Are Dollar Fundamentals Lagging the Technical Improvement?

The US dollar extended its recovery that began on May 3.  Its technical condition remains constructive, even though up until now, the gains are still consistent with a modest correction rather than a trend reversal.  

The details of the employment report, if not the headline, coupled with the 1.3% increase in retail sales, have boosted confidence that the US economy is rebounding in Q2 after a six-month slow patch.   The average of the Atlanta Fed (2.8%) and NY Fed GDP trackers (1.2%) is 2%, and that is considered trend growth.  

The April FOMC statement recognized that the strength of the labor market was generating domestic demand.   The retail sales report changes that assessment, and revisions from Q1 suggest consumption was not quite as weak as earlier estimates indicated. More favorable data is likely in the week ahead in the form of April industrial production, manufacturing output, and housing starts.    The May Philly Fed manufacturing survey is expected to increase.  

However, this has not resulted in a change of investors' views on Fed policy or inflation expectations.   The Fed funds futures strip implies a 20% chance of a hike at either the June or July FOMC meetings. The market's skepticism about a hike has not been this great in a couple of months. 

The gap between the market and economists has been an important talking point this year, but the Wall Street Journal survey found convergence.   For the first time since February, a majority of economists do not expect a hike at the June FOMC meeting.   A little more than half see a hike in either June or July. Three-quarters of economists surveyed in April thought a hike was likely in June. There is a greater appreciation for the potential disruption of a Brexit decision several days later.

Investors would be more confident of the durability of the dollar's recovery if it were supported by changing expectations for higher US interest rates.  Stronger economic data alone seems insufficient. The April CPI, due out Tuesday, is unlikely to do what the strongest retail sales report in a year was able.  The headline may rise due to gasoline prices, but the core rate is expected to tick down to 2.1% from 2.2%. 

The risk is that the April FOMC minutes are more hawkish than the FOMC statement.  Recall in March several governors were playing up the possibility of an April move but were shot down by Yellen at the NY Economic Club at the end of March.   The market may have a knee-jerk reaction but look past it as the Fed's leadership mostly drives policy. 

The record of the ECB's April meeting also will be published.  After the multi-prong measures were announced in March, the ECB was not about to announce any fresh initiatives.  We suspect that operational issues will dominate the Executive Board over the coming months.  Investors are still hungry for more details about the corporate bond buying program.  

Corporate treasurers seem not to be waiting.    Corporate bond issuance is surging, and heavy slate is expected to continue in the week ahead.  Estimates suggest around 20 bln euro of corporate bonds were sold last week, among the highest on record.  And not only in Europe, as last week's US issuance was among the strongest of the year with more than $36 bln of fresh investment grade paper brought to the market.  

Several US companies have issued euro-denominated bonds last week.  Reports suggest US corporates account for a little more than a fifth of investment grade euro offering this year.  There may be some tactical decision to "strike while the iron is hot" and avoid the volatile market conditions that may prevail around the UK referendum.  

Rather than from the record of the ECB's meeting, the greater risk is from midweek's release of the final April CPI estimate.  The advanced estimate put the CPI at minus 0.2% year-over-year, and there is little reason to expect a revision.  Nevertheless, it is a reminder that deflation in the euro area is as strong as it has been over the past year.   

Conventional wisdom holds that monetary policy is too easy Germany and not easy enough for most others.   Sometimes it is argued that what in effect is an undervalued euro for German producers is what explains the current account surplus beyond what EU rules.  However, both arguments need to address the deflation that Germany is experiencing.   Last week, Germany confirmed April CPI was minus 0.3% from a year ago.  It for all practical purposes on the cyclical low set in early 2015 (-0.4%).  

The UK reports April CPI on Tuesday.  Last week's Quarterly Inflation Report indicated the BOE was prepared for a slowing to 0.3% year-over-year from 0.5% in March.  Half of this decline may come from the core components.   The market appears to have already responded to this "news" last week. 

