ECB: Coping with Conflict, Covid, and Climate

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Marc Chandler
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Overview: Heightened warnings from Japanese officials has helped the dollar steady against the yen, while the euro hugs parity ahead of the outcome of the ECB meeting, where a 75 bp hike is anticipated. Most Asian equity markets rallied in the wake of yesterday’s gains in the US. China and Hong Kong were notable exceptions. Europe’s Stoxx 600 is practically flat as are US futures. The US 10-year yield is softer, a little below 3.25%, while European benchmark yields are slightly firmer. The 10-year JGB drew closer to the 0.25% cap. Emerging market currencies are mixed, but the Chinese yuan rose for the first time this week, albeit a little. Gold is extending yesterday’s recovery from below $1700 and is hovering around $1722 now. Crude oil tumbled 5.7% yesterday and the October WTI contract is a little softer today. It held below $83 a barrel and tested the $81 area. US natgas is off 05% after falling around 11% over the past two sessions. Europe’s natgas benchmark is off 9%. It is now lower on the week. Recall that it was the end of last week that Gazprom announced the indefinite shutdown of the Nord Stream 1 pipeline. Iron ore snapped a two-day fall and rallied 3.6% today. December copper is up 1%. December wheat is up for the fourth consecutive session.  

Asia Pacific

The dollar has surged more than 6% against the yen in the past month. It almost reached JPY145 yesterday. The (38.2%) retracement from the pre-Plaza high (1985, almost JPY263) is found near JPY147. There is nothing to stop the dollar from rising even further. Of course, everyone and their sister seems to be talking about the 1998 high near JPY147.65. Another 3.5% from here will bring the greenback to JPY150. In 1990, it pushed slightly above JPY160. The finance ministry, the BOJ, and the Financial Services Agency officials met earlier today and comments from Vice Finance Minister for International Affairs Kanda who climbed another step on the verbal intervention ladder and threatened action to what he called "excessive " moves, which he claimed cannot "justify recent yen moves."  He said Japan is ready to act and counter the one-side yen moves. He warned that all options are on the table. Still, one option is not on the table. Coordinated intervention and/or intervention that would signal a change in Japan's monetary policy. The dollar slipped to session lows on the comments near JPY143.45. After approaching nearly JPY145 yesterday in early North American dealing yesterday, it traded as high as JPY144.55 in Tokyo today.

Yet, this is not a crisis. It is not a problem that needs to be fixed. The yen's weakness reflects the divergence of monetary policy, for which economists accept the BOJ's view that core inflation is going to fall next year back to 1.4% (that matches the median forecast in Bloomberg's survey) and the deterioration of its terms-of-trade. The depreciation of the yen may be boosting Japan's inflation but not so much. Yes, it is exacerbating the energy shock. The weaker yen also has helped boost Japanese corporate profits to the highest in a generation. As we have noted, unlike in past episodes of yen weakness, US industry, like autos and steel, for example, are not complaining. The strength of the dollar has not prevented US exports from setting new records. Japan may emerge as the strongest G7 economy in H2. 

In fact, earlier today, Japan revised Q2 GDP higher to 3.5% from 2.2% at an annualized pace. Consumption and capex drove the revisions, while inventories were less of a drag and net exports were a touch stronger. Separately, Japan July current account surplus was about a third of expectations at JPY229 bln. This underscores the terms-of-trade challenge for Japan. The July surplus was down a little more than 85% from a year ago. The goods deficit was JPY1.21 trillion and the service deficit (includes shipping and passenger transport) rose by more than a quarter to nearly JPY790 bln. The deterioration of trade more than offset the improved primary income account, which captures the return on foreign investment (profits, dividends, licensing fees, royalties, etc.) It rose by almost 24% to JPY2.43 trillion.

