Dollar Drivers: Central Bank Meetings, US Jobs, and More

March is said to come in like a lion and leave like a lamb.  It does indeed appear to be coming in like a lion for investors.  There are four major central bank meetings and the US employment report.  Although Yellen did not convince many that the Fed is set to hike rates in June, yields in the eurozone continue to fall in anticipation of the bond buying scheme that will start later this month.  The resulting widening of the interest rate differentials lent the dollar support.

Two emerging market central banks are in play as well.  Brazil is one of the few central banks engaged in a tightening cycle.  It is set to continue. The Selic rate bottomed in 2012-2013 at 7.25%.  It stands at 12.25% now.  The consensus expects another 50 bp rate hike.   A 25 bp rate hike would be seen as a potential signal that a pause and possibly the end of the tightening cycle is at hand.  

Poland is expected to cut the base rate by 25 bp to 1.75%.  It had cut the base rate 50 bp last September. The main issue is not growth.  Fourth quarter GDP expanded 3% year-over-year.  Rather Poland, like so many countries in Europe, is experiencing deflation.  In January, consumer prices were 1.3% below year ago levels.  

There were three developments over the weekend that may help shape the investment climate. First and most likely to impact trading on Monday is the rate cut by the People's Bank of China on Saturday.   The 25 bp cut in the key one-year lending and deposit rates (to 5.35% and 2.50% respectively).   The fact that the PBOC cut rates is not very surprising, but the precise timing is nearly always unpredictable.  Most of the speculation has focused possible yuan depreciation, and some analysts have been playing up the risk that the 2% dollar-yuan band would be widened.  The rate cut overshadows the official PMI readings that were also reported over the weekend.  The manufacturing PMI ticked up to 49.9 from 49.8 while non-manufacturing PMI firmed to 53.9 from 53.7.  

The PBOC explained the rate cut in terms of a decline in inflation, which results in an increase in real rates.  Consumer prices were 0.8% higher year-over-year in January while producer prices have been falling for three years.  Also on Saturday, China reported that housing prices in the 100 major cities fell by 3.84% in the year through February.   The rate cuts are not expected to reverse the slowing of the economy, arrest the deflation, or lift house prices.  They will, though, help large businesses and state-owned enterprises to cope with the more challenging economic conditions. The rates cuts will help facilitate the rolling over of existing debt.

The second important development over the weekend was the Sunday election in Estonia (the results are not know at pixel time).  The latest polls showed that a party with formal ties with Putin's United Russia Party is ahead of both of the governing coalition parties.  The government is pro-EU and pro-NATO.  However, a third of the population (~1.3 mln) comprises ethnic Russians.

As it has with several countries, Russia has made incursions into Estonian airspace.  In recent years Russia has developed a hybrid warfare in Moldova, Georgia, and Ukraine,  Although Russia's economy is being squeezed through sanctions; its tactics have seemingly succeeded.  It continues to occupy part of Georgia.  It supports a separatist region in Moldova.  Its annexation of Crimea stands and Ukraine's dismemberment is a fait accompli at Minsk, where the cease fire was agreed before the insurgents made one more strategic thrust.

Estonia could be a target of Russia's ambitions should Putin chose to challenge NATO itself, which up until now Russia has shied away from doing.  Narva is town in Estonia near the Russian border. Half the people do not have Estonian passports, and 90% are native Russian speakers, according to press reports.  Given Putin's view of the world, and the apparent success of his tactics, Narva (or a town like it) would seem to be a potential target as the next theater of Russian ambitions.

The third development takes us from Russian foreign policy to domestic.  One of the leading opposition critics of the Russian government, Boris Nemtsov was assassinated early Saturday morning in Moscow.   Putin called it a "provocation" which opposition leaders took as an indication the President was going to blame the opposition itself.  A large opposition rally to be held Sunday, protesting the economic crisis and Russia's involvement in Ukraine turned to more of a memorial for Nemstov.  

II

Four major central banks meet in the week ahead.  The least interesting is the Bank of England's meeting.  It is still seen to be at least a few quarters away from hiking rates, and despite the low inflation, and possible deflation, the bar is high for an easier policy.  More important for sterling and UK assets than the MPC meeting are the PMI reports.  They will likely confirm that the UK's economic recovery remains on track after slowing in H2 14.

The ECB meeting on the same day will command more attention.  However, it is most unlikely to do anything, having announced a larger and more aggressive effort to expand its balance sheet through asset purchases at its last meeting; no new measures are likely to be announced.  Still, it can provide more operational color to its bond purchase program.  The ECB's staff will produce new macro-economic forecasts.  Growth may be revised higher, but inflation forecasts may be shaved.

