Saturday 24 August 2019

Daily Market Update: Fed‐ECB policy divergence very much in focus


Simon Barry

Markets continue to digest the implications of Friday’s strong US jobs figures.

Interest rate markets are now assigning a 68% probability to a 25bps hike in rates next month, up from 50‐55% last week prior to the payrolls release. While that is a meaningful shift higher in the market’s assessment of likelihood, we are somewhat surprised that the market hasn’t gone further. In our view (subjective of course), the probability of a December move is now perhaps somewhere in the region of 80%, with Friday’s figures having provided a crucial piece of the pre lift‐off jigsaw. Indeed, it was interesting to note the commentary from a couple of the more dovish‐leaning Fed officials yesterday. Boston Fed President Rosengren indicated that December lift‐off would be appropriate unless the economy slows, while his counterpart in Chicago Charles Evans – one of the most dovish policy makers at the Fed – indicated that he would not be predisposed to vote against lift‐off in December.

As we noted yesterday, the bottom line for us is that the Fed will now go in December barring any significant downside news in the meantime. Some unforeseen downside surprise is always possible of course, which is why one would not expect the market to see the outcome as nailed on 5 weeks ahead of time. But current market pricing for December does look light to us. One other theme which we think is likely to gain traction is an increased focus on the pace and extent of policy tightening, now that the timing of the commencement of the process is looking clearer. Fed commentary has emphasised the intention for tightening to proceed at a gradual pace, and the Fed’s own latest (September) explicit guidance envisaged just 1% of hikes in 2016 (i.e. one 0.25% hike per quarter on average), which would leave official rates at about 1.4% at the end of next year. Here again, however, market pricing looks light, with Fed Fund’s futures for December 2016 currently at 0.84% i.e. 55bps lower than the Fed’s communicated intention. Thus, if the economy stays on track (an important if of course), then US market interest rates are likely to continue to push higher in our view in the period ahead, in turn providing support for the dollar.

Meanwhile, on this side of the Atlantic, the debate on further policy easing in the euro zone is heating up. A Reuters story yesterday indicated that a consensus was forming in the Governing Council to take the deposit rate deeper into negative territory in December, and potentially by more than the 0.1% reduction currently expected in markets. The story also indicated that an expansion of the QE programme is also under consideration but that this option is seen as more contentious, implying that a depo rate cut could be the preferred policy tool. It was interesting to us to see that the focus of the story was about how to provide more stimulus rather than whethe more stimulus was needed. We have been wondering (and continue to wonder) whether some hawkish Council members would be inclined to push back against providing more accommodation given the modest improvement in trends in some recent indicators lately (including unemployment, economic sentiment, credit conditions and inflation). While it is difficult to know how representative the story is of the views of the wider Council it doesn’t suggest the hawks have much traction at present, making it more likely that Draghi will succeed in pushing through the extra stimulus he signalled in October.

As we have been emphasising for some time, this prospective further divergence in policy between the Fed and ECB is an important fundamental reason to expect further downward pressure on Eur/USD. As recently as mid‐October the pair traded as high as $1.15, while the pair opens at $1.0730 this morning with further downside favoured in the weeks and months ahead, depending importantly on next month’s key policy updates from the ECB and Fed.

Turning to the day ahead, the import price index is released in the US. Import price deflation is expected to ease somewhat to ‐9.4% y/y in October after ‐10.7% in September (mainly due to base effects as earlier falls in oil prices begin to fall out). This may attract some interest as analysts track the effect of weak commodity and oil prices on domestic cost pressures. The NFIB small business optimism is also reported and is expected to increase from 96.1 to 96.4 for October. The survey contains an employment component and markets will be curious as to whether hiring trends in the small business sector corroborate with the strong payrolls report last Friday, with particular focus on both plans to hire and earnings increases.

Finally, ECB Executive Council Member Coeure gives a speech at the French German Business Forum and analysts will be sure to watch for any comments regarding the probability of a policy move in December and the relative merits of cutting interest rates further versus expanding its quantitative easing programme.

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