Fed campaign toward neutrality and the difficult row to hoe for the ECB

The coming days are eventful. And that is with the known unknown, Russia's actions in Ukraine, held in abeyance.  

It does not seem as if either side is truly serious about negotiations. Kyiv's proposal of a security guarantee by Poland or the US is not realistic. It would be tantamount to joining NATO. Ukraine President Zelensky appears to think a military victory may still be had.  

There are many claims about Putin's intentions and state of mind. It seems to be largely speculation and can be consistent with the kind of psych-ops one would expect in the fog of war. Ironically, the mad-man tactic is often associated with US President Nixon, who wanted to convince North Vietnam that he was sufficiently unhinged to do anything, including the use of nuclear weapons. Nixon apparently also wanted the Soviet Union to think that he was dangerously mad. In October 1969, Nixon put the US military forces on full global war readiness, and bombers with nuclear weapons flew patterns near Soviet territory for three days. Machiavelli, the first "realist," appreciated the tactical advantage under certain conditions.  

Putin seems crazy but crazy like a fox. He must be as surprised as everyone at the depth and breadth of the sanctions. After all, Russia invaded Ukraine and annexed Crimea, and the world's response was minimal at best. Who would have thought that into the supposed vacuum left by the end of the Merkel-era, an SPD-led government of Greens and Free Democrats would commit to such a volte-face and make a significant commitment to boosting its military capability? The Economic Minister (from the Green Party) even suggested a willingness to discuss planned closures of the country's last three nuclear plants to reduce reliance on Russian energy. However, Chancellor Scholz insisted on sticking with the shutdowns.  

Putin must be surprised, as are so many Western observers who exaggerated Russia's military prowess. It has cost the head of French military intelligence his job. Some of Russia's military spending may be feathering someone's bed, and the funds that were spent too often acquired shoddy goods. This is all the more reason why Putin is unlikely to negotiate without a significant military victory in hand. It could include securing the territories claimed by Donetsk and Lugansk. Ironically, negotiations, at this stage, seem unlikely to be fruitful until there is a change in the war itself.

The ECB finds itself in a pickle as it meets on April 14! Consumer inflation surged to 7.5% in March (preliminary estimate) from 5.9% in February. In March alone, it rose 2.5%. At the same time, food and energy shock and other economic disruptions from Russia's invasion of Ukraine and the sanction response will hit growth. The key issue is whether an economic contraction can be avoided. 

There may be two mitigating factors. First, many EMU members are cutting taxes on fuel. This will ease one pressure on CPI for as long as it lasts (~six months). Second, military and energy spending look set to increase to move into the space being vacated from the slowing of Covid-related efforts.  

However, the ECB's track record leaves something to be desired. Consider the last two times the ECB hiked rates. First, in 2008, with Brent pushing about $140 a barrel, Trichet led the ECB into hiking rates in July, in between, as it were, Bear Stearns's demise and the epic failure of Lehman Brothers. The recovery from the 08-09 contraction stalled as the sovereign debt crisis phase unfolded. However, prices pressures were evident. The mild bout of deflation in 2009 had given way to higher prices, and CPI was pushing above 2% in early 2011. Trichet again led the ECB to not one but two hikes in 2011 (April and July). Draghi replaced Trichet, and at his first two meetings as President, the ECB unwound both of Trichet's hikes. Nevertheless, the eurozone contracted for six quarters from Q4 11 through Q1 13.  

Can history do more than rhyme? The swaps market has a 25 bp hike discounted by the end of Q3 and another by the end of Q4. The near-term economic risks seem squarely on the downside, though the March composite PMI looked fairly resilient (54.9 vs. 55.5). Even before the war, the eurozone economy was vulnerable. The composite PMI was 52.3 in January, the lowest since February 2021 and the fifth month of slowing activity in six months. German and French industrial output were considerably weaker than expected in February, while Russia's invasion of Ukraine did not take place until late in the month.  

