Monthly survey data show that economic activity growth remains robust at the beginning of 2018.....
However, the more mature phase of the cycle also implies greater volatility on the markets: after the forex market, rate curves are also proving more volatile.
The FOMC meeting consolidates expectations for a Fed rate hike.
In Europe, despite the strong euro, the inflation trend is causing increasing concern.
Political risk is no longer in vogue: the opening of the election campaign in Italy has not prevented a further reduction of the risk premium.
- The global economy is still in good health in the opening weeks of 2018. January PMI surveys outlined a marginal drop in the global manufacturing index, from 54.5 to 54.4, but this a level almost one standard deviation higher than the long-term average. These PMI levels are compatible with a slight acceleration in global economic growth compared to 2017. At present, the only shadows concern China, which seems to be experiencing a new modest deceleration phase, as currently signalled by the trend of new domestic and foreign orders. Almost all economic data releases in the US over the past few days were very strong, with the sole exception of auto sales, down again in January. European data were less brilliant but confirm that growth remains robust.
- Stronger and more widespread economic growth implies higher market volatility, destabilising inflation expectations and the prospected rate path after a generally quiet 2017. The currency markets led the way in recording increased volatility, but yield curves are following the same path.
- In the United States, the market is now almost fully pricing three policy rate hikes by the end of 2018, and almost four by January 2019. The rate curve in dollars moved violently, with the 10Y UST yield surging from 2.41% to 2.82% in the past month. In this case, the movement was due more to the inflation component than to the real rate component. The January FOMC meeting was not the cause of the movement: the Committee left rates unchanged, expects the evolution of economic conditions to “warrant further gradual increases in the federal funds rate”, using an almost identical wording compared to the previous statement, and totally ignored the trend of the dollar and the fiscal measures approved by Congress. However, the FOMC expects inflation to rise this year, and made no mention of the past downtrend. Expectations for a rate hike in March were and remain solid.
- In Europe, in addition to the strong exchange rate, the risk of an acceleration in inflation, driven by economic growth, is starting to cause concern. This week’s data outlined an increase in the overall rate from 1.1 to 1.2% after three stable months. The rise is marginal and could be reabsorbed in the coming months.
However, it comes at a time when the real economy is growing at a lively pace in the euro area, while energy prices are on the rise, and could therefore aid in the next few months the passing of the self-sustainability test considered necessary by the ECB president Draghi to proceed with the monetary policy reversal.
The European Commission’s monthly survey shows that capacity utilisation has increased in both the manufacturing and services sectors to levels that are now close to the long-term highs, and expectations for higher prices are widespread in all business sectors sensitive to domestic demand.
Although the strong euro will cause some disruption, the ECB staff’s inflation forecasts could therefore be revised up already in March. This will probably not have a great impact on the normalisation process, still focused on terminating the APP programme by the end of the year, but it could make the timing of the first interest rate hike in 2019 more uncertain.
- Political risk may have played a role in weakening the dollar, but is not having any effect for the time being on the European rate curves. In 2017, the French elections were decisive first in undermining and then in supporting confidence in the euro and in the Eurozone markets.
Subsequently, the elections in Austria went almost unnoticed, despite the inclusion of the eurosceptic FPÖ in the government coalition. Now, the runup to the Italian political elections on 4 March, which in theory could be a source of uncertainty, is being accompanied by a narrowing of the 10Y BTP-Bund spread, from 160pbs at the beginning of the year to 123bps. And this is taking place despite the reduction of purchases under the APP, which is calling the market to absorb positive net issues for the first time since 2014, and despite the proposals for an easing of fiscal discipline included in the campaign manifestos of almost all political parties. The significant upward shift of the German rate curve is resulting in a tightening of the spread for now.
This may also be aided by the modest share of Italian public debt held abroad (around 30%), the conviction that electoral promises will not be effectively implemented, and the perception that in the near term none of the potential election outcomes will cause the trend of the deficit and debt trend to stray much from the planned path. Also of help is the disappearance of the euro as an election campaign theme. However, confidence in the public accounts consolidation process must not be undermined for progress to continue.
The week’s market movers
In the Eurozone, focus will be on December industrial output data. We expect a temporary correction in Germany (-0.3%m/m) and Spain (-1.0% m/m), after a solid trend in November. France and Italy should show modest improvements (+0.1% m/m and +0.3% m/m respectively). Retail sales in the euro area are estimated to have corrected (-1.4% m/m), partly eroding the progress made in November.
This week, only a few noteworthy releases are lined up in the United States. The January non-manufacturing ISM should record a modest rise in line with widespread growth, whereas the trade balance deficit is forecast to widen in December, confirming the negative contribution of net exports to 4Q growth.
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