- Short rates globally have rallied. From here, further gains will be much more difficult, in our view. This is in particular the case in the euro area where the ECB is likely to deliver a hawkish message on Thursday. Euro short rates, and the euro, are likely to both push higher in the near term (see Focus below).
- We have revised down our US GDP forecast. We now look for Q2 11 growth of 2.0% (down from 3.5%) and Q3 11 growth of 3.0% (down from 3.5%). Full Story. However, we believe risks to the inflation outlook have become more skewed to the upside, but we doubt that the Fed will respond. Full Story.
- We have pushed back our forecast of the first BoE rate hike from August to November. Full Story. In light of the change, we have lowered our GBP forecast modestly. Full Story
FOCUS
ECB stance likely to push short-end euro rates and the EUR higher
The short end of the curves everywhere has rallied a lot over the past two months, almost on a daily basis, as the economic data have disappointed, in particular in the US. While data surprises are unlikely to be as negative as what we have seen for much longer, short rates are still above the lows reached in September/October last year in most markets (before QE2 was announced). So one could, at first blush, see more room for a rally in short rates from here. Still, we think the room for a further front-end rally is very limited, for a number of reasons.
First, we would point out that rates have already rallied close to their previous lows (10bp in the US, 20bp in the UK, 70bp in EUR, but with very front-end rates more than 50bp higher), despite the (core and headline) inflation picture having changed a lot. In particular, core inflation has increased by 0.5% in the euro area and US and a full 1% in the UK since last year’s lows. The higher inflation, other things equal, raises the bar for any additional round of easing/QE. Also, if one looks at the total amount of tightening priced in by the forwards on a one- or two-year horizon adjusted for the core inflation, levels are already below what was priced in September/October last year. The one exception in the majors is in the euro area, where the amount of tightening is a bit higher, but is easily explained by the central bank stance and the fact that the tightening cycle has already started (as noted above, very front-end rates are 50bp higher).
Second, and linked to the change in the growth/inflation picture, it is worth noting that the market pricing is quite at odds with what the consensus of economists is expecting. Obviously, it is difficult to capture economist expectations in real time, especially when data are volatile or turning. But based on the latest surveys (which are very recent for the UK and euro: early June), the market seems now to be reflecting large negative term premium at the one- and two-year horizons (-25bp and -30bp and -30 and -60bp, respectively, for euro and UK). Negative term premium is not unusual, and it was even more negative in the US in Q3 10, for example. But in the case of the euro and UK markets, the implied negative term premium is now back to its lowest level. It is worth noting that for the euro area, the forecasts have not changed at all recently, while the market forwards have obviously rallied a lot.
Third, we suspect that a lot of outright short positions, or flattening positions, have been unwound already. While these positions were generally widespread in all markets, they were not generally very large, and given the limited loss tolerances of a lot of participants these days, they probably have been covered.
We have just revised our growth forecasts in the US down (to 2% in Q2 and 3% in Q3), and pushed out our first BoE rate hike from August to November: the triggers for a substantial sell-off at the short end in these markets are unlikely to be present in the very near term. More likely, these short-end rates will stabilize around current levels, or rebound slightly as data stabilize. This is reflected in our new forecasts for UK and US yields, which show broadly stable short-end rates in the coming quarter, before a back up in Q4 11.
The picture might be a bit different in the euro area, though. One of the key events in the coming week will be the ECB meeting, in our view. There will be no actual rate hike, but the ECB will likely flag a July 25bp rate hike, while keeping full allotment on all its operations. Net, the ECB is likely to send a relatively hawkish message – after all, growth in the euro area has been amongst the most resilient (and data surprises the least negative), and the ECB’s attitude to inflation is quite different than that of the Fed or MPC. This should weigh on short-end euro rates, which, as noted, are now outright rich and price in very limited additional tightening. We expect short-end euro rates to rebound further from here, and be the most volatile near term.
In the coming days, we should, thus, see a further re-widening in the interest rate differential between euro and US rates, which should be a positive for the euro/$ exchange rate. This is especially the case since the FX positions now seem to be much closer to neutral than in early May, when there were widespread longs of EUR and shorts of USD, according to our own FX flows indicator. It is therefore quite possible that the euro retests higher levels, especially against the backdrop of an improvement of the picture for peripheral bond markets (see Time for tactical longs in core EGB periphery, June 3, 2011). Indeed, our 1m and 3m FX forecasts are 1.48 and 1.50, respectively, for EUR/$.
MARKET INSIGHTS AND EVENTS
Global
Metals demand and autos: Changing gears
After a strong start to the year the global automotive market has begun to weaken. As an important consumer of the base and precious metals, accounting for 42% of lead consumption and a massive 57% of palladium demand, is this something the metals markets should be worried about?
