Back in July 2012 Mario Draghi introduced the "whatever it takes” mantra to the central bankers’ lexicon and in conjunction the conceptual (and still untested) threat of OMT. Since then, the stress in peripheral bonds has eased dramatically, indeed to levels that, as we have stated before, are demonstrating (potentially very) misleading risk premia across the region.
Indeed, tighter spreads in peripheral bonds do not solve the ‘debt snowball’ caused by nominal growth remaining below debt servicing costs – particularly when low (or negative) inflation is making the debt profile far worse. Later this week the GDP releases from the eurozone will be keenly watched, yet the indications from the high frequency data are that activity in March was very weak, the base effects of which may point to weaker a Q2.
The big question is whether or not the ECB will act (and if they do in what form) or whether they are merely living on a prayer!
"Whoooaa Livin’ on a Prayer” – Bon Jovi (Livin’ on a Prayer)
Last week’s press conference enabled Draghi to state that in the governing council there was a "consensus about being dissatisfied with the projected inflation path.” … and that the council was ready to act in June unless the projected path improve. In many respects, however, we have been here before.
In November when the ECB cut rates by 25bps, the impact on market rates (and ultimately FX markets) was minimal, due to the fact that overnight rates were already trading below the post cut level. In analysing the potential impact on the EUR from further ECB measures therefore we feel that it would take one of two things (or both).
The first would be a cut in the deposit rate into negative territory – in essence a tax on deposits – and while the implications for bank balance sheets is a concern, the implications for the EUR value on foreign exchange markets are likely significant. The second would be a move into QE territory (almost certainly in a very different format to that of US QE), which would ultimately increase the size of the ECB balance sheet (most importantly relative to the US) and significantly see the relative balance sheet trajectories of the US and eurozone moving in opposite directions. This is again significantly negative for the EUR.
"We’ve gotta hold on to what we’ve got”? – Bon Jovi (Livin’ on a Prayer)
For this relative (rate / balance sheet) move to really take hold of the EURUSD rate in particular it is likely that we also need a more hawkish sounding Fed. The weakness in wage growth that accompanied the strong April US employment report only likely detracts from any urgency to remove stimulus. A continued pedestrian pace of tapering is all too uninspiring. Indeed the situation is further confused by the fact that the "new normal” long term rates may not be that far away, despite Fed Funds being at zero. For the USD to benefit significantly we may need rate hikes being priced in sooner.
"Whoooaa we’re half way there” – Bon Jovi (Livin’ on a Prayer)
In the UK the macroeconomic data has reaccelerated in line with our expectations of continued outperformance. The gap between UK growth and rates is edging towards 4% (average of 50bps the past 30 years), thus it is no wonder people are beginning to think rates should rise and while some commentators are (and the market) are shifting their expectations of the first UK rate rise into Q1 2015, we maintain our view that Q4 2014 remains increasingly likely.
"Tomiko used to work on the docks”(!) – Bon Jovi (Livin’ on a Prayer)
On a broader note USDJPY is beginning to show signs that its correlation to US yields is reasserting itself. Higher US yields and higher equities, in conjunction with yesterday’s terrible Japanese trade data are potentially very bad for the JPY and we are watching very closely at the near term developments of GBPJPY in anticipation of a break into new high ground.
"We’ll give it a shot” – Bon Jovi (Livin’ on a Prayer)
Equities will likely continue to grab the headlines over coming days as the S&P closes in on 1900 and the FTSE on the 1999 high around 7000. As ECU Global Macro Team member Kit Juckes notes this morning "This speaks volumes for the ability of QE and ZIRP (Zero Interest Rate Policy) to trump minor details like sluggish growth.
