US
Data released since the September meeting should have supported the Fed in its position to leave interest rates unchanged for now, as the employment report for September disappointed with payroll gains of 142k. Although a loss of momentum was to be expected since full employment has all but been achieved, the slowdown from a monthly average of 213k recorded in the first half of the year is likely to have been too rapid from the Fed’s point of view. It will hence wait for more data to see how the labour market develops; all the more so because two more employment reports are due ahead of the final meeting of the year in mid-December.
In the third quarter, US growth looks set to have slowed to around 1.4%, although this is primarily due to the volatile effects of inventories and the trade deficit. The domestic economy continues to be robust, and private consumption ought to have risen strongly again by around 3%.
In contrast to the target of maximum employment, inflation is still far from the Fed’s objective. Whilst recent inflation data are suggesting that underlying price pressure has increased somewhat, this is probably not yet enough to convince the Fed that the 2% target can be achieved in the medium term.
Against this backdrop, the Fed will likely decide to remain on hold again at its meeting on 27/28 October. As no press conference will be held after the meeting, the statement will be the only source of potential changes in the Fed’s communications. However, major adjustments are unlikely. At the most, the Fed might point to slightly lower growth, but should keep all options open for the upcoming meetings. It is unlikely the Fed will give a broad hint in order to prepare markets for a looming rate hike in December. Jeffrey Lacker, the President of the Richmond Fed, could again dissent at the meeting and vote in favour of a 25 basis-point increase.
By keeping all options open, the policymakers avoid making a clear decision. Should the Fed still consider a rate hike for December, and recent statements from Dudley (New York Fed) or Williams (San Francisco Fed) leave this option open, it therefore faces a challenge in its communications. According to the Fed Funds futures, financial markets believe the likelihood of a rate hike in December has fallen to 33%. As the Fed does not want the first increase to come as a shock to the markets, it would have to soon prepare the ground.
The communications of the US Federal Reserve has become increasingly uncoordinated and contradictory in recent weeks. Evidently, there is a major tug-of-war under way between the hawks and the doves, which is occasionally also waged in public. Janet Yellen and Vice Chair Stanley Fischer will have to take the reins soon to put the Fed’s communications straight again. Two solid employment reports at the beginning of November and December could be of help in this respect and would open the door to the first rate hike since 2006. A major source of uncertainty for global markets.
Existing home sales jumped almost 5% in September to near eight year highs. With less than five months’ supply of resale listings to choose from, more buyers are eyeing new homes, keeping builders hopping. Housing starts leaped over 6% last month, also back to pre-recession peaks. They look to pole-vault further, as the NAHB builders’ survey showed sales expectations hitting decade-highs. The problem isn’t a lack of buyers; it’s a shortage of workers, at least according to one major developer. Look for another near double-digit advance in residential construction to add a quarter percentage point to Q3 GDP growth. It won’t fully offset the bite from trade, but it helps.
To be sure, millennials remain skittish due to student debt and scarring from old housing-bust wounds. First-time home buyers accounted for just 29% of sales last month, well below long-run norms above 40%. However, young people have plenty of reason to take the plunge. According to Trulia, they are better off buying than renting in 98 of 100 major markets, saving an average of 23% on monthly costs, and more than 40% in some cities such as Houston, Miami and Tampa.
Based on starts and affordability, the housing recovery is still in the middle innings. Although median home prices are testing record highs, affordability remains better than normal, courtesy of low mortgage rates. With the Fed hoarding $1.8 trillion of mortgage bonds (13% of outstanding residential mortgages), rates are going nowhere fast. Additionally, despite rising 18% in the past year, housing starts remain below long-run norms and levels warranted by household formation and replacement rates (about 1.4 million units annually). This suggests plenty of leg room.
As per other indicators, US GDP data are likely to show a significant slowing in growth in Q3. The estimate is that the drag from net exports and slower inventory accumulation will push GDP growth to 1.5% q/q AR despite still solid growth in private consumption of 3.2% q/q AR. Q3 will mark the low point of GDP growth this year and look for a return to above 2% growth next year.
