Will Draghi go out with a bang or a whimper?

Chris Scicluna
Emily Nicol

With Donald Trump having tweeted that, “as a gesture of goodwill”, he will postpone the 5ppt increase in US tariffs on $250bn of Chinese goods by a fortnight to 15 October, by and large the major Asian stock markets remained in positive mood today. Despite a decidedly mixed bag of Japanese economic data (detail below) and a further weakening of the yen (briefly through 108/$), the Topix ended the day up 0.7% even after slipping back towards the close. China’s CSI300 closed up 1.1%.

In the bond markets, however, an early increase in UST yields earlier in the session was subsequently reversed, with 10Y yields currently back at 1.72%, close to the middle of yesterday’s range. JGBs were a touch firmer, with 10Y yields close to -0.22%. And ahead of today’s all-important ECB policy announcement, euro area govvies have opened higher (10Y Bund yields down 1.5bps to close to -0.58%, and 10Y BTP yields down a little more than that, to below 0.95%). Significant shifts are well within the bounds of possibility later today depending particularly on whether the ECB launches a new QE programme, and if so, how big that package of asset purchases will be. And the extent of any rate cut, as well as the share of excess reserves exempted from the negative rate via any new tiering framework, will also be key for the shorter end of the curve. (Our view on what to expect is repeated below).

Finally, Gilts are also slightly firmer (10Y yields down 1bp to close to 0.625%) too while sterling is broadly stable as the Brexit stench becomes ever more pungent. After Scotland’s highest court yesterday judged the Prime Minister’s advice to the Queen and the prorogation of Parliament to be unlawful, the risk of a constitutional crisis continues to rise ahead of a crucial decision next week by the UK’s supreme court. And the publication late yesterday of a summary of the Government’s own dire assessment of the impact of a no-deal Brexit gave a mere taste of the devastating impact that outcome would have on the UK economy. While the anti-no-deal legislation given royal assent at the start of the week significantly reduces the probability of such an event at end-October, the probability of it occurring at a later date – particularly after a new general election – is certainly non-negligible.

There were several top-teier economic releases out of Japan overnight. While the latest activity-related data for July came in slightly ahead of expectations, a September survey further highlighted the downside risks ahead while August inflation figures fell short of expectations.

The total value of machine orders in July was effectively unchanged from June, rising just 0.1%M/M, as a rebound in government orders (up 11.0%M/M) negated a decline in orders from the private sector (down 6.5%M/M) and abroad (down 6.0%M/M). The closely-watched measure of core private sector orders, which excludes orders for ships and those from electric power companies, and can provide a useful guide to domestic business investment roughly three months ahead, fell 6.6%M/M. That decline was smaller than expected, and followed a surge the prior month, of 13.9%M/M, a series high. So, while it left the level of core private orders up just 0.3%Y/Y and about 1.0% below the Q2 average, it suggests that the Cabinet Office survey forecast of a decline of 6.1%Q/Q in Q3 might well prove overly downbeat. Nevertheless, overall, the data suggest that a likely rise in business capex over Q3 ahead of October’s consumption tax hike will be followed by an inevitable decline in Q4.

Within the detail, domestic orders from manufacturers were up for the first month in three, with a relatively broad-based rise of 5.4%M/M taking the level 1.5% above the Q2 average. However, following an extraordinary 30.5%M/M surge in June flattered by one-offs from the transportation and postal sector, core orders from non-manufacturers inevitably recoiled in July, dropping 15.6%M/M to move almost 3.0% below the Q2 average. That weak headline figure, however, masked a significant (likely temporary) pickup in orders from construction and wholesale/retail trade. Meanwhile, reflecting the weakening global investment environment, the decline in orders from abroad left the level more than 2.0% below the Q2 average, suggesting that – contrary to the Cabinet Office’s survey – a third consecutive quarterly decline in Q3 is well within the bounds of possibility. Orders from government were still down on the Q2 average too. But we would fully expect a rebound over the remainder of the quarter in this category, even if its growth falls short of the near-20%Q/Q survey forecast.

Meanwhile, in contrast to an anticipated further fall at the start of Q3, tertiary activity rose for the first month in three in July (0.1%M/M), to leave activity 1.5% higher than a year earlier, the strongest annual rate since January. But the detail of the report was mixed. The improvement principally reflected an increase in the wholesale trade sector (1.6%M/M) and the admittedly volatile finance and insurance sector (1.5%M/M). However, retail activity fell for the third consecutive month and by a steeper 1.5%M/M, taking the level of output in the sector to the lowest since early 2016. And with the Reuters Tankan having signalled that retailers were significantly more downbeat about conditions in August – the relevant index fell to a 21-month low – a sudden lasting turnaround in activity in the sector seems unlikely even if the approaching consumption tax hike temporarily brings forward some spending.

Indeed, no doubt due to the imminent tax hike, September’s Reuters Tankan survey, published today, was somewhat more upbeat about retailing conditions this month, with the diffusion index rising 15pts on the month to +10. As such, despite a further notable deterioration in conditions reported by construction firms (the relevant index fell 7pts to +20), the headline non-manufacturing DI increased 6pts from the near-three-year low hit in August to +19. But this was still considerably weaker than the level at the start of this year. And on average over the third quarter as a whole, the index was the weakest since 2016. Moreover, reflecting the anticipated decline in domestic demand after next month’s tax hike, firms were predictably more downbeat about the outlook over the coming three months, with the headline non-manufacturing DI forecast to fall to its lowest since 2012.

