Macro Developments Will Not Stand in Way of Dollar Move Lower

Through the first part of the year, the swinging pendulum of expectations for the trajectory of Fed policy has been a major driver in the foreign exchange market.  This is true even though the ECB and BOJ continue to ease monetary policy aggressively.   The Australian and New Zealand dollars appear to influenced more by the shifting view of Fed policy than the expectations in some quarter that the RBA and RBNZ could cut interest rates as early as this week.  

Indeed, anticipation of Fed policy is shaping the investment climate more broadly than simply the dollar's exchange rate.  The dollar's setback will likely support a broad array of commodity prices, including oil and gold.  It may also support so-called risk assets, emerging market stocks.

The market responded dramatically to the shockingly poor jobs growth.  At its recent peak in late May, the June Fed funds contract discounted about a 50% chance of a hike this month.  Now the pricing is consistent with no chance of a hike.  Because the July meeting is so late in the month, the August contract is useful guide, and it too moved dramatically.  At the end of May, the August contract had priced in 16.5 bp of a 25 bp hike, or roughly 2/3 or 66%.  After the employment data, the market now is pricing in 7.5 bp or 30% of a quarter-point hike.

To be clear, the employment growth and economic growth have different cycles.  Knowing the former does not help forecast GDP.  Consider our recent experience.  The US posted an average monthly gain in nonfarm payrolls of 192k in Q3 15, 282k in Q4 15, and 196k in Q 116.  The economy expanded at annualized rates of 2.0%, 1.4%, and 0.8%.

Job growth is averaging 80k here in Q2 16. At the end of last week, both the Atlanta and NY Federal Reserves updated their GDP tracker.  They are nearly identical.  The Atlanta Fed tracker is at 2.5%, and the NY Fed's is at 2.4%.   The point to be appreciated, and not to diminish the disappointment with the jobs data, is that the economy appears to be rebounding smartly, even if May is a bit off April's heady pace.  The NY Fed is also "tracking" Q3 GDP.  It is also above 2%, which is regarded as trend growth for the US.

One of the implications of slower jobs growth is better productivity figures and lower unit labor costs.  This will likely be evident in the revisions to Q1 figures due out in the coming days, and especially in Q2.  

We had argued that a June hike was not particularly likely given risk-rewards considering the UK referendum, and the Fed's cautious DNA.  However, we are reluctant, with the current information set, to rule out a July hike.  While weekly jobless claims have stopped falling, there is no compelling reason not to expect the May weakness to be a statistical fluke, the kind of which is not so uncommon.  In March last, year, the US economy grew only 84k jobs, in December 2013, there were 45k jobs created, in April 2012, job growth fell to 75k, and in May 2011, a net 73k jobs were created. 

In no case was the disappointment a signal of the end of the economic or labor cycle.  In two of the four example, the following month jobs growth was over 200k.  One time it reached only 187k the next month.  Only in 2012 did it take several months.  

Yellen speaks shortly after midday in the US on Monday.  Most recently she acknowledged that it might be appropriate to raise rates again in the coming months, without being very specific.  As a labor economist and an experienced policymaker, she will likely look past the noise of high frequency data and focus on what is the underlying signal.   From this vantage point very little changed on June 3.  Simply maintaining the assessment, she offered on May 27 would be sufficient to keep the July FOMC meeting live.  

ECB President Draghi rendered moot any interest there may have been in the final revision of the eurozone's Q1 GDP.  He noted that Q2 growth is likely slower.  The details of Q1 will likely show that the 0.5% expansion was driven by consumer spending and investment. Rather than data, which will not change the investment climate one iota, the most important development in the EMU next week is the beginning of the ECB's corporate bond purchase program.  It is likely to begin off slowly with a few billion euros being bought in the first week.  As with the case of the asset-backed bonds, covered bonds, and corporate bonds that are already being purchased, the ECB will provide a weekly update of its efforts.  

The dollar's general tone is the key to sterling's direction.  Although the UK reports several time series, including industrial and manufacturing output, trade, construction spending, that will help shape expectations for Q2 GDP.  However, the referendum overshadows the economic data.  Tuesday evening, UK TV will carry a program with separate interviews and question/answer with Prime Minister Cameron and UKIP head Farge.  Thursday evening will be a two-hour program devoted to the referendum.  

