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Shaping the Investment Climate and the Dollar Trade

There are two events this week that will shape the investment climate potentially for the rest of the year.  The first is the Bank of England meeting. The following day is the US employment report.  

 

Both events take on added significance.  The Bank of England enters a new era.  The Monetary Policy Committee meets as usual, but shortly after it, the minutes will be published, and this will contain the vote itself.  There will no longer be a couple week delay. It will be interesting to see if other central banks, including the Federal Reserve and Bank of Japan adopt a similar approach over the medium term. 

 

It took the European Central Bank more than a decade to see the wisdom of providing some record.  It may be too much to expect it to make it nearly immediately available. 

 

Also, the BOE will release its Quarterly Inflation Report at roughly the same time.  This report has become an integral part of assessing the policy stance.    From giving little information at the time of the MPC meeting, the BOE is going to deluge the market with information.  It will dominate August 6 but on what should investors focus?

 

Two considerations will ultimately generate the underlying signal for investors.  The first is the vote itself.  Many observers expect three MPC members to dissent:  Weale, McCafferty, and Miles.  If any more dissent, sterling's reaction is likely to be more pronounced, and the impact on UK rates may be dramatic.  It would drive home what has been a tail-risk, namely a November rate hike.  On the other hand, this is Miles' last meeting.  His vote might be dismissed by investors, as his successor, Gertjan Vlieghe, has wisely not shared his views.  

 

The second consideration is the quarterly inflation forecast of inflation on a two-year time horizon.  If it is on the inflation target (2.0%), it will reaffirm market expectations for a hike in late Q1 15 or early Q2.   Above the inflation target would be seen as a signal of an earlier lift-off.   In this context, the BOE may not just lift the upside, but it may downplay the downside risks, now that the Greek drama is somewhat less urgent.  

 

The monthly US jobs data is the most important of the high-frequency reports.  The July report that will be released on August is exceptionally important.  It follows the FOMC statement that called job growth "solid," and appeared to lower the bar for a hike by modifying the continued improvement in the labor market with the word "some."  Provided that the US economy continued to generate a net of 200k+ jobs in July that qualification would have been met.  

 

The other reason the employment report has added significance is that a robust report would help neutralize the effect of the record low rise in Employment Cost Index reported on July 31.   Most of the volatility in the report is coming from commissions and bonuses.  Excluding those with incentive pay, the employment cost index was 2.0% in both Q1 and Q2.   

 

We suspect the investors and observers misunderstand how wage growth fits into the FOMC's reaction function or its policy-making equation.  Simply, if crudely put, wage growth would be a helpful confirmation of the absorption of labor market slack, but it is not a necessary precondition for a rate hike.  

 

Yellen is plain spoken, and she could not have spoken more plain:  "I have argued that a pick-up in neither wages nor price inflation is indispensable for me to achieve reasonable confidence" that inflation will reach the Fed's target in the medium term.  

 

Underlying Yellen's (and appears most economists') views is the acceptance of the Phillips Curve, which illustrates the historic trade-off between unemployment and inflation. Of all people, Alan Greenspan questioned this relationship, and part of the reason, he had kept interest rates low was that inflation had remained lower than the unemployment rate would have suggested.  However, on this side of the Great Financial Crisis, the Phillips Curve has come back into fashion.  

 

To be sure, the employment report is not simply about nonfarm payrolls, where it may be most helpful to think about the consensus as a range around 210k.  The unemployment rate itself (U-3) was rounded up to 5.3% in June.  A small improvement could see it rounded down to 5.2%, which is the upper-end of the Fed's range of what qualifies as full employment.  An acceleration in average hourly earnings growth would be helpful, but like we noted about the ECI, it is not necessary for the Fed to hike rates. 

 

There are three other US economic reports that we will be watching.  First are US auto sales.  A third consecutive month of more than 17.0 mln annual unit pace is expected to be reported.  The six-month average is at its highest level in a decade.  Second, the June trade and construction spending will shape expectations for revisions of Q2 GDP.  Third, the senior loan officer report is a helpful read on lending conditions.  

