Flash PMIs Play Second Fiddle to US PCE Deflator and Accelerating Inflation
• The broad strokes of Q4 growth appear known. Europe, including the UK, will likely slow, while China and the US is set to accelerate. Japan’s economy is returning to growth after contracting in Q3. The flash PMIs will help flesh out these developments.
• A critical driver of the dollar’s recent gains has been market participants anticipating the reaction function of the Federal Reserve to the acceleration of US price pressures. This issue remains in the fore with this week’s release of the PCE deflator. The targeted measure of inflation is set to accelerate not only in October but this month as well.
• The FOMC statement underscored the necessity of it being able to respond to a range of possible outcomes of this situation, which has few precedents.
• What is limiting the Fed’s degree of freedom now is the pace of the tapering. If inflation were to reach levels in the next few months that the Fed wanted to respond to, it could not until the tapering is completed around mid-year.
• It is prudent then for the Fed to accelerate the pace of its tapering. This will give it the opportunity but not the commitment to raise rates earlier (Q2 22), and some of the derivatives are pointing in this direction, though it does not appear to be the majority view.
• Among high income central banks, Israel, Sweden, and New Zealand meet. Only the last is expected to hike. It would be the second hike in the cycle. Some suggest the risk of a 50 bp move rather than 25 bp.
The flash November PMIs would be the main focus in the week ahead if it were more normal times. But these are not normal times, and growth prospects are not the key driver of the investment climate. This quarters’ growth is largely baked into the cake. The world’s three largest economies, the US, China, and Japan, are likely to accelerate for different reasons in Q4 from Q3. Europe is the weak sibling, and growth in the eurozone and UK may slow sequentially.
The fiscal and monetary induced rebound from the global shutdown last year has peaked. However, there is still sufficient support for growth in most high-income and medium-income countries to remain above trend for a few more quarters. The rebuilding of inventory will also help sustain growth through the first half of next year. And then things will get interesting. The Fed will likely begin taking away some monetary accommodation rather than inject it at a slower pace (tapering) just as economic growth ratchets down, below 3% on a sustained basis. The swaps market has the UK raising the base rate by 100 bp over the next 12 months, while the economy is expected to steadily slow. Moreover, given the variable lag times for monetary policy to impact the real economy, central banks will join governments in pursuing a pro-cyclical course.
Given the market’s sensitivity to inflation, the US October PCE deflator may be the most important data point in the coming days. Recall that the Fed targets the PCE headline deflator (average over an unspecified period of 2%), not CPI or the core PCE deflator. In October 2020, the headline deflator was unchanged. It remained unchanged in November. This suggests powerful base effects that will accelerate the headline pace. The median forecast (Bloomberg survey) expected the October PCE deflator to rise by 0.7%. That would likely lift the year-over-year rate a little above 5%. Assuming that the PCE deflator is rising by its 2021 average (January-September) of 0.4% now, it would suggest a pace closer to 5.5% when the November data are reported.
Fed officials often cite the core rate. The core rate excludes food and energy, not because they are volatile, but because over time, the headline rate converges with the core rate–not the other way around. The base effect here is similar to the headline rate. In October 2020, the core PCE deflator rose by 0.01%, and in November, it was flat. The median forecast (Bloomberg survey) calls for a 0.4% increase. This will lift the year-over-year pace slightly above 4.0%. Through September, it has risen by an average of 0.36% a month. If it does so this month, the year-over-year rate will accelerate to 4.4-4.5%.
There are two important elements of the Federal Reserve’s reaction function that were revealed. The first was in the FOMC statement, and the second was in Chair Powell’s remarks after the meeting. Powell said, “Given the unprecedented nature of the disruptions related to the pandemic and the reopening of the economy, we remain attentive to risks and will ensure that our policy is well-positioned to address the full range of plausible economic outcomes.” Essentially, Powell is saying that the Federal Reserve needs to secure the maximum degree of flexibility because of the higher degree of uncertainty.
In announcing the tapering, the FOMC statement specified the tapering in November and December at a $15 bln pace per month. The statement went on to say that, “The Committee judges that similar reductions in the pace of net asset purchases will likely be appropriate each month, but it is prepared to adjust the pace of purchases if warranted by changes in the economic outlook.” The key question is whether there has been a change in the economic outlook.
