Another Strong Jobs Report may Not be Sufficient to Reignite Dollar Rally

The die is cast.  The Federal Reserve is on an extended pause after the rate hike last December. The market remains convinced that the risk of a June hike are negligible (~ less than 12% chance).   The ECB has yet to implement the TLTRO and corporate bond purchase initiatives that were announced in March.  The impact of its programs have to be monitored before being evaluated.   It is unreasonable to expect any new initiative in the coming months.  

The Bank of Japan did not take advantage of the opportunity to ease policy as it cut both growth an inflation forecasts.   The focus ahead of the G7 meeting in late-May, being hosted by Japan, will likely be on fiscal policy, where the Abe government is reportedly trying to cobble together a front-loaded spending bill for earthquake relief and economic support.  There have been some calls for a JPY20 trillion (~$185 bln) package, in part funded by a new bond issuance that would be included in the BOJ asset purchase program.  (Note that Japanese markets are close for a couple days in the week ahead for Golden Week celebrations).

The US jobs data is typically the data highlight of the first week of a new month.  It has lost its mojo.  This is more because of the Federal Reserve's reaction function than the ADP estimate that comes out a couple of days earlier.  The Fed accepts that the labor market continues to strengthen.  The nearest real-time reading of the labor market, the weekly jobless claims, has recently falling to its lowest level since 1973, and continuing claims are at 16-year lows.  It is clearly not sufficient for the FOMC to lift rates.  

The March core PCE deflator stands at 1.6%, which is a little higher than prevailed when the Fed met last December.  Similarly, the 10-year breakeven (10-year conventional yield minus the 10-year inflation-linked note) is also around 30 bp from where it was when the FOMC hiked.  

Another 200k increase in nonfarm payrolls is not a game-changer.  Even modest earnings growth is unlikely to do much to help the dollar.  The FOMC has already taken this on board.  The issue is not jobs or income; it is consumption and investment.  We suspect the dollar-risk is asymmetrical.  It is more likely to be sold on disappointment than rally on a stronger report.  

Another highlight at the start of a new month are the European PMIs, and so too next week.  The eurozone flash PMIs (Germany and France) were little changed, and that is likely to be seen in the final reading which includes more German and French data as well as other countries, notably Italy and Spain.  

Given the seeming urgency of the ECB and the doom-and-gloom commentary that continues to write eulogies for EMU, one would hardly know that growth in the eurozone in Q1 reached 0.6%.  This outpaced the UK, which slowed to a 0.4% pace.  Rather than report the quarter-over-quarter pace, America reports an annualized figure.  The world's largest economy grew at an annualized pace of 0.5%. Incidentally, the Atlanta Fed's GDP tracker projected 0.6% and the NY Fed's version, 0.7%.   The point is that eurozone growth looks fairly stable near levels that economists estimate is near trend growth (despite unemployment being above 10% in the region).  

The UK will be very much in the limelight next week.  Economics and politics will command attention.  The UK reports three PMIs; manufacturing, construction, and services.   The gradual slowdown is set to continue.  The composite PMI, which provides an overall reading, is expected to slip to 53.2 from 53.6.  It averaged 54.2 in Q1 and 55.5 over the past year.    

Many observers are attributing the slowdown to next month's referendum.  We are not convinced as the moderation began in the middle of last year.   Moreover, at 2.1% the Q1 year-over-year pace matches the five-year average.  An exogenous factor (referendum anxiety? in this case) is not needed to explain the quarter-to-quarter vagaries in a GDP estimate, which like all GDP estimates may give a greater sense of precision than justified by the methodology.  

The referendum has dominated political discussions.  It was exposing fissures in the coalition that makes up the Tory Party.  It seems to be an open question whether the relationship can heal after the referendum.  A vote to leave the EU over the government's wishes is a vote of no-confidence.  A political crisis would ensue, and either national elections are called, or the Brexit-wing of the Tory Party replaces Cameron as party leader.  Under such a scenario, many suggest the current London Mayor Boris Johnson would be a top contender.  

However, in the week ahead it is the Labour Party's difficulties that come to the fore.  Labour Party leader Corbyn is from the left-wing of the party while many of the large donors are considerably more moderate.  This fissure has seen donations to the Labour Party as such dry up, with a few moderate candidates who can challenge Corbyn have been favored.   

Corbyn's critics have found a new front of attack in recent days.   The former mayor of London, Ken Livingstone made some injudicious and controversial remarks that brought fresh attention to undercurrent of anti-Semitism hidden by anti-Zionist rhetoric that is thought to percolate in parts the Labour Party.  

The timing is awkward, to say the least.  One of the key races is for the Johnson's replacement for London Mayor.  Sadiq Khan is running for Labour, while Zac Goldsmith, from a prominent Jewish family, is the Conservative candidate.  The polls indicate Khan is a 20 percentage point favorite.  

Typically, the opposition party picks up several hundred local council seats.  If Labour does worse than average, Corbyn's critics will blame him, and an effort to replace him may intensify.   The most recent polls show a drift toward Brexit unwinding part the previous tilt toward Remain in mid-April. Given the margin of error, many of polls are a virtual dead heat.  The outcome may be determined by how the undecided voters break, for which it may be too early to see a clear pattern

Sterling's gains have lifted it to four-month highs against the dollar but may reflect the broadly weaker US dollar tone more than UK positive developments.  Many observers focus on the benchmark three-month tenor in the options market.  Seeing lower implied volatility and a smaller premium for puts over calls, conclude the market angst about Brexit have eased.  However, the referendum is within two months, and two-month options are telling a different story.  Implied volatility is at six-year highs, and the skew in the options market has never been larger.  

