Who's the Driest Towel Now?

Imagine that when the year began, the US economy was hit with a sharp tightening in financial conditions and a sharp drop in the stock market.  The government was in a partial shutdown, and the winter was bitter.  It looked to many, including ourselves that the economy was stagnating.  Indeed it was, but the high-frequency data, on balance showed improvement.  Nevertheless, the 3.2% preliminary Q1 GDP blew away the formal and sophisticated models economists use and more elementary approaches like ours. 

It has become nearly a sport to point to the poor economic forecasts of the IMF, central banks, and other officials but the private sector also struggles.  In addition to the US GDP, economists as a whole missed big on two other forecasts in recent days.  The South Korean economy, a regional bellwether, contracted by 0.3% in Q1 instead of the 0.3% expansion of the median forecast in the Bloomberg survey.  Japan's March industrial output was expected to be flat in March after a 0.7% gain in February.  It fell by 0.9%. 

In fairness, the US Q1 growth overstates the health of the economy, but the contrast is stark.  The inventory accumulation in a very literal way borrows production (growth) from the future.  Consumption, which drives the economic growth was half the Q4 pace (1.2% vs. 2.5%).  The increase in infrastructure spending by state and local governments offset in full the measured cost of the federal government shutdown.  Business investment in structures fell for the third consecutive quarter, while the 0.2% increase in equipment spending was the weakest since 2016. 

The first reading of a quarterly GDP estimate in the US is subject to statistically significant revisions.  This is doubly true with this report as government's closure leaves the official economists with an information set that is more incomplete than usual. 

Nevertheless, the US economy has shown itself to be fairly resilient. The April employment figures will be released at the end of next week.  The six and 12-month average rise in non-farm payrolls is about 200k.  The three-month average of 169k is the lowest since late 2017, but it is a reflection of the freakish 33k increase in February.  A 0.3% increase in hourly earnings, which many economists project, would lift the year-over-year pace to 3.3%, where it has averaged for the past six months. 

Watch manufacturing jobs.  March saw the first drop (-6k) since July 2017, and although the consensus forecast in the Bloomberg survey is for a 15k increase, the risk may be on the downside.  With the dollar at new highs, the translation impact of foreign earnings of US multinationals will become a greater concern.  Given President Trump's willingness to use his bully pulpit to try talk about the dollar and Fed policies, attempts at verbal intervention cannot be ruled out. 

April auto sales will be reported May 1.  The March gain (from 16.56 mln units to 17.50 mln) foretold the increase the surge in retail sales that has sparked this leg up in the US dollar (along with the disappointing flash EMU PMI).  Fleet sales rather than household purchases seemed to have been the driver of the March increase, and auto sales are expected to have slowed to about 17.0 mln, which is roughly the 3- (16.9 mln), 6-(17.18 mln), and 12-month (17.08 mln) average.  The slower buying of light trucks weighed on consumption in the Q1 GDP report.  Auto inventories are relatively high.

In the busy week, the FOMC is the highlight, but there is not much for it to say.  Monetary policy acts with a lag, and despite the widespread claim that the hike in December was a mistake, above-trend growth continues unabated.  The Fed' will likely recognize the resilience of the economy while acknowledging the moderation in consumption, housing, and business investment. 

The biggest doubters of Fed policy comes from those who are anticipating a rate cut.  The January 2020 fed funds futures contract implies a 2.18%.  Recently, the effective Fed funds rate has been averaging 2.44%, indicating expectations of a 25 bp cut been fully discounted.  If the Fed were to lean against those expectations, it would have to begin downgrading the cross-currents and, most importantly, upgrade how it talks about inflation.  In earnings calls, several consumer goods companies (e.g., Kimberly-Clark, Whirlpool, P&G, Coca-Cola,) already raised prices or planned to do so.  Higher oil prices will lift headline CPI and PCE.