Powell acknowledged that growth was likely to accelerate this quarter. The strength of the US October employment report, retail sales, industrial production, and housing starts to point in that direction. The Atlanta Fed’s GDPNow sees growth tracking almost 8.2% (November 17), while economists are closer to 5%.
The acceleration of growth by itself would unlikely have moved the needle. However, the surge in inflation and the base effect pointing to the likelihood of further increases widen the range of “plausible outcomes.” This is especially true given some studies suggesting that prices pressures are broadening, not just intensifying.
Even though September’s dot plot (summary of economic projections) showed that half of Fed officials did not think a hike next year would be necessary, the Fed needs to have the flexibility to raise rates sooner. Currently, it is hamstrung by the pace of tapering, which means that the Fed cannot presently raise rates before mid-year. In order to give itself the flexibility to hike rates earlier, the Fed will have to accelerate the pace of tapering. St. Loius Fed President, and noted hawk, has argued in favor of completing the tapering by the end of Q1. To achieve that after the November and December tapering requires the Fed to double its pace to $30 bln a month in Q1 22 to complete the operation.
The effective Fed funds (weighted average) have been steady at eight basis points since the beginning of September. The Fed funds futures are bringing forward the likelihood of a Q2 22 rate hike. It is not entirely discounted, but the market is recognizing the increased risk. The implied yield of the May and June contracts are 18.5 bp and 24 bp, respectively.
The divergence of monetary policy is a significant dollar driver. Consider that next month, as the Fed accelerates its tapering, the ECB provides the “modalities” of its bond-buying program after the Pandemic Emergency Purchase Program ends next March. There are different ways to capture the divergence. One way is the December 2022 Eurodollar-Euribor spread, which has moved above 120 bp for the first time since March 2020. Another way is to look at the two-year rate differential. The US premium rose from around 90 bp ahead of the September FOMC meeting to average about 125 bp last week.
The dollar-yen exchange rate is more sensitive to the US 10-year yield. The correlation over the past 60-day of the change in the exchange rate and yield is nearly 0.55. The correlation with the two-year yield is 0.35. Often, the yen is seen as a safe-haven currency, meaning that as stocks more up, the yen should weaken and vice versa. From February through early August, the 60-day correlation of the change in the exchange rate and change in the S&P 500 was inverse. As the US index rallied, the dollar weakened against the yen. Since then, the correlation has turned positive, rising stocks and a weaker yen, but not statistically significant (less than 0.1).
Three high-income central banks meet in the week ahead: Israel (November 22), New Zealand (November 24), and Sweden (November 25). The shekel rose last week to its best level against the US dollar since 1996. The October CPI was reported lower than expected, rising by 0.1% rather than 0.4% as economists (Bloomberg median) forecast. The year-over-year rate eased to 2.3% from 2.5%, the first decline of the year. Although the base rate is at 10 bp, the central bank will stand pat.
Sweden’s Riksbank is not in a hurry to adjust monetary policy either. The monthly prints for GDP in the July-September period warn of a contraction when Q3 GDP is published at the end of the month. Inflation is elevated, but the underlying core measure, which adjusts for fixed mortgage rates and excludes food and energy, stood at 1.8% in October. The krona has depreciated against the Norwegian krone, as its central bank has begun and will likely continue to the normalization process with another hike next month. However, from late August through early this month, the krona appreciated by around 4.7% against the euro. Those gains have been pared since the US CPI spurred sharper greenback gains.
The Reserve Bank of New Zealand is likely to move again. It hiked the official cash rates 25 bp in October and is set to match that now, though some see the rise of a 50 bp move. Price pressures are rising faster than expected, and the labor market has tightened. At 3.4%, the unemployment rate is well below the 4.0% level seen at the end of 2019 and is at a 14-year low. The economy contracted sharply in Q3 (-6.5% quarter-over-quarter) as the new lockdown bit, but the economy appears to be recovering quickly and strongly.
The New Zealand dollar rose almost 4% in October but is struggling this month. It is off 2.4% so far. If it could, it would plead extenuating circumstances. First, it has fared the best of its micro-universe of other currencies that often trade like it (Australian dollar and the Scandis). Second, aggressive rate hikes have been discounted in the swaps market for some time. The market has a little more than 100 bp priced in over the next six months and another 100 bp+ in the following six months.
Bannockburn Global Forex