Like a Newtonian law of motion, market participants will continue to rely on a particular trading style or system until it stops working. Betting that volatility stays low is a cash register for many, and there appears to be what Soros called "reflexivity" here, like a self-fulfilling prophecy. Why is volatility low? Because it is being sold in various ways besides directly selling options. Buying equity pullbacks and selling euro bounces, for example, also seem to be expressions of short volatility.
There is little on this coming week's calendar that threatens to pull the plug on this cash register. In other circumstances, the eurozone's preliminary February PMI could have potential. It is to be reported at the end of the week ahead. The composite had not fallen since last September when it reached 50.1. In January, it was at 51.3, little above where it finished 2018 (51.1). However, one of the most important reasons market participants pay attention to sentiment data, of which this purchasing manager survey is an example, is that it ought to shed light on real sector developments.
Yet the market was shocked by the magnitude of the decline in the December industrial figures. The December manufacturing PMI for EMU eased to 46.3 from 46.6, having bottomed in September at 45.7. The 2.1% decline reported last week was tipped by the national figures, but the aggregate decline was the largest since February 2016 (-2.2%), which itself was the biggest drop since early 2009. While the flash PMI may pose headline risk, it is most unlikely to turn the market.
The ECB's course also appears set. Lagarde has not "cleaned house" as Georgieva has at the IMF, and continues on the path set out by Draghi. However, her presence has already been evident in the lack of sniping and media leaks. This represents an improvement in communication. There have been reports in the media claiming a backlash against negative interest rates. Yet, Lagarde has given a spirited defense. Last week so did Germany's Executive Board member, Schnabel, who may be the first in her position to defend it (and vigorously). The ECB's chief economist Lane also endorsed its efficacy.
China's economic data for January and February was always going to be distorted by the Lunar New Year holiday. This year, because of the new coronavirus (Covid-19), the data is, particularly, of little value. In addition to monitoring the progress of the virus in China, where the cases and mortality are the highest, the setting of the Loan Prime Rate will be an important signal.
Recall the one-year Loan Prime Rate has become the new benchmark, and it is set by a survey of the leading banks. In this sense, it is a more market-driven metric than previously administered attempts. It is set on the 20th of every month and currently stands at 4.15%. The median forecast in the Bloomberg survey looks for a 10 bp cut. If it is wrong, it is likely because rates have fallen faster. The PBOC granted banks this week funds that can be re-lent to businesses struggling to cope with the effects of the Covid-19 for 100 bp below the one-year Loan Prime Rate.
The signal from Beijing is to go for growth. Yet, the inclusion of CAT scan diagnosis (rather than the nucleic acid test) saw a jump in confirmed cases, and nearly doubling of fatalities. This raises new questions and prompts an extension of closures and disruptions. While the initial reaction is this was a one-off adjustment, it is not immediately clear. There are problems outside of China too, with some observers, for example, seeing that Indonesia's claim of having no cases, is a bit unlikely. Also, there is concern in some quarters that the incubation period may be longer than initially estimated.
The political consequences are already materializing. The death of Li Wenliang, a young doctor who was among the first to detect the virus and was harassed by local officials for doing so, and ended up being infected himself, is an unexpected catalyst for change. It seems clear that public health requires clear and forthright communication, and yet in China (like several other places), this does not exist. In fact, the lack of open and honest communication costs lives. It is in this way that this experience is similar to the Soviet Union's Chernobyl tragedy in 1986. A campaign pushing for open communication has begun on social media.
Another political fallout is the replacement of the Communist Party heads in Hubei and Wuhan. However, the replacement of the Director of Hong Kong and Macau Affairs suggests that Xi may be using Covid-19 as cover to pursue a broader agenda. It may not be so dissimilar from using the anti-corruption campaign to also punish rivals and secure greater power. A common understanding is that there is a social contract between the Chinese people and the Communist Party. The latter delivers the goods, literally: rising living standards, and the people defer to the Party. However, the lack of trust that was simmering below the surface is becoming manifest. This is another window of opportunity for a change, a concession to people, a civil liberty, but the greater probability is the opposite. Push hard for a quick resumption of economic activity and repress dissent.
At the start of the week, investors will learn just how bad last year ended for Japan with the first official look at Q4 19 GDP. The tax hike and typhoons are expected to have led to a 1% quarter-over-quarter contraction and risk is on the downside. The reason the market will not act much is that the data is historical, and there are no new policy implications. More important is how the economy is doing in Q1. There are concerns about the disruption of trade due to Covid-19 and the sluggishness of consumption after the sales tax increase. This may translate into an economic contraction here in the first quarter.
