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Negative rates, asset purchase programs, financial support for systemic banks in distress (read, the Italian Banca MPS) and a few words here and there about helicopter money: by the end of July the ECB had committed almost everything it had to supporting the European Monetary Union (EMU). Although, we are still missing debt cancellation, which is what probably should happen for Greece at some stage.
Monetary policy intervention and the commitment of various leaders is what it takes to keep the patchwork of 340 million people across 19 countries united in the EMU. However, as everybody who has witnessed the last 18 months of economic developments knows, monetary policy has substantial limitations when it comes to the long-term goal of sustainable growth. It is associated with fiscal policy, or in other words , the development of a stable, innovative and productive economic environment, attractive to foreign investment and capable of exporting goods and services and establishing a strong ‘soft power’ in foreign policy.
Unsurprisingly, EU institutions, mostly by design but also because of increased distance from real problems and the rising distrust that people afford them, are unable to do most of it. The current status quo does not suffice.
Proof that some sense of reality is kicking in came last week, when the European Commission dropped fines claims against Portugal and Spain for being late in returning their fiscal deficit within the 3% target. While one cannot award plaudits to a country for breaching the rules, at the same time there has to be some understanding of the difficulty in justifying a deflating fiscal manoeuvre whilst dealing with 20% unemployment (Spain), or 0.9% growth (Portugal) after such a long crisis. This could be particularly difficult in Spain, where the People’s Party (PP) and Ciudadanos have not managed to agree a format for government after more than a month. To top it all off is the total hypocrisy that nobody is even hinting that France should be fined despite never having come in under the same 3% target.
The Olympics are on, so let us award a few medals:
Spain takes gold for being the country most benefiting from the aftermath of the UK’s June referendum. The yield on its 10 year Bonos del estado dropped more than 50 basis points to below 1.0% for the first time. Whether this is good news is a moot point, but July’s year-on-year GDP growth was 3.2%, with expected 2016 GDP growth about 2.5%, and unemployment is expected to drop below 20% by December, which is all unequivocally good news. Meanwhile, yield curves flattened across Europe, and there is clearly something wrong with the fact that every financial asset that can go up is trading at all-time highs, with the clear exception of EU bank stocks.
Silver goes to Germany, whose 10 year bunds started trading with negative interest rates. This record-breaking, eye-popping price move saw them trading higher to a yield as low as -0.11% p.a., and in doing so they managed to surpass their Japanese equivalent for the second time since 1988.
Still on the podium, bronze medal goes to (the resilience of) the European banking system, whose improvement since 2014 has been substantial. Sure, problems are still out there, but they are mostly (albeit tentatively) being addressed. While everybody speaks of Banca MPS, we would like to focus your attention on RBS, a UK government-owned bank, trying to shed worn financial assets in a country that could soon enter recession.
There is very limited scope for large market surprises during the coming weeks: most market participants have already slowed down activity from last week. The Reserve Bank of New Zealand is the only central bank due to meet (1 August) for the rest of the month, and very little of significance is expected to happen before 1 September. The next substantial event for interest rates may be Yellen’s speech on 26 August at the usual August conference in Jackson Hole, Wyoming. Last year Yellen did not attend the event, but this year we can be assured that a lot of attention will be given to any word hinting at the timing of the next interest rate hike. The futures market is currently pricing a 47% chance of a 25bp hike by December, which could in reality occur either 14 December or 31 January – 1 February 2017.
Finally, a few words on currency markets. Everybody has seen gold and silver prices skyrocketing to $1,350/oz and $20.3/oz; similarly, the USD trade-weighted index (DXY) appreciated by about 3%. It is worth mentioning that at least one of the reasons USD and precious metals have appreciated so much during the year is still unresolved: the impending US presidential election on 8 November.
Until then it is reasonable to expect that the Fed will stay on hold but it could be pressured to act soon afterwards as the US economy continues to create jobs, and annualized Core inflation measures flirt with the 2.0% mark. ; As August turns into September the election race will heat up, and due to the high stakes, divergent policies between candidates, and Trump’s antics, USD crosses will become more volatile. In a similar pattern to what we have witnessed in GBP crosses in the last few months, options on the USD may become extremely expensive, and markets illiquid.
All views expressed here are the author’s own and are based on information available at the time of writing.
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