The ECB, through the Eurosystem, will launch its bond buying program later this month.  It still appears to be some legal and technical, operational issues that need to be sorted out before the purchases can begin.  Many participants are skeptical that it will lift price pressures for consumers (CPI) which is its declared objective.   The BOJ, which is many times more aggressively expanding its balance sheet, has seen consumer prices pressures fall steadily for several months and could slip back into deflation in Q2.  

Many participants also are wary potential operational difficulties.  In the US, foreign holders of Treasuries were more willing to sell them to the central bank than domestic investors.  In Europe, banks and pension funds appear to be among the largest holders of government bonds.  There are many reasons why they may not be so eager to part with their securities.  What can replace them and the yields they generate (remember the yields are locked in at the purchase of the fixed income instrument)?  Selling them is a tax event that some investors will not want to incur.  Some of the demand for sovereign bonds by banks stems from the regulatory considerations.  

Another significant group of investors are foreign central banks.   They could pare holdings by selling to the ECB.  This could be reflected in a reduction of the euro's share of reserves, but it might not be clear until the COFER report at the end of the year.  Nevertheless, the investors will be sensitive to market talk along these lines.  

The central banks in Australia and Canada meet.  These meetings are live in the sense that rate cuts are possible.  Both  central banks have cut interest rates already this year.  The derivative markets show a high degree of confidence that both central banks will cut rates again.   The issue here is timing, and it effects short-term traders more than medium and longer term investors.  

In the past week, the pendulum of expectations for next week's meetings shifted away from cuts now. A weak capex survey from Australia at the end of last week encouraged the doves to stick with their views.   It is a close call, and our impression is that officials had framed the issue as February or March last month.  Back-to-back cuts may be more aggressive than is warranted by the data.  

With some verbal guidance by Bank of Canada officials, investors had been convinced that another rate cut would be delivered at the March meeting.  However, last week Governor Poloz was understood to mean that a cut is not imminent.  In our reading, Poloz simply restated the official policy--that the January rate cut was an insurance policy meant to buy time for the economy to adjust to the fall in oil prices.  

We suspect that there is a greater risk of a Bank of Canada rate hike than an RBA rate cut in the week ahead.  That said, the failure to cut rates might not spur a strong rally as the lack of action now will simply raise the conviction for a later move.  

III

It is a hellacious week for US economic reports, culminating with the employment report at the end of the week.  There is an economic report every day.  The economic data will provide insight into the pace of growth in the first quarter, but the key is the impact on Fed policy.  High frequency data may help create the price action that short-term participants like, but no one wants policy to be based on such noisy time series.  The general picture of the economy, namely one that has returned to what appears to be trend growth after a period of acceleration in April-September period last year.  

Headline inflation has been pulled down by the drop in oil prices, but the core rate, which is the aim of policy, is steadier.   Weakness in the parts of the country most linked to oil production will also likely be born out by the Beige Book prepared the mid-March FOMC meeting.  However, most businesses have lower input costs, and households have more disposable income.  The data is expected to confirm consumers are not necessarily increasing their consumption, though household consumption did rise 4.2% in Q414.  Rather, at least at the start of the 2015, it appears households bumped up their savings.  

The core PCE deflator is not expected to have changed in January from the 1.3% pace in December. The Federal Reserve would feel better if this measure ticked up in the coming months.  It would make the June rate decision easier.   Fed Chair Yellen was clear on the matter, however.  The core rate has also likely been knocked down by the drop in oil prices.  This is transitory, and the base effect wanes late this year and early next.  At the January FOMC meeting, the statement indicated that the Fed continued to expect that after some near-term softness, it continued to expect inflation will approach the 2% reference rate.  

It is that expectation coupled with continued improvement in the labor market that underpins our expectation for a June hike.  There has been a clear acceleration in jobs growth.  The three-month average is 336k while the six-month average is 282k.  Growth growth in February is expected to have slowed considerably.  The consensus expectation of 235k would be the slowest since last August.   Hourly earnings, which had fallen 0.2%  in December rose 0.5% in January and are expected to have risen 0.2% in February.   This would cause the year-over-year pace to slip  to 2.1% from 2.2%.   

On balance, the Federal Reserve will likely see the employment report as consistent with continued improvement.  There is no compelling new piece of evidence that would shake their confidence that the 2% inflation target will be achieved in the medium term.  Yellen argued that the international factors are mixed, and net-net are in neutral.  We think the most likely scenario is that the Fed drops "patience" in March, and true enough, it will not signal an immediate rate hike, which would be April.  Instead, it really is still patient and waits for June.