The economic institutes that advise the German chancellor cut this year's growth forecast from 4.6% to 1.8%. Italy reportedly cut this year's GDP projection to 3.1% from 4.7% and 2.4% from 2.8% next year.  The Bank of Italy warns that the economy may contract in Q1. These still seem optimistic. The IMF/World Bank will update their forecasts at the Spring meetings (April 18-24). It seems clear that slower growth in China, Eurozone, and Russia is a foregone conclusion. The World Bank and the IMF have US growth at 3.7% and 4.0% this year. That, too, looks too high. The median Fed forecast in March was 2.8%.  

Without action or updated forecasts, the interest in the ECB meeting will be in its forward guidance about its bond purchases. The ECB needs to have greater flexibility going forward precisely because of the high degree of uncertainty. Like the Federal Reserve, it is committed to ending its bond purchases before lifting rates. That sequence is important, but it also ties the ECB's hands. It needs to finish its bond-buying sooner to give it the freedom to hike rates in Q3. In March, after detailing the monthly purchases in Q2, it said, "The calibration of net purchases for the third quarter will be data-dependent and reflect its evolving assessment of the outlook."  The ECB is unlikely to make a firm commitment, but some guidance in this direction would be helpful.  

In the two days before the ECB meets, the central banks of New Zealand and Canada will hold policy meetings. Both are likely to raise rates. The RBNZ has hiked its official cash rate by 25 bp for three consecutive meetings. It now stands at 1.0%, where it was from August 2019-January 2020 before the pandemic struck. The market expects the RBNZ to get more aggressive. The pricing in the swaps market suggest participants lean toward a 50 bp hike. There are almost 90 bp of tightening discounted by the end of next month and nearly 190 bp of tightening in the next six months.  

The Australian dollar, where the central bank has not hiked yet, is the strongest among the major currencies this year with a 2.7% gain against the US dollar. The New Zealand dollar is next with about a 1.5% gain, and the Canadian dollar is in third place with around a 0.5% gain. The Bank of Canada is also about to ratchet up its tightening cycle, which began last month with a 25 bp rate hike. The swaps market settled last week with a 63 bp of tightening discounted for April 13.  This implies the market is split between a 50 bp and 75 bp hike.  This seems a bit much and warns of the downside risk in the Canadian dollar. The swaps curve has almost 120 bp of tightening discounted over the next three months. In addition, the Bank of Canada is expected to slow the reinvestment of maturing proceeds from its holdings, allowing the balance sheet to begin shrinking. Like the US, the market now sees a terminal policy rate around 3% in Canada.  

The central bank of South Korea and Turkey also hold policy meetings on April 14. Neither one is expected to change policy. However, we suspect that after the 4.1% March CPI print, South Korea's central bank is more likely to surprise than Turkey. South Korea's 7-day repo rate stands a 1.25%. It hiked rates three times in the cycle that began last August. After hiking in both December 2021 and January 2022, the Bank of Korea stood pat in February. With a 2.7% unemployment rate (3.7% at the end of 2019), a strong economy, rising price pressures, and a soft won (-2.4% year-to-date), there may not be a compelling reason not to raise rates.  

Turkey's experiment with non-orthodox economics is failing, and it is poorer because of it. Since the end of 2019, during the Covid-era, the lira is the weakest currency in the world, depreciating by nearly 60%.   The CPI in March had risen by a record 61.1% year-over-year. In March 2021, Turkey's CPI had increased by almost 17% over the previous 12 months. Nor has the currency depreciation boosted the external balance. The average monthly trade deficit was nearly $2.5 bln in 2019 and almost $4.2 bln in 2020. Last year's average was $3.85 bln. The rise in energy and food prices is spurring new deterioration. The January-February 2022 trade deficit stood at about $18.1 bln. In the first two months of 2021, the deficit was $6.4 bln.  

The People's Bank of China does not have regular policy-making meetings. However, officials need to act soon, given the lockdowns, the economic disruptions, and the sub-50 PMI readings. The benchmark 1-year medium-term lending facility will be set next week. It was cut by 10 bp in January to 2.85%. When the pandemic first struck, the 1-year MLF was at 3.25%. A cut is likely, and a move on par with the 20 bp cut in April 2020 would signal the seriousness that policymakers regard the economic slump. A cut in the MLF would also set the stage for a reduction in the loan prime rate, set on the 20th of each month.  

