Sterling Steals Some Of The Fed's Spotlight

It was supposed to be all about the Federal Reserve today, but the strong UK weekly earnings data has sent sterling to four-week highs and brought forward market-based measures of the BOE's first rate hike. Previously, the SONIA forwards had implied that UK's lift-off would take place in July-August 2016. With today's news, it has been pushed into near June.

Average weekly earnings (3-month year-over-year) rose 2.7% while the March series was revised to 2.3% from 1.9%. This is the strongest increase since mid-2011. Although the claimant count fell by half of expectations (-6.5k vs Bloomberg consensus for a 13.8k decline), and the ILO unemployment rate was unchanged (5.5%), the higher earnings are consistent with a tighter labor market. Indeed, the UK, US, Germany, and Japan are approaching what economists regard as full employment, and this is seeing the beginnings of some (modest) upside pressure on wages/labor costs.

The BOE minutes were also released. There were no surprises, but of note, two MPC members indicated their decision for standpat policy was a close call. Today's earnings data would seem to play down the risk of deflation. This seems to increase the likelihood of dissents in future MPC meetings.

Sterling has not traded below the previous day's low since June 6. The next target is the year's high set last month near $1.5815, and above there the $1.5880 area, which corresponds to a 50% retracement of sterling's losses since last summer's peak near $1.72.

There is a strong consensus around today's FOMC meeting. At the start of the year, many, like us, thought today's meeting would be when the Fed's lift-off took place. However, the chances of a move today are negligible. Expectations have been mostly pushed to September.

Due to the Q1 disappointment, the Fed is expected to lower this year's GDP forecasts. It may also shave 2016 and 2017 growth to recognize that trend growth is lower than it may have previously anticipated. At the same time, the Fed is widely expected to recognize that economic momentum has picked up and that the headwinds, which it had argued were transitory, were in fact abating.

There has not been any dissent at the Fed this year. That could change today. Many observers see the most likely dissent coming from Lacker, who seems to have signaled a desire to raise rates now.

The dot-plots remain the subject of much controversy. Yellen herself has played down their significance. Many observers embrace the dot plots for Fed funds as a forecast, but they are not. They are meant to identify the level of Fed funds that the individual Fed official sees as appropriate, based on their macro-economic forecasts and the subjective trade-offs they make.

We take Yellen's caveat at face value and argue that their is a high noise to signal ratio in the dot plots. Perhaps the most important thing to take away from them today is the number of hikes that are anticipated. At the March FOMC meetings, the dot plots implied that seven of the 17 expected two hikes this year. This is likely to fall. The market has largely priced in one hike before the end of the year.

There are four other developments to note. First, the Swiss National Bank and Norway's central bank meet tomorrow. The SNB is not expected to change policy, but it may introduce an element of forward guidance, which would be aimed at ensuring investors that policy will be easy for a long time. Meanwhile, as an aside, the SNB's 7-day dollar repo rate ended higher to 64 bp from 62 bp. The outlook for the Norges Bank is a close call. Prior to last week's capex news, the market seemed comfortable with a 25 bp rate cut that would bring the deposit rate to 1.0%. We still think that is the risk.

Second, Japan's May trade deficit was largely in line with expectations. The unadjusted deficit was JPY216 bln compared with a consensus forecast of a JPY259 bln deficit. What caught our eye was the slowing of exports. They were up 2.4%, not the 3.0% the market expected, which is down from 8% in April and 8.5% in March. This is pace is well below the 6-month average (8.5%) and the 12-month average (6.1%). Capex, which boosted Q1 GDP, was partly driven by stronger foreign demand. The inventory accumulation in Q1 may have also been in anticipation of foreign demand.

Third, Australia's leading economic indicator index slipped, and news that China's iron ore futures slumped to its lowest level in a month has taken a toll on the Aussie. It is the weakest of the majors, losing about 0.8% against the dollar to fall to its lowest level in a week. There is an A$1.5 bln $0.7700 strike that rolls off today.

Fourth, the Greek financial crisis continues, and Greek stocks are bucking the better European equity performance today. Tomorrow’s Eurogroup meeting has become more important though finance ministers have failed to resolve the issue even after Greece changed their negotiating team. Reports suggest that while the US has been critical of the austerity drive in Europe (on sequential grounds--growth first then austerity), Treasury Secretary Lew has spoken with the Greek Prime Minister to add pressure for a compromise.

Ultimately, the official creditors are demanding greater austerity from Greece so that they can give the beleaguered, even if not innocent, country the funds that can be used to service its debt to them, the official creditors. We remain struck by the fact that by the EC’s reckoning its demands and Greece’s offer is different by 2 bln euros (a year). The economic and financial forecasts are hardly precise enough to regard this as anything but a rounding error. Surely a Greek exit would cost the EC directly and indirectly some multiple of this.