A sleight of hand, a change of heart, and central bank policymakers are about to change the rulebooks on monetary policy. To date, the forex market has been cocooned by a Group of 10 low rate monetary policies resulting in a low volume, low volatility trading landscape. It would seem that the squeeze is on central banks to change their policies to stay ahead of the curve. The diverging views at the Jackson Hole economic summit appear to favor the current bullish USD trend. Consider that Federal Reserve Chair Janet Yellen’s language is regarded as “neutral,” the European Central Bank (ECB) is seemingly warming to the idea of initiating quantitative easing (QE) after Mario Draghi acknowledged the region’s weakened inflation outlook (German 10-year Bunds are below +0.95%), and Haruhiko Kuroda, the Bank of Japan (BoJ) governor, conceded that the BoJ might have to pursue its aggressive monetary policy easing for longer period.
For the Bank of England (BoE), the question has always been about ‘when’ it will hike; especially now there is dissent among Governor Mark Carney’s rank and file. From the Fed’s perspective, it is clearing its own runway, while at the same time talking through the whole process in detail with dealers and investors alike. The two entities that are the most vulnerable are the ECB and the BoJ. The BoJ will try to talk its way through economic problems and it is considering using more upbeat language to describe the state of the economy. That suggests that it does not see the need for any immediate action to give “faltering growth a shot in the arm.” The ECB, on the other hand, does not have the luxury of time. In his speech last Friday, Draghi insinuated that the ECB is about to change tact.
ECB Looks to Change Course
Draghi has called for a departure from the austerity-focused mindset that has dominated eurozone policymaking. This is sensible since to date the strategy is not really working; the eurozone continues to grapple with stagnating growth and disturbingly low inflation. Focusing on the recent slump in long-term inflation, Draghi insisted that the risks of the ECB “doing too little” outweighed those of “doing too much.” The market has interpreted his comments as meaning that broad-based asset purchases have become more likely and necessary.
Draghi’s comments that eurozone policymakers will “use all the available instruments needed to ensure price stability” is extending the QE market bid this morning despite the U.K. long holiday weekend and the last week of August. Italian 10-year BTP (generic debt paper) futures have rallied a whole point and are leading the cash markets. Regarding spreads, Bund-Italian debt has tightened -4bp to Bunds, which suggests that intraday dealers are bidding the market up as they grab the most liquid of instruments (Italy is one of the largest fixed-income traders in the world and the third-largest economy in Europe). Spanish bonds are doing even better: the 10-year benchmark to Bunds are -5bp tighter, probably reflecting investors’ greater comfort level for Spanish debt, and the fact that Italy does have midweek supply to contend with. Draghi’s comments last week mark a significant turning point to the ECB’s rhetoric. A program of QE along the lines of the BoE or the Fed will continue to support both bond and equity markets while applying pressure to the 18-member single unit (€1.3197).
Germany Faces Headwinds
An indicator for German business confidence fell more sharply than expected earlier this morning. The German Ifo business climate index fell to 106.3 from 108, indicating that Europe’s strongest economy has gotten off to a sluggish start in the second half of the year. The weak headline does not mean that Germany is on the immediate road to recession. The strength of the domestic labor market is helping to keep up private consumption, an important source of growth. Digging deeper, the construction sector remains in good shape, and along with the latest purchasing managers’ indexes and Ifo readings, it could be indicating that the disappointing German second quarter may not necessarily be seeping directly into the third quarter. The market is expecting the German economy to expand this quarter; nevertheless, the compiling of recent data would suggest that the recovery from last quarter could be muted at best.
The Euro Heads South
This morning’s weaker data has managed to push a new high in U.S.-German bond spreads — 10-years at +146bp. The market has not seen these lofty levels in 15 years and there is no reason to suggest that it cannot take on that year’s high spread of +171bp in the near term. The market continues to see decent support on pullbacks (139bp and 141bp for starters).
The EUR has managed to penetrate through the psychological €1.32 handle to a session low of €1.3180 where there was a good demand for the single unit the first time around. Again, and not too much of a market surprise, barrier options are plentiful and well scattered. The first real line of supported defense in the way of option barriers can be located at € 1.3150. On the flipside, there is interest to offload more EURs at €1.3220-30, at least on the first go-around. In general, the EUR continues to be weighed down by a dovish Draghi and a hawkish Yellen.