The EU Recovery Fund proposal will be a key area of discussion at the EU Summit July 17-18. Since the initial Franco-German proposal that was followed by the proposal now under consideration, the euro has been buoyed not only by hopes of more stimulus but also further fiscal integration. On a historical basis, European authorities have shown a knack of overselling their programs, but the risk remains for markets to be disappointed by the details of the ultimate deal.
To be sure, the Recovery Fund provides needed fiscal stimulus. While Germany has acted decisively with its fiscal response, other European countries with less fiscal space have been more limited. The EU Recovery Fund should bring the total EU fiscal stimulus on par with the rest of the G10. Notably, the proposal included grants, which was a red line for many countries including Germany. It seems reasonable to assume the final version will also include grants of some form. This is important because it signals solidarity in response to a common shock that has asymmetric impact on various EU countries. Grants will also allow high debt countries to stimulate their economies without adding to debt issues.
The above factors do justify a euro relief rally, but market positioning appears to suggest markets are expecting more. Keep in mind the Recovery Fund just brings the EU to level with other countries. Moreover, the proposed fiscal stimulus is not ideal. The money would not be available immediately. Instead, it will be doled out starting next year through the next 4-7 years. EU countries would not be able to use it for social spending (unemployment benefits etc.) in response to the crisis experienced today. Instead, the money will be used for project financing in upcoming years with countries needed to come up with proposals and apply for funding. Needless to say, this is a slow and inefficient process. The proposal also includes the possibility for conditions based on reforms for countries to use funds. While fiscal responsibility has clear merits, if fiscal rules lead to austerity in subsequent years, the net fiscal stimulus might not be large.
In regards to market implications, expect the markets to focus on the size of grants and the formula to distribute money. The current proposal has EUR500 billion in grants. Significantly weakening this part of the proposal will be a negative. EU countries don’t need more loans as they already have access to historically low rates and the ECB is already buying their bonds. Regarding distribution, the EU Commission intentionally came up with a formula that supports the Eurozone periphery. Any changes to this will have a market impact.
Of course there is the risk that the Europeans fail to reach a deal in July. If this is done under the context of progress with more time needed to iron out the details, then it should not matter. However, if there is no agreement and things get pushed to the October meeting, expect the markets to start questioning the viability of a final deal.
Cross currents continue to categorize the FX markets. Better than expected economic data supports the rebound. Markets will also be focused on the EU Summit and prospects for Europe’s Rescue Package. The potential for further fiscal support is a positive as several key countries, including Germany, turn expansionary. While caution is advised in extrapolating the steps taken into a full blown fiscal union, the removal of some negative risk premium is warranted as positive progress has been made. Opposition still exists so the potential for disappointment remains. Conversely, rising infection rates around the world puts uncertainty around the prospects of reopening. With little political will for renewed blanket shutdowns, the reopening process should continue and support cyclical currencies.
The UK government continues to push ahead with its re-opening and faces the same dilemma as the rest of the world. Economic data should continue to improve as the economy re-opens but rising infections present a headwind. On balance, the government’s response based on local lockdowns should give the economy some room to run near term. On Brexit, the deadline for requesting an extension has passed so barring a rule-breaking extension, the transition period will end this year. Intensified talks have started, but a skinny deal is likely the best case outcome with spikes in volatility likely as markets try to price in its view on the ultimate outcome. For this week, the focus will be on Chancellor Sunak’s summer economic update for hints on any further stimulus measures.
The yen has traded in a narrow range since the middle of June, but looking ahead, the bias is skewing towards yen appreciation. Japan is facing a prolonged period of disinflation, if not outright deflation. Conversely, inflation expectations are rising in the US, which makes it likely that real rates will rise faster in Japan than the US and support yen appreciation. On a global level, expect safe haven currencies, such as the yen, to continue to be moved by overall market sentiment. With infection rates rising, the risk skews towards re-openings getting delayed and safe haven currencies being supported. As a final note, investment outflows have picked up again after a period muted activity.
Over a longer window, the CAD has strengthened on re-opening optimism. However, over the past week the CAD ranks near the middle of the G10. Despite the CAD’s run of strength through the first half of June, we have been bearish on the CAD due to its unique vulnerabilities to the COVID-19 crisis. Expect USDCAD to remain range bound as markets weigh the positives from policy support with the risks from rising infections.
The yuan has received support from a more-dovish-than-expected US response to China’s moves in Hong Kong. In particular, the markets were concerned about the viability of the Phase 1 deal. Multiple reassurances from both the US and China that the deal remains intact puts confidence behind the deal and reduces the risk of further tit for tat escalation. While skepticism is warranted that risks have fully receded over the medium term, especially as we move closer to the US election, expect continued stability for the CNY near term.
The Aussie’s link to global risk assets is likely to remain intact for the time being, but over the medium term, the risk still remains for weakening. COVID numbers are steadily increasing but these numbers, on their own, have been shrugged off. Likely it will take actual follow up actions due to rising infections to make a difference. To this point, PM Morrison hinted that Australia could keep its borders closed to international visitors until the middle of next year. Near term, domestic and global policy support should continue to provide a base for the Australian and global economies and the AUD. The picture is a bit different over the medium term with valuation elevated and uncertainty around Australian-China tensions lingering. The RBA meets this week and should keep rates unchanged.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
Expectations for rates to remain unchanged at 0.25%
KEY MARKET MOVING ECONOMIC RELEASES
United States and Canada
US Services PMI
Expectations for a 47.0 print
US ISM Non-Manufacturing Index
Expectations for a 50.0 print
US Initial Jobless Claims
Expectations for another elevated print
Canadian Jobs Report
Expectations for the economy to add 550k jobs
German Industrial Production MoM
Expectations for a 10.0% increase
UK Construction PMI
Expectations for a 46.0 print
Asia/Japan, and New Zealand
Chinese Foreign Reserves
Expectations for reserves to rise to $3.11 trillion
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