Weekly Economic Commentary • Principal Global Investors
Covering the week ended May 9, 2014 — Published on May 15, 2014
Will the European Central Bank Use Its Bazooka?1
Maybe. At his press conference this week, European Central Bank (ECB) President Mario Draghi sent a clear signal that the bank's governing council expects to ease policy at their June meeting. In announcing that intention, Draghi revealed no specific action to be taken, but noted that the governing council would be "comfortable" with acting with ease at the next meeting after they see new staff projections in early June. Draghi said this was not a commitment, just "a preview of the discussion we will have next month."
Draghi has often noted that the strength of the euro is a "cause for serious concern" in an economic environment faced with the threat of too low inflation or deflation. The annualized price inflation for the Eurozone was 0.7 percent in April, up slightly from 0.5 percent in March, but less than half the ECB's target of "just under 2.0 percent." Investors have been worried about the threat of Japanese-style deflation as the Eurozone just emerged from a two-year recession and growth may barely exceed 1 percent this year and 1.5 percent in 2015. And the average unemployment rate for the Eurozone is still a whopping 11.8 percent. Draghi's comments were enough to send the euro sharply lower as traders placed bets that the ECB might actually deliver on its long standing pledge to use its bazooka, er, other policy levers, if needed.
What policy levers? No one knows, but they most likely would be a negative bank deposit rate along with a further drop in the official interest rate. One option that doesn't seem to be on the table is a program of bond purchases, or quantitative easing (QE), in the style of the Federal Reserve (Fed) or the Bank of England. But, investors would likely consider taking deposit rates negative and the official rate to zero to be sufficiently forceful actions. While there was no pledge, the ECB did issue a very strong statement of intent. Draghi and the council would have to consider potential negative reaction very carefully if for whatever reason they took no action in June.
1 Recall former U.S. Treasury Secretary Hank Paulson's memorable comment that if your bazooka is big enough, you won't have to use it. His wasn't; Draghi's has been, at least so far.
More Rumination on Too-Low Treasury Yields
The consensus forecast is for a moderate pickup in U.S. growth to an above-trend range of 3 percent to 3.5 percent. Yet, yields on ten-year U.S. Treasury bonds have been stuck between 2.6 percent and 2.8 percent since mid-January. Investors need to know why, and it's a good question. Is the bond market sensing that growth won't pick up after all? That is a contrast to the still-resilient stock market; and the bond market has a better forecast record. Last week, On the Other Hand suggested several possible explanations for too-low yields. They included: soft inflation; growth skepticism; low real interest rates; too much credit chasing too few borrowers; excess global productive capacity; and investors buying Treasuries to reverse a bet on rising rates.
Other reasons came to mind. First, the U.S. federal budget deficit continues to fall, as do state and local deficits. From nearly 10 percent of U.S. GDP in 2009, the deficit is estimated to fall below 4 percent of GDP this year and near 3 percent next year. So, fewer bonds are available. Second, China's currency has weakened dramatically since late January from 6.04 RMB/dollar to 6.26 the first of May, the biggest drop since the 57 percent plunge from 1990 to 1993. To engineer that decline, the People's Bank of China likely had to markedly step up its purchases of U.S. Treasuries.
These reasons proffered are all reasonable, interesting, and likely part of the story. But, the real impetus for too-low Treasury yields is probably skepticism about U.S. growth prospects. After all, how many times have investors expected a better pace of expansion only to be disappointed when it doesn't show? Plenty, given the slowest recovery in the post-war era. So, while this analyst believes a moderate acceleration will come yet this year, the bond market may not push rates higher until it's clear that the next GDP report will boast something above a three-handle.
U.S. Data Validates Optimism
Both national purchasing manager surveys at 55 or so are consistent with above-trend U.S. growth. On the job front, the Conference Board's Employment Trends Index edged up 0.2 percent in April to the highest level since February 2008. Small business employment hit a record level of 48.8 million employees in ADP data, 1.3 million above the pre-recession peak. Jobless claims are in good shape.
Retail sales across the currency union rose in March and are up 2.7 percent annualized in the first quarter over the fourth. The employment part of the Purchasing Managers Indexes (PMIs) moved above 50 for the first time signaling more job growth than the 0.3 percent of the fourth quarter. The composite and service PMIs were 54.0 and 53.1, respectively with the latter the best since May 2011. U.K. PMIs suggest growth this quarter could hit 4 percent; the permanent salaries index of the Markit PMI jumped to 64.7, very near the highest on record; and the further drop in staff availability is the lowest since October 2004. U.K. exports are surging, up 5.9 percent in March over February.
Growth in China is settling in the 6 percent to 7.5 percent range. But the weaker economy is getting attention. According to the Xinhua News Agency, President Xi noted the slowdown by cautioning that China needs to adapt to a "new normal," stay "coolminded," and not over-react to slower economic growth. He wanted the country to remember China's strategic opportunities and suggested the government would offer selected measures to mitigate the negative effects of the downturn; officials raised the target for railway investment this year to 800 billion Yuan and gave tax breaks to selected lower-income groups. Purchasing manager surveys have stabilized in a low range: services around 55 and manufacturing some ticks below 50. Consumer-price inflation is falling, now 1.8 percent over the prior year.
All of the above is evidence that the economic expansion continues and the global economy is on a path of gradual rebalancing. Growth seems likely to pick up in the United States and Eurozone, and stabilize in China and emerging markets. So, the pace of progress is diverging, but even in Japan, where the April 1 tax hike has been a real headwind, anecdotal evidence suggests that the tax hit to consumers and business has not been as bad as initially feared.
The concerns about United States and Chinese growth that developed over the winter may be dissipating. If that is the case, equities could be about to exit the lackluster pace of the first quarter with renewed optimism. But, the U.S. stock market rally turned five years old in early March and the expansion will hit the same mark the end of June. So the U.S. investment cycle, while likely to run a while longer, is surely well past the mid-point. And with the Fed likely to start removing its extraordinary policy next year, the era of cheap capital is in its late stages.
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