(On vacation for the rest of the month. Going to Portugal. Commentary will resume on June 1. Good luck to us all.)
The market is a fickle
mistress. The major
central banks were judged to be behind the inflation curve. Much teeth-gashing,
finger-pointing. Federal Reserve Chair Powell was blamed for denying that a 75 bp
hike was under consideration. Bank of Japan Governor Kuroda was blamed for keeping
the 0.25% cap on the 10-year Japanese Government Bond yield. Even though European
Central Bank President Lagarde had indicated previously that rates could be increased within weeks of
the end of the bond purchases, many observers embraced
it as a new sign that the ECB was belated to hike rates as early as July. For
the better part of three weeks, the swaps market has been pricing in a 20 bp
rate hike. It peaked not when Lagarde spoke last week but on April 22.
The US 10-year breakeven
rate (the difference between the yield of the inflation-protected security and the
conventional note yield) rose from 2.60% at the end of last year to a high a
little bit above 3.05% on April 22. Since then, it has been trending erratically lower and bottomed
near 2.63%, before the CPI report. It finished last week around 2.74%, falling
about 12 bp on the week. The three-week decline is the longest since January.
Many observers write and
speak as if the Fed needs to catch up to the market. But this seems like a variant of the
hubris virus that they often diagnose the central bank with. The relationship
is much more complicated. Consider that a week ago, the swaps market was pricing
in a terminal Fed funds rate of 3.75%. After elevated CPI and PPI prints, the terminal rate is now, ironically, projected close to 3.0%. Or consider
that shortly after the Fed's statement and before Powell's press conference, the
December Fed funds futures contract implied a 2.89% yield. It finished last week near 2.63%.
There is an industry built
on criticizing the Federal Reserve. The Fed is damned if they do and damned if they don't. It
is an easy mark. When it raised by 25 bp in March, it was criticized for not
being more aggressive. When the Fed raised rates by 50 bp earlier this month, it was blamed for taking
75 bp off the table. Often, the same voices criticize the Fed for risking a
recession.
Many accept that the economic contraction in Q1 was the result of GDP math. Importing too many goods (relative to exports) and accumulating inventories at a slower pace than the record set in Q4 were critical drags. Consumption and business investment rose. That is ultimately what drives the economy. Nevertheless, some pundits play up the risk that the US is on the verge of a recession. We have expressed concerns about tightening monetary and fiscal policy as the economy slows. We brought attention to the doubling of oil prices, which has preceded the last three US recessions. The inventory cycle looks mature and is unlikely to be the tailwind going forward. The build-up of savings and pent-up consumer demand appear to have run their course.
However, the doom and gloom
camp is over-hyping the case. Monetary policy is known for its variable lags. The federal deficit may be halved this
year, but that still leaves it above 5% of GDP. The US job growth remains
impressive. Through last month, non-farm payrolls have risen by over 2 mln this
year. It is not far off the pace in the same period last year (~2.2 mln). Weekly
initial jobless claims are hovering around 200k, roughly half the pace of May
2021. Yes, the improvement in the labor market will slow, and it will have to slow much more than it has to support a recession scenario after the contraction in Q1.
Like those who see a
currency war every year or so, the doom and gloom camp or the always-critical of
the Fed crowd are crying wolf. And therein lies the importance of the economic data in the days
ahead. There may be no reason to let the facts interfere with a good story, but
the economic data may show a solid gain in consumption and continued growth in
industrial output. Or, to say the same thing, the data should
show an expanding, not contracting, economy.
April retail sales are
expected to rise by a solid 1% by the median forecast in Bloomberg's survey
after a revised 0.7% (from 0.5%) gain in March. We already know that auto sales were
stronger, which likely lifted the headline figure. Some economic models use components for GDP calculations, which exclude autos, gasoline,
building materials, and food services (the models pick up the information from
different time series), are expected to rise by 0.6% after a revised 0.7% gain
from -0.1) in March. Industrial output rose by nearly 3% in Q1, and that pace
will not be sustained. Last year, industrial output rose by 0.3%
a month. In April, output may have increased by 0.4%.
Among the first places to
look at financial conditions biting are the interest rate sensitive sectors, like
housing. April housing
starts will be reported on May 18. A decline is indeed expected after two
months of gains, but the takeaway is that the level of activity is elevated. March
housing starts were the highest in 16 years. The same is true of permits.
Another place to look for
financial conditions biting is in the translation of foreign earnings into
dollars for US companies. Figures
cited in Barron's from Sentieo, a financial analytics company, noted that 20 US
companies with market caps of more than $100 bln cited the dollar's
appreciation as a headwind, which is twice from a year ago. What was left
unsaid was that there are around 100 such companies, meaning something on the
magnitude of 80% of the giants did not complain about the dollar's appreciation.
