Global Daily – Fed to signal wait-and-see stance

by: Nick Kounis , Tomas Kinmonth , Hyung-Ja de Zeeuw

Central banks: Fed preview – The FOMC meets on Wednesday, with very low expectations of a policy change. Fed funds futures see only a 10% chance of an increase in the target range for the fed funds rate at this meeting. Only two of the 88 economists surveyed in the Bloomberg poll expect a hike. Recent communication suggests the Fed is in wait-and-see mode and we expect the FOMC to signal this remains the case in the July statement. It would like to assess the US economic data and any potential fall-out from the UK’s vote to leave the EU. Up until now the economic data have been relatively positive, and the financial market reaction to the Brexit vote has been relatively benign. As such, some FOMC officials have signalled that a rate hike later in the year could be on the cards. Nevertheless, the jury is still out. Even though the US economy looks set to have expanded at a strong pace in Q2, this follows two extremely weak quarters. Similarly, strong job growth in June followed hardly any gains in May. Indeed, the trend in employment growth has slowed significantly since the start of the year, consistent with weak demand and shrinking profits. In addition, the rest of the global economy looks to be in bad shape, with growth weak, financial vulnerabilities in emerging markets and political risks in Europe. Markets price in a 45% chance of a hike in December, while the consensus of economists expects a rate increase by then. Our base case is that the Fed will remain on hold until early 2017. (Nick Kounis)

 

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Euro financials: Italian banks need to address their NPL stockpiles – The number of non-performing loans (NPLs) within the Italian banking system is colossal, in total grossing EUR 360bn. This equates to 23% of GDP. The Italian authorities have often tried to play this down, pointing at the high level of provisions that the banks have against these NPLs. Indeed, the Italian banks have set aside a sizeable amount of provisions. In total, provisions reached EUR 146bn at the end of Q4 2015, a value that is 41% of the gross NPL number. As provisions are currently 41% of the gross NPL value, this would mean that there would be limited financial impact to the Italian banks if the NPL portfolios would be sold at a price of 59 cents to the euro. However, the average recovery rate for all NPL procedures was 41% during 2011-2014. If the NPL portfolios of the Italian banks were priced at 41 cents, the amount of capital required for the banking sector would be EUR 66bn. Of this EUR 66bn, EUR 45bn would be required from banks outside the top five banks, which worryingly are banks that are not supervised by the ECB and not in scope for the upcoming stress tests. For more on this issue, please see our note here that is intended for professional and eligible clients only – see disclaimers in note. (Tomas Kinmonth)

Euro non-financials: Spreads approach record lows – Euro non-financial credit spreads are approaching the record low levels seen in March of last year. In January 2015, when the ECB announced the Public Sector Purchase Programme, credit spreads rallied. Supported by a very constructive risk-on sentiment, spreads for senior Non-financials tightened to a record low of asset swap +49 on 6 March 2015. Last Friday, spreads for senior Non-financials closed at asset swap+51 on extremely low trading volumes as the summer lull kicked-in. Only during the pre-crisis years of 2004-2007, did credit spreads trade at these depressed levels. But we find ourselves in a completely different market situation today. The ECB is in the market with its Corporate Sector Purchase Programme. It bought around EUR 8bn of corporate bonds in the last month. In that same timeframe we’ve only seen EUR 7.5bn of investment grade benchmark supply. So, the ECB corporate buying programme and corporate supply net each other out. However, redemptions, including coupons, in the investment grade benchmark were EUR 7,5bn in the last 30 days. That money had to be reinvested, driving spreads tighter. In August, when the holiday season reaches its peak, there won’t be much supply, if any. We also don’t see a clear catalyst for spreads to move wider. This means that with the ECB still buying bonds, albeit at a slower pace, and EUR 3bn scheduled redemptions, spreads will only grind tighter. (Hyung-Ja de Zeeuw)

Euro macro: Ifo headline resilient, but expectations deteriorate – Germany’s Ifo business climate indicator slipped only slightly in July. The index declined to 108.3 from 108.7 in June, which was a smaller fall than expected (consensus: 107.5). This seemed to echo the message from other business surveys reported at the end of last week. For instance, the eurozone composite PMI fell only to 52.9 from 53.1 in the previous month. It could therefore be concluded that up until now, the uncertainty triggered by the UK’s vote to leave the EU has had very little impact on the eurozone economy. However, this is probably too optimistic a take. Although there may not have been an immediate impact on orders, output and hiring, there is evidence that confidence has been impacted, which may affect business decisions in the future. For instance, the Ifo expectations index fell more significantly, to 102.2 in July from 103.1 in June. This is also a trend seen in the expectations measures in the service sector PMI. So we still think that Brexit will have a negative impact on the eurozone economy, albeit likely a moderate one. (Nick Kounis)