"This is pretty new for me, both songwriting and singing” Krist Novoselic
Last night the focus of market attention turned back towards US monetary policy and the release of the July statement from the FOMC. While there was no expectation of any policy action from the meeting, market participants were acutely focussed on the implications of the statement as to the timing of the first rate hike. September or December remains the key debate and while Janet Yellen gave no explicit timing references, we do believe that (in a metaphoric sense at least) she is warming her vocal chords.
Overall the statement from the Fed likely did little to change perceptions of the underlying progression. The acknowledgement that the "labor market continued to improve”, amid "solid job gains”, were complemented by the view of moderate expansion of the overall economy in recent months and the Fed stated that the risks to both the economy and jobs outlooks were "nearly balanced”.
"...difficult to look further than you can see” Winston Churchill
The Fed did, however, retain the caveat to the policy implications of the statement in retaining its data dependent policy mantra. In stating that rates will "rise after some further job market improvement”, the Fed narrows the data focus. From our perspective, payroll growth steady at 200 and perhaps an unemployment rate that edges lower over the next two releases could be enough to signify a September hike.
Overall though, it is unlikely that many forecasters or commentators will change their view based on last night. Some remain in the camp that the Fed will wait until December. We remain of the view that the Fed will begin its normalisation process in September and barring any seismic jolts through global markets, hike again in December. Those in the December camp may argue that the (inadvertent) release of the Fed staff projections late last week point to just one hike in 2015. However, we would argue that this is a misinterpretation of the summary of economic projections (SEP’s) in which the Q4 2015 projection of 0.35% is not a closing forecast but an average for the period. Thus we remain of the view that 2 rate hikes from the Fed in 2015 is likely the base case scenario.
Waiting in the wings?
GBP also performed well yesterday as rate hike expectations begin to move closer for the UK also. We maintain the view that the BoE will be hot on the heels of a September rate hike from the Fed, with Carney raising rates modestly in November. Prior to that we would expect dissent to appear in the ranks on the MPC and anticipate a split vote (perhaps even a 6-3) at the August meeting. The dissenters are likely to be messrs Weale and McCafferty (who stated this week that Greek uncertainty was at its max for the July vote - suggesting his swing is imminent now that Greek uncertainties have diminished), joined perhaps by one of the external voting members, perhaps Kristin Forbes.
Against this backdrop we continue to see value in GBP particularly against the EUR, however, following the performance of James Anderson in the first innings of the 3rd Ashes test yesterday, perhaps we could add AUD to the list.
Economics over Politics
"Its the economy stupid” Bill Clinton
Over recent sessions the deterioration in the commodity complex and signs of persistent weakness in the global economy (epitomised in some respects by the huge volatility the Chinese equity markets) have damped expectations for normalisation in monetary policy in those regions where it is most apt, namely the US and the UK. The next couple of sessions will likely prove an important watershed in this regard, with the advance estimate of UK Q2 GDP and the July FOMC meeting.
In the UK, the Q2 reading is important in signifying that the slowdown in Q1 was temporary and that the recovery has been sustained and is sustainable. Headline PMI’s in the UK have disappointed in Q2, relative to Q1. However, other data, such as that from the BCC and CBI, suggest a solid ongoing pace of economic activity. This morning’s first estimate of Q2 GDP came in as expected at +0.7% quarter on quarter, as business services and finance strengthened and North Sea oil output surged, boosting industrial production. The first estimate of UK GDP is based on data covering only about 44% of the economy’s output in the quarter and, historically, subsequent revisions have an upward bias.
