Sticky US Inflation and ECB Meeting to Finish Groundwork for July Hike Featured in the Week Ahead
• The ECB meeting on June 9 will likely see the projections for growth cut and inflation lifted. Officials are expected to signal the beginning of a hiking cycle in July. The swaps market has 100 bp of tightening priced through October.
• The terms of the Targeted Long-Term Refinancing Operations (three-year loans) are expected to be adjusted as well.
• US inflation, like developments in the labor market, is expected to moderate but not sufficiently to deter the Fed from its more aggressive course. The central bank’s balance sheet will begin shrinking in earnest this month.
• A clear consensus has emerged in favor of 50 bp this month and next and the Fed funds market is pricing in about a 65% chance of a similar move in September.
• The swaps market has the Reserve Bank of Australia hiking by 30 bp, but economists are looking for 40 bp.
• China’s policy response to Covid is likely to have distorted trade and prices last month, while lending is expected to have recovered from depressed April levels. Producer prices are expected to have fallen for the seventh consecutive month. CPI may have edged higher.
The ECB meeting on June 9 and the May US CPI estimate the next day provide the two highlights for the first full week of June. The ramifications of both extend well beyond the headline risk.
Breaking from the past, the ECB is expected to signal its intent to hike rates at next month’s meeting. Traditionally, the ECB shows a clear preference for changing policy under cover of updated staff forecasts.
The new staff forecast provided at the ECB meeting will shave this year’s growth forecast, which was seen at 3.7% in March. The market is closer to 2.5%. The staff’s forecast for next year of 2.8% also looks too high. Something near 2.0% may be more appropriate. It could leave 2024’s projection of 1.6% alone.
The inflation forecasts are too optimistic and will likely get lifted. In March, the staff projected CPI at 5.1% this year. It may need to hike it by 1.0-1.5 percentage points. Next year’s forecast of 2.1% appears more be aspirational, but the European Commission’s forecast of 2.7% may be more realistic. The market and the ECB converge with the 2024 CPI forecast. The median in Bloomberg’s survey is 2.0%, while the ECB staff put it at 1.9% in March.
The ECB has taken a hawkish pivot. At the end of last year, President Lagarde did not expect to sanction a rate hike this year. Now she and the ECB’s chief economist Lane seem prepared to hike rates by 75 bp this year, which would lift the key rate over zero for the first time since 2014. Central bankers from the Netherlands, Austria, and Latvia seemed to advocate a 50 bp hike in July even before the May CPI surged to 8.1% (from 7.5% in April). The situation is still evolving. The hawks, while vocal, do not appear to have a majority. Still, the swaps market recognizes the risk that the hawks will win out and is pricing in 100 bp of tightening in the three meetings after this week’s.
In addition to the updated staff forecasts and the forward guidance to prepare the market for the beginning of the tightening cycle, the ECB has some administrative tasks well. For example, it has signaled that it will adjust the Targeted Long-Term Refinancing Operations rate. In addition, the bond purchases, a common feature of quantitative easing, the ECB also made attractively priced loans available to the banks. These accounted for about a quarter of its balance sheet.
This facility, originating in the Great Financial Crisis, has been successful and will be a permanent addition to the ECB’s crisis playbook. The loans were a cheap funding source and provided a risk-free arbitrage for banks. When the pandemic struck, the ECB lowered the rate of these loans to a mind-boggling minus 100 bp. Banks that met specific lending targets could borrow from the ECB at -100 bp and put the funds on deposit at the central bank at -50 bp, collecting 0.50% in a world where even Italian and Greek two-year yields were negative.
Meanwhile, the EC and ECB have given their preliminary approval for Croatia to become the 20th member of the European Economic and Monetary Union at the start of next year. A final decision is expected next month. Croatia is a small and relatively poor country, with a population of around 4 mln and a GDP per capita of a little less than $17k. It was the last country to join the EU (2013). Despite the challenges some see as congenital, others want to join the monetary union. Lithuania was the latest member of EMU (2015), and Bulgaria is the next likely member, though not until 2024 at the earliest. In fairness, the enthusiasm to join by Czech, Poland, and Hungary has waned.
In the US, the pendulum of sentiment swings between inflation, which President Biden reiterated was his number one economic concern, and fear of a pending slowdown. The day after the FOMC meeting in May ended, the swaps market priced in a terminal Fed funds rate of 3.75%. However, as the pendulum swung, it fell to just below 3.0%, the same day that Atlanta Fed President Bostic suggested that a pause in September might be appropriate if inflation falls. As it became clear that the case for a pause was not widely shared, expectations recovered somewhat. It now stands at around 3.25%.
Housing activity and the labor market are moderating, which is what the Fed wants. Yet, from the official point of view, much more work needs to be done. House prices continued to rise through Q1, even though financial conditions had been tightening for six months before the Fed’s first hike in March. However, sales are slowing from elevated levels. The labor market remains strong. The number of vacancies is nearly double the number of people looking for work. Continuing unemployment compensation claims are around 30% lower than at the end of 2019. Non-farm payrolls rose by 2.6 mln in the first five months of 2021 and a little more than 2.4 mln in the first five months of this year. Average hourly earnings rose by 5.2% year-over-year in May, which is off the 5.6% peak in March, but not enough to move anyone’s needle.
