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Policymakers' Intentions are More Critical Drivers than Macroeconomics in Week Ahead

Normally we look at macroeconomic news to provide the incremental additional information that shapes the expected returns on investments.  However, in the week ahead, the macroeconomic data is of less importance than the reaction function of policymakers. What we mean by this how policymakers will respond to the recent data may be a bigger driver of financial assets than the new data.  

 

Recall that the ECB staff cut its growth and inflation forecasts.  Is that not a necessary pre-condition for a policy response?  Japan recently reported an unexpected decline in industrial output and the BOJ's core inflation measure (excludes fresh food) slipped back into negative territory for the first time since April 2013.  Is this something that monetary policy can address or should fiscal policy?   Will the apparent pick-up in wage pressure in the UK over the past few months push the Bank of England toward a more hawkish posture?

 

The Federal Reserve officials were likely as surprised by the weakness of the September jobs report as were market participants.  There was nothing in the ADP estimate or weekly jobless claims that had hinted at the weakness.  Did the disappointing jobs data really redeem the Fed was criticized for not raising rates last month?  Will the jobs data be understood by the central bank as a sign that the economy is deteriorating, as the cynics have argued, and require additional monetary stimulus in the form of new asset purchases as former Treasury Secretary Summers and others have claimed?  

 

II 

 

There are three major central banks that meet in the week ahead.  They are the Reserve Bank of Australia, the Bank of Japan, and the Bank of England.    None is expected to change policy.  If there is a surprise, the Reserve Bank of Australia is a most likely candidate.  The policy has been on hold since May.  The headwinds emanating from China and through a negative terms of trade shock are still feeding through the economy.   However, with recent economic data firm, and the Australian dollar chopping around its recent trough, the RBA need not be in a hurry to cut rates now.

Despite some investment houses and media playing up the risk that the Japanese economy contracted in the June-September quarter for the second consecutive quarter, the Bank of Japan continues to be relatively optimistic about both inflation and growth.  The unexpectedly strong rise (2.9%) in August overall household spending suggests a contraction was likely averted.

 

BOJ Governor Kuroda has repeatedly indicated he would look past the impact of the decline in energy prices on inflation.  Although the BOJ has not formally shifted its target measures, Kuroda does appear to be giving greater weight to a measure of inflation (core-core?) that excludes food and energy.    This measure stood at 0.8% in August, which is the highest since last year's retail sales tax dropped out of the year-over-year comparison.   There is some risk that even this level of inflation overstates the case.  The past weakness of the yen appears to have contributed to the increase in import prices.  The yen is essentially flat this year, meaning that the upward pressure on import prices may lose a support.

 

Expectation for BOJ action is more focused on the meeting at the end of the month, which is when Kuroda surprised the market last year.  With a 5-4 majority, the BOJ announced then that its new monetary base target would be increased from JPY60 trillion to JPY80 trillion.  While there may be scope at some juncture, to tweak the assets being purchased, from an operational standpoint, we think that the BOJ is still satisficed with what it sees to be the underlying economic signals.   Kuroda's press conference after the BOJ meeting may be more important than the meeting itself.

 

The Bank of England meets.  There is practically no chance that it changes policy.  In fact, it does not appear that the one hawk from last month, McCafferty, found any allies on the MPC that want to hike rates immediately.    The case to raise to rates stands appears to stand solely on the increase in average weekly earnings.  They did rise further since the MPC last met.

 

On a three-month year-over-year view, which is how it is reported, average weekly earnings rose 2.9% in August, while the July pace was revised to 2.6% from 2.4%.    This may be reflecting a change in the composition of the new hires rather than wage pressure per se.  There are four major economies that are regarded to be near full employment, the US, Japan, Germany and the UK.  Only the UK appears to be showing any significant wage pressure.  

 

Nearly every other key piece of economic data warns of slower growth and subdued prices. Since the last meeting, the MPC have learned that consumer price increases year-over-year slipped back to zero in August.  This was not only energy as the core inflation slowed to 1.0% from 1.2%.  Retail sales and investment are slowing on a year-over-year basis.