The rebound takes UK GDP per head "back to broadly level with its pre-economic downturn peak” according to the ONS and, after the slowdown in Q1, "overall GDP growth has returned to that typical of the previous two years”. Over time, therefore, we anticipate we will get to the +0.8% mark that we had highlighted as our expectation some weeks back. We maintain our view that the UK economy has sufficient strength and momentum to require (let alone withstand) a modest rate rise in November. Despite near term volatility, we retain a positive bias towards GBP
"Ulysses finds himself unchanged, aside from his experience at the end of his Odyssey” -Raymond Queneau
In the US, it is highly unlikely that there is any change in policy at the July meeting. However, with so much market uncertainty as to the timing of the first rate hike, the statement will be highly scrutinised, along with the subsequent data, in assessing the likelihood of a September rate hike from the Fed. We would expect a modestly more hawkish bias to the statement given the reduced Greek tensions, continued strength in labour markets and (albeit volatile) housing activity.
With the US initial estimate for Q2 GDP ready for release on Thursday, it is likely that the FOMC will have some idea of its content, if not the final release, ahead of its deliberations and subsequent statement. Considering the data dependence maxim of the board, it is also likely that the tone of the FOMC in some way reflects the stance of the Q2 GDP print. Our expectations are for a bounce back above 3.0% on an annualised basis.
While the (inadvertent) release of the latest Fed staff projections last week, gave a slightly more dovish tone, given that the average only suggests one rate rise this year, we continue to expect that the Fed (should and) will, barring any significant rout in equities, embark on monetary normalisation at the September meeting. A subsequent December hike, remains firmly dependent on the data but we would by no means rule that out at this stage. By then, activity will likely have strengthened further and the base effects of past oil price declines will mean headline inflation will also be rising (perhaps sharply) back towards target.
US Case Shiller house price data, along with the July service sector ISM, will also so be key for the USD in the short term as the data continues to shape rate expectations. US generic 2 year yields have rebounded this morning after declines on Friday and Monday and we would anticipate that data strength this afternoon will further buoy short term rates and the USD.
"In politics, stupidity is not a handicap” Napoleon Bonaparte
In the eurozone, the backdrop continues to be mixed. There are some areas of good news in Spain and other areas of the peripheral growth. However, the recent political shenanigans over Greece have drawn criticism over the long term prospects for the region. Wolfgang Munchau in the FT today says articulates the view that the EU is "making up the rules as they go along to suit their own political purposes”, a view we share.
The IMF have also issued stark warning to eurozone leaders that the economy is at risk of tipping back into stagnation unless it implements structural reforms in labour markets and promotes competition. "A moderate shock to confidence - whether from lower than expected future growth or heightened political tensions - could tip the block into prolonged stagnation”. The IMF also warns that the Greek crisis could still flare up and that the ECB should be ready to expand its QE programme. Despite its recent buoyancy, we expect EUR to remain on the back foot for a significant time.
"All the world has its limit - Iron ore cannot be educated into gold” Mark Twain
Elsewhere, AUD remains under pressure as the commodity sector declines continue. In the very near term, the bounce in iron ore and copper have given the AUD something of a reprieve. However, continued declines in oil and technical weakness in Gold paints a weak backdrop for the AUD which we would expect to attempt to break the 0.7000 level over coming weeks.
"The worst wheel of the cart makes the most noise” Benjamin Franklin
In FX, the broad focus of attention turned back towards the UK this week with the highlights of an otherwise quiet data calendar. Yesterday, saw the release of the minutes from the July Bank of England policy setting meeting, where the MPC maintained the view that they expected "inflation to pick up notably towards the end of the year” and that "all” of the MPC saw "shrinking slack and rising domestic costs”. A further (albeit modest) hawkish progression.
The vote was 9 - 0 for unchanged rates (and QE) at the July meeting, however, the minutes stated that "for a number of members, the balance of risks to medium-term inflation relative to the 2% target was becoming more skewed to the upside” and that "Greece was a very material factor in their decisions’ to vote for no change in rates.”
We now expect that following more progress in the (mutually uncomfortable) Greek bail out situation, the August vote will likely be a 6 - 3 in favour of maintaining policy with the dissents likely coming from Messrs Weale and McCafferty, likely joined by one of the other external members, perhaps Kristin Forbes.
