UK industrial output slows less than expected in January, but manufacturing and construction activity both shrank more than expected. Data released by the Office for National Statistics showed Friday UK industrial production decreased 0.4 percent in January compared to a 0.9 percent rise in December.
This was the first decrease since October 2016 and was less than expected fall of 0.5 percent. On a yearly basis, growth in industrial output eased to 3.2 percent in January, in line with expectations, and compared to 4.3 percent in December.
Both manufacturing and construction activities shrank more than expected in January. Factory output was down 0.9 percent in the opening month of 2017 against expectations of a 0.4 percent decline, while construction sector output dropped 0.4 percent compared to forecasts of a 0.2 percent fall, according to the Office for National Statistics.
The figures follow a strong end to 2016, and markets were anticipating a pullback. However, there is little evidence of a dramatic slowdown as Brexit talks loom, with the falling pound continuing to underpin exports.
“The data suggest the Bank of England will adopt an increasingly dovish view in coming months, with rhetoric highlighting the downside risks to the economy posed by rising inflation and heightened political uncertainty,” said Chris Williamson, Chief Business Economist, IHS Markit
Cable could see range break-out Stronger US rates and a stronger dollar have pushed Cable down to recent lows at 1.2350. Further dollar strength, plus Brexit news could push Cable to 1.2250. Here the UK’s upper House of Lords could tonight win an amendment on the rights of EU nationals, sending the Brexit bill back to the lower house for further debate. This could delay plans for Article 50 being triggered March 9th .
FX Update- European Politics and the UK
It will be hard for markets to get away from discussing political developments in the Eurozone this year. Friday’s risk off market, driven by what appeared to be shifting probabilities for the French election, is showing just how vulnerable the EURJPY cross has become. The Japanese investor owns 12% of the French OAT market, mostly accumulated in the past 2years. This large asset position is now at risk should volatility in this EUR bond market increase. The Japanese have been net sellers of foreign bonds since the middle of January. While Japanese lifer hedge ratios for EUR assets is generally high (82% in 3Q16), the liquidation pressure and, more importantly, sentiment, will still affect FX markets, we think. The risk of EURJPY falling has increased and so we have chosen to sell as a tactical play for our trade of the week. The next support area is around 119.30.
Markets will watch efforts of the French left combining to bring one of its candidates into the 2nd round. A possible scenario of a 2nd round vote between a hard left and a hard right candidate may increase the chance of the Front National’s Le Pen becoming President. Her agenda to leave the EU and the EUR would require Parliamentary approval and hence represents an unlikely outcome. However,a potential scenario of a hard left or hard right future French President could perhaps reduce Franco-German co-operation which could potentially disrupt EMU for years, leaving the ECB in charge, which might win time by introducing a policy of prolonged period of negative real rates and yields.
The 15 March General Election in the Netherlands could increase jitters further should the outcome point towards increasing populism. Polls over the past week show a tight race, with the PVV party (Geert Wilders) only on a narrow 3-4 point ahead of the VVD party, relative to the 9 point lead seen at the start of the month. Since 8th February,3m implied volatility for EURUSD has diverged from USDCHF, which we think needs to play catch up. The SNB’s sight deposit volumes will be watched again today.
A lot of the anticipated weaker economic data in the UK appears to be in the price for GBP.Friday’s miss on retail sales (0.2%M) showed consumers may have brought forward spending ahead of anticipated price hikes, causing GBP to weaken as markets priced out some probability of a hike by the BoE this year (currently around 3bp). The impact of UK data on GBP goes as far as that. We think that it will be loose global liquidity conditions, increased political uncertainty in the Eurozone, combined with an undervalued GBP which will drive the EURGBP pair lower. The Brexit debate will continue with the FT reporting today on Michel Barnier’s (EU’s Brexit negotiator) proposal that any trade EU-UK talks be denied until progress is made on a EUR60bn exit bill, which could make progress difficult for the UK after they trigger article 50 this quarter. We think however that GBP could be driven higher as global reserve managers start to reallocate into GBP assets.
