Two major macro trends were seriously challenged this week, with the US dollar finally managing to stem its losses after weeks of broad declines, and US equities seeing their first major setback since March’s carnage.
One of the early movers against the dollar this week was the euro, which began to pare back some of its scorching 12% rally from March’s lows after Philip Lane said the EURUSD exchange rate was “important” to the European Central Bank. Like a modern-day finance-twitter Helen of Troy, the Chief Economist’s comments launched a thousand takes by traders and analysts about the ECB jawboning the single currency lower. For now, we are sceptical about the ECB’s ability to create durable euro weakness: the days when Mario Draghi could threaten substantial declines in real yields across eurozone sovereign curves are over, while political and legal opposition to ECB purchases remains fierce. Given the flatness and low levels of eurozone sovereign yields, although the ECB has room to expand purchases and possibly cut rates slightly, it’s unclear if this will be sufficient to offset the seismic changes underway in US monetary policy.
With EURUSD now in such a specific focus for both markets and policymakers, Thursday ECB meeting will be the week’s centerpiece, although the Bank of Canada will also be of note on Wednesday. A number of other interesting data points dot next week’s calendar.
Dollar sees first solid weekly gain since June
Monday 7th Is likely to be a slow day for markets, with the US and Canada observing Labour Day. Nonetheless, a few second-tier indicators will be released including German Industrial Production for July, and eurozone Sentix investor confidence.
Tuesday 8th A smattering of Japanese data will be released in the morning, including household spending and the final reading for Q2 growth. Of greater interest than the figures themselves will be any developments in the leadership race for the ruling Liberal Democratic Party, which must replace the departing Shinzo Abe. With USDJPY remaining stuck below 1.07, a further decline in the dollar may tempt Abe’s successor into daring markets to sell JPY and Japanese sovereign debt by pursuing more expansionary fiscal policy. Various eurozone data will be released, beginning with quarterly French payrolls data and trade balanced for Germany and France. Revised eurozone gross domestic product data for the second quarter will be released at 10:00 BST. Later in the morning at 11:00 BST, the widely followed NFIB small business optimism index for the US will be released. One of the most interesting aspects of the previous survey was the sustained increase in the hiring plans sub-index, which rose to a level of 21, consistent with levels seen in Q1 before the covid-19 shock to the global economy.
Wednesday 9th Major regional banks Westpac and ANZ will release sentiment survey indices for Australian Consumers and New Zealand business at 01:30 BST and 02:00 respectively. Of the two releases, ANZ business confidence has the potential to prove more consequential for currency markets, due to its large sample and the substantial amount of new information Kiwi businesses have had to digest in recent weeks with re-imposed lockdown measures across much of the country. After rising to -31.8 in July, the main business confidence index slipped to -41.8 in August and is likely to have fallen further. Later in the morning, monthly Chinese inflation figures will be released at 02:30. In the afternoon at 15:00, the Bank of Canada will announce their latest policy decision – discussed in depth below, and the Job Opening and Labour Turnover Summary will be released in the US. In light of August’s solid non-farms report, the figures will be read as another look at the rate at which employer appetite for re-hiring is developing.
Thursday 10th A string of releases have pointed towards a very strong recovery in the UK housing market, ranging from surveys to house price indices. The release of the Royal Institute of Chartered Surveyors monthly residential market survey is likely to further confirm this trend, with the balance of surveyors reporting price increases rising further into positives. However, it’s unclear how long the recent upswing in the housing market can be sustained. Firstly, with Government furlough schemes ending, incomes are likely to face a substantial shock. Secondly, factors such as pent-up demand and a temporary stamp duty cut may suggest the rally will not be sustained. The last RICS report saw many surveyors express concerns that prices would fall over a longer horizon – the evolution of these views will be the most interesting aspect of Thursday’s report, which will be released around midnight. September’s European Central Bank meeting will dominate the rest of the day, and is discussed in depth below.
Although the releases are likely to be overshadowed by the ECB press conference, producer prices and weekly unemployment claims will be released at 13:30 BST in the United States. At 18:00, Bank of Canada Governor Tiff Macklem will follow Wednesday’s policy decision with a speech.
Friday 11th Will feature several European data releases in the morning, including monthly output data for July from the United Kingdom. Much hype has surrounded the UK economic recovery from March’s lows, partly due to alternative data such as from electronic payments pointing towards a surge in consumer spending. This was admittedly mostly validated by hard data from the second quarter. Bundesbank President Jens Weidmann will participate in a panel discussion at 09:00 BST, potentially adding further color to Thursday’s ECB meeting. Finally, August inflation figures in the US will be released at 13:30 BST.
