The ECB’s reduction of both its main refi rate and deposit rate was anticipated, though some had expected a larger cut than the 10bps announced in respect of both rates. Importantly, Mr Draghi stated that the reduced rates were now at the lower rate bound ie no further rate cuts should be expected. In addition, previous bond purchases under the SMP programme would not be sterilised. A targeted long term financing operation (4 years) amounting to a maximum of E400bn was also announced, though only on the basis that the banks use the funds (which will be lent to banks at a fixed rate of just 10 bps above the refi rate) to lend to the nonfinancial private sector. The longer term LTRO may well be material for EZ economies and the financials. In addition, the ECB is working on a plan to buy asset backed securities (ABS’s). Generally, the announcement exceeded prior expectations and Mr Draghi stated that additional measures could be announced if necessary. The additional liquidity is positive for equity markets, with European markets rising on the news.  In addition, Eurozone (EZ) bond yields, in particular of the peripheral countries, declined. Emerging markets should also benefit from the increased liquidity.

Since its recent low of 2.40%, the US 10 year bond yield has risen to 2.60%. Shorts have capitulated and have had to cover their positions. The higher US yields should be US$ positive (especially as the ECB has cut rates), in particular against the Euro and the Yen. Yields still appear low, especially as the US economy improves and as the FED continues to taper. Furthermore, there are continuing signs that inflationary pressures are building up, though the FED maintains that inflation remains muted.

US markets continue to rise to record highs, with European markets around multi year highs. The increased liquidity provided by the ECB should be positive for risk assets and I expect that equity markets will continue to trend higher.

US
The ISM May manufacturing index came in at 55.4, roughly in line with expectations of a gain to 55 and up from April’s 54.9. The production, new orders and employment components were weaker, though the prices paid component came in higher – yet another data data point suggesting higher prices/increasing inflation.

The ISM May non-manufacturing index came in at a 9 month high of 56.3, better than the 55.5 expected and the 55.2 in April. The business activity component surged to 62.1, from 60.9 in April, the highest reading since February 2011. The prices paid component was higher (61.4, as opposed to 60.8 in April), new orders were better (60.5, as opposed to 58.2) with employment improved (52.4, as opposed to 51.3).

US factory orders increased by a better than expected 0.7% in April. Furthermore, the March numbers were revised higher.

The US trade deficit rose by +6.9% to US$47.2bn in April, the highest in 2 years and above the US$40.8bn expected. The March number was revised higher to US$44.2bn. Exports were -0.2% lower, though imports rose by +1.2%. The higher deficit will act as a drag on Q2 GDP.

The ADP report stated that the private sector created 179k jobs in May, below the 210k expected and the revised 215k in April.
Initial jobless claims came in at 312k, roughly in line with the 310k expected. The less volatile 4 week moving average declined to 310k, the lowest level since June 2007.
May non-farm payrolls increased by 217k, slightly better than the 215k expected. The unemployment rate was unchanged at 6.3%, a near 6 year low. The number employed now exceeds the pre recession peak. Hourly earnings increased by +0.2% M/M, or +2.1% Y/Y. The data suggests that GDP should rebound strongly in Q2, to around 3.0%+.

The FED’s Beige book reported that economic growth increased in all 12 districts. Growth was described as “moderate” or “modest”, with employment conditions improving and consumer spending increasing across almost all districts. Interestingly, the report stated that price pressures were “subdued”, though recent data suggests that prices are increasing.

Europe
The ECB cut both its main refi rate and deposit rate by 10 bps to 0.15% and a negative -0.10% respectively. In addition, it reduced its emergency overnight lending rate by 35 bps to 0.40%. It is the 1st time that a major central bank has introduced negative deposit rates. Inflation forecasts have been reduced to just +0.7% for this year (previously +1.0%), +1.1% next and +1.4% for 2016. The GDP forecast, for the current year was reduced to +1.0%, though increased to +1.7% for 2015, with 2016 remaining the same at +1.8%. Mr Draghi announced that there was unanimous agreement on the package, which included cheap long term LTRO’s, stopping the sterilisation of previous bond purchases and possibly an asset purchase programme involving ABS’s .