Separately, China will report its March inflation gauges and trade figures. When China's PPI was accelerating last year, some observers tried linking its rise to upward pressure on US CPI. We were skeptical, and few are making such connections now. China's PPI likely declined for the fifth consecutive month in March. It peaked at 13.5% in October 2021. and is expected to have fallen toward 8% in March after finishing last year at 10.3%. China's CPI has not risen since last November when it was at 2.3% year-over-year. It was steady at 0.9% in January and February and is expected to have increased to about 1.4% in March. It finished last year at 1.5%. Unlike in the US, of Beijing's challenges, inflation is not among the most pressing, where Fed Governor Brainard called it the "paramount" challenge.   

China's trade is being disrupted by its shutdowns. The monthly trade surplus hit a record high of $94.4 bln in December 2021 and has fallen sharply. It stood at $30.6 bln in February and likely fell further last month. The median forecast (Bloomberg survey) sees a $22.4 bln surplus, which would be the smallest since March 2021.  

The US reports prices (CPI, PPI, import/export), consumption (retail sales), and a measure of output (industrial and manufacturing production). Inflation likely accelerated from the 7.9% year-over-year pace in February toward something closer to 8.5%. The core rate will edge up to a little more than 6.5%. Producer prices also look like they firmed last month. Meanwhile, industrial output is expected to have increased by 0.4% after a 0.5% gain in February. However, manufacturing cannot maintain the 1.2% surge seen in February. It increased by an average of 0.4% over the past six months. If it comes in there, it is still a solid report. The capacity utilization rate likely rose to a new post-Covid high of almost 78%. At the end of 2019, the capacity utilization rate was about 76.5%.  

The optics of the retail sales report may be better than the details. Higher prices likely flattered this report made in nominal rather than real (inflation-adjusted) terms. What this means is, like February, the more costly gasoline squeezed out other purchases. Excluding autos and gasoline, retail sales are expected to be flat (median, Bloomberg survey) after falling by 0.4% in February. When autos, gasoline, building materials, and food services are excluded, which GDP models do, while picking up the excluded items in other time series, retail sales are expected to fall by 0.2% after February's 1.2% drop.  

The data may help fine-tune the Q1 GDP forecast. The Atlanta Fed GDPNow sees Q1 data tracking a 1.1% annualized pace. The median forecast in the Bloomberg survey is a little more optimistic at 1.5%. There may be some impact for headline traders and momentum players.   However, the high-frequency data points may not impact Fed expectations very much in terms of monetary policy. The market appears to accept that the Federal Reserve has begun a campaign that will bring the Fed funds target rate back to neutral, where it is expected to be in the longer term, ostensibly assuming its policy goals have been achieved. In March, all but three officials saw the neutral rate being between 2.25% and 3.0%. The Fed funds futures imply a 2.55% Fed funds rate at the end of the year.  

Let us conclude with some thoughts about the French election. Even though the polls have tightened, little has changed. No candidate is expected to win in the first round on April 10. The run-off between the top two candidates, expected to be Macron and Le Pen, is thought to most likely result in Macron's re-election. Anything that threatens this scenario, like Le Pen emerging ahead of Macron, rather than the other way around, in the first round, would probably be seen as negative for the euro. 

With Merkel retiring, Macron may have wanted to fill the leadership vacuum, but the SPD-led coalition government in Berlin has risen to the occasion. However, Macron's vulnerability has domestic roots. Macron wants to make it a contest over leadership and values, and Le Pen wants to make it into a referendum about the rising cost of living. The far-right candidate Zemmour's lasting influence may be to have made Le Pen seem more moderate. A Macron-Le Pen contest could discourage voters from the center-left. In 2017, Macron won the second round with 2/3 of the vote. This time he may be lucky to get more than 55%. The implications for Macron's domestic agenda will depend on the legislative elections in June.