- Three of the four G5 central banks meet in the week ahead: the Fed, the BOE, and BOJ
- These central bank meetings and last week’s ECB meeting may render the market somewhat less sensitive to this week’s high frequency data.
- Political developments compete with economic developments for investors’ attention
The dollar is mixed against the majors in narrow ranges as the new week begins. Nokkie and the yen are outperforming, while sterling and Kiwi are underperforming. EM currencies are mixed but also in narrow ranges. ZAR and TRY are outperforming, while KRW and INR are underperforming. MSCI Asia Pacific was down 0.3%, with the Nikkei falling 0.5%. MSCI EM is down 1%, with the Shanghai Composite falling 0.6%. Euro Stoxx 600 is down 1% near midday, while S&P futures are pointing to a lower open. The 10-year US yield is flat at 2.20%. Commodity prices are mixed, with Brent oil up 0.4%, copper down 0.6%, and gold up 0.2%.
Three of the four G5 central banks meet in the week ahead: the Federal Reserve, the Bank of England and the Bank of Japan. Only the Fed is expected to change policy, and investors are as sure that a 25 bp hike will be delivered as they can be.
Our calculations, based on assumptions where Fed funds will effectively trade (weighted average) for the second half of the month and where it may trade on the last day of the month (quarter end), suggested that fair value on a 25 bp hike would have the June contract imply a yield of 1.04%. Before the weekend, it closed at 1.0325%. Bloomberg, which recently changed its methodology, suggests the market has discounted a 97.8% chance of a hike, while the CME is even higher at 99.6%.
Ironically, the third hike since the US election last November is so greatly assumed that it is not the most important element of the FOMC meeting. However, if it is not delivered, that would indeed overshadow everything else. The simple, even if unpleasant, truth is that the economy’s rebound from the typical Q1 weakness is disappointing, and more, to the point, the preferred core PCE deflator has drifted lower for three consecutive months.
The Atlanta Fed’s GDP tracker for Q2 has fallen from a little more than 4.0% to 3.0%. It has converged with the median in Bloomberg’s survey, but the risk is that it is too high still. Our own thinking is more in line with the NY Fed’s tracker that puts it at 2.25%. The NY Fed’s model is not optimistic about Q3, for which it puts GDP at 1.8%.
The most important part of the outcome of the FOMC meeting is what it reveals about how officials see these challenges. The market is not convinced that there will be another rate hike this year (Bloomberg and CME calculations show about a 42% chance that Fed funds target will be at 1.25%-1.50% before the end of the year). Some officials, like Governor Brainard, have already expressed some concerns. Are those shared? What about the reduced expectations for fiscal support this year? The economic projections (dot plot) may take on heightened significance.
There has been much discussion that financial conditions eased in the face of the Fed’s gradual effort to remove accommodation. There are several different measures, but they agree that financial conditions, which take into account various interest rates, equity prices and exchange rates, are at two or three-year lows. This is a powerful argument in favor of additional Fed efforts. It judges that level of monetary accommodation that the economy needs. It judges it needs less, but for various (and admittedly not always well understood) factors, conditions are more accommodative.
This need not be a question of whether monetary policy is market-dependent or data-dependent. The confusion may lay with the popular claim that the Fed has a dual mandate. In truth, it has three. In addition to full-employment and price stability, is financial stability. The tightening of financial conditions in Q3 15 deterred the Fed from hiking in September, as it had encouraged investors to anticipate.
Investors also will focus on indications about the coming new balance sheet regime, where the Fed will not simply roll over all maturing issues. In effect, it will unwind the swap that has been dubbed QE. The Fed swapped reserves for Treasury bonds and mortgage-backed securities. Officials want to make the process as least disruptive as possible.
A preliminary proposal was for a very small start (understood to be a few billion dollars) and gradually (quarterly) increasing. There seemed to be an inclination to include both Treasuries and MBS in the process. There was little indication of the end game or desired size of the Fed’s balance sheet, but it seems to be understood that it should be bigger than status quo ante.
The Bank of Japan meets. There seems to be increased interest in the Diet and media about the exit strategy. The message from the Bank of Japan is patience. It is too early to have a meaningful discussion. Although some measures deflation has abated, the Q1 GDP deflator, which some economists argue is a more accurate measure of prices, was minus 0.8%.
