Fed chair Janet Yellen’s testimony to Congress and ECB President Mario Draghi’s press conference were the economic highlights of last week. Both were dovish. As a result, we have adjusted our interest rate and bond yield forecasts somewhat. The exact details of these changes are explained by Nick Kounis in the interest rate section of this document.
Whatever the case may be, this weak data is not enough to change our optimistic view.
Han de Jong Chief Economist
Confidence indices in the services sector improved in the US and in Europe, and Chinese trade data was positive. March industrial production data in a range of eurozone countries was weak. I am assuming this weakness is temporary.
On balance, it looks like things are moving our way. The global recovery is on track, risks in China and Ukraine appear unlikely to derail that process in the foreseeable future and central bankers continue to massage down borrowing costs.
Services sector confidence
Last week’s indices on services sector confidence in the US and in the eurozone showed an improvement from already healthy levels. In the eurozone, the Markit services sector PMI rose from 52.2 in March to 53.1 in April. The performance of the peripheral countries was particularly impressive. The same index in the US edged marginally lower in April: 55.0 versus 55.3, but the more authoritative ISM non-manufacturing index rose strongly: from 53.1 to 55.2, the third highest level in the last twelve months. These developments fit in nicely with the picture of strengthening global growth and global trade. Another important piece of data consistent with this picture was Chinese April trade data. Chinese exports beat expectations, improving from -6.6% yoy in March to +0.9% yoy in April. Exports to the US and Europe were particularly strong, +9.3% and +17.3%, respectively. Exports to Hong Kong were very weak, down more than 30% yoy, but this is a ‘fake’ number as the data a year earlier was bloated hugely by overreporting.
EU retail sales rose modestly in March: 0.3% mom and 0.9% yoy. That does not sound very impressive, and it isn’t, but the upward trend in retail sales is clear. And the Markit confidence measure for the retail sector rose strongly in April, reaching its highest level since this series was launched in 2011.
Industrial production eurozone countries
On a much less positive note, industrial production was weak in many eurozone countries in March. On a month-on-month basis, output fell 0.5% in Germany, 0.7% in France, 0.5% in Italy and even 3.8% in Holland, while it also posted hefty deteriorations on a yoy basis in Spain and Greece. Even the UK was unable to escape this development. Despite its recent almost neck-breaking pace of growth, output was down 0.1% mom. Ireland was one of the few odd ones out; industrial production was up 5.5% mom.
My problem is: how do I explain such weak output data across the board and yet maintain an optimistic view on the near-term outlook for the eurozone. The first point to make is that industrial production data can be volatile. That is not a particularly strong argument, however, as volatility in the data is unlikely to have hit all these countries at the same time and in the same direction. Perhaps more to the point, such European weakness is not consistent with a lot of the other data we are seeing. And, importantly, perhaps it reflects the earlier weakness in the US and in China. Another possibility is that the mild weather in Western Europe at the beginning of the year has flattered earlier data, leading to some payback in March. Whatever the case may be, this weak data is not enough to change our optimistic view. The upward trend of output growth remains intact.
At his monthly press conference, ECB President Mario Draghi said that the ECB is comfortable with changing its policy stance next month when it will have seen new staff projections for the eurozone economy. This raises three questions: why would they act, what action will they take and what might those new staff projections say?
Starting with the last question, we think the ECB economists might raise their growth forecasts a little but lower their inflation forecasts, particularly the short-term inflation forecasts. This might explain why the ECB would do anything in the first place. Draghi was very explicit on the issue. The strength of the euro is a concern against the background of low inflation. That concern must increase if one lowers the inflation forecast. Looking at the various possible policy options, we believe that an interest rate cut is the most likely action. This will bring the deposit rate - the rate banks are paid for holding money at the ECB - into negative territory. Another possibility is that the ECB will launch a ‘credit easing’ programme in which they commit to purchasing a certain amount of Asset Backed Securities. We think it likely that such a programme will be employed, but probably not in June. And it will be of modest size relative to the full-blown quantitative easing the US Fed has undertaken. The possibility of large-scale quantitative easing by the ECB through buying large amounts of government bonds is still the least likely option.
Some commentators have noted that Draghi is often long on words, but short on action and they are wondering if Draghi will ‘drag’ his heels in June. This is very unlikely in my view. The ECB has really put itself in a tight corner this time. Non-action in June after such a strong commitment would possibly lead to a significant rise in the euro, so the whole exercise would be completely counterproductive. Therefore, we feel that the likelihood of ECB action in June, in particular a rate cut, is extremely high.
A day before the ECB governing council met, Fed chair Yellen testified to the US Congress. The Fed is involved in a clear policy of tapering its asset purchases and everything is going according to plan here. So Yellen’s comments were not particularly important to the immediate policy outlook. Instead, her statement must be seen in the light of policy questions further into the future. She focussed some of her remarks on housing. This sector was one of the main drivers of the recovery until borrowing costs started rising in May last year. It goes too far to argue that the housing market is weak now, but it certainly is less strong than it was a year ago. A further rise in borrowing costs may weaken the housing market further and undermine the overall economy. This is not a risk the Fed wants to take. Another issue Yellen raised was that while unemployment has fallen, it remains well above an acceptable level. As long as unemployment is above this acceptable level, the Yellen-Fed will be willing to provide monetary stimulus. I read Yellen’s testimony as an effort to provide comfort to markets that the Fed will not actually tighten policy for a long time yet. This, in turn, is aimed at trying to keep borrowing costs along the yield curve low, a plan that seems to be working very well indeed!