Macro as July Winds Down

After a lull in important economic data and major central bank meetings, the calendar picks up next week.  The highlights include the US and EMU's first estimate of Q2 GDP, the FOMC meeting, and China's July PMI.

Investors may be informed by these developments, but they are unlikely to change the investment climate, which is still anchored by the policy response to the pandemic.  Of course, the virus itself is part of that context, and the US, Australia, and Hong Kong reporting record cases.  Some super-high frequency data does suggest some moderation in economic activity may be taking place like daily economic activity indices.  At the same time, there is some optimism about the progress of several vaccines.

Correlations in the foreign exchange market are notoriously unstable, but we experience phases.  For example, the rolling 60-day correlation on the return (percentage change) of the S&P 500 and the Dollar Index was positive from early August last year through the middle of June this year.  It is now negative and by the most in four-years.

This space has argued for about a year that the third large dollar rally since the end of Bretton Woods is over.  The pandemic gave it one more boost, and now it has fallen out of favor.  Indeed, it seems to be a strong consensus view, and the increase in the number of articles warning of a dollar crisis, the end of the dollar's role in the world economy is part of that cyclical development.  The historian Harold James titled his piece on Project Syndicate, "Late Soviet America," that foretells the end of what he called "dollar hegemony."

While we expect a cyclical decline in the dollar, we don't anticipate that the dollar's role in the world economy, as the numeraire is going to change anytime soon.  The primary reason is that there is no compelling alternative to the depth and breadth of the US Treasury market.  The EU's Recovery Plan entails the issuance of a collective bond.  While  ECB President Lagarde has recognized this a critical step to increase the internationalization of the euro, a one-off issue of long-term bonds may be helpful, and it may offer opportunities for investors.  However, for central banks, the market needs both depth and breadth, and not just now in the short-run, but for the long-term.  The lack of a common bill market may also limit the euro's ability to gain a significant market share from the dollar.

In the US, June durable goods orders and the trade figures due out early next week will help economists fine-tune their forecasts for Q2 GDP, where the first estimate will be published on July 30.  The median forecast in the Bloomberg survey was for a 34% annualized contraction, which is close to the Atlanta and St. Louis Fed GDP trackers (34.7% and 31.28%, respectively).  The NY Fed's model has the low bid at a 14.3% decline.

The data, of course, is old news and is unlikely to have much impact aside from headline risk.  The stalled re-openings and reversals are dampening what could have been a more be a robust rebound, as the economy continues to recover.  The New York Fed's GDP tracker projects 13.2% growth here in Q3, while the market (Bloomberg survey) is a near 18.5%.  Presently, the risk looks on the downside rather than the upside.

The GDP report, although subject to statistically significant revisions, renders most of the remaining data for June, including the personal income and consumption figures moot.  It is interesting to note, though, in passing that most of the run-up in savings, which earned so many columns of commentary, was not voluntary. June is likely to have seen another jump in consumer expenditures, a much broader measure than retail sales, and June retails sales surprised on the upside, and May was revised higher.  Personal income may have fallen for the second month.

It doesn't really matter that FOMC meets before the GDP release.  The central bank is forward-looking, and the precise magnitude of the contraction is not really material.  The pandemic and economic shutdown wreaked havoc that will take at least a couple of years to heal.  A good part of the economy, including around a quarter of the workforce, is still getting assistance.  Despite cries that the central bank is bailing out business and allowing "zombie" companies to survive, companies are defaulting at the fastest rate in a decade.   Several Fed officials have expressed concern that although the economy appeared to bounce in May and June, the momentum may be faltering.

The FOMC meeting will likely be about laying the groundwork for a move at the next meeting in September.  There are two moves the Fed may make.  First, a consensus appears to be forming in favor of average inflation target.  This is really part of the forward guidance and signals that it will not raise rates simply because the economy is on track for the PCE deflator to reach the 2% target.  The Fed would be indicating the willingness to tolerate somewhat higher inflation.  Second, officials are still working through the issues, but they appear to be edging toward yield curve control, where a medium-term rate along with the Fed Funds rate would be targeted.   The 3-5 year yields are near-record lows, but a pre-announced cap would also signal its commitment to low-interest rates for some time.  By fixing the yield, the Fed would commit itself to buy as many notes (bonds) as necessary, theoretically open-ended.

There is something else the Fed can do, though few are talking about it.  The Fed can step up its purchases of government bonds.  Back in March, when it was buying $75 bln of Treasuries a day, the purpose was to stabilize the market.  The focus now has shifted to supporting the economy, and yet its balance sheet peaked a month ago. There continues to be a slow take-up of many of the facilities that were launched.

The eurozone reports both the preliminary July CPI and the first look at Q2 GDP.  They are both released at the same time on July 31, the day after the US GDP report.  Economists look for around a 0.5% decline in the headline CPI in July, matching the decline in July 2019.  If so, this would keep the year-over-year rate at a lowly 0.3%  pace.  The core rate has fared a bit better, but it may slip to 0.7% from 0.8% in June.  The disinflation forces remain powerful, and the euro's 3%+ appreciation against the dollar here in July blunts the roughly 6% rise in Brent. 

Talk after the recent ECB meeting that the full Pandemic Emergency Purchase Program funds may not be used is a distraction.  In fact, the odds might favor the opposite scenario, namely that the program gets increased and extended.  At the current pace of buying, the funds will run out around the middle of Q1.  The ECB did not only specify the size of the program, but also its duration.  It was extended to the middle of next year.  It seems probable that the ECB will again lengthen PEPP, perhaps toward the end of the year.

The eurozone economy contracted by 3.6% in the first three months of the year, and it looks like something on the magnitude of 10%-11% in Q2.  It would mean that output is around 13%-14% below a year ago.  The third quarter is off to a considerably better start. At 54.8, the preliminary July is at its highest level since mid-2018.  There was some weakness below the surface in employment and order backlog that will need to be monitored.  

China's data seems nearly universally eyed with suspicion that it is politicized.  Nevertheless, efforts from others to triangulate it find that the official estimates are probably not far off.  Most acknowledge that the world's second-largest economy has turned the corner.  Growth in Q2 was estimated at 11.5% (quarter-over-quarter), leaving H1 output down 1.6% from a year ago.  

The PMI at the end of next week will be the first data for July and Q3.  The composite PMI stood at a heady 54.2 in June, the highest in two years.  This may overstate the case a bit, and investors ought not to be surprised if the momentum slows.  The non-manufacturing PMI is likely to hold up better than the manufacturing PMI, which is more sensitive to the external sector.  

Despite concerns that China may weaponize the yuan, this does not appear to be the case.  From the end of May through late last week, the dollar fell almost 3% against the yuan.  Still, the takeaway is the stability of the yuan against the dollar.  In Q1, it fell by about 1.7% against the dollar, and in Q2, it rose by 0.25%.  So far in July, the yuan has edged up by about 0.8%, leaving it off about 0.65% for the year.   Chinese officials do not want the US to get an edge on it by pushing the dollar down, which has been part of US President Trump's rhetoric.  However, the nominal stability of the yuan-dollar exchange rate, in a weak dollar environment, suggests the yuan will likely depreciate against China's other trading partners.  

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