BOC IN HOLDING PATTERN UNLESS ECONOMIC DISRUPTIONS REAR THEIR HEADS
With its monetary policy toolkit practically emptied in response to the outbreak in Q2 and the data yet to show signs of the recovery stalling, the Bank of Canada is likely to remain in a holding pattern until the current situation changes. Economic vulnerabilities remain below the surface for now, namely the threat of a strong currency and high household debt-to-GDP levels. Should either of these disruptions begin to rear their head, the Bank of Canada is likely to take swift action. For now, with house prices continuing to rise and USDCAD still trading above the 1.30 level, the Governing Council may take the opportunity to strike a cautiously optimistic tone in next week’s policy statement. With no press conference to follow, eyes will be on Governor Macklem’s appearance at the Canadian Chamber of Commerce on Thursday to give any extra clarity on the Governing Council’s macroeconomic outlook.
It has been a story of so far so good for the BoC. Monetary policy has effectively eased financial market stresses, while fiscal policy has come to the rescue and driven the economic recovery.
A budget deficit of around 16% of GDP is expected from the Trudeau administration this year, with a potentially seismic fiscal plan for next year set to be announced once Parliament resumes on September 23rd. Prior to the next fiscal announcement however, the signs of the recovery have been positive. The Q2 GDP print surprised to the upside, with an annualised reading of -38.7% vs expectations of -39.6%, rendering the Q2 QoQ contraction at around 11.5%. The Q2 reading not only beat economists’ expectations, but also those of the central bank, which estimated a 44% annualised contraction in the July MPR. The details of the GDP report pointed to an even more promising rebound than initially expected in Q3 also. Inventory disruption dragged on the GDP reading by 6.7 percentage points, which will likely reverse in Q3. Additionally, the June GDP reading outstripped expectations by 0.7 percentage points, posting a 6.5% MoM rebound, while the preliminary reading for July also looked promising at 3%. Should this trajectory continue, the overall damage of the pandemic on the Canadian economy will likely undershoot the Bank’s expectations of a 7.8% contraction this year. Looking past the lagged data to softer measures of the economy, the RBC weekly debit and credit card spending data has started to show consumption levels are back above 2019 averages, while consumer confidence indicators remain in positive territory as per the Bloomberg Nanos Confidence Index. Strong readings from the Ivey PMI and CFIB Business Barometer also highlight growing optimism over the recovery from the supply side, although this isn’t yet represented in the labour market by a rise in job openings. In conjunction with the CFIB average selling price expectations index showing a non-energy source of inflationary pressure, the above data points will give the Bank a reason to strike a cautiously optimistic tone in its policy statement.
However, much of the recovery to date has been a natural response to the scaling back of lockdown measures, suggesting the pace of the rebound is likely to slow.
In addition to this, the level of fiscal stimulus is also set to taper, with the most obvious catalyst that could derail the current economic recovery coming in the form of the withdrawal of the Canada Economic Response Benefit scheme. Although the scheme has been extended by four weeks until October 19th, its withdrawal will finally make the level of labour market scarring more visible and take a key source of income away from many Canadian households. While it isn’t clear how many households still remain dependent on the CERB scheme, with the most recent data showing 268,000 applications were submitted in the Week of August 17th, the level of support the C$71.25bn scheme provided shouldn’t be understated. Even though the exit strategy has been coupled with other schemes such as the Canada Economic Wage Subsidy scheme, which has currently paid out C$31.73bn in subsidy measures for returning workers, the ending of the CERB scheme will still pose a significant challenge for the economic recovery.
Monetary policy makers will be closely monitoring the economic data once this lifeline is removed and will pay special attention to the effects this will have on the housing market – an area we see as the biggest economic and financial vulnerability to the recovery given Canada’s household debt-to-GDP levels of around 101.89% as of Q1 2020.
For now, the Bank’s purchases of mortgage backed securities are slowing back down to the minimum C$500m a week quota, but the pace of purchases in this space could quickly be ramped up should the housing market begin to falter. Additionally, due to the Bank’s decision to reduce the proportion of bonds and bills it buys from the primary auction back to 20% from 40%, its holding of Treasury bills has begun to decline as previous purchases mature. This has offset the minimum $5bn a week of government securities that it currently purchases under its LSAP programme, leading to a cooling of the pace of balance sheet expansion. This is another area that the Bank could tweak its actions in the scenario that the CERB scheme disrupts the economic recovery or if another shock is imminent.
