Monday, June 29, 2015

Greece update

The Greek Prime Minister Alexis Tsipras surprised everyone at the weekend by calling for a referendum on the latest proposal from the bailout institutions (the troika).  The referendum was approved by the Greek parliament and will ask whether the electorate supports the latest proposal from the institutions.

The relevance of such a referendum, to be held on Sunday July 5th is in question given it will come after Greece’s scheduled €1.5 billion payment to the IMF on June 30, which is likely to be missed without access to the funds available under the current bailout agreement.  It seems the referendum can only be legitimised if the IMF allows Greece to be in "arrears" until the outcome of the referendum is known. The bailout institutions rejected a call from Athens over the weekend to grant a one-month extension to the current bailout.  Patience is clearly wearing thin. 

Mr Tsipras has said he will campaign for a “no” vote.  This could put him at odds with electorate.  The Greek people will likely see this vote for what it is: a referendum on continued membership of the euro zone.  Various polls have suggested the Greek people want to stay in the euro zone, even if it means more pain.  If they are consistent, a “yes” vote will likely prevail which would hopefully then open the door to fresh negotiations.  But it’s hard to see how Mr Tsipras could then continue to negotiate on behalf of the Greek people and fresh elections could be called.  A “no” vote seems likely to put Greece on the path to exit from the euro zone.

With no resolution over the weekend the Greek banks will be closed on Monday, capital controls have been introduced and the European Central Bank has suspended Emergency Liquidity Assistance to the banks.  Greece is already getting a taste of what life outside the euro zone may look like, and it’s not good.

At this point it’s probably worth repeating that if Greece is forced out of the Euro the only good news is the rest of Europe is in far better shape now than in 2010-12 with Portugal and Ireland now both off bailout support, peripheral countries have reformed their economies and reduced their budget deficits and the ECB has built and strengthened the financial firewalls around the euro zone.  But that doesn't stop us from hoping they don’t need to be tested.

Thursday, June 25, 2015

China starting to stabilise?

We have seen a sharp slowdown in the growth rates of key China activity indicators over the first half of 2015.  That has led to the stepping-up of easing measures to now include three interest rate reductions since November last year, cuts in the Required Reserve Ratio (RRR) and a number of fiscal stimulus initiatives.  Most recent activity data suggests those measures may be starting to have an impact on the economy.  But with inflation still low and spare capacity still high further easing measures remain likely over next few months.

The Manufacturing PMI from Markit/HSBC came in at 49.6 for June, still below the 50 benchmark but up on the 49.2 recorded in May.  Importantly the improvement came in the production and new orders (more precisely new export orders) components supporting the contention of a stabilisation in activity.  Indeed this result suggests the official PMI index will tick higher in June.

But it wasn’t all good news – the employment index dipped further to 46.8.  While we tend to focus mostly on the growth indicators it’s important not to under-estimate the importance of the labour market in the Government’s policy considerations.

The PMI followed the release of May activity data which saw growth in fixed asset investment picking up slightly, driven by manufacturing and property.  That coincides with a small uptick in property prices in May, the first monthly increase since April last year. The recovery is being led by the Tier 1 cities (Beijing, Shanghai, Guangzhou etc).  We’ve previously identified stabilisation in the property market as critical for broader economic stability.


Growth in industrial production also picked up in May.  While it doesn’t look like much a turnaround yet, the better result comes off a low base last year.  Stronger export growth is driving the improvement right now but we expect recent easing measures will see improved domestic demand kicking in later this year.


Credit and money supply growth also supported the stabilisation story in May.  M2 growth accelerated to 10.8% in May, up from the historical low of 10.1% in April, the likely direct result of the recent policy loosening.  Lending growth appears to be leveling out at around the 14% level.

However disinflationary pressures remain strong.  The annual rate of non-food inflation is running at or just below 1%. Low commodity prices are having a significant impact but weak domestic demand is also an important factor in continued low CPI inflation.




Official GDP growth is likely to come in at around 6.7% in June, down from 7.0% in March.  Early signs are we will see a stabilisation at that level into the third quarter.  Until that becomes more certain, and we start to see some improvement in labour market indicators, we expect the Government to continue to ease with further cuts to the RRR and interest rates in the months ahead.

Saturday, June 20, 2015

Crunch time in Greece

It’s crunch time in Greece.  Last week’s Eurogroup meeting of Finance Ministers failed to break the impasse with the Eurogroup President Dijsselbloem declaring that “no agreement is yet in sight”.  A special euro area summit has now been called for Monday.   Overnight the European Central Bank has again increased its emergency lending to Greek banks a further €1.8 billion following the €1.1 billion made available last Wednesday.

