Hawkish ECB comments compound fiscal pressures

Economic

Summary:

Prospects of increased EU military spending are keeping bond yields under upward pressure, this time compounded by hawkish comments from the ECB. Hotter UK CPI figures on Wednesday also pushed in the direction of a more hawkish adjustment of BoE rate cut expectations.

Hawkish comments from ECB against backdrop of defence spending

Rates are still pushing higher, now compounded by hawkish remarks from the European Central Bank’s Isabel Schnabel. While dismissing the possibility of hikes, she mentioned the ECB was getting closer to where rates should be kept on hold or cuts at least paused. Coming from her, such remarks should not surprise as Schnabel has previously been estimating the neutral rate as high as 3%.

But what has changed in the meantime is the perception of the fiscal backdrop, where aside from the immediate supply implications, the prospect for larger defence investments also argues for a more expansionary stance ahead. The question of course remains to what degree such investments translate into economic activity.

Markets have pushed their expectations for the ECB deposit facility rate at year-end towards 2%, trimming chances that the ECB could end up in more accommodative territory. While front-end rates nudged up 3bp, the back-end bond yields still rose even more against the backdrop of higher debt issuance expectations. German Bunds underperformed versus swaps with the 10y yield back at more than 7bp above swaps – on closing levels that is the cheapest valuation to date.

This time around, however, the hawkish ECB tone has also prompted other sovereign spreads over Bunds to widen out – but not much yet. A 10y Italy-Bund spread of 108bp is still very tight coming from 115bp at the start of the year and levels over 150bp in June last year. However, we still feel the market may be a bit optimistic about the degree common EU issuance can cover the additional military spending needs, at least in the short run.

Markets are taking hotter UK inflation at face value

The UK’s headline CPI number for January came in at 3.0%, up from 2.5% the month before and above the consensus of 2.8%. Rates ticked higher, but in our view the underlying message from the data was actually more on the dovish side. Services inflation is admittedly still high, but at 5%, just about undershot consensus. And our estimate of core services inflation would now be just 4.2%, well below the 4.7% from two months back.

The 10y gilt yield rose by some 4bp to 4.6%, but markets are still close to fully pricing in a 25bp rate cut in May. A rate cut in March seems off the table and we tend to agree that the Bank of England will opt to cut rates gradually at a quarterly pace. With inflation still trending down, we think risks are tilted to the downside and any growth headwinds could quickly accelerate the path of easing. For the front end, we maintain an overall bullish view, and given the back end is more tied to the US, the next move will likely be a steepening of curves.

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Warren Takunda

Economic

Australia's unemployment rate ticked higher in January even though job creation handily outpaced forecasts, data showed on Thursday, a mixed outcome that does little to clarify the outlook for further cuts in interest rates.

Figures from the Australian Bureau of Statistics showed net employment rose 44,300 in January from December, when it jumped 60,000. That was well above market forecasts for a 20,000 rise, and all of the gains came in full-time employment, which climbed by 54,100.

Annual jobs growth accelerated further to a blistering 3.5%, more than twice the pace seen in the United States.

The jobless rate still nudged up to 4.1%, from 4.0%, as the workforce expanded by even more than the increase in jobs. This was largely due to more women looking for work and finding jobs, which lifted the participation rate to a record high of 67.3%.

The ABS noted a pattern had emerged since the pandemic where an unusually large number of people were not employed in January but expected to start a job in the near future.

This phenomenon tended to see the unemployment rate rise in January, only to fall back in February.

"The uptick in joblessness overstates the extent to which the job market loosened last month," said Abhijit Surya, a senior economist at Capital Economics.

"The tight labour market reinforces our view that the RBA will deliver a shallow easing cycle."

The Reserve Bank of Australia this week trimmed its cash rate by 25 basis points to 4.10%, but cautioned further easing could not be guaranteed given upside risks to inflation.

It noted the strength of employment was a hurdle to further cuts since it could stoke cost pressures and prevent core inflation from slowing to the middle of its 2-3% target band.

with the S&P 500 gaining about a quarter of a percent to notch its second straight closing high,

Core inflation ran at 3.2% in the December quarter and is expected to slip under 3.0% this quarter. The RBA now expects it to bottom out at 2.7% and above its 2.5% target, in large part due to the "tight" labour market.

However, the main inflationary effect of strong employment is typically through rising wages, and they are actually heading in the opposite direction.

Figures released on Wednesday showed wages rose by a surprisingly subdued 0.7% in the December quarter, pulling annual growth down to 3.2% and a long way from its 2023 peak of 4.2%.

"This will keep the RBA alive to the prospect the labour market may not be as inflationary as their forecasts imply as they weigh the case for further easing," said Taylor Nugent, a senior markets economist at NAB.

