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Divergence Drives the Dollar

The key take away from recent developments is that the divergence theme that has lifted the US dollar remains very much in play even after the dovish spin given to the March FOMC meeting and the disappointing jobs data. The new cyclical low in the weekly jobless claims and continued improved in the JOLTS report give investors reasons to doubt that the weak job growth in March represents anything significant. 

 

A Wall Street Journal poll confirmed our impression that in effect the market shifted expectations for the earliest that Fed can raise rates (June) to the next earliest (September).  It is true that there is a July FOMC meeting, but a press conference does not accompany it.  Moreover, if one were called, it would tip the Fed's hand.  The recent WSJ poll found 83% expect a hike in June or September (18% and 64% respectively).  The previous poll had 86% expecting a hike in June or September (48% and 38% respectively).  

 

The Fed has de-emphasized market based measures of inflation expectations in favor of surveys.  We suggest adopting a similar attitude regarding the outlook for Fed policy.   This warns of the risk that yields implied by the Fed funds futures strip and the Eurodollar futures strip adjust.   Between March 9 and April 3, the implied yield on the December 2015 Eurodollar futures fell nearly 30 bp to 0.58%.

 

The economic data due out in the coming days will likely reinforce the belief that another weak Q1 was a bit of a fluke, with weather, the port strikes, and payback from a surge in consumption in Q4 slowing activity.  The US economic expansion remains intact.  We expect the Beige Book prepared for the upcoming FOMC meeting to provide anecdotal evidence that economic activity is strengthening.    

 

Retail sales fell three consecutive months through  February but likely bounced back with a vengeance.  We already know that auto sales were strong.  An early Easter and a seasonally adjusted gasoline prices  can combine for a strong report.   The GDP component (excludes autos, gasoline and building materials) has not posted a gain since last November.  It is expected to have risen by at least 0.5% in March.

 

The Fed's preferred inflation measure, core PCE deflator, is not being reported next week, it close cousin, core CPI will.  The small month-over-month rise in both the core and the headline will likely only be enough to keep the year-over-year readings steady at 1.7% and 0 respectively.  From the view of numerous officials, including the leadership at the Federal Reserve is influenced by ideas that over time the tightness of the labor market will boost the general price level (inflation). That means that as long as the labor market continues to improve, higher measured core inflation is not necessary to reach a consensus on lift-off.  However, a decline in core inflation would not be particularly helpful in this context.  

 

Manufacturing output has also been soft, declining in the three months through February.  It should bounce back in March, even if industrial output as a whole is weak.   Similarly, US housing starts have begun Q1 poorly.  The flat January reading was followed by a sharp 17% decline in February. Expect the thaw in March to have helped fuel recoup the loss almost in full.  Softness in permits, however, warns that housing is still likely to disappoint.  

 

The eurozone is likely to grow faster than the US in Q1, as it did in Q1 14.  It says more about the pattern of weak growth at the start of the new years in the US than strong growth in the EMU.  This week's industrial production and inflation data are unlikely to change views.  Industrial output expanded in Q1 and will contribute positively to GDP.  Deflationary pressures have eased, helped by the stability of oil prices.  

 

The ECB's lending survey is will be released a day before the ECB meeting itself on Wednesday this week.  Lending conditions have stabilized and are improving gradually from a low base.  This bodes well for future TLTRO operations.  The ECB meeting itself is unlikely to cause much of a stir. The ECB will likely claim success of its asset purchase program and argue that the markets are still performing fine and that finding sellers has not been a problem.   If there is a new initiative it could be in the follow up to Draghi's indication last month that the ECB could review the eligibility of some international/supranational bonds, which is complicated by the numerous institutions, locations, and ownership structure.  

 

The ECB's rotating voting system is well underway.  At the April ECB meeting, the governors from Netherlands, Cyprus, Lithuania and Latvia will not vote.  It will be the first time this year that Greece votes.  Germany will not vote at the May meeting.  

 

The UK reports its inflation measures, and given that CPI had fallen to zero in February, there is some risk that it falls into negative territory.  A 0.2% monthly gain is necessary to keep it flat.  Employment data are reported at the end of the week.  The focus will likely be on earnings as it is largely taken for granted jobs are being created and the unemployment level is trending lower (ILO measure 5.7% in February may fall to 5.6% in March).  

 

Earnings data re reported with an another month lag, which means that data will cover the three months through February compared with the same period a year ago.  With and without bonuses the pace of growth is likely to be little changed at 1.8% and 1.6% respectively.  Ironically, the drop in oil prices has boosted real wages than what businesses themselves have done.   

 

Politics can expected to continue to trump economics until at least the May 7 election.  The fear that many have is the politicians will be unable to cobble together a majority government.  The era of now single party governments could have given the Lib Dems a key role, but it has gone an eviscerated itself and will be punished in the polls.  Partly Cameron ensured this by not allowing the Lib Dems to give their constituency any meaningful policy victories.  UKIP seems to believe its own propaganda and has a self-serving interpretation of its strong showing in last year's EU parliamentary elections.  It will be lucky to win more than a handful of seats. 

