Some Like it Hot But Many Do Not
• Of next week’s economic reports, the market may be most sensitive to the US non-farm payroll on July 2. Estimates are gravitating around 700k.
• At this year’s pace, the US won’t recoup the 6.5 mln private-sector jobs until the end of Q3 22.
• Federal Reserve chairs Greenspan and Yellen also argued to run the economy hot. The Fed’s average inflation target formalizes this approach, but already seven of 18 Fed officials see a hike appropriate next year.
• Many economists see the pace of economic growth near a peak in the US. Europe’s peak still lies ahead.
• The eurozone’s preliminary estimate of June CPI is due as the quarter draws to a close. A soft report may have more impact than an upside surprise.
Three events highlight the week ahead. The quarter-end can often experience heightened intraday volatility as investors and banks adjust positions and hedges. Hours before the end of trading for the quarter, the eurozone’s preliminary estimate of June CPI will be published. Then, on July 2, ahead of a three-day holiday weekend in the US, the BLS will report the June employment data, which has disappointed expectations in the last couple of months.
There are many asymmetries of information around the month-end and quarter-end adjustments. It seems very much the case that while a single order book may not be very revealing, an amalgam of several may not be any more representative. Nevertheless, for some market participants, simply being aware that month-end and quarter-end can produce their own echo effect may be sufficient to adjust one’s tactics accordingly.
Asset managers use industry benchmarks and compete not just against the faceless market but against companies that offer a similar service. It appears that adjusting hedges on a monthly basis has become a more widespread practice. In addition, we know from trade-cost analysis that the best time to trade is when every else is, which helps explain the self-reinforcing mechanism that made the London fix so important.
The operational and execution is fascinating in its own right, and short-run discontinuities can and do result. Ultimately, the macro factors influence the flows themselves. There seems to be a dialectic dance between the reaction function of markets and that of central banks that are mediated by positioning. The ECB has taken itself out of the game. It will not review the pace of its asset purchases until September. That reduces the significance of the preliminary June estimate of CPI.
In this dialectic dance, we can take the analysis further. The weakness of the euro and the rise in energy prices, coupled with the frictions from the uneven re-opening, suggest upward pressure on prices. However, last June prices rose by 0.3%. This will drop out of the year-over-year measure, and June’s 12-month rate may slip from May’s 2.0% pace. However, the next challenge is just around the corner. In July and August last year, CPI fell by 0.4% each month. This means that when the ECB meets on September 9, inflation will likely appear to appear have accelerated again.
Moreover, the economy will appear to be accelerating. After contracting in Q4 20 and Q1 21, the eurozone has begun to expand again here in Q2. Given the increased inoculations and the return to work that can be expected after the summer and the beginning of the disbursement of EU funds (mostly grants), growth will likely broaden and strengthen. That is likely the macroeconomic backdrop at the ECB’s September meeting.
A key consideration is what the Fed will be doing when the ECB meets at the end of the summer? The September FOMC meeting is not until September 22, well after the ECB’s meeting. The ECB must hope, like many market participants, that the Fed’s intent is strongly hinted at the Jackson Hole conference in late August, if not before. Since earlier this year, surveys have shown a firm expectation for this timeframe for the tapering announcement.
There is good reason to expect the tapering this time to be different from after the Great Financial Crisis. One way it could be different is that there seems to be some broad concern about the Fed’s MBS purchases. The initial stages of the tapering could focus on this sector. Another way the tapering could be different than before is that the pace may be quicker. It is noteworthy that the ECB emergency bond-buying program (PEPP) is presently supposed to run through March 2022. Could it end before the Fed has completed its tapering?
The employment data will inform the Fed’s discussion. The early forecasts are centered around a 700k increase in non-farm payrolls. Without considering potential revisions, job growth needs to be a bit better than that for the Q2 average to exceed the Q1 average (518k). However, the government jobs have flattered the results. Consider that the private sector would need to add more jobs this month than it did in April and May combined (711k) to surpass the Q1 average (489k). Although GDP is back to where it was on the eve of the pandemic, it has done so without about 6.5 mln private sector employees.
Last September, the Federal Reserve announced it would target the average rate of inflation (headline PCE deflator) at 2% rather than just a constant point target. An overshoot will be tolerated after an undershoot. Leaving aside the period of time that should be considered, for which the Fed has refused to be pinned down, this formalizes what Yellen had tried to do less formally and is encountering similar opposition.
At a Fed conference in Boston a little less than a month before the 2016 election, Federal Reserve Chair Yellen waxed eloquently about the benefits of letting the economy run hot for some time. It would entail letting the unemployment rate fall further and spur more consumption and investment. It would spur innovation and new business formation. Still, Yellen recognized that “we, of course, need to bear in mind that an accommodative monetary stance, if maintained too long, could have costs that exceed the benefits by increasing the risk of financial instability or undermining price stability.”
The average inflation target could give teeth to Yellen’s five-year-old idea, which itself was a refinement in some ways of Greenspan’s experiment in letting the economy run stronger due to unrecognized productivity gains without causing price pressures. From 1996 through 1999, Greenspan led the Fed to postpone raising rates as early in the cycle as they have in the past, and then, when rising inflation expectations forced his hand, the pace of tightening was slow.
The new formal inflation target framework is not even a year old. Just as the worst of the last year’s deflation drops out of the 12-month comparison and exaggerates the year-over-year rate, several Fed officials push back. Seven of the eighteen Fed officials think a rate hike next year will be appropriate. At this year’s average pace of private-sector job growth, it will take until the end of Q3 22 before the net loss of 6.5 mln jobs private sector jobs are recouped. Making some modest assumptions, by the time the Fed meets in September, the four-week moving average of weekly initial jobless claims may approach the pre-pandemic levels. The participation rate is a different matter. It averaged about 63.2% in Q4 19. It was pretty flat, around 61.5% for the past year.
Moreover, the seeming loss of patience is taking place near what many economists see as a peak in the pace of growth. By the second half of next year, above 3% annualized quarterly growth likely will be seen only in the rearview mirror. The pent-up demand, fiscal stimulus, and bottlenecks in supply chains will have run their course. The growth and price cycle are not twins, but it is reasonable, as a working hypothesis, to suspect they are not very distant cousins either.
The coming fiscal cliff and excesses spurred by the rapid growth, coupled with the doubling of the price of oil since the early last November before the vaccine was announced, seems to point to the risk of an economic downturn in late 2022 or early 2023. This may not be the baseline view, but it is powerful and dangerous even as a risk scenario. To the extent that the economy impacts voters’ preferences, how the Fed manages the post-covid economy could influence next year’s mid-term elections and the general election in 2024.
Bannockburn Global Forex