Consumer confidence has come off the winter/ spring highs but remains at elevated levels, supporting our view that the current dip in growth will be temporary. October data for both the Conference Board’s measure of consumer confidence and the measure from the University of Michigan will be available next week. In particular the Conference Board’s measure will give some valuable input about the strength of the labour market with the gauge on “jobs plentiful” and “jobs hard to get”.
Real US capital goods orders ex aircraft and defense showed a significant increase in Q3 after a very weak run over the prior three quarters. August data showed a moderation in growth and September durable goods order data will show if this was a one-off or if order growth is coming down further in response to global weakness.
EU
At the press conference, European Central Bank President Draghi gave clear signals the markets had hoped for: at its next meeting in December, when the new growth and inflation projections will be available, the ECB will assess whether monetary policy needs to become more expansionary.
It was a shared belief that the ECB’s current projections for growth and core inflation in 2016 are each about half a percentage point too high. As a consequence, there are good reasons to adhere to the forecast that the ECB will use a downward revision to its projections as an opportunity to announce new steps.
But what measures will the ECB take? President Draghi did not rule out any monetary policy tools at his press conference and explicitly mentioned the option of lowering the deposit rate further, although in the first half of the year he had repeatedly emphasised that interest rates had reached the floor.
Nevertheless, adjustments to the purchase programme are regarded as more likely than other measures: QE2 will come! Indeed, if the ECB now switched to using other tools, it would signal that it is no longer convinced that bond purchases are effective. This may have been one reason why the ECB emphasised in the important “introductory statement” to the press conference that the bond purchase programme “in particular” could be adjusted. In contrast, Draghi only mentioned a rate cut in the later course of the press conference.
The ECB explained in more detail that it could change the size, composition and duration of the purchases. But it would be surprising if the ECB only adjusted the composition of the purchases, as this would not change the degree of monetary policy expansion. But according to Draghi, this is precisely what the ECB council intends to decide on at the next meeting in early December. While a change in the composition of purchases is quite likely, it would probably be a supporting measure to prevent shortage problems in buying bonds.
Two options thus remain for the ECB: it can increase the monthly purchasing volume from current levels of €60bn or it can officially extend its buying programme beyond September 2016. The second alternative is more likely; a longer duration of purchases. While an increase in the monthly purchasing volume would definitely have a stronger signal effect in the short term, this signal could quickly become negative if markets were to speculate that the supply of bonds would become tight for the ECB all the sooner, and the ECB could therefore run into difficulties with effective implementation of its programme.
That said, if the ECB does act this year, an announcement of an extension to the programme would not change anything for the foreseeable future, i.e. for the coming months, and the important signal effect of any such decision would consequently be small, especially because most analysts and market participants expect an extension of the programme in any case. The ECB is therefore likely to accept the risks associated with a higher purchasing volume in December. At the same time, it will probably at least nurture speculation of asset purchases beyond September 2016. For example, it could delete the reference of a possible end to purchases in September 2016 and hence signal an open end to buying (“for as long as needed”).
Although adjustments to the purchase programme are still possible, a further reduction of the deposit rate has become more likely in light of Draghi’s remarks. But just like changes to the composition of the programme, such a reduction would in our view more likely to be a supporting measure.
As noted, if the ECB increases the monthly purchasing volume and/ or extends the programme beyond September 2016, this will increase the difficulties for the ECB to find enough asset sellers. Thus the negative signal effect of possible market speculation could endanger the success of the programme.
What can the ECB do to prevent a shortage of assets? A reduction in the deposit rate would be an appropriate tool. When the yields of many Bunds fell under the deposit rate of -0.2% in the spring, this provoked discussion on the markets about a further cut in this rate. The reason for such speculation was that the ECB had said that it would only buy bonds whose yields were above the deposit rate.
If the yields of many bonds dropped below this mark, as they did in the spring, it would become increasingly difficult for the ECB to find enough bonds to buy. If it emerges that such a development is on the cards, it will become more likely that the ECB will lower the deposit rate again. However, the ECB will probably wait initially, to be able to react later if necessary, rather than shooting all its bolts straight away.