Japanese officials must be frustrated.  After bottoming on May 5 near JPY105.50, the dollar strengthened to almost JPY111.50 by the end of May.  The dollar eased in the three sessions before the US jobs data.  The yen soared after the report more than 2% against the dollar and reached three-year highs against the euro.  The yen strengthened 4.3% against the dollar last week, and the five-yen move in four days is likely coming close to the Japanese definition of disorderly market. 

However, despite the rhetoric that may be rolled out, the fact that it appears to be more of a dollar move than a yen move may dissuade Japan from intervening.  Moreover, the record of unilateral intervention by the BOJ, even when done in size, is not particularly inspiring.   

In addition, next week's economic data, which includes a likely upward revision to Q1 GDP (due to capex) and a large April current account surplus.  Recall that the March surplus was the second largest in the past two decades.  April is expected to be only a little smaller.  The yen finished last week within 0.5% of what by the OECD's calculation is purchasing power parity.  

The Reserve Bank of Australia and New Zealand meet in the week ahead.  The risk of an RBA rate cut as eased over the past week or so, helped by stronger than expected exports and Q1 GDP.  We have consistently argued against back-to-back rate cuts, and the market has come around to this conclusion as well.  Only one of the 25 institutions (a Canadian bank) surveyed by Bloomberg expect a cut.  The RBA statement will mostly likely be dovish especially given the Australian dollar is looking perkier.  Technically, we see scope for the Aussie to continue to retrace the losses suffered from late-April through late-May.    

The risk of an RBNZ rate cut is seen as somewhat greater than an RBA move.  The Bloomberg survey was nearly evenly divided.  Of the six banks based in Australia and New Zealand that participated in the survey, only one expects the RBNZ to cut rates. Disappointing economic data, soft milk prices, and a rebounding currency make us inclined to anticipate a cut that would bring the cash rate to 1.75%.   Unlike the RBA that cut rates last month, the RBNZ has not reduced rates since January. If it does not move now, many participants may consider doubling up for a move in August when it meets again. 

China's new monthly cycle of economic data hits in, earnest in the week ahead. Four pieces of data tend to capture the investors' attention.  Reserves (as a proxy for capital flows), trade, inflation, and new lending.  The broad picture that is likely to emerge is one of little improvement, but little evidence that the world's second-biggest economy is collapsing under the weight of debt that the pessimists have predicted.

If the shifting expectations of Fed policy is one of the key drivers of the investment climate, then the decoupling from China is another important feature of what has transpired in recent months. Consider that over the past 100 sessions, the Shanghai Composite and the S&P 500 are correlated on a directional basis (value) 0.24.  In mid-February, that correlation stood near 0.80.  On a percentage change basis, the correlation is statistically non-existent at 0.02.  Last August is recorded a multi-year peak near 0.45. 

Investors also seem less sensitive to the yuan's movement.  Over the past year, the yuan has fallen in three phases.  The first two phases were disruptive to the capital markets.  Last August, in a couple of days, the dollar appreciated 3.8% against the yuan, and then in the November-thru-early-January, the dollar rose 4.5%.  The third phase, which lasted two months, and appears to have ended last week, saw the dollar appreciate by 2.2%.  

The dollar peaked near CNY6.59 in the middle of last week.  It was sold after the US jobs data, finishing the week, just below CNY6.55.  In a softer dollar environment, we expect the yuan to track the dollar as if Chinese officials are reluctant to give the US any advantage for devaluing.   In a stronger dollar environment, the yuan may track the basket. The dollar may ease into the CNY6.50-CNY6.52 band.  

We have argued that China's overcapacity in numerous industries is not simply a domestic problem, but is a threat to stability of the global economy.  Judging from comments from Treasury Secretary Lew, the US recognizes the increased saliency of this issue.   However, it will be up to the next Administration to go down this path.  The Obama Administration's last Strategic, and Economic Dialogue with China will be held in the week ahead.  It may mark a transition in the focus.  

The US Treasury, even before the Obama Administration, had placed much emphasis on the yuan's exchange rate. In part due to its own successes in encouraging Chinese officials to accept yuan appreciation, and in part due to policy divergence that underpins the dollar, the yuan's exchange rate is of less urgency.  Also, the PBOC has intervened on both sides of the market, and this weakens the oft-cited accusation that China is seeking wholesale depreciation of the yuan.    

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