Recent EA macro data have continued to underwhelm – the latest subdued credit data follow Friday’s weaker than expected flash PMI – while US durable goods orders were better than expected (although core shipments disappointed). Yet the EURUSD has bounced a couple of big figures to above 1.11, apparently as China-weakness induced risk aversion and other factors caused EUR shorts to be unwound (plus potentially some support from the German IFO unwinding some of its recent falls). But the EA’s relatively large export exposure to China and AXJ means that such near-term EUR supportive effects will likely be vulnerable to a more substantive China/AXJ slowdown. Conversely EUR would also likely fall back should the Chinese authorities manage to stabilise the situation: EUR’s recent funding currency nature would likely be reignited as risk appetite recovered.
Continued uninspiring EA data
My 22 July post highlighted the downside risks to the EA recovery from the recent weakening of the credit impulse to non-financial companies and bank lending prospects likely being less positive than suggested by Draghi’s press conference comments. And the latest EA credit data were again fairly unimpressive. The loans to non-financial corporations (excluding securitisations) series which the ECB focuses on remained flat at 0.1% yoy, with only a small pick-up in the flow of credit (see Chart). So there is not much evidence of a fresh credit impulse to support corporate investment and hence help broaden out the EA recovery. While households loans growth to ticked up to 1.7% yoy from 1.4%, the growth rate of loans to the private sector (excluding securitisations) actually fell back to 0.9% yoy from 1.0%.
This follows Friday’s below-consensus flash PMI data, where both services and manufacturing disappointed despite the apparently small impact of the Greek crisis on confidence. And within that new orders and new export orders both fell back. This morning’s German IFO data were more optimistic, but all the series remain below April’s levels despite the near-term bounceback (see chart).
To be clear, the data are in no way disastrous: they have certainly since ECB started QE and there are reasons for optimism (hence the consensus that EA prospects are improving). But to me the likely credit headwind facing the EA suggests that risks are more skewed to growth remaining modest rather than gaining the momentum required to close the EA’s output gap and definitively move inflation back to target. And this morning’s ECB Economic Bulletin is cautious about whether inflation has reached a turning point, despite the apparent signal from several statistical measures of underlying inflation. The euro’s bounceback, with EURUSD rising back above 1.11, is also unhelpful in securing the EA recovery (which EA net trade has yet to contribute to).
China and EUR: heads you lose tails you don’t win?
The euro’s bounceback seems to reflect a combination of factors causing the unwind of EUR: (i) stops being triggered – stops of EUR shorts seem likely to have been tight given the history of disappointments – i.e. a self-reinforcing near-term dynamic; (ii) traders nervousness in advance of Wednesday’s FOMC decision – the absence of new forecasts or press conference militates against substantial news but traders will be watching for language changes in the press notice (Yellen’s recent cautious approach suggests that fireworks are unlikely); (iii) heightened risk aversion, driven by today’s 8.5% fall in Chinese equities as PBOC actions to support the market have apparently lost traction. The important context is that EUR has become a funding currency in the post ECB QE and negative EA interest rate world – so risk aversion causes a EUR short squeeze. The retracement in EURUSD risk reversals over the past couple of weeks, to pre-QE levels, is consistent with such a short squeeze. While CFTC data show EUR shorts being slightly rebuilt in the latest two weeks, they lag the market.
It obviously hard to distinguish between(i)-(iii). But Chinese problems, encompassing last Friday’s disappointing manufacturing PMI release (falling more decisively below 50), seem to have been important. Certainly we can cross-check it via the recent weakness of commodities and commodity currencies (given more dovish central banks) one of the other main FX market themes. On one level distinguishing between (i)-(iii) is academic since they all may provide only near-term euro support e.g. once EUR shorts are reduced to more appropriate levels the self-perpetuating dynamic of (i) will diminish. So we could well be going through another one of the periods of temporary EUR strength which have occurred within the broad USD bull market since mid-2014 (although they seem to have become more frequent).
But, importantly, the recent EUR support from bad Chinese news may well turn into a drag either if the Chinese situation gets worse or if the Chinese authorities manage to stabilise it. In other words EUR may be heading back down unless the China situation remains unresolved, which the Chinese authorities will be keen to avoid.
• A more substantial China growth slowdown would represent a genuine headwind to EA exports i.e. representing a further reason to be concerned about the EA recovery running out of steam and a EUR-negative. Any Chinese slowdown would likely spread to other Asian countries, given the tight interlinkages and the latter’s vulnerability to prospective Fed tightening given their large external debts. And it is notable that China and AXJ account for 30% of EA goods exports. So we could in principle for some time end up with a double-whammy of both weaker export markets for EA goods and a stronger EUR. The way out would be for the EUR to weaken, either as the markets stop romancing the EA reflation theme in the wake of downside activity news or if the ECB started hinting at extending QE beyond September 2016.
• Alternatively, the Chinese authorities managing to stabilise Chinese equities and achieve a soft landing for the economy would support market risk appetite and hence encourage EUR shorts to be reinstated. Certainly entry levels for EURUSD shorts will look more attractive and the trade will be less crowded given the recent short squeeze.
Of course, China/AXJ weakness can affect the EA via other channels: most obviously via downward pressure on commodity prices. Draghi stressed the support to household real income and corporate profits from lower commodity prices, rather than worries about inflation expectations again heading downwards, given the ECB’s policy response. That is probably correct for moderate/gradual commodity price falls – EA 5y5y breakevens have been relatively stable in the face of the recent renewed oil price weakness. But it would be open to question in a more stressful scenario, especially should the credit headwind start biting. So the ECB will likely be continuing to monitor breakevens carefully.