Known Unknowns and the Dollar

There are three, and arguably interrelated, known unknowns that are seemingly on everyone's mind.  

First is the decline in global equity markets. Is this simply a long overdue correction? Wasn't August 24 some sort of capitulation?  Is this a re-test of those extremes, which is not particularly unusual, or is it the start of a new leg down?

Second, is China.  In the space of a couple of months, China has gone from the invincible and irrepressible to the gang that couldn't shoot straight.   The veneer has been ripped over, and the emperor does not appear to be wearing clothes.

The equity market collapse and the clumsy efforts in terms of intervention and crackdown on individuals, including reporters, have shaken China's reputation.  The policy response to the Tianjin tragedy was disheartening at best and revealed the authoritarian fist that is often hidden by the commercial glove.  

Its declarations to the contrary, Chinese officials have still not truly allowed market forces to drive the yuan though it has managed to close the gap between the spot market and the central reference rate.   There is little transparency of the intent of Chinese policy makers or confidence that they have the technical ability to manage what PBOC Governor Zhou referred to as a "burst" to the G20 meeting.

Third is the Federal Reserve.  Despite efforts to increase transparency, and the clear communication style of Yellen, the uncertainty over Fed policy was cited in reports from the G20 meeting as contributing to the market volatility.  The market, judging from the September Fed funds futures contract, has all but given up on rate hike this month.  The contract has closed at an implied yield of 17 bp for the past three weeks.  The effective rate, a weighted average, which is what the contract settles at, has gravitated around 14 bp in recent weeks.

However, if the Fed were to raise rates on September 17, it would hardly be a surprise.  Slightly more than 80% of economists surveyed by the Wall Street Journal in July and August anticipated a September lift-off.   At 5.1%, the unemployment rate is lowest it has been for decades, with a few exceptions, and within a range that the Fed believes is consistent with full employment.  Broader measures of the labor market confirm that conditions have steadily improved.  

Yet, the Fed seems hesitant.    The IMF has cautioned against a hike this year.  The price stability mandate, operationalized to by 2% a year increase in the core PCE deflator, remains elusive.    The driver of core inflation is thought to be wages, and wage growth has been lackluster compared with past business cycles.    

On top of this, some Fed officials, notably NY Fed President Dudley, that the international and financial market developments, made a September move "less compelling".   Dudley also seemed to suggest that the August employment report would not capture the impact of more recent developments, the Vice Chairman of the Federal Reserve suggested the report would provide a key data point.  

The Fed may be of two minds because it wants to say two seemingly conflicting things.  On one hand, Yellen instructs investors not to make such a big deal about the initial lift-off.  The point is that the path to normalization will be gradual and that terminus rate is anticipated to be well below the peak of the past cycle.  On the other hand, seemingly linking the decision to short-run high-frequency data or particular market conditions seems to recognize its significance.  

Imagine the Fed puts off the September rate hike, and reluctant to potentially disrupt the markets by calling for an impromptu press conference in October, it waits until December for lift-off.  Then, as books are being closed on the year, and in anticipation of a Fed hike, the markets turn a bit more volatile.  The Fed has painted itself into a corner.   It gives credence to some critics who claim the Fed is a slave to the markets.  The Fed's credibility is at stake.  

The Fed's decision on September 17, the eight-year anniversary of the collapse of Lehman, is unlikely to be influenced by next week's data, which includes the JOLTS report, and the Fed's new Labor Market Index, consumer credit and producer prices.   The quiet period around the FOMC meeting means that there will not be any official guidance after the dove Kocherlakota speaks on September 8.  

Chinese and European data will be more important.  ECB President Draghi signaled a flexible approach to its asset purchases program that will likely make investors more sensitive to economic data.  Whether the asset purchases program is expanded or extended is, well, data dependent.  We suspect an expansion of the program is the more likely policy response.  If the expansion is effective, there is no need to extend.  Operationally, European officials seem loath to extend deadlines before they are approached, or surpassed.  

The July industrial output figures, the new news for the region, are expected to confirm what investors already know.  The German recovery remains very much intact.  Industrial output in July likely recouped nearly June’s entire 1.1% decline. The French recovery is not showing much momentum.  Industrial output fell in the three of the four months through June and may have risen slightly in July, according the consensus forecast.  Italy, the other large European country with a center-left government, is doing better and is expected to have started Q3 with a healthy 0.8% increase industrial production.  Spain continues to operate a high level, nearly its cyclical peak.  

There is scope for disappointment on the German trade figures, especially exports.  The consensus expects a 1% increase in exports after a 1% decline in June.    Germany has not reported two consecutive monthly declines in exports since April-May 2013.  However, weaker demand, which has been picked up in other exporters underscores the risk for German, the world's second-largest exporter.  

