Lower For Longer
|• Covid-19 is again threatening to derail or slow the economic recovery. New social restrictions are being introduced in an increasing number of countries.|
• The market is tempering the expectations of the trajectory of monetary policy in the UK, Australia, Canada, and the US.
• The FOMC is unlikely to change its stance on an important aspect of monetary policy, while talks to taper proceed. Jackson Hole and the September FOMC meeting still seem like reasonable opportunities to announce a decision about when to being adjusting the pace and possibly the composition of the purchases.
• The US and eurozone report Q1 GDP. Growth likely accelerated in the US, while the EMU expanded for the first time in three quarters.
• The eurozone reports its preliminary July CPI. It looks set to rise above 2%., though like the Federal Reserve, the ECB sees the price pressures as transitory.
The Delta variant of the virus has emerged as an important economic force, just as more countries appeared to adopt the attitude that we should now live with it like we do with the flu, which kills hundreds of thousands every year. While the existing vaccines seem to have lost some of their ability to prevent the illness, they remain a power prophylactic against hospitalization and death. Nevertheless, new social restrictions have been introduced in some high-income countries, even those like Israel, that have been fairly successful in vaccinating a large part of their population.
The virus is once again raising the prospects of slowing the economic recovery that was unevenly unfolding. The preliminary July PMI for Australia, UK, France, and the US disappointed. Expectations for the trajectory of monetary policy are being impacted. Consider that the implied yield of the December 2022 Eurodollar futures fell to 40 bp in the middle of last week from 55 bp on July 1. A similar futures contract in the UK, the December 2022 short-sterling implied yield fell from 58 bp in mid-July to almost 40 bp on “Freedom Day” as the UK dropped all social restrictions and mask requirements. The implied yield of the December 2022 Bank Acceptances in Canada fell 20 basis points from July 14 to nearly 105 bp ahead of the weekend. In Australia, the December 2022 bill futures contract’s implied yield fell a little over 60 bp on July 6 to 36 bp last week.
The December 2022 Euribor futures contract has been considerably steadier as it is widely accepted that the European Central Bank will not lift rates until after 2023. The implied yield has been confined to a -42 bp to – 50 bp trading range since the end of April. The yield finished last week at -49 bp, falling about five basis points since the ECB meeting. The ECB’s new forward guidance signaled that bond purchases and low rates will prevail until the staff forecasts that the 2% target can be sustained. In June, the staff forecasts projected 2023 CPI at 1.4%.
The signal of lower for longer helped drive European bond yields to new 3-4 month lows. The French 10-year bond yield had been offering a positive yield since the second half of April but recently moved back below zero. One has to pay Greece 50 bp to lend to it for two years, which is a little more than one would pay to Italy for the same maturity. Greece takes about 15 bp a year from those lending to it for five years, while Italy’s five-year yield has dipped below zero for the first time since early April. The amount of negative-yielding bonds in the world has increased to almost $16 trillion from below $13 trillion in late June, and that does not include Japan’s 10-year bond, where the benchmark yield is less than a basis point.
The ECB’s dovishness likely minimizes the impact of the preliminary July CPI figures. In July 2020, the eurozone saw consumer prices fall by 0.4% on the month and again in August. This speaks to a likely acceleration of the year-over-year pace from 1.9% in June. Also, note that since at least 2000, prices gained less in July than in June (and consistently rose more in August than July). The monthly increase in June was 0.3%. The Bloomberg survey shows economists anticipate sharp month-over-month declines in Italian and Spanish prices. French CPI is also expected to have fallen slightly in July. German inflation may have ticked up. These considerations suggest the year-over-year rate may have edged above 2%.
The eurozone will provide its first estimate of Q1 GDP at the same time as the CPI figures on July 30. Recall that in Q4 19, before the pandemic struck, the eurozone economy was stagnant. Last year contracted in H1 before recovering in Q3. However, unlike the US experience, the eurozone economy contracted against in Q4 20 and Q1 21. Despite the spread of the Delta mutation and the floods in parts of Europe, including Germany, the recovery now appears to be on more solid footing, and the EU Recovery Funds are at hand. The regional economy likely expanded around 1.4%-1.5% in Q2 and is poised to accelerate further here in Q3.
The highly contagious, though less lethal mutation (if vaccinated), has pushed investors to reconsider the recovery theme that had two drivers last November, the US election and the vaccine announcement. Of course, this does not mean that it is the only development in the market, but it seems to be a relatively new and powerful one. The US dollar rallied as the pandemic first struck, partly as a safe haven as US Treasuries were bought and partly as a function of the unwinding of dollar-funded purchases of risk assets (e.g., emerging markets).
When things began to stabilize at the end of last March 2020, and the NBER now dates the end of the US recession as April 2020, the dollar trended lower and accelerated into the end of the year and began to recover in early January. From the end of March through December last year, the Antipodeans and Scandis led the move against the greenback and appreciated roughly 20%-25% against the US dollar. These currencies are often perceived to be levered to world growth and are often more volatile than the other majors. Over the past three months, they have been the weakest, losing 3.0-6.50%.
