Dollar Drivers

The bull case for the US dollar rests on two legs. The first is that the policy response to the crisis has produced superior economic results in the US that would lead to the Fed raising rates later this year. The second was the ongoing challenges faced by Europe and Japan.  For several months both legs had strengthened.

A combination of factors has frayed the consensus about the trajectory of Fed policy and the strength of the US economy.  Weakness in retail sales and the decline in hourly earnings helped swing the pendulum of market sentiment.  The FOMC statement, which added a new concern about international developments, was unable to assuage investors’ anxiety, despite upgrading the growth assessment.

Oil prices recorded new cyclical lows last Thursday before bouncing before the weekend.  The deflationary headwinds are widely understood to mean that headline inflation will likely turn negative in the coming months.  Add to this the rise of the dollar to round out the dovish argument.

The doves have won some adherents.  Over the course of January, the implied yields of the December Fed funds futures and the generic two-year Treasury both fell 20-25 bp.

The next string of US economic data is likely to push back against this dovish shift.  There are three pieces of key data in this context.  First, US auto sales are expected to ease on a serial basis, but at a 16.6 mln unit pace the consensus expects, they will still be above last year's average.  In addition, US producers are expected to have picked up market share.  Despite the disappointing December retail sales, the real message is that household consumption rose by 4.3% in Q4, the fastest since Q1 06, and without much use of revolving credit (credit cards).

Second, the US reports December trade figures.   Even though the government provides an estimate of Q4 GDP, not all the data have been reported.  That is why the first estimate is subject to statistically significant revisions, which is one of the reasons why the FT's Weekend headline "Weak exports undermine US recovery hopes" was misleading.  In addition, the FT failed to even acknowledge the slowdown in the West Coast ports as part of a labor dispute is more than two months old and is impact both imports and exports.  In any event, the consensus expects a December trade deficit of $38 bln, which would be the smallest monthly shortfall in 2014 and will likely prompt revisions in the GDP estimate. 

Third, the January employment data are expected to extend the streak of more than 200k net new jobs being created.  Weekly initial jobless claims recorded new cyclical lows after the survey week (265k).   The December decline in hourly earnings will likely be reversed.    This is not to say wage growth in the US is strong; it is just not as weak as the December report implied.  In addition, many economists have begun arguing that the pent-up wage cuts that could not be delivered during the crisis have been now absorbed via smaller increases during the recovery.

There is also something larger at work here.  Regardless of the relative tightness of their labor market, wage growth has been anemic in other high income countries.  This continues to be a threat to Abenomics.  The UK's average weekly earnings are recovering now after falling into negative year-over-year territory briefly in the middle of last year. German wage growth has not kept pace productivity gains.   It appears that the economic elite facing lower returns on their capital have increased their share of the productivity gains, which are divided between profits to capital on one hand, and wages to labor on the other.

A common refrain against a mid-year Fed rate hike is the idea the US cannot be an economic oasis.  And yet, isn't this precisely what happened in 2014?  Even with the 2.6% pace growth in Q4, the US has strung together three quarters of the fastest growth it has experienced in a decade.  During this period, the euro area was stagnant, and Japan contracted. In addition, US exports, and foreign sales more broadly, appear more linked to foreign demand than the exchange rate.

The euro zone and Japan are taking fiscal and monetary measures that will help relieve some pressure on their economies.  The cyclical low point is probably past for both economies.  The drop in oil prices and the decline in the euro and yen in H2 14 have not worked their way through the system completely yet.  For the last six quarters, including the contraction in Q1 14, the US economy grew by at an average pace of 3%. By most economists’ calculations, this is probably somewhat above the long-term sustained (non-inflationary) pace.

Prior to the start of the expansion of the ECB's asset purchases in March, there are signs of an economic spring.  Money supply and lending are improving.  With the LTROs repayments nearly complete, the downward pressure on the ECB's balance sheet will subside.

December retail sales will be reported on February 4.  Even with a flat showing, Q4 14 would be the strongest quarterly gain since Q4 06.  The unexpected strength reported last week by Spain and France warns of the risk of an upside surprise.  The latest PMIs will also be reported.  The results are likely consistent will small but positive growth.  German industrial orders and production data are expected to be consistent with somewhat better growth in the world's fourth largest economy.

Meanwhile, the European political landscape is changing.  We believe clients are best served regarding much of the rhetoric from Greece and the Troika as negotiating posturing.  We continue to believe there is plenty of room for compromise when the negotiations begin in earnest.

Framing the issue as who will blink first, as many observers are doing, is not particularly helpful or valid.   It sees the situation as a zero-sum exercise, and that is to give up analysis for a partisan role.  The basis of a compromise both sides get some of what they want.  There are many areas where Syriza and the official creditors agree. Syriza supports structural reforms that break monopolies enjoyed by the rent-seeking, non-tax paying oligarchs.   The old guards have driven the country to ruin, and their apologists blame the new government for its lack of experience.

Greece will sell T-bills at mid-week to replace a maturing issue.  It will have to do it again the following week.  Anecdotal reports suggest deposit flight from the banks, who are also seeing their portfolio of government bonds lose value.  In anticipation of this, at least a couple of Greek banks have requested funds from the national central bank (Emergency Lending Assistance) which the ECB is likely to approve around the middle of the week.  It may impose some extra conditions that would keep the pressure on Greek officials to reach an agreement by the end of the month.

Greece's new Prime Minister Tsipras and Finance Minister Varoufakis visit a number of European countries in the days ahead.  Although much of the traditional media is portraying Greece's new government as isolated, Tspiras and Varoufakis will find much sympathy for its anti-austerity thrust.  French Finance Minister Sapin has already expressed some sympathy for Greece's position.    

Italy Prime Minister Renzi has been strengthened by the successful conclusion of the presidential selection process that saw his candidate Mattarella win on the fourth ballot and solidify support within the PD coalition.    Spain, another potential candidate for southern European anti-austerity bloc, appears some what less sympathetic to Greece. The Spanish government faces its own challenge from the Syriza-like Podemos.  Despite the still high unemployment levels, Spain's Rajoy is the creditors' favorite debtor.    

The future of Renzi's reform agenda is in doubt.  In effect, he chose to solidify his left flank at the cost of antagonizing Berlusconi whose support he relied on for his labor and electoral reforms.   There could have been little doubt that Berlusconi would be antagonistic to Mattarella, a judge (Berlusconi has often claimed the judiciary was persecuting him), and a former cabinet minister who resigned over Berlusconi-inspired laws that favored his media empire.  Berlusconi accused Renzi of breaking their pact. Renzi is a better position now to return to win a national election and a democratic mandate.  There is some risk that Berlusconi tacks to the right and seeks a new alliance with the Northern League, which appears to be on the rise with a new charismatic leader.  

Lastly, we note that both Denmark and Switzerland appear to have intervened in the foreign exchange market last week to buy the euro.  Denmark is defending a 1% range against the euro.  That is more restrictive that the 2.25% bands permissible in ERMII. Unlike the Swiss cap, the narrow range for the krone is endorsement by the ECB.  The ECB does not appear committed to defending the narrow 1% band.  Denmark's deposit rate at - 50 bp was cut three times in the second half of January.  The is talk of large speculative players, seeing the kind of franc move after the cap was lifted, are looking for a repeat.  

The SNB's intervention undermines arguments suggesting that the ownership structure (~55% the cantons and their banks and ~45% publicly traded on the stock exchange) forced its to abandon the cap and stop growing its balance sheet.  We suggest this was a tactical decision not strategic.  It chose not to predictably defend a Maginot Line,  but still intervened and expanded its balance sheet.