Mario’s Tune

Inflation in Europe returned
At least for last month, so we learned
Does that mean in June
That Mario’s tune
Will change and QE’s overturned?

Markets continue to relax after Tuesday’s panic over the situation in Italy. Yields on Italian debt have fallen sharply, although not yet nearly to their pre-crisis levels. US Treasury yields are climbing again as investors are no longer desperately seeking safety, although yields here remain below levels seen last week. While the political situation in Italy remains ‘fluid’, it appears, as of now, that the Five-Star / League coalition is going to return to President Matarella with a new government proposal, rather than trying to force a new election. Of course, until Matarella approves the list, the potential for a repeat of Tuesday’s price action remains. However, the market has moved on for now.

Instead, this morning the surprising news has been the inflation data from the Eurozone, where the May data showed a much larger than expected increase to 1.9% with the core level rising to 1.1%. While expectations were for both rates to rise, it appears that rising energy prices had a much bigger impact than forecast. And that is really the crux of the matter as the ECB will be loath to react to inflation that is solely driven by changes in gasoline prices. This begs the question as to what the ECB will do when they meet in two weeks’ time.

If you recall the beginning of the year, the narrative had described a situation where synchronous global growth would push the ECB to announce by the June meeting that they would be ending QE completely in September, and then raising rates sometime in Q2 2019. Of course reality intervened and as it became increasingly clear that global growth remained US led, with the Eurozone starting to lag, that story changed. The latest iteration has been that the ECB will wait until its July meeting to announce its plans, and that a reduction in, though not elimination of, QE was likely to be revealed. Estimates are for QE to decline to either €10 billion or €15 billion per month for the final three months of 2018, with an option to continue if deemed necessary. This altered timeline also pushed the first potential rate hikes back until the second half of 2019. And of course, as this process evolved, the euro declined.

But now the ECB has a different problem, politics is intervening again. Not only is the situation in Italy disruptive, but Spain is also looking at a modest upheaval, where PM Mariano Rajoy, a pro-market, center-right leader is about to face a vote of no confidence from parliament there. The ECB’s problem is that he appears likely to lose the vote, as he leads a minority government with limited support. This opens the way for a more radical left-leaning leadership with designs on increasing government spending and worsening the country’s fiscal outlook. If both Italy and Spain see political shifts to the left, where fiscal rectitude (not that Italy ever had any) is ignored, and market turmoil increases, it will become that much more difficult for the ECB to contemplate tighter monetary policy in the near term. With the July meeting only two months away, Signor Draghi is going to find that he will be unable to please any constituents no matter his actions. The German bloc remains uber hawkish and is very keen to see QE end and higher rates return. The peripheral nations could be devastated if that policy is followed.

It is with this in mind that I continue to look for the ECB to err on the side of easier policy. My contention is that the ECB will not even reduce QE in September, but extend it at €30 billion/month through the end of the year as they await further data to see if inflation is actually beginning to take hold, and to see how things play out in both Italy and Spain. And given that expectation, I continue to look for the euro to decline further as the year progresses. While this morning it has continued its rebound from its Tuesday lows, it is only higher by 0.3%, and trading at 1.1700 as I type. While I don’t doubt we could see a little more upside, I strongly believe it is limited.

In fact, the dollar is softer overall this morning, as the panic attack from Tuesday continues to abate. G10 currencies are all performing well, with a number of others (GBP, CAD, CHF) all rising similar amounts to the euro. Of these, CAD is of interest as it had a much larger move yesterday, jumping 1% in the immediate aftermath of the Bank of Canada announcement yesterday. While they left rates on hold, as universally expected, they removed dovish language from their statement and hinted strongly that they would be raising rates twice more this year, with the next move coming in August. That is a more hawkish stance than the market had expected as there continue to be concerns over the housing market in Canada and the fact that the entire nation seems to be somewhat overleveraged. However, the BOC is looking at the overall growth picture as well as the fact that inflation there is running at 2.3% according to the latest data, and concluding that the economy can withstand modestly higher rates. Consider, that even if they raise rates twice more, their base rate will still only be 1.75%, hardly restrictive. However, given the change in perception, the CAD rally is not surprising.

Turning to the EMG bloc, while APAC currencies all performed well, led by IDR (+0.7%) after the central bank there raised rates for a second time in two weeks, the story in EEMEA is a bit different, with the CE4 all rising, but both TRY and ZAR down a bit. TRY remains extremely volatile as President Erdogan continues to roil markets with his unorthodox economic views, but ZAR appears to be more technical in nature, with profit taking driving the market right now. Finally, both BRL and MXN remain under broad pressure as the issues of elections in both nations and NAFTA for Mexico add to uncertainty in investors’ eyes.

This morning brings a bunch more data as follows: Initial Claims (exp 224K); Personal Income (0.3%); Personal Spending (0.4%); PCE (0.2%, 2.0% Y/Y); Core PCE (0.1%, 1.8% Y/Y) and finally Chicago PMI (58.4). Given the Fed’s utilization of PCE in their models, all eyes will be there at 8:30. But in reality, unless the number is surprisingly different, investors will start to focus on tomorrow’s payroll report. Yesterday’s ADP number was a touch softer than expected, but still a robust 178K. The problem seems to be more about finding workers than job openings available. In the Fed’s eyes, they will be searching for more evidence that wages are rising, as Powell and company will assume that will feed into the general inflation level and encourage continuing policy tightening.

So while the dollar is under pressure today, I expect that this modest correction is coming to an end soon, and that we are far more likely to see it resume its strengthening trend, perhaps as soon as this morning if the data warrants. But the trend remains in place for the dollar to go higher in the medium term.

Good luck