Dollar Bounces Back; ECB On Tap

The US dollar has recouped much of the ground lost yesterday in response to the US retail sales report, which while softer than expected was the best in a year. Year-over-year excluding the volatile auto and gas components, retail sales are up a respectable 4.1%, and as we continue to note, it is being funded without an increase in revolving credit.

The main development so far today, ahead of the ECB and Bank of Canada meetings, has been the generally weaker Chinese data. Outside of Q1 GDP of 7.0% (7.3% Q4 14), every other report was softer than expected. Industrial production slowed to 6.4% in Q1 from a year ago. Retail sales slowed to 10.6%. The consensus had expected both reported to have an increase. Fixed investment, which was expected to have steadied at 13.9% slipped to 13.5%.

The market has already largely taken on board the fact that reported growth in China is slowing. Many have been skeptical about the accuracy of the official measure of growth in any event. The disappointing data did spur profit-taking in the high-flying Chinese stock market, with the Shanghai Composite slipping 1.25% and the Shenzhen Composite falling 3.70%.

The weak data may have encouraged selling into the short squeeze that had lifted the Australian and New Zealand dollars. Investors are also cautious ahead of the Australian jobs report and the milk auction. Indicative pricing in the OIS market is consistent with about a 70% chance of a cut by the RBA in a few weeks.

In contrast, the OIS market has discounted about a 15% chance that the Bank of Canada cuts rates today. The central bank may have anticipated the poor data here in Q1 with the insurance policy of a 25 bp rate cut in January that surprised the market. The case for a cut today is that although oil prices have stabilized, the economic shock continues to resonate through the economy.

Last month, Canada shed 28k full-time jobs (which would be something on the magnitude of a loss of 280k on the US non-farm payroll report, something seen amid a serious economic contraction). On the other hand, house prices appear to be stabilizing with increases reported in eight of the 11 major markets, and sharp year-over-year increases in Vancouver and Toronto.

A surprise rate cut would likely spur US dollar gains toward CAD1.2600-50. The bottom end of the US dollar range that has confined the price action over the past three months or so is seen just below CAD1.24. Initial support is seen near CAD1.2450-70.

The ECB meeting is likely to be rather uneventful. There is not much scope for new initiatives. There may be some tweaking of the supranational institutions whose bonds can be including in the central bank's asset purchase program. This is not purely a technocratic exercise, but overlapping jurisdictions, (such as with the EU) and the location and legal structure of those institutions require some judgment calls.

We expect Draghi to make three points. First, he will recognize the better economic data. However, he will use it to urge governments to get on with the structural reforms. In fact, the US Treasury's report released recently on the international economy and foreign exchange advocates precisely the same thing. Second, Draghi will likely confirm that the asset purchase program is already seeing some successes. He will likely refer to the recent lending data and yesterday's survey confirming that the new liquidity is facilitating the extension of credit, especially to businesses. Third, Draghi will likely affirm that the purchase program is being smoothly implemented and play down concerns, like those expressed by Moody's yesterday that the -20 bp limit on bond 2-30 year bond purchases may need to be re-examined .

Ironically, the key here, at least now, might not be the deposit rate (-20 bp), but the repo rate, which is a rate at which liquidity can be secured. If banks can raise funds cheaper than -20 bp, then they may still exert downward pressure on yields. This appears to be what is happening. In January, 5% of Germany’s 2-30 yr bonds had yields less than -20 bp. Now a little more than a full quarter does. Today Germany 2-, 3-, and 4-year notes have yields below -20 bp. The 10-year yield has slipped below 13 bp, a new record low.

The US reports the April Empire manufacturing survey. If Q1 weakness is to be transitory, the April data should begin showing improvement. We think the mixed data seen in March is also somewhat typical of a turn. The Beige Book, out late today, should provide some anecdotal support for this view. March industrial output will be reported and is expected to have fallen by 0.3%. It will be the fourth decline in six months. On the other hand, the consensus expects the three month decline in manufacturing output to be halted by a small increase in March.