 

II

 

In addition to these two drivers, there are several additional events, which, while of less significance for the macro-investment climate, may still be important. 

 

Both the Reserve Bank of Australia and the Bank of Japan meet.  Neither is expected to change policy.  If there were to be a surprise, it would more likely come from the RBA rather than the BOJ.  BOJ's Kuroda is gently guiding investors (and other policy makers) to accept a narrower measure of inflation, which would be more similar to the US core rate, which excludes food and energy.  It is using such a measure that Kuroda can say that price developments are in a constructive direction, and why he continues to play down the need for more stimulus.  

 

The unexpected weakness in Japanese households overall spending (-2.0% vs. expectations of a gain of a similar magnitude) underscores the risk that the world's third-largest economy contracted in Q2.  Japan's labor market is also near full employment, but earnings are not reflecting it.  Cash earnings are expected to have risen by 0.9% year-over-year in June.  It would be the highest of the year, but it's still subdued.  Arguably, more importantly, real (adjusted for inflation) cash wages have not been above zero since April 2013.  

 

Canada reports the June trade balance.  It has been consistently in deficit since last October.  A CAD2.8 bln shortfall is the consensus forecast.  A larger than expected shortfall would weigh on sentiment as it would been seen as a sign that raises the likelihood of a negative GDP print in June. At the end of last week, Canada surprised investors by reporting that the economy contracted in May.

 

At the end of the week, Canada, like the US, reports its July employment data.  The unemployment rate is expected to be unchanged.   Canada is expected to have grown 9.8k jobs after losing 6.4k in June.  The impact on the Canadian dollar may be obscured by the simultaneous release of the US jobs data.  Short-term traders tend to put more emphasis on the headline, but the mix of full-time and part-time jobs is even more important.  

 

In June, full-time jobs jumped 64.8k.  This would be as if the US reported a 650k increase in nonfarm payrolls. Some correction should not be surprising.  The market appears to be pricing around a 50% chance of another rate cut, which would be the third of the year.  A disappointing jobs report would weigh on the Canadian dollar, and there is scope for further decline of short-term interest rates.

 

The eurozone is expected to report a decline in June retail sales.  A 0.2% decline would offset in full the May increase.  Several countries report industrial production figures.  Of the two regional laggards, French data has been improving, even if unevenly while it is still not clear that the Italian economy is gaining much traction.  

 

Italy's industrial output is expected to have given back 1/3-1/2 of the 0.9% rise posted in May. It would be the second decline in three months.  The year-over-year pace will be at least halved from 3.0% pace reported in May.   The July PMIs will likely show the softening at the end of Q2 has carried over into Q3.  

 

The Greek stock market re-opens on Monday, but will remain highly restricted for domestic investors, and the capital controls are still in place.  During the first three sessions, trading will be halted if shares fall 7%.   There were such circuit-breakers before but they were triggered by a 10% decline.   There is some concern that the restrictions make it easier to sell than to buy for domestic investors.  

 

The ETFs that a linked to the Greek stock market have traded in the weeks that the Athens Stock Exchange has been closed.  The main ones have fallen by 20%-25% since the domestic market was shut.   The exchange's platform for trading Greek bonds will re-open as well.  There has been reports of foreign asset manager small purchases.  In anticipation that the ECB will buy Greek bonds under QE has spurred at least one bank to recommend buying some first.  

 

The press coverages of the negotiations weaken hope that an agreement can be struck in time for Greece to service this month's debt.  Another bridge loan may prove necessary if an agreement is not reached in the next fortnight.  

 

This would increase the amount of funds Greece would need in the initial disbursement.   It needs 7.1 bln euros to repay the first bridge loan, 3.2 bln euros for the ECB bond payment, it needs another couple of billion euros for other debt servicing, including a small payment to the IMF.  It also needs funds to begin recapitalizing the banks.   

