Money for nothing can lead you to dire straits. All too true and the European Central Bank is finding this out now. The euro is in dire straits now as the central bank is so far away from its objective and now has an even bigger problem in terms of fragmentation. EUR/USD sunk to 1.0330 this morning, its weakest since 2003 as PMIs highlight euro area recession risks. Unless the ECB gets its act together it could be at parity soon. These are important levels and it should be noted that USD is bid across the board.
Why worry? Its new anti-fragmentation tool, which is designed to close spreads between bond yields across members, could lead to “dire straits”, according to Bundesbank chief Joachin Nagel. In a speech yesterday he said “it would be fatal if governments were to assume that the Eurosystem will ultimately be ready to assure favourable financing terms for the Member States” and issued a caution “against using monetary policy instruments to limit risk premia, as it is virtually impossible to establish for sure whether or not a widened spread is fundamentally justified”. Indebted member states shouldn’t expect money for nothing forever.
We always knew the anti-fragmentation tool could prove tricky for the ECB...as it fundamentally amounts to funnelling money from the wealthy northern nations to the more indebted periphery. And there is an obvious risk that the ECB needs to avoid in wandering into monetary financing of governments’ debts. Draghi strong-armed the north into accepting QE etc as inflation was persistently low. The same is not true today. The tide is going out fast and the naked swimmers are being revealed – QE and ultra-easy policy papered over trouble like high debt-to-GDP ratios. And even if you keep spreads tight, funding costs are still going to rise just as economic growth stalls.
Nagel stressed that “unusual monetary policy measures to combat fragmentation can be justified only in exceptional circumstances and under narrowly-defined condition”. The task for the ECB is to tread this exceptionally narrow path. Nagel might be in a minority but it underscores the division and the possibility that the ECB could be seen to exceed its mandate...Germany’s constitutional court is bound to have a say in this. All this serves to highlight the mess the ECB finds itself in – looking to do some new form of QE just as it is supposed to be raising rates shows it’s painted itself into a dangerous corner.
Meanwhile, today’s Eurozone services PMI slipped to a 16-month low and indicated growth sliding fast. Recession seems inevitable though there are signs inflation might have peaked in April according to the survey.
European stock markets edged up again on Tuesday's early doors, looking to build on the solid foundations of Monday’s session, before sharply reversing early gains to trade between 0.5-1 percent lower. Oil is a little lower as it wrestles with its 50-day moving average. US futures point a little lower as Wall Street returns from the July 4th holiday. The yield on the benchmark 10yr Treasury note is lower at 2.90%. Heading into the weekend the S&P 500 closed back above the key May 20th low of 3,810, with futures indicating a positive open around 3,835. Norwegian oil workers to go on strike...tighter supply. Asian shares mixed with the China Caixin services PMI for June rose to 54.5, well above the expected 47.3. Elsewhere, the dollar is sharply higher this morning as the US comes back from its holiday. Sterling is lower with cable taking a 1.20 handle again. Bitcoin is a little firmer above $20k.
Overnight the Reserve Bank of Australia hiked by another 50bps. AUD/USD is weaker on the update since the statement from Governor Lowe was maybe not quite as hawkish as expected...”Medium-term inflation expectations remain well anchored, and it is important that this remains the case,” Lowe said in his statement, adding that “inflation in Australia is also high, but not as high as it is in many other countries”.
Everyone looking for peak inflation...but we’re probably at the point where it’s at its most dangerous as it becomes sticky. High and sticky inflation is the worst combination since it means expectations have been unanchored. This will only push the Fed and other central banks to inflict more pain. The Atlanta Fed’s GDPNow estimate for real GDP growth in the second quarter of 2022 fell to -2.1 percent on July 1, down from -1.0 percent on June 30th.
So far, the declines in the stock market have all been about inflation and yields – Fed-induced multiple compression. I don’t think investors are all that prepared for the kind of decline in earnings that we could see over the next three quarters. This means the bottom isn’t in yet.
Tesla (NASDAQ:TSLA) will halt production at its Berlin and Shanghai plants this month for a period of 2-3 weeks. This is to carry out upgrade work. Given the Berlin plant was only opened in the spring it doesn’t say much for Tesla’s manufacturing nous. It also didn’t make mention of these outages in its July 2nd production and deliveries statement. In June production was strong, though deliveries missed expectations. Earnings are due July 20th.