January February 2015 Outlook: Hamlet Economics
"Brevity is the soul of wit" as Shakespeare wrote. In the context of present day monetary policy one could wish that the top caliber minds behind central bank policies had the knack for keeping their efforts clear, concise, and finite. Instead, going into the seventh year since the financial crisis erupted, the policy makers at the forefront of responding to the economic malaise are still hemming and hawing like Hamlet, offering up soliloquies when action is demanded. After waiting through most of 2014 for the Fed to wrap up its quantitative easing program and turn toward contemplating normalization, markets are now lining up to see the same show again in Europe.
The drama for the global economy has only been heightened by the plays within the play Greece's latest political crisis, Russia's land grab and the resulting sanctions, Saudi Arabia's high stakes game of chicken with rival oil producers, and the two top Asian economies still struggling to restore their former glory. How these stories play out in the months ahead will ultimately help determine whether or not this period in time will be regarded as a tragedy.
To QE or not to QE
The question of whether the last resort of quantitative easing is needed has already been answered in the affirmative by the Fed and the Bank of Japan, and now it looks like the European Central Bank will soon join the club. The euro currency has broken below the $1.20 mark, its weakest since 2006, on the growing expectation that the ECB will foray into QE and on reports that ejecting Greece from the euro zone may now be a palatable alternative.
The ECB has taken its time laying the groundwork for a full blown QE program, announcing last fall it had started the technical work for a possible program, even as it took other measures in the form of its ABS purchase program (dubbed "QE light"), refreshing its long term repo operation, and cutting rates to the zero bound. At the December policy meeting, ECB President Draghi said they were still assessing the success of these programs and signaled a decision on QE would likely come in Q1 though probably not until the second meeting under the new bank schedule, meaning early March.
Incoming inflation data may cause him to step up the timetable for the initial QE announcement to the January 22 meeting, as deflation fears might overcome worries about giving member governments more slack to avoid making tough fiscal choices. Adding oil market weakness into the mix, the upcoming December euro zone CPI data (Jan 7) could fall into negative territory after hitting a 5-year low in November. This would put more pressure on even the most reluctant ECB council members to act sooner rather than later on QE. Even if it was entirely driven by depressed oil prices, any negative inflation readings could break the fragile psychology of the European recovery thesis.
One formality that needs to be cleared for QE to launch is getting the go-ahead from the European Court of Justice, which said a few months back it would render its official opinion regarding the ECB Outright Monetary Transactions (OMT) program in mid-January (ruling to be issued Jan 14). Formulated in 2012, the OMT program undertakes outright transactions in secondary, sovereign bond markets, aimed "at safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy." German officials, including the ECB's Weidmann have argued that the OMT blurs role of economic and monetary policy, but a stamp of approval from the high court may stifle those objections and by extension clear the path for quantitative easing.
The implementation details of QE will be closely scrutinized and the latest reports indicate that three main options are being considered. The first and most straightforward option would be for the ECB to buy government bonds in quantities proportionate to each euro zone member state's shareholding in the central bank. The second option would be for the ECB to stick with buying only AAA-rated government bonds in the hopes that it would inspire investors to then buy riskier sovereign and corporate debt. The third option would empower national central banks to purchase their own bonds at their own risk, a move that might placate Germany's concerns about QE.
How the Greek situation plays out this month may help determine which route QE takes. The latest political crisis in Athens has come down to a snap election on January 25, and has some euro zone leaders up in arms. The leftist opposition Syriza Party, which is leading in the polls, has paid lip service to remaining in the euro zone, while simultaneously bashing austerity measures that have helped the country restore its standing within the common currency zone. Meanwhile newspaper reports say that, even though the refrain during the first Greek crisis in 2010 was that the euro zone is "irreversible," this time around Germany is willing to countenance a Greek exit from the euro. Both positions are likely negotiating tactics. If thrust into power, Syriza's leader may find he has to take a more pragmatic approach to governing that would keep Greece in the euro, while the Germans can't be thrilled about a "Grexit" eroding their goal of "more Europe" and creating a precedent for other peripheral nations to throw in the towel on the euro experiment.
As the polls narrow into the election, the worst outcome might be a stalemate that leads to a second election and keeps Greece in the spotlight. The IMF has temporarily suspended its financial aid to Greece pending the formation of a new government and should that process drag on it could impede ECB plans to start buying sovereign debt as long as it is unclear if the euro zone will have 19 or 18 members going forward.
