Saturday, November 6, 2010

Global Update: QE-II raising tensions

Fed delivers
The FOMC meeting was this week’s main event but the Fed did not spring any surprises. Market expectations were for an additional round of treasury purchases of 500bn over the coming six months. The FOMC did not disappoint and announced an intention to buy 600bn over the coming eight months.

Importantly, the size and pace of the purchases will be subject to review and adjusted in relation to economic developments. Given that core inflation is close to bottoming and the labour market will improve gradually over the coming months, we think that ultimately the risk of a downward adjustment in the total purchase size is larger than an upward adjustment.

The move from Fed gave rise to renewed criticism from among others Brazil, Germany and China. The increase in USD liquidity is leading to further depreciation of USD and adding to the challenges facing countries that see their currencies appreciate. The global environment ahead of next week’s G20 Summit is not the best – to say the least – and the US seem to stand quite isolated on the QE issue as both Bank of Japan and Bank of England this week abstained from adding to QE measures.

The ISM surveys released this week were a positive surprise as both the manufacturing and non-manufacturing ISM managed to improve in October with the details of the surveys encouraging as well. We do expect the manufacturing ISM to continue the downward trend over the coming months (see Flash Comment - US: ISM edges higher, but temporarily). However, the report highlights that the slowdown in the manufacturing sector will be moderate and the sector will remain a growth engine. Further, the improvement in the service sector ISM supports the signs that the growth rotation from manufacturing into services is progressing.

Finally, Tuesday’s mid-term election gave the Republicans a landslide victory in the House of Representatives, while the Democrats managed to hold on to the majority in the Senate (see Flash Comment US: Mid-term election - Republicans take the House). While the risk of a gridlock in US politics over the next two years is present, we believe that the Democrats and Republicans will be able to find compromises on at least some issues which would support economic growth. First on the agenda will be the extension of the so-called Bush tax cuts set to expire on 1 January 2011.

Plans for a European restructuring mechanism are spooking
Sovereign bond spreads have widened further during this week in particular for longer maturities as investors have been increasingly concerned that a post-2013 “Sovereign debt restructuring mechanism” as proposed by Germany could be an expensive acquaintance. The Irish finance minister Thursday evening said that the German plans for a restructuring mechanism are spooking markets and that a sovereign debt restructuring would be an economic suicide note.

The Irish government also put forward its plan for 2011-14. The plan implies a substantial frontloading of the tightening. Ireland expects that a EUR6bn adjustment will cut the deficit to 9.25-9.5% of GDP in 2011. In 2012 another EUR3-4bn in tightening is planned,then 3-3.5bn in 2013 and EUR2-2.5bn in 2014. As a result the budget deficit should bejust below 3% of GDP in 2014 and the debt-to-GDP ratio should have started to decline.

We believe that the ECB has purchased government bonds in moderate amounts this week, but it has not yet succeeded in bringing sovereign spreads under control. Final manufacturing PMIs released this week were generally positive, with upward revisions for the euro area as a whole and both Spain and Ireland moving up above 50, thus signalling growth.

At the ECB press conference ECB president Jean-Claude Trichet did not seem much affected by the fact that US monetary policy is moving in a very different direction from the ECB’s. If anything, the introductory statement was slightly more hawkish than last month. Trichet was rather harsh on the proposal for reform of the European Union’s economic governance, which he does not consider to be the quantum leap needed.

BoJ did not announce further QE
Bank of Japan (BoJ) did not announce further QE in connection with its monetary meeting on Friday. This meeting had been pushed forward and was held just one week after its previous monetary meeting. The official reason for pushing the meeting forward was that BoJ wanted to complete the final details of its JPY5trn asset purchase programme announced in early October. However, it has probably also played an important role that BoJ wanted to be able to respond if there was a major impact on JPY from the Fed’s QE announcement. However, so far there has been little impact on the JPY from Fed’s QE announcement and for that reason BoJ chose to stick to the official agenda and just announced the final details concerning purchase of exchange traded funds and real estate investment trust (REIT) as part of its asset purchase programme.

We still expect to BoJ to extend its asset purchase programme further, most likely in early 2011. The Japanese economy will be balancing dangerously close to a double dip recession in H2 2010. For that reason Japan will probably respond with further QE and possible intervention in the FX market if JPY strengthens further, and as long as we are in a race of quantitative easing it is hard to see any relief for JPY.

Both China’s manufacturing PMIs improved markedly in October, suggesting that Chinese growth is again accelerating in Q4, see Flash Comment - China: Manufacturing PMIs improve markedly. The official NBS PMI improved from 53.8 to 54.7 and HSBC manufacturing PMI improved from 52.3 to 54.8. The details were strong with new orders improving significantly and now above 58 in both surveys. Export orders also improved slightly, but are not as strong as total new orders, suggesting growth in China is primarily driven by domestic demand. Only concern is that the price component in the PMI surveys suggests that inflationary pressure is again increasing.

In Asia outside China, the manufacturing PMIs released in the past week paint a more mixed picture. It improved in India, but declined in South Korea and Taiwan. However, as China tends to lead the rest of Asia, manufacturing PMIs outside China should start to improve in the coming months on the back of the recent improvement in China’s PMIs.
Full report: Global Update: QE-II raising tensions

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