THE BLOG

Currency Wars Are Heating Up

11/06/2014 12:27 BST | Updated 09/08/2014 10:59 BST

The yawning gap between Europe's economic fortunes and those of the US and UK becomes ever wider.

Last Wednesday saw the release of US Vehicle Sales data for May-a very useful macro-indicator, and total sales were 16.7m, well ahead of the expected 16.1m, and the highest since February 2007. I also note that the excellent Rasmussen US Employment Index rose to 100.1 in May, the highest level in six years, up from 95.6 in April, and that their Consumer and Investor Confidence Indices are also at their highest levels for the year. The official May employment reports were really very solid, with the headline rate stuck at 6.3%, and non-farm payrolls close to consensus at 217k, but some of the underlying detail was also definitely encouraging; average hourly earnings ticked up a tad to 2.1% YoY, the number of people working part-time for economic reasons fell by 200k, and the broader U6 measure of employment, (watched closely by Yellen), fell again to 12.2%, a new post-recession low.

This week we also learnt that the UK Composite PMI, produced by Markit/CIPS, was 59.0, (expected 58.7), close to recent highs, and that the Halifax sees house prices as having risen by 3.9% in May! In contrast the Eurozone Composite PMI, at 53.5 for May, seems to be turning down, led by Germany and France-in the case of the latter the data has still failed to break above the crucial 50 level. Crucially the estimate for May Eurozone CPI fell to 0.5% YoY.

Therefore, the ECB did bend over backwards to craft a package which went absolutely as far as possible to address concerns over growth and the threat of deflation and, importantly, they made unanimous decisions. In summary we got--10bp rate cuts in the Refinance Rate and the Deposit Rate, taking the latter negative. The Marginal Lending Rate for emergency overnight lending was cut by more, 35bp, but this is pretty irrelevant, as banks shun that window as much as possible.

-a new Targeted LTRO, or TLTRO, which will give fixed rate, full allotment until Sept 2018-the rate being the pertaining Refi Rate +10bp, it also boasts generous repayment terms and collateral rules-so banks can borrow at 0.25% for 4 years and lend at 5%+, say, to corporates. It also effectively allows them to drawdown on this facility, without making any new qualifying loans, until September 2016.

-extension of fixed rate, full allotment shorter term Refinancing Operations to Dec 2016

-suspension of SMP liquidity drain

-preparatory work upon an ABS purchase programme, conditional upon the ABS being, 'simple, (no toxic squared or cubed rubbish), real and transparent'

Key answers to news conference questions-

-'can official rates go lower?-in all practical senses, no'

-'this means rates can stay lower for longer than before'

-'are we finished?-no'

The ECB staff forecasts saw lower inflation going forward-a key justification for today's measures, of course.

Through this package of measures, the ECB may well address the transmission of money to corporates and to the periphery, addressing growth concerns, with the effects coming thru in 'perhaps 2 or 3 quarters' and that may ultimately drive up inflation in the medium term, but markets operate with a vastly shorter timescale and I fear the market will take the Euro higher, now that the ECB confesses rates are not going any lower. Just as the market smells blood when central banks try and defend weak currencies, in this case the market may feel the ECB has shot as many arrows as it can now, short of measures like full-blown QE, which will now become the assumed end-game for the ECB.

This could presage a problem for the US and UK; in that the ECB seems determined to weaken the Euro, and has every possible economic justification to do so, but strong currencies in the US and UK will serve only to allow Europe to export disinflation-the low level of which is already a concern for the Fed and BOE.

China is also quietly embarking on targeted monetary easing to address its growth dip, with selective Reserve Ratio reductions, loosening in the loan to deposit ratio rule and a currency which has mysteriously weakened by over 3% vs. USD since the start of 2014.

Numerous explanations have been profferred for the obstinate refusal of the US yield curve to steepen over the last couple of months, even in the face of increasingly robust economic data, such as PMI's, headline employment readings and consumer confidence and spending. These ranged from the export of deflation from Europe, China and Japan, thru lack of Treasury supply, to excessive short positioning.

In fact I believe it really just does seem like the markets have been listening carefully to what Chair Yellen and other premier Fed thought leaders have been saying. They want to see evidence the output gap is narrowing, they want stronger housing numbers and they want higher inflation.

These metrics have not delivered unequivocally as yet, and the FOMC is unconvinced. May's employment report was just an incremental step in the right direction.

The demands of Currency War may mean lower rates for longer in the US and UK.

MORE: