The easier monetary policy trajectories in the eurozone and Japan are taken for granted. The debate has been over the timing of the normalization in the US and the UK. Talk that had emerged recently, that the Bank of England could hike rates before the Fed, was never very compelling. Last week's developments increase the likelihood that the FOMC raises rates at least 5-6 months before the BOE.
The strength of US economic data, and especially the July jobs report, has prompted market participants to upgrade the risk of a September rate hike by the Federal Reserve. The implied yield on the September Fed funds futures contract is the highest since the mid-June FOMC meeting and dot plot, which the market read more dovish than ourselves.
One of the developments that make this cycle unique is that the Fed has adopted a target range instead of a fixed point. The Fed funds effective average has gravitated around the middle of the 0-25 bp target range. Our interpolation of the odds of a September rate hike priced into the Fed funds futures assumes that the effective rate, which is the key to the value of the contract, as opposed to the policy rate, continues to hang in the middle of the policy range.
We assume that the effective Fed funds rate will average 13 bp, as it has for the past hundred days, and we expect for the first 17 days of September. If the Fed hikes the target range by 25 bp, we assume that Fed funds will average 37 bp (a conservative assumption) for the remaining 13 days in September. That would produce an effective average of 23.4 bp.
Before the weekend, and after the jobs data, the September Fed funds futures contract implied 19.5 bp. This is the equivalent of a 62.5% chance of a hike, and this is likely to drift higher in the coming weeks. We subjectively assess an 80%-85% chance of a rate hike next month. A small decline in the JOLTS index that the consensus expected (5290 vs. 5363 in May) is unlikely to have much impact as it will still be the third highest on record (since 2000) after April and May.
Recent economic data (e.g., construction spending, inventories) has spurred economists to revise up expectations for Q2 GDP from 2.3% toward 3.0%. It appears that the favorable momentum carried into the start of Q3. Industrial output in July is likely to have risen for only the second time this year. Manufacturing output has fared better, but it slipped in June. July plays catch-up and a 0.4% rise the consensus expects would be the strongest since last November.
The July retail sales report should show that US consumption remains fairly stable, rising at about a 3% pace. This is faster that the increase in average hourly wages (2.1%), but there are other sources of income, including commissions, bonuses, dividend/interest, transfer payments and social security. The 4.8% savings rate in June matches the 24-month average and remains well above the 1.9% trough set ten years ago last month. Moreover, this consumption
Retail sales account for about 40% of personal consumption expenditures. They unexpectedly fell 0.3% in June but are expected to bounce back in July. Auto sales rose sequentially, and retail sales were likely boosted by more people working, a longer workweek, and earning a little more an hour. The scope for an upside surprise arises from the difficulty in assessing with any degree of confidence the impact of Amazon (NASDAQ:AMZN)'s Prime Day, which spurred a competitive response from other retailers, like Walmart (NYSE:WMT). While some of the buying may have indeed been a substitute/replacement of purchases that would have been made in any event, and it might have brought forward some pre-school shopping, the impact could still be substantial.
II
Over the last year and a half or so, the hawks at the Bank of England have warned of inflation risks. They have dissented from stand pat decisions, advocating immediate rate hikes. Their objections fade, and they return majority. Governor Carney himself has never voted for a rate hike during his tenure at the BOE but has on occasion fanned expectations that rates would rise sooner than he has delivered.
The bark is worse than the bite. There were fewer dissents from the stand pat majority than had been expected. A lone dissent suggests that the hawks are content to bide their time, are not as strong as the markets feared, with talk creeping in of the risk of a November hike. The emerging consensus is for a Q1 '16 rate hike or early Q2.
The strength of sterling and the drop in oil prices are helping to dampen UK inflation. The Bank of England recognizes both of course. It argues that the restraint is not sufficient to keep price pressures in check for long. The main source of pressure is thought to be emanating from the labor market. It is in this context that the market will interpret the employment data.
Whereas the US labor market continues to strengthen, the UK's labor market appears to be softening. The consensus expected the claimant count to have risen in July and an increase in June. If it does, this would be the first back-to-back increase since September-October 2012. This matches up with the decline in employment.
What caught the attention of policymakers and investors was the increase in the average weekly earnings. The UK reports average weekly earnings on a three-month year-over-year basis. It is reported with an extra month lag. In the middle of the week when the UK reports July claimant count, it will report June earnings.
This measure of average weekly earnings fell by 0.2% in June 2014, and except during January-February, they have risen to reach 3.2% in May. The consensus expected a 2.8% pace in June. Excluding bonus payments, average weekly earnings rose 2.8% in May and are expected to have maintained that pace in June. In May-June 2014, earnings excluding bonuses bottom at 0.7%.
Not all increases in earnings are in fact inflationary, even if one accepts the Phillips Curve. There are many key issues that may be exaggerating. Some sectors may be experiencing a skill shortage and must pay up to acquire those skills. While overall productivity in the UK remains disappointing, sectors with higher productivity may be raising wages. It is likely to take several more months to sort out the issues. It may become a less urgent issue if the improvement in the labor market slows and productivity begins increasing.
III
The reason that Sweden's Riksbank has adopted negative interest rates and an asset purchase program is not due to weak growth. The Swedish economy expanded by 1.0% in Q2 on a quarter-over-quarter basis. Its primary challenge is deflation. This will ensure much attention is paid to the July CPI figures that will be released Thursday.
The consensus calls for no change from June when prices were off 0.4% from a year ago. Last July, CPI fell 0.3%, and a decline of the same magnitude is expected now. The underlying rate, which uses fixed rate mortgage interest, is also expected to be unchanged at 0.6%. Any downside surprise would likely weigh on the krona.