Chinese data may also be important though the performance of the stock market does not seem particularly dependent on it.   Although many question the veracity of China's GDP estimate, the reserve declaration is taken at face value.  The August reserve figures out early in the week are expected to have fallen a sharp $71 bln according to the Bloomberg consensus.  China is said to have sold billions of dollars of Treasuries to support the yuan from falling after the August 11 mini-devaluation.  That would be more than the decline in reserves in July ($42.5 bln) and June ($17.3 bln) combined.   

Capital flight is not limited to the loss of reserves, but the external surplus (current account) means that reserves would be been under upward, not downward pressure.  In any event, there are two sources of those funds leaving: domestic and foreign investors.  In addition to the opaqueness, the other thing that makes China more difficult to understand is Hong Kong. 

Of the markets that seem to show an impact of the capital flight from China is the Hong Kong dollar. The demand for HKD was sufficient to push the US dollar to its floor at HKD7.75, forcing the Hong Kong Monetary Authority to intervene for the first time in four months.    In effect, the PBOC was selling dollars to the HKMA.  

China's exports to Hong Kong are not true exports in the same way that New Jersey exports to New York are not really exports (from a national accounting point of view).  Only a fraction of the capital flows from China to Hong Kong are truly international.  Moreover, instead of mainland yuan (CNY) being converted to Hong Kong dollars (and then into US dollars by the HKMA), the offshore yuan (CNH) also appears to converted to HKD.  The flow from CNH to HKD (and into USD) would not show up in China's external accounts.  

China will also report inflation figures next week.  They are important but for different reasons. China's CPI is expected to rise to 1.9% from 1.6%.  This means that China's consumers are not experiencing deflation and that there is plenty of scope for the PBOC to reduce interest rates if needed  (one-year lending rate is currently 4.6%) and required reserves of 18.5%.    Deflation is expected to intensify for producer goods.  They are expected to have contracted by 5.6% on a year-over-year basis.  This is the most since 2009.  The year-over-year pace has not been above zero since January 2012.  

There are three considerations that point to a weak start to equity trading in Asia on Monday. The US market posted steep declines on Friday, ahead of the long holiday weekend.  ETFs that track Chinese markets were off around 3% since the close of Chinese markets for its holiday. The Hong Kong Enterprise Index, which is composed of Chinese companies that trade in Hong Kong, fell by nearly 1.5% when the Hang Seng re-opened on Friday (September 4). 

Before the weekend, the Nikkei fell through the lows set on August 25-26 that had seemed to many to be a capitulation.  European markets also sold off in the second half of last week, and a poor showing in Asia could see local markets gap lower.  Since it was more psychology than news, we think, that triggered the accelerated losses, we look for some signs that sell-off has played itself out from a technical perspective, such as a reversal pattern.  Risk discipline requires respecting the price action.  

Given preference of using the euro has a funding currency, or hedging euro currency exposure, sharp losses in European equities could spur another round of position adjusting.  In addition, as we have noted above, at heightened volatility the equity market could make some Fed officials more reluctant to want to hike rates in such an environment.  That is another channel that could be dollar negative.  

II

There are three central major central banks that meet in the week ahead:  New Zealand, Canada, and the UK.  Only the Reserve Bank of New Zealand is expected to cut rates.  A 25 bp cut in the cash rate would bring it to 2.75%.  It would be the third consecutive cut.   We suspect there is scope for one more cut in the cycle 

With a rise in non-energy exports and healthy jobs report, the Bank of Canada may suspect it has past the worst, and that two rate cuts this year, the last being in mid-July, complete the mini-easing cycle. The Canadian dollar has fallen about 27.5% against the US dollar since the end of H1 2011, and decline does not appear to be over.  The divergence in monetary policy this year has been driven by the Canadian side of the equation.  Over the next year, it will likely be driven by the US side.  

The Bank of England meets, and under its new practices will publish the minutes from the previous day's meeting at the same time as announcing the results.  Ideas that were being bandied about that the BOE could raise rates this year ahead of the last BOE meeting are far from the center of the discourse now.   The easing of overall earnings growth and that fact that all three PMIs last week were weaker than expected may discourage any new hawkish dissents.  The service sector PMI, which covers the largest part of the British economy, was particularly disconcerting.  It fell to 55.6 from 57.4, which is the lowest level since May 2013.  

The recent decline in sterling is likely welcomed by policymakers though it cannot be spoken. On a trade-weighted basis, sterling has unwound the summer tightening gains and returned to early July levels.   

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