BOE's Quarterly Inflation Report Pushes Sterling Down

Today will likely prove to be the most eventful of the week.   It has already featured Q2 Japanese GDP, a slew of Chinese data, euro zone industrial output and UK employment and the BOE's quarterly inflation report.  Still to come are US retail sales and Fed talk.  

The most important development has been the BOE's quarterly inflation report.  It has been understood as dovish; driving down short-term interest rates, with implied yield of the March short-sterling futures contract falling 8 bp to 91 bp, the lowest in more than two months.  Sterling has extended its pullback that began on July 15.  It is posting a big outside down day, having initially built on yesterday's gains only to be sold off hard.  It has approached the $1.67 level, the lowest also since early June.  The next objective is near $1.6630.  

There were three dovish elements of the report.  First was the cut in 2014 wage growth projects to 1.25% from 2.5%.  Second was the projection it will take three years to eliminate the economic slack.  Previously it has suggested 2-3 years.  Third was shaving of Q3 GDP forecast to 0.7% from 0.9%, recognizing as the market has that the data points to some moderation in activity after a strong H1.  

This more than offset the as expected 31k decline in the claimant count and the dip in unemployment to 6.4% from 6.5% in  July.  On the other hand, June earnings (reported with an extra month lag) fell 0.2% on 3-month year-over-year.  This is the weakest since H1 09.  Despite the falling in the claimant count and the unemployment rate, wage growth is non-existent.  This is an issue that cuts across the high income economies and is baffling investors and policy makers alike.  

It is particularly important for the UK and US as they are perceived to most likely to raise interest rates first. The lack of wage growth says something about the slack in the labor market, but it also poses a challenge for sustaining aggregate demand.

As widely expected, the retail sales tax increase led to a sharp contraction of the Japanese economy.  The 1.7% quarter-over-quarter decline was the largest since the 2011 tragedy.   Although the Bloomberg consensus called for a 1.8% decline, we would not make much of the "better than expected" report.  Nor would we read much into the fact that the GDP deflator rose 2% rather than the 1.6% the consensus had forecast.  That inflation measure is distorted by the sales tax increase.  

Private consumption contracted by 5.2%, which is more than surveys had anticipated.  On the other hand, capex and net exports fared a bit better than expected.  The government and BOJ are likely to put an optimistic spin the on the data.  We have argued that officials were willing to write off Q2 and that the key for policy going forward is the economic performance in Q3.  This still seems like the right idea.  

For the third day this week, the dollar is recording a higher high and a higher low against the yen.  At the end of last week, the dollar was testing JPY101.50.  Today it will likely push through JPY102.50.  The top of the four-month trading range is JPY103.  

The euro zone economy continues to struggle.  Today it reported June industrial output figures.  The consensus was for a 0.3-0.4% expansion.  It contracted by 0.3% after the 1.1% decline in May. Separately, the final inflation reports from Germany and Spain were in line with the preliminary report, while the French CPI saw the year-over-year rate remain unchanged at 0.6%.   Q2 GDP will be reported tomorrow and the risk is on the downside of the 0.1% consensus forecast.  

The euro has established a base near $1.3330-40 over the past week or so, but upticks have been difficult to secure and sustain.  The speculative community has built a large short euro position, but this has not proven to be a very useful contrarian indicator.  Rather squeeze higher in a correction, the sideways movement appears to be alleviating the over-sold technical condition.  It may require a move above $1.3400-30 to signal anything important.  

China's data--retail sales, industrial output and fixed asset investment--were all a touch softer than expected in July.  However, the report that has drawn the most attention is the near collapse in the lending figures.   New yuan loans (traditional banking sector) rose by CNY385 bln.  This is less than half the increase the market expected and follows the CNY1.08 trillion in June.  Aggregate social financing (includes other sectors; e.g. shadow banking) rose CNY273 bln.  The Bloomberg consensus was for a CNY1.5 trillion increase after CNY1.97 trillion in June.  

There does seem to be something important happening in China, but we are reluctant to see this a collapse of the shadow banking system as some observers are suggesting.  There was a decline in banker acceptance bills, fx loans and trust loans. Chinese officials themselves played down the significance, suggesting seasonal factors, base effects, the reduction of wealth management products, and credit being diverted to the IPOs. We would not expect an immediate policy response, as this is seen as largely desirable by officials.  

The North American session features the US July retail sales report.  The headline may be constrained by softer auto sales, but the measure used for GDP calculations (excludes autos, gasoline and building materials) is expected to be up 0.4%, which is also the three-month average.   The Fed's Dudley and Rosengren address wholesale financing at a conference in New York this morning.