Real Sector Data and Prices in the Week Ahead

The focus shifts in the week ahead away from central banks directly and toward the macro data at the start of the year.  It is about real sector data and prices.  However, the US warned late Friday that Russia will invade Ukraine as early as next week. Reports suggested Putin made the decision and told his top aides.  Russia of course denied it.  Indeed, Putin may score a victory of sorts by not invading and making the Americans look like they are crying wolf (again).  

The knee-jerk reaction in the markets seen on the US warning is understandable even if exaggerated.  The markets did not respond nearly as dramatically in 2008 when Russia invaded Georgia or in 2014 when Moscow sponsored and fomented a separatist effort in Ukraine and annexed Crimea. However, in case of the failure of the enhanced deterrent efforts, anything may be possible. And not just in the European theater but other actors thinking there is a significant distraction that they may pursue their own agenda. Moreover, Putin's full agenda may not be known immediately.  Some strategists think that if Russian forces invade, they may stop at the Dnieper River. 

The market seems to fear a disruption in the energy prices.  March WTI rallied almost 3.6% ahead of the weekend, which saw it recoup the week's losses and make new multiyear highs near $94.65.  It was the eighth consecutive weekly advance.  US natural gas prices rallied but the March contract still slipped lower ahead of the weekend.  European gas prices may be a different story.  

Some grain prices also rallied in fears of loss of supply.   May wheat futures jumped 3.25% before the weekend, the largest increase in nearly a month.  Around 22% of Russia's arable land (which is only around 7%-8% of Russia land) is used to grow wheat.  

Until the pre-weekend drama, the key development was aggressiveness that the market was pricing in central bank action.   The swaps market is pricing in almost 70 bp of ECB tightening over the next 12 months, with the Fed going 170 bp, after last week's CPI print.  The violent adjustment to the outlook for the European Central Bank and the Federal Reserve may be nearly over.   St. Louis Fed's Bullard, the leading hawk, who called for 100 bp of hikes by here in H1 (three FOMC meetings) will appear on CNBC around 8:30 am ET Monday.  Given the market's reaction to his earlier comments, some expect him to tone it down, though his comments seemed pretty clear.  The FOMC minutes from last month's meeting will be scrutinized for insight in how the Fed was thinking about the maximum flexibility they have achieved.  

The Board of Governors meets in a regularly scheduled meeting on Monday.  Among the issue the Board of Governors may discuss is the discount rate.   It is not really a discount but a penalty rate for not being able to go to the market for funds.  It is ostensibly the cap on the short-term rates and is set now at 25 bp.  It seems a possible lever for the Fed to pull considering the sharp market reaction to the CPI.  The University of Michigan's consumer survey of long-term inflation expectations remained at the cyclical high of 3.1%, while the shorter-term (one-year) ticked up to 5.0%, a new high after bouncing between 4.8% and 4.9% in the last four months of 2021.  One way to signal its intent and at a low cost is to hike the discount rate.  It would have to be requested by a regional Fed branch, but it is not a stretch to see someone like Bullard doing so.  

While an aggressive path of monetary tightening has been discounted, there is another dimension to the normalization process in this cycle: the central banks' balance sheets.  The March ECB meeting will lay out new thinking about the Asset Purchases Program that was intended to double to 40 bln euros a month in Q2 after the Pandemic Emergency Program ends next month. The Bank of England's balance sheet will begin shrinking next month.  

The details have yet to be announced, but the Federal Reserve and the Bank of Canada are expected to begin allowing their balance sheets to unwind passively by not fully recycling maturing proceeds.  One US-based bank estimates that in the 12-month period starting in May, "G4" central bank balance sheets will be reduced by around $2 trillion.  This is about four-times more than the largest 12-month decline recorded in the 2018-2019 period.  To defend its Yield-Curve Control cap for the 10-year bond, the BOJ has pre-announced its willingness on Monday to purchase an unlimited amount of bonds at the 0.25% ceiling. 