"We assess the labour market is near balance and forecast the unemployment rate will rise only modestly."

The moderation in wages is one reason markets are still pricing in a 75% chance the RBA will cut rates again in May, after skipping a move at its April meeting.

The easing cycle is expected to be shallow, with rates finding a floor at 3.6% by year-end.

Source: Reuters

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Owen Li

Economic

US President Donald Trump's decision to impose a 25% tariff on automotive, semiconductor and pharmaceutical imports will be a challenge for Malaysia.

Foreign Minister Datuk Seri Mohamad Hasan said this is because 60% of Malaysia's total trade with the US comprises electrical and electronics (E&E) exports.

“This is a huge blow if we can't get this resolved soon.

"That's why yesterday (Wednesday), I mentioned in this honourable assembly that Asean plans to hold a special Asean-US summit immediately to present to the new US administration (on the matter).

“We need to confer on how to provide the views from Asean countries to ensure the proposed tariffs do not burden us,” he said during a question-and-answer session in the Dewan Rakyat on Thursday.

He added that what the US is doing is ‘reshoring’.

"By [reshoring], it means the US is imposing this high tax, so that large companies operating outside the US return to the US and establish operations in the US itself," he said in reply to a question from Manndzri Nasib (Barisan Nasional-Teggara), who wanted to know the extent to which Malaysia can benefit from the organisation of the 2nd Asean-Gulf Cooperation Council (GCC) Summit and the Asean-GCC-China Summit in increasing economic cooperation, trade and national and regional investment.

Mohamad, who is also known as Tok Mat and Mat Hasan, said the three blocs of Asean, GCC and China should sit together to discuss the matter.

"This is because China is a country with one of the largest markets, the GCC is a country with capital, and Asean is a block of countries with many natural resources.

"If these three blocs can negotiate, we can develop the intra-Asean economy, making Asean the fourth largest economy in the world by 2030," he said.

Source: Theedgemarkets

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ING

Economic

The EU agreed on a 16th sanctions package against Russia, which includes a ban on aluminium imports and additional curbs on Russian vessels.

Energy – EU sanctions Russian vessels

Supply uncertainty continues to support the oil market, which faces multiple risks, including disruptions to Kazakh flows, the potential for a delay in the return of OPEC+ barrels, weather events in the US, and ever-present sanctions risks hanging over the market. The concerns pushed ICE Brent back above US$76/bbl yesterday.

This week, the market is dealing with supply disruptions in North Dakota due to extremely cold weather. The North Dakota Pipeline Authority said that oil production is down between 120-150k b/d, while natural gas production has also taken a hit. These disruptions will likely last until the weekend when warmer weather is forecast in the region.

As for sanctions, the EU agreed to a new sanctions package against Russia. It includes targeting oil exports by sanctioning 73 additional vessels that are part of Russia’s shadow fleet. The EU had sanctioned 79 vessels previously. While similar sanctions from the US on Russia have not led to a significant drop in export volumes, floating storage has increased. This has buyers less willing to accept sanctioned vessels.

However, potential restarts of oil flows from Iraq’s Kurdistan region, and soon, are offsetting these supply risks. There's talk that these flows could resume soon, after being offline since early 2023. A resumption could bring 300k b/d of supply onto the market. This isn’t the first time that there’s been talk of an imminent restart of flows. In addition, it’s unclear how Iraq would manage its OPEC+ production target if these flows were to resume.

Overnight, data from the American Petroleum Institute showed that crude oil inventories rose by 3.3m barrels over the last week, close to market expectations. Meanwhile, crude stocks at the WTI delivery hub increased by 1.7m barrels, fitting with recent weakness in the prompt WTI timespread. On the product side, gasoline inventories increased by 2.8m barrels, while distillate stocks declined by 2.7m barrels. The widely-followed Energy Information Administration inventory report will be released later today.

Metals – Aluminium rises after EU agrees to ban on Russian imports

LME aluminium prices rose above $2,700/t briefly yesterday, for the first time in a month. This followed reports the EU agreed on a sixteenth package of sanctions against Russia, including a ban on primary aluminium imports. Prices later gave up the gains.

The package is expected to be adopted by EU foreign ministers on Monday to mark the third anniversary of Russia’s invasion of Ukraine. This comes as the US conducts talks with Russia on a peace deal to end the war in Ukraine. The US has signalled that sanctions relief could be part of an agreement.

