Euro devaluation only exit bolt-hole for the ECB

Outlook

The BIS is catching up to pr ivate sector economists (like us) who say ther e is a ter r ible disconnect between market pricing and the real economy. BIS economist Borio told the WSJ, "Financial markets are euphoric, in the grip of an aggressive search for yield…and yet investment in the real economy remains weak while the macroeconomic and geopolitical outlook is still highly uncertain." Borio also said “the effectiveness of policies aiming to boost domestic demand—and therefore growth—has been stunted by large overhangs of debt. Governments in advanced economies have made progress in reducing their fiscal deficits since the crisis, but debt levels are higher than ever and still rising. The BIS report cited data that showed 2014 debt exceeding 100% of gross domestic product in most major economies, including Italy, Spain, France, the U.S. and the U.K.”

BIS GM Caruana said yesterday that high debt levels make ability to repay really hard if income falls and interest rates rise. "Thus, higher debt translates into greater financial fragility and financial cycles that may become increasingly disruptive," he said. Chances are that investors are unprepared for the consequences of normalization, which is too late and too gradually. Besides, extreme accommodation has stopped working.

Tell that to Mr. Draghi, who is trying to signal “lower for longer” while at the same time, analysts are busy trying to fig-ure out just when that ends. Well, it was inevitable, because we want to know what the banks will do. Everything hinges on them. Should they borrow short-term to fund credit or use the newly enlarged and extended long-term system? Bloomberg reports the long-term repo (LTRO) program is a get-out-of-jail-free card for the banks, “who can borrow funds for two years with no strings attached, and even use them to roll over existing emergency ECB loans.. [but] they must prove the money has been lent on to companies and households if they want to keep the funding until the program ends in 2018. … Banks can borrow in the ECB’s weekly and three-monthly operations at the benchmark rate, currently 0.15 percent. While the TLTROs will be priced at a 0.1 percentage-point premi-um, and so probably cost 0.25 percent in the first round of offers, the rate will be fixed for the term of the loan. The appeal therefore hinges on banks’ expectations for when and by how much the benchmark rate will increase.”

Draghi seems to have said lower for longer to end-2016, but maybe it’s 2017. We wonder whether banks think this far ahead… We know that they are reluctant to lend while credit quality/capital adequacy and stress tests are under review, delaying even further an already lagging process. Maybe they won’t increase lending to companies and households at all over the next three years. That leaves euro devaluation as the only exit bolt-hole for the ECB. We have been saying this for nearly a year: the ECB must want a weaker euro to make up for banks’ “intransigence.” We should all be on tiptoes waiting for more comments along this line from Mr. Draghi.

One of the big-picture consequences of the Fed tapering ending and the BoE raising rates early next year must be emerging markets taking a hit, again. The BIS is worried about the $2 trillion in new debt that EM’s have taken on since 2008. Another consequence is domestic—debt-based consumer spending must fall. The biggest case of debt-based consumer spending is houses, autos and durables. We get the NAR pending homes sales data for May today, with May and June the two important months for this metric. Wall Street guru Lynne notes that people want to buy houses in those months so that by closing, their kids qualify for the new school district. The May rise in existing home sales (by 18%) may have been led by this factor. Therefore, “there’s a lot rid-ing” on today’s number—and also tomorrow’s auto sales.

Tomorrow brings the US PMI and ISM manufacturing index, plus construction spending. Wednesday brings the ADP estimate of private sector job growth, factory orders and the oil inventory report. Thursday is non-farm payrolls, a day early because of the Fri-day holiday. We also get the June PMI services index and ISM services index. Note that Thursday is a half day for just about every market. Also Thursday is eurozone retail sales and the ECB policy meeting and Draghi press conference. Euro bulls might become skittish in case Draghi says something dramatic.

Realistically, the big number is the same as it always is—payrolls. Estimates range from 199,000 to 250,000, but analysts fret and fume that even 250,000 is not likely to drive the 10-eyar yield back to where we want it to support the dollar—over 2.65%. The me-dian estimate in the Market News survey is 208,000, not enough. And a disappointing number like 150,000 would be wildly dollar-negative. Also potentially negative are revisions to the headline number and other included data like the participation rate.

At least one analyst (at RBC) worries that the yield can dip to 2.40% on the news, the low from May 29. We could also get a positive surprise, like 250,000 and a rise in yields to 2.60% or more upon a resurgence of the recovery scenario, but optimism is in short sup-ply on a Monday morning. Don’t forget that the dollar almost always rises on the Wednesday before the usual first Friday payrolls, so if we jack back the release date, maybe we should jack back the dollar rising date, too—which could give us a classic pullback Tuesday.

Note to Readers: Friday, July 4 is a national holiday in the US, Independence Day. Market are closed. We will not publish any reports.