Fiscal policy will also be less accommodative.  According to OECD figures, the US and UK budget deficits are likely to fall by 3.6-3.7 percentage points.  It has the-aggregate EMU deficit falling by almost 4 percentage points.  Most dramatic is the reduction in Canada's fiscal shortfall.  The OECD projects the deficit falling to 1.6% of GDP from 13.1% in 2021.  The market is a little less sanguine, and according to the median forecast in Bloomberg's survey, the deficit may fall to 2.7% of GDP, which would still a marked development.  Japan stands out as an exception here too.  The OECD has Japan's budget deficit edging higher this year to 6.9% from 6.4%. 

II

The US real sector data in the week ahead includes January retail sales and industrial production.  The key take away is that a recovery from a weak December is likely.  We already know that auto sales jumped back, well more than expected.  The 15.04 mln unit seasonally adjusted annual pace represented a nearly 21% increase from December.  The median forecast (median Bloomberg survey) was for about a 4.5% increase.  It was the most vehicle sales in seven months, but it was still about 10% lower than a January 2021 and was the weakest January since 2014.  

While auto sales (and higher gasoline prices) may have flattered the headline retail sales (median forecast in Bloomberg survey 1.7% after -1.9% in December) the details may look poor.  Given the unprecedented pandemic, seasonal adjustments, like with the employment data, may add an extra layer of distortion.  Excluding auto and gasoline, the rise in retail sales may be a third of the headline.  The core measure that also excludes food services and building materials group may be rising an uninspiring 0.4% after plummeting 3.1% in December.  Retail sales account for about 40% of the household consumption (PCE) and underrepresents services.  

January industrial output figures are released on February 16.  It rose by an average of 0.6% in Q4 21, its best quarter of last year, even after slipping by 0.1% in December.  It is expected to have risen by 0.4% in January.  The extractive industries and utilities likely pulled their weight.  Manufacturing output is expected to have risen by 0.2% after declining by 0.3% in December.  Despite what may be an uninspiring report, the capacity utilization rate is expected to make new Covid-era highs near 76.8%.  In January 2021, it was slightly below 75%.  At the end of 2019, the capacity utilization rate was trending lower after peaking in 2018 above 79.5%.  

Recall that while headline growth in Q4 was an impressive 6.9% annualized, trade and inventories accounted for nearly three quarters of the growth.  Final sales to domestic purchases rose 1.9% after 1.3% in Q3.  Production and imports replenished inventories.  A jump in business inventories (~.15% in December after 1.3% in November) will confirm that Q4 22 likely set the record for re-stocking.  It may not be such an important tailwind going forward.  Elsewhere, the weather and virus may have weighed on housing starts.  January may have experienced the first decline since September.  New home sales are expected to have fallen for the second consecutive month.  

At the risk of burying the lead, the year-over-year measure of producer prices likely fell for the second consecutive month in January.   The key factor is the base effect.  In January 2021, headline PPI rose by 1.2%.  This will drop out of the year-over-year comparison and is expected to be replaced by a 0.5% gain.  This is still elevated, but less so.  If accurate, the year-over-year rate will fall to around 9%.  It peaked last November at 9.8%.  The core rate, which excludes food and energy may have risen by around 0.4% last month, which would allow the headline rate to push back toward 7.8% after peaking in December at 8.3%.  

 III

Several other major countries report January inflation figures in the days ahead.  China's January CPI is expected to have fallen for a second month, to 1.0% from 1.5%.  A low print feeds ideas that the PBOC has scope to ease policy.   China's producer prices are likely to have fallen for the third consecutive month in January.  Talk about how China's producer prices drive US CPI always seemed overblown to us, but it has quieted down in any event.   

Japan's headline CPI is likely to accelerate but it is mostly due to food and energy prices.  Later, in April, when the reductions in mobile phone fees drop out, underlying measures will rise too, but Japanese officials cannot be confident that deflation has truly been arrested.  Consider that early on February 15 in Tokyo, the preliminary estimate for Q4 GDP will include the deflator, which is expected to be negative for the fourth consecutive quarter.  But more than that, after -0.1% in Q1 21, and -1.1% in Q2, it fell to -1.2% in Q3 and is forecast (Bloomberg survey median) to -1.3% in Q4, the most since 2011.  While the Japanese economy returned to growth in Q4 21 after the Covid-related contraction in Q3, the risk is that the economy contracts again here in Q1 22.  

