Five Questions that May Be Answered in the Week Ahead

1.  After the US economy appears to have contracted (-0.5%/-0.8%) in the first quarter, how is the economy doing here in Q2 which is half over this week?

Last week we learned that after a simply dismal March labor report, April job growth bounced back above 200k.  The May employment survey will be done in the week ahead. Weekly initial jobless claims have fallen to new cyclical lows, as has the unemployment rate.  

The gradual improvement is widespread.  The under-employment slipped to 10.8% from 10.9%. It peaked above 17% but remains elevated.  Those who have involuntarily taking part-time work fell by 125k to 6.58 mln, which is also a positive trend that needs to continue.  The same can be said of the long-term (27 weeks+) unemployed.  Those fell 38k to 2.53 mln.  

The employment report was good but not spectacular. The March JOLTS report should confirm the continued absorption of labor market slack, as job openings rise (February highest since 2001) and quits increase (10% year-over-year).  

The most important US report in the week ahead, however, is about the consumer, not the worker. The consumption component in Q4 14 rose 4.4%, the fastest increase since 2006. In Q1 15, the pace slowed to 1.9%.  If the US economy is strengthening in Q2, it is important to see it in the consumption data.  We anticipate consumption to accelerate toward 2.5%.  After falling for three months through February, retail sales rose in March by the most in a year.  The retail sales likely eked out a small gain in April.  We already know that auto sales fell month-over-month.  Excluding autos, the retail sales may have increased by 0.5%.  

The components used for GDP calculations also fell for three months before rising 0.4% in March. The consensus calls for a 0.5% in April. If true, the March and April period offset in full the decline in December-February.  

Manufacturing output fell over the same period and posted a modest 0.1% increase in March. The consensus expects a 0.2% increase in April.  Overall, industrial output likely stabilized after falling 0.6% in March  (mostly on utility output and energy sector).

2.  Is the meltdown in German bunds over?

There has been what appears to be a flash crash of sorts in the German bund market that has had knock-on effects throughout debt markets, equities and currencies.   The 10-year bund yield slipped below five bp on April 17, and the 30-year yield eased below 44 bp.  At their peaks last week, the 10-year yield reached almost 78 bp and the 30-year pushed above 1.40%.  

Deflationary pressures have eased recently and may account for some of the backing up of yields. Market positioning was also extreme as many were anticipating a fall into negative territory due to a shortage of bunds for investment and collateral purposes.  

However, the magnitude of the move, and ripple effects through the capital markets, suggests something more may be taking place.  Increasingly market participants are discussing the decline in liquidity not volume.  In this context, liquidity is about the size of a transaction that moves the market. Precisely what is taking place is not clear.  It does seem to reflect changes in the micro-structure of markets, the role of officials directly, through asset purchases, and indirectly through regulation.   The US Treasuries, Japanese government bonds and now German bunds have all experienced similar situations.  More work needs to be done in this space.  

In any event, the dramatic move in the bund market stabilized after what may prove to be a climactic sell-off. An unexpected contraction in German industrial production was reported just as the selling appeared to have exhausted itself.  Germany will release its preliminary estimate of Q1 GDP on May 13.  The consensus expects a 0.5% pace after 0.7% in Q4 14.  

The eurozone economy as a whole is expected to have grown by 0.4% on the quarter (0.3% in Q4 14). This is, of course, faster than the US, though, on a year-over-year basis, the eurozone economy is about 1.0% larger while the US economy is 3% larger.  

3.  Will Greece get new aid or default?  

It is doubtful that the May 11 Eurogroup meeting will resolve what has proven intractable for the past year, going back to the last months of the previous Greek government.  Officials still seem to be talking past each other.  The Syriza-led government claims the old agreement has failed, and it wants a new one.  The new one cannot impose more austerity via wage cuts or pension cuts. The official creditors say that the new government must adhere to the agreements struck by the previous government. The creditors themselves seem divided on the relative importance of pension and wage cuts and primary budget targets.  

The improved atmosphere of the negotiations has been widely commented upon.  The results have been the same.  There is slow progress, and agreement seems some distance off.  If there is not sufficient progress, the ECB could decide as early as this week to raise the discount (haircut) applied to Greek bonds used as collateral under the ELA facility.   We also continue to suspect that investors may misread the significance of the ECB not extending the ELA facility.  It gives Greek banks only the amount that it believes they need.  The lack of increase would be a sign that the situation stabilized (good news), not that the ECB has cut them off (bad news).  

A new pressure may be building on the Syriza government.  Although Syriza did not get much more than a third of the popular vote (36%), by February its negotiating position was supported by 82% of Greeks.  It has fallen to 54% according to the latest polls.  

However, the fact that it only had a third of the popular vote to begin with makes Syriza's threats/pledges to hold a referendum if it is forced to compromise its principles seems like more political theater.  These acts, like re-hiring 600 cleaning staff in the finance ministry or abolishing annual performance reviews of civil servants, are mischievous and ultimately counter-productive.  

If Plan A is for a deal to be struck that allows Greece to kept its creditors whole, than Plan B is for Greece to restructure its debt.  One of the problems with this is that some countries are counting on being repaid by Greece for them to meet their own fiscal targets.  The impact of a write-down of Greece's debt would seem to vary by how countries have accounted for the bilateral loans and the contingent exposure via guarantees.   It also depends on how much of a write-down is forced. An orderly process within EMU would seem to increase the odds of a smaller loss than if it is a disorderly process that leads to Greece's exit.  