But with the external environment still challenging, today’s Tankan survey also suggested that, in contrast to non-manufacturers, large manufacturers were even more pessimistic in September, with the headline DI falling 3pts to -7, the lowest for 6½ years. And the forecast index similarly implied a further modest deterioration over the coming three months too. This survey often provides a good guide to the more comprehensive BoJ’s Tankan (due 1 October). As such, we expect to see a further notable drop in the headline manufacturing index to its lowest since 2013, while the non-manufacturing index might well fall to its lowest since the post-2014 tax hike.

With respect to inflation, the latest goods producer price data provided further evidence of disinflationary pressures down the pipeline. Indeed, with producer prices down for the third month out of the past four in August, the annual headline PPI rate fell further into negative territory, down 0.3ppt to -0.9%Y/Y the largest such drop since 2016. And while the yen has recently depreciated, the impact of previous yen strengthening was again evident – indeed, import prices in yen terms were down more than 8%Y/Y for the second successive month, while the annual decline in contract currency terms moderated slightly to 5.2%Y/Y.

Within the detail, the largest price decline came from petroleum and coal products (-9.9%Y/Y), while prices in the chemicals sector (-4.7%Y/Y) were once again down too. Given the significant declines in the price of raw materials and intermediate goods, there was further downward pressure on final corporate prices for consumer goods too, with annual inflation on this measure falling further into negative territory in August at -2.1%Y/Y, the lowest since 2016. And while prices of imported items were down a hefty 5.5%Y/Y, there was a further weakening in domestic inflationary pressures too.

Euro area:
Of course, most attention today will be on the latest announcements from the ECB, which seem bound to include the unveiling of new stimulus measures. The precise measures which the Governing Council will agree, however, are highly uncertain. We currently anticipate a package along the following lines:

I. A cut of 20bps in the deposit rate, to -0.60%, a larger reduction than is currently priced in to the market. The ECB will also revise its forward guidance to make clear that interest rates could be cut further still, and will not be hiked for a long time to come, at least until the inflation outlook significantly improves.

II. A new tiering framework for reserve remuneration to mitigate possible adverse side-effects on the banking sector from the negative deposit rate. But how this might work in practice is highly uncertain. We suspect that the Governing Council will prefer a system which excludes from the negative rate only a relatively small share of excess reserves (as is the case in Denmark or Switzerland, for example) rather than one which excludes a large share (as is the case in Japan), and as such might have a relatively limited initial market impact.

III. A new QE programme, to demonstrate the ECB’s willingness to try whatever it takes to achieve its inflation target, and as a full policy package combining rate cuts and net asset purchases should be considered more effective in boosting inflation than a sequence of selective actions. This policy decision will not be unanimous. But the hawkish members who did not favour the ECB’s original QE programme (i.e. Weidmann, Lautenschläger and Knot) are again likely to be in a minority. In particular, we expect ECB Chief Economist Lane (and Draghi) to persuade a majority of members to back a new programme of net asset purchases of about €30bn per month lasting through to end-June 2020. This will also require a decision to increase the ECB’s self-imposed issue and issuer limits, from 33% to 50%.

To justify the new policy package, the ECB will cite its updated economic forecasts, which we expect to revise down the outlooks for euro area GDP growth and inflation over the projection horizon. Indeed, we suspect that the key forecast for inflation at the end of the horizon, in 2021, will be revised down to 1.5%Y/Y, well below target. Draghi will also continue to emphasise the downward skew in the balance of risks to the outlook. And with market- and survey-based inflation expectations recently having fallen to record lows, he will emphasise the need to act to counter concerns about the ECB’s lack of credibility.

Today will also bring euro area IP figures for July. With output in the four largest member states having slipped back at the start of Q3, we expect the euro area figures to report a decline in production (excluding construction) of at least ½%M/M.

This morning has also brought final August inflation figures from Germany and France. There were no surprises from the German release, which saw the headline EU-harmonised rate confirm the 0.1ppt drop reported in the flash estimate to 1.0%Y/Y, the lowest since November 2016. But while the equivalent French figure was revised higher from the flash release by 0.1ppt to 1.3%Y/Y (leaving it unchanged from July) this was merely cosmetic – to two decimal places the annual rate was nudged only 0.01ppt higher to 1.26%Y/Y. As such, notwithstanding any significant surprises to the Italian (due Monday) and Spanish (due tomorrow) figures, final euro area inflation data are likely to confirm that the headline CPI rate moved sideways in August at 1.0%Y/Y.

The data highlight from the US today will be CPI figures for August. Lower energy prices are likely to keep headline CPI constrained, with a 0.1%M/M increase set to leave the annual rate unchanged at 1.7%Y/Y. But core inflation is expected to have ticked slightly higher, by 0.1ppt to 2.3%Y/Y, which would be the highest for thirteen months. This afternoon will also see the release of the Federal monthly budget statement and weekly jobless claims numbers, while the Treasury will sell 30Y notes.

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