the JPY and would view weakness as potential long opportunities.
Source: Bloomberg. Please note that this is not a product we offer at Forex.comFed inching closer to more easing
Earlier this week, the Federal Open Market Committee (FOMC) met and made no change to policy. The Fed maintained its forward rate guidance for low interest rates through late-2014. The Fed indicated its readiness to take further action, however despite a more downbeat assessment of the economy from the prior statement, no action was taken. The Committee said that it will continue to monitor developments and will “provide additional accommodation as needed”. This is consistent with our view that the Fed is buying time to take into account European developments and US employment data before making the decision to commit to more stimulus. Additional accommodation is most likely to come in the form of another round of asset purchases (QE3), however there are a range of possibilities as indicated by the Chairman himself. He indicated that options include the purchase of treasuries and/or mortgage backed securities (QE3), reducing the interest rate on excess reserves, use of the discount window, and altering communications on the forward guidance of interest rates.
July employment figures released on Friday showed an increase in the pace of jobs growth with an above consensus print of 163K in nonfarm payrolls (cons. 100K, FOREX.com forecast 129K), however the prior month’s 64K was revised lower from 80K and the unemployment rate unexpectedly ticked higher to 8.3% form 8.2%. Overall, the jobs report was not strong enough to significantly change market’s outlook on the potential for more quantitative easing. Indeed, the numbers released today may be revised by the time the FOMC next meets to decide on policy and therefore may not be considered at that time. Broadly speaking, economic activity remains soft with slowing GDP growth, a frustrating labor market, and reduced consumption. Inflation is slightly below the Fed’s 2% target and the case for more stimulus is strengthening as the economic recovery shows signs of faltering. Therefore, the USD will continue to be sensitive to economic data releases and Fed commentary. The economic calendar for the week ahead in the US is relatively light with June trade balance and weekly jobless claims as the key releases. Bernanke will speak on Monday and Tuesday but is unlikely to address monetary policy.
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