ECB, Global Curves and China Inflation
Yesterday’s ECB action and today’s release of China’s November inflation data have provided another shot into the arm of the global reflation trade, pushing the USD higher. However, the 10-year US bond yield has not yet breached their previous 2.45% high and with global debt market momentum and option market related indicators at levels which in jargon puts it into ‘oversold’ territory, we suggest caution. We like seeing the USD correcting its vibrant rally seen since September before breaking higher. The EUR may be the exception to this rule. EUR positioning in light of yesterday’s ECB decision ticked all the boxes suggesting the EUR coming under prolonged selling pressure for EURUSD but also EUR crosses. With the ECB adding another EUR 540bln via its 9 month program extension, the SNB will find itself within an even more difficult position to reduce CHF appreciation pressure.
China’s November inflation data have exceeded expectations. Its CPI increased from 2.1% to 2.3%, but the biggest jump has been recorded by the PPI. The PPI accelerated from 1.2%Y to 3.3%Y, increasing by 1.5%M in November alone. Global reflation is the current dominant market theme pushing nominal bond yields higher, curves into a steeper position, but with inflation expectations inspired by rising headline inflation rates, real yield expectations have remained muted allowing risk appetite to stay strong. Today markets should follow this line exactly. With equity markets breaking higher, higher yielding EM should remain supported. Only when US real yields start to rise again in earnest, which we see not before the Fed accelerates its pace of hiking rates, high yield EM will come under renewed selling pressure.
Local, not global reflation. Markets trade on impressions, which can divert from reality. Global reflation is an impression, but not reality. Reality is local reflation. It is about rising inflation pressures within economic areas seeing their output gaps closed. The US belongs in this category, but China – despite today’s bullish inflation prints – does not. China’s falling capacity utlilisation rate is inconsistent with rising inflation. Indeed, when stripping out the impact of higher commodity prices, China’s inflation rate looks as lack lustre as it did last year. The message is clear. Local reflation within a world of global output gap differentials should lead to central bank policy divergence. It will be FX which will turn into the preferred asset class for trading this divergence. For now investors seem instead focused on bond markets, trading within the medium term towards higher bond yields.
ECB ticking relevant boxes. The ECB’s policy announcement dealt with all market relevant topics. Prolonging the QE program and staying flexible on the QE amount should keep peripheral bond spreads within desired ranges. The scarcity issue was addressed by allowing local central banks to move below the two-year sector and buy bonds below the deposit rate. Via this measure the ECB has increased the pool of eligible bonds while avoiding a large increase in German 2-year yields. Before the ECB’s policy announcement, markets assumed that reduced scarcity would lead to higher front end yields. This is why markets went long positioned into the meeting. Yesterday’s decline in short-term yields and the consequent steepening of the curve was a textbook-like operation to weaken the EUR.
Steep curve policy. Finally, central banks seem to understand that curve flatness does not deliver positive economic results. For too long, policy markets were trapped by the idea of low long-term interest rates helping to inspire investment spending. We make the differentiation between cost of capital and availability of capital. When yield curves are pushed into ‘exhaustion’, that is when curves are flat and nominal yields are near zero, commercial banks tend to operate cautiously, reducing the money multiplier. Here central bank liquidity cannot convert into high powered liquidity. This was why the EUR has been trading sideways since March 2015. The money multiplier not increasing enough to compensate for the general consolidation of Eurozone bank balance sheets has prevented the EUR from declining. This is now going to change.
Banks and capital exports. EUR trades should not only have an eye on rates and yield differentials. Bank share price performance is important too. In mid September, we made a similar statement in respect of the JPY, arguing how steeper yield curves support bank profitability, increase lending and borrowing, ultimately leading to capital exports. Since then the JPY has lost 14%. Now the ECB seems to have learnt from the BoJ, by creating conditions supporting bank profitability and implicitly the money multiplier. Yesterday saw EMU’s bank share prices outperformed , rising 2.7% against more moderate index gains. Bank shares closing the valuation gap to book value tell us that balance sheet consolidation pressure within this sector may ease, opening the door for exports of EUR denominated capital.