(Foggy) postcard from Sintra

Key points: 

  • Euro area cycle: we still have a pulse (just)
  • Sintra: Foggy bottom
  • Fed: see how quickly neutral rates move
  • Brexit: Is Boris Johnson mellowing?
  • What the Street is saying: climbing the EU summit

Euro area cycle: we still have a pulse (just)

The composite PMI for the Euro area – a key gauge of the cycle – improved in June, albeit still at a low level. It rose to 52.1 from 51.8 in May to reach its highest level in seven months. It still is a quite low absolute level though. According to Markit it is only consistent with annualised GDP growth of 0.8%, slightly below the Euro area trend (c.1%). In addition, the forward-looking components of the index are deteriorating. All in all, not enough there to qualify as the “improvement” Mario Draghi would want to see (see the next section) but at least there might be a measure of stabilisation at play, with some countries showing signs of rebound.

That is mostly the case for France where both manufacturing and services did better in June. France’s outperformance of Germany in manufacturing is striking (see Exhibits 1 and 2). Lower dependence on China, less dependence on cars and investment goods continue to help France. 

Exhibit 1

Exhibit 2

However, although we don’t have the data for all the countries yet, comparing the German and French PMIs with the Euro area one suggests the peripheral countries did poorly. We suspect this mainly comes from Italy, which only barely exited from recession in the first quarter (Q1). This is the country which would certainly benefit the most from an extra dollop of monetary stimulus, but it is also the country whose politics make it difficult for the European Central Bank (ECB) to decide on such stimulus.

Sintra: Foggy bottom

Sintra confirmed the ECB’s dovish bias, but without much clarity on the choice of instruments. Politically, cutting the deposit rate would probably be more palatable for the central bank than Quantitative Easing, but after Donald Trump’s unexpected irruption in the European monetary policy debate, it is now probably less tempting. True, Jens Weidmann’s new acceptance of the legitimacy of quantitative easing (QE) is a positive move, but it came with so many qualifiers that we don’t think it means he would be ready to support this option now, nor is a majority of the council.

While Draghi continues to make the best of a terribly constrained situation, for now we still see the ECB on hold. The market is now fully pricing a 10 basis-point (bp) cut in the deposit rate in September. It is a very close call, but we are not so convinced. True, Draghi has now reversed the burden of proof (they would act “in the absence of improvement” instead of “if risks materialise”) but we think a lot of market-based indicators, such as break-even inflation, are currently incorporating a lot of worse case scenarios (e.g. a proper escalation in the trade tariffs). If as we expect we stay this summer with “trade guerrilla” rather than “trade war”, the case for action in September will be lower than today.

The ECB’s annual event in Sintra is about two things: discussing medium to long term issues relevant for monetary policy and fine-tuning the ECB’s communication on its next moves. Those two aspects are not always necessarily coordinated, but for Mario Draghi’s last conference in his present capacity they were. Olivier Blanchard’s address the first evening set the tone: a fiscal stimulus is probably what is needed in the Euro area, and Draghi the following morning opened the door further to resuming QE, which is what would make a fiscal push financially sustainable.

Of course, this smacks of “fiscal dominance”, i.e. a monetary policy which becomes subservient to public finances considerations – which goes against the spirit of the European treaty. But we note there is no conflict of objective here. Fiscal dominance would be obvious if monetary policy remained too accommodative, in order to keep public debt cheap, against a background of mounting inflationary pressure. The opposite is currently happening.

Another interpretation is not so much that the ECB wants to make fiscal policy possible, but rather that it is sending a message to governments in core countries: they can’t have both fiscal rectitude and positive yields. In clear, the less fiscal policy will help keeping the Euro area cycle above the flotation line, the more the ECB will have to engage in unconventional policy which will take yields in negative territory (very unpopular with savers).

All this is obviously a second-best approach. A proper “federal” fiscal capacity big enough to offer some cyclical stabilisation when the Euro area is faced with an external shock would be ideal. Many panellists in Sintra called for this (including, albeit succinctly, Jean-Claude Juncker in his speech on the last day of the conference, when he mentioned a “stabilisation function” in the Euro area) but in the absence of any meaningful progress on this for now, the ECB remains a central ingredient in any fiscal response. Indeed, the “dedicated budget line” for the euro area proposed by France and Germany is restricted to fostering competitiveness and convergence.

Yet, the waters are muddied by other policy options for the ECB, in particular taking the deposit rate further in negative territory. In Sintra Draghi strengthened the already well-anchored market view that the deposit rate is the best tool to deal with currency appreciation. This is at least how we read Draghi’s comment on “the impact of negative rates on inflation and financing conditions via the exchange rate is more powerful [than in the US]”.

This pointed to an implicit sequencing here in our view: taking the deposit rate down would be the tool of first intention if the Fed’s own looming cuts were to send the euro exchange rate too high. QE – which is politically more difficult – would come at a later stage only, if the global economy continued to soften. After all, the consensus view on what would be the technical bottom for the deposit rate is probably around -1% (the rate at which banks would start to physically hoard cash instead of filling their account at the central bank). There is still some – limited – space there.

But Donald Trump has thrown a spanner in the works. Participants in Sintra (including yours truly) were in general delighted to see that a conference which started in a fairly low-key fashion six years ago could attract the attention of the President of the United States. However, his tweet accusing the ECB of “unfairly manipulating the euro” as Mario Draghi was speaking has to be taken seriously against a background of “trade war.