The fact that the central bank’s balance sheet is growing by less than the JPY80 trillion target ought not be confused with tapering. It is a modification to QQE. The shift to targeting the 10-year yield necessitated buying fewer government bonds. Ideas that the BOJ would revise up its growth forecasts were dashed last week when the estimate for Q1 GDP was halved to 0.3%. Nevertheless, the stronger foreign impulses and the increasing investment may be bolstering the official confidence of that economic growth is solid a little above trend, and the output gap gradually is being closed.
Given that monetary policy is still open-throttle easing, then it follows that officials would prefer the movement of the currency not run in the opposite direction. Our general impression remains that Japanese businesses and officials are content with JPY110-JPY120. However, barring a change in rhetoric or practices, the near-term direction seems broadly driven by the change in US yields.
The Bank of England’s Monetary Policy Committee meets. No one expects a change in rates. Forbes, recently the lone dissent for an immediate rate hike will likely persist, but it is her last meeting. The MPC is also short a Deputy Governor, making a 7-1 vote the most likely scenario. The electoral outcome may not be a direct economic factor or featured in the minutes.
Sterling’s decline is not material. It appreciated by nearly 1.6% against the dollar so far in Q2 and was up about the same in Q1. The euro-sterling exchange rate has been in broad trading ranges since the second half of last November, roughly GBP0.8300-GBP0.8850. It was at GBP0.8340 at the end of June 2016. Sterling’s decline was not capital flight in the face of political uncertainty. British bonds and stocks rallied. Both the two and 10-year government yields eased 2.5 bp. The FTSE 100 rallied (~1.0%) ostensibly aided by a weaker sterling, but the more domestic FTSE 350 advanced nearly as much (~0.9%).
These central bank meetings and last week’s ECB meeting may render the market somewhat less sensitive to this week’s high frequency data. The high frequency data is expected to confirm the general macro situation. Of note, the US reports CPI (core likely stable at 1.9%), retail sales (soft headline and steady but inspired 0.2% increase in the GDP components), and industrial output (consensus expects a small gain, but the risk is for small declines especially after the outsized 1.0% increase in industrial output and manufacturing in April).
In Europe, the Eurozone reports April industrial production. It fell in February and March, but it is expected to have improved, rising 0.5%. It will reaffirm the sense that the Eurozone economy is growing at a steady pace. In Sweden, price pressures are expected to ease in April after a squeeze higher earlier.
The UK reports on inflation, employment, and retail sales. Simply put, CPI and labor conditions are expected to have been little changed, and retail sales will most likely weaken. The preferred CPIH expected to have risen 2.6% over the past year, the same pace as in April. It finished last year near 1.8%. The core rate may have eased to 2.3% from 2.4%.
Employment growth is expected to be steady in May, and average weekly earnings are expected to have been steady in April, 2.4% above a year ago level (3m/3m). The ILO measure of unemployment is expected to be steady at 0.6%, but the claimant count spiked higher and remains elevated. Retail sales jump 2.0% in April, partly due to the calendar effect of Easter. Half or more of the rise will likely be unwound.
Australia reports June inflation expectations. It has been between 4.0% and 4.3% since the start of the year. Even though in May was at the lower end of the range, we see downside risks. It finished last year at 3.4%. Australia also reports May employment data. It is likely to return toward earth from its recent stellar performance, creating 60k jobs in March and 37.4k positions in April. Last year’s average was a little less than 9k a month. The 2015 and 2016 average was almost 17k.
Political developments compete with economic developments for investors’ attention. UK Prime Minister May announced a cabinet reshuffle over the weekend that gave two of her former rivals (Gove and Leadsom) join the cabinet, while she lost two of her close advisers. She faces the backbenchers in Parliament today. There is great uncertainty whether May survives as Prime Minister, but it is not clear either who would replace her and if they have greater support about the Tory base. Brexit negotiations were to begin shortly, and it is not clear if they will go forward and if and how the newly chastened government’s position will be modified.