 

The failure of the ECB to grant more ELA borrowings last week reflected the absence of a fresh request from the Greek central bank.  There have been anecdotal reports of the deposits stabilizing and a quick increase in tourism receipts.  

 

III

 

Although the Reserve Bank of Australia is not expected change policy, the economic data due out in the coming days, including retail sales, trade, and employment, will likely support expectations for another rate cut before the end of the year.  The RBA statement and the monetary policy statement a couple days later can be expected to show that the decline in the Australian dollar thus far is still not sufficient for the central bank.  

 

New Zealand will report employment figures as well, but more important for short-term investors may be the dairy auction on August 4 and Fonterra, the milk coop meeting on August 7.  Investors will focus on the payout to farmers and the anticipated reduction in supply.  

 

The Trans-Pacific Partnership negotiations failed to conclude at the end of last week.  One of the sticking issues is New Zealand's insistence on the free milk trade, which is being resisted by several countries, including the US.  

 

Two other issues remain stumbling blocks.  Freer auto trade can be agreed to by the US and Japan, but as Japan sources product in Thailand, which is not included in the TPP talks, Canada and Mexico (the latter accounts for 40% of the auto jobs in North America) are objecting.  The other remaining issue is the length of patent protection for new pharmaceuticals.  The US alone is insisting on a decade    Other countries are divided.    Australia has five years, for example, and Chile has none. 

 

Lastly, there are several important readings on China's economy that will be released in the coming days.  We note that the official manufacturing PMI was reported on August 1 at 50.1 down from 50.2 in June.  The Bloomberg consensus was for 50.1.  The government's PMI tends to focus more on the large state-owned enterprises rather than the smaller private companies, as does the private PMI.   

 

China reports its July trade balance.  Exports growth has been in a clear slowing trend for five years.  The June year-over-year increase (2.8%) snapped a three-month streak that saw exports contract.  It was only the second month of the year that saw export growth increase. Exports in July are expected to be unchanged year-over-year.  

 

Imports are expected to continue contracting.  They fell 6.1% year-over-year in June and are expected to have fallen 7% in July.  While part of this may reflect a slowing of the Chinese domestic demand, it partly reflects the decline in prices.  The role of prices will be highlighted by another decline in producer prices.  The July PPI is expected to have fallen 5%, a little faster than June (-4.8%) and the largest fall since 2009.   Nevertheless, we should not forget that global trade flows have not picked up post-crisis as much as world growth.  

 

China reports consumer prices for July as well.  The pace of increase is expected to remain broadly stable around in the 1.2%-1.6% range that it has been in for the past year, with one brief exception in January.    

 

The on-shore yuan remains rock steady, and this can only fan speculation of the PBOC's hand at work.  In contrast, CNH, the offshore yuan has weakened, and the gap between the two is the largest in nearly six months.  Although the IMF has opined that the yuan is no longer undervalued, it has argued that China needs to allow market forces to have a greater role.  There is much speculation that the PBOC will soon expand the acceptable yuan-dollar daily range.  

 

We are not convinced this is imminent.  The current 2% band (around the daily fix) is not being explored.  A wider band that is not used would highlight the official role during the period in which the IMF is reviewing the SDR composition.  Also, a wider band risks currency depreciation. Some fear the opposition to include the yuan in the SDR would seize upon currency weakness to push their objections.  

 

All eyes remain on the Chinese stock market, though as we have noted foreign investors have a small stake in the A-share market.  They use the H-share market in Hong Kong, and to a lesser extent Taiwan, as well as the ADR market in the US.  The 200-day moving average comes in near 3554, near the bottom of the speculated lower end of the officially sanctioned range of 3500.  The top end of the range is thought to be 4500.  Since the low was recorded on July 9, the Shanghai Composite had traded up to almost 4200, which is near the halfway point (4275) of the decline.