True, the euro exchange rate is not particularly weak at the moment. In trade-weighted terms it is actually almost one standard deviation above its long-term average (see Exhibit 3), while the euro is slightly weak against the dollar. This illustrates a simple fact: if the dollar is “too strong”, it is not because of the euro. It is because on average the other currencies have depreciated vis-à-vis the dollar. And in any case, it is very difficult to see the gyrations in the euro exchange rate having had any major role in either the Euro area’s overall trade balance or its bilateral trade balance with the us (see Exhibit 4).

Exhibit 3

 

Exhibit 4

But whether or not the US issue with “FX dumping” by the ECB is fair is beyond the point. It should tilt the scales away from a deposit rate cut”. Indeed, whatever additional stimulus is brought about by cutting the deposit rate by 10 or 20 bps could be easily offset by an escalation of the trade conflict between the US and the EU area (such a 25% tariff on cars). And in any case the deposit rate is far from a perfect instrument, even with “mitigation” measures such as exempting part of the banks’ excess reserves.

QE would be preferable, but remains politically sensitive. We close the loop by returning to QE as the “least bad” option in the current circumstances. Mario Draghi insisted again that the European Court of Justice gave the ECB wide discretion on such a programme, which is a way to tell us that the self-imposed limit of 33% of investible debt for the central bank’s holding of public debt, or using the capital key to apportion the bond purchases across national central banks, could be revised.

But Italy is the elephant in the room. Re-opening QE would be basically accepting what the Italian government was requesting, at a time when the conflict between the European Commission and Rome is rife. It would be a bold move for the ECB. True, Jens Weidmann in an interview accepted the legitimacy of QE, but also stated on 26 May that “this is not a situation where prices are falling and we have to react now”. We suspect he is far from alone in the council at the moment on this view. It would take more deterioration to shift opinion. An escalation in the trade war, with in particular a 25% tariff on cars, could to the trick.

All in all, barring such adverse scenario, the sum of constraints may move the Council towards compromise solutions such as backing “soft decisions” in the next meetings, such as altering forward guidance to include the option of a rate cut.

Fed: see how quickly the neutral rate moved

Our call on the Fed (two rate cuts, likely in September and December) is now consistent with the new “dots” released this week. But beyond the incoming policy decisions, we want here to focus quickly on the long run median “dot”, to re-emphasise a point we made in the first issue of Macrocast: the Federal Open Market Committee (FOMC) is not just telling us that it is taking into account the new risks (trade war in particular) in its assessment of the US economy in the next few quarters, but also that the neutral rate continues to fall.

The median forecast for the longer run Fed Funds rate is now standing at 2.5% (see Exhibit 5), the lowest level ever (the previous trough was at 2.8% in the second half of 2017). Larry Summers’ secular stagnation view has won the intellectual battle, at least at the Fed. This should be taken seriously by the US bond market.

Exhibit 5

Brexit: is Boris Johnson mellowing?

And then they were two: after the eliminatory rounds within the conservative parliamentary group, only Boris Johnson – clearly ahead – and Jeremy Hunt will now vie for the votes of the party members. This should make Boris Johnson more moderate in his campaign. Indeed, the competition is now between an ex-remainer (Hunt) and the ex-leader of the Leave campaign. Boris no longer needs to bolster his “hard Brexit” credentials. Actually, it is interesting to note that Johnson has in the last TV debate refrained from “guaranteeing” that the UK would leave the EU without a deal on 31 October if the re-negotiation with the EU were to fail. In other words, another extension – our base case – is no longer explicitly excluded by ex-mayor of London.

This does not solve anything – both candidates pledge to “re-negotiate”, which has been time and time again rejected by the EU – but at least it may reduce the probability of “hard Brexit” on Halloween, in line with our “laws of gravity” points in last week’s Macrocast. When it comes to the Brexit saga, we have learned to be grateful for small things.

What the Street is saying: climbing the EU summit

The EU leaders failed to agree on five top EU jobs - including ECB President - at last night’s dinner. Goldman Sachs’ Roxane Van Cleef on her European daily “four questions on the EU summit” published a detailed review of the various options - and kudos to her, she was not expecting a breakthrough last night.

The leaders will meet again on 30 June. Roxane notes that they need to agree by 2 July (election of the President of the EU parliament). Technically they don’t have to agree on all five at the same time, but they would lose degrees of freedom by operating step by step.

From the market’s point of view, focus is on the replacement of Mario Draghi, who leaves on 1 November. Given his voting record against some of the ECB’s key decisions (QE in particular), the arrival of Jens Weidmann at the helm of the central bank could herald a significant policy shift. So far, ECB watchers saw his chances as very low (the more “centrist” French and Finnish candidates are constantly seen as favourites). With Manfred Weber, a German national, normally due to become President of the European Commission as leader of the biggest parliamentary group – according to the “Spitzenkandat” principle – Weidmann’s chances are indeed low. However, the “Spitzenkandidat” principle is overtly rejected by several key stakeholders, in particular the French President. If Manfred Weber is not nominated to the Commission, it may be difficult for Berlin to accept “passing its turn” again on the ECB.

Still, it is not obvious to us that it is automatically in the interest of the German government to get Jens Weidmann appointed at the ECB. Indeed, if under his presidency the ECB were to refuse to “do whatever it takes” in a crisis and use monetary policy tools to keep the monetary union together, the next line of defence would be some form of fiscal union implying massive budgetary transfers from Germany to the periphery.

All data sourced by AXA IM as at 21 June 2019

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