At the same time, there is a technical problem that could be mistaken for a policy problem.  Here is the issue:  the interest rate on reserves (both required, and excess are paid the same interest, IOER, interest on excess reserves, is often the conventional way to talk about it) should be the cap on short-term rates.  Since March 20-21, the effective average fed funds rate has consistently, excluding quarter end, traded, above the interest on excess reserves (2.40%).  It has pushed higher recently to 2.44%.  The secured-overnight funding rate finished last week at 2.45%.

The Fed funds market is relatively small and lightly traded.  It seems that a significant participant, a government agency itself (Federal Loan Home Banks) had less funds to lend.  It cannot deposit with the Federal Reserve and typically is an important supplier of fed funds.  A policy adjustment could entail reducing the interest paid on reserves.  To do so is tricky.  In H2 18, it lifted the interest on reserves a little less than the fed funds target, introducing a 10-bp spread between it and the upper end of the fed funds corridor.

If it were to cut the interest it pays, the market would interpret it as an easing, even if it left the fed funds rate target alone.  Messaging would be difficult, and there is no guarantee of success. As policy normalized, the effective average fed funds rate has consistently with a firm bias for a couple of years.  Fed officials seem to recognize this, and instead cut the interest on reserves, it seems more likely to introduce a new tool, what the minutes from last year called a ceiling facility (repo) or accept having to conduct "frequent sizeable" open market operations.

Even with all of its wrinkles and warts, the US economy's divergence from Europe is stark.  The eurozone, where many markets are closed for May Day, will report preliminary April CPI figures and the first estimate of Q1 GDP in the week ahead.

The median forecast in the Bloomberg survey calls for eurozone growth to have accelerated in Q1 to 0.3% after a 0.2% pace in Q4 18 and 0.1% in Q3 18, even though the composite PMI (3-month average) fell from 54.3 in Q3 18 to 51.5 in Q1 19.  It seems that it is a prima facie case for downside risks.  France, Spain, and Italy report national figures the same day (April 30) as the aggregate estimate is made.  Germany does not report until mid-May. 

Headline CPI is expected to have edged up to 1.5% from 1.4%. The core rate may have risen to 1.0% from 0.8%.   Some underlying measures of inflation have been firmer than the much follow metrics, but the increase is not sufficient to change the judgment that progress toward the target is too slow.  A new targeted long-term refinancing operation is still very much in the cards.    

The extension of Brexit until the end of October prolongs this headwind.  The UK's economy is playing second fiddle to Brexit and has little resistance to offer when the US dollar is bid.  For many Tories, May is too soft, but for a majority of parliament, she seems too hard about Brexit.  A compromise that would move the ball forward would be for May to accept a customs union, but it could very well force a fissure in the Tory Party, which may already be evident in the EU Parliament elections that the UK is most likely to participate. Conservative voters who still want a more complete break may abandon the Tories for Farage's new Brexit Party. 

Local elections will be held on May 2.   There are many moving pieces and conflicting considerations.  The outcome, though, will likely be perceived through the conceptual framework dominated by Brexit.  A particularly poor showing for the Tories will be laid at May's feet by a party led by some that reportedly considered changing the rules to force her out, all in the good name of defending democratic principles and the referendum results.   

The Bank of England meets in the long shadow of Brexit.  It will not do anything, but it will take a bit and present new forecasts in its Quarterly Inflation Review.  The UK economy appears to have also been resilient in Q1.  It does not report its quarterly GDP estimate until May 10, but the January-February pace is the best two-month average of monthly estimate since January 2017.   Recent CBI surveys show businesses building inventory (stockpiling), while retail sales surged by a monthly average of 0.9% in Q1 19, matching the Q2 18 high, which itself was the strongest pace April 2015. 

Japan's markets are closed for the next ten days, and this will impact liquidity conditions, leaving the market vulnerable to flash crashes, people fear.  The dreadful Japanese industrial output data underscored the likelihood that the Japanese economy contracted in Q1.  China announced an extended May Day holiday.  Before it is celebrated, the official April PMIs will be reported.  Small increases would appear to be consistent with the official narrative.  The Caixin manufacturing PMI will be published on May 1, and it is also expected to edge higher (and remain above the official measure). 

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