Curiouser and Curiouser

In response to the disappointing preliminary Q2, the market took bond yields lower and the dollar with it. The market downgraded the likelihood of a Fed hike on August 8. Indicative pricing in the Fed funds futures market implies the odds of a hike have fallen to about a 33% chance, the lowest since mid-June and well off the 85% chance seen at the start of the month and even as recently as July 19th. The risk is that the market is exaggerating the significance of Q2 GDP on the formulation of the monetary policy in the middle of Q3. Moreover, the data will not tell Fed policy makers anything it did not already know. Economic growth moderated and price pressures remain elevated and above the Fed’s comfort–zone.

The US will release a number of economic reports next week that will likely generate more insight for policy makers and investors into the state of the economy and price pressures. This includes the ISM surveys, auto sales and the July non-farm payroll data. Given other survey data, the market expects slippage in the ISM reports, but the readings are expected to be consistent with close to trend growth for the US. Auto sales are expected to be a healthy near a 16.7 mln annual rate pace, up from 16.3 mln pace in June. The early consensus calls for a slight improvement in job growth in July to around 145k from 121k in June. Average hour earnings are expected to rise 0.3% after June’s 0.5% rise. The year-over-year rate will remain elevated just below 4%.

Policy makers show more in unit labor costs than average hourly earnings and as luck would have it, the Q2 unit labor costs will reported the morning of the Fed’s meeting. All other things being equal, the weaker than expected Q2 growth likely translates into a larger rise in unit labor costs. Prior the GDP report, the Bloomberg consensus called for a 3.5% increase up from 1.6% in Q1. The risks then are on the upside.

If the outcome of the Aug FOMC meeting is a close call, then this analysis warns that once again the market’s rush to judgment risks reversing if the economic data comes out as expected or stronger. That the US economy is moderating is beyond debate, even if the preliminary reading of Q2 GDP exaggerates the slowdown. The real question is whether the economy is slowing sufficiently to bring inflation and inflation expectations back to more acceptable levels.

The upcoming string of data is likely to suggest that this is not the case—that price pressures are still rising. One of the Fed’s favorite inflation measures is the deflator for core personal consumption expenditures. It has risen by 0.2% in April and May and is expected to have done some in June (data to be released on Tuesday August 1). The year-over-year rate stood at 2.1% in May and is likely to firm in June further beyond the Fed’s self-proclaimed comfort-zone of 2%.

The future trajectory of the core consumer price index is similar. Price pressures have not peaked. Even though the four-month string of 0.3% monthly increases might not be repeated. As the low monthly prints from H2 2005 drop out of the year-over-year comparisons, the risk is the core rate rises above 3%. Whether one deflates the Fed funds rate by the core CPI measures or the core PCE deflator, the real Fed funds rate remains historically low for a cyclical peak.

Next week US Treasury Secretary Paulson delivers his first public speech. It comes amid heightened speculation that China may either revalue the yuan or widen its 0.3% band against the dollar. Earlier this week Paulson met with US Senators Schumer and Graham who afterwards reiterated their disappointment with the pace of currency reforms (read appreciation) in China and their plans to push for a vote on their punitive measure in late September. Given all the deals Goldman Sachs participated in within China and Paulson’s frequent visits with high placed Chinese policy makers, many have high hopes that the new Treasury Secretary can persuade the Chinese to move faster. Fat chance. Chinese contacts report more disappointment that Robert Zolleick was passed over for the post and left the Bush Administration than they were excited about Hank Paulson’s selection.

Some observers, both within and outside China have argued that since current fluctuations of the yuan are well within the narrow band, widening of the band serves no purpose and is unnecessary. However, a wider band still seems like the most likely “next step” on the currency front. First, it is a political ploy as old as dirt to appear to give up something one doesn’t really have or something that has not cost. Widening of the dollar-yuan band would allow China to deflect some international pressure and steal some of its critics thunder by widening the official band and not necessarily use it in practice. Moreover, for China, the nuances of the currency regime might be something they are willing to barter for.

Although US officials often say that it is in China’s interest to do this or that, they all too often confuse an assertion with an argument. If a stronger currency is so much in China’s interest, why haven’t they done it ? Arguably, if it is in the US interest for the dollar to fall against the yuan (though it is not as obvious as many pretend that a stronger yuan will reduce the US trade deficit), then the US should try the carrot rather than the stick.

Next week the Reserve Bank of Australia meets as does the Bank of England and the ECB. The Reserve Bank of Australia is widely expected to lift its overnight rate to 7.0% and the accompanying statement is expected to keep the door ajar for another rate hike. If the RBA fails to raise rates or issues as statement not sufficiently hawkish, the Australian dollar, which has been among the strongest of the major currencies over the past month (+5% against the US dollar), the disappointment could trigger a dramatic bout of profit-taking.

A Reuters poll found 85% of the economists surveyed do not expect the Bank of England to change policy next week. However the survey and the short-sterling futures market indicate a rate hike is widely anticipated before end of the year. A rate hike next week would surprise the market, but given the impressive run sterling has enjoyed, not just against the dollar, but on the crosses as well, it might not produce the drama that a surprise from the RBA would.

The ECB is widely expected to lift its key rate by 25 bp to 3.0%. In the press conference that follows, ECB President Trichet is likely to reiterate the bank’s vigilant stance, even if he does not use that word per se. The market expects at least one more rate hike before year-end and Trichet is unlikely to throw cold water on such ideas. Barring a significant surprise the risk is that the market quickly looks past the ECB rate hike and to focus on the US jobs data the following day and the Fed meeting the following week.

The euro is flirting with a trendline that connects the early June and July highs. It comes in now near $1.2800 and the high for the month of July was $1.2861. This general area is may prove to be a formidable obstacle for the euro bulls ahead of next week jobs data and if the analysis presented here is close to the money, the upper end of the euro’s trading range is likely to remain intact until the FOMC meeting. The dollar has approached a key objective against the yen near JPY114.50. A break of this area could signal another leg down toward JPY113.50. Both portfolio managers and speculators have been selling yen in recent weeks and as these short yen positions are covered, against the dollar and the crosses, the yen may a few days in the sun next week.