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Divergence Theme Continues to Shape Investment Climate

The key fundamental fact that is shaping the investment climate was underscored last week.   The ECB announced that it will begin its accelerated asset purchases on March 9.  The following day the US reported a sufficiently robust employment report to reinvigorate expectations that the Federal Reserve will raise rates before the end of the summer.  

 

The BOJ continues to buy 90% of the net government issuance.  The Government Pension Investment Fund is aggressively diversifying its portfolio away from government bonds and toward domestic equities and international stock and bonds. Other pension funds reportedly are doing much of the same.  

 

A concrete consequence of the divergence is the new leg up in the dollar.  After spending last month moving broadly sideways, there was a growing sense in some quarters that the dollar's run was over. There had been a modest reduction of the net short euro, sterling and yen positions in recent weeks.  At the end of last week, the dollar appeared to have broken out against the euro and yen. 

 

However, the sharp advance left the dollar stretched from a quantitative point of view.  It is 2-3 standard deviations from its 20-day moving average against the major currencies.  This suggests the medium and long-term investors should not chase the market at the start of the new week,  and at the same time have confidence that the dollar's bull market has not ended.  Dollar (and sterling) based investors should continue to hedge European and Japanese investments.  Given the short-term interest rate differentials--essentially the cost of the hedge--dollar (and sterling) based investors are paid to sell the euro and yen forward.  

 

To be clear, the divergence in policy is the key determinant of the investment climate, not the divergence in high frequency economic data.  That divergence may have peaked in the April-September period last year.  US growth was 4.8% an annualized clip while the eurozone stagnated, and the Japanese economy contracted.  In Q4 14 the US economy slowed while growth strengthened in the euro area.  The Japanese economy expanded in Q4.  

 

As employment growth accelerated in the US, its growth has slowed.  The 12-month streak of monthly job growth in excess of 200k has not been experienced since 1995. Some of the other, less publicized measures, such as under-employment, have also improved.  Meanwhile, poor weather and a labor dispute disrupting the country's two largest ports may exaggerate the economy's moderation to a pace more consistent with economists' estimate to be trend growth.  

 

Retail sales are the main US economic data in the week ahead.  January's report that showed a 0.9% decline in sales excluding autos and only a 0.1% increase excluding autos, gasoline and building materials (a core component used for GDP calculations, with those items being incorporated from other reports).  It fanned worries that the assumption that the fall in oil prices was a net positive was wrong.  

 

The high frequency data is noisy and it often takes time to see the effects of a rise in disposable income, though we note that personal consumption in Q4 14 rose 4.2%, the fastest in a decade. After a pause in January, when savings were boosted, Americans went shopping again.  February retail sales are expected to have risen by 0.4% and 0.5% excluding autos.  The core rate is expected to have risen by 0.4%.  

 

The impact of the weather is a bit of a wild card.  We had feared for naught that weather may have depressed February's job growth.  The Bureau of Labor Statistics reported that some 328k people could not get to their jobs last month compared with ten-year February average of 387k.  Auto dealers reported that the weather slowed showroom traffic.

 

The main economic report in Europe will be the January industrial production figures.  Germany and Sweden both reported larger than expected gains.  This probably sets the regional tone.  The focus for investors will not be on the economic data.  It is on the impact of the launch of the ECB's bond buying program.

 

The ECB announced a flexible and decentralized purchases program.  National central banks are given broad discretion.  The rules seem minimal.  There is no duration target and 2-30 year bonds can be purchased.   No more than 25% of any issue can be bought and there is a 33% country limit, including the earlier SMP purchases (that means that Eurosystem cannot hold more than a third any country's debt).   These caps, as well as the fact that the ECB cannot continue to be in the Troika, appears a consequence of the Advocate General preliminary finding for the European Court of Justice.  

 

Investors and policy makers continue to wrestle with the implications of negative interest rates,  something that seemed nearly impossible (outside of an administered rate) a year ago.  If zero is not the lower bound of nominal interest rate what is? 

 

The ECB seemed to have put a soft floor for 2-30 year bonds at -20 bp, the deposit rate.  Neither the ECB not the national central banks will be allowed to buy bonds with that tenor that have a yield lower than -20 bp.   The ECB can cut its deposit rate further if desired.  Bond can rally in price, (decline in yields) beyond where the Eurosystem would be a buyer.  We suspect that that alone may discourage investors as well, even if there are exceptions, like the German 2-year that has recent been straddling the -20 bp level.  

