US Prices Back to Center Stage in the Week Ahead
• Following the robust employment report, the US reports four different price metrics in the coming days. The year-over-year pace of CPI may ease for the first time since last October.
• The second consecutive job growth of more than 900k keeps the Jackson Hole confab at the end of the month the next opportunity for the Fed to confirm a tapering announcement as early as the September FOMC meeting.
• Following the Bank of England meeting, the market has nearly fully discounted a rate hike in the middle of next year. The BOE anticipates that this week’s Q2 GDP will show a 5% expansion.
• The EC has given Poland until August 16 to explain why it refused to abide by the European Court of Justice’s ruling seeking to defend the country’s judicial independence.
• The central bank of Turkey is under pressure to cut rates next week, but elevated price pressures do not allow much room to maneuver. A rate cut would likely weigh on the lira. The central bank of Mexico meets and it is expected to raise rates again after hiking in June. The Philippines’ central bank may have limited scope to cut rates, but has hinted at a possible cut in reserve requirements. Peru’s political climate left the sol as the weakest currency in the world last month but the central bank is reluctant to tighten policy.
The main contours of the investment climate have not changed. The evolution of the virus is seeing the re-introduction of social restrictions, extending lockdowns (e.g., Sydney), and prolonging formal emergencies (Japan). The return to the office in the US is being postponed for many companies. Confidence in mass transportation will likely take longer to return.
The direct economic impact is difficult to tease out of the data. This could, at least, in part, be due to the lags in economic reports. It may also be difficult to distinguish between the maturing of the recoveries in several Asian countries and the increase in the virus. Bottlenecks and shortage of supplies may be another consideration sapping some economic momentum.
The strength of the US employment data keeps the Jackson Hole conference as the next opportunity for an update on the pace (and possibly, the composition) of the Fed’s bond purchases. With the Treasury net issuance to slow in the coming months, the Fed is buying a larger share of the new supply. At the same time, price pressures may be cresting. Prices paid in the ISM manufacturing report fell to 85.7 in July from 92.1. It is the lowest reading in four months, and the second decline in three months.
The US reports July CPI on August 11. The headline rate is expected to ease for the first time since last October. To be sure, it will remain elevated and likely above 5% year-over-year. The possible slippage of the headline rate will probably reflect the decline in the core rate. Of course, it is too early for officials to draw much comfort from it. However, recent comments underscore our sense that the “transitory” nature of the increase in inflation means that prices pressure should slacken before the end of the year, or the hypothesis will be re-examined.
As central banks move from providing emergency support to pursuing policy targets, there is scope for diverging opinions. It is perhaps easiest for the media to see it at the European Central Bank, or more recently, the Bank of England, but it is also clear at the Federal Reserve, even though there have been no dissents. Traditionally, there is greater discipline among the Board of Governors than the regional presidents, and structurally, when fully staffed, the Board of Governors (seven) outnumber the regional presidents, who share five votes. The power of the regional presidents is also circumscribed by the fact that the NY Fed has a permanent vote on the FOMC, is often part of the leadership, and rarely dissents. However, recent comments from Governors Clarida, Waller, and Brainard suggest that the consensus at the Board may be fraying.
Three other data points involve prices in the week ahead. The first is the producer price index. The monthly increase of both the headline and core rate may be halved from the 1.0% increase in June. Yet, given the base effect, the year-over-rates are unlikely to change much from the 7.3% and 5.6% for the headline and core rate, respectively, in June. Second, import and export price increases are likely to moderate, and this will see the year-over-year pace slow. It is notable that during the covid period, the US is experiencing a positive terms-of-trade shock. In the year through June, the index of export prices rose 16.8%, while the index of import prices rose a more modest 11.2%. Third, the University of Michigan’s August consumer confidence survey also asks about expected inflation, and some officials have cited the long-term (5-10 years). It peaked in May at 3.0% and stood at 2.8% in June and July. The low for the year is 2.7%. It averaged 2.4% in 2019.
Real sector eurozone data from June has been downgraded as a market factor since the release of Q2 GDP (2.0% vs. 1.5% expected, the first quarterly expansion since Q3 20). The Sentix investor confidence and ZEW survey typically do not have the heft to have much market impact. The economic highlight for the UK is the first look at Q2 GDP. The UK economy contracted by 1.6% in Q1 21 but looks to have rebounded smartly in Q2, with many anticipating a 5%-6% jump in economic activity. The Bank of England’s updated forecast anticipates 5% growth in Q2 and 3% in Q3. Over the past month, judging from the swaps markets, the market has gone from a one in three chance of a hike by the middle of next year to nearly completely pricing it in (~90% chance).
The EC has chosen not to immediately proceed with legal recourse with the UK over implementing the Northern Irish protocol involving checks on goods from other parts of Britain being checked as they enter Northern Ireland. Although often an advocate of the sanctity of treaties and contracts, the UK now is ultimately seeking a re-writing of the agreement.