There has been some optimism creeping into the market recently.  The 10-year bond yield peaked below 14% on April 22 and finished last week near 10.7%.  The Athens Stock Exchange has rallied 21% over the past month (since April 12). 

4.  What's next for the UK?  

Defying polls and expectations, the Tories took a majority of parliament, spurring a resignation of leaders from several opposition parties.  Even if Labour had not lost a single seat in Scotland, it would not have been sufficient.  It appears the Tories succeeded in linking Labour and the Scottish Nationalists while Labour ran an uninspiring campaign.  In addition to taking seats from Labour, the Tories took seats from its former partner the Liberal-Democrats.  With the opposition in disarray, Prime Minister Cameron will push ahead with the Conservative's agenda of tax cuts, Scottish devolution, and the EU referendum.  

The UK Independent Party managed to secure but one seat in parliament.  However, this is a reflection of the fact that its supporters are dispersed.   It drew 12% of the vote nationally.  Under Cameron, and perhaps as a backlash against the involvement in Iraq, Britain seems to be withdrawing.  The debate about the EU is only one dimension.  The reductions to the British navy is another.  The negotiations with Russia are happening under a Berlin-Paris condominium.  The UK appears to have sidelined itself.  

Investors' focus will return to economics in the week ahead.  Due to last Thursday's election, the MPC meeting was pushed to May 11.  There will not be a change in policy. The inflation statement on Wednesday will serve to update the market on the MPC's economic views.   Previously the BOE warned that the pass through from sterling's depreciation could be quicker than in the past.  

Investors will also have the latest updates on the UK industrial output and the labor market.  April industrial production is expected to be flat.  It conceals expectations for a 0.3% rise in industrial output, for which the Q1 monthly average was zero.  Such a report would bring the year-over-year rate to 1%.  In April 2014, it stood 4.6% above year-ago levels.  

The claimant count has fallen on average about 30k a month over the last three, six and 12-month periods.  It may slow a bit, but the market's focus is on the average weekly earnings, which are reported with an extra month lag.  The March average weekly earnings are expected to be unchanged from February at 1.7% (three-months year-over-year).  However, excluding bonus payments, the pace may have accelerated to 2.1% from 1.8%.  If so, it would match the fastest pace since July 2011.  

5.  How is China's economy performing?  

Chinese policy makers have acted quickly.  Last week the Politburo intimated it was considering stronger stimulus. On May 9, it reported April consumer prices rose less than expected, though the 1.5% increase was slightly faster than the 1.4% reported for March. Still, food prices are masking the deflationary forces.   Non-food prices have risen 0.9% from a year ago.  This compares with the 1.6% pace in April 2014.  Food prices have risen 2.7%, the same as it has averaged over the past 12-months. 

The PBOC responded on May 10 with a 25 bp cut in the key one-year lending rate to 5.1% and the deposit rate to 2.25%.  It is the third rate cut in six months.  It is unlikely to be the last in the cycle.  In addition, and consistent with the gradual liberalization, the PBOC announced that banks could pay as much as 150% of the deposit rate to attract savings compared with 130% previously.   Another cut in requires reserves would appear to be the next step.  

China is encouraging some competition among banks for deposits.  This may facilitate greater risk taking by some banks.  In turn, this may generate bank failures.  The newly introduced deposit insurance, which is to mitigate the impact on small depositors.  

Before the weekend,  Chinese regulators announced that the bad loans at banks rose by more than 16% in Q1 15, the most since the data is available (2004) to CNY962.5 bln. And that assumes that the loans have been properly categorized.  The deterioration in Q1 was about 55% of the amount of loans that soured all of last year.    

There seems to be a general recognition that the Chinese economy is slowing faster than desired, though the retail sales, industrial output and fixed investment figures due out in the days ahead are likely to have stabilized in April.   The April trade figures probably exaggerate the slowdown.  Many saw the 16% decline in imports as a sign weak demand.  However, this is partly a function of price.  Volume numbers are not down nearly as much.  Iron ore volumes are flat on a year-over-year basis, for example.  

Also, consider what is happening in the energy sector.  The volume of oil imports has risen 8.6% over the past year.  China's exports of oil products have risen by 23%.  China is moving up the value chain, but importing the raw material and exporting the processed and refined product.  

Before the weekend, for example, Chinese regulators announced that the bad loans at banks rose by more than 16% in Q1 15, the most since the data is available (2004) to CNY962.5 bln. That assumes that the loans have been properly categorized.  The deterioration in Q1 was about 55% of what the loans that soured all of last year.  

The dollar has been trading in a relatively narrow range of CNY6.18-CNY6.20 for the better part of two months.  We continue to see no sign that depreciating the yuan is being considered to stimulate the economy.  Indeed, the ongoing talks to about the possible inclusion of the yuan in the SDR argue against depreciation.  While the IMF has opined that the yuan is near fair value (which puts them at odds with the US Treasury), it has called on China to pursue greater currency flexibility and resist such frequent intervention. 

The PBOC's rate cut may renew demand for Chinese stocks.  The Shanghai Composite fell 5.3% last week to leave it almost a third higher (30%) thus far this year. By extension, it may end the pullback in emerging market stocks more broadly.  The MSCI Emerging Market equity index pulled back 4.3% from the seven-month high seen in late April before stabilizing ahead the weekend.  The pullback of European and US bond yields and the strong rally in US equities last Friday will also likely lift emerging market assets at the start of the week