USD Strength, Employment Growth, Trump
US data continue coming in on the strong side, with yesterday’s NFIB small business optimism index reaching 105.8, well exceeding the 99.5 consensus expectations and accelerating sharply from the 98.4 November reading. Small business is inward looking and with this index rising to its highest level since 2004 it seems that animal spirits have come back to the US economy. Overcoming a balance sheet recession is fundamentally different from dealing with an inventory overhang-caused recession. Notably,a balance sheet recession sees capital expenditure staying weak for longer as corporates react to better demand indications by hiring into their work force instead of adding to their capital stocks. Most DM countries have experienced what we call a ‘monetisation’ of their capital stock,allowing the depreciation of the capital stock to exceed the replacement of investments. This capital stock monetisation allowed corporates to add to their cash flow and provide the foundation to engage in record equity buy-back programs.
At a certain point capital stocks reach a low point which is typically the case when the marginal costs of labour exceed the marginal risk adjusted cost of capital. The labour / capital ratio has increased since Lehman and with underinvestment and employment growth reaching an ever widening gap productivity declines. Surging small business optimism suggests that the US may now finally leave the post Lehman balance sheet consolidation recession behind,adding weight to our call suggesting the USD will rally. It is the US closing its output gap while others,especially AXJ, widening their output gap which suggest investment return differentials working increasingly in favour of the USD. All this happens when there are increasing signs of a international USD shortage as manifested by press reports suggesting Saudi Arabia tapping the USD market in February to cover for domestic fiscal deficits.
Some stumbling blocks for the USD to clear. While the big picture turns increasingly clearer helped by reports such as business optimism, there are still some stumbling blocks for the USD to clear before resuming its rally. The US consumer has sent out mixed signals with the December consumer climate indices as provided by the Conference Board and the University of Michigan showing pre-Lehman readings, but our in-house Alphawise Retail Tracker suggesting a retail dip in December. The US December retail sales report will be released on Friday and with the MS projection way below consensus we wait for the USD to dip before trading the USD aggressively from the long-side again.
Trump will b etalking. Today the focus will be on the content of President-elect Trump’s press conference (16.00 Ldn).From a currency perspective, markets will aim to get a clearer picture on trade, fiscal stimulus and the new administration’s relationship to the Fed. Recent press reports leave the impression that corporate tax reform in conjunction with a border tax adjustment may have a better chance of finding stronger support with the GOP and hence has a better chance of implementation. Should Trump hint at something in this direction the USD is likely to move immediately higher. The USD would rally against commodity currencies as the border adjustment tax may not bode well for global trade.
Trump supporting measures allowing the US to export more energy combined with a border adjustment tax may provide a substantial boost to US energy exploration and production. Consequently, the US, which is currently the globe’s third largest oil producer, could add to global supply. International oil prices would fall. China will listen. China’s Security Times suggested China may seek retaliation should the US erect a trade barrier. Concretely, the paper threatened to “cancel orders from Boeing, disrupt Apple’s supply chain or even impose higher tariffs on imported agricultural products from the U.S.” Hence,any talk about serious trade restriction plans will not bode well for global risk appetite. The USD rally would move from turning a low-yielding currency event towards a high-yielding currency event. Commodity FX should fall most should the designated US President focus on trade. A different market reaction should occur should fiscal policy expansion make the headlines. In this case,a rising USDJPY would be the best game in town.
Brexit Balance Shifting?
The battle over the Brexit timeline is intensifying. Brexit Secretary David Davis is “not really interested” in a deal that would allow a longer period to manage the Brexit adjustment than the 2 years set by Article 50. Chancellor Philip Hammond responded, “there is, I think, an emerging view… among thoughtful politicians” that some form of transitional deal would “run less risk of disruption”. BoE Governor Carney agrees and PM Theresa May has said she is wary of a “cliff edge”. EU lead negotiator Barnier seems open to the idea of extending talks. This reduces the risk of a “hard” Brexit happening in 2019.
The Bank of England’s move to a “neutral” stance on the path of policy, combined with a sharp rise in inflation and economic resilience, has lifted market expectations for a 2017 rate hike. We are looking for inflation to rise above 3% in 2017, but that’s much lower than when CPI peaked above 5% in 2008/11. The BoE “looked through” price rises then and we suspect it’ll do the same now. UK growth risks are a higher priority. Brexit-related uncertainty is leading to big falls in business surveys regarding investment and hiring plans. Taken together with the squeeze on household incomes, lower corporate and consumer spending poses downside risks to growth next year. That’s why we still think a rate cut is much more likely.
