Eurozone Uncertainty: Breaking Badly?

Mid Week Bond Update

Eurozone Uncertainty: Breaking Badly?

Policy uncertainty is among the largest challenges for euro-area economies.

Economic uncertainty in the Euro area is on the upswing, as measured by Bloomberg’s composite measure, which combines readings on three key areas: financial markets, general economic policy, and surveyed busines sentiment. The composite has now reached a level not seen since the European financial crisis of 2011-12: no wonder European Central Bank (ECB) President Mario Draghi, in his penultimate appearance after the Governing Council’s meeting last week, described the Eurozone’s economic outlook as  “worse and worse”,  setting the stage for a repeat of the ECB’s post-crisis rate cuts and bond-buying.

That’s in contrast with the generally sanguine outlook of several indicators designed to look at similar factors in the U.S., according to Brandywine Global. That disconnect has caused some observers to wonder out loud if U.S. financial conditions truly warrant the Fed rate cut that markets see as all but certain.
 

Eurozone Economic Uncertainty: Reflecting Regional Realities

Chart: Bloomberg Economics Euro Area Uncertainy Guage

Source: Bloomberg, as of July 30, 2019.  Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Given the dovish tilt of both the Fed and the ECB, it’s noteworthy that the U.S. dollar has appreciated nearly 100 basis points1 since 22 July – despite expectations that a U.S. rate cut could drive the greenback down. By the way, don’t blame the plummeting pound for the dollar’s strength; the largest component of the dollar index is the euro, at over 57%; sterling comes in third at just under 12%, behind the Japanese yen’s 13.6%.
 

On the rise: New broom: Turkish Lira

Turkey’s new central bank governor wasted little time after taking the reins three weeks ago.  Last Thursday, Murat Uysal slashed Turkey’s benchmark borrowing rate by 4.25 percentage points to 10.75%, citing “weaker global economic activity and heightened downside risks to inflation”.  This was the bank’s first rate cut since 2016, and the biggest since the bank began targeting inflation in 2002, After a brief wobble on the day of the announcement, the Turkish lira has risen nearly three percent to 5.55 per U.S. dollar.

The policy bet appears to be that inflation, already on the downtrend, would fall further as a result of the Lira’s rise, driving down costs of non-Turkish imports. If it works in the near to medium term, add Turkey to the list of countries where cutting rates drives up growth That said, given the high starting point (24%), it’s unclear whether the lesson would resonate outside of high-rate emerging market (EM) economies.
 

On the slide: U.S. balanced budget

Last week’s agreement between the White House and Congress suspended the ceiling on U.S. borrowing, previously set at about $22 trillion, and added about $320 billion to the budgeted spending of the U.S. for the budget year ahead, which begins on October 1, 2019.

The agreement is intended to run for two years, which means that it will expire after the upcoming Presidential and Congressional elections in November 2020, taking off the table a new  debt ceiling debate, as well as the prospect of closing the Federal government in response to that ceiling being  reached. By doing so, the agreement substantially reduces overall economic policy uncertainty, though at the cost of a rapid increase in spending and U.S. overall indebtedness.  Adherents of “Modern Monetary Theory” may generally believe that the increase in indebtedness is a positive; others clearly disagree, but are bowing to the political realities of the current U.S. political environment.

 

All data Source: Bloomberg as of July 30, 2019 unless otherwise specified.

 

1 Source: Bloomberg, July 30, 2019, 2:00 PM ET.

 

Definitions:

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The European Central Bank (ECB) is the  central bank of theEuropean Union (EU).

The Bloomberg Economics Euro Area Uncertainty Gauge is a composite measure comprising three key aspects: financial market uncertainty; economic policy uncertainty; uncertainty based on business surveys. The units of measure are standard deviations from the mean between January 2000 and December 2018.

One basis point (bps) equals one one-hundredth of one percentage point

The Turkish lira is the national currency of Turkey.

Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.

Modern Monetary Theory (MMT), not widely accepted, has the following basic attributes: A government that prints and borrows in its own currency cannot be forced to default, since it can always create money to pay creditors. New money can also pay for government spending; tax revenues are unnecessary. Governments, furthermore, should use their budgets to manage demand and maintain full employment (tasks now assigned to monetary policy, set by central banks). The main constraint on government spending is not the mood of the bond market, but the availability of underused resources, like jobless workers.

 

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