Asia Pacific
This week’s data highlights in Japan
Kyohei Morita, Yuichiro Nagai
This week features Q1 second preliminary GDP data, May money stock and April balance of payments. We expect Q1 real GDP to be raised to -1.3% q/q saar in the second preliminary data from -3.7% in the initial release. This assumes upward revisions to -0.8% from 0.9% for real private-sector capital investment and to -0.1 pp from -0.5 pp for the GDP contribution of real private inventory investment.
North America
Weak economic data amid positive news from Europe makes for a rollercoaster day
Anshul Pradhan
Economic data were weaker than expected, and 2y, 10y and 30y yields finished lower by 2.8bp, 3bp and 2bp respectively, though intraday yields were much lower. In the morning, non-farm payroll disappointed consensus. Employers added only 54K jobs in May (versus an average of 220K in the prior three months), and the unemployment rate inched up to 9.1% from a low of 8.8% in March, even as the participation rate stayed unchanged. Partially offsetting the bad employment release was the ISM non-manufacturing print, which at 54.6 was greater than the consensus forecast of 54. However, much of the rally post-payroll number was unwound due to a European Commission, ECB and IMF report on Greece that cited significant progress in the area of fiscal consolidation, likely facilitating the continuation of the Greek bailout monies. Separately, in the 7-10y purchase operation, the Fed purchased 60% of all offered securities, the highest since the start of QE2, indicating the likely investor sentiment after the payroll report.
Our economists have revised their Q2 11 real GDP growth forecast to 2.0%. Although the Treasury market has rallied significantly, we believe it has not fully priced in the weakness in data, for two reasons. First, some investors are worried about the possibility of a debt ceiling impasse resulting in a technical default (a delay in interest payment), as indicated by the doubling of the 1y US sovereign CDS spread in the last month. Second, they are likely deterred by the end of QE2 on June 30 from initiating long positions/covering their short positions. However, these concerns should fade, in our opinion. Even if the Treasury decides not to pursue asset sales beyond August 2, the US government would not have to default on its debt, but would have to cut deficit elsewhere in the fiscal budget. The resultant negative effect on growth and risky assets should outweigh any credit concerns. Further, we believe the end of QE2 will most likely be a non-event, as it has been well telegraphed and the stock of securities held by the Fed should remain constant. Even if the flow effect were to dominate, we believe there would be sufficient demand from both foreign and domestic investors to absorb extra supply facing private investors.
Consequently, we recommend being tactically long yields at current levels, despite the recent rally. But as uncertainty about the economic outlook fades by the end of the third quarter, rates should rise towards the end of Q3 and into Q4. We now expect 10y yields to finish Q3 11 at 2.90% and Q4 11 at 3.25%.
US real GDP growth forecast revised lower
Dean Maki
We have revised down our US GDP forecast. We now look for Q2 11 growth of 2.0% (down from 3.5%) and Q3 11 growth of 3.0% (down from 3.5%). We discuss these changes in more detail in the 3 June Global Economics Weekly.
Inflation dynamics are shifting
Peter Newland
We believe that inflation dynamics have shifted: Goods and services prices are now contributing positively to inflation and should continue to do so. The output gap is narrowing, wage growth should soon recover and productivity growth has slowed, adding up to rising unit labor costs. However, the Fed’s focus on core inflation and its view that a large degree of slack remains suggests that policy is unlikely to respond unless inflation expectations rise materially.
US payroll growth slows abruptly in May
Michael Gapen
Nonfarm payrolls rose 54k in May, well below our forecast (190k) and consensus (165k) estimates. Private payrolls rose a much weaker-than-expected 83k, and the unemployment rate rose a tenth, to 9.1%. The one bright spot was labor income, with gains in hours worked and average hourly earnings.
US: ISM non-manufacturing index improved in May
Nicholas Tenev
After dropping 4.5 points, to 52.8, in April, the ISM non-manufacturing index rose to 54.6 in May, above our (53.5) and consensus (54.0) forecasts. The business activity index ticked lower to 53.6 from 53.7, but the new orders index bounced to 56.8 from 52.7.
Europe
Greece: EU to provide more funds contingent on Greek parliament approval of MTFS
Antonio Garcia Pascual, Frank Engels, Julian Callow
As we had expected, the IMF issued a statement on Friday evening reporting that the troika of the EU, ECB and IMF had reached a staff-level agreement with the Greek authorities on additional policies to keep the programme on track. As we also noted on Friday, the key to the release of additional EU/IMF loans was parliamentary approval of the medium term fiscal strategy (MTFS), including the enhanced privatisation program (EUR50bn by 2015) and the setup of an independent agency to carry out the privatisation plans.
