The Eurozone Consumer Price Index registered an increase of 1.8% year-over-year in January versus December’s reading of 1.1%. This means the ECB’s inflation target mandate of “close but below 2%” has effectively been satisfied at least a year earlier than intended.
Next comes a series of goal post moving exercises. Policy makers and central bankers in Europe desire continued stimulus pumping to help limp past the banking crisis in Italy, the ongoing debt crisis in Greece, and significant political risk posed by elections in France, Germany, and the Netherlands.
Expect central planners in Europe to disregard the steepening inflation trend for as long as possible. Public discourse will gravitate toward new arguments downplaying headline CPI. These will include shifting focus to core CPI, blaming transitory effects from higher energy prices, highlighting unfavorable base effect comparisons from the prior year, and potentially even fears of trade barriers constraining future global growth. The ECB will get further behind the curve to the chagrin of Germany. Bullish pressure will continue to boil hotter for the euro currency unless politics get in the way.
Mario Draghi is one of the better communicators in modern central banking. Everything he conveyed during the ECB’s 19th of January press conference was intentional. Each time he was presented with questions about whether the ECB should consider winding down its bond buying program faster in light of strengthening economic and inflation data he repeatedly stated, “it wasn’t discussed.” The last thing the native Italian central bank chief wants is a market eager to front run an accelerated QE taper, causing an unstable spike in Eurozone bond yields and in the value of the euro. Any tiny crumb of hope tossed to the hawks risks massive market repercussions similar to the Bernanke-inspired taper tantrum of 2013. Maintaining ultra loose monetary policy risks a rubber band snap back toward tightening the instant the tension is relieved.
ECB’s Nowotny took the prevailing dovish tone a step further today by saying the ECB won’t discuss tapering at the March meeting either. Euro currency pairs quickly dropped 50 pips. But the move was short lived. The euro boomeranged right back up and then some. It is proving difficult at the moment to sustain EUR/USD below 1.07 without a new politically inspired catalyst. So what happened? Why are dovish ECB comments from officials either not effective or even counterproductive in the sense they are actually boosting the euro?
The ECB is undoubtedly behind the curve in tightening monetary policy. Markets know it. Inflation is sharply advancing higher in Germany to the point where it has been front and center headline news in the newspapers. Germany may be known for outsized fears of inflation but this time it is correct to have such views. Wholesale inflation (PPI) is gapping higher at an even faster rate in global regions which typically lead the others – China to name a big one.
If you believe as I do that the ECB is behind the curve in tightening monetary policy then you’d also believe digging in with continued dovishness puts it even further behind the curve. As long as you think the ECB has enough credibility to eventually catch up in the tightening cycle then the more dovish it is now, the faster it will have to tighten later to catch up. Dovish statements and actions will only strengthen the euro at this point because it raises the bar for how fast the ECB will need to tighten later. The only issue waiting in the wings with the potential to drag down the euro in a big way is anti-EU political risk. Consider monetary policy jawboning to be rendered ineffective or even counterproductive from here on out in inflicting losses to the single market currency. ECB dovishness will only boost the euro further.
If you must limit yourself to only two macro risks worthy of flaring up your insomnia they are these:
1.) Trade war contagion – Globalization and open borders are going out of style in mainstream developed market politics. Fast. In theory, trade reform can be targeted to narrow trade deficits, increase wages for the middle class, and make every developed country great again. In reality, there are tremendous risks of unintended consequences shaking the foundation of modern global economies. Modern economies function with tightly intertwined international supply chains. What would happen if every US import from Mexico, China, or even Germany rose in price by 15-20% at the stroke of a legislative pen? Would it really stop there? Would it not spark a wave of race-to-the-bottom retaliations, currency devaluations, and nasty inflation eroding real incomes across the board? This is the top known economic and market risk as 2017 swings into gear. Pay attention to statements of pre-retaliation by public officials in trade-dominated economies.
2.) China’s currency reserves burn rate – China is burning through reserves at an alarming rate to prop up the yuan rather than suppressing it for competitive purposes as commonly alluded to by US President Trump. It has depleted more than 25% of its currency reserves in the past 1 1/2 years. It may only have another 6-18 months left before it is forced into a massive yuan devaluation of at least 15% to stop the bleeding. This would increase pressure on other Asian economies to also devalue their currencies, inflict trauma on US exporters and multinationals, compound default risk for dollar-denominated debtors, and destabilize financial markets. Imagine the turbulence seen in August of 2015 multiplied by at least 10; then tack on second-round effect multipliers. It is certainly worthy of being on the top macro risk short list.
Honorable mention goes to political election risk in the Eurozone this year. This will be a topic covered in more detail on this site in the future.
This is the first post on the site and hopefully you tune in for the other 99.99% of posts still to come! Let’s dig right in…
US GDP in 2016 registered a paltry 1.6%. The annualized rate in Q4 was only slightly better at 1.9% vs. expectations of 2.2%. It is clear economic growth in the USA was fairly meager and underwhelmed expectations. Here is why it doesn’t matter all that much: with the huge political changing of the guard that just occurred last week markets are focused on what will happen in the future given the sizable uncertainty surrounding Trump-onomics. The same goes for the U.K. Markets are overlooking much of the recent resilient economic data out of the U.K. and wondering more so what a post-Brexit world might look like for a British economy not part of the European Union.
Politics are the driving force in markets right now. Keep your eye on the impact of Trump Administration policy proposals and Brexit negotiation news and commentary. The dollar will live and die on the battle field of bullish tax cuts/regulation reductions/infrastructure stimulus vs. bearish trade barriers and even physical barriers in the case of “THE wall.” Pound sterling will live and die on the battle field of a bullish soft Brexit vs. a bearish hard Brexit.