Throughout the last few months, we have identified three forces that are shaping the investment climate: the economic and monetary divergence that favors the U.S., the decline in commodity prices, and a slowing of China. These forces remain very much intact, and if anything, have strengthened and reinforcing each other.
The unexpected upward revision to Q3 US GDP is likely to be matched by a downgrade in Q3 eurozone GDP (to 0.1% from 0.2%) in the week ahead. The slowdown in China, coupled with falling house prices, rising bad loans, and low inflation prompted the PBOC to deliver its first rate cut in a couple of years, and is spurring speculation of a cut in the required reserve ratio in the coming weeks.
There are two ways that the precipitous decline in energy prices and commodity prices more broadly, will impact the world economy. U.S. policy makers will likely emphasize the spur to growth. The IMF, for example, estimates that a $10 fall in oil prices boosts world growth by 0.2%. The decline in gasoline prices can be expected to boost discretionary spending by American households, who have largely forsworn the use of revolving credit (credit cards) during this expansion cycle.
On the other hand, European and Japanese officials will find in the decline in energy prices an additional obstacle in their mission to arrest the disinflation or deflationary forces. Under Trichet, the ECB failed to look past the increase in oil prices in 2008, and hiked interest rates on the eve of a great economic downturn from which is has not yet escaped. It is likely to repeat that from the opposite direction now. It is likely to see the deflationary impact of the drop in energy prices rather than enhancing growth prospects.
The ECB meeting is one of four major central banks that meet in the week ahead (Australia, Canada, and UK central banks meet as well). It is the only one that could do something. Some believe that the Draghi and Constancio have expressed a sense of urgency that is consistent with announcing a sovereign bond purchase program at this week’s meeting. We are less sanguine.
Moreover, we do not think that sovereign bonds are the next asset that the ECB will purchase. We think the supra-national bonds have much to commend themselves. The ECB is already buying covered bank bonds, and with the Asset Quality Review and stress tests behind us, a case can be made for uncovered bank bonds. The idea of buying corporate bonds has also been floated.
There is scope for some disappointment if our assessment of the ECB is correct and now sovereign bond purchase scheme is unveiled. The euro could bounce and peripheral bonds may see some profit-taking after ten -year yields have fallen to record lows. However, the forward guidance, and specifically the promise to do more if needed (to expand its balance sheet), which appears to have unanimous support, may prevent a significant reversal. January or February may be a more likely time frame for more action. The second TLTRO (expected take down 120-150 bln euros) on December 11, and the progress on the covered bond and ABS purchases will likely confirm that a wider range of assets need to be purchased if the ECB is going to meet is balance sheet goal. In addition, pay down of the outstanding LTROs may weigh on the balance sheet, even if some is replaced by other refi facilities.
