Three events stand out next week. The preliminary PMI readings for many high-income countries and the policy meetings of the Federal Reserve and the Bank of Canada. The geopolitical backdrop remains elevated over the build-up of Russian troops and armament seemingly poised to invade Ukraine. No new talks between Russia and the US are scheduled (yet?). Meanwhile, the surge in Covid cases appears to be slowing in some parts of Europe and the US, while Japan imposed quasi-emergency rules in Tokyo and thirteen prefectures until mid-February. China appears to be stepping up its zero-Covid efforts as the Olympics approach.
The collapse
of December US retail sales (-1.9%) and the unexpected drop in industrial
output gives the world's largest economy little momentum. Indications
last week showed the New Year is off to a poor start. The January
Empire State manufacturing survey crashed to -0.7 from almost 32 in
December. Economists understood that activity slowed. The median forecast
was for 25.0 in the Bloomberg survey, warning the slowdown may be much sharper
than economists have understood. The evaporation of new orders (-5.0 vs. 27.1
in December) is particularly troublesome. While the January Philadelphia Fed survey appeared better, the details were disappointing.
The slowdown
also appears to be taking place in the eurozone. The
German stats office warned that the economy contracted between 0.5% and 1.0% in
Q4 21. Market rates are rising. The German 2-year yield rose by around 20 bp since end of last November to reach its highest level since April 2019 (~-0.55%), before falling in second half of last week. The 10-year yield briefly turned positive for the
first time since May 2019. The ZEW January survey found that the
assessment of the current situation fell to -10.2, the lowest since last May,
and worse than economists projected.
The
preliminary January PMIs will be reported and weakness should be expected. However,
this is not new. The eurozone composite PMI was at 53.3, the lowest since
March. It fell in four of the past five months. The trend in the UK
has been similar. The composite PMI has fallen in five of the past seven
months, and at 53.6 is the weakest since last February.
The US
composite PMI has held in better. At 57.0 in December, it was the
lowest since September. But there here too the recent trend has been
clear. December was the sixth month of slowing in the last seven months
of 2021.
Japan marching
to the beat of a different drummer. It recovered from the
long Covid slump in September, though recall that it was below the 50 boom/bust
level in Q4 19. The composite PMI rose above 50 last October, though
pulled back slightly in December. The conditions that are leading to the
imposition of new restrictions may weigh on the PMI.
Because of its
July-September flare up of Covid, Australia's composite PMI profile looks a bit
like Japan's with a recovery before softening in December. The
composite spent Q3 below 50. It bottomed in August at 43.3 and improved
to 55.7 in November before easing back to 54.9 in at the end of the year.
Lockdowns may weigh activity.
More notable
are the Bank of Canada and Federal Reserve meetings. The Bank
of Canada meeting concludes early in the North American session on January
26 and the FOMC meeting ends later the same day. Rather than
re-hash how we got here, let's simply recognize both central banks are about to
initiate a sequence of rate hikes. The markets have been pricing in an
aggressive move in the months ahead.
The overnight
index swaps (OIS) curve has about 160 bp of tightening priced in for the Bank
of Canada this year and another 30 bp in 2023. In
effect, compared with the end of last year, the market has moved to discount another
rate hike this year. The two-yield has jump 30 basis points in the
first three weeks of the year. At the end of 2021, the market leaned
slightly in favor of a January rate hike (~55%). Now it is a little above 70%.
The
Bank of Canada ended its bond buying last October. In
addition to hiking rates, the Bank of Canada may also provide some forward
guidance about its balance sheet strategy. Most aggressive would be to
stop the recycling maturing proceeds almost immediately, say next month.
However, more likely, officials would give investors more notification. The
following meeting is March 2. The point is that like the Bank of England and
Federal Reserve, the Bank of Canada will likely allow its balance sheet to unwind considerably earlier than after the Great Financial Crisis.