The Australian dollar was barely able to extend yesterday's recovery before selling pressure re-emerged. There are two developments to note. First, weaker coal and iron ore exports and stronger imports saw Australia's July monthly trade surplus fall more than expected. It was halved from the record A$17.1 bln in June to A$8.7 bln. Exports fell 10% after rising 5% in June. Imports rose by 5%. The median forecast was for flat imports after a 1% rise in June. Second, in the policy statement following the central bank's 50 bp hike earlier this week, RBA Governor Lowe seemed to confirm what the market had suspected. After four half-point moves, the RBA could slow the pace of tightening, but more tightening is coming. Yesterday before Lowe spoke, the futures market was pricing about an 83% chance of a 25 bp move next month rather than 50 bp. After Lowe's comments, the market is closed to an 88% chance.

The dollar is trading within yesterday's range against the yen (~JPY142.70-JPY144.99). This is to say, that Japan's verbal threats were unable to push the dollar below yesterday's lows. It is difficult to assess the extent of speculation, but one indicator, from the US futures market, showed that the net speculative short position was a third of where it was in April as of the end of August. Still a period of consolidation would not be surprising as the market will turn its attention shortly to next week's US CPI, where the month-over-month rate may decline after a flat July. The Australian dollar's recovery to $0.6770 yesterday after slipping slightly below $0.6700. It set a high today just shy of $0.6775. The selling pressure knocked it back to around $0.6715 where it has stabilized. The intraday momentum indicators are neutral. The Chinese yuan ticked higher against the dollar for the first time this week. The greenback slipped through yesterday's roughly CNY6.9625 low to CNY6.9545 today. Trading slightly below CNY6.96 now, it is off about 0.1% on the day, to barely shave this week's gain of 0.85%. The PBOC set the dollar's reference rate at CNY6.9148, well below expectations (median in Bloomberg's survey) of CNY6.9543. Not that first thing tomorrow, Japan is expected to report August CPI and PPI figures. The former may have ticked up (to 2.8%) while the latter continues to fall (~3.2% vs. 4.2%).

Europe

The ECB meeting is the key event of the day. Arguably encouraged by rising US stocks and a pullback in US yields, a bout of short covering lifted the euro a little above $1.0005. It has recorded a fresh 20-year low on Tuesday near $0.9865. Back in July, when the ECB hiked by half-a-point, which at the time was seen by the swaps market as a nearly 50/50 call, the euro closed up half-a-cent. That said, it took it another week-and-a-half to surpass the high scored on the day the ECB meeting. Floated by the hawks and accepted by the markets after the preliminary August CPI (9.1% headline vs. 8.9% in July, and 4.3% core rate, up from 4.0%), a larger hike is possible. More than possible, the swaps market has about a 66% chance of a 75 bp move. This might understate the case, as between now and the end of October, the swaps market has 125 bp increase nearly completely discounted.

In addition to the rate decision, there are two other things the market is looking for. First, the staff will update its forecasts. The direction seems obvious: lower growth and higher inflation. Recall that in June, it projected 2.8%, 2.1% and 2.1% growth for 2022-2024, respectively. The Bundesbank has already warned of a recession. This year and next year's forecast seem plump for revision. That said, given the shocks of the conflict, Covid, and climate, the eurozone's economic weakness seems mild but also still early days. The eurozone grew by 0.7% in Q1 quarter-over-quarter. Growth in Q2 was revised yesterday to 0.8% from 0.6%. It is unlikely to see those kinds of numbers for a while. Indeed, over the next several quarters, stagnation may be the best that can be reasonably hoped. The ECB's June CPI forecasts were 6.8%, 3.5%, and 2.1% for 2022-2024 respectively. The market (median in Bloomberg's survey) sees this too optimistic this year and next. It has eurozone CPI at 8.0%, 4.3% and 2.0%, respectively. 

Second, investors and businesses look for more details from the ECB about the re-investment of the corporate bond portfolio. Starting next month, officials indicated that they prefer businesses that a better for the environment. It is not immediately clear why officials should prefer the "E" over the "S" or "G" in the popular lexicon. There are many questions and few answers so far. What are the criteria?  Who is the judge? Is it willing to sacrifice return? How should it be evaluated? The broader market impact may be minimal and overshadowed by the rate decision and the updated forecasts. Still, its importance as a first step down this path will be watched by other national policymakers who are also are wrestling with how monetary policy can help facilitate more sustainable development.

