After this Week, Does August Matter?

There are four events this week that will command the attention of global investors.  

1. The Reserve of Bank of Australia is first.  It is a close call, though the median in the Bloomberg survey favors a cut, including most of the banks in Australia that participate in the poll. 

The case for it is that price pressures are weakening, and credit growth is slowing.  The currency has begun appreciating again, and the Federal Reserve cannot be counted on to lift US rates until the end of the year, at the earliest.   

The argument against the RBA moving is that there is no urgency to exit the "watch and wait" mode.  A rate cut would not necessarily weaken the currency as Australia would still offer highest policy rate (after New Zealand) among the high income countries. It is also not clear that the record low interest rates are a constraint on credit growth. Better keep the powder dry and see how events evolve, though it can be fairly confident that New Zealand will cut interest rates later in August.  

2, Investors are more confident of the outcome of the Bank of England's meeting than the RBA meeting.  After the recent dismal survey readings, indicative prices suggest that a 25 bp rate cut is fully discounted.  A newswire survey found 95% of the sample anticipated a rate cut, and of those, 95% expect a 25 bp cut in the base rate. 

There are two other measures that the BOE is expected to consider.  A little more than 80% of those who expect the BOE to do more than cut rates expect the funding for lending scheme to be extended.  Participants are nearly evenly split on the prospects for a new round of asset purchases.   About half of those that expect a new round of QE expected it to be between GBP25 and GBP50 bln. Outside of that ranges the response were heavily in favor of a larger than a smaller Gilt buying program.  

Sterling eased to the lower end of a $1.30-$1.35 trading range as the market priced in the easing of monetary policy.  It may firm back toward the upper of the range as the soft US dollar environment we anticipate, coupled with "sell rumor, buy fact" type of activity.  In the futures market, speculators have a near record short gross sterling position and have a record net short position.  

3.  Japan's Prime Minister Abe seemingly hurriedly confirmed some details of his fiscal plan.   If he intended on cajoling the central bank into joining the fiscal stimulus with a large dose of monetary support, it was insufficient.    Abe is expected to provide more details of the fiscal package.  The cabinet will formally approve it, and it is not clear whether the cabinet will do so before of after it is reshuffled, and the sequence may not matter.  

Reports already indicate that the only about a quarter of the headline JPY28 trillion will be real fiscal spending.  The freshwater number may also include spending associated with a supplemental budget that Japan habitually announces.   Even a slimmed down estimate needs to be discounted because frequently all the earmarked spending goes unused.   At the end of the day, the large fiscal package is not so large really, and it may not provide as much stimulus as head figure of around 6% of GDP suggests.  

And even if there was greater real spending, it is not clear that it would change investors' views. At its best government spending would create a short-run demand shock, and even given a reasonable multiplier, one cannot be very optimistic.  The recent data shows domestic demand (overall household spending) and foreign demand (exports) are weak and falling.  

It is not as if this is priming the pump in the popular Keynesian image or that the Japanese economy has been starved of public investment as some European countries.  Japan has recorded an average budget deficit of 8.1% of GDP in the last six years.  The deficit has been below 8%of GDP for the last two years when it has averaged 7.2%.  This year's deficit was to come in below 6% before this latest round of stimulus, and the details will help economists and investors update their forecasts.  

Expanding the monetary base by JPY80 trillion a year (more than 15% of GDP) is not stimulating inflation expectations or actual inflation.  Running a significant and sustained budget deficit has been unable to push the world's third largest economy onto a self-reinforcing growth path. Observers may differ on precisely what Japan should do, but many appear to be growing increasingly convinced that it is not a question of a marginal tweak.  

Although Abenomics is usually associated with the three arrows of fiscal and monetary stimulus and structural reforms, there was a fourth component.  Pension funds, including the government's gigantic GPIF, diversified overseas and with apparently low hedge ratios...initially. Some suggest that it was these outflows that helped drive the yen's decline.  Reports now suggest that since that hedge ratios are being increased, and that this is one of the important drivers of the appreciating yen.   It may be a bit of a vicious cycle.  As the yen appreciates, pressure mounts on Japanese global investors to buy yen as a hedge, driving it higher, requiring more hedging.  

4.  The US July employment report caps the week.  Economists do not expect a repeat of June's 287k jump, not that they had expected either.  The median guesstimate is for an increase of around 175k, which is above the three and six-month averages (147k and 172k respectively).  The unemployment rate may tick down to 4.8%.  Average hourly earnings need to increase by 0.2% to maintain the 2.6% year-over-year pace.  

In the aftermath of the disappointing Q2 GDP estimate, we suspect the markets will have an asymmetrical response to US data.  The markets are more likely to respond to negative surprises than positive surprises.  For all practical purposes, no matter how strong the data surprises could be would sufficient to get the market to believe a hike in September is anything but an extremely small tail risk.   On the other hand, disappointing data could prompt more investors to give up on a hike at all this year.  

That said, our impression is that the low Q2 GDP was more teeth-gnashing for investors than the Federal Reserve.  Past comments by Yellen suggests a focus on GDP excluding inventories and exports.  Consumption, which was identified in June as a concern, rose at 4.2% annualized pace in Q2 after a 1.5% clip in Q1.  Consumption added 2.8 percentage points to GDP.  The other components of GDP, (government spending, business investment, and net exports) subtracted 1.6 percentage points from GDP.  The result was 1.1% GDP, adjusted for rounding.  

Inventories are not a large part of GDP, but they are volatile, and seemingly a challenge to forecast accurately.  The introduction and dispersion of better inventory management (e.g., just-in-time inventories, register-to-inventory interface) apparently has not ended the inventory cycle's role of driving the larger business cycle.   The three-quarter drawdown in inventories is probably the single most important factor behind the nine-month streak of growth below 2% (for the first time four years).   

The rundown in inventories, however, is expected to lead to greater output, especially if demand holds up.   A increase in July auto sales (17.2 mln annualized pace vs. 16.61 mln in June) points to a solid start for Q3.  It should not be surprising if economists shift some of the growth they had anticipated for Q2 into the second half.   

In many ways, it seems that the August cake is already baked.  The BOJ and ECB have signaled reviews in September.   The September FOMC meeting is late in the month, which arguably makes the July high frequency data less significant, and in any event, is unlikely to boost expectations for a September hike.  

Yellen's presentation at the Jackson Hole confab at the end of the August may be more important than the data per se.  Advance reports should make the first estimate of GDP more accurate, and time will tell, but for the time being it, investors need to keep in mind that it is often subject to statistically significant revisions.  The first revision is due August 26.   

The European Bank stress tests results were announced after the North American markets closed for the week.  The only bank whose capital would be wiped out was Monte Paschi, who hours before announced a new plan, approved by the ECB.  It made the stress test result immaterial.  Only one other bank that tested, Allied Irish, had a "fully loaded capital ratio" of less 5.5%, which is regarded as an important threshold.     

Several banks will likely raise capital, but officials will find solace in that large banks appear more resilient to economic stress.  Perhaps more of more immediate concern to investors is not the stress situation as much as the continued grind of the status quo.  Negative interest rates, weak growth in lending to businesses and households, and a new regulatory environment that is exerting pressure to de-lever creates formidable challenges.  Capital gains, for some investors, may blunt the sting of negative interest rates, but this is not the purpose of fixed income investment for many.  

The euro trended lower from early May through the UK referendum on June 23, dropping seven cents to roughly $1.0915.  Speculators in the futures market accumulated a large gross and net short euro position.   We suspect that a correction has begun that may carry the euro toward $1.1350-$1.1400 in the coming weeks. 

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