EU President Tusk noted that the end date of Brexit negotiations is fixed, but the start date is not. The controversial positions of the DUP, upon who the government will rely on to support the minority government, in some ways makes the Tories appear even more desperate and weak rather than strong and stable. Rates will likely remain lower for longer, and sterling may be a bit weaker than it otherwise would have been. The UK appears to have entered a more fluid political situation just as the negotiations were to begin. Its position seems to have been compromised. There still seems to be little scope for a soft Brexit if by that is mean a dilution of the EU’s demand that the four freedoms must be respected.
At the same time, the risk is hubris among the celebratory Labour. It is not clear how much was due to Corbyn’s newly discovered charisma and how much was a vote against something (what that something seems to be a bit of a Rorschach Test presently). Moreover, a moral victory may sound nice, but Labour still lost, and it follows a drubbing in the local elections last month. Even if another election is forced, as many now think will be the case, perhaps later this year, a Labour government still does not seem a likely scenario.
In France, Macron’s new party (Republic on the Move) appears to have won a little more than 31% of the vote, suggesting that in the second round it can secure 415-455 seats in the 577-seat parliament. It polled about 10 percentage points more than the center-right Republicans, the party from which the Prime Minister hails. The Socialists were decimated. It will likely see the number of seats it controls fall to 20-30 from 331. Marring the results a little was the extremely low turnout. Nevertheless, Macron efforts to reshape French politics and economics took a step forward. His signature program is labor market reforms, which seek to break the tradition of industry-wide settlements, will go full steam ahead. Macron wants the measures ready before the end of the quarter.
Out of France and Germany, where Merkel is in a strong position to be re-elected, the political climate in Europe has a few areas of concern. Catalonia has indicated it will hold a referendum on independence on October 1. This will be a protracted conflict with Madrid, which has not given its approval. In Italy, the great political compromise of adopting a German-like electoral system appeared to collapse last week after a deputy from the Five-Star Movement submitted an amendment. The prospect of fall elections had weighed on Italian bonds, and the collapse of the compromise saw the Italian bonds rally.
Separately, we note the large Italian banks are considering injecting capital into the two troubled regional banks so to allow a precautionary recapitalization. This would avoid equity investors and subordinated creditors from realizing losses. Reports suggest that a junior credit of one of the troubled banks matures on June 21, so a decision would seem to have to be made before then.
Meanwhile, the Eurogroup meeting will approve the tranche payment so Greece can make a seven bln debt servicing payment to it official creditors next month. However, the meeting promises to be dramatic. Unless the finance minister is prepared to reduce Greece’s debt burden in a meaningful and substantial way, the IMF will participate as an adviser and not provide funds. More importantly, it means that Greece still will not be able to return to the markets, and that, as we have warned, makes a fourth assistance package likely.
At the same time, given the thrust of the US Administration, it is possible that it would block the IMF participating in a new package in any event. There is the talk of converting the ESM into a European IMF, with how the power is allocated to the institution an important distinction.
Lastly, US political drama will not go away. It is still, however, too early to tell the extent of the distraction on the legislative process that is taking place. Committee work continues. The Financial Choice Act that seeks to replace and repeal the national financial regulatory framework (Dodd-Frank) passed the House of Representatives last week. However, its fate is similar but different than the attempt to replace and repeal the Affordable Care Act (Obamacare). The House version will not pass the Senate, and the Senate leaders have indicated they have other priorities.
US Attorney General Sessions is expected to testify before the Senate Intelligence Committee on the investigation into Russia’s attempt to influence the US election. Sessions reportedly met with Russian official more time that he initially acknowledged. Separately, he also is being blamed for the ineffective strategy to impose a ban on immigrants from a select number of countries. There are reports that he offered his resignation. He is thought to be a likely candidate for the reshuffle of President Trump’s senior team that has long been rumored to be taking place soon.
Many are closely following the tight congressional race in Georgia to fill the seat vacated by the new Secretary of Housing and Human Services. It has become the most expensive congressional election in history, and between the first round (April 18) and the second round (June 20), the UK called and held a national election. In any event, both parties see it as an important harbinger for the midterm elections in 2018.
EM FX was mixed last week but in general held up well in the aftermath of Super Thursday. EM is starting the week mixed, but the global backdrop seems relatively benign right now. We still think investors need to differentiate. For instance, TRY, ZAR, and BRL at current levels seem too rich given the underlying risks in all three. On the flip side, we think China is looking stable right now and should help Emerging Asia’s outlook near-term.