The ban on Russian aluminium imports will be phased in a year from the official adoption of the package. Any impact is likely to be limited. Although the EU continues to import Russian aluminium, volumes have fallen, with European buyers self-sanctioning since the invasion of Ukraine. Russia now accounts for around 6% of European imports of primary aluminium, half 2022 levels. The gap left by Russian supplies has mostly been filled by imports from the Middle East, India, and Southeast Asia, and this trend is likely to continue. Meanwhile, more Russian metal has been shipped to China, the world's biggest aluminium consumer.

The US and the UK banned the import of metals produced in Russia in 2024. The EU has so far banned aluminium products, including wire, tube, pipe and foil, which account for less than 15% of EU imports.

Russia is the world’s largest aluminium producer outside China, accounting for about 5% of global aluminium production.

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ING

Economic

The standout move in overnight FX markets has been the drop in USD/JPY close to 150 as traders get excited about another hike from the Bank of Japan. Expect USD/JPY to stay offered today before tomorrow's January CPI data release. Elsewhere, we think a new fiscal risk premium could emerge in the euro as national bond markets take the strain of defence spending.

USD: The Fed doesn't seem worried about the consumer

The DXY dollar index is a little softer. Yet this is not a broad-based decline but is largely led by developments in Japan. Here, local investors seem impressed that there has been little official push-back against the recent rise in JGB yields and that the Bank Of Japan may hike again this summer. The OIS market prices 21bp of a 25bp hike in July – which would take the policy rate to 0.75%. We have been surprised by the yen's strength in response to these relatively modest moves in Japanese interest rates. And we do note that speculative positioning is now quite long for the yen. However, we don't want to stand in the way of further short-term term USD/JPY losses, because tomorrow's January Japan CPI release could trigger another leg lower. That said, we are not looking for a sizable USD/JPY move sub-150 and instead prefer yen out-performance on the crosses – especially against the euro (see below).

When it comes to the dollar, we largely see it staying supported. Even though short-dated US yields fell 2bp on last night's release of the January FOMC minutes, the release did not look particularly dovish. The clear message was that the Fed needed to see additional evidence or progress before cutting rates again. At the same time, the Fed released a very interesting speech from Vice Chair Philip Jefferson. He noted that those from the entire income spectrum had been enjoying the benefits of wealth effects and seemed to suggest that US household balance sheets were in relatively healthy shape.

For today, FX markets will also be digesting some overnight comments from President Trump that the US could sign a new trade deal with China. That saw USD/CNH come off a little in Asia, but we doubt it is enough to prompt a big re-rating of the Rest of the World currencies just yet. Assuming that there is no big spike in the US weekly jobless claims data today, we think DXY can find support under 107

EUR: New theme alert – fiscal risk premium

The euro is looking soft on the crosses and a new theme may be coming into play on the back of geopolitical developments. US isolationism means that Europe is going to have to ramp up defence spending sharply. Please see our team's views on the subject here. The question is: who's going to pay for it? Will spending be undertaken at the European supranational level? Or will a failure to reach any collective agreement put pressure back on local and national budgets? Italy could be in focus here with perhaps one of the greatest needs to increase defence spending but a debt-to-GDP ratio already close to 140%. Our rates strategy team feels that the recent narrowing in Italian-German sovereign bond spreads could well reverse as it dawns on investors that national governments will be paying the defence bill.

Some of these trends started to show through in financial markets yesterday, where European debt really started to underperform. We are seeing a bearish steepening of European bond curves, where the German 2-10-year Bund curve, now at 38bp, has steepened to the highest levels since October 2022. We are wary that the theme of increased government bond supply can pressure peripheral spreads and demand a new fiscal risk premium of the euro.

This comes at a time when there is not much trade risk premium priced into EUR/USD either. As above, there do not seem any immediate signs that the US consumer is about to crumble or that the Fed is about to pull the trigger on another rate cut. Overall we have a slight preference that EUR/USD stalls in the 1.0450/70 area and could drop to 1.0350 should we start to see Italian longer-dated government bonds coming under pressure.

The eurozone data calendar today sees February consumer confidence at 16CET. No fireworks are expected here. And despite low unemployment and high real wage growth in Europe, it looks as though the twin threats of trade and European security will keep European savings rates high and demand subdued.

GBP: The European bond market sell-off is unwelcome

If European bond markets are going to sell off further, life may become even harder for UK Chancellor Rachel Reeves. Remember she is going to provide a spending update on 26 March and needs to credibly argue how the government will hit its fiscal rule of a balanced budget in FY29/30.

Higher gilt yields mean a higher bar for a credible spending plan and questions whether she can present a plan that defers spending cuts to the later years. If gilt yields are pressing their January highs at the time of the March review, this means either: a) the Chancellor will need to deliver deeper spending cuts or b) UK asset markets get hit should her plans not look credible. Neither scenario is a good look for sterling and that is why we doubt GBP/USD holds any near-term gains over the 1.26 area.

