Fasten Your Seat Belts: Tomorrow Promises to be Tumultuous

Tomorrow could be among the most challenging sessions of the third quarter.   The focus is primarily on Japan and Europe, but the US reports its first estimate of Q2 GDP.  After a six-month soft patch that heightened fears in some quarters that the world’s largest economy was headed for a recession, the US economy appears to have returned to trend growth.  It enjoyed good momentum as the quarter wound down, and currently, Q3 GDP is also projected to be above trend.

Japan, though, will get the ball rolling.  It will report a slew of data before the Bank of Japan announcement.  Due to the pending BOJ announcement, the data may have little impact.  However, the takeaway is despite a tight labor market and aggressive BOJ monetary policy, consumption, production is weak, and deflationary forces remain formidable.

Since last September, there has been only one month (February) that overall household spending was higher on a year-over-year basis.  It is expected to have been 0.4% below a year ago levels in June.  Retail sales, a component of household spending is expected to have risen by 0.3% in the month of June.  Retail sales have fallen consistently on a month-over-month basis since last November, with March being the sole exception.

Industrial production has been moving in a saw tooth pattern since the end of last year.  A decline in one month is followed by a gain, which is then followed by another fall. Industrial output fell 2.^% in the month of May, and to maintain the pattern; output would have to have risen in June.  The median forecast is for a 0.5% gain.   In the first five months of this year, the average monthly change has been a 0.2% decline.

Consumer prices are expected to have fallen by 0.4% in the year through June.  This would match the May reading, which was the largest fall in consumer prices for three years.   Excluding food and energy, the year-over-year pace is expected to slip to 0.5% from 0.6%.  That would be the weakest since May 2015.

These reports, coupled with the signals from the Abe government about its fiscal intentions, will be the backdrop for the BOJ meeting.  Economic and political pressure will likely force the BOJ to move.  Given that there is no agreement on the precise meaning of “helicopter money”, we find ourselves in agreement with one of Abe’s advisors that suggested that the current BOJ purchases are a form of “helicopter money.”

 If  Abe’s fiscal plans call for the issuance of new bonds, and the BOJ increases its purchases of JGBs, this would reinforce our sense that “helicopter money” is already being deployed.  Japanese officials have denied reports suggesting 50-year bonds will be issued.  However, this does not rule out other long-term bonds and/or a new issue, which the BOJ could buy.

Surveys suggest many expect the BOJ to buy more ETFs. This would seem to be among the least disruptive courses.  However,  ETFs alone would not be seen as sufficient.   Although Japanese banks have complained about the negative deposit rate, and some have quit being primary dealers, many expect the BOJ will either cut the “policy rate” to -15 bp from -10 bp.  It is also possible that the BOJ applies the negative interest rate to a greater part of reserves.  It could also cut its basic balance rate, which is set at 10 bp.

We are skeptical of the efficacy of such moves.  It is important to recall that when the US undertook asset purchases, officials did not claim it would boost inflation. And so far it has not done so in Japan.  The BOJ is increasing its monetary base by JPY80 trillion a year.  It that is not achieving the desired effects, why should we expected JPY85 trillion or JPY90 trillion, or even JPY100 trillion to do the trick.  Alas, it might not be about size after all.

Still, if the BOJ were to do nothing, the market will be disappointed.  It would likely take the yen higher.  And even if the BOJ eases policy–cuts rates, buys ETFs and JGBs and provide forward guidance that it is prepared to do more, if necessary– it is not clear that this would lead to a sustained rally in the yen.

Europe promises its own fireworks.  There are three key reports.  The is expected to confirm June’s preliminary estimate of 0.1%, which was the first positive reading since January.  The ECB, like the BOJ, has argued that its asset purchases are needed to reach its inflation target.  There seems no relationship between the ECB’s purchases of government bonds, ABS, covered bonds, and now corporate bonds, and consumer prices in the eurozone.  Yet in any event, the many expect that the ECB will announce as early as September that it will extend the purchases again for another six months, through September 2017.

The eurozone will also report its first estimate of Q2 GDP.  We have already seen that UK growth accelerated slightly, even if it was front-loaded.  By all accounts, US growth also accelerated in Q2.  Eurozone growth most likely slowed from the heady 0.6% quarter-over-quarter pace in Q1.  It is expected to have slowed to 0.3%.  The year-over-year pace is expected to moderate to 1.5% from 1.7% (same as Q4 15), which was the fastest since Q2 11.

The European Banking Authority and the ECB will also announce the results of the latest stress test.  The focus has been in Italy’s Monte Paschi, but it reportedly submitted a proposal to the ECB yesterday that seeks to sell a fifth of its bad loans or 10 bln euros to a combination of the new Atlas Fund and private investors and raise five bln euros of new capital from private investors.  We are skeptical.   Even if the bad loans could be offloaded, at what price, and what about the other 40 bln euros of troubled loans.  And will private investors really put five bln euros of fresh cash to work in the twice rescued bank, whose market cap is close to one billion euros?

However, since the proposal has been delivered, investors may focus on other results outside of Italy, assuming the other Italian banks pass as has already been suggested.  German, Austrian, Portugal and Dutch banks have been cited in press reports has potential candidates for needing more capital.

Since the UK referendum, the euro has been largely confined to a $1.0950 to $1.1185 range.  The euro has approached the upper end of that range today (~$1.1120).    The 20-day moving average is near $1.1060 today, and the euro has not closed the North American session about this moving average since the day of the UK referendum.