This morning’s Retail sales data were a little disappointing, recording a mild drop on the month and slowing the annual rate of expansion to (a still strong) 4.2%. In fact, the official data this morning was counter to other retail sales activity data that showed marked increases on the month and we maintain a positive bias on UK domestic consumption. The data may take some wind out of the sails for GBP in the very short term, but we continue to expect consumer strength to compliment business investment and, along with rising wages (and broad inflation gains as the year progresses), anticipate rate normalisation expectations to continue to move closer, supporting GBP against a number of alternate currencies.
Tour de rate hikes
While the UK’s Chris Froome may be the current holder of the yellow Jersey in the Tour de France, in monetary policy I would anticipate that Mark Carney is keen that Janet Yellen takes the Yellow Jersey in the ‘Tour de rate hikes’ and that Carney would be happier in the chasing peloton.
In the US, the data calendar has been light, however, market sentiment towards US policy normalisation has maintained its broadly hawkish bias, keeping front end US yields supported. Following yesterday’s existing home sales data (rising to the strongest level since 2008) 2 year US swap rates rose to 0.97%, significant since they have not traded above 1.0% since 2011. Longer dated yields across the board have stuttered, implying expectations of more modest sequential rate rises moving forwards, at least for now.
The recent sharp declines in the broad commodity complex have confused markets further over recent sessions. On the one hand, in conjunction with weakness in emerging markets and and the Greece debacle, it could be viewed as adding further uncertainty to the US rate normalisation urgency (as if Yellen needed any more excuses). Form our perspective, however, it likely adds further to the case for slower rate hikes, rather than a delayed liftoff. Lower long end rates over the past few days are perhaps testament to this. Either way the commodity decline maintains our negative bias towards commodity currencies such as AUD and CAD.
Who’s watching the watchmen
ECU Research has just published a commentary, normally only available to ECU Research subscribers, where Neil MacKinnon, Kit Juckes, Stephen Jen, George Magnus and Michael Petley share with us their thoughts and analyses with respect to recent events in Greece, and what it means for the future of the Eurozone and the European Union.
Due to the wide interest we decided to make it available to our Market Commentary subscribers and it is available for download here.
PLEASE NOTE - This is not research and is not intended as such. This has been prepared by individuals in the investment and trading departments. This material does not represent a formal or official view of The ECU Group plc as the views expressed herein are solely those of the author(s), which may also differ from those of our investment managers. All prices are indicative only. All references to "we/our” refer to the observations of the authors.
"Go not to the elves for counsel for they will say both no and yes” J. R. R. Tolkien
The Greek Parliament voted a clear ‘Yes’ to the measures proposed (imposed) by the eurozone creditors, however, few appear to agree with the measures, but rather fear the alternative. So on we go kicking the can down the road. This time the ‘can’ has been kicked down the road so many times that at some point it is liable to burst and take on an unpredictable fizz of its own.
As ECU Global Macro Team member Kit Juckes put it "The scale of the fiscal autonomy in the eurozone was always known to be the weakest link in the system. The rules on deficits and debt were the chosen sticking plaster and their failure requires a comprehensive rethink that almost certainly can not result in a satisfactory conclusion.”
In the eurozone today the focus turns back to Mario Draghi and the ECB on two counts. Firstly, we have the regular ECB meeting and press conference. It is likely that Draghi will try and keep the emphasis on the region as a whole, while the Q&A is likely to be very heavily weighted towards the Greek debacle. Secondly, the ECB must decide whether or not to extend the ELA support for Greek banks. Stability risks remain.
The recovery in the eurozone has been encouraging on a number of metrics of late, Q1 GDP data was encouraging and there have been some improving signs of regaining economic momentum (and stabilising inflation). However, the impact and implications of the Greek negotiations are likely yet to be felt in the eurozone data. From a political and economic standpoint, the events of recent weeks have arguably caused greater divergence within the eurozone. All of this uncertainty will require the ECB to maintain super-easy monetary policy for even longer than was the case previously.