CEE: Markets have priced most of the positives

After a rather quiet first half of the week, we will see a busier calendar today. The main focus should be on Poland, where labour market data including wage growth, industrial production, and PPI will be released. Although recent PMI readings give some ground for optimism, industrial activity remains subdued and the ongoing recession in Germany is weighing on Polish manufacturing. Industrial output remains stagnant with annual changes swinging from positive to negative, depending on the calendar effect. We forecast a slightly negative reading for January. At the same time, PPI deflation is moderating, and we should see growth in producers’ prices in the coming months. Wage growth fell below 10%YoY in December and we expect pay in the enterprise sector to continue rising at a single-digit pace in 2025 after three consecutive years of double-digit growth.

Yesterday, the market saw the first correction after several weeks of rally in CEE FX under the positive sentiment coming from the Ukraine negotiations. As discussed here earlier, we believe the main driver of the rally was and still is sentiment only, while the fundamentals of the economy remain almost unchanged for now. At the same time, we have seen some rally in CEE rates while EUR rates are flat or higher. This leaves the market with a narrower interest rate differential across the board which we believe will start to weigh on strong CEE FX once positive sentiment starts to fade. Yesterday could thus be the first day of this correction and PLN and HUF in particular may be vulnerable given the heavy positioning built up in recent weeks. Although we are not calling for a significant correction, we believe that for now the rally is done and the market is pricing in most of the positives. Any surprise will come rather on the negative side from these levels.

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Cohen

Economic

China has been "doing its best" to push for negotiations with the European Union over its tariffs on Chinese-made electric vehicles, a commerce ministry spokesperson said on Thursday, almost four months after the punitive import curbs took effect.

The bloc voted to increase the tariffs to as much as 45.3% in October after the European Commission — which oversees EU trade policy — launched an anti-subsidy probe into whether Chinese firms benefited from preferential grants and financing as well as land, batteries and raw materials at below market prices.

"China has been doing its best to push for negotiations with the EU," He Yadong said. "It is hoped that the EU will take notice of the call from industry and promote bilateral investment cooperation through dialogue and consultation."

China launched its own probes last year into imports of EU brandy, dairy and pork products.

He told reporters China's anti-dumping probe into Europe's pork products and anti-subsidy investigation into the 27-strong bloc's dairy trade were still ongoing, when asked how the cases were progressing.

"We will conduct the investigation in an open and transparent manner in accordance with Chinese laws and regulations and World Trade Organization rules," he added.

China's commerce ministry in December decided to extend its anti-dumping investigation into EU brandy imports by three months to April 5.

Source: Theedgemarkets

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Warren Takunda

Economic

"We are getting closer to the point where we may have to pause or halt our rate cuts," prominent ECB board member Isabel Schnabel told the Financial Times midweek.

The comments caused a readjustment in market expectations as forward curves now show that the ECB has less than three interest rate cuts left in the year.

As of November, the pricing was far more generous, with the market priced for as many as five cuts this year.

"Her comments have opened up the debate in the long run-up to the March meeting. We expect the rate cut then to be followed by a pause at least through April, ending the back-to-back sequence since September," says Mathias Van der Jeugt, an economist at KBC Bank.

The readjustment in expectations coincides with a recovery by the Euro against the Dollar through much of January and into February. The repricing in ECB expectations helped fortify the Euro against the Pound in the midweek session, limiting losses following a strong UK inflation report.

Interest rate expectations feed bond valuations, an important determinant of global capital flows. The Euro stands to appreciate if the Eurozone's rate differential with the likes of the UK and U.S. shrinks.

"ECB executive board member Schnabel is the first to suggest that the direction of travel (of monetary policy) is not so clear anymore," says Mathias Van der Jeugt, an analyst at KBC Bank.

The ECB has cut rates five times since June as policymakers worried about slow eurozone economic growth, but with a trade war on the horizon, concerns about inflation have returned.

Above: Market expectations for the depth of ECB rate cuts have reached a nadir and are climbing again.

Schnabel's comments are the latest in a trend change in ECB communications, in place since December's policy meeting, leading markets to no longer fully 'price in' an April rate cut.

"We need to start that discussion," she said, adding, "we can no longer say with confidence that our monetary policy is still restrictive."

A third ECB rate cut is priced at 88%, meaning there is scope for this to reduce further, providing scope for an additional 'hawkish' adjustment in expectations in favour of the Euro.

"Even though another rate cut is still widely expected at the next meeting in two weeks’ time, there’s now more doubt among investors about whether that’ll be followed up by many more," says Henry Allen, a macro strategist at Deutsche Bank.