 

This month is a new act in the Greek drama.  The liquidity squeeze is intensifying like the creditors knew it would.   It has to find about 6.2 bln euros between maturing T-bills and principle and interest payments to the IMF.  New government's T-bill sales could help. It sold 1.14 bln euros of 6-month T-bills last week (2.97% vs. 2.75% at the previous auction).  The bid-cover was 1.3. It will auction 3-month bills on March 11 and will likely raise another 1 bln euros  It has another bill auction scheduled for March 18.   However, the ECB is keeping firm its cap on T-bills that can be bought by domestic banks.  

 

Many officials feign disbelief that the liquidity crisis has pushed Greece into such dire straits.  At the same time, others accuse it of already raiding the cash buffers in government programs.  Meanwhile, the Eurogroup of finance ministers meet on March 9 to discuss some concrete measures the Greek government is proposing as alternatives to the past conditions demanded by the official creditors in exchange for assistance.  

 

Recall that the previous Greek government also struggled to meet the creditors' demands.  Aid has been cut off since mid-2014.  The clash with official creditors was already happening. Samaras ill-advised fated political gambles led to the first national election victory by an anti-austerity party. The official creditors would like it to be the last one.  The inexperience and style of the new government provides additional color for the confrontational theater.   

 

ECB officials opining that Syriza over-promised its voters, as if it would be first politicians do to so, is not particularly helpful either and contributes to the siege mentality of the new Greek government.  Despite the name calling, the Greek government is hardly radical.  It says it supports 70% of the previous agreement.  It is willing to commit itself to a permanent budget surplus.  It wants to dramatically step up tax collection, though some the methods it has suggested seem almost Orwellian.  It wants to curb the rent-seeking endemic rent-seeking behavior of the political and economic elites.  Is this not broadly compatible with the neo- and ordoliberal agenda?   

 

On March 10, the finance ministers of the European Union meet.  There are two main issues. First, EC President Junkers investment program.  It is highly centralized and mostly puts existing funds under the new program, with ideas of leveraging it and inducing private sector investors.  As the main initiative to boost aggregate demand, it seems weak and uninspiring.  However, it may be launched as the impact of the lower interest rates, the weaker euro, and lower energy prices help lift growth.  

 

Second, France continues to be the laggard in structural reform and progress toward its fiscal targets. While many, if not most, European officials seem willing to make an example of Greece, many of the same officials are loathe to make  an example of France.  Recall its was France (and Germany) that first violated the Stability and Growth Pact and the first to look to skirt the rules regarding penalties.   French President Hollande first resisted the demands of austerity, but since appointing Socialists from the pro-business wing, there appears to be a rapprochement with Germany and other officials and European Institutions.  

 

The week ahead also sees a flurry of Chinese data.  While the reports pose headline risks, they will be quickly shrugged off an account of the New Year celebration distortions.  The big picture will not change.  The Chinese economy is slowing with cyclical and structural headwinds.  As the world's largest manufacturer and an inefficient user of energy, China will be a major beneficiary of the halving of the price of oil and the decline in other commodity prices.  

 

Indeed, China's February trade figures released over the weekend showed another record trade surplus.  It was the second consecutive month of a $60 bln+ trade surplus. Exports surged 48.3% from a year ago, more than three times the consensus expectations. There was a positive base effect and distortions caused by the Lunar New Year. Stronger US growth also helped.  Imports were plummeted 20.5% from a year ago, weighed down by falling commodity prices and slowing domestic demand.   

 

It has cut interest rates twice in the last four months and have provided targeted assistance to lenders. The dollar has risen 2.8% against the yuan over this period.  There are only a few currencies that the dollar has appreciated less against than the yuan.  

 

Among the major currencies, there is only one: the Swiss franc, which has fallen on 2.4%.  The Indian rupee has lost 1.3% against the dollar; the Thai baht is flat, and the Philippine peso has actually risen 1.8% against the dollar over this time.  The point is that the yuan has appreciated on a trade-weighted basis, though a little less when adjusted for inflation differentials.   

 

The official pledge to let allow market forces great sway in setting the yuan's exchange rate, which was repeated at the start of the National People's Congress last week does not necessarily mean a wider band for the dollar-yuan (from the current 2%) as some observers suggest.  Given the modest capital outflows from China, it may signal official tolerance of a soft yuan against the US dollar. After all, US and China's monetary policies are also diverging.