 

The Japanese economy ended the Q2 14-Q3 14 contraction, not with a bang but a whimper, and even now the world's third largest economy has still not found a convincing growth path.  A decline in February core machinery orders underscores one of the findings of the Tankan survey: Businesses plan to cut capex.  This will be the second consecutive decline (-1.7% in January) after an 8.3% surge at the end of last year.  The average monthly gain over the past 12-months has been 0.6%.  The average over the past 24 months is twice that.  

 

The minutes from the mid-March BOJ meeting will be published.  The recent data, including the disappointing Tankan survey and the inflation measure targeted by the BOJ is at zero, renders the minutes too dated to have much market value.  Many, if not most, market participants expect a policy response by the BOJ.   The bar to more action may be higher than appreciated.  If it is coming, it is not imminent.  

 

The spring wage round needs to be seen.  The BOJ also appears to be counting on the same thing that all the central banks are anticipating:  last year's sharp fall in oil prices will fall out of the year-over-year comparisons.  The recent US Treasury report gave voice to concerns that have also found expression inside Japan and the government.  The US cautioned against the overly relying on monetary policy. 

 

The BOJ's money base is already growing at an unprecedented.  Bank lending is improving.  The stock market is at fifteen year highs.  Growth itself is weak and fragile.  Labor market is tight by nearly any measure, yet wage growth remains minuscule.    

 

The first round of local elections was held in Japan.  A second round will be held on April 26.  The opposition DPJ has imploded, is challenging the ruling LDP every place, and has not articulated a clear alternative to Abenomics.  An important fissure in Japanese politics is between the Abe government and the Japanese agriculture cooperatives, which has been a constituency within the LDP.   The coops object to Abe's reform agenda, which includes the Trans-Pacific Partnership trade agreement that would compromise agriculture's protection.  

 

It will be a busy week of Chinese economic reports.  Outside of smaller trade surplus, the economic reports are likely of little consequence.  The slew of data for the month of March leads up to the release of Q1 GDP April 14.  The pace of growth is expected to have slowed to 7.0% from 7.3%, according to the Bloomberg consensus, but there is some risk of disappointment.  

 

More interesting that the data are the capital flows.  The Hong Kong-Shanghai link was expected to allow greater access to the mainland market, but most recently it has been more active the other way. Chinese buying Chinese companies listed in Hong Kong instead of Shanghai because of the valuation gap.  

 

There is a logic to the  large rallies in European and Japanese stocks this year.  The three largest equity markets in the eurozone are up more than 20% year-to-date (France 22.7%, Italy 25.6% and Germany 26.2%).  The ECB has driven short-term rates below zero, short- to medium-term coupon yields have also been driven down.  This drives funds into equities.  

 

In Japan, as part of its version of QE, the Bank of Japan is buying equity ETFs.  In addition, the largest pension fund has announced and is implementing, a diversification program out of government bonds into equities (and foreign assets).  The Nikkei is up 14.1% this year.

 

China's Shenzhen Composite is up 51.9% this year and the Shanghai Composite is up 24.7%. Valuations are incredible.  According to the Financial Times, the Shanghai and Shenzhen trade at 30-times forward earnings.  US stocks (S&P 500, NASDAQ and Russell 2000) trade at 18-times forward earnings.  Chinese tech stocks trade at twice the multiplier US tech stocks did at the peak of the bubble.   Admittedly, caution should be applied when making cross-border p/e ratio comparisons. The point is that a tsunami of Chinese savings can be as disruptive as a tsunami of Chinese goods and most investors think about the latter not the former.  

 

If there is to be a significant surprise this week, perhaps it comes from the Bank of Canada meeting. Bank of Canada officials has argued in favor of giving the surprise January rate cut some time to work.  Meanwhile, Governor Poloz has warned of an "atrocious Q1 GDP." Canada lost full time jobs over the quarter.  Retail sales were down hard in December and January (-1.7 and -1.8% respectively), and a small bounce in February (~0.5%) will not very much.  Retail sales have not risen for two consecutive months since the first half of last year.   

 

Unlike most high income countries, disinflation/deflation is not pressing.  Canada will likely report headline and core inflation for March were unchanged at about 1.0% and 2.1% respectively. The pressure to cut comes from the economy, not prices.  The economy could use another insurance policy to help the economy, which was levered to energy, cope with the shock.   We suggest there is about a 1 in 3 chance of a rate cut. 

 

The Reserve Bank of Australia stood pat, but the market simply pushed the expectation for a 25 bp rate cut into May.  A disappointing employment report early on April 16 in Sydney will boost the market's confidence.  

 

Lastly, the US earnings season features US banks in the week.  They could be a bright spot, being less impacted by the headwinds of a stronger dollar and lower oil prices.  GE's announcement of its intention to divest its banking caught the market by surprise.  It also indicated that it would repatriate $36 bln cash from its overseas coffers.  The tax GE will pay is significantly less than it expected. GE indicated that it will be paying $6 bln in taxes to repatriate the capital, which is a 16.7% bite, not the 35% tax schedule rate.  One of the consequences would be to undermine the calls for (yet) another tax holiday to allow corporations to bring their overseas cash stash home.  

 

The impact on the balance of payments may be a noticeable bump, especially if it is done in a single quarter. The impact on the dollar less so.  Much of cash on US corporate balance sheets is thought to be largely in dollar-denominated securities.