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Ahead of Mario Draghi’s speech at the Jackson Hole symposium on 25 August, many market participants confidently expected the ECB president to talk down the euro. The fact that he did not meant that EUR/USD put on over two cents, peaking at 1.2069 – a rate not seen since January 2015 – in the couple of days following his speech. The single currency has given back a little of those gains, but still trades at 1.1940, compared with its closing rate of 1.0490 at the end of last year, when traders had piled into what became a very over-crowded short EUR/long USD trade. This dollar bullishness was based on the then expectation that ‘Trumponomics’, involving a huge infrastructure stimulus, would cause the Fed to tighten significantly and strengthen the dollar in the process.
Nine months later, by virtually every standard economic measure bar unemployment, the US is underperforming the eurozone. Perhaps we should coin the new phrase ‘Draghonomics’ to mean ‘an economic doctrine based on extended, eye-wateringly loose monetary policy and imperviousness to criticism’. At long last, however, the ECB’s policies do seem to be working. Yesterday’s eurozone PMI data, with a composite reading of 55.7, were still strong (despite being slightly below expectations) and Q2 GDP growth was a healthy 0.6% quarter on quarter or 2.2% year on year. Nonetheless, it is clear that despite the growth, the eurozone in aggregate has not yet fully escaped the spectre of deflationary forces. The rate CPI growth in the year to August was 1.5%, showing good progress towards the target of ‘close to but below 2%’. Lower energy costs meant that core CPI came in at a disappointing 1.2%, which shows there is still work to be done. Perhaps the market is correct in not expecting a rise in interest rates until 2019.
The process of normalising eurozone interest rates has not been made any easier by the euro’s powerful performance so far this year. At 1.1900 at the time of writing, the single currency has strengthened by over 13% against the USD since year-end. While we are still some way off the 1.4000 level, above which Volkswagen once declared that they could not sell cars in the US, the single currency’s strength is already a cause for concern at the ECB. It will certainly have a bearing on the timetable for tapering QE and – beyond that – for the normalisation of interest rates.
While a further protracted period of ultra-loose monetary policy will be well received in the weaker member states, it will not help the German housing market, which, while not yet in bubble territory, has already become a point of concern on which the Bundesbank warned earlier this summer. Indeed, having until recently enjoyed an undervalued currency and monetary policy that continues to provide unnecessary stimulus, it is only the famous caution of the German consumer that has kept a lid on the economy and prevented a red-hot boom.
While Germany and other northern states continue to receive superfluous stimulus (the Dutch economy expanded 1.5% quarter on quarter – 3.3% year on year – in the second quarter), the two-speed nature of European growth remains very apparent. Greece managed a growth rate of just 0.8% year on year, with Italy at 1.5% year on year. German Finance Minister, Wolfgang Schaueble, commented in the middle of August that ”interest rates are rather too low for the strength of the German economy”. This is undeniably true, and indeed they have been for some time; however, while German inflation hit a five-year peak of 2.2% in February it is now down to 1.8%. Mario Draghi is likely to consider that luck is on his side and that he still has the headroom to pursue ultra-loose policy for some time to come. As noted above, the market judges this to mean until 2019 at the earliest and unless there is a pick-up in growth in the southern member states (in Italy in particular), with a more general uptick in inflation – in core inflation in particular – this view is unlikely to change.
In France, labour market reform is to the fore. Emmanuel Macron’s proposed reforms are not overtly radical, and there even seems to be an acceptance of inevitable change amongst trade unions – with the notable but, hopefully, irrelevant exceptions of some of the more extreme unions, led by the communist CGT. This being France, protests have, of course been promised. These will begin on 12 September, hosted by the CGT and friends, with Presidential candidate Jean-Luc Mélenchon calling for a people’s protest on 23 September.
Resistance to Macron’s reforms will be the President’s first big test of his office and, although the markets are calm, there is much to play for, not least since Macron’s popularity ratings are in freefall. On Monday this week, a YouGov poll put the President’s approval rating at just 30% - representing an unprecedented decline for any French president. Macron will have no problem passing his reforms onto the statute book – after all, he is the leader of a brand new party, with the vast majority of deputies owing their position to him alone. Instead, potential resistance will come from the unions and street protests. On this front, despite the benign mutterings of most unions, things are far from certain. With the President’s approval ratings so low, and a minority in favour of the very reforms which stand to define his presidency, Macron’s first big test is rather more important than the markets suppose. The fact that the 10-year OAT/Bund spread is only 31 basis points suggests that markets have priced in little risk of Macron running into serious trouble – or that, even if his presidency does run into problems over his labour reforms, this would have few major implications for France. Both these assumptions are quite likely to be vindicated. However, a spread of 31 basis points represents only a small cushion should the unlikely actually happen.
Given the French unemployment rate of 9.5%, flexibility in the labour market is to be welcomed – and is indeed very much so by business leaders. However, for the 90.5% in work, reform will mean they are more likely to lose their jobs – hence the majority that opposes reform. The implications make even Mario Draghi’s monetary balancing act look relatively simple. For now, though, the markets will concentrate on tomorrow’s ECB meeting and the subsequent press conference.
All views expressed here are the author’s own and are based on information available at the time of writing.
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