In terms of impact on monetary policy, January CPI readings from Canada and the UK are unlikely to be significant.  The market is pricing in a little more than a 40% chance that each hikes by 50 bp, which is slightly more than what the Fed Funds futures strip implies for FOMC.  After rising every month in H2 21, Canada's CPI on a year-over-year basis may ease from the 4.8% pace at the end of last year.  In January 2021, CPI rose by 0.6%.  In the year-over-year measure, it is likely to be replaced by a lower number.  Last year, there were only three months that saw a larger than a 0.5% increase.  The underlying measures averaged 2.9% in December, which is up from 2.7% in September. 

The UK is a different kettle of fish.  In January 2021, UK consumer prices fell by 0.2%.  Price rose by an average an average of 0.6% in H2 21. There is a large seasonality component to UK prices.  The monthly change in January has been less than December since at least 2000.  In December 2021, CPI rose by 0.5%.  The seasonal pattern is even stronger.  Consider that since at least 1995, there has been only one year that UK consumer prices rose in the month of January (2011, +0.1%).   The eurozone has a similar pattern of lower prices in January.  Rising energy prices broke the pattern on the continent, and it could have done so in the UK as well.  

There are two other measures of UK prices out next week.  First is the earnings data in the labor market report.  BOE Governor Bailey asked workers to show restraint in seeking wage increases when he spoke after the BOE meeting.  Some suggested that it may be at odds with the government's desire for strong wage economy.  However, despite the instability of the relationship between the labor market and inflation, when you push many central bankers, you get some version of the Philipps Curve.   The ECB's Chief Economist Lane recently said he saw wages as central to the inflation outlook, but at least he allowed for productivity gains.  If higher energy prices are driving headline inflation, it is not clear how this a wage-push story.  If the lack of chips and other supply chain disruptions are lifting prices, the role of labor is not obvious.  If businesses were simply passing on higher input costs, corporate earnings would not have accelerated.  

Still, we must take the reaction function of the BOE seriously, and an increase in average weekly earnings.  The swaps market is pricing in almost 140 bp of tightening over the next 12 months.  It expects the tightening cycle to be fairly short even if steep.  It is expecting the terminal rate of around 2%.   Of course, the balance sheet is being brought into play in a passive way with the base rate at 50 bp, but could accelerate the unwind and could be more active, i.e., outright liquidation.  

The other price measure that the UK publishes are the producer prices.  There are two indices.  One for the price inputs into manufactured goods and the other tracks output prices for manufactured goods.  Hence, it may say more about profit-margins than inflation per se.  Input prices rose 13.5% in December, easing from the peak (so far) at 15.2% last November.  Even with December's 0.2% month-over-month decline, the input prices rose by an average of 1.1% a month last year.  Output prices rose 9.3% last year.  The peak was in November at 9.4%.  It was the first decline in 14 months.  If input prices rise by less than 1.1% and output prices by less than 0.7%, the year-over-year pace will decelerate again, but of course both will remain at elevated levels.  

The Reserve Bank of Australia also hitches its monetary policy to the labor market.  Its January employment report will be released early on February 17 in Canberra.  A flattish report is expected.  The RBA is ending its bond buying operations, but it is still pushing back against ideas that it is on the verge hiking rates. The swaps market and the cash rate futures have completely priced in a hike in July.  

The policy rate stands at 0.10%.  The market is pricing in almost 1.3% by the end of the year.  Covid sent ripples through the Australian labor market in August-October last year when it "lost" about 355k jobs and grew them (366k) back in November.  All told, Australia added 375k jobs last year.  The vast majority (~356k) were full-time positions.  To affect the reaction function of the RBA, an acceleration in jobs and wages are needed.  

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