ECB, Italian Referandum and Bond Yields
Relief marked yesterday’s session as reports that the ECB stood ready to temporarily step up its purchases of BTPs in the wake of the Italian constitutional referendum. 10yr BTPs tightened by 14bp versus Bunds, outperforming SPGBs by up to 7bp. Note though, that Spain still has auctions scheduled for Thursday while this week’s Italian supply is out of the way. Temporary deviations from the capital key in the country split up of the ECB’s PSPP purchases is not uncommon. Monthly PSPP data shows that the ECB also skewed purchases to the periphery in June this year, when the Brexit vote led to spikes in EGB spreads. We calculate that this additional skew translated into some €0.5bn each for Italy and Spain above their average pace of monthly purchases. The lower weekly purchase figures released on Monday suggests the ECB might have made some room already. More crucially, this reaction function does indicate that the ECB is aware of the important support that QE lends to the periphery. As political uncertainties are unlikely to be resolved with the referendum, we believe that Draghi is unlikely to provide any reason to believe that the ECB is about to reduce its stimulus anytime soon. We stick to the view that an extension of €QE alongside technical adjustments to increase the pool of PSPP eligible assets will be announced at the ECB press conference next week. This should also be supported by yesterday’s German and Spanish inflation data, which do not point to an increase in underlying inflationary pressures in the Eurozone. Yesterday improved risk back drop has helped to push the 10yr Bund yield above 0.20% alongside ASW spreads tightening. The push higher was in part also a spill-over from better than anticipated US data. The next focus here is Friday’s labour market report with today’s ADP release providing a first taste. EGB Supply: Today Germany will tap the OBL 10/21 (€3bn), the penultimate German auction for 2016. The 5yr yield of -0.45% is still above ranges seen before mid-October, but sub depo yields should become PSPP eligible. While ASW levels might seem rich after increasing 10bp in November, the drivers of collateral scarcity remain in place.
Asymmetric yield response to US elections
The risk-on mood that prevailed yesterday belies the uncertainty that is still present in tonight’s US presidential election. We believe that a Clinton win would see 10yr Treasury yields climbing somewhat higher, although we draw a line at 2% – our expectation for the terminal rate for the fed funds rate. To be sure, a major risk-off move in the wake of a Trump victory is likely to drive down the UST 10yr yield by least 25bp.
While 10yr Bunds stuck close to 0.15% amidst low volumes, intra-EMU spreads displayed a notable tightening yesterday. While a tentative risk-on was prevalent, idiosyncratic country stories added to the tightening. The 10yr PGB-Bund spread narrowed by more than 7bp as the Portuguese parliament passed the 2017 budget. Moreover, while still tightening vs Bunds, SPGBs lagged behind BTPs as Moody’s warned that Spain’s minority government was “credit negative” for the country.
In line with last year’s practice, the ECB yesterday announced to suspend QE purchases over Christmas and year-end due to low liquidity. Purchases would be front loaded into the first three weeks of December. However, frontloading is already well underway. Overall ECB QE purchases amounted to €85.4bn in October – €5.4bn over the monthly target. This leaves the ECB with a buffer over the accumulated target amount of €13bn already. The ECB’s latest set of detailed monthly PSPP data revealed that the ECB continues to purchase relatively more in the larger markets to compensate for shortfalls versus country targets in the smaller countries. Still, the Bundesbank was able to shorten the average maturity of its (monthly) purchases to below 11 years which ties in with generally higher yields also at the shorter end of the curve.
Germany will re-open the DBRI 0.1 4/26 for €0.5bn today. Elsewhere, the DSTA will reopen the DSL 0.5 7/26 for a targeted amount of €1.5-2.5bn. This will be the last tap of the year and the final re-opening of this line as the outstanding amount will reach the €15bn target. Despite the richening since end October, the roll versus the DSL 7/25’s at 13bp remains close to the upper end of its historic trading range. This also more or less applies to the pick-up over the DBR 8/26, which, at around 11bp, still offers decent compensation for any liquidity premium that exists versus Bunds. Do note though that the Dutch 10yr benchmark did not trade special in repo yesterday, while the DBR 0 8/26 traded almost 50bp below GC.