Our view has been that a compromise would be reached, although it would likely fail to solve the actual problem of the unsustainability of Greece’s debt burden (see here).  Negotiating positions signal the Greek Government appears determined to deal with the fundamental problem while the bailout institutions seem determined to continue to muddle through.  Whichever side you’re on the essential point is that any deal between Greece and its creditors that doesn’t deal with Greece’s unsustainable debt burden simply kicks the can down the road.

So as it stands there is still a significant gap in negotiating positions between Athens and the bailout institutions and time is running out.  Greece has a payment of €1.6 billion due to the IMF at the end of this month with a further €2.2 billion due by the end of September.  Failure to meet those payments will see Greece in default and the IMF has indicated there will be no grace period.  However, if a late agreement is reached the IMF, ECB and EU may agree to delay payment until any necessary parliamentary votes and referendums can take place.

A German newspaper has reported the possibility of an extension in the current bailout program to the end of the year, although that would be without the participation of the IMF.  That would see the €10 billion currently earmarked for the recapitalisation of Greece’s banks being used to settle Greece’s pending obligations to the IMF and ECB out to the end of the year.  While this has been refuted by a number of EU diplomats as being “unworkable”, given the tight timeframe to the end of the month it’s an option to avoid default.

So Monday’s meeting is critical.  It’s in the interest of both sides to reach an agreement: for Greece to avoid a banking crisis, economic mayhem that would follow if they have to balance their budget immediately and forced exit from the Euro; and for creditors to preserve as much as possible of the €300bn or so lent to Greece and to head off any contagion.

If Greece is forced out of the Euro the only good news is the rest of Europe is in far better shape now than in 2010-12 with Portugal and Ireland now both off bailout support, peripheral countries having reformed their economies and reduced their budget deficits and the ECB in a far stronger position to protect countries from attacks on their bond markets (via both its QE program and its Outright Monetary Transactions program which enables the buying of bonds in troubled countries).

Tuesday, June 16, 2015

What will the Fed do this week?

The main event in markets this week is the meeting of the Federal Open Market Committee (FOMC).   The Committee can be expected to acknowledge the recent improvement in the data, leave rates on hold, but signal their preparedness to raise rates at some point this year.

Activity data is clearly on the mend with the Surprise Index now trending higher.  This supports the FOMC’s view that much of the weakness in in the first quarter was transitory.  The most recent and perhaps best bit of that story was the recovery in April retail sales which rose a better than expected 1.2% over the month.  The control group (the component of retail sales that feeds directly into GDP) was also stronger than expected telling us that second quarter GDP is off to a solid start.



Core CPI inflation is also looking firmer although much of that has been driven by the shelter component with core PCE lower than it was when the FOMC went all dovish on us in March.  Perhaps more importantly in terms of the outlook (market based) inflation expectations are on the rise again.

In terms of the labour market payrolls employment growth has improved after a quiet couple of months.  The month of May saw a return to solid employment growth with a jobs gain of +280k.  The annual rate of growth in average hourly earnings also ticked higher to +2.3%, still low by historical standards but a high for this cycle.  Most wage measures are now trending higher.  Forward looking data tells us the Committee can have some confidence jobs gains will remain solid in the months ahead with job opening trending sharply higher recently.


This meeting will also see the release of updated economic forecasts and interest rate expectations in the SEP ((Summary of Economic Projections) with the range and median of FOMC participant’s views captured in the now infamous dot plots.  It seems unlikely that we will see any significant shift in the dots this time around following the downward revisions to inflation and interest rates forecasts in March – at least not for the real economy (labour market, inflation or GDP growth).


Most attention will be on the interest rate dots where the Committee’s outlook has interest rates increasing at a faster rate than the market is current pricing.  There is therefore room for downward movement in the Committee’s expectations, especially if they want to reinforce the message from recent FOMC-member speeches that the pace of increase will be slow and, in the words of Stanley Fisher, closer to a “crawl” than a “lift-off”.   We still pick September for the first move.

Thursday, June 11, 2015

RBNZ cuts the OCR

Contrary to my expectation the Reserve Bank of New Zealand today cut the OCR 0.25% to 3.25%.  The Bank’s interest rate track flags a further cut is likely. 


While I had acknowledged the chance of lower interest rate this year I didn’t think the Bank would be prepared to pull the trigger today.  When the Bank adopted its easing bias in April that bias came with conditions around weaker growth in demand and wage & price setting behaviours settling at levels inconsistent with 2% inflation.  My view is those conditions may still not be met but the Bank has clearly been prepared to move in anticipation of them being fulfilled.