 

Since the middle of July, the implied yield of the June 2016 short-sterling futures contract has fallen from 110 bp to 68.  Indeed before the weekend the yield touched 66 bp, the lowest since the contract began trading more than five years ago.   During this period, sterling has been the second weakest major currency, losing 2.9% against the US dollar (The Australian dollar's 4.6% loss is the weakest in this period.).  

 

As a point of reference, at expiry, the implied yield of the September 2015 short sterling futures contract was 59 bp.  It would seem unreasonable to expect this level to be significantly penetrated. We anticipate sterling to find better buyers, especially on the crosses, as the interest rate drag lessens.

 

III 

 

Minutes from the ECB and Fed's recent meetings will be released.  At least five Fed officials speak, as will Draghi (Tuesday in Frankfurt).  What investors want to know is whether ECB officials intend on adjusting their asset-purchase operations in light of the downgrade of the economic outlook and prices.  The market anticipates this at the December meeting.  

 

The BOJ's asset purchases, like the Fed's under QE3, are open-ended.  The ECB wanted it both ways.  It has the authorization to continue to buy government bonds for another year, but it has also repeatedly claimed it was open-end.  This is that the ECB would continue to buy until its confident that it is on the path to reaching its inflation target. There is some consideration now to extend the program.  As a signal, this may be a fairly mild one.  It is an admission that the asset purchases over the next year will not be sufficient.  It is a weaker response to that assessment than boosting the chances of success by buying more bonds presently.  

 

Changing the composition, adding other instruments to buy, could be a victory of hope over experience.  The reasons the bond purchases are not having as much economic impact as officials may have something to do with the low yields that were already prevailing before QE, and that the problem has morphed from primarily one of a shortage of credit to the lack of demand.  It could be that growth potential has fallen, and the current pace of around 1.5% is the most that can be delivered.  

 

There are at least three different ways to make sense of the disappointing US employment data. The first is to regard it as a bit of a statistical fluke.  Other readings of the labor market have not deteriorated as markedly, consumption remains firm, and August and September nonfarm payrolls are often volatile.  

 

The second is to regard slower pace of net job growth as a reflection of the maturing business cycle. It is unreasonable to expect any economy to be generating as many jobs in the sixth year of an expansion cycle as it did in last few years.   The Federal Reserve recognizes that the US growth potential has slowed, and it regards recent year-over-year growth as above trend.  It would not be prudent for the Federal Reserve to base their economic assessment on a high-frequency economic report that will be revised a couple times this year.  Instead, what is of interest is the cumulative improvement.  

 

The third way to see the jobs data is that the economy failed to reach escape velocity, and the slow nominal growth is acting as a drag.  It left the US economy particularly vulnerable to destabilizing waves from China.   Weak foreign demand and a strong dollar squeezes US producers. The Atlanta Fed said the economy appears to be tracking 0.8% annualized growth in Q3, and that was before the employment data.  The corporate earnings season formally kicks off on October 8 with Alcoa.  The consensus calls for a 4.1% decline in Q3 earnings, which includes a 65% drop from the energy sector.  

 

The debate over the three main scenarios will take place in op-ed pages, economists' commentary, and in the decisions by investors.  Industry estimates suggest investors liquidated about $22 bln of US equity funds and put three-quarters of it into US Treasury bond funds.  However, the Fed itself need not make a firm judgment.  It can afford to wait.  

 

A rate hike this month was never regarded as a likely possibility.  The reasons the Fed cited last month for not hiking had nothing to do the labor market, but with global developments and the low market-based measures of inflation expectations.  The significance of these may not be known by the end of this month.  

 

In addition, despite the denials by Fed officials, we suspect that not having a scheduled press conference poses an obstacle to making it a likely candidate for the initial hike.  It is true the Fed could call an impromptu press conference, but as soon as word got out, and it must be assumed it would, it would steal the Fed's thunder, and deny it an element of control.    This may be acceptable for future hikes, but the first is special.  

 

A broad array of economic indicators, including consumption, the strongest auto sales since 2005, and some other labor market indicators point to the continued relative strength of the US economy.  The vagaries of quarterly GDP, notwithstanding, based on the current information set, we suspect the Fed's leadership regards the first two scenarios as most likely, with the third scenario being more a risk than a baseline forecast.  This is to say that the majority of the Fed officials will likely continue to anticipate a hike in December.