Three Events will Shape the Path Ahead

The beginning of a new month starts the usual cycle of economic data.   Among these only the US employment report is significant.  A weak report would not only rule out a June hike by the Fed, but would call a September move to question as well. A strong report could mark the return of the dollar bulls after taking a six-week spring vacation.  

In addition to the US jobs report, two other events stand out.  First is the UK election on May 7.  The polls and personalities make it difficult to envision a majority government being formed.  In fact fragmented voting means the results of the election may not be known for some time after the votes are counted.  

Second, last week's news that the eurozone had emerged from deflation helped trigger a sell-off in German bunds that seemed to have reverberations through the capital markets.  The 22 bp increase in yields brought the 10-year German yield nearly back to levels seen on March 9 when the ECB began its sovereign bond purchases.  

The dollar bull case rested on two legs, easy monetary policy abroad, and the normalization of monetary policy at home.  The better eurozone economic performance in Q1 and the easing deflation fears, helped by the rise in oil prices, had softened perceptions of one of the legs.  The disappointing US economic reports weakened the other leg.  

There are two camps.  The first says that the weakness in Q1 is the beginning of the end of the US expansion cycle and that the Federal Reserve will not find the opportunity it is looking for to hike rates this year.  The second says that Q1 is a bit of a fluke.  The economic performance in the first quarter is not representative of the state of the US economy, and that growth will rebound.  

The April jobs report will be a key factor in determining the relative merits of each side.  The report will set the tone for the data in the coming weeks.  A strong report would strengthen the second camp of course.  It is not just about the net new jobs created (non-farm payrolls), but the unemployment rate and average hourly earnings.  

The Bloomberg consensus calls for a 225k increase in non-farm payrolls after a disappointing 126k increase in March.  An increase of more than 260k, which is the six and 12-month average, would ease concerns.  The consensus expects the unemployment rate to tick down to 5.4% from 5.5%. Average hourly earnings are expected to have risen by 0.2%, which would lift the year-over-year rate to 2.3%, the strongest since August 2013.  

Although the weak data was often cited in the press to explain last week's dollar sell-off, interest rate hike expectations increased not declined.  The implied yield of the December 2015, Eurodollar futures contract rose 4.5 bp to 63 bp.  The implied yield of the December 2015 Fed funds futures contract rose three bp to 36 bp.   Going forward, data through March is mostly inconsequential give that Q1 GDP has been reported.  The March trade balance is an exception.  A large shortfall could offset the positive impact of the revisions to retail sales announced last week.  

The UK election is imponderable and overshadows high frequency readings of the economy.  The week ahead features the PMI reports for April.  A profound irony lies in Scotland.  Although its bid for independence was easily rejected (and the inaccuracy of the pools, which had it close should be a warning about the UK election), the Scottish Nationalists may have greater influence over policies than if referendum had won.  With the Conservatives and Labour running close, and neither with a majority, a coalition will likely be necessary.  

Given the destruction of the Lib-Dem base by seeming to lose its identity as the junior partner in the coalition, its support alone may not be sufficient to give either party a majority.  UKIP and the Greens are also not likely to win more than a handful of seats.  The Scottish Nationalists will have a blocking minority.  The risk that the election does not produce a government should also not be entirely dismissed.  While it may be a low probability scenario, the impact could be significant for investors.  

The euro's depreciation, the decline in interest rates and oil was going to act as a stimulus for the regional economy, and indeed it is.   However, the stimulative impact may moderate, and growth will likely stabilize rather than accelerate.  Moreover, the growth remains unbalanced.  This will be reflected by news that retail sales contracted for the second consecutive month in March.  The German current account surplus, which the Bundesbank defended as a function of the ECB's ultra-easy monetary policy (that it opposes) and long-term demographic cycle (as its population ages the savings will be drawn down), is expected to jump to 20 bln euro from 16.6 bln.  

The ECB's bond buying program that is only two months into the 18-month anticipated program. The emergence from deflation should not be exaggerated.  CPI was zero year-over-year in April, and that is after a 47% rise in the price of oil since mid-January.  The core rate of 0.6% matches the cyclical trough.   

Meanwhile, the market has become less pessimistic toward a Greek deal.  In the past seven sessions, the 10-year yield has fallen by about 350 bp to a little less than 10.5%.  The 3-year yield has fallen by 830 bp to about 22.3% over the past four sessions.  Greek stocks have rallied 11.7% over the past five sessions.  

At is non-monetary policy meeting this week, the ECB is expected to discuss the haircut given to Greek bonds, used by Greek banks as collateral for the ELA borrowings.  The progress in the negotiations and the rally in Greek bonds likely deters ECB action now.   At the same time, however, there is risk that the market misreads a smaller ELA allotment.  The ECB appears to be simply giving Greek banks the funds it needs to offset the drain of deposits and other factors.  A smaller expansion in the ELA would actually be a positive development, indicated the stabilization of Greek banking system's needs. 

Elsewhere, we note that the Reserve Bank of Australia and Norges Bank meet.  The risk is that both cut key rates, though they are close calls.  The continued deterioration of the terms of trade for Australia, coupled with the recent appreciation of the Australian dollar may tip the scale.  

For its part, the Norges Bank is not troubled by low inflation. Headline CPI was 2.0% in March, and the underlying rate is 2.3%. Rather, the predicament is the knock on effect on the overall economy from the drop in oil prices while credit growth remains strong. The krone has appreciated by nearly 6% on a trade-weighted basis since the middle of March.  A rate cut would likely neutralize this tightening of monetary conditions.  On balance, we suspect the risks are greater that RBA cuts rates than the Norges Bank.  

Lastly, HSBC reports its PMIs for China, but these will be overshadowed by China's trade and inflation measures due in the second half of the week.  After a shockingly small trade surplus in March ($3.1 bln), we expect lunar New Year distortion to fade.  The trade surplus is expected to jump toward $34.25 bln, helped by a recovery in exports (2.9% vs -15%), while imports remain depressed (-9.8% vs. -12.7%) by weak prices of commodities and a slowing economy.  

Fears of imminent deflation are likely exaggerated.  Consumer prices in April are expected to have risen to 1.6% from 1.4% in March.  Deflation remains evident in producer prices, which it has for three years.  The last time China's producer prices rose on a year-over-year basis was in January 2012.   

Part of the rally in Chinese shares (37% year-to-date advance for Shanghai and 60% for Shenzhen) has been fueled by expectations for additional stimulus by officials.  However, the stimulus may be targeted rather than broad, and the technical indicators are flashing caution.  The RSI has not confirmed the recent run-up (bearish divergence) and the MACDs are about to turn lower. 

That said, China's equity market rally has been driven by domestic participants, while global fund managers are been reducing their exposure.  According to Morningstar data, international investors were net sellers of $4.4 bln of greater China equity funds last year.  It was the fourth consecutive year of divestment.  The sales have been largely accounted for by the international funds domiciled in Europe (but distributed globally).  This year has begun off in similar fashion with net sales of $1.8 bln.