CREDENCE CAPITAL

(Investment Club of IIM Lucknow)

Central bank policies and market developments

Source: Bloomberg Week ending: 19 Jan 2019
INDIA
Data on Monday showed that CPI growth eased to 2.19% in December, and was the lowest
reading in 18 months. While food inflation has turned negative since October 2018, and fuel
inflation has been highly volatile, inflation excluding food and fuel remains sticky at close to
6%. The RBI targets headline retail inflation at around 4% in the medium term. Such wide
divergence across major inflation indicators pose challenges ahead of the next MPC meeting
on Feb 7th .
During the week, the rupee rose by the most in 2 weeks amid gains in bonds and the Sensex.
Increased selling of the greenback by exporters and lower crude oil prices were the primary
contributors to this rally. The rupee was also aided by the central bank easing some overseas
borrowing norms for companies. All eligible borrowers can now raise external commercial
borrowings up to $750M or equivalent per FY under the automatic route, replacing the
existing sector-wise limits.
On Friday, the rupee and 10yr gilt fell after Finance Minister, Arun Jaitley hinted at the farm
relief package ahead of the budget. Rupee weakened to a one-month low of 71.18 down 0.15%
from the previous close. Yield on the 2028 paper rose 5bps to 7.593%. Limited room for
bonds to rally as traders are still concerned about India’s fiscal deficit. India’s trade deficit
narrowed in December to $13.1Bn from $16.7Bn shortfall in November.
CHINA
China has offered to go on a 6-year buying spree to ramp up imports from the US, in a move
that would reconfigure the relationship between the world’s two largest economies,
according to officials familiar with the negotiations. China will also cut taxes on a larger scale
to help support its slowing economy, according to senior policy officials. Chinese exports
slumped in December, fuelling concerns about global growth. Public Bank of China (PBOC)
deputy governor Zhu Hexin stated that current monetary policy is in line with the economic
situation and prices. Additionally, Trump administration officials are considering measures
to roll back tariffs on Chinese products in order to calm financial markets.
On the back of China’s offer to escalate imports, oil prices spiked to a 6-week high on Friday.
China’s government bond yields are looking more likely to fall below the 3% level for the first
time since 2016. The key level may be broken around the Lunar New Year with possibility of
more cash injections from the central bank. Chinese bonds have rallied as authorities eased
monetary policy to shore up the economy and meet seasonal funding needs.
China’s December trade data intensifies concerns about a collapse in China’s trade. Exports
fell 4.4% YoY. The consensus forecast was for an increase of 2.0%. Imports showed a deeper
contraction, down 7.6% YoY, likely reflecting the combined impact of slowing outbound
shipments, weaker domestic demand and lower commodity prices.
EURO AREA
Growth has fallen substantially in the Euro area’s largest economies this year. France saw
quarterly growth slump 0.2% in the first 3 quarters of 2018 from an average of 0.7% through

Central bank policies and market developments

 CREDENCE CAPITAL
(Investment Club of IIM Lucknow)

2017. Activity contracted in Germany and Italy in 3Q18. In contrast, Spain appeared to keep
steaming ahead, posting growth of 0.6% in each of the first 3 quarters of 2018.
When the ECB announces its monetary policy decision on Jan 24th, it will be against a
backdrop of deteriorating economic performance. This does not appear to be symptomatic of
a nascent global downturn. Rather, it appears to be a series of country specific shocks and
their knockon influences on sentiment that have driven Italy and Germany close to recession
and acted as a material drag on the growth of France. The expectation is now for the Euro-
Area economy to expand by just 0.2% in 4Q, the same as 3Q and materially below the ECB’s
December projection for 0.4%.
At the last ECB meeting, Draghi emphasised the role that market expectations of interest
rates have in softening and stimulating aggregate demand as the data evolves. If the ECB’s
reaction function is known, there is no need for it to explicitly signal that it expects to delay
lifting interest rates for the economy to get extra support. Financial markets will reprice as
the data evolves, and is exactly what we see. The ECB shadow policy rate, a composite of
risk-free lending rates weighted by the share of lending made at each maturity, has declined
in recent months.
JAPAN
Japan’s core inflation slowed more than expected in December, pressured by lower oil prices.
Falling prices of fresh food also pushed down headline inflation. Fluctuations in prices of oil
and fresh foods don’t usually change the dynamics of the consumer price over the medium
term. Even so, the setback is likely to cause some consternation at the BoJ, which holds a
board meeting next week.
The outlook for Japan’s growth and inflation this year has dimmed amid signs of slowing
global growth, including in China. The US-China trade war poses a risk to Japan’s export
dependent economy, as does a stronger yen.
There is a good chance that the Yen could strengthen to 100 against the dollar in the coming
months as slowing global growth and US-China trade tensions keep investors on edge. The
currency, seen as a haven asset, has surged in recent weeks as investors sought shelter from
market turmoil.
The BoJ is set to keep policy rates unchanged next week. Even so, discussions are likely to be
lively, as the board faces a combination of slowing inflation and growth, and increasing
external risks. Downside risks to growth have risen since its last meeting, with exports under
pressure from weaker external demand and a jump in the Yen. Core inflation slowed to 0.8%
YoY in December (versus the BoJ’s 2% target), pressured by oil prices and narrower output
gap. The expectation is for the BoJ to trim its growth forecast for fiscal 2019 and 2010.
UNITED STATES OF AMERICA
Following the year-end turbulence, NY Fed president John Williams asserted that it is
appropriate for the Fed to pause and reassess economic conditions while the residual effects
of 2018 rate hikes, in addition to the ongoing balance sheet unwind, percolate through
financial markets and the economy. The FOMC pegs longer-run growth near 1.9%. If policy
makers see growth on track to top 2.25% in the first half of the year, they will likely begin
gearing up for additional normalisation.

Central bank policies and market developments

 CREDENCE CAPITAL
(Investment Club of IIM Lucknow)

Initial jobless claims edged lower in the January payrolls survey week. The government
shutdown, now in its fourth week, does not appear to have affected claims numbers yet.
US Industrial production data for December demonstrated that the manufacturing sector
remained on solid ground. Although the trade war dominated the comments section on the
release, there was no indication that the ongoing skirmish has had any impact on real
production or demand for manufactured goods.
BRITAIN
The scale of defeat for PM Theresa May’s Brexit deal raises the likelihood of a delay to
Britain’s departure from the EU. That would mean yet more uncertainty weighing on an
already bruised economy as well as a delay to the next hike in interest rates. The vote raised
the chances of a softer exit or no Brexit by more than it lifted the probability of no deal.
May’s deal was defeated by 432 to 202, an unprecedented loss in modern history. Her
immediate response was to make way for a vote of no confidence in her government, which
the opposition Labour Party leader Jeremy Corbyn duly tabled.
The EU is willing to delay Brexit well into the second half of next year, as governments
examine ways of preventing the UK crashing out of the bloc without a deal. The EU is likely
to approve any UK request to extend the Article 50 negotiation period beyond March 29th
and the extension could go well beyond the first sitting of a newly elected European
Parliament at the start of July. May said on Wednesday that it is still her plan to leave the EU
on March 29 but didn’t rule out a possible extension.

Central bank policies and market developments