Next week is the last full week of 2020. But before it can be bid good riddance, the Federal Reserve and the Bank of Japan hold policy meetings and a batch of high-frequency data, including the preliminary December PMI readings, which will give investors a better sense of the economic momentum going into next year.
Central banks and investors are wrestling with the same thing: a faltering recovery as the social restrictions disrupt economic activity, while at the same time cognizant that the medium-term prospects have improved as the vaccines begin rolling out. Moreover, if the near-term has become more sobering, enthusiasm for the post-Covid world in the second half of next year is, well, contagious. The reflation scenario featuring pent-up demand for leisure and recreation services, tourism, and business travel resumption seems to be dominating client conversations and investment strategies as the year winds down.
What can monetary policy, with the unpredictable and variable lags, do under such conditions? The Bank of Japan will likely extend some of its special crisis programs aimed at ensuring ample funds for markets and secure corporate financing. In the scale of easing, extending of current facilities from the end of March next year through September, or possibly December, is a modest step, and the modesty of the step may preclude reducing its bond purchases.
This seems especially true given Prime Minister Suga's fiscal stimulus (~JPY73.6 trillion or ~$710 bln). Both fiscal and monetary policy should continue to work together. The independence of the central bank is not at risk. After all, we are talking about an institution whose leadership has often come from former Ministry of Finance officials, including Governor Kuroda. In the US, Yellen, like Geithner before her, is going the other way (from the central bank to Treasury), though it is unusual (Volcker went from Treasury to the Fed).
Consider, for example, that both the Japanese government and the central bank share a common concern over the viability of so many regional banks. Previously, the BOJ offered regional banks a positive return of 10 bp on some of their reserves if they consolidated or cut costs. In his first budget, Suga offed some fiscal inducements to the same end, including subsidies for mergers, promotion of digitalization, and review of antitrust regulations.
The Federal Reserve operates in a different institutional setting. It is at odds with Treasury Secretary Mnuchin over the failure to extend several backstops. It is at odds with Congres over the need for additional fiscal support, which remains elusive despite months of talks and nearly everyone saying how nice it would be. At his last press conference, Chairman Powell sketched out the numerous dimensions in which monetary policy can be adjusted. However, now market discussions center around two: increasing its purchases or shifting the existing purchases toward the longer-end. The idea that the Fed may do either appears to have tempered the reflation pressure on the long-end of the curve with bearish steepeners kept in check.
Officials seem content with the pace of purchases ($80 bln of Treasuries and $40 bln of Agency MBS a month). Speculation in the market has focused on shifting the current buying further out, and the disappointing jobs report encouraged such expectations. The FOMC minutes suggested that the Fed would boost its guidance about the bond-buying "fairly soon." Reaffirming the existing pace and modalities would provide such guidance. The key may come down to one sentence in the statement:
"In addition, over coming months the Federal Reserve will increase its holdings of Treasury securities and agency mortgage-backed securities at least at the current pace to sustain smooth market functioning and help foster accommodative financial conditions, thereby supporting the flow of credit to households and businesses."
The Fed can choose to anchor its policy in terms of time or conditions. It often begins with the former and evolves toward the latter. Updating its forward guidance on its bond-buying could be as straightforward as attaching some economic conditions such as "until the FOMC judges the economy to be on a self-sustaining path toward the objectives of full employment and price stability." Powell will want to avoid a repeat of a taper tantrum but could work in tandem with new economic projections. Perhaps, the Bank of Canada statement last week points to a possible framing. It indicated that its purchases would continue until the recovery was well underway.
The prospects for the vaccine should make officials more confident that the medium-term risks are on the upside. And, if anything, the prospects for more fiscal support, maybe worth almost 5% of GDP, has increased. In September, the median Fed forecast for next year was lowered to 4% from 5% (June), while the unemployment projection was cut to 6.5% to 5.5%, and the PCE deflator forecast edged up to 1.7% from 1.6%. With capital markets performing normally, are those the macroeconomic conditions that warrant purchases of $120 bln a month in long-term assets?