The euro is in a narrow range around parity. A move above the $1.0025 area would help lift the tone, but it probably takes a push above the $1.0060 to signify anything important. With the market pricing in a 75 bp hike and 50 bp next month, any disappointment would weigh on the euro. There are 2.2 bln euros of expiring, options struck at $1.000 but they have likely been neutralized. Tomorrow, there are 1.2 bn euros in options struck at $0.9950 that will expire. Sterling looks to have put in a hammer candlestick yesterday but follow-through buying has been limited to 2/100th of a cent. It is straddling the $1.15-area in the European morning after settling yesterday near $1.1535. There are options for about GBP410 mln at $1.1550 that expire today. Despite the new government's proposal to cap household energy bills and the knock-on effects cost-of-living, the swaps market is pricing in about a 55% chance of a 75 bp BOE hike next week, down from around 82% at the start of the week.

America

Toward the end of the ECB's press conference, Fed Chair Powell will take part in a discussion on monetary policy at the Cato Institute in Washington. Between his remarks at Jackson Hole, and Vice-Chair Brainard's comments yesterday, there seems to a low chance that new ground will be broken. Brainard was clear, Fed will move into restrictive territory and as policy becomes more restrictive the risks become more two-sided. On the one hand, Fed officials recognize they must avoid declaring "pulling back too soon." On the other hand, Brainard explained, "The rapidity of the tightening cycle and its global nature, as well as uncertainty around the pace at which the effects of tighter financial conditions are working their way through aggregate demand, create risks with over-tightening." At Jackson Hole, Powell left the door clearly open to another 75 bp hike this month, saying that it depended on the "totality" of the date. Brainard too did not commit. Brainard, who previously was the Under-Secretary of International Affairs, seemed more mindful of the global headwinds emanating from Europe and China. Yet, she also drew comfort from the improvements in delivery times and the rise in the labor force participation rate last month. The market is not waiting. Based the recent string of data, and cognizant of another soft headline CPI next week, the market is pricing in almost an 85% chance of a 75 bp hike later this month.

With a new congressional delegation in Taiwan, the US is hosting a two-day summit starting today in Los Angeles for Asian nations in attempt to fill the gap left by the unilateral "disarmament" announced when the US pulled out of the Trans-Pacific Partnership. The US is trying to construct an alternative. It is positioning it as not just about trade, but broader economic ties, including supply chains, clean energy, taxes, anti-corruption. However, the US has thus far been unable to pass the legislation needed to implement the global tax agreement that it had championed. The legislation that it did pass, like the domestic content for electric vehicles, or the semiconductor bill that allows foreign companies to participate provided they do not help China advance its industry for a decade, has not been well received.

The Bank of Canada delivered the 75 bp hike that was widely expected yesterday. At 3.25% the target rate is slightly above the range of neutrality. There was little beyond the statement yesterday. That will come later today with Deputy Governor Rogers speech. The market expects the pace of tightening to slow. The swaps market shows investors are inclined to see a 50 bp hike next month and see the terminal rate near 4.0%. The October 26 meeting will include a monetary policy statement and updated projections. With rising US equities yesterday, the US dollar pulled back from the probes of CAD1.32 and fell to almost CAD1.3110. The CAD1.3100 area held in Asia. The CAD1.3200 area remains an important cap, and today, it is reinforced with a $650 mln option that expires. We continue to emphasize that Canada acts as a risk currency rather than a petro-currency and the Canadian dollar's strength yesterday, in the face of the 5.7% slide in WTI lends credence. The US dollar continues to trade in the set last Friday against the Mexican peso. That range, roughly MXN19.9260-MXN20.2085 has held this week. It may be challenged today with Mexico's August CPI. It is expected to have accelerated with the headline rate rising toward 8.7% and the core, pushing above 8%. Banxico is expected to deliver a 75 bp hike when it meets toward the end of the month.