Three Questions to be Answered in the Week Ahead

The Greek issue has been sufficiently resolved for now that investors' focus will shift elsewhere in the week ahead.   The answers to three questions will dominate the market's attention.  

  * How strong are the deflationary forces?

  * Are the cyclical recoveries still intact?

  * What is the outlook for Fed policy? 

The January inflation readings from the US, EMU and Japan will be released in the coming days.  The euro area preliminary data has already been reported.  This week's report is expected to confirm the -0.6% year-over-year headline rate and a 0.6% core rate.   

Germany and Spain will offer preliminary February readings.  Both are not expected to deviate much from the January pace of -0.5% and -1.5% respectively.  The monetary response, the ECB's accelerated asset purchase plan, which will include sovereign bonds, will be launched next month.  

Even if the ECB's bond buying program can be successfully implemented, for which there is increasing skepticism, it is not clear that it will boost inflation.  The BOJ's balance sheet is expanding by 1.4% a month.  In the H1 15 it will expand by more than the ECB's over 18-month initial projection.  Yet, it is not clear that Japan has slayed its deflation demon.   When allowances are made for the retail sales tax increase last April, Japanese CPI is barely positive.  Neither the nation's January report nor Tokyo's February report is expected to change much from the previous readings.  

Headline US CPI is expected to slip into negative territory (-0.1%) on a year-over-year basis, with a 0.6% decline in January alone.  Such a report will likely spur speculation that the Fed cannot raise interest rates with a negative headline inflation.  However, the key for policy makers is not headline inflation.  They accept that the dramatic decline in energy prices dampens inflation, but its impact on prices is transitory.  By this time next year, the bulk of the impact will be dropped by the base effect.  The core rate, which in the US excludes food and energy, is more stable and is expected to be unchanged from the 1.6% paces seen in December.  

The cyclical recoveries in the euro area and Japan continued into the early part of this year.  Perhaps encouraged by strong December exports (17% year-over-year), Japan's industrial production is forecast to have risen by 3% in January.  Output rose 0.8% last December and 1.0% in November.

New data from the euro area is thin next week.  Outside of the inflation reports, the other two reports that will confirm the cyclical recovery.  First, Germany's IFO business survey is expected to rise for the fourth consecutive month.  Second, money supply growth (M3) has begun strengthening, and this is expected to have continued.  The same can be said for bank lending.

Apart from the housing market, which has continued to disappoint, the main new information from the US will be durable goods orders.  The January orders are expected to have increased for the first time since last October.  A modest 1.6% increase is expected after last December's 3.4% drop.  

New from the world's second largest economy may not be as favorable.   The February PMI readings will be reported this week.  The risk is on the downside.  The economy is in a transition and growth has slowed.  This should not be exaggerated.  Chinese officials appear to believe that within reason, this slowing is acceptable and "natural" given the labor force dynamics. It also allows a catching of the collective breathe and reducing some excesses as it continues its quest for "the China dream" (doubling GDP and GDP per capita between 2010 and 2020).

From a global point of view, even assuming 6 3/4% growth this year, China will contribute about $660 bln to the world economy.  This still outstrips the US.  Making a generous assumption of 3% growth this year, the US economy will contribute around $520 bln to the world economy. 

Some link the likely downward revision in Q4 US GDP to below 2.0% from 2.6% and the fact that Q1 15 growth is looking soft (2.3-2.5%) to the dovish January FOMC minutes.  We suspect this is a mistake and expect Fed Chair Yellen to correct this impression in her testimony before Congress.  

What resonates with the Fed is not GDP, which as we all know is a flawed measure, but the fact that personal consumption rose 4.3% in Q4, the strongest in more than a decade.  Moreover, for those concerned about debt-financed consumption, revolving credit has barely grown. What will resonate with the Fed is that in the last three months the US created over a million jobs for the first time in nearly 20 years.  

The leadership at the Federal Reserve had led many to expect a mid-year lift off.  However, doubts have grown, and this has corresponded with a consolidative phase for the dollar.  After the FOMC minutes, the December Fed funds futures contract implied an average effective rate of less than 50 bp.  Although the market corrected this view a little before the weekend, we expect Yellen make it clear the Fed's patience is not limitless.   A hike, not today or tomorrow, but four months from now is still reasonable.  

The way the Fed communicated its tapering decision was effective and appears to be deployed again. Tell the market what you are thinking about doing.  Offer some time frame.  Give investors plenty of time to adjust.  The timing is data driven, but it is not completely unpredictable. Finally, execute.   

The Fed rightfully did not let the economic contraction in Q1 14 distract it from its tapering strategy, despite the appeal of many.   It understands that the recent slowing follows a well-above trend six month growth (April-September) that is partly being corrected now.  Even the expected downward revision to Q4 GDP is not all negative, as the downward revision in inventories suggests tat some of those excess being absorbed.  

The Fed's leadership has been preparing the market gradually for a change in US monetary policy. The emergency settings that were so necessary in the darkest days are no longer needed.  To be sure, the economy is not firing on all cylinders, but no one is really talking about a dramatic increase in interest rates.   

Look for Yellen to be patient with US Congress as she explains why the Fed's patience with emergency-level rates may be drawing to a close, and that this is a constructive sign.  It is also through this lens that Yellen will likely address questions about the dollar.  The exchange value of the dollar is one of the factors taken into account in assessing the monetary conditions.  

It is true that all else being equal a rise of the dollar on a broad-traded weighted basis adjusted for inflation will dampen growth.  However, all things are not equal, and the strength of the dollar has been offset by the decline in interest rates and oil.  The dollar's strength is a reflection of the relative performance of the US economy.  Of course, part of the dollar's rise has been fueled by expectations of a Fed hike.  Such anticipation will not be an important hurdle to the decision to hike rates later.