Europe | Global | Monetary Policy & Inflation | US
Data to Show US Economy Moving Back to Trend / Russian Gas, Italian Elections and ECB
- By Dominique Dwor-Frecaut and Henry Occleston
- 7 min read
US Key Points
- S&P PMIs to confirm that manufacturing is slowing faster than services.
- Residential data to show that the market is slowing but not crashing.
Europe Key Points
- Scheduled maintenance on Nord Stream pipeline is set to end. Europe holds its breath as to whether the gas flow restarts.
- Italian politics at a key juncture – will Draghi’s unity government collapse, heralding new elections?
- The ECB to make its first hike in a decade (25bp) – but likely to under deliver on anti-fragmentation.
- UK labour market data and inflation will be key for BoE decision makers. Final July PMIs are released.
US
Fed
Following another really bad CPI print, the Fed pre-meeting consensus building discussions slipped into the open this week, with some to and fro on 100bp vs 75bp at this month meeting. In the end, 75bp seems to have won the day.
The Fed is reluctant to go for a 100bp hike when inflation is above 9%, unemployment at multi-decades low, the FFR 7.5% below inflation and an inverted curve blocks the transmission of policy tightening to the economy. This suggests the capitulation I am looking for, basically a SEP showing the FFR rate close to 8% and unemployment close to 6%, is still many months away.
At the same time the conversation on FFR has shifted. Before the CPI print, 50bp per meeting was the base line and 75bp a risk. Now the base line seems 75bp and 1% the risk.
The pre-meeting blackout started this weekend.
Data
CPI, retail sales, business surveys confirmed that the economy is not sliding into recession. The economic surprised index seems to have turned a corner.
Covid hospitalizations are gathering pace (Charts 1 and 3). I have stopped reporting test positivity due to poor data quality. In any event, from a policy perspective hospitalizations and deaths matter much more than cases.
This is a data light week. The most important data will be the S&P PMIs where the consensus expects a small decline, more so for manufacturing than services and I agree.
Other data includes:
- Housing market data, where the consensus expects a small decline in existing home sales and the NAHB index, which I agree with. Residential real estate is normalizing to trend rather than about to go through a crash, see Real Estate Market Resiliency Highlights Fed Conundrum.
- Philly Fed manufacturing survey, Conference Board, leading index, and unemployment claims.
Events/Political Developments
Due to his concerns over soaring inflation,Senator Manchin seems to have finally put to death the administration climate and tax plan, the latest incarnation of the (originally) $2tn Build Back Better plan. Instead, Senator Manchin favors a plan that would lower prescription drug prices and extend health care subsidies for 2 years. Senator Manchin’s plan has bipartisan support and president Biden has indicated that he would sign off on it.
Links to New York Fed POMOs/TOMOs: Repos, Treasury, MBS, CMBS
Europe
High Risk Events for Europe Next Week
Equities found support on Friday after early weakness last week on the back of overshoots in US inflation, and the rising worry about the security of future Russian gas flows to the EU. The outlook for Europe is highly uncertain. Next week will be critical. With a war on its border, the risks of fallout to the EU have been elevated for some time. However, the recent restrictions in Russian gas supply and the current shutdown to Nord Stream flows has focused the market on just how such an escalation may manifest.
We have previously covered the catastrophic economic ramifications of a gas supply cut. If Nord Stream flow does not resume on 21 July (next Thursday), or even, the probability of such an outcome rises (such as Russia making new threats/conditionality around it), European equities could go into freefall.
The week will bring volatility from other sources too. The day that Russian gas should resume (21 July), is also the day that the ECB announces interest rate policy (likely a 25bp rise) and more detail on their anti-fragmentation tool (likely to be a disappointment). Meanwhile, just a day before, on Wednesday, Italian PM Draghi will return to Parliament to attempt to win support for his government from M5S. If he fails, it will probably mean new elections.
Equities Weak, But Not Pricing Major Risk
How do we quantify the risk? In a worst-case scenario, a gas supply cut from Russia would mean a certain recession across the EU. A study commissioned by the Bavarian VBW put the decline in H2 GDP at €193bn (6% GDP). That would be at least comparable to the slowdown seen in 2020. If the bloc is simultaneously dealing with a tightening ECB, unable to cap spreads, and an Italian government unable to enact the reforms necessary to receive EU monies, then the equity sell-off could be huge. For context, the formation of a Eurosceptic Italian coalition in 2018 saw FTSE-MIB down 13% in the following month, while the lockdowns in 2020 saw European indices down 40-45% over the same period. Even the most recent spike in BTP/Bunds coincided with an 11% drop in FTSE-MIB.
Will Russian Gas Flows Resume?