Words, Words, Words
What's in a word? Going into the last rounds of QE3, Fed watchers waited months for a sign that policy has turned a corner toward rate lift off in 2015. Finally in December, the Fed policy statement substituted the word "patient" for the phrase "considerable time." And that was it. The change was meant to indicate a shift away from a calendar based concept of rate tightening policy (that was assumed to be about six months after the end of QE3), but then the Fed went right on to say that patient is consistent with its considerable time language and explained that patient means no action for at least two more meetings.
This explanation did have the effect of easing concerns about any early action by the Fed as the hawks have been urging. But it opens up a new question for Fed policy regarding how the word patient carries forward. If the January 28 FOMC statement still says the central bank is "patient," then does that signal an all clear for no policy action for an additional two meetings? Indications are yes. It may be the eventual removal of that word that tells us the Fed is ready to act within the next couple of meetings, but the central bank will have to clarify this through future communications.
The FOMC voting rotation will see 2014's two hawkish dissenters, Fisher and Plosser, not only move out of the voting membership of the committee but also step down from the Fed entirely. The new more decidedly dovish slate of FOMC voters should give Yellen the latitude to conduct monetary policy the way she deems fit without putting her feet to the fire on the close calls between action and waiting that may be ahead.
What could cement or even accelerate Fed rate liftoff would be evidence of wage inflation. Payroll gains have averaged above 220 thousand for the last year, but the latest reading hit a four year high at 321 thousand, perhaps portending a breakout. If the US can post more job gains like this it could quickly take unemployment down to its natural level around five to five and a half percent, and more importantly ignite some wage growth, which is one of the missing pieces of a healthy US economy. This will be helped somewhat by 21 states enacting minimum wage increases this year, though for the most part they are modest stepping stones toward the $10.10 minimum wage that the Obama Administration has proposed. Countering that may be the loss of many high paying shale oil jobs in Western states as the fracking industry contends with the precipitous drop in oil prices.
Something is Rotten in the State of...
Analysts continue to debate the impact of lower oil prices on the national and global economies. The majority view is that though the price drop has been unnervingly sudden, it will ultimately be a boon for consumers, acting as a tax cut as pump prices drop.
The counter arguments consist of stability concerns. The drop in energy prices was so fast that it begs these questions: where is the demand, and could it be the sign of a fresh global slowdown that is being masked by the robust US economy? The oil plunge is already affecting high yield bonds linked to energy investments and there are concerns this could spread contagion to other asset classes.
Russia is the poster child for the destabilizing effects of the oil plunge. The double whammy of lower oil prices and western sanctions extinguished growth prospects for Russia, sent the ruble spinning lower, and forced the central bank into a large emergency rate hike.
If President Putin, who has thus far shown his foreign policy can be unpredictable and capricious, feels backed into a corner with no chance of saving face, he may see his best path forward as pursuing the notion of restoring "Novorossiya," a process already started with the seizure of Crimea. The latest actions from the Kremlin naming NATO as Russia's greatest threat and the increasing incidents of Russia military planes violating neighboring airspace don't point to de-escalation any time soon. Lately, however, Russia's foreign ministry has been stepping up its diplomatic profile, volunteering to act as an arbitrator for the conflict in Syria between the Assad regime and rebel groups. This tactic may suggest that President Putin might be looking for an opportune moment to extract himself from the Ukraine conflict in a way that would allow him to claim the mantle of "peace broker" and could lead to destructive sanctions being lifted (while keeping Crimea as his prize).
The oil market's supply side issues begin and end with Saudi Arabia, whose policy has become to use its low production costs to try and force out higher cost competitors while maintaining its own market share. The Saudis haven't made this a secret after strong arming OPEC into maintaining current production targets, the Saudis basically said that it is up to North American producers to deal with the glut in the market. Some gulf oil producers have stated they expected oil to stabilize at around $60/bbl for Brent crude, though they have also made it clear they will leave that determination up to the market, at least for now. A slide toward $40/bbl as some market mavens are squawking about could change the Saudi perspective as even their high margins turn razor thin, and a February meeting with a working group of three other large producers (Mexico, Russia and Venezuela) may be a window for reconsidering production policy.