US May CPI will be reported on June 10. The headline and core pace may ease, but the year-over-year pace will prove sticky with the expected monthly increase of 0.5%-0.7%. The median forecast in Bloomberg’s survey projects the headline to slow to 8.2% from 8.3%, while the core eases to 5.9% from 6.2%. The implied yield of the September Fed funds futures never really bought Bostic’s suggestion of a pause, but the market did have second thoughts about a 50 bp increase after the seemingly pre-announced moves of the same size this month and July. It has recouped some of the ground lost and is now pricing in about a 70% chance of a 50 bp move in September rather than 25 bp.
Treasury Secretary Yellen and Fed Chair Powell have acknowledged that their earlier view of inflation was wrong. They can be expected now to minimize their biggest regret. Their biggest regret would be to be bitten by the same dog twice, i.e., not fighting price pressures hard enough or long enough. Ironically, as admirable as it might be, the contrite attitude makes a hard-landing more likely rather than less. Despite the complexities behind the increase in prices, the Democratic Party, and President Biden in particular, are being blamed, like incumbents in other countries. Biden’s public recognition of the Fed’s independence and mandate for stable prices puts him in an unusual position to endorse tighter monetary policy in the run-up to the November mid-term election.
Three other US data points will draw attention. First is the April trade balance on June 7. Recall that net exports were a significant drag on growth in Q1. The advanced report on goods trade showed a dramatic narrowing (~$106 bln from $126 bln). Of course, what matters for GDP are “real” net exports, but it should point to a small drag in Q2.
Second, on June 7, April, consumer credit figures will be released. March saw a record surge ($52.4 bln), which does not include mortgages. Consumption is being sustained by credit cards (revolving debt jumped by nearly $31.5 bln in March). Non-revolving debt, which picks up student and auto loans, rose by $21.5. Savings have been drawn down, and home equity loans have risen sharply. To monetize the dramatic rise in house prices, cash-out refinancing is running at its highest level in two decades.
Economists often cast consumption in the context of the wealth effect. The wealth effect is driven by two main streams, income (primarily wages and salaries) and the appreciation of assets (primarily houses and equities). Household net worth for Q1 will be reported on June 9. CoreLogic Case-Shiller 20-city house price index rose by a monthly average of about 1.25% in Q4 21 before accelerating to a 2.2% average in Q1 22. The S&P 500 rose by about 10.6% in Q4 21 but fell by nearly 5% in Q1 22. As a rough rule of thumb, the wealth effect from housing is thought to be twice as significant as equities. Household net worth rose by $5.3 trillion or 3.7% in Q4 21. In aggregate, leaving aside the important distributional issues, Americans have never been wealthier, and it probably increased a bit more during the first three months of the year.
The Reserve Bank of Australia meets on June 7. It began its tightening cycle with a 25 bp hike last month. The swaps market had priced in a 15 bp more that would have brought the cash rate target to 0.25%. It was the first hike since 2010. The swaps market has around 32 bp of tightening priced in for the meeting and a little more than 100 bp in Q3. The market sees a terminal rate near 4% in the middle of next year. The Australian dollar rallied on the larger than expected May rate hike, but that proved to be the high (~$0.7265) that was taken out at the end of last week, but only after it fell to $0.6830, its lowest level since July 2020.
Lastly, we turn to China, which will report May reserves, lending figures, trade, and inflation measures. Most reserve currencies appreciated in May, which would lift the valuation of China’s holdings when converted into dollars. However, it will be blunted by the decline in the value of the assets in which the reserves are invested. Although US Treasury prices rose (yields slipped), the sell-off in European bonds continued. With the help of the government’s suasion, lending is expected to have more than doubled from the Covid-inspired collapse seen in April. We expect that lockdowns distorted Chinese trade last month.
That brings us to China’s inflation. Of course, it is likely that the Covid experience continued to skew prices to the upside, but the moderation in producer prices has been underway since peaking at 13.5% year-over-year last October. The PPI is expected to have slowed for the seventh consecutive month in May. The median forecast in Bloomberg’s survey is for a 6.5% pace, down from 8% in April. If so, it would be the lowest since March 2021.
Consumer prices likely edged higher, but at a little more than 2%, inflation is not the most pressing issue; growth is. The lockdowns lifted food prices in April, which probably continued in May. Fresh vegetable prices rose by almost 25% from a year ago in April, up from slightly more than 17% in March. Pork prices are off a third from a year ago but appear to be beginning to recover. Like elsewhere, fuel costs in China have surged, and its 28% increase is the most of any component in the CPI basket. If pork were eliminated, the CPI would be closer to 3%. Yet, April’s core CPI rose 0.9% from a year ago, excluding food and energy. While this would appear to give scope to the PBOC to ease monetary policy, officials have moved almost begrudgingly on rates and have preferred fiscal policy to support the economy.
Bannockburn Global Forex