Already before the government bond buying programme was announced, several governing council members had spoken out in favour of purchasing corporate bonds. Against this backdrop the ECB council may indicate that it is open to changes in the composition of QE. Such changes to the composition of the programme are quite likely, but more as a supporting measure to prevent asset shortages.
This is because from a monetary policy perspective, such a measure of itself appears ineffective: The signal effect would be quite low here too. After all, ECB representatives had always defended the need for government bond purchases with the argument that potential buying volumes in all other market segments would be too low to have sufficient effect. Moreover, purchases of corporate bonds are problematic due to their uneven distribution, and the ECB would thereby expose itself to the suspicion of financing individual companies.
In addition, the ECB could lift the percentage upper limit for purchasing individual bond issues. Originally, the ECB had fixed the limit at 25% in order to prevent the possibility of it having a blocking minority in the case of potential debt restructuring if a country is experiencing payment problems. In this case it would face a choice between blocking the restructuring or agreeing to monetary financing, which is forbidden by EU Treaty.
The ECB has recently lifted the upper limit to 33% for bonds where there is no such blocking minority. Another increase in this segment is conceivable at a later point in time.
The ECB could also tackle the shortage problem by no longer using the capital key to determine the distribution of government bond purchases across euro member states. Instead it could increasingly buy the bonds of countries that are highly indebted and where the supply of bonds is therefore high.
ECB governing council member Liikanen, who normally does not stray from the official ECB line in his statements, recently rejected this option. Such a decision is unlikely; the reason for using the capital key is that while the ECB was always ready to take far-reaching measures, it was also cautious to observe any legal restrictions. By applying the capital key, the ECB is signalling a balanced distribution of purchases in which no country is shown preferential treatment. If it were to buy many bonds precisely from countries with high public debt, it would be exposing itself to the suspicion of monetary financing.
The problem of asset shortage could be smaller than feared, even if the buying volume is increased, because the ECB could get support from outside.
Indeed, the Fed’s turnaround on interest rates could help. In particular, international investors should be all the more willing to sell euro bonds as more attractive investment options are to be found abroad. And US Treasury yields should rise at an even sharper rate, i.e. become more attractive, the more the Fed increases interest rates in relation to the current market expectation. Investors would then be more willing to part with euro bonds.
Moreover, the shortage problem would also be mitigated if Eurozone countries increase their debt and thus the supply of bonds. The ECB would be entering difficult terrain here though. In its official statements, the ECB has always stressed that countries should not use the QE programme to increase their own debt by issuing additional bonds because the ECB would therefore expose itself to suspicion of monetary financing, which is prohibited. However, the ECB would probably de facto tolerate a “limited” increase in the debt level.
And finally, continued selling of FX reserves by China would also alleviate the problem of asset shortages. Since the renminbi should remain under selling pressure, it is likely that China will sell not only American, but presumably also European government bonds on a large scale and use the proceeds to buy renminbi, thereby supporting the Chinese currency.
UK
The main release is the first estimate of GDP growth in Q3. Based on the key economic figures for Q3 released so far (only have 44% of all information is available), the estimate for GDP growth is a slowdown to 0.5% quarter on quarter (q/q) in Q3 from 0.7% q/q in Q2. This is still a trend. PMI services declined fairly sharply during Q3 indicating slower growth in services (78.4% of GDP). Still, growth in services increased to 0.7% q/q in Q3 from 0.6% q/q in Q2 due to overhang from a large increase in June. This corresponds to GDP growth contribution of 0.6pp in Q3, up from 0.5pp in Q2. Manufacturing production was weak in Q3 but this was offset by higher mining and quarrying, implying that total production (14.6% of GDP) most likely neither contributed positively nor negatively to GDP growth in Q3 (+0.1pp in Q2). Construction data (6.4% of GDP) have also been weak and a negative GDP growth contribution of 0.1pp (+0.1pp in Q2) is to be expected.
