Draghi's turn in the spotlight

Chris Scicluna

With US markets having failed to provide guidance yesterday (the S&P500 closed little changed on the day), the major Asian equity indices have been mixed today. Weakest of all have been markets in Japan, where the Topix closed down 0.7% weighed among other things by a modest strengthening of the yen (back to 108.3/$), a deterioration to a 2½-year low in manufacturing sentiment (see below), and comments from Governor Kuroda flagging “the strong downside risks regarding the Sino-US trade friction and China’s economy” ahead of the BoJ’s two-day policy meeting starting tomorrow. China’s stock markets, however, saw modest gains (CSI300 up 0.35%), while the Hang Seng is currently up a little more than 1%. And Aussie stocks and ACGBs made gains (ASX up about ½% and 2Y yields back down to 1.00%), while the AUD fell below 68.40/$ to its weakest level in about a decade (notwithstanding January’s flash-crash) after the minutes of the RBA’s latest policy meeting stated explicitly that it was “more likely than not” that the cash rate would be cut further.

Ahead of tomorrow’s key Fed announcements, meanwhile, USTs made modest gains in Asian time, with 10Y yields down a couple of bps to 2.07%. In Europe too, government bonds are firmer ahead of Mario Draghi’s speech to the ECB’s Sintra Policy Forum, due shortly, which is expected to bring further dovish commentary. Nevertheless, euro area equities have opened lower across the board.

Today’s Reuters Tankan gave a first glimpse of business conditions in June and also provided a hint of what to expect from the BoJ’s comprehensive Tankan when it’s published at the start of next month. And, unfortunately, the survey was decidedly downbeat, adding to evidence of a weak second quarter for Japan’s economy and tallying with today’s remarks from BoJ Governor Kuroda that there persist significant downside risks from external demand, not least related to China.

In particular, the survey’s index of conditions in manufacturing fell 6pts – the most in more than a year – to 6, the lowest since September 2016. While the survey forecast index of manufacturing sector confidence three months ahead wasn’t quite so bad, it still fell 4pts to 11, matching the lowest since end-2016. Within the detail of the manufacturing survey, there was a significant deterioration in conditions reported by general machinery producers, with the respective index down 10pts to 6, similarly the lowest more than two years. And conditions among autos firms dropped even more sharply, down almost 30pts into negative territory for the first time in almost three years.

The survey’s index of conditions amongst non-manufacturers weakened too, down 5pts to 22 to match the bottom of the range of the past 2½ years. Likewise the survey’s forecast for conditions among non-manufacturers three months ahead also fell 5pts, to 21, just 1pt above the recent low, to suggest little optimism that demand brought forward ahead of October’s consumption tax hike will provide much of a boost. Indeed, the detail suggested that conditions among wholesalers deteriorated markedly, with the relevant index down a sharp 19pts to zero, even as the equivalent index for retailers rose 9pts to 13, its highest since January. The survey measure of conditions in real estate and construction, meanwhile, fell 9pts to 19, close to the bottom of the range of the past five years.

Euro area:
Following dovish comments published yesterday from ECB policymakers Benoît Cœuré and Pablo Hernández de Cos, Mario Draghi’s speech to the Sintra Forum, which will kick off shortly, is widely expected to be dovish, flagging concerns about the ongoing slide in financial market measures of inflation expectations and restating the readiness of the ECB to take further action if and when the downside risks to the economic outlook crystallise. Whether or not Draghi specifies in more detail precisely how the ECB would be willing to respond to different scenarios, whether by means of a further rate cut (with or without tiering) or a restarting of QE (presumably with an increase in the self-imposed issue and issuer limits) remains to be seen.

Data-wise, meanwhile, today’s releases will offer little cheer. While yesterday’s labour cost data showed a further rise in wage growth to a six-year high, today’s final inflation release for May is likely to confirm that underlying price pressures remain highly subdued in line with the preliminary estimates. So, the headline CPI rate will come in down 0.5ppt from April to 1.2%YY, a thirteen-month low, with core inflation also down 0.5ppt to just 0.8%Y/Y, less than half the ECB’s target.

Euro area trade data for April are also due today and seem likely to suggest a poor start to Q2 for exporters. In particular, the trade surplus on an adjusted basis is likely to have narrowed to its lowest level so far this year not least due to a sharp drop in exports to the UK as precautionary Brexit-related stockpiling came to an end. Finally, having fared better in April, and despite strong growth in Germany (9.1%Y/Y0, car sales had a disappointing May, with new car registrations data this morning showing a drop of 1.7%Y/Y, leaving them down 2.0% on a year-to-date basis.

Today should be a quiet day for economic news from the UK with no top-tier data due. However, the second round of the Conservative Party leadership election will take place this afternoon, with a second televised debate among the remaining candidates – for the first time to include the populist Brexiteer Boris Johnson – to follow this evening. While major question marks hang over his integrity due to several past ignominious events, last Thursday’s first-round vote suggested that Johnson already has sufficient support to qualify later this week as one of the pair of candidates to be put forward for the final vote among party members. And nothing that has happened since then has dented his status as clear favourite to become the next Prime Minister. Today’s second-round ballot will see the elimination from the contest of whichever of the six candidates comes bottom, as well as any other that fails to win a minimum of 33 votes from MPs.

The RBA’s minutes of its June policy meeting strongly validated market expectations of future policy easing. Most notably, Board members concluded that “it was more likely than not that a further easing in monetary policy would be appropriate in the period ahead” with a detailed discussion of the labour market key in that respect. And they added that “lower interest rates were not the only policy option available”, seemingly a nod to Deputy Governor Debelle’s assertion at the end of last year that the RBA could also at some point seek recourse to QE, something that could become necessary if downside risks to the outlook crystallise if and when the Bank runs out of room on rates.

Most notably, with the Bank’s estimate of the unemployment rate consistent with stable inflation having been revised down to about 4½% (compared to a latest reading of 5.2%) and labour participation up to a new all-time high, members revised up their assessment of spare capacity in the labour market, acknowledging that that “there was now more capacity for the labour market to absorb additional labour demand before inflation concerns would emerge”. At the same time, they also noted that “forward-looking indicators of labour demand pointed to a moderation in employment growth in the near term, merely to around the rate of growth in the working-age population”, suggesting that sizeable spare capacity will persist for some time. And as the housing market adjustment continues and inflation remains weaker than the RBA expected, with underlying inflation just 1½% in Q1 still firmly below the 2-3% target range, the case for further easing looks strong.

Ahead of tomorrow’s pivotal FOMC announcements, May housing starts and permits data are due today. A third consecutive month of growth, albeit relatively modest, is expected, with an increase in the single-family component perhaps offsetting weakness in the multi-family sector.


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