US Data is Key for the Dollar

Surveys suggest that a little more than 80% of the economists expect the Federal Reserve to hike rates in September.  The September Fed funds futures, the most direct market instrument, has only about a 50% chance discounted.
  
This week's FOMC meeting is the last one before September. The economy is performing largely in line with the Fed's expectations. Investors may be looking in vain if they expect some hint from the FOMC that it will in fact hike rates in September.  It is more reasonable to expect a non-committal statement on the timing of the liftoff, as Yellen was in her recent Congressional testimony.  

The Fed diligently worked to shift the focus of the outlook of policy from a date-specific commitment to a data-dependent path.  A signal of a September rate hike would bring investors back to thinking about the date and unwind the Fed's efforts.  This is unlikely.  There are still much economic data to be released, including two employment reports.  Also in the coming weeks, there will be a greater sense of the economic performance for the first couple of months of Q3.  

The day after the FOMC meets, the US will publish its first estimate of Q2 GDP.  The Atlanta Fed says it is tracking about a 2.4% annualized pace.  We suspect the risk is on the upside.  Economists may take advantage of the June durable goods orders report to tweak their forecast.  

We know that Boeing orders jumped to 161 in June from 11 in May.  This bodes well for headline orders, which may rise 3.2%-3.5% after a 1.8% decline in May.  The details, especially the orders and shipments for nondefense and non-aircraft durable goods, should point improving business investment, and better overall growth.  

Annual benchmark GDP revisions will also be announced.  With new seasonal adjustments, the biggest impact is likely not to be so much on growth itself, but how it is distributed between the quarters.  There is some risk that the first quarter may be revised up, but this may take from Q2.  The precise details are unlikely to be particularly salient in considering the trajectory of monetary policy. 

The Employment Cost Index (ECI) will be released at the end of the week.   It is a measure of labor costs that Fed officials have cited on occasion.  Every measure has strengths and weaknesses of course.  The ECI uses fixed weights for individual industries and occupations.   It has posted a quarterly average increase of 0.65% over the past year.  It has averaged 0.51% over the past three years.  It is expected to have risen 0.6%-0.7% in Q2, which would keep the year-over-year pace near 2.6% as it was in Q1, which is the fastest since 2008.  

Fed officials, including Yellen, who is one of the foremost labor economists, understand that headline inflation converges to core inflation, and core inflation, in turn, is driven by labor costs.  They are confident that as the labor market tightens there will be upward pressure on wages.  Provided the labor market tightens, the Fed will be "reasonable confident" that its medium-term inflation target will be reached.  

Last week, the weekly initial jobless claims fell to new cyclical lows.  Not just cyclical lows, but at 255k, it is the lowest in 42-years--since November 1973.  If there are many on Wall Street that have not seen the Fed raise rates, there are even fewer that have seen initial filings for unemployment compensation this low.  And of course, the population and workforce is much larger.  There did not seem to be any distortions or irregularities.  

The report has extra significance because it corresponds to the week that the monthly nonfarm payroll survey is conducted.  It would be helpful if this week's report confirms the improvement, but in terms of market impact, it may be overshadowed by the GDP report that is released at the same time.  

The US is also in the middle of the earnings season.  According to FactSet, 187 of the S&P 500 have reported.  Three-quarters (76%) have surpassed the mean expectation, and 54% have surpassed revenue expectations.  A blended (combines those that have reported and expectations for the others) suggests an earnings decline of 2.2%, which would be the first decline since Q3 2012.  It would be about half of what was expected before the earnings season began.  Revenues are expected to be 4% lower.  

In the week ahead, both Exxon and Chevron report earnings.  It is a timely reminder of the drag from that sector.  Earnings are expected to be off more than 50% from a year ago, and revenues more than a third lower.  If the energy sector were excluded, earnings growth would be 4.1% and revenues up 1.5%.   Even if not spectacular, the message is that earnings growth are not as weak as expected, and especially given the concentration of magnitude of the bad news coming from the energy sector. 

II

Four other high income countries report GDP figures.  They are all expected to show faster growth.  The UK first estimate of Q2 GDP will be reported on Tuesday.  Growth accelerated from the 0.4% in Q1.  The BOE says it was 0.7%.  A strong report will keep the market looking for the hawks to being pushing for a rate hike at next month’s MPC meeting.  

Spain and Sweden estimate Q2 GDP on Thursday.  Spain's economy enjoys the fastest growth among the high income countries.  It is expected to have grown by 1% quarter-over-quarter, slightly faster than the 0.9% reported for Q1.  The year-over-year pace would accelerate from 2.7% to 3.2%.  Spain's Rajoy is counting on the stronger growth, and the humiliation of Greece, to bolster his support and sap the strength of anti-austerity calls that are beginning to filter through the PSOE, the opposition Socialists.  Spain's national election will be held later this year.  Portugal's national election will be first (October 4), and polls show a close contest.  