Japan's January trade figures will be released. The interest lies not in the balance itself but the components. Exports were off 6.3% year-over-year in December, which of course, was before the public knew about China's new virus. Recall that in December, Japan's exports of semiconductor fabrication equipment to China jumped by 60%. This is important too because semiconductor chips (design and manufacturing) are seen to be a bottleneck for China.
Japan reports CPI and the preliminary February PMI. The composite PMI was at 50.1 in January. Any decline would fan recession (two quarters of contraction) fears. While much has been done in the name of the core inflation (excluding fresh food), it tends not to elicit much of a market reaction. The headline may ease from 0.8% to 0.6%, while the core rate is likely steady at 0.7%.
The UK reports employment, CPI, retail sales, and the flash PMI. A couple of weeks ago, the market was particularly sensitive to speculation that Bank of England Governor Carney would cut rates at his last meeting. Not only wasn't it delivered but now the data might not be so important either. The two dissenters at the BOE have been unable to convince any colleagues to join them, and the new governor is unlikely to start his tenure with a rate cut. The market is fully pricing in a 25 bp rate cut around the middle of Q3. Meanwhile, the fiscal rules were already relaxed before Chancellor Javid unexpectedly resigned as a consequence of the cabinet and staff shuffle. The market anticipates an expansionary budget when it is presented in less than a month.
Last week, the Reserve Bank of New Zealand flagged that its easing cycle was over, and the markets believed it. The currency rallied, and yields rose. The Reserve Bank of Australia and the Bank of Canada are in somewhat different positions. The Bank of Canada withstood three Fed cuts last year and stuck to its neutrality. It has since softened its tone, and the January employment data was sufficient to refute any sense of urgency. The January CPI report, due in the middle of next week, is expected to reinforce this message. After finishing last year at 2.2% (November and December), it is forecast to rise to 2.4%, which would match last May's pace, which itself was the strongest since the 2.8% rate in August 2018. The core measures are expected to remain broadly steady 2.0%-2.2%.
The Reserve Bank of Australia's cautious optimism rests on the labor market, which naturally draws attention to the January employment report. The market is expecting the RBA will cut the cash rate by 25 bp in June or July. Australia created an average of almost 22k net new jobs a month last year after nearly 21k a month in 2018. The median forecast in the Bloomberg survey calls for a 10k increase last month. Full-time positions grew by an average of 12.7k month in 2019 and 13.5k in 2018. This may overstate the recent trend. Full-time jobs fell in Q4 19 for the first time since Q1 18. If the Australian dollar sells off on a strong report, it would be revealing about psychology and positioning. It has depreciated by 4.4% so far this year to multiyear lows. According to the OECD's measure of Purchasing Power Parity, the Aussie is less than 1% undervalued (~$0.6720).
The key to the dollar's outlook and to Fed policy does not hinge on the high-frequency data that will be reported in the week ahead. The market continues to discount one rate cut fully and is roughly half-way toward factoring a second cut. The logic is the same as last year. The PCE deflator measure of inflation, which the Fed targets, is at 1.6%. The target is 2%. Officials continue to see mostly international risks and continued weakness in the industrial sector (contraction four of the past five months), indicating that some risks are, in fact, materializing. The economy, they assure us, is in a good place, but that does not preclude taking further insurance out, possibly in Q2, extending the business cycle further and pushing the envelope of full employment.
Last week's retail sales and industrial production reports for January told investors and policymakers that the new year has begun pretty much the way 2019 ended. The consumer continues to shop but at a more subdued pace. It should not be surprising as investors also learned last week that real weekly pay is flat year-over-year even though average hourly pay has increased (higher hourly is offset by working a few hours). Revolving debt (credit cards) has increased to pick up some of the slack.
The production cuts at Boeing (NYSE:BA) are being felt. Aerospace and parts output fell 9.4% in January, and without it, manufacturing output may have gained 0.3% instead of contracting by 0.1%. On the other hand, auto production picked up, and without it, manufacturing output would have fallen by 0.3%. Manufacturing accounts for around three-quarters of industrial output (which includes mining/drilling and utilities). The output of utilities also fell in January due to unseasonably warm weather that helped other sectors. More troubling is the continued decline in capacity utilization. At 76.8%, it is the lowest in nearly 2.5 years. The low usage rates are associated with weaker profitability and deter new capital expenditure.
The Empire State and Philadelphia manufacturing surveys may draw attention because, outside of weekly jobless claims, they will offer the first insight into economic activity in February. The Fed's term repo will also attract interest. Despite the last three repos being oversubscribed, the Fed announced it would reduce the amount it would make available, and taper further next month. The Fed is implicitly assuming that it is the cheapness of the funds it makes available that attracts the strong demand and not a shortage of reserves.