Yet, the high-frequency data will provide more evidence of the other horn of the dilemma. The near-term risks are on the downside. October industrial output and retail sales are expected to have sequentially. Of course, that is what it means to say that the pace of growth will moderate from that 33.1% annualized clip in Q3. The Atlanta Fed's GDPNow suggesting 11.2% growth in Q4 is an outlier. The New York Fed's model, which typically is at the lower end of estimates, projects a 2.5% pace, and the St. Louis Fed's tracker has it at 4.56%. The median forecast of the Bloomberg survey puts sees it at 4%.
We have already learned of an unexpectedly large decline in US November auto sales. It was the second consecutive slowing of auto sales, and apart from the pandemic outbreak in the spring, it is the first back-to-back decline since January-February 2019. This could see headline retail sales post an outright decline as well. The November manufacturing PMI accelerated, but the ISM eased. Manufacturing hiring slowed for the second consecutive month. Industrial output and manufacturing likely slowed dramatically from the 1.1% and 1.0% October increase, respectively. A few hours before the FOMC meeting concludes on December 16, the preliminary December PMI will be published.
Europe sees its December flash PMI hours before the US, but with the ECB moves behind it, and ahead of the holidays, it may lose its oomph. Another sub-50 composite reading and the extension of social restrictions may solidify expectations that the eurozone economy is contracting by around 2.5% here in Q4. However, investors, looking forward, are more optimistic that the recovery will be on a more durable path next year. Moreover, the prospects for the 750-bln euro Recovery Fund have been brightened by the compromise struck with Poland and Hungary. In September, the ECB staff forecast 5% growth in 2021, which is a little above the median forecast in Bloomberg's survey (4.6%).
China's high-frequency data include November industrial output, retail sales, and fixed investment figures. The broad strokes are known. Both the official and Caixin November PMI reports surprised on the upside, and net exports were much stronger than expected (exports rose 21.1% year-over-year, up from 11.4% in October, while imports slowed to 4.5% year-over-year from 4.7%) resulting in a record trade surplus of over $75 bln.
Trade tensions between the US and China may enter a new phase, but they are not going away any time soon. The Trump Administration is putting a favorable spin on the Phase 1 trade deal, for which many other observers, including the Peterson Institute, China has not lived up to its commitments. The Trump Administration estimates that US agriculture and related sales to China were $18.8 bln through October compared with $17.9 bln in 2017, which is the baseline. Ultimately, it will be up to the Biden Administration to evaluate the first year of the Phase 1 agreement.
China's reserves jumped by $50.5 in November, the most since 2013. The dollar value of reserves stands at $3.178 bln, which is the highest in four years. Still, the increase in reserves pales compared to the combination of the current account surplus and the portfolio inflows (estimated at around $225 bln through Q3). Moreover, the jump in November reserves is not direct intervention but largely reflects valuation adjustments.
The question is, how is China absorbing those inflows generated by trade and investment. There are several offsets, including the relaxation of investment outflow controls (under the Qualified Domestic Institutional Investors) and companies retaining export proceeds. However, as has been the case for some time, large Chinese banks are running large short yuan positions and long foreign currency. Given that large trade and capital flows, the yuan's exchange rate is too stable, and most observers have long concluded that it is closely managed. In China, with extensive state-control and influence, it is difficult to draw a sharp line between public and private purposes. It may not be as simple as holding on to a depreciating currency. For example, dollars can be swapped into yen and secure a higher return sometimes than US Treasuries. There are many moving parts and levers, including the sovereign wealth fund, policy banks, and a growing catch-all category of "errors and commissions" that can conceal just about anything.
Still, China has managed an appreciating yuan this year. It has appreciated by nearly 6.5%, which recoups the bulk of depreciation in 2018 and 2019. The trade surplus shows the yuan competitive and the appreciating yuan is in line with salient macro fundamentals, like the external surplus, plump rate differentials, and an expanding economy. Assuming a broadly weak dollar environment in 2021 and that other countries in East Asia resist but accept further currency appreciation (e.g., Japan, South Korea, Taiwan), the Chinese yuan can appreciate another 5-6% in 2021 (putting the dollar in the CNY6.15-CNY6.20 area.
Disclaimer
Reviewed by Marc Chandler
on
December 12, 2020
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