On the Way to the FOMC Meeting

The main focus, today, is on the FOMC meeting; the statement, forecasts, and Yellen’s press conference. Since the April meeting, nearly every inflation measure, core PCE, CPI, PPI and the price components of the ISMs have ticked up. The slightly stronger than expected CPI report for May that was released yesterday suggests the next (May) core PCE reading likely rose, lifting the year-over-year rate to 1.6%.

We look for the Fed’s statement and forecasts to recognize that its mandates are being approached. However, attempts to model Fed action based on past business cycles may be fundamentally flawed. Some approaches have produced paradoxical results: that Yellen’s past behavior suggests she should have already supported a rate hike. Such historicist approaches lead to “false positives."

Indeed, in both word and deed, the Federal Reserve will indicate that additional accommodation is still necessary, even as its policy goals are approached. That it recognizes that its policy goals are being approached will be reflected in its forecasts, where unemployment is likely to be revised lower and inflation higher. We do not expect a change in the Fed’s forward guidance.

This will offer a stark contrast to the Bank of England. BOE Governor Carney had leaned against calls for an early rate hike in the forward guidance provided until last week and then says the market underestimates of an earlier start in the rate hike cycle. We expect the FOMC to stick to the course, broadly outlined by Bernanke, under which the Fed continues its “measured” tapering ($10 bln) a meeting and winding down QE3+ (no one is calling it QE-infinity anymore), with the first rate hike likely in H2 15.

In the US, headline inflation has historically converged to core inflation. Core inflation itself tends to regress to wage growth. Wage growth in the US remains dismal. It is difficult to envisage sustained elevated prices without rising labor costs.

Carney's hawkish tone last week was reflected in the BOE minutes. Officials commented on the low probability that the market was assessing of a rate hike this year. However, contrary to some speculation, the vote was unanimous not to raise rates. While the hawks, like Weale and McCafferty, may dissent later this summer, in favor of higher rates, we suspect that price pressures are likely to continue to moderate and allow the majority to hold off hiking rates until next year.

Although the UK economy is only now surpassing its pre-crisis peak, in someways it is doing better than the US. When the final revisions are made, the US economy may have contracted by something close to 2% (annualized) in Q1 and the housing market continues to be disappointing. In the UK, the economy continues to expand at a robust pace and house price increases have accelerated.

Sterling, which briefly pushed through the $1.70 level at the start of the week and saw another half-hearted attempt today. It was hit by a bout of profit-taking on the BOE minutes, for which Carney stole most of the thunder last week. Sterling was actually sold in response to the minutes and slipped through yesterday's lows, to post an outside day. A close below yesterday's lows (~$1.6938) would be a poor technical development. However, sentiment is constructive, and we suspect buying on dips will continue.

The other development to be aware of ahead of the FOMC meeting is Japan's May trade balance. The deficit was somewhat smaller than expected at JPY909 bln (unadjusted). The consensus forecast was for a widening of the deficit to JPY1.189 trillion from JPY811 bln in April. Japan has been recording monthly trade deficits for nearly two years (23 months) as imported energy offset exports.

What is new in this report is that exports fell for the first time in fifteen months. The 2.7% decline (year-over-year) was twice the contraction the market expected. Simply put, foreign demand is not offset the weakness in domestic demand spurred by the April sales tax increase.

Exports to Asia, which account for a little more than half of Japan's exports fell 3.4% year-over-year. This is despite a small (0.4%) increase in exports to China. Japanese exports to Hong Kong, South Korea, Taiwan and Singapore all fell, warning of the risk that the regional economy has slowed and the rise in oil prices cannot help matters. Japan's exports to the US, its second largest trading partner, also fell. The 2.8% decline follows a 1.9% increase in April.

The deficit would have been greater if not for another surprise. Imports unexpectedly fell. The 3.6% year-over-year decline contrasts with consensus forecasts for a 1.8% increase. Crude oil imports collapsed by 15.1%. The decline in crude imports seems to be a function of seasonal maintenance and some extra stockpiling ahead of the sales and energy tax increase in April. We suspect that Japan's demand for energy has not collapsed as these figures would suggest.

The dollar is trading at five-day highs against the yen, ostensibly helped by recent increase in US bond yields. The JPY102.30 area provides the immediate cap, but a further backing up of US yields, as the downtrend line in the 10-year Treasury yield from the start of the year is violated, the next target for the dollar is in the JPY102.80 area.

For its part, the euro is trading quietly within yesterday's ranges and remains on the $1.35 handle as it has done for the previous five sessions. Through the Asian session and the European morning, it has been confined to about 15 ticks on both sides of $1.3550.