Norway's experience is somewhat different. Weakened domestic demand and the drop in oil prices makes growth a more urgent concern than inflation. That said, lower inflation would give the Norges Bank more scope to act. July headline CPI is expected to have fallen back to 1.9%, making the 2.6% spike in June look to be a fluke. Such a rate in July would match the February low, which itself was the lowest since Q2 '14. The underlying rate, which excludes energy and tax changes, is expected to have eased to 2.6% from 3.2%. As expected, data may be sufficient to fan expectations of a Norges Bank deposit rate cut (currently 1.0%) at its next meeting on September 24.
Whereas the inflation reports from Sweden and Norway will likely impact their currencies, the eurozone data probably won't. The flash CPI report steals the thunder from this week's report. The end of the week sees the release of Q2 GDP estimates. Overall EMU is expected to have expanded by 0.3% from 0.4% in Q1. This would keep it on pace of the EU and private sector consensus of 1.5% growth this year.
France may the laggard of the large EMU members with growth expected to slow to 0.2% from 0.6%. Italy is expected to have expanded by 0.3%. It would be the third consecutive quarter of growth in EMU's third largest economy. It has not managed to do so since Q4 '10-Q2 '11. Greece is likely to have contracted by 0.5%-0.7%.
IV
China's flurry of monthly economic data has begun. The PMI data showed that the manufacturing sector has yet to respond to the lower interest rates and economic stimulus. Over the weekend, China reported trade and inflation figures. In the coming days the latest readings on lending, retail sales, industrial output and investment will be provided. We expect to see signs that the Chinese economy is stabilizing.
That stabilization is going to have to offset a potentially bigger drag from the external sector. China's July trade surplus was reported at $43.03 bln, well below market expectations for a $54.7 bln surplus. It was $46.5 bln in June. Exports fell 8.3%. The market had expected only a 1.5% decline, after a 2.8% year-over-year increase in June. Imports were in line with expectations, falling 8.1% (consensus -8.0%) after a 6.1% decline in June.
China's exports this year to the European Union are off 2.5%. This makes sense as growth in much of the EMU reflects foreign not domestic demand. Exports to Japan have fallen 10.5%. Over the past 12 months, the yen has depreciated a little more than 17% against the yuan, and there are reports that some Japanese companies have brought some production home (from China and the US). Chinese exports to the US are 9.3% over the past year. Given the little yuan movement, the important factor must be relative US economic strength.
By volume, China's oil imports are holding up, helped imports by some private refiners. Iron ore imports rose by 15% in July, the largest increase of the year as steel mills reportedly rebuild inventories. Weaker domestic demand has seen Chinese steel companies step up foreign sales. Steel exports rose to their highest levels since January. The competition is driving down global steel prices.
At the end of last week, the PBOC reaffirmed its commitment to allow the market to play a bigger role in setting foreign exchange prices. It also indicated its commitment to a "reasonable equilibrium level". To investors and economists, this sounds like a contradiction.
The dollar-yuan has been in a CNY6.2065-CNY6.2115 range for a month. Somehow, despite giving market forces more sway, Chinese officials have figured out a way to re-peg the yuan. This seems quite the opposite of widening the allowable trading band that some observers had been anticipating.
Perhaps to show greater conformity with the IMF's best practices, the PBOC announced its July reserves figures before the weekend. Typically China reports its reserves quarterly. The July reserves reportedly fell $43 bln to $3.65 trillion. This represents a marked acceleration of the decline in reserves seen recently. Reserves fell by about $150 bln in the first half of the year. About a third July's decline may be attributable to simply the fluctuations of other reserve currencies in the SDR. The euro, which may account for 20%-25% of China's reserves fell, 1.5% in July. The yen and sterling likely play considerably smaller roles in China's reserves, but they fell 1.1% and 0.6% against the dollar in July.
July's merchandise trade surplus likely exaggerates the capital inflows into China generated by trade. It runs a growing trade deficit in services. There may also be some accounting adjustments as it deploys some of its reserve assets for policy purposes, such as the development bank. However, it also speaks to capital outflows, especially in light of the dramatic drop in Chinese shares. Some of the reserves might being used to prevent the yuan from weakening, which is one way this intervention differs from the past when it was acting to slow the yuan's appreciation.
Economists bemoan that trade growing slower than the world's economy unlike prior to the Great Financial Crisis and China is surely part of this. This is a function of excess capacity, as a result of excessive reliance on investment to drive growth and the decline in prices. China reported that its producer prices fell 5.4% in July from a year ago. It is the largest decline in nearly six years. Consider that its oil and natural gas prices are off by more than a third (34.6% year-over-year) and ferrous metals prices have fallen by a fifth (20.1%). Producer prices in China have for nearly 3.5 years (41 months) uninterrupted.
Consumer prices ticked up as a result of higher meat prices China's CPI rose 1.6% from a year ago in July. Prices rose 1.4% in June. Non-food prices slipped to 1.1% from 1.2%. Food accounts for about a third of the Chinese CPI basket, and contributed 0.9 points of the 1.6% increase.
Food prices accelerated to 2.7% from 1.9% in June, largely as a result of 16.7% jump in pork prices. The rise in pork prices is a function of supply not demand. Reports indicate that pork farmers cut supply to lift prices over the past year, and appear to have succeeded. The combination of the weakness in exports and softer non-food prices, will keep investors expecting additional easing measures by the PBOC.