The 10yr sector of has shown a clear underperformance on the DSL curve over the past week (yesterday notwithstanding). On the fly versus the 5yr DSL 1/22 and the older DSL 2.5 1/33 line, the to-be-tapped benchmark still looks attractive indeed. This is partly due to the steepening of the 5s10s, but also reflects the 10s15s having lagged behind the steepening of the 10s30s. The possibility of the ECB increasing the issue share limit for non-CAC bonds from the current 33% in December – which could support the 1/33 line – and relaxing the depo rate floor for PSPP purchases – which may support shorter dated lines including the 5yr –could well cheapen the 10yr further on the fly. However, the QEinduced discount for relatively young benchmark lines such as the DSL 7/26 should fade as it reaches its target size. Moreover, the DSTA looks set to re-open older lines including the 1/33 (which has an outstanding size of €12.5bn) next year. In this context, please note that next year’s total DSL issuance is likely to come in close to €40bn, well above the €26bn printed this year
FOMC and Global Bond Yields
The Fed´s second rate hike for this cycle is looming, but the Fed is highly unlikely to pull the trigger tonight, with the presidential elections now in their final week. At most we could see a firmer guidance for a hike in December for which markets are currently discounting a c. 70% probability. In any case, the 16% discounted chance for a move tonight would still have to be priced out at the front-end.
10yr Bund yields continued to hover below their 5-month high of 0.20% yesterday, while Bund volumes remained contained with large parts of Europe off due to All Saints day. Having managed to dodge a broader EGB widening trend amid positive domestic political developments, SPGBs have taken a breather and widened by some 8bp in the 10yr sector versus Bunds. €2.5 to 3.5bn in 5yr, 10yr and 15yr supply are scheduled for tomorrow, which may already call for some concession. Nonetheless, also BTPs have been dragged wider alongside again. Just to highlight how lopsided sentiment has become here: the latest Sentix survey reveals investors now see a greater chance for Italy leaving the EMU than Greece. The 10yr BTP/SPGB spread looks increasingly stretched having widened to 45bp.
TLTRO take-up: Interestingly, the ECB yesterday published the country breakdown of the consolidated financial statement of the Eurosystem for the end of September. The breakdown revealed that banks in Germany and Italy were the main users of the second TLTRO-II (two additional operations are scheduled for December and March 2017). Indeed, LTRO borrowings provided by the Bundesbank and Banca d’Italia jumped, respectively, by €10bn and €14bn in September (Figure 1). Banks in Italy now have almost €190bn in LTRO borrowings. EGB supply today, Germany will tap the 10yr on-the-run DBR 8/26. “Elevated” outright yields, Bund ASWs in the middle of their QE range (if one ignores the episode surrounding the Brexit vote) and the prospect of QE extension should catch the interest. But demand should also be ensured by the fact that the bond has been trading very special in repo over the past few days. Ireland has announced to tap the IRISH 2.4 5/30 for €0.75bn tomorrow.
10 Yr Bunds, Gilts and EFSF re opening pushing European Yields Higher
10yr Bund yields closed at the highest level in four months yesterday (i.e. 0.09%), and broke above the upper end of the -0.10%-0.05% trading range we identified for the coming weeks. Still, with the steepening pressure in EUR swap 10s30s remaining contained, we doubt whether the sell-off has further legs. Indeed, part of the sell-off seems Gilts-driven and due to a one-off reassessment of the UK monetary policy outlook in the wake of hawkish comments by Mark Carney (i.e. “there are limits to the MPC’s willingness to look through a temporary inflation overshoot”). Moreover, the wave of (SSA) issuance hitting the market yesterday, including a €2bn 10yr re-opening by the EFSF, surely also weighed heavily on Bunds. Note that the €1bn 24yr deal printed by Slovenia at MS +90 implied a 5-7bp concession to secondary market levels, though some would argue that it is the new bond that is fairly priced. Stronger-than-expected US macro data accounted for the remaining share of upward yield pressure. Here we need to see whether the upbeat picture painted by the preliminary PMIs will be confirmed in next week’s ISM surveys. All in all, we continue to believe that risk events including the US elections and Italy’s referendum plus speculation about an extension of ECB QE in December will keep a lid on any further sell-off pressures. Interestingly, Reuters reported yesterday that the ECB will almost certainly keep buying bonds beyond March next year and that changes to the capital key, issuer limit and depo rate floor for PSPP purchases were all under consideration. We stick to our view that a combination of increasing the issuer and ISIN limit for non-CAC bonds and relaxing the depo rate floor will be preferred over abandoning the capital key or more exotic options like buying senior bank bonds (although an expansion to bank loans would make a better choice). Tomorrow’s EGB supply. The Italian Tesoro will reopen the BTP 0.35 11/21 (€2.25- 2.75bn) and the BTP 1.25 12/26 (€2-2.5bn). It will also launch a new floater CCTeu 2/24 (€2.75-3.25bn)