It gives the appearance of Prime Minister Johnson so determined to oversee Brexit that he was willing to agree to nearly anything, even drawing a border in the Irish Sea, which had previously been mocked by his predecessor. However, now that Brexit has taken place, the Johnson government says the agreement is impractical and needs to be re-done. The EC has threatened remedial action but chose to negotiate over the summer. This will likely strengthen its hand later by being more willing to talk now.
Meanwhile, the UK is outperforming the EU, and sterling has outperformed the euro. Sterling is the best performing major currency, appreciating about 1.5% against the US dollar. In contrast, the euro has lost about 3.7%. Sterling finished last week at its best level against the euro since February 2020 (the euro was near GBP0.8470).
The EC’s confrontation with Poland is approaching an infection point. The EC has given Warsaw until August 16 to explain its refusal to accept the European Court of Justice ruling that the mechanism the government that disciplines judges encroach on the independence of the judiciary in violation of the EU basic treaty.
There are two big issues here. First is the narrow issue of judicial independence. Poland is not alone. The EC is critical of Hungary, Croatia, and Slovakia too. Every system has its own checks and balances. Some variation must be accepted, but this raises the broader issue of who decides what is acceptable and what is not. Second, the EU is still struggling to establish the primacy of European law over national law, and the European Court of Justice is the final judicial authority. Germany had questioned this principle over the ECJ’s rulings on the ECB’s bond-buying.
There is much talk about fines and withholding at least some of the “Recovery Fund” assistance (~24 bln euros). On the one hand, this may be understandable. On the other hand, the Polish government, led by the Law and Justice Party, enjoys popular support, even if not quite as much a pre-Covid. Eastern and Central European countries are less experienced with the shared sovereignty. They also are less socially liberal than where most Western European countries are at this historic moment. If a modus vivendi (an agreement to disagree) cannot be forged, the material benefits of EU membership wane, and the asymmetrical risk perceptions regarding Russia persist, can the divided house survive intact?
Finally, next week there are a few emerging market central bank meetings that will draw attention. The central banks of Turkey and Mexico hold policy meetings on August 12. As many are familiar with, the monetary policy has been politized in Turkey. President Erdogan made it clear that it wants lower interest rates and has fired several governors following orders. Kavcloglu, the current governor, may sincerely want to do as Erdogan wants, but the data gives him little room to maneuver. July inflation was reported last week. It rose more than expected, 1.8% on the month and 18.95% year-over-year. Producer prices rose by nearly 2.5% after a 4% increase in June. The year-over-year rate is near 45%. The 12-month inflation outlook from the central bank’s survey continues to trend higher.
One positive development for Ankara is that the Turkish lira was the strongest currency in the world in July, rising 3% against the US dollar. Of course, the gain needs to be understood within the context of its 5.25% decline in Q2 and 9.8% in Q1. It leaves a year-to-date loss of a little more than 12%. However, a rate cut that does not appear to be justified by traditional macroeconomic metrics would put the recent lira gains at risk.
Mexico’s central bank reversed the rate cut delivered in February in May, leaving the cash rate at 4.25%, where it began the year. The year-over-year increase in CPI has been around 5.9%-6.1% in Q2. Growth is gaining better traction. The economy expanded by 1.5% in Q2 after a 0.8% expansion in Q1. The economy is not overheating, but inflation is providing the spur to action. The current governor (Alejandro Diaz de Leon) has clashed with President AMLO and was not given a second term. His current term ends in December, and the swaps market appears to be pricing in a hike in each of the remaining four meetings. Finance Minister Arturo Herrera was given the nod and tends to be less hawkish. When everything has been said and done, the peso remains one of the strongest emerging market currencies this year, slipping nearly 2/3 of a percent against the dollar.
The Philippines central bank meets on August 12. The economy appears to have contracted by over 1% in Q2 after a meager 0.3% expansion in Q1. The GDP will be released on August 9. With inflation at 4% and the key interest rate (overnight borrowing rate) at 2%, the central bank does not have much scope to cut interest rates. Instead, it suggested a cut in required reserves is possible. The ratio currently is 12%, which is significantly higher than others in the region. The government has put the Manila capital region into a strict two-week lockdown to arrest the contagion. The peso has fallen by 4.7% this year, and a little more than half of the loss (2.4%) took place last month.
The dubious honor of the weakest currency in the world last month goes to the Peruvian sol’s nearly 5% decline. The central bank also meets on August 12. The pressure on the currency stems from both economic and political considerations. Investors are concerned about the policies of the new left-of-center government. But, of course, there are different types of leftists in Latam, and the uncertainty may be more the issue now than certainty. Inflation is near 4% and rising, while the reference rate is at 25 bp. Other emerging market central banks, including three in the region (Brazil, Mexico, and Chile) have already begun the tightening cycle. Peru is reluctant.
Bannockburn Global Forex