Daily Comment (July 25, 2016)

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] It was another mostly quiet night.  We did see European equities lift on better economic sentiment data (see below).  The G-20 meeting ended with a mostly banal communiqué.  There was some discussion of fiscal policy by the group.  However, the G-20 structure is so unwieldy that any real group-wide adjustments only occur during crises.

For summer, this could be a momentous week.  First, the FOMC meets tomorrow and Wednesday.  No change in policy is expected.  This meeting will not produce dots or changes in forecasts, so the statement will be the most important item to emerge from the meeting.  The fed funds futures put the odds of a hike at this week’s meeting at a mere 10% and don’t record a greater than 50% reading until next March.  Thus, the financial markets could be vulnerable to comments that suggest a rate hike may be back on the agenda.  We would not be surprised to see some leaning in a hawkish direction but would not expect the FOMC to make a clear case for higher rates.  Still, one important risk to the “goldilocks” conditions we are experiencing would be a change in policy perceptions.

Also this week, the ECB will be releasing the results of its bank stress tests on Friday.  All eyes will be on Italy’s results.  Italian officials continue to claim that any problems are under control.  EU officials also claim that measures already taken have made the system safer.  We would be surprised to see any major banks fail the tests.  After all, they are political in nature.  We will be watching the market’s reaction to an expected good result.  If bank equities rally, it would suggest that investors view the tests as credible.  Today’s FT reports that Portuguese banks are bracing for massive losses from the government’s inability to find buyers for Novo Banco, the lender that emerged from the resolution of Banco Espirito Santo, which failed nearly two years ago.  Novo Banco was the “good bank” that came from the failed bank, and the government’s inability to privatize the good bank is not a good sign for financial markets in the EU.

Also on Friday, the BOJ will hold its policy meeting.  There are high expectations that the BOJ will “do something” to support the economy.  There is growing speculation that the Abe government will try to coordinate stimulus policy with the BOJ, although that may not happen at this meeting.  We would not be surprised to see the BOJ increase its buying of non-traditional assets, such as equity ETFs, but the hope for “helicopter money” is likely to be dashed, at least at this meeting.

In other news, the Guardian is reporting that the EU may be willing to offer Britain a seven-year exemption to freedom of movement rules while allowing the U.K. to remain in the single market.  France is strongly opposed to the concession but we suspect Germany does not want to see a major trading partner’s economy hurt by a hard Brexit.  Britain would still need to pay into the EU budget and would give up its seat at the negotiating table, but unchecked immigration seemed to be the biggest issue triggering the Brexit vote.  The risks for the EU are that such restrictions on movement inside the EU would be popular with other states but, if widely implemented, it would represent a major retreat from a unified Europe.  On the other hand, this might be the best solution available.  If this rule does come to pass, it would be supportive for U.K. financial assets.

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