Every year the Nord Stream pipeline from Russia to Germany undergoes a period of maintenance when gas flows are ceased. Usually, the halt in gas there is made up for by flows elsewhere (via Ukraine or Belarus). This year is different. Russia has cut its gas flows via all routes significantly, leaving Nord Stream increasingly important. The fear now, is that after gas flow stops for the annual shutdown (scheduled 11-21 July), it may never start again. While the probability is probably skewed towards the gas restarting as planned on 21 July (Thursday), there is a high risk of further hawkish comments from Russian officials. We would not put it past Russian PM Putin to use the situation to force new concessions, and to delay the resumption of flow if too little is earned.
Early Italian Elections?
Wednesday will see Italian PM Draghi attempt to gain support in the Senate for his proposed package of household support measures. Last week saw Conte’s M5S abstain from the vote, leading to Draghi’s (attempted) resignation of the premiership. If he is unable to get them onside this week, new elections are a high probability. They would see M5S suffer, and while right-wing Lega would suffer also, it may still be preferable to them if they end up governing in a right-wing coalition alongside the FdI. Polls suggest a right-wing, Eurosceptic coalition would be able to take the lead. Based on 2018’s experience, the market would probably not be too happy with this, which would put Italian assets (BTPs and FTSE-MIB) under significant stress (see chart below). That being said, we are in a different world now vs then – ‘Italexit’ is no longer popular, even amongst the Eurosceptics, and retaining access to EU monies will likely be high priority for whoever takes the lead.
ECB to Hike 25bp, but Underdeliver on Anti-Frag
Alongside the risks to European risk-tone on the back of gas supply and Italian politics, the ECB will be hiking interest rate on Thursday, almost certainly by 25bp. This has been so well telegraphed, that even if the gas is not flowing by then, I’d expect they still hike (followed by a swift walk-back if needs be). Market expectations for hiking further out (including 50bp in September) seem relatively reasonable right now (assuming there are no shocks on the gas front), although with surveys still deteriorating, and core-inflation looking close to peaking (details released on Tuesday), there is an increased risk that Lagarde plays up the dovish side. The bigger question right now will be what they can tangibly deliver on the anti-fragmentation front. The market does not seem to have its hopes high (they’ve been burnt before), but that doesn’t mean they can’t be disappointed.
Recent comments from Buba’s Nagel suggest he would require strong conditionality upon any attempt to fight fragmentation (that is the widening of periphery EZ bonds [Italy] to core ones [Germany]). He made the valid point that it is almost impossible to differentiate between reasonable and unreasonable spread widening, and in this we agree. The timing could not be worse for President Lagarde. If spreads are under threat from a breakdown in Italian politics it is an issue that will be impossible to avoid in the Q&A. There was already disagreement on what entail ‘fragmentation’ when Italy/Germany spreads widened back in June. If they are now rising on Italian election risk there will be even more disagreement. Where the ECB draws the line will be important. I consider on this front that risks are most likely weighted towards the downside for risk assets.
UK Data
It’s an important week for UK data. The May labour market (Tuesday) and June inflation reports (Wednesday) will be most important. Inflation is likely to continue to surge higher. The peak is still expected in Q4. At that time, the rate will probably beat already stratospheric BoE forecasts (>11% YoY) on the back of Ofgem price cap changes (1Y ahead power has surged recently). In that context, the monthly CPI print may not be that informative. The labour market will be more important. In the context of the BoE being split between hiking 25bp and 50bp come August, signs that labour market tightness are continuing or building will be important to watch out for. Inactivity rates (which have grown since COVID) will be particularly important on this front.
July Preliminary PMIs
The week ends with the preliminary July PMIs for the UK, EZ, France and Germany. The readings have been in decline across much of the Eurozone in recent months. For the UK there will be some volatility with regards the Queens Jubilee in the data (as there was with monthly GDP). The market is looking for a continued decline in readings across the space, but given the scale of recent months’ moves, and the big, obvious worry of gas supply looming, there is a large risk that declines are larger than the market is expecting. There is little reason to expect a reprieve from the negativity, and the risk of readings falling into contractionary (<50) territory is high, particularly in manufacturing. In spite of this, market reaction may not be that strong to the release itself. The more obvious risk event is the resumption of gas supply. That is probably what will have weighed on PMIs, and by Friday we should at least have some more information on that front. If it has been resolved the market will probably be able to overlook big PMI weakness as temporary, if it has not then they will have bigger things to worry about.
Other G20 Countries
This week the BOJ is holding its policy meeting and is expected to keep policy unchanged. The RBA is publishing its minutes and Lowe and Bullock are speaking.
Key data releases this week include Japan’s CPI and China’s FX data.
Links to BOJ Rinban , BOE OMO
COVID-19 Monitoring