The final EZ May manufacturing PMI came in at 52.2, lower than the 53.4 in April and the preliminary reading of 52.5. The German and Italian data came in weaker than the initial estimates, whilst Spanish data was revised higher. France was revised higher, though remains in contraction territory.

EZ May inflation declined to +0.5% Y/Y, below April’s +0.7% and the +0.6% expected. Core inflation declined to +0.7%, from +1.0%, suggesting that energy prices are not the main reason for the decline. Food, drink and services prices were lower. German inflation fell sharply to just +0.6%, from +1.1% in April and well below the +1.0% expected. EZ April PPI came in at -0.1%, in line with expectations and as opposed to -0.2% in March.

The EZ final Q1 GDP was confirmed at +0.2%, down the +0.3% in Q4 last year.
The EZ final May services PMI was revised lower to 53.2, from the initial reading of 53.5. Germany and France were revised marginally lower, with Italy marginally higher. Spanish May services PMI came in at 55.7, lower than the 56.1 expected and 56.5 in April.  The composite PMI was also revised lower to 53.5, from 53.9 previously.

EZ April retail sales increased by +0.4%, better than the unchanged level expected and the downwardly revised increase of +0.1% in March.

German factory orders increased by +3.1% M/M in April, well above the rise of +1.4% expected and much better than the decline of -2.8% in March. Export orders rose by +5.5%, with domestic orders unchanged.
Industrial output increased by +0.2% in April M/M, lower than the rise of +0.4% expected.
Whilst the Bundesbank expects growth to slow materially in Q2, it has raised its 2014 GDP forecast to +1.9%, from +1.7% previously.

UK May services PMI came in at 58.6, above the forecast of 58.2, though marginally lower than April’s 58.7. Importantly, the employment component rose to the highest level since May 1997. The composite PMI came in at 59.0, above the reading of 58.7 expected, though slightly below the 59.2 in April. GDP is expected to increase by +0.8% this Q.

As expected,the BoE kept its interest rates unchanged at 0.5%.

Japan
The Japanese Government Pension Investment Fund (GPIF) is likely to change its asset allocation model, away from its traditional policy of holding predominantly Japanese government bonds. An announcement is expected this August. In particular, the GPIF is expected to increase its holdings of foreign investments (both bonds and equities) and Japanese stocks. The likely changes should support Japanese equity markets and could well weaken the Yen.

China
Chinese manufacturing PMI rose to 50.8 in May, the fastest rate in 5 months, above the reading of 50.4 in April and the forecast of 50.7. Most of the subindexes came in higher, with the exception of employment, which was marginally lower at 48.2, as compared with 48.3 in April. The governments mini stimulus programme has helped. However, the property sector remains a serious problem, as does the level of unrecognised bad debts in the financial sector. The HSBC final May manufacturing PMI came in at 49.4, lower than the 49.7 reported initially. The export component rose to a 4 year high, though the components relating to domestic demand and employment were weak. Whilst reluctant to do so, given the problems arising out of the massive stimulus program a few years earlier, it is likely that the government will have to increase the size of its current mini stimulus programme, with the Central Bank, the PBoC continuing to relax monetary policy. The PBoC continues to inject funds into the banking system. The Yuan looks set to weaken further.
The official services PMI reading came in at 55.5 in May, a 6 month high.

Other
Australian Q1 GDP rose by +1.1% Q/Q (+3.5% Y/Y), higher than the increase of +0.9% expected and the fastest growth in 2 years. Exports increased by +4.8% from the previous Q, the most since 1999. However, the economy, in particular the mining sector, is susceptible to a slowdown in China and recent data suggests that the economy has slowed in Q2. It posted a trade deficit of A$122mn in April, as compared with a surplus of A$510 expected. Exports were -1.0% lower, with imports +2.0% higher.
As expected, the RBA left interest rates unchanged at 2.5%, repeating that they saw a period of interest rate stability.

Kiron Sarkar
7th June 2014

Category: Markets, Think Tank

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