The primary rationale for today’s move appears to be the renewed weakness in dairy prices and the impact that will have on domestic demand. That is one of the factors we had identified, along with the TWI and wages, as ultimately determining the next move in interest rates. 

Our concern about dairy prices had been ameliorated by the fact that the terms of trade has continued to hold up pretty well and would likely remain high relative to history.  We have been expecting a fall of 7-8% overall – the RBNZ’s forecast is for a decline of 8.4%.  That will still leave the terms of trade at around the level of its previous peak in 2011.

While the Bank has lowered its forecasts for domestic demand their growth forecasts are broadly in line with ours with GDP holding up at 3% this year and into next and then tailing off from later next year.  With respect to capacity pressures the Bank believes the output gap is closed and will become positive over the forecast horizon.

So why did they cut?  The big question is how much inflation that level of growth and a modestly positive output gap is going to generate and the appropriate level of interest rates that comes with that.  Towards the end of today’s MPS (Box 2, page 29) the Bank acknowledges the uncertainty around the answer to those very questions.  I thought the Bank would be prepared to wait for a bit longer for more certainty on the answers before cutting.


How wrong I was (I hate being wrong).  I did think, however, that if the Bank did cut rates it would probably cut twice.  Indeed the Bank’s interest rate track signals a second cut is in the offing.  That appears likely at either the July OCR review or (more likely) the September Monetary Policy Statement.  The precise timing will depend on the data flow. 

Friday, June 5, 2015

Inflation in the US and the Euro zone

Recent CPI inflation data out of both the US (for April) and the Euro zone (for May) were higher than expected.  In the US that tells us to be wary about pushing rate hike expectations out too far while the Euro area data confirms deflation fears were overblown.

Annual headline inflation in the Euro zone reached +0.3% in May, up from 0% in the year to April which followed four months of negative readings.  The annual rate of core inflation also moved up, rising from +0.6% to +0.9% over the month.  This is good news and supports our view that the recent experience of deflation would prove temporary.  Indeed we attribute much of the move higher in European bond yields recently to the unwinding of deflation fears.

That said the risk of a period of sustained low inflation in the Euro zone is still as great as it was when the European Central Bank (ECB) increased the size and scope of its asset purchase program earlier this year.  We expect GDP growth to remain modest overall with significant spare capacity keeping inflation subdued.  We expect the ECB’s asset purchase program to run its full course to September next year.

The +0.3% rise in the core US CPI took the annual rate of increase to +1.8%, or not far off the Fed’s 2% target.  Much of the increase can be attributed to core services, in particular owners’ equivalent rent (up 0.3% m/m) and what appeared to be a bit of catch-up in the cost of medical services which blipped 0.7% higher in the month.


We don’t see this as a sudden lurch higher in underlying inflation pressures.  Indeed core goods prices remain subdued thanks to low inflation globally and the stronger US dollar.  The Fed’s preferred inflation measure, the core personal consumption expenditure (PCE) deflator, also remains subdued rising at an annual clip of just 1.2% in the year to April, down from 1.3% in the year to March.

So is inflation rising or not?  I look to the labour market, in particular productivity and unit labour costs, for signs of underlying inflationary pressure.  But that data can very volatile quarter-to-quarter and is fraught with measurement challenges.  Last night’s release of revised March quarter data will attest to that fact with productivity falling at annualised rate of -3.1% while unit labour costs rose +6.7%.  That’s largely the result of weak March quarter growth.

Year-on-year growth rates are a tad more meaningful with productivity up +0.3% in the year to March and unit labour costs up 1.8%.  The low productivity result is a continuation of the trend observed since the end of the Great Recession when it has averaged +0.8% per annum, below the long-term trend rate of +2.2%.  Unit labour costs, while highly volatile, appear to be trending higher which is consistent with recent trends in indicators such as the Employment Cost Index. 

The message I expect the Fed to be taking from this is that despite still low core PCE inflation and the move higher in core CPI not yet being the result of rising underlying inflation pressures, they can still have comfort in their view that inflation will move towards target over time.


It’s interesting therefore that the Fed Funds futures market isn’t expecting rate hikes till the end of the year.  While June is highly unlikely, I think a September “lift-off” is still very much live.  Interest rates at zero seems inconsistent with an unemployment rate that is trending down towards 5%, low productivity growth and most wage measures tracking higher.  Plus getting the first one out of the way means we can start focusing on what matters most – the extent of the interest rate cycle rather than when it starts.  In the meantime,back to watching the data….