The ECB is looking through mixed messages on the economy

Political tensions have ebbed away, at least for the time being. The eurozone is back to what it does best: muddling through. At the same time, the mist of weakening soft indicators and solid hard data is thickening. While this has increased downside risks for the growth outlook, it did not prevent the ECB from taking a huge step towards the end of quantitative easing (QE).

Economic data released over the last few weeks still leaves policymakers and forecasters a bit in the dark. How strong is the eurozone recovery? As 2017 ended at record highs, with almost endless upward revisions of growth forecasts and a general feeling of europhoria, the middle of 2018 has seen diminished expectations, dented enthusiasm and even concerns about the beginning of the end. The gradual decline of confidence indicators since the start of the year as well as erratic and often disappointing hard data contributed to increased nervousness about the state of the eurozone economy. Soft patch, severe downswing or simply the transition towards normalisation? What is it? 

Trade tariffs have had little economic impact so far

President Trump’s protectionist push had been blamed by some analysts as the reason why 1Q GDP came in at a relatively disappointing 2% annualised growth. However, we think bad weather and the 'typical' seasonal soft patch at the beginning of the year offer a better explanation. There is little evidence that the modest trade tariffs enacted so far have had much impact, especially with high-frequency indicators suggesting that the US economy probably grew by 4% in 2Q18.

Unemployment is at a 50-year low, business and consumer surveys are close to all-time highs and wages are finally showing some evidence of a long-awaited pick-up as firms struggle to find suitable workers. As such, economic momentum is strong and it will take a lot to derail this story. Trade tariffs alone are unlikely to do that.

There’s more value in outlining potential scenarios

This is a particularly uncertain time for FX markets; where the escalation in the global trade war ends nobody knows. This makes a baseline FX scenario exceptionally difficult.

Rather than delivering back-to-back cuts in our baseline EUR/USD profile (despite mounting pressure in that direction) this month we believe there’s more value in outlining potential scenarios. Our full scenario analysis can be found here.

Below we summarise four potential paths for EUR/USD into 2019, all supported by various assumptions for some of the key inputs, such as rate spreads and risk premia.

The 'too low' 30bp German 10yr yield

The fall to sub 30bp for the 10yr German yield is remarkable when contextualised against an ECB intending to (1) end quantitative easing (QE) this year and ready to (2) raise rates next year. While there is lots of talk about a weakening economy, that’s neither the driver nor a persuasive argument. We think there are two dominant influences, which added to a number of sideshows, are keeping rates under wraps.

Tankan survey and Japanese GDP

Japanese growth appears to have peaked in 1Q18, if the latest Tankan survey can be taken at face value, and unlike the official Japanese GDP data, it probably can. But although the headline index fell, and by more than had been expected, there are one or two reasons not to get too downbeat about the Japanese economy just yet. 

For starters, the non-manufacturing surveys- and diffusion indices for smaller firms- were a lot less negative (indeed, sometimes actually rose) than the large manufacturing series. Though this might simply be a factor of timing. Large manufacturing firms are typically more export-oriented and so have probably been more rapidly affected by plunging sentiment about trade and export orders than their more domestically-oriented and smaller suppliers and service sector support firms. Should the global trading environment worsen further - and we expect it to do so - then it is probably only a matter of time before these other firms go the same way as their larger manufacturing counterparts. 

The trade war officially begins

On Friday, the US imposed tariffs on $34 billion of Chinese goods prompting China to respond with levies of its own. The US administration is keen to close the trade deficit, and it believes that imposing tariffs on China can do the trick. We don't agree with this rationale. 

We expect that this is just the beginning of the trade war. The US will likely hit back, and though this may not happen immediately, it's just a matter of time. When the US does retaliate, China will too, probably without any delay. The momentum of this trade battle is controlled by the US. It can retaliate quickly to rock the market, or do so more slowly to allow investors to adjust.