The Swedish economy is expected to have grown 0.6%-0.7% in Q2 after 0.4% growth in Q1. Monetary policy, which includes negative repo (-35 bp) and deposit (-1.10%) rates, and bond purchases is a response to deflation, not growth.  The 2.6% year-over-year growth is the upper end of growth over the past three years, and most high income countries would be pleased with such a performance.  

Canada reports May GDP on Friday.  It is expected to snap a streak of four negative monthly prints, but only just barely,  The Bloomberg consensus is for a flat report. It will not be sufficient to arrest the slowing year-over-year pace.  It was 2.9% in December 2014.  It was 1.5% in March 2015.  In May, it is expected to have slowed to 0.8%. Additional easing by Canada can be ruled out especially if the economy continues to struggle with the negative terms of trade shock.  

III

Japan does not report its Q2 GDP until mid-August.  After 1.0% quarterly growth in Q1, there is much talk of the risk that the economy stagnated or worse in Q2.  Even with a 0.3% rise in June industrial output as the consensus expects, it would still have fallen on the quarter, for the first time since Q2 14.  Despite relatively full employment (expected unchanged at 3.3% in June), upside pressure on wages is modest.  Consumption is soft.  Overall household consumption is expected to have risen at a 1.8% year-over-year in June, a considerable slowing in this admittedly volatile series from 4.8% in May.  May was the first positive reading since March 2014, just before the sales tax was hiked.  

Japan reports CPI figures at the end of the week.   Even though the BOJ is engaged in the most aggressive quantitative easing ever, it is unable to generate inflation.  In fact, in June, headline CPI is expected to slow to 0.3% year-over-year from 0.5% in May.  The core, which exclude fresh food, is expected to return to zero from 0.1%.  Excluding food and energy leaves prices is only a little better at 0.4% year-over-year.  

Tokyo reports July prices, which will not provide much cause for optimism about the national figures.   The headline is expected to slow to 0.2% from 0.3%.  Tokyo's core rate is expected to have slipped back to zero from 0.1%.  Excluding food and energy Tokyo's July CPI is expected to be unchanged at 0.2%.  

The eurozone is expected to confirm on Friday its earlier estimate of July CPI at 0.2% year-over-year. The core rate, which excludes food and energy, is unlikely to be unchanged from the 0.8% initial estimate.  Recall that before Q2, aggregate inflation in the euro area was negative for four months. The latest drop in oil prices, and commodity prices more generally (foodstuffs, industrial and precious metals, and energy) warn that deflationary forces may reemerge, unless the euro weakens further.    

The eurozone will also report money supply and lending figures for June on Monday.  The gradual increase in money supply is expected to continue, and both supply and demand for credit is likely to continue to improve.   Any interruption may be linked to the Greek turmoil, and regarded as transitory.  At the end of the week, the June unemployment rate will be reported.  It is expected to slip to a new 3-year low of 11.0%.  

Using the similar measures, in October 2009 the US unemployment rate was 10.0%, and the eurozone's was at 10.1%.  They have been diverging since.  Eurozone unemployment peaked at 12.1% in Q2 13.  It has since dropped one percentage point.  At the end of Q2 13, US unemployment was at 7.5% and stands at 5.3% now. 

IV

An FOMC that does not indicate a September hike is likely, rather than simply possible, may see the US dollar move lower.  However, dollar weakness will be corrective in nature,  and we expect it to be relatively shallow and short-lived.  The prospects of a strong July employment report may encourage the market to price in more than a 50/50 chance of a September hike. While there is some talk of a BOE hike this year, this still seems premature, and we note that implied yield on the December 2015 short-sterling futures contract has fallen seven bp since mid-July.  

The central banks of the other major countries are all easing policy.  This divergence is significant, and will last several more quarters.  Many continue to expect the BOJ to step up its efforts.  The ECB's asset purchase program has another full year to run.  

Contrary to the speculation of an early exit, the risks are that it may have to be extended. Expanding the central bank's balance sheet does not seem to be an effective way to boost consumer prices, and this is clearly Japan's experience as well.  With double-digit unemployment and falling commodity prices, the ECB may find what every other central bank that has tried QE has found, namely the it takes more than an initial round of purchases.    

The Federal Reserve's real broad trade-weighted measure of the dollar rose 4.6% in Q4 14 and 4.7% in Q1 15.  It rested in Q2, slipping 1.0%.   The uptrend appears to be resuming in Q3.

disclaimer