Creating a wrinkle in this situation are reports that Saudi King Abdullah is in poor health again after a bout with pneumonia. Though the kingdom has a solid succession protocol in place should the 90 year old monarch become incapacitated, a change in leadership can always create some uncertainty, and there is the question of whether Crown Price Salman will stick with the policies of his half brother Abdullah. There is also always the outside chance that a regime change will create an opening for the Arab Spring to finally reach the Arabian Peninsula (the regime helped quell a nascent movement in 2011 by liberally spreading money around).
Suffering the Slings and Arrows
Asian two powerhouse economies have continued to spread their own money around, but stimulus has met with mixed results. Chinese trade flagged during late 2014, as indicated by lower than expected exports in November and negative year over year imports. The Ministry of Commerce let the cat out of the bag when it erroneously published its year end 2014 trade forecast, showing slower than expected growth. Trade officials tried to paper over the mistake by announcing a list of qualitative goals, but the implication is that the PRC might miss its 7.5% GDP forecast for the year.
In contrast, Chinese stocks rocketed higher in the last six weeks of 2014 after the PBOC cut its key rates and regulators opened the Shanghai-Hong Kong connect, providing domestic investors much greater access to the stock market. The latter move was also aimed at luring more foreign capital in China's latest effort to reshape its economy. If the central government ventures more bold reform efforts like this and its year-long crackdown on corruption, the markets may be more forgiving of its fabled growth engine easing back on the throttle.
China will be the first of the major economies to report Q4 GDP results (Jan 19). The report will need to be fairly strong to raise the 7.4% average for the first three quarters of the year by one tenth. A slight miss of the 7.5% target would not be a devastating blow, however, as all signs are that the official forecast for 2015 growth will be stepped down to around 7% at the spring party plenum in March. Growth readings in Q1 may be dampened somewhat by the Chinese New Year on February 19, kicking off the Spring Festival Golden Week, a period when economic activity grinds to a near halt. In light of slower growth, many analysts are expecting Chinese institutions to provide liberal stimulus this year, and one should not discount the chances of another PBOC rate cut as early as in Q1.
In Japan, the springtime tax increase hurt growth more than expected and pushed the economy into a fresh recession. To counteract it, the government just approved a slightly larger than expected $29 billion stimulus package for the next fiscal year that is forecast to boost the GDP by 0.7%, mostly by providing money for local projects.
This may be the make or break year for Abenomics. It provided some early success, and optimism was demonstrated by a revitalized stock market, but the latest data are calling into question whether the three arrows hit their mark. In late January the BOJ will issue new economic predictions, which are increasingly expected to include a cut in price forecasts. If the country cannot beat off deflation and pull out of its present recession even with the additional stimulus being provided, Mr. Abe could quickly end up as just another name on the list of failed Japanese PMs of the 21st century.
The yen may be the best barometer for predicting Japan's near future. So far, the weakening Japanese currency has been a helpful side effect of the implementation of Abenomics, boosting exports. But prosperity through currency debasement can only work for so long, and some analysts are now positing that if the yen moves past the decade low of 123 against the greenback, it could create a panic that would erode confidence in the JGBs that undergird Japan's QE strategy. While this is an outside scenario, it has to be contemplated given the jarring 10% move in the yen during the last quarter.
Methinks She Doth Protest Too Much
For all the hand wringing going on over the present situation it helps to recall how much progress has been made. A global depression was avoided even if at the expense of an extensive stimulus structure that may be difficult to dismantle. Stock markets in the US, Japan, and China had a great 2014, and even European bourses posted modest gains.
The Fed is now contemplating the first move toward reversing the global stimulus apparatus, though it will be tricky with other central banks in the midst of expanding their own accommodation programs. The first part of the year will be full of speculation about whether the Fed will finally start tightening rates mid-year or if global economic headwinds will be strong enough to keep Chair Yellen vacillating about rate policy. Good news as bad news sentiment may arise in the US if the jobs picture continues to improve and wage inflation emerges clearly enough to justify accelerating rate lift off.
It is as yet unclear if US economic strength is a harbinger for the rest of the world or if it will capitulate to the global weakness. The compression in government bond markets argues for the latter. The German government debt curve has compressed so much that yields are now negative up through the 5-year bund, which has bad implications for deflation alarmists, and the US 10-year yield is back below 2%.