BoC balance sheet tapers as maturing Treasury bills offset bond purchases while intervention in MBS market also cools back to C$500m weekly pledge as housing market shows robust price growth
For now, while the recovery continues to maintain a steady pace, the BoC is likely to change very little of its previous policy statement. With Deputy Governor Wilkins also showing signs of openness to an inflationary overshoot at the Jackson Hole Symposium, it is likely that the Bank will reiterate its stance of holding rates at the effective lower bound for some time to come. One area of change from July’s meeting, however, could come in reference to the strength of the loonie. While we don’t see it as a cause for concern just yet as USDCAD trades above the 1.30 handle, another wave of broad USD weakness resulting in a sustainable break lower could cause the BoC to verbally intervene in a similar fashion that was witnessed back in October 2019 and January 2020’s meetings. A tilt of the hat by monetary policy makers has been a growing theme in the G10 space of late, starting with the Reserve Bank of New Zealand and has recently extended to European Central Bank policymakers. With no press conference scheduled for Wednesday’s meeting, Governor Macklem’s appearance at the Canadian Chamber of Commerce could provide a platform for the Bank of Canada to verbally weaken the loonie, although with current market pricing this may be a premature action.
Bank of Canada has a track history of verbally weakening the loonie near current levels when the economy shows lackluster growth, will Macklem follow Poloz’s suit?
ECB TO STAY ON HOLD WHILE ADDRESSING RECENT CONCERNS ON EURO STRENGTH
The ECB has regained the market’s attention ahead of the upcoming policy meeting on September 10th, after several staff members have recently expressed concerns about euro strength. The single currency has appreciated nearly 12% since early May against the dollar to two-year highs, while it has risen about 8% to nearly record highs against a trade-weighted basket of currencies. The euro surge has been a combination of positive sentiment in response to Eurozone stimulus measures and broader US dollar weakness. The recent change to the Fed´s strategic inflation and employment goals has also added upwards pressure to the euro. A stronger euro could potentially dampen the effectiveness of ultra-loose monetary policies by a counterproductive pass-through into inflation and tightened financial conditions via the stock market.
The recent euro strength might not be enough to trigger policy action by the ECB yet.
When adjusted for differing inflation rates, the real effective exchange rate remains comparable to levels often seen in the last decade. The REER is just some 3.4% above its 10-year moving average, following a long period of low valuation. This noteworthy given that pass-through effects of real exchange rates to inflation are typically lagged. This means that even the current euro appreciation might not considerably affect the inflation profile over the years to come, especially since ECB studies show that pass-through from the exchange rate to inflation has weakened over time. For the time being, investors from the most large open economy in the world might be more concerned about the sharp drop in external demand as advanced economies fall in record recessions this year. In turn, as the euro surge steams from boosted confidence in eurozone´s recovery prospects and institutional consolidation, this might play as a factor on investor´s tolerance towards a stronger currency.
The real effective trade-weighted exchange rate is barely overvalued with respect to the 10-year moving average
Either way, as a stronger currency might not be welcomed by the ECB in the current juncture, verbal efforts by policymakers hoping for a weaker currency may become trendy. ECB member Philip Lane triggered a slide in the EURUSD rate last week by acknowledging that the currency pair “does matter” to the ECB. In this framework, downplaying the importance of the euro in next ECB presentation could lift off downside pressure from the euro, provoking undesired further strength. This line of reasoning brings back memories of the former ECB President Mario Draghi, who was popularly credited with the ability to talk down the euro. However, it could be argued that there is little jawboning can do to effectively weaken the euro in a sustained manner when real yield differentials across the Eurozone, and outside of it, are so low.
Instead, further easing will be contingent on dramatic changes to the economic outlook. Investors will therefore be watching fresh staff projections in the September meeting, with potential downside risks heavily contingent on the evolution of the pandemic. The euro area´s recovery seems to have run out of steam midway through the third quarter due to increased restrictions to some travel and leisure activities. However, as long as a full lockdown and other excessively stringent measures have been averted, the June baseline projections seem fairly aligned with the upcoming figures. Crucially, market-based inflation expectations hasn´t fallen substantially despite futures pricing of the euro-dollar rate indicating the longest net position ever.
Inflation expectations haven’t subsided amid longest-ever EURUSD long calls
Finally, the Fed’s recent amendment to its inflation and full employment goals is likely to receive high attention in ECB´s press conference after the policy announcement. While Lagarde might stick the script and avoid pre-empting potential shifts on a strategy review that is scheduled to be finished by end 2021, the pressing topic might merit some comments. As hinted at a few months ago, the ECB is likely to move in a similar direction than the Fed, by prescribing a policy guidance linked to a symmetric 2% inflation target as opposed to the current below-but-close to 2%. A mere mention of the subject may be one means by which Lagarde could try her hand at weakening the euro as her predecessor was famed for doing. For now, Christine Lagarde will make sure to stress the full commitment of the ECB to maintaining accommodative financial conditions to boost the recovery efforts, by assuring markets the Bank is ready to use the full €1.35 envelope of PEPP purchases and adding further ammunition if needed.
Ranko Berich, Head of Market Analysis
Simon Harvey, FX Market Analyst
Olivia Alvarez Mendez, FX Market Analyst