Risk sentiment around the world was buoyed by positive headlines around Brexit and US-China trade last week. While these incremental developments are positive for the markets, the headwinds that have slowed the global economy this year still remain. Clearly, fiscal stimulus is needed but, unfortunately, it is unlikely to be realized. As a result, exhausted monetary policy continues to carry too much of the burden, forcing central banks even further into unconventional territory.
Within the universe of unconventional policies, the merits of negative interest rates represent one of the more contentious debates. For the ECB's part, it has long argued that its negative interest rates policy does not harm euro area banks; yet, the banks themselves paint a different picture. So what exactly is going on?
A key ECB argument is that interest income, on a system wide level, has been steady since 2010, which supports the view that negative rates do not compress interest income. While this is true, system wide analysis glosses over several important details.
Due to reputational and legal reasons, banks are unable to fully pass on negative interest rates to customers. As a result, a further decline in negative interest rates leads to a decline in the banks' interest bearing assets without an offsetting decline in household deposit liabilities.
Because of margin compression, banks have decreased low margin activities in favor of higher margin consumer and corporate lending. Additionally, European banks have benefited from a decline in provisions on loans. To the ECB's credit, these results support the ECB's view that its monetary policy would support growth and consumer income that would lead to loan growth and a reduction in nonperforming assets.
The issue is that this credit expansion hasn't happened in a sustainable way. For starters, non-performing loans have hit a very low level and are unlikely to decline much further. Moreover, loan growth is more supply driven than demand driven as strong loan growth has been accompanied by falling loan prices. Eventually, low profitability will hinder banks from making more loans. In essence, the ECB will have hit its "reversal interest rate" or the level where easier monetary policy actually contracts the economy. So while the ECB is not wrong in its assessment on the industry level, it will eventually have to make changes to its policy. "
The euro is coming off one of its best weeks since June due to increased optimism around Brexit and US-China trade. While recent developments are positive, the overall picture of slowing global growth remains broadly unchanged. Near term, positive momentum has certainly picked up, but longer term, the bias remains to remain defensive, albeit at a scaled back level, until there is more visibility on exactly how Brexit and US-China trade gets resolved.
The GBP spiked up sharply on headlines that have revived hopes for a Brexit deal, however there is still a long ways to go as any potential deal still needs to gain EU and UK approval. As the parliamentary math goes, any UK concession that gains support from one group of MPs likely loses support from another group of MPs. In the end, details matter, and as of this writing, we are light on details. Regardless, the prospects for an orderly exit have risen, but serious challenges remain. Expect the GBP to continue to move with headlines with the EU summit on October 17-18 and the parliamentary session on October 19 being key dates.
This past week provided a clear illustration that politics, more than anything, are a dominant driver of the global macro outlook. Positive news on Brexit and US-China trade helped USDJPY move higher on scaled back safe haven demand and higher US yields. While recent developments are positive, details around Brexit and US-China remain thin. With the global economy weak, more visibility needs to be gained before we are able to understand the real economic impact. Until then, the slight bias remains to the defensive side.
A strong Canadian jobs report reinforced the narrative that the BoC is operating on its own path as opposed to other central banks who have taken out "insurance" cuts. Over the past six months, the Canadian economy has added an average of 40.4k jobs. Put in "US terms," this would be around 400k. As with other currencies, constructive headlines on Brexit and US-China trade has helped the CAD strengthen. For the week, expect USDCAD to remain range bound.
The partial deal between the US and China provides support for the yuan by releasing pressure on a key yuan depreciating factor. While tariffs will not go up this week, current tariffs remain in place. Looking forward, the October 15 soft deadline for the next semi-annual currency manipulation report has increased in importance especially given the recent out-of-cycle naming of China as a currency manipulator. With trade pressure reduced, expect CNY stability this week.
The AUD closed last week near a 1-month high. Given Australia's exposure to commodity prices, the Chinese economy and global growth in general, this isn't a surprise. Momentum has clearly been for AUD strength however high tariff levels should continue to weigh on global growth and the AUD despite the recent positive headlines. Keep an eye on this week's jobs report as the labor market is a key variable for the RBA's future rate path.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
Expectations for rates to be cut 25 bps to 1.25%
KEY MARKET MOVING ECONOMIC RELEASES
United States and Canada
Expectations for a gain of 0.3% following a 0.4% gain
Expectations for a decline to 1,320,000 from 1,364,000
Expectations for a -0.2% print following a 0.6% gain
Expectations for a -0.3% print; YoY at 2.0%
Germ. ZEW Bus. Rep.
Expectations for a -23.0 print following a -19.9 print
U.K. Jobs Report
Expectations for job gains of 26k; UR remains at 3.8%
Asia/Japan, and New Zealand
China Trade Report
Expectations for a slightly smaller trade surplus
China CPI and PPI
Expectations for PPI to print at -1.2% YoY
Chinese Indust. Prod.
Expectations for a gain of 5.0% following a 4.4% gain
Expectations for GDP to decline from 6.3% to 6.2% YoY
Japan Nat'l. CPI
Expectations for a decline to 0.2% YoY from 0.3%
Aussie Jobs Report
Expectations for a gain of 15k; UR to remain at 5.3%
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