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December 16,2017

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Oil Falls, Pushing Euro Area Into Outright Deflation

Oil prices have continued to slide. Brent briefly traded below $50. Crude Oil is below $48. Both have fallen about 10% this week. Prices are stabilizing in late morning in Europe. However, unlike yesterday the fall in oil prices is not sending stocks or core bond yields lower. The MSCI AC Asia Pacific Index was flat, while the Dow Jones STOXX 600 in Europe is up 0.5%, near midday in London. All of the main industry sectors are higher in Europe, even energy.

 

US shares are trading higher in Europe. German, French, U.S., and U.K. benchmark 10-year are 1-3 bp higher. Spanish and Italian yields are slightly lower. Greek bonds remain under pressure, and 10-Year yields are at new highs for the move, pushing through 10% for the first time since September 2013.

 

The dollar itself is broadly higher, and North American traders are likely to follow suit. The euro, Swiss franc, and sterling have made new lows while the greenback was bought in Asia against the yen to return to the JPY119.25 area. The US reports the ADP employment estimate, which will steal some thunder from Friday's official data. There is some concern that the energy sector job losses will weaken the US labor market. It is important to keep it in perspective. Employment in the energy sector accounts for less than 1.5% of US jobs. The US will also report the November trade balance. Here there is a bit of a tug-of-war. Growth differentials would be expected to widen the deficit while the decline in oil prices pushes in the other direction.

 

Later in the session the FOMC minutes from the December meeting will be reported. We argue that the FOMC minutes have a high noise to signal ratio. Policy signals are clearest from the Fed's leadership, Yellen, Fischer, and Dudley. The instrument that best expresses their views is the FOMC statement. The minutes obscure the signal. Recall that there were three dissents at the December meeting. The dissents are peculiar for two reasons. First, the dissents are not like they are at the BOE, where two members of the MPC have voted in favor of immediate hikes. Rather the dissents at the Fed are over how future guidance is stated. No one, including the so-called hawks, have dissented in favor of an immediate hike in rates. Second, the three dissenting regional presidents have indicated intentions to resign in the coming months.

 

There have been two important economic reports in Europe. First, the preliminary December CPI reading now shows outright deflation. It fell to -0.2% from +0.3% in November. It appears solely due to the price of energy. The core rate actually ticked up to 0.8% from 0.7%.

 

The ECB was given a mandate, price stability. How it defined it was in its hands. It could have focused on the core as the Federal Reserve does, but instead it insists on the targeting the headline rate, which has generated poor policy signals in the past, such as the rate hike in mid-2008. Draghi has guided the ECB more in the Fed's direction in terms of number of meetings, rotating voting and publishing a record (soon) of the meetings. However, the focus remains on the headline rate, which leaves the ECB vulnerable to pursuing a pro-cyclical monetary policy.

 

There are two main reasons why officials fear deflation. First, it creates stress for debtors, and through that channel creditors. Second, is that deflation could set off a downward spiral in demand as consumers hold back purchases, expecting lower prices. While the first is indisputable, the second is questionable. Look at Spain and Germany for examples. Spain's retail sales have been improving even though it is experiencing outright deflation. Today Germany reported a 1.0% rise in November retail sales. The market expected a 0.2% increase.

 

This follows an upward revision to 2.0% (from 1.9%) in the October series.

On the other hand, the divergence with in the euro was driven home by the contrasting employment reports in Germany and Italy. German unemployment in December unexpectedly fell to a record low of 6.5%. Italy reported an increase in unemployment to 13.4%, the highest since 1977. Youth unemployment in Italy rose to a new record high of 43.9%. Perhaps it is our own confusion, but it is hard to see how another 50 bp decline in Italian yields, if that is what is hoped for by a bond buying program, or a 0.5% increase in headline inflation, would begin to address this divergence.

 

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