IIFT Daily Note with Peter Brown

David’s daily Note

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Daily Note – Bundesbank RIP 1945-2014


Eurozone: Draghi goes all in!

United Kingdom: Bank of England on hold but interesting times ahead

United States: Better initial claims ahead of key US employment report

Good morning,

This day seventy years ago the Allies – including an estimated 60,000 Irish troops in British uniforms (two of my own relations) – landed in Normandy. Today in a rather terse commemoration, Putin and Obama will stand together, shake hands and remember one of the few events which still bind the old superpowers together.

However, one of the interesting aspects of the defeat of the Nazi was the unbelievable success of the country that emerged from the ashes, namely West Germany. At the core of the Federal Republic was a constitution which protected the citizen’s liberty against the State and a powerful constitutional court in Karlsruhe to police the State on behalf of the citizen. The other institution was one that protected the citizen’s money against the State: the central bank – the Bundesbank in Frankfurt.

From day one, the aim of the Bundesbank was to protect the citizen’s savings from inflation. When the problem is inflation, the solution is deflation.

However, what the Bundesbank never contemplated was what happens if there is deflation. By logical extension, if the problem is deflation, the solution is inflation. But it is heresy for central bankers to embrace inflation. But that’s what they have to do in Europe.

Writing as a former central banker, schooled in the traditional way to be always on the look out for inflation, I know how difficult it is for these guys in Frankfurt to realise that they have to turn policy on its head and generate inflation now.

Their intellectual difficulty in making this leap is evident in the tardiness of the ECB’s reaction to Europe’s deflationary spiral. They are beginning to respond, but far too slowly. Yesterday, we saw movement from the ECB in the right way in cutting rates, but it will have to do a lot more. And ultimately, a lot more means QE.

Yesterday, the ECB nibbled at the deflationary problem. To get the economy going properly it will have to take super-sized-portion mouthfuls. This will happen in time.

And when it does, it will mark the death of the Bundesbank,1945-2014 RIP.

US equities followed the lead from Europe, closing in the green. Sector breakdown for the SPX all closed positive, with industrials and financials leading, +1.05% and +0.90% respectively.

Yesterday was a tough day for EUR traders – both bulls and bears. In many respects it was a tale of two trading sessions. Initially, the EUR  sold off in response to the various dovish headlines (rate cuts across the board, 2 LTRO’s, a decrease to the ECB’s 2016 inflation projection and preparatory work on potential ABS purchases). Then the currency moved  higher after Draghi’s suggestion that rates had reached their lower levels.

The lack of clarity surrounding what a European asset purchase programme would actually look like, also contributed to the EUR squeeze. We took profit on a portion of our Euro short after the ECB press conference. We are returning to overweight this morning adding back at $1.3655

Looking ahead, we  have US payrolls out later today. Our sense is that given all the focus on the EUR and the ECB in the past few weeks, a surprising number later could potentially cause some excitement and corresponding volatility in the market.

Following the ECB announcement, gold spiked before settling into a tight range for the remainder of the session. It closed up +0.7%.

Let’s go now and analyse what the ECB did yesterday and what it means.

Eurozone: Draghi goes all in!

Here’s a nice little table which shows you exactly what the ECB did and didn’t do.

Table 1: ECB Policy Decisions

Table 1 6 June

The death of the Bundesbank was completed yesterday as Draghi delivered policy easing across a variety of measures. We now have  a negative deposit rate, a targeted LTRO plan, no sterilisation of SMP purchases, an announcement that the ECB will explore purchases of Asset Backed Securities, forward guidance, anchoring of interest rates and, perhaps most importantly, a promise (dependent on macro developments and, critically, inflation) that the ECB is not yet finished!

The ECB has pushed rates down to zero and provided clear guidance that rates are now on hold for four years. The targeted LTRO is actually more ambitious than we anticipated and the impact from the macro perspective could be most significant here on the periphery.

A giant cash for trash scheme has been unveiled, which will allow bust banks to lend to bust governments, all financed by a money printing central bank. Now this is how it’s done!

Just so you know, that’s what the LTRO allows. It allows banks to exchange dodgy assets on their balance sheets for real cash and the bank can then lend this real cash to governments, who spend the money in the economy.

