U.S. jobs growth slowed in August, but nearly all the subsequent data, including retail sales, industrial and manufacturing output, housing starts, permits, existing home sales, and leading economic indicators were stronger than expected. Core CPI accelerated to an 11-year high of 2.4%. Economic surprise models have exploded, and Citibank's measure reached an 18-month high last week.
The FOMC rate cut, statement, forecasts, and the chair's press conference did not alter the expectations of the trajectory of Fed policy for the remainder of the year. The fragmentation of Fed views (dots) notwithstanding, the implied yield of the January 2020 Fed funds futures settled at 1.63% on Monday (two days before the FOMC decision) and Friday (two days after the Fed's decision). The August trade and personal income and consumption data, alongside the preliminary September PMI, pose headline risks but are unlikely to change to significantly impact the outlook.
Despite the acceleration of core CPI, the FOMC statement said, "On a 12-month basis, overall inflation and inflation for items other than food and energy are running below 2 percent." It appears the Fed looked past the CPI and focused on the PCE deflator. The August report is due at the end of the week. The headline, which is what the Fed targets at 2.0%, is expected to be unchanged at 1.4%. The core rate, which Fed officials often emphasize, may tick up to 1.8% from 1.6%. If so, it would be a new high for the year. No fewer than 11 Fed official speak next week, including all four of the five voting presidents and two governors.
European reports include money supply, confidence surveys, and flash PMI. The ECB's die is cast. The market is trying to digest the implication of the new measures. We caution against drawing hard and fast conclusions about the weak reception to the new Targeted Long-Term Refinancing Operation. We suggest reserving judgment until after the next tranche which will be available in December after the tiering (exempts some ECB deposits from negative rates).
Japan's course is not as clear, but the issue will not revolve around the flash PMI or leading economic indicator. The fulcrum is the yield curve and the yen. While the narrative seemed obvious when U.S. yields surged, of course, the dollar appreciated against the yen. The 10-year Treasury yields fell every day last week for a cumulative 14 bp decline, and the dollar continued to straddle the JPY108 area. It reached its best level since August 1 before pulling back. Next week's highlight may be Trump and Abe meeting on the sidelines of the UN's opening session to ostensibly sign a preliminary trade agreement. It is an executive agreement, which means that the U.S. Congress does not need to ratify it, as it does the NAFTA 2.0. The sales tax increase on October 1 from 8% to 10% looms.
Several central banks meet next week. In East Asia, the Philippines and Thailand hold policy meetings. The former is expected to cut, but the latter is not. The Reserve Bank of New Zealand meets, and although it is not expected to cut rates now, the market has about 20 bp cut discounted for November. Czech and Hungarian central banks meet, and neither is likely to change policy. Colombia is expected to keep policy on hold. Banixco, Mexico's central bank, surprised investors last month by cutting the overnight rate by 25 bp to 8.0%. The market leans toward another 25 bp rate cut. The derivatives market suggests about 18 bp of easing has been priced in.
Instead of high-frequency data, the investors and businesses will likely take their cues from the evolution of several larger issues. Below is a sketch of our views:
U.S.-China Trade: A preliminary agreement is possible because China needs soy and pork, and the U.S. needs for the uncertainty to be lifted or risk the historic-long expansion. It does not change the underlying dynamic that we think is pushing toward disengagement: not entirely and not overnight. Chimerica was really two ships passing in the ocean. It was a naive (and arguably dangerous) illusion. Nationalism and national security interests are in ascendancy over the interests of economic efficiency. The bean counters argue that because the trade imbalance is so extreme in China's favor, the U.S. dominates the trade escalation ladder. They do not adjust for quality. The rare earths the U.S. buys from China cost less than a couple hundred million dollars—a rounding error of the bilateral flows. Consider how many years a ban on Chinese inputs for U.S. government and military drones will set the U.S. back. Consider that the last facility that produced penicillin in the U.S. closed 15 years ago and that the U.S. is nearly entirely reliant on China for antibiotics, including what is used for anthrax (ciprofloxacin).
Federal Reserve Policy: It is important to keep clear what one thinks the Fed ought to do and what it will do. We are sympathetic to the argument that the economic and financial conditions do not require easier policy. What is sold as low-cost insurance to extend the expansion may prove quite expensive if it only encourages leverage and financialization. However, we expect the Fed to cut rates one more time this year. The dramatic funding squeeze dominated attention more so than the second rate cut of the year. The Fed has pre-announced overnight refi operations through October 10 and three 14-day term operations that carry over into October. These measures will do two things: 1) demonstrate that the Fed has the tools and will to control the very short-end of the yield curve, and 2) ease the quarter-end pressures. Powell indicated that at the October meeting that there likely will be sufficient information about the demand for reserves to make some decisions next month. The Fed could decide to continue the overnight repo operations to address periodic dislocations, a standing repo facility, and/or allowing the balance sheet to grow organically again (as it did historically until 2007). Although some, including Simon Potter, who ran the Fed's market desk until mysteriously being let go earlier this year (without a permanent replacement being named yet), suggest that a resumption of QE may be necessary. We suspect this it will be the last resort rather than the go-to move now. It would confuse investors between monetary policy and these "plumbing" issues. We suspect that all things being equal, it would be better to keep the focus on the plumbing in October and return with the third cut in December, ahead of year-end,
Brexit: It seems like it has been one blunder after another since the referendum was first proposed as non-binding, which meant there were few rules (such as a required margin). What rules there were seemed to be recognized more in their violation than respect. Article 50, the decision to leave the EU, was made before there was an agreement among the representative of the people (House of Commons) on how best to implement the flawed referendum's results. The cart went ahead of the horse. At the heart of the problem is that leaving the EU conflicts with another UK obligation under the Good Friday Agreement, which commits to no hard border between the Republic of Ireland and Northern Ireland. When the UK leaves the EU, a hard border to check people and goods crossing must be drawn. The open-ended backstop was to force a reconciliation of the conflicting demands. Next week is likely another week of pussyfooting around. The real crunch comes after the Tory Party Conference. Johnson will have a week or two to convince the EU. According to PredictIt.Org, the market sees the UK leaving at the end of October as currently slated at about a 1-in-3 chance, At the end of August, it was slightly favored (57%). Although EU policymakers seem to be as prepared as possible for the UK to leave, a plea for a final three-month extension to hold an election would likely carry the day.