Portugal: Daunting task ahead for the conservative government
Antonio Garcia Pascual
According to preliminary results, the social democrats (PSD) have won the 5 June elections but will need to seek a coalition to form a majority government (most likely with the conservative CDS-PP). The new government will have to deliver macroeconomic policies consistent with the 3-year EU-IMF programme. In our view the programme may work but it will have to deliver the fiscal plan and, more importantly, it must succeed in raising long-term growth, without which Portugal will not grow out its debt.
GBP forecast change in light of new BoE rate profile
Paul Robinson
Our UK economics team changed its Bank of England rate call following the weaker-than-expected services PMI this morning. We show the old and new profiles: the new profile is 25bp lower than previously from August 2011 until November 2012. The new forecast profile remains above the market’s current expectation. In light of the change we are altering our GBP forecasts modestly.
MPC now expected to wait until November to raise rates
Chris Crowe, Simon Hayes
A majority of the MPC seems unlikely to back a rate rise in the next few months. We have therefore pushed back our forecast of the first rate hike from August to November. This call follows renewed signs of economic softness in the UK and globally. The latter is of particular concern, given the UK’s current dependence on external demand.
Euro area final May PMIs: Significant revision in German services suggests upside risks to our euro area Q2 GDP forecast
Francois Cabau
The euro area services PMI has been revised up from 55.4 to 56.0 reflecting a strong upward revision in the German services PMI from 54.9 to 56.1. This is consistent with an upward revision to the euro area composite PMI from 55.4 to 55.8, pointing to upside risks to our Q2 GDP forecast of 0.4% q/q.
UK services activity weaker than expected pointing to slower sector growth
Blerina Uruci
The UK services PMI came in weaker than expected for the second month running in May falling to 53.8 from 54.3 previously (BarCap: 55.0, consensus: 54.2). Earlier this week, the manufacturing PMI also came in weaker than expected for the second consecutive month. Taken together the data raise concerns about the fragility of the recovery and will provide more ammunition for those MPC members that favour unchanged Bank Rate rates during the MPC meeting next week.
Euro Themes: Implications of Greece restructuring for banks and CDS
Sherif Hamid, Frank Engels, Antonio Garcia Pascual, Julian Callow, Laurent Fransolet, Huw Worthington, Cagdas Aksu, Brian Monteleone, Jeroen Julius, Miguel Hernandez
Amid all of the recent media reports regarding a potential near-term extension of the current EU/IMF bailout, we believe it makes sense to expand upon our recent note Greece: The (long) countdown to restructuring, 11 May 2011. In particular, we walk through some of the key approaches and the implications for financial institution balance sheets and the CDS market.
EEMEA
Turkey: Upside inflation surprise in May
Christian Keller
Turkish inflation for May came in at 7.2% y/y (2.4% m/m), significantly above market expectations.
Russia: OFZ – Global 2018 rouble bond spread set to narrow but unlikely to disappear
Piotr Chwiejczak, Koon Chow
At the end of the year, Euroclear wants to connect Russian local bonds to its global bond settling system. Once Russian OFZ government bonds become euro-clearable, a major obstacle for foreign investors to become more involved in the Russian local bond market will be removed. However, we do not expect the premium (richness) of Russian 2018 rouble-linked global bonds to the local equivalent (OFZ government bonds) to disappear entirely.
Latin America
Brazil GDP: Strong, but with consumers taking a breather
Guilherme Loureiro, Marcelo Salomon
Q1 11 real GDP growth in Brazil was in line with expectations, reaching 1.3% q/q SA. But the relevant piece of information was hidden in the demand breakdown of GDP. If we set aside inventory changes, domestic demand slowed to 0.8% q/q SA from 1.4% and 1.6% in Q4 and Q3 10, respectively. And this was largely driven by a softer-than-expected private consumption performance, which we believe is only temporary.
THE NEXT 24 HOURS
Asia Pacific
Australia: RBA policy meeting: The RBA has stated its intention to tighten monetary policy in the near future. Given the central bank’s elevated forecast of underlying inflation 9-12m forward, we continue to believe a rate hike is imminent.
Taiwan: Higher vegetable prices and stronger pass-through from energy into services costs.
North America
US speaker: Philadelphia Fed President Plosser (FOMC voter) will discuss “Central Bank Policy after the Crises” at 15:30 Monday.
Europe
Euro area – PPI: We are below the consensus in expecting euro area PPI to be 0.8% m/m (consensus: 0.9% m/m) on account of a moderation in energy prices.
EEMEA
Russia: May CPI will likely continue to plateau at around 9.5% y/y.
Latin America
Chile IMACEC (Economic activity index): Despite weaker mining production, industrial production showed a strong reading, and unemployment figures speak for ongoing tightness in the labor market. The forecast is consistent with a 1.7% m/m sa gain, though this may be exaggerated by some noise associated with the positive base stemming from the 2010 earthquake.
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