The behavior of the forex market may be the best leading indicator for the months ahead. After the recent powerful move in the yen and the scary gyrations in the ruble, greater stability in currency markets would be a blessing. Dollar strength may not end until crude finds a bottom, which means the euro and yen could fall further in the months ahead as BOJ and ECB pump money into QE programs. The stronger dollar will result in lower prices for US imports, which could delay progress toward the Fed's 2% inflation target, and could also take the wind out of US earnings as Q4 results start to come in during January. Along with the fear of deflation, Europe still has growth concerns, but euro weakness will provide a tailwind and along with lower energy prices could get investors more excited about continental markets in the months ahead if they believe QE will instill some new confidence and that Grexit worries will fade.
On the other hand, markets have already baked in expectations that European QE is imminent so more market turmoil could be in store if the new ECB measures are delayed for any reason. For the ECB, the time for jawboning and deliberation is over. Draghi needs to heed the admonition "more matter with less art."
CALENDAR
January
5: Germany CPI
6: US ISM Non-Manufacturing PMI; US Factory Orders
7: Euro Zone CPI Estimate, Euro Zone Unemployment; US Trade Balance; FOMC Minutes
8: Euro Zone Retail Sales; BOE policy decision; China CPI & PPI; China Trade Balance (tentative)
9: UK Manufacturing Production; US Unemployment and Payrolls
12: Japan Current Account
13: China New Loans (tentative); UK CPI & PPI; US Jolts Job Openings
14: ECJ ruling on legality of OMT; Euro Zone Industrial Production; US Advance Retail Sales
15: US PPI
16: US CPI; US Industrial Production; Preliminary University of Michigan Consumer Sentiment
18: China Industrial Production
19: China Q4 GDP; China HSBC Flash Manufacturing PMI
20: Euro Zone Flash Manufacturing PMI; Germany Zew Economic Sentiment; Philadelphia Fed Manufacturing Index;BOJ policy statement
21: UK Claimant Count & Unemployment; BOE Minutes; US Housing Starts & Building Permits
22: ECB policy statement
23: UK Retail Sales; US Existing Home Sales
25: BOJ Minutes; Japan Trade Balance; Greece snap election
26: German Ifo Business Climate
27: UK Prelim Q4 GDP; US Durable Goods Orders; US Consumer Confidence; US New Home Sales
28: FOMC policy statement; Japan Industrial Production; Japan Retail Sales
29: Germany Prelim CPI; Tokyo CPI
30: Euro Zone Flash CPI Estimate; Euro Zone Unemployment; US Advance Q4 GDP; Chicago PMI
31: China Manufacturing PMI
February
1: China HSBC Final Manufacturing PMI
2: US ISM Manufacturing PMI
3: US Factory Orders
4: Euro Zone Retail Sales; ISM Non-Manufacturing PMI
5: BOE policy statement; US Trade Balance
6: UK Trade Balance; US Unemployment & Payrolls
8: Japan Current Account
9: China CPI & PPI; China Trade Balance (tentative)
10: UK Manufacturing Production; US JOLTS Job Openings
11: China New Loans; BOE Inflation Report
12: Euro Zone Industrial Production; US Advance Retail Sales
13: Various EU Prelim Q4 GDP readings; Prelim University of Michigan Confidence
15: Japan Prelim Q4 GDP
16:
17: UK CPI & PPI; German Zew Economic Sentiment; BOJ policy statement
18: UK Claimant Count & Unemployment; BOE minutes; US Housing Starts & Building Permits; US PPI; FOMC minutes; Japan Trade Balance
19: Chinese New Year, start of Golden Week; Euro Zone Flash Q4 GDP; China HSBC Flash Manufacturing PMI
20: Euro Zone Manufacturing PMI
22: BOJ Minutes
23: German Ifo Business Climate; US Existing Homes Sales
24: Euro Zone Final Q4 GDP; Updated EU Forecasts; US Consumer Confidence; Philadelphia Fed Manufacturing Index; G20 meetings begin (tentative)
25: US New Home Sales; Japan Industrial Production; Japan Retail Sales
26: German Prelim CPI; Targeted LTRO announcement; US CPI; Tokyo CPI
27: US Prelim Q4 GDP (2nd reading); Chicago PMI
28: China Manufacturing PMI