Three Keys to the Week Ahead

There are three things that will command investors' attention in the week ahead.  The first, and most important, is whether the global capital markets will continue to move toward stability after the huge drama over the past week or two. The instability appears to have shaken the confidence of some Fed officials and market participants that a September lift-off is the most likely scenario.  

Our assessment of the technical condition of the market is that the panic is over, some capitulation was seen, and equities, interest rates, and currencies took a big step toward returning to status quo ante in the second half of last week. We recognize the technical condition as a reflection of market psychology. It is as if Mr. Market was shaken out of its melodramatic response with an ostensibly refreshing slap.  While the precipitous drop of the magnitude we experienced was indeed scary on many levels, the system showed a comforting resilience, both operationally and psychologically.  

The markets had not reached the point of breakdown in which everyone was forced to be short-term traders.  Speculators capitulated (e.g., the gross short yen futures position were slashed by more than 37k contracts, which in percentage terms is the biggest short squeeze in three years).  Margin calls were made.  Yet there were medium and longer-term investors that recognized the exaggerated sell-off as a new opportunity.  The break of dramatic momentum was able to feed on itself.  Those short-term momentum traders then were forced to cover

The second is the ECB meeting.  The updated staff forecasts will likely point to slower growth and less price pressures than had been expected in the June forecasts.  Rather than end early as some had previously speculated, the ECB's asset purchases may be increased.  This could happen through increasing the monthly amount from the current 60 bln euros, or it could extend beyond September 2016.  

It seems unreasonable to expect any such announcement now.  ECB President Draghi is likely to emphasize the flexible nature of its asset purchases.   Draghi has often cautioned that the cyclical upswing would be contained by the lack of structural reforms.  Also, financial conditions have become somewhat less accommodative.  

On a trade-weighted basis, the euro has risen by 4.7% since March, and most of it has been recorded since the middle of July.  Indeed, since July 6, the euro has been the strongest of the major currencies.  European equity markets have continued to surrender the year's earlier impressive gains.  

With a 9% bounce off the extreme low recorded on August 24, the Dow Jones Stoxx 600 is still off a little more than 10% since the August 5 high.  The DAX had risen more than 25% in the first part of the year, but it has all been wiped out.  It spent the first part of last week in negative territory for the year.  It finished last week up 5%.  

Bond yields have risen in recent months.  Over the last six months, the 10-year benchmark bund yield has risen by 41 bp.  Spain's benchmark yield is up 80 bp.  Italy is up 60 bp.  More than half (25 bp) of the bund increase has taken place over the past three months.  The backing up of Spanish and Italian yields occurred earlier.  In the past three months, Spanish and Italian 10-year yields have risen by 22 bp and seven bp respectively. 

Market measures of inflation expectations have fallen, and although headline consumer prices are rising on a year-over-year basis, the risk is on the downside.  Similarly, core inflation has risen from 0.6% in March and April to 1.0% in July, but the best news may be behind it.     The final August reading will be published on Monday, August 31, and it is expected to be unchanged from the preliminary estimate of 0.9%.  

Even with mild downgrades in the staff forecasts, it is unreasonable to expect the ECB to respond this week by increasing the quantity of assets being purchased, or extending the current program beyond September 2016.  A consensus must be forged to implement the former, and it is too early for this. There is no urgency for the latter.  It can be used as a signal to the market, but the incremental advantage over Draghi noting this is a policy option may be minimal given the political capital likely needed to be expended.  

Draghi's press conference will likely be a timely reminder ahead of the third key event next week, US jobs data, that both sides drive the divergence of monetary policy between the Federal Reserve and the ECB.  As we have noted before, every central bank that has tried purchased assets to expand its balance sheet, to compliment near-zero interest rates or even negative deposit rates, has chosen to do more than one round.  ECB may break this pattern, but it is not a certainty, even if the German representatives on the ECB object.  

US nonfarm payrolls are notoriously difficult to forecast.  There are few meaningful inputs.  The ADP report does a good job of catching the important trends, but on a month-to-month basis can be wide of the mark.  Still, it has stolen some of the thunder from the monthly BLS report.  The consensus expected the ADP to show a 200k increase in private sector jobs in August, up from its 185k estimate for July.  

August is particularly problematic, especially given that this is the last jobs report before the FOMC meeting.  The historic pattern is for August to disappoint on the initial release and subsequently be revised higher.   This is not a secret, and Fed officials likely are cognizant of it.  This suggests that some headline weakness may be tolerable, especially if some of the internals is robust. 

There is, for example, a reasonable chance that the unemployment rate dips to 5.2%, which is the upper end of the Fed's estimate of full employment.   Economists did not expect hours worked to have increased in July and hence expect it to fall back in August.  There is potential for a surprise here.   It will be more difficult for hourly earnings to surprise.  Last August hourly earnings rose 0.3%.  If it is not matched now (consensus 0.2%), there is a risk that the year-over-year rate slips back to 2.0% where it was in June.  

We suspect that the outcome of next month's FOMC meeting does not rest on one high-frequency report.  The underlying trends in the US economy have been persistent.  Growth on a year-over-year basis has been largely stable.  It may not be an impressive pace, but it has been sufficient to gradually close the output gap and absorb slack in the labor market.

While the nonfarm payroll change is difficult to forecast, it has been amazingly stable.  The 12-month average stands at 243k; the 24-month average is 236k, and the 36-month average is 222k.  That is nearly eight mln net new jobs created over the past three years.  

It is the price stability mandate that is more elusive that the full employment goal.   For the past two decades, the core PCE deflator has also been amazingly stable.  It has been confined to a 1.0%-2.5% range, with some brief exceptions to the downside (June 1998 0.95%, July 2009 0.97% and December 2010 0.94%).  It has averaged about 1.7% over the past 20 years.  The report at the end of last week indicated it stood at 1.2% in July.  

Fed officials would clearly prefer a bit higher of inflation.  However, the consensus, especially among the leadership, is that 1) most of the elements dampening prices are transitory and 2) the key to core inflation is the continued absorption of slack in the economy, especially the labor market.  It also seems clear that the Fed's leadership does not want to wait for the core PCE deflator to rise to 2% before beginning to normalize monetary policy.  

In the market's panic, and arguably aided by NY Fed President Dudley's admission that a September rate hike had become less compelling over the last couple of weeks, the market slashed the odds of a hike.  The effective Fed funds rate has been averaging 14-15 bp.  At its extreme last week, the implied effective funds rate next month in the September Fed funds futures contract was 15.5 bp.  It finished the week at 17.5 bp.  

The risk is that there is a greater chance than this implies of a rate hike.  This is also what the 2-year note seems to be saying.  It had closed the first half yielding 64 bp.  It reached 75 bp in July though finished the month at 66 bp.  At the low water mark last week it fell to almost 53 bp and finished the week near 72 bp.   Fed comments at and around Jackson Hole are also consistent with this view.   

At the risk of oversimplifying, the domestic US situation makes a rate hike very likely, but the Chinese international developments and the apparent panic in the financial markets are of concern.  The situation is fluid, and a decision will be made when it has to (September 16-17). 

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