GfK consumer confidence is also due next week. Consumer confidence usually falls in October and thus a small drop to 2 in October from 3 in September is to be expected. Notice that consumer confidence would still be at a very high level.
As per the pound, there have been huge swings in sterling exchange rates over the past 20 years. The first act of this saga saw sterling rocket in value by almost 40% in trade-weighted terms between 1995 and 2000. This surge was followed by a period of relative stability in nominal effective exchange rates, although sterling did depreciate slightly in real terms as UK inflation outpaced that of its trade partners. The next major adjustment came in the wake of the financial crisis. Both real and nominal measures of the effective exchange rates plummeted by 28% between 2007 and 2008. Again, this rapid and pronounced move was followed by a period of relative stability, with the pound bumping around its new low for a number of years. However, a rebound began in earnest in 2013, helped by a blossoming economic recovery. Nominal effective exchange rates appreciated by 14% over the subsequent two years and are currently standing just 9% below their pre-crisis peak.
Large and pronounced swings in exchange rates present headaches for policymakers. Changes in relative prices for imports and exports affect growth and inflation, but quantifying these impacts can be difficult. It had been hoped that the large depreciation in sterling seen during the financial crisis would help to rebalance the UK economy towards exports. This did not materialise, probably on account of weak growth in the UK’s largest trading partners, suggesting that the goods and services that the UK exports are less price sensitive. It is fair to say that currency fluctuations have had more of an effect on inflation.
A weaker pound was one of the reasons why UK inflation was so high in the aftermath of the crisis, peaking at 5.2% year on year (y/y) and persistently overshooting target. Policymakers now have the opposite problem. Sterling appreciation generates another drag on price growth, alongside lower commodity prices and subdued domestic cost pressures. This was illustrated in the latest CPI report. Headline inflation fell 0.1% y/y in September, largely on account of lower fuel prices. Core inflation, which strips out these more volatile components, was unchanged at 1.0% y/y.
However, scratching beneath the surface shows a disappointment in clothing prices at -0.6% y/y (which have a high import content), while services price growth actually accelerated to 2.5% y/y.
Indeed, if the CPI basket is broken down to show the import intensity of different goods, much of the decline in recent inflation has been driven by those components of the index which have a high share of imports.
How should policymakers react to currency-driven fluctuations in inflation? The Bank of England looked through imported inflationary pressures in the aftermath of the financial crisis, citing its flexible inflation target. While it should, theoretically, take the same approach to the current bout of disinflation, it may tread a little more cautiously in the current environment.
First, sterling appreciation has come alongside weak global activity and commodity prices, raising fears over the trajectory of the global economy. Second, domestic cost pressures still remain muted at present, despite the recent upturn in unit labour costs. Finally, monetary tightening against the backdrop of a stuttering global economy could trigger further appreciation, which would prolong the drag from imported inflation.
China
While the 6.9% year on year growth rate in Chinese real GDP in Q3 was slightly higher than the expectations of most analysts, it still represents the slowest year-ago pace of growth in more than six years. A breakdown of real GDP into its demand side components is not yet available, but preliminary data showed that output growth in the “secondary sector,” which includes manufacturing, mining and construction, slowed further in Q3.
However, growth in services output picked up in the third quarter, marking the fourth-straight quarter of acceleration in Chinese services activity. The shift of growth drivers from the industrial sector to the services sector has been widely publicized as a policy objective of Chinese authorities, and these figures will thus likely be viewed as a positive development in that regard.
Still, growth is clearly slowing in China, and our forecast looks for continued deceleration. However, the adjustment will likely be managed carefully so as to avoid a “hard landing.” Earlier this morning, the People’s Bank of China (PBoC) cut its benchmark lending rate by 25 bps to 4.35% and trimmed its reserve requirement ratio (RRR) by 50 bps to 17.50%. The PBoC has now cut its lending rate by 165 bps over the past year and has trimmed its RRR for banks by 250 bps year to date.
Sources: Commerzbank, BMO Capital Markets, Danske Bank, Wells Fargo