Hong Kong: Unlike previous demonstrations in the Special Administrative Region, including the Umbrella Movement (2014), the current protests mark a turning point. Concessions from Hong Kong officials have been too small. The protesters have been emboldened and are demanding the free election of the Chief Executive. It seems more than Beijing can allow, and Chief Executive Lam is its hand (and fist) in HK. China appears torn between using its own anti-riot police (not the army, though the distinction in terms of force may be without a difference) and having Lam trigger the Emergency Powers, which seem to be almost like martial law. The point at which the situation could be resolved before the early October holiday and the commemoration of the 1949 Revolution has been passed. Although Chinese President Xi is the most powerful leader since Mao, he reportedly faces two important criticisms: the handling of HK and prematurely antagonizing the U.S. (can't hide an elephant behind a tree). Economically, the protests will drive HK into contraction. We have argued that the so-called internationalization of the yuan has really been more a Sino-ification of Hong Kong. The demonstrators in HK are determining the timing, and it might not be ideal for China, but we have long expected Shanghai would supplant HK as the main financial center for the PRC. To be sure, it won't happen overnight, and again this year, speculators anticipating a break of the peg have been rebuffed.
Negative Interest Rates: Former Federal Reserve Chairman Alan Greenspan recently suggested that due to demographics, it is only a matter of time before the U.S. too experiences negative interest rates. This is certainly possible, but the reason Europe and Japan have negative interest rates is not because of demographic considerations. They have negative interest rates because their policymakers chose to introduce a negative deposit rate. Asset purchases by themselves as the U.S. and UK experience shows does not necessarily lead to negative interest rates. In addition to a policy choice, the other shared characteristic of countries with negative interest rates is they have current account surpluses. The Great Financial Crisis forced central banks to develop new playbooks. Not all the measures and approaches are understood to have been successful. We think the jury is still out, and notably, the analysis that led the U.S. to reject it during the crisis continues to hold sway, judging from Chairman Powell's comments. A firm conclusion may be premature until a country has emerged from negative rates. Negative rates are were chosen to address a problem. The underlying problem remains. One way to think frame the problem is that the long-term fed funds equilibrium range rate or r* is below the inflation target. Currently, and after several years of gradually being reduced, the median Fed forecast is that long-term equilibrium rate is 2.50% and no one estimates that it is below 2.25%. What if it is closer to 1.50%? The Bank of Japan has become the largest holder of JGBs and ETFs in its quest to push core inflation (CPI minus fresh food) to 2%, which it has singularly failed to achieve. Its r* is surely below its inflation target.
Dollar: The dollar has risen against all the major currencies this year, but the Japanese yen and Canadian dollar. From an economic impact point of view, the real broad trade-weighted dollar index that the Federal Reserve tracks is more important than bilateral exchange rates. That said, it often does a fair job tracking the euro. The Bloomberg chart above shows the real broad traded-weighted dollar index in white and the inverse of the euro in yellow (i.e., euros per dollar rather than dollars per euro). The three big dollar rallies since the end of Bretton Woods are clear. The real TWI ended last year at 102. Seemingly unbeknownst to many, it remained below there until last month, when it closed nearly at 102.5. We have suggested that the third one (Obama-Trump) is over or nearly so. Our argument is three-fold. First, the policy-mix has changed from tight monetary-loose fiscal, which is most supportive for a currency to its opposite. Second, we find that the last phase of a long-term dollar rally is often characterized by interest rates differentials moving against it. Two-year interest rate differentials have been moving against the U.S. ( vs. Germany, UK, and Japan) since last November. The U.S. 2-year premium over Canada recorded a 12-year peak in March near 85 bp. By earlier this month, it had fallen to below five basis points before consolidating. Third, the by most measures of valuation, the greenback is rich. OECD currencies rarely move beyond 25% of its model of purchasing power parity. Near $1.1025, the euro is about 23% undervalued according to the OECD. Only the Swiss franc (~16.5%) and the Norwegian krone (~11.5%) are overvalued by this measure. This is not going to help short-term momentum traders and trend followers. However, strategic investors and business should begin preparing for the end of the dollar's super-cycle.
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