"If you are looking for a monument then just look around you” Christopher Wren
Earlier in the week, David Miles, oft thought of as the arch dove on the MPC, delivered a speech in which he suggested "the time to start normalisation is soon”. In his summary of the current UK economic situation Miles stated "unemployment is down to just under 5.5%; annualised GDP growth has been near 3% for several quarters; consumer and business confidence has risen sharply over the past year or so; the household saving rate is low and suggests that spending is not being held back by expectations of low near term inflation; wages are rising; the availability of finance has increased and its cost fallen; corporate profitability looks solid”. In quoting Christopher Wren (above) Miles moved some way towards undoing his dovish associations. The market responded by bringing rate expectations forward.
It has long been our central expectation that the BoE will begin its path of monetary normalisation in November 2015. Having temporarily (at least) avoided the possibility of a Grexit, the removal of political uncertainty in the UK, and further signs of solid UK economic momentum, market interest rate expectations are moving in from as far out as June 2016. Some analysts are now even suggesting a November rate hike!
"Not lying awake at night worried about a downturn” Janet Yellen
Another Central Banker with the ‘arch dove’ moniker over recent months and quarters has been Janet Yellen. In her testimony to the House, the (in our view overly cautious, hesitant) dovish tone to her remarks was replaced by a more balanced view which we feel paves the way for a Fed rate rise (albeit very modest) in September.
"A lean compromise is better than a fat lawsuit” George Herbert
After 17 hours of negotiations on Sunday, Tsipras finally ceded to a bailout package that few would have expected after the months of ‘game theory’, backtracking and intransigence. For today at least, however, we will put to one side the concerns about whether or not the ‘compromise’ is the best route for the embattled Greek populace to take, or, indeed, whether or not the implementation of agreed measures is ultimately likely (both of which were concerns raised by ECB’s Benoit Coeure overnight) .
Assuming that the Greek and German (most importantly) parliaments pass the "compromise” then perhaps markets can afford a moment to look up from their focus on a country that makes up just 2% of eurozone GDP (and an insignificant amount of global growth) and glance at the broader global economy. In doing so, there are a number of reasons to be markedly more cheerful.
Following the Greek announcement yesterday, we saw markets unwind a significant amount of ‘safe haven’ flows that have been built up as the tensions became increasingly acute. From our perspective, it is the resultant levels in US and UK yields that should be the biggest drivers of FX in the near term. 2 year US yields rose back to around 68bps and the equivalent part of the short sterling interest rate curve fell (rising rates) by around 9bps.
If the Greek can has been kicked yet further down the (albeit still bumpy) road, market expectations of rate lift off in the US and, to an even greater degree the UK, are too dovish. Our central view is that the US will begin the rate normalisation process (initially at least at a moderate pace) in September and the UK will begin the process in November. Current OIS, SONIA market pricing suggests the first US rate rise is not full priced until January 2016, and its UK equivalent not until June 2016.
"The time for BoE rate increase is moving closer” Mark Carney
In the US, with the unemployment rate nearing long term equilibrium, GDP growth running at around 3%, corporate profits at record levels and core inflation running at around 1.8%, we maintain our view that the ‘emergency’ monetary accommodation that prevails leaves the Fed significantly behind the curve. The same can be argued of the UK, with retail sales growth rising at around 4.5%, wage growth expected to rise to around 3.3% y/y (tomorrow), and significant strength in services and business investment. Furthermore as we move towards the end of 2015, the BoE has been clear in stating that it expects stronger inflation (as energy base effects drop out) and a further reduction in economic slack.
Rates in both the US and the UK may well need to rise significantly further than the market or the respective central banks expect (currently) over the next 2 years. On this basis, the risks to the USD and GBP in FX markets remain to the topside in our view on an economic and monetary differentiation that, by the same rationale, is likely to widen further.
You only Sing When you’re winning?
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