The Week Ahead: Eye On The Eurozone

The week ahead is sandwiched between last week, which featured an FOMC meeting, the launching a new four-year funding scheme by the ECB and the Scottish referendum, and the week after this which sees an ECB meeting and details about the ABS/covered bond purchase program, and the US monthly jobs report.

The most important data in the week ahead comes from the eurozone. The flash PMI reading is interesting in its own right. In August, it stood at 52.5, the low for the year. However, to keep it in perspective, the multi-year high was set in April at 54.0. This is consistent with the weak and fragile expansion that prompted the OECD to cut its forecast for this year's growth to 0.8% from 1.2%. Next year's growth estimate was slashed to 1.1% from 1.7%, and that still might be a stretch.

In light of the disappointing participation in the initial TLTRO offering, there is more talk that a sovereign bond purchase program is needed. We warn against the false dichotomy. There are other assets that the ECB could buy that may be less controversial on political and legal grounds than sovereign bonds. These could include bank bonds, corporate bonds and multilateral bonds (e.g., EU, ESM, EFSF). The ECB could also take a page from the Federal Reserve during the Great Depression. US banks were unwilling or unable to disintermediate between savers and investors, and the Federal Reserve stepped into the breach and loaned directly to small businesses, for example.

More immediately, the ECB is unlikely to rush to any conclusion. The December TLTRO is likely to go a bit better. The ABS/covered bond program will be launched. Many observers have made a fetish of Draghi's goal of about a one trillion increase in the ECB's balance sheet. Are the capital markets really such a fine tuned instrument that if the balance sheet expands by only 700-800 bln euros that it is the difference between success and failure?

The second phase of the TLTROs begins in March 2015. The borrowings then are predicated on the expansion of the banks' loan books against a pre-defined benchmark. Current lending will shape that benchmark. The money supply and credit data the ECB will report on September 25 will be closely studied. The ECB's data suggests that credit conditions are easing, and demand is improving for some types of loans. Money supply growth bottomed in April and has quickened consistently since. The pace is expected to have ticked up to 1.9% year-over-year in August, which would be the fastest pace since last September.

On the political front, France's Prime Minister Valls, fresh off a (narrow) confidence vote victory, will visit Germany to start the week. Whatever smiling photo opportunities are recorded, there is little doubt that there will be a heated exchange. The controversy stems from two developments last week. First, French President Hollande declared (unilaterally) next year's budget will not contain any fresh spending cuts, and next year's budget deficit will overshoot the target that had been negotiated with the EU. It is not exactly clear what Germany can do to express its displeasure more forcefully, and many large institutional investors continue to view French bonds as slightly higher yielding German bunds.

Second, what Draghi had made implicit, fellow ECB Director Coeure from France, former German ECB Director Asmussen (SPD) made explicit. Coeure and Asmussen called on Germany to exercise the fiscal space it has to boost investment and reduce the tax wedge (the gap between wages and take-home pay). Merkel and Schaeuble will object what the Financial Times has called "intervention" by the ECB. They reject the substance of the argument as well and will not waver from the aim of a balanced budget next year.

Even if Germany were to use the fiscal space that Coeure and Asmussen identify using German Finance Ministry data, (18 bln euro in 2015 and 10 bln euros in 2016), it is not clear how much that would help matters. It could add to Germany's surplus capacity that relies on foreign demand to consume 40% of what it produces. Germany's low propensity to import suggests the added aggregate demand would be domestic.

Merkel and Schaeuble might take what Draghi says about monetary policy—namely that it is not a substitute for structural reforms in France, Italy and elsewhere—and apply it to fiscal policy. Building a high-speed railroad in Germany or a new school is not the solution to what ails Europe. France and Italy simply need to proceed with the reforms "everyone" knows are needed that Coeure and Asmussen identify: reducing barriers to entry in protected services, promote SMEs, facilitate job creation.

In the US, there are two main issues. The first relates to wrestling with the seeming contradiction between the dovish FOMC statement and the hawkish forecasts. The second is the latest reading on the US economy.

On the surface, the numerous (at least seven) speeches by Fed officials in the week ahead will only add to the cacophony. However, our advice has been to concentrate on the policy signal, and that emanates most consistently from Yellen, Fischer and Dudley. We argue that the FOMC statement captures their views, while the dot-plot and FOMC minutes allow fuller expression the broader Federal Reserve (all the regional presidents, which outnumber the Board of Governors).

Investors will likely learn this week that the US economy grew faster than previously estimated in Q2 of 4.2%. The consensus is now for 4.6% and there appear to be some upside risks. The durable goods data is unlikely to be very helpful in helping assess how the economy is faring in Q3. The headline will be distorted by the July surge in commercial aircraft orders. The shipments of capital goods, (non-defense, excluding aircraft), are used for GDP calculations, and may have ease after July's 1.5% surge. It was the strongest in four months.

Existing house sales in the US have continued to recover, even though mortgage rates have risen. The same cannot be said for new homes. Both will be reported in the week ahead. Existing home sales are expected to have risen in August to extend the advancing streak to the fifth month. The anticipated 5.20 mln unit annual pace would be the fastest since last September. New single family home sales are languishing in 400k-450k range for the better part of the past two years (with a brief exception last summer).

We were surprised by last week's unexpectedly sharp decline in weekly jobless claims. We had cited the recent increase as an early warning sign that the labor market may be losing some momentum. The high-frequency data is noisy, and the smoothed four-week moving average is well above the low made in early August. Looking ahead to the August jobs data, the second sub-200k private sector net job creation seems likely, as economists await inputs, including the PMI/ISM reports.

Japan’s inflation report at the end of the week may inflame expectations for more QQE from the BOJ. However, it is too early to reasonably expect the sharp depreciation of the yen to have translated into higher prices, but it will. We expect that a renewed rise in Japanese inflation that we expect in Q4 to take pressure off additional monetary stimulus and allow the focus to shift to a supplemental budget.

While a weakening yen has helped fuel gains in the Japanese stock market, foreign demand for Japanese bonds has been unusually strong recently. Foreign purchases have eased a bit since late-August, when the weekly MOF data showed the strongest buying in three years. Large asset managers are reportedly buying JGBs and swapping (basis swap) into dollars to earn a yield superior to US Treasuries (as much as 80 bp).

Along the same line, last week Japan 1-Year bill rates fell into negative territory for the first time ever. This is one sign of distortions caused by QQE. The BOJ has already bought 3 and 6-Month bills with a negative yield and may soon purchase one-year bills at negative rates too.

The US Dollar Index has finished higher for ten consecutive weeks. This is the longest streak during the modern era of floating exchange rates. It finished last week at four-year highs. The first serious effort by speculators in the futures market to pick a tradable dollar top was evident in the Commitment of Traders report that covered the week through September 16.

The movement of volatility would suggest that they were early, but maybe not wrong. The euro's decline in the spot market last week saw a reversal of the recent pattern, and three-month implied volatility fell. Despite sterling's gyrations, volatility also fell. The dollar reached new multi-year highs against the yen and 3-month implied volatility is below the September 10 high. The medium term dollar trend is higher, but current conditions warrant caution.