The opposite is also true in the sense that the Swiss franc and Japanese yen, other currencies often used for funding, hence the appearance of safe-haven appeal, were the worst performers against the dollar in the last nine months of 2020 (rising about 8.25% and 4.5% respectively). However, over the past three months, they have been among the most resilient in the face of the dollar’s surge. The Swiss franc is off less than three-quarters of a percent, while the yen is off by about 2.4%.
A challenge for investors and policymakers is the evolution of the virus that renders some of the high-frequency data rather dated and arguably less impactful outside of the headline risk posed. The Federal Reserve has succeeded in securing for itself much room to maneuver and is not tied to a particular time series, like the monthly jobs report or data point. The FOMC statement is likely to hardly change from the previous one.
Discussions about the pace and composition of the Fed’s bond-buying will continue. Still, Fed Chair Powell was speaking for the central bank when he told Congress recently that the bar to adjust the purchases (substantial further progress toward the Fed’s targets) has not been met. The Jackson Hole symposium at the end of August has long been seen as the first realistic window of opportunity for the Fed to signal its intention to slow, possibly alter the composition of its bond purchase, and shape it more formally at the September FOMC meeting. Ahead of Jackson Hole, there is one more jobs report, and the early call is for around a 750k increase.
Reporters may try to draw Powell out but are unlikely to have much more success than the US Senators and Representatives. There is ongoing interest in the size of the reverse repo facility, for which the Fed now pays five basis points at an annualized rate, the same as a six-month bill. In addition, Powell pushed back against suggestions by some officials that the central bank’s MBS purchases are lifting house prices beyond the access of many American families. Will reporters press him on this or the buying of inflation-protected securities that arguably distort the price discovery process and the break-even metric?
Stable coins’ regulatory framework may be questioned. Recall that just before Biden took office, the Comptroller of the Currency allowed federally chartered banks to used distributed ledgers (blockchain) and conduct business with stable coins. There is a push to treat stable coins as securities for regulatory purposes. While the ECB recently announced it was going forward with a research and design phase of its development of a digital euro, the Federal Reserve’s report is expected in September. Powell said what many officials seem to believe that the introduction of a digital dollar would likely dry up demand for stable coins and crypto.
The day after the FOMC meeting concludes, the US reports its first estimate of Q2 GDP. The median forecast in Blomberg’s survey has crept up in recent days to 8.5% at an annualized pace, up from 6.4% in Q1. The NY Fed’s GDPNow model puts growth at 3.2%, while the Atlanta Fed’s model is closer to the market at 7.6%, while the St. Loius Fed Nowcast stands at 9%.
Even before this surge in the virus in the US, where about half of the adult population is fully vaccinated, we suggested there was a reasonable chance that Q2 marks the peak in growth. Fiscal policy will increasingly be a drag, pent-up consumer demand will be satiated. Monetary policy is near a peak. Perhaps the recent increase in the rate paid on deposits at the Fed and on the reverse repo facility and the recent sales of corporate bonds bought in 2020 mark the end of the easing cycle. We have also underscored the restrictive impact of doubling the oil price since the end of last October.
While there does not appear to be an iron law, it would not be surprising to see price pressures peak with a bit of a lag. This dovetails with the timeframe suggested by both Powell and Yellen. Some recent industry data suggests that the US used car market (accounting for around a third of the recent monthly increases in CPI) is normalizing in terms of inventory, and prices have softened in the wholesale markets. We note that input prices and prices paid components Markit PMI have fallen in June, and the preliminary report suggests a further decline is taking place this month. Airfare and the price of hotel accommodations, and food out of the house, appear to be a one-off adjustment rather than persistent increases.
The US will report June personal income and consumption figures ahead of the weekend, but the data will already be embedded in the GDP estimate. On the other hand, the PCE deflator, which the Fed targets rather than the CPI, may draw attention. It is expected to post a sharp 0.7% increase on the month for around a 4.2% year-over-year. It rose by 0.4% in May and a 3.9% year-over-year rate. The core rate, which the Fed does not target but makes references from time to time, is expected to accelerate to 3.7% from 3.4%.
Lastly, the infrastructure debate in the US Senate looks to come to a head in the days ahead. It could, in turn, shape the political climate until next year’s midterm elections. The latest wrinkle is that what might serve as the basis of a compromise in the Senate may be rejected by a number of Democrats in the House. The failure to find a bipartisan solution for even the physical infrastructure components will not defeat the Biden administration but force it to rely on the reconciliation mechanism, which is confined to fiscal policy. It would likely hamper the administration on non-budgetary fiscal issues. The debt ceiling looms. The Congressional Budget Office sees the Treasury running out of room to maneuver in October or November. Biden’s spearheading of a 15% minimum corporate tax rate might not need their approval, but the approval of 60 Senators may be needed for the other component of the global tax reform, the agreement to link the sales and taxes for the largest companies.
Bannockburn Global Forex