The UK also report April jobs data (though average weekly earnings is reported with an additional monthly lag) and retail sales next week as well.  The broader context is the gradual moderation of growth.  The pace of employment gains is slowing, while the unemployment rate has been steady at 5.1% since November and is expected to remain there with the ILO's March estimate. Retail sales are anticipated to bounce back and recoup around half of March's decline.  

Everything pales compared with the risk of Brexit.  We fear too many people are assuming that like the Scottish referendum some opinion polls may be exaggerating the tightness of the contest. The options market suggest that the pressure to hedge remains relentless.  At the end of last week, two-month volatility was at new multi-year highs, and the put-call skew was near record levels.  On May 23, the referendum falls under the purvey of one-month options.  This is where one ought to look to monitor this pressure, which may be understood as the price of insurance.

Like the UK, Canada reports CPI and retail sales in the week ahead.  Retail sales were strong in January (2.1%) and grew further (0.4%) in February.  It overstates the strength, and there appears to have been a pullback in March (~0.7%).  A decline in auto sales won't help.  The risk is that the payback continues into Q2.  

Canada's headline inflation may tick up, but the core rate is likely to be stable and match the six-month average of 2.0%.  When transitory factors like energy and the exchange rate pass, the Bank of Canada sees underlying inflation running at 1.7%.  The Canadian dollar was among the strong currencies in the February through April period.  During that period short-term interest rates (implied yield of the June BA futures) trended higher.  This ended May 3, and the current phase, be it a technical correction or a trend reversal, it does not appear to be over.  The economic data do not look sufficient to stop it. 

We have a similar assessment of the Australian data.  It is unlikely to be sufficient to end the current phase of currency weakness.  The key economic report is the April employment data. Australia reported job losses in January and February and a 26k gain in March.  The median guesstimate from the Bloomberg survey is for a 12k increase.     The minutes from the RBA meeting in which rates were cut are due out at the start of the week.  These minutes ought to read with a clear a dovish bias.   A rate cut at the next RBA meeting, on June 7, may be too soon to anticipate a follow-up rate cut, but the minutes will be looked at for clues.  

Japan reports several pieces of March data, including industrial output, but the most important data point in the week ahead is the first estimate of Q1 GDP.  The median forecast from the Bloomberg survey is for a 0.1% increase on the quarter, which would extend the saw tooth pattern seen last year with alternating quarters of positive and negative growth. In 2014, there were also two-quarters of contracting growth.    

Given the marginal, the process of rounding could easily produce another growth-less quarter.  At the end of the day, though, a 0.1% expansion of a 0.1% contraction is essentially the same thing. Investors ought not to be fooled by the implied precision of measuring growth by tenths of a percentage point.  The fact of the matter is that the BOJ estimates trend growth in Japan to be a lowly 0.2%, which is one tenth of US trend growth.   

Small variance around zero is seems to have little policy significance at this stage.  The Abe government already appears to be moving toward fiscal support, including, as has long been rumored, the postponement of the retail sales tax increase due next April.  

Facing criticism of over-reliance on monetary policy, Abe may chose the G7 meeting to unveil his fiscal initiatives.  The G7 may issue its traditional boilerplate statement, reaffirming market-driven exchange rates.  As hosts, Japan will likely insist on retaining the recognition that excessive volatility needs to be avoided.  There is also likely to be a call on those with the ability to boost domestic demand.  

BOE Carney's recent allusion to negative interest rates being a form of currency manipulation may be theoretically true, but is a different story in practice.  The yen has appreciated 11.5% since the BOJ adopted negative interest rates.  The euro has depreciated since the ECB pushed deposit rates into negative territory in June 2014. However, the cyclical low for the euro was set in March 2015, more than a year ago, and rates have been cut further since then.    Any new initiative will likely wait for the G7 Summit (heads of state rather than finance ministers and central bankers) at the end of the following week.  

Disclaimer