Global Daily – Soft patch or downturn?

by: Nick Kounis , Bill Diviney

Euro Macro: Eurozone recovery to continue at a more modest rate – GDP data this morning confirmed the slowdown in the eurozone economy in the first half of this year. GDP growth eased to 0.3% qoq from 0.4% in Q1, and way down from the 0.7% growth rates we saw in the last three quarters of 2017. This raises the question whether the slowdown represents a soft patch in the recovery or whether the eurozone economy is on the way to a downturn. We think that the economy is most likely in a soft patch. The slowdown has been driven mainly by the weakness in world trade over recent months and there are signs of stabilisation there recently as well as in a number of business confidence indicators in the eurozone. At the same time, domestic fundamentals remain good. Financing conditions are accommodative, the housing and labour markets are doing well and the revival in investment spending looks to be on track. Our baseline scenario is that the economy should regain some traction later in the year, as world trade firms and the inventory correction in the industrial sector is completed.

Nevertheless, there remains uncertainty about the economic outlook. The escalation of protectionism could undermine business confidence. In addition, there are as yet few signs that eurozone economic indicators are turning up. So the risks look to be skewed to the downside for now.

What are the implications for monetary policy? The economic uncertainty supports the ECB’s cautious approach and forward guidance that interest rates will remain on hold for more than a year from now. In addition, the risks are skewed towards a slower recovery in inflation than it expects given a slower pace of growth, which means that slack in the labour market will take longer to dissipate. Indeed, although core inflation rose in July (to 1.1% from 0.9% in June according to today’s flash estimate), the trend has been roughly sideways over the last few months. In addition, wage and unit labour cost growth remain at subdued levels. (Nick Kounis)

BoJ View: Super easy policy until 2020 – The BoJ made some important changes to its policy framework today, somewhat sooner than expected (we felt a change was more likely in October). The most important change was to increase the flexibility of its Yield Curve Control (YCC) policy, by allowing the 10y JGB yield to trade in a wider range. BoJ governor Kuroda later clarified that he saw a ‘doubling’ in the trading range from +/-0.1% (i.e. to +/-0.2%), although this was not specified in the formal written communications. In addition to this, the BoJ added new forward guidance on interest rates, stating that rates would be kept ‘extremely low’ for an ‘extended period’, with explicit reference to the planned consumption tax hike of October 2019 (and the need to assess the potentially negative effects of this) as an anchor point. In other words, a further change in policy before 2020 is unlikely.

Viewed in isolation, the change to the YCC framework could arguably be viewed as a tightening step for the BoJ. Indeed, while the target for the 10y JGB yield is still ‘around zero’, the cap is now at 0.2%, up from 0.1% previously. However, if this is a tightening step, it has been communicated about as dovishly as possible. The impetus for the change is – counter-intuitively – a significant downgrade to the BoJ’s inflation forecasts (by 0.2pp for FY2018, 0.3pp for 2019, and 0.2pp for 2020). While inflation is moving in the right direction, it will ‘take more time than expected’ for the BoJ to reach its 2% target. The BoJ’s rationale is that with easier policy likely to be in place for longer, it must be made more sustainable – more needs to be done to reduce the side effects, particularly for the banking sector (sustained low rates are thought to negatively affect bank profitability). While Governor Kuroda stated that it is not his job to improve the profitability of banks, he did nonetheless reiterate concerns over the risks to financial intermediation that could arise if the BoJ did not make adjustments to policy.

All told, while the move to a more ‘flexible’ YCC framework is arguably a tightening step, the weaker inflation outlook and the strong accompanying forward guidance on rates has more than offset the tightening impact. Indeed, markets clearly interpreted the BoJ’s decision as a dovish one, with both JGB yields and the yen falling in the aftermath. (Bill Diviney)