Two new LTROs are being fired up for September and November this year. These will have maturities out to September 2018. After that they will be available quarterly from March 2015 to June 2016 with repayments not due for 24 months after each issue. New LTROs can be made every 6 months. Interest will be paid in arrears after the borrowed money has been repaid. The interest rate paid by the bank to the ECB for this crisp new money will be decided at the time of each issue and will be 0.01% over the main refinance rate at the time.

This plan gives banks time to plan how they want to offer the money to the economy. It puts the ball firmly in their court. Let’s hope they do something this time. This is an intriguing development.

Finally, by opening the door to ABS purchases (something that may actually be hard to get off the ground in practice), we think that Draghi moved a step closer to QE which will allow the ECB to buy sovereign debt.

The ECB most likely will do nothing until December. If however, the various measures unveiled today don’t move the Euro, boost activity and push-up inflation, then, as Draghi clearly stated, the ECB is prepared to move further into the world of unconventional policy.

From a markets perspective the ECB managed to surprise relative to high expectations by delivering a full package of easing measures including a negative deposit rate, liquidity- and credit-easing measures (LTROs).

See below the drop in Eurozone interest rate expectations. The rate curve is now very flat, suggesting little prospect of any rate move higher in the Eurozone before 2016.

Figure 1: Eurozone Interest Rate Expectations

Chart 1 6 June

We expect limited further impact at the very short end of the curve, as the rate cuts were expected and seem unlikely to be repeated.

The ECB’s dovish measures and rhetoric are good for EUR rates markets overall and especially for the belly of the curve (5s). We are looking at a long 5 Year German investment to go with our short US 5 Year investment.

Euro equities are a tougher call given the rally (and lack of supporting earnings) in recent months. Ultimately, I think Euro stocks will trade in line with their US counterparts with a marginally higher beta.

Turning attention to the Euro.

I think we are at the beginning of a game-changing move. In rugby, you can see attacking teams going through phases of play which stretch the opposition and ultimately with the opposition stretched all over the park, holes in the defence open up. It is a grueling process for the players but it is effective. Watch Ireland do it against Argentina in Buenos Aires this weekend.

The ECB is now moving into the phases too. It will take time but it will knock the Euro down relentlessly, but gradually.

However, looking at how the Euro moved yesterday, one would never have guessed. The ugly reversal yesterday caught many off-guard. But in this trendless/low volume environment, pockets are not deep and intraday moves should not be over analysed.

Try to see the big picture. Draghi has managed to push the spread between the US and EZ 3mth bank rate down (see chart below). We now see the US side of the equation taking over because better US data will drive up the US side of the equation in coming months.

Figure 2: United States vs Eurozone 3mth Bank Rate and Euro FX

Chart 2 6 June

We took some profits in our core Euro short towards the $1.35 level yesterday afternoon.

But one word of caution. This is not the end in Europe. The EU economy is experiencing a liquidity trap and it will take a long time for interest rates alone to fire up the economy. This is why we are at the beginning of a process, not the end.

United Kingdom: Bank of England on hold but interesting times ahead

Table 2 6 June

The MPC announced no change to the existing asset purchase programme (which now totals £375bn) and no change to the bank rate (maintained at 0.5%). In the UK the problem is incipient inflation, so the solution is deflation engineered by higher interest rates.

There has been some speculation recently that a minority vote for a rate hike may emerge on the MPC soon. Some committee members noted that the “policy decision was becoming more balanced” in the minutes of the May meeting – that’s banker-speak for a rate hike.

While we are wary of attempting to forecast the individual voting behaviour of all nine members of the committee, we nevertheless do not expect a minority vote for higher rates until the August Inflation Report (at least).

In any case, looking at past MPC voting behaviour, we have found that minority votes are not a particularly good predictor of future policy decisions.

United States: Better initial claims ahead of key US employment report

Table 3 6 June

Initial jobless claims moved up a bit to 312,000 in the week ended May 31 (vs. consensus 310,000), from 304,000 in the previous week.

Figure 3: United States Weekly Claims 4WK Moving Average

Chart 3 6 June

On the whole, this report is consistent with continued improvement in the labour market and supports a solid rise in nonfarm payrolls, later today. We expect a number greater than 200k. Lets just put that in context because with so much focus on Europe, its easy to forget what is happening in the US. I know Americans sometimes can’t understand that!

But if the figure later today is 220,000 new jobs in May, as consensus expects, it will make it four straight months above 200,000— a feat the US economy hasn’t pulled off since the go-go years of the late 1990s, when Bill was on the Hill.

Portfolio: Waiting for the US employment report

Table 4 6 June

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