Even though
most of the real sector data softened in December, the market's reaction
function to the FOMC minutes and official comments is to price in a more
aggressive trajectory of Fed policy. Consider that on New Year's
Eve, the futures market was pricing in about a 63% chance a 25 bp lift-off hike
in March and nearly three hikes this year. Now the market is pricing in about
fully pricing in the March hike and a small chance of a 50 bp
move. Moreover, the market is 100% confident of four hikes this year. At its peak, before the equities swooned, the Fed funds futures had about a one-in-three chance of a fifth hike priced. The swaps market has 102 bp of
tightening discounted for this year and around 50 bp next year.
In his
confirmation hearings, Fed Chair Powell suggested that the officials have begun
discussing its balance sheet strategy. It may take two-four meetings
to reach an agreement. This would also the Fed's balance sheet to begin
unwinding late Q2 or Q3. Indeed, many watchers seemed split between June
and July. When the balance sheet begins to unwind is one issue, the pace
is another. Last time, it began at a $10 bln pace a month and a year
later lifted it to $50 bln a month. Atlanta Fed’s Bostic has suggested he
favors a reducing the balance sheet by $100 bln a month.
Also, unlike
the previous episode, Fed officials seem to be talking about unwinding the
balance sheet to complement or even supplant rate hikes. The
December FOMC minutes said that "some participants" argued that
tightening more from the balance sheet than rate hikes "could help limit
yield curve flattening." Price pressures were considerably stronger
now than they were in the 2017-2018 period.
There is still
a great deal of uncertainty over quantitative easing and its opposite.
Bernanke once quipped to much amusement that QE works in practice but not in
theory. While most discussions are around quantities and prices, we find
that the signaling channel is often under-appreciated. Consider
Japan. It has reduced its asset purchases quietly and indicated there
were no implications for monetary policy, which would remain highly accommodative.
Sure enough, the market reaction has been muted. The ECB has also
fluctuated its purchases of sovereign bonds but appears to be little
perceptible market impact.
Finally, we
note that the day after the FOMC meeting concludes, the US will announce its
first estimate of Q4 GDP. The advanced merchandise trade
balance the day of the FOMC meeting give economists fodder for last minute
adjustments. Unfortunately, personal consumption expenditures (PCE), a
key input for GDP comes out at the end of the week. However, the 1.9%
drop in December retail sales has already pressured forecasts lower for PCE.
The median forecast (Bloomberg) is for a 0.4% contraction. The Bloomberg median forecast for Q4 GDP has slipped in recently from 6% to 5.3%. The Atlanta Fed's GDP tracker has fallen to 5.1% from 7.3% late last
year.
With inflation
top of mind, the PCE deflator will attract attention. It may have
stabilized in December. It may not be the peak, but it is close. The 0.3%
rise in the headline rate in January and February 2020 (0.2% and 0.1% in the
core rate, respectively) may make for easy comparisons. One implication is that
in the near-term the core may converge with the headline rather than the other
way around. However, the year-over-year of inflation may begin slowing
later in Q1 or Q2. Polls find that inflation is held against Biden
and helps explain why the Democrats are still projected to lose both houses of
Congress in November.
Politics is always bubbling near the surface of the foreign exchange market. The focus next week is on Italian presidential selection process. One possible scenario that may be best received by the market would entail the current president (Mattarella) agreeing to stay a little longer, as a caretaker like Napolitano did in 2013. This would allow Draghi to lead his coalition government until the end of the legislative session next year. It would provide a steady hand at what is arguably an inflection point. Italian bonds would likely rally on such a development and it could lend the euro support. Meanwhile, in the UK, Gray's internal investigation of the government parties during social restrictions is expected. It may not reveal a smoking gun, but it may do little to bolster the Prime Minister's support, while other reports talk about a handful of Tory MPs considering defecting to Labour. One increasingly gets the sense that Johnson is fighting for his political life.
Disclaimer
Reviewed by Marc Chandler
on
January 22, 2022
Rating:
