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In spite of a renewed extension of the deadline to correct the deficit, full compliance with the Stability and Growth Pact is still at risk given the current political deadlock. Until a consensus about constitutional, geographical and fiscal reforms is reached, political uncertainty will linger and weigh on fiscal metrics. Sustained nominal growth and exceptionally favourable financing conditions should nonetheless allow the fiscal deficit to decrease gradually.
FOMC voters thought it was appropriate to wait for additional information in order to gauge the underlying momentum in the labor market and economic activity before taking another step in removing monetary accommodation. "Most participants anticipated that economic growth would move up to a rate somewhat above its longer-run trend during the second half of 2016 and that the labor market would strengthen further." We believe that Chair Yellen is willing to test the downside of the natural rate of unemployment in order to meet the Fed's maximum employment mandate.
We have analysed the scarcity issue for German bonds as it is the most obvious impediment to the smooth running of the purchase programme until a suitable end time. Our conclusion was not extremely reassuring as it pointed to difficulties for the ECB starting this winter.
July nonfarm payrolls rose by a robust 255K. The 3-month moving average of payroll gains moved up to 190K in July. We look for average monthly payroll gains to decelerate this year with the economy near full employment. The July unemployment rate was unchanged at 4.9%. Alternative labor slack measures were generally stable. The participation rate rose to 62.8%.
On 4 August, the Bank of England lowered its key policy rate by 25bp to 0.25% as a response to the expectation of a Brexit-induced weakness in demand. Furthermore, it delivered a package of unconventional measures aiming to provide additional support to growth. These included a restart of the purchases of government bonds to the tune of GBP60bn, the purchase of corporate bonds (up to GBP10bn) and a new Term Funding Scheme.
Most political pundits look for Hillary Clinton to win the November election and be sworn in as the 45th President of the United Sates on January 20, 2017. Current poll results suggest that the electoral path to victory for Donald Trump is possible but much more difficult. Additional state polls will be needed to clarify the odds as we move closer to the November 8th election.
The FOMC maintained its current monetary policy settings today, in line with market expectations. Neither the 0.25% to 0.50% Fed funds target range nor the Fed's current portfolio reinvestment policies were changed. The assessment of current economic conditions in the policy statement was more upbeat, reflecting stronger job gains in June and an expected acceleration in Q2 real GDP growth to be reported on Friday.
The ECB press conference has been in line with expectations: Mario Draghi only gave us a rendezvous in September, when the ECB will publish its new macroeconomic projection and when the consequences of Brexit on the Eurozone will be clearer. We agree with the ECB that the Eurozone does not need an acceleration of monetary easing and that the Brexit does not change things dramatically. We maintain our view that the ECB will extend QE by six months and that it will be announced in September. This extension will probably come with an easing of the purchase modalities to face the bonds scarcity.
In the current conditions, the ECB will face a shortage of bond before the end of this year. We think that Eurozone economic conditions will encourage the ECB to extend QE until at least September 2017, and the basic conclusion to that is that the ECB will have to change its PSPP. Several options are possible – and in reality the PSPP already has enough flexibility to address this shortage: the ‘substitute purchases'. However, while these substitutes appear sufficient to address the shortage of bonds from small countries, things may be more complex where Germany is concerned (and the Netherlands soon after). We do not think that the ECB will let the flexibilities come into force for Germany without making a formal decision about it, and we see the dropping of the capital key as highly complex politically. Scrapping the deposit rate limit appears to be a better option, even if it could push short-term sovereign rates way lower and then pose difficulties for money-market funds – beyond distorting the market further in unchartered waters.
The ECB's QE started in March 2015; 15 months later it was widened (inclusion of corporate bonds and sub-sovereign bonds), increased (to EUR80bn per month) and extended (until March 2017 or beyond if necessary). Other changes are possible, and we think that at the very least QE will be extended until September 2017 – or beyond.
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