The Reserve Bank of Australia will make its policy announcement early on May 3 in Sydney.  A weaker than expected Q1 CPI report (1.3% vs. 1.7% in Q4 15) spurred speculation of a rate cut.   We are less convinced but see risk of a rate cut later this year.  In recent months, the RBA has recognized that subdued price pressures give it scope to ease policy should it be necessary to provide greater monetary accommodation.  

The Q1 CPI creates more scope but not necessarily a greater need.   The RBA may not have a sense of urgency.  Like other central banks who have met recently, watch-and-wait stance may be infectious.  Several hours before the RBA's decision, March retail sales will be reported, and the median estimate is for a 0.3% rise after a flat reading in February.  The 0.3% increase would match the six, 12, and 24-month averages.  

Canada also will report its April employment data at the end of the week ahead.  The risk is that the March surge is corrected.  Recall that in March; StatsCan estimated that 35.3k full-time job created and 40.6k jobs overall.   The median guesstimate on Bloomberg is for a 5k increase in jobs in April. The interest rate on June BA futures (three-month banker acceptances) have continued to trend higher, reaching 1% at the end of last week.  It reflects a 50 bp backing up in yields, as US rates have drifted lower.  

Before the weekend, the US Treasury released its assessment of the international economy and the foreign exchange market as is required by Congress (since 1988).  A change was necessitated by recent legislation in the direction of forcing the executive branch (Treasury) to be more forceful. Under the previous framework, no country was cited for manipulation in the currency market since China in 1994.  

Treasury evaluated countries by three criteria:  The size of its bilateral trade surplus with the US, the country's current account surplus and repeated efforts depreciate its currency.  There are three numbers here to note:  20, 3 and 2.   

Bilateral trade imbalances of $20 bln of more will draw attention, which may mean smaller countries are vulnerable to this criteria.  Also, it is not clear if the US Treasury will take into account the new OECD database that looks at trade flows in terms of value-added.  Another problem with a bilateral trade balance criteria is the importance of interfirm trade.  US multinationals are not only large exporters, for example, they are also larger importers and often from their affiliates. 

A current account surplus more than three percent will also draw US attention.  In contrast, the EC rules on imbalances, which it does not appear to be enforcing, is for a 6% imbalance. 

The US Treasury is wary of countries intervening in the foreign exchange market, even if countries invest the proceeds of intervention in US bonds.  If a country is engaged in intervention that leads to a rise of foreign assets of two percent of GDP, it meets the third criteria.  

If the three criteria are met, it would force the President to initiate discussions.  Possible actions could include cutting US development assistance and exclude companies from the violating country from government contracts.  

In the report, the US Treasury indicated that no country met all three criteria, but said that three countries, China, Japan, and Germany would be monitored closely.  It cited their trade and current account positions (along with South Korea).  Taiwan was cited for its large current account surplus and its persistent intervention.  

South Korea also intervenes more than US thinks is justified.  The US Treasury encouraged South Korea to limit its intervention to only disorderly markets.  It judged the yen market to be orderly, which means it would lobby against MOF intervention.  The report sought more clarity over China's goals and looked for additional real yuan appreciation over the medium term.  It argued that Germany had scope for to implement measures to boost demand.  

In many ways outside of a new framework, there is little in the report that seems surprising. Therefore, we would not expect much of a market reaction.  

These five countries have been discussed in recent US Treasury reports.  The advantage of the criteria is that it offers a quantitative framework, which may be helpful, especially to avoid by stringent legislation, even if they are subjective.   On the other hand, there still a network of obligations and responsibilities under treaties, such as the WTO, that take precedent over national action.  The IMF may be in a better position to issue an authoritative report that would not be rebuffed on grounds that it is simply an expression of national interest.  China may try to dilute the significance of the US Treasury report by issuing its own. 

Over the weekend, China reported its official manufacturing and non-manufacturing PMIs.  Many had expected a small improvement but instead the manufacturing PMI  was essentially unchanged.  It slipped 0.1 to 50.1.   The details seems somewhat worse than the headline.  Although production slipped to 52.2 from 52.3, employment continued to contract (47.4 vs. 48.2), new orders and new export orders slipped, the order backlog continued to dry up, falling to 44.8.  

The non-manufacturing sector, which includes services, is faring better as Chinese officials try to facilitate a structural shift in the economy away from manufacturing.   The non-manufacturing PMI stood at 53.5 in April, down from 53.8 in March.  The contraction in new orders (48.7 from 50.8) is worrisome.  The increase in construction (59.4 vs 58.0) is consistent with a recovery in property and real estate that has recently been reported.  

Chinese markets for a few days next week for an extended May Day celebration (whose origins are to be found in an anarchist confrontation with police in Chicago).  Nevertheless, the government is set to introduce a VAT for services (instead of the current tax on income). It will generate around CNY500 bln in savings, worth an estimated 0.7% of GDP.  Although many investors may not be aware of it, it does not provide net new stimulus as the government had already included it in the 3% (of GDP) this year's budget deficit target. 

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