Thoughts on the Week Ahead

The most important driver in capital markets is the assessment of when the monetary authorities of the largest economy in the world will reduce its stimulus. A consensus in the market for a September tapering and a complete stop by mid-2014 before a rate hike in late 2014 or early 2015 had emerged. Bernanke's comments shook that consensus and in response US rates fell, dragging down the dollar, and helping to lift risk assets.

Bernanke delivers his semi-annual testimony before Congress this week--before the House of Representative on Wednesday and the Senate the following day. Barring fresh impulses, we suspect that ahead of the testimony, market participants will be content consolidate the recent price action. 

Investors are well aware that tapering is not tightening and even if the Fed were to reduce its asset purchases by $20 bln a month in Q4, it would still be buying $450 bln of Treasuries and MBS between in H2. They are also aware that the protracted exit from the extraordinary policies is like an escalation ladder. Talking about tapering is the initial rung. 

It is one type of investment climate when there is a reasonable expectation for lower interest rates. It is another investment climate when there is a general expectation that interest rates have bottomed and will generally increase going forward. It is this latter climate that the Fed has created.

There are reasons to be skeptical of the September/October time frame. We note that the unexpected 0.5% decline in wholesale inventories in May, reported last with, with the April series revised to -0.1% from +0.2% means that economists will be revising down Q2 GDP estimates closer to 1.0%. While the rise in gasoline prices may have boosted consumer prices, which will be reported Tuesday (and underpin Monday's report of retail sales), the core measure of inflation will remain subdued.

In fact thinking about the data set the Fed will have when it meets in September, Q2 GDP will be the third consecutive quarterly growth rate below 2% (annualized pace) and the core PCE deflator is likely to be closer to 1% than the 2% target. 

The Fed is seemingly putting more weight on the labor market, which is continuing to improve slowly. Bernanke himself warned that the drop in the unemployment rate is likely exaggerating the improvement. The Beige Book, (out on Wednesday) is not often a market mover, but investors will likely be sensitive to signs that the rise in interest rates and somewhat tighter financial conditions is having an impact on economic activity.   Given that and the Fed's desire to drive home the message that even after completing QE3, that interest rates will stay low, we continue to see a reasonably good chance that the Fed lowers its unemployment threshold to 6.0% from 6.5%. 

The most important impulses from Europe are unlikely to be generated by the economy over the next week or so, but from politics.  Greece's government must get parliament approval for its latest concessions agreement with the Troika.  In Portugal, the coalition government, which had seemed to work out their immediate differences, has been forced into negotiations with the opposition Socialists, who are demanding that its aid package be renegotiated.  

In Spain, the corruption accusations continue to sweep through the government at the highest levels.  In Italy, the Supreme Court has agreed to hear Berlusconi's second and final appeal before the statute of limitations runs out at the end of the month.  There is some fear that in retaliation for what he says is "judicial persecution" Berlusconi could pull the PDL's support for the Letta government.  

We do not see lasting influence from Fitch's decision before the weekend to take away France's triple-A credit rating.  The other two major rating agencies, S&P and Moody's, had previously done so, making Fitch's move, catch-up, rather than initiating a fresh round.  In addition, as we have noted before, the rating agencies do not have access to private information when it comes to sovereign ratings, especially among the major economies.  Lastly, we attribute no significance ownership structure of the rating agencies and see no relevance of the fact that Fitch is partly owned by a French concern.   

There will be much news from the UK in the week ahead.  Inflation (CPI and PPI) will be reported on Tuesday, employment Wednesday, and retail sales Thursday.  The data dump comes in the context of survey data (PMIs) pointing to a stronger UK recovery, while real data, like May industrial output and manufacturing production was very disappointing.  

The midweek release of the BOE minutes from Carney's first meeting earlier this month may be more significant than the economic data itself.  The market will likely scrutinize the minutes for insight into the kind of forward guidance that is being contemplated and whether it would include a resumption of gilt purchases.  

By comparison, the Japanese calendar is light on data and the markets are closed on Monday for a national holiday.  The main economic report is a rough proxy for the strength of the economy, the All-Industries Index.  The 1.2% rise the consensus expects in May would be the strongest reading since December 2011 and would solidify Japan's claim as the fastest growing G7 country.  

The minutes from the June BOJ meeting are likely to be less interesting than the BOE minutes.   Subsequent to that meeting, it has become clearer that the BOJ is less likely to take on additional measures to ensure that its 2% inflation target is reached.   We also know now and the BOJ did not then was that the JGB market has stabilized albeit at higher interest rates than when the new policy was announced in early April. 

Meanwhile, opinion polls suggest the LDP-led coalition will sweep the Upper House elections in a week's time.   This will bolster the LDP's ability to make lasting changes.  There has been some thought that Abe was waiting until after these elections to pursue his political agenda of constitutional reform with eye toward strengthening its military capabilities.  However, in recent weeks, those favoring continued focus on economic issues appear to be gaining in importance.   

The Bank of Canada is the only G10 central bank that meets in the week ahead.  We do not expect at at its Wednesday meeting will result in a change in policy.  Policy is expected to be on hold for the foreseeable future.  Canada does report CPI at the end of the week.  The headline remains tame and the core will remain, like the US (core PCE) closer to 1% than 2%.   

We note that US rates are rising faster than Canada's.  The premium the US pays over Canada on 10-year yields is the largest since Q1 2011.  This may remove another one of the supports that the Canadian dollar has enjoyed.  

China will report a slew of data before its markets open on Monday.  These include:  Q2 GDP, industrial production, fixed investment and retail sales.   The market casts a sufficient skeptical eye toward the accuracy of Chinese data to ensure that they are often not market movers.  The fact of the matter, which is not lost on investors, is that the Chinese economy is expanding at a moderate pace and that the new government is content to push for reforms rather than fresh stimulus.  It appears that the past stimulative efforts aggravated the underlying problem of excess capacity in the economy. 

The yuan appreciated from late February through late May.  The 2% appreciation made it the strongest currencies over that period.  However, it has now entered a new consolidative phase, which we suspect will be protracted.   That said, their does not seem to be very much sympathy in official circles for the claim by some economists that the yuan is now significantly over-valued.