In addition to translation,
there is an issue of competitiveness too. According to the OCED's
model of purchasing power parity, the euro, sterling, and yen have not been
this undervalued in at least 30 years. It may not be a short-run consideration,
but it can impact the relative competitiveness and exposure of even purely
domestic US companies to a foreign competition that may not have been there a
couple of years ago.
In addition to the divergence of
monetary policy, part of the current political and economic environment is that America's two rivals, Russia and China, are shooting
themselves in the foot. America's
penchant for exaggerating the strength of Russian strength has again proved
wide of the mark. Moscow's ability to project its power will be curtailed. NATO
will be bigger than before--more members and a greater presence--and Russia's
economy has been traumatized despite the capital-controls induced rouble
appreciation. China's Covid response seems over-the-top and is hobbling the
economy. Despite the best efforts of the Chinese government, the world has
gotten a glimpse of the gap between the Chinese people and the rulers in
Beijing. For years, Chinese officials have raised questions about the US model,
but the chickens have come home to roost, and China's developmental model is
being questioned in new ways.
The sharp drop in Chinese
lending in April is a warning of a dismal economic performance as the lockdowns
and social restrictions crippled around half of its economy. The silver lining is that Shanghai may appear
from the lockdowns shortly, and a "V" type recovery is possible if
Covid can be brought under control. There is scope for China to cut its
benchmark 1-year medium-term lending facility (MLF) rate, which has remained at
2.85% since being cut by 10 bp in January. A reduction in the MLF at the start
of the new week would boost the chances of a cut in the loan prime rate at the
end of the week.
Japan has two data points that
will be of interest. First,
it will report Q1 GDP. It is expected to have contracted by 0.4%-0.5%. The
Covid restrictions and earthquake weakened the economy after growing by 1.1% in
Q4 22. The government has responded with a spending package, and in any event,
the economy already appears to be recovering. Second,
Japan will report the national CPI figures for April at the end of the week. The market got a hint of
what to expect from the surge in the Tokyo CPI. In addition to rising food and
energy prices, the dropping of last year's cuts in cell phone charges will
lift measured inflation. Excluding fresh food and energy, Japan's CPI rose
above zero in April for the first time since July 2020.
The market does not pay much attention to Japan's trade figures. That seems to be the most straightforward explanation why so many
observers insist on characterizing Japan as export-oriented. Japan will report
its April trade figures early on May 19 in Tokyo. A sharp deterioration is
expected (~JPY1.2 trillion deficit from a JPY414 bln shortfall in March. It
will be the ninth consecutive monthly trade deficit. In April 2021, it recorded
a nearly JPY227 bln trade surplus.
The UK reports employment
figures, April CPI, and retail sales. Employment growth is expected to slow, and average earnings growth
will likely be little changed. Economists anticipate the unemployment rate to
remain in the trough near 3.8%, which is also where it was at the end of 2019. Still,
it is understood to be a lagging indicator. UK
retail sales likely fell for the third consecutive month when gasoline is excluded. With two exceptions,
it has been falling since last May as the cost-of-living squeeze intensifies. Meanwhile,
CPI will surge. A 54% rise in the household energy cap was announced in
February, effective in April. That alone will lift the month-over-month rate by
more than 1.5%. The Bank of England forecast the year-over-year rate to rise to
9.1% from 7.0% in March.
Lastly, we note that UK
Prime Minister Johnson is expected to address Northern Ireland's protocol in a speech in the coming week. Tensions have been rising, and the recent election defeat for the Democratic
Unionist Party allows it to play the obstructionist role. It refuses to join
the government unless the protocol that was a result of extended negotiations
is jettisoned.
Turning to the price
action:
Dollar Index: The Dollar Index rose for the
sixth consecutive week and pushed to almost 105.00 for the first time since
late 2002. The main driver is the aggressiveness of the Federal Reserve and, secondarily, the poor news stream from Europe, Russia, and China. The momentum
indicators are stretched but do not appear poised to turn lower. The 104.00
area may provide support as it capped the upside for a little bit. There is
little on the charts until closer to 106.00.
Euro: The single currency continues to
struggle to sustain even minor upticks. It has fallen for the past four
sessions and made a new five-year low near $1.0350 ahead of the weekend. A
break of the 2017 low ($1.0340) leaves very little to deter a test on parity. Given
the elevated volatility (three-month ~9.5%), a move to $1.0 is not so much a
tail risk. The $1.05 area now may offer the nearby cap. A convincing move above $1.06 would suggest a bottom of some import could be in place.
Japanese Yen: The exchange rate and US yields continue
to move nearly in lockstep. The direction seems more important than the level
on a day-to-day basis. In the first four sessions last week, the 10-year US
yield fell nearly 30 bp, and the dollar fell from around JPY130.50 to about
JPY128.30. The yield rose ahead of the weekend, and the dollar traded a full yen
off the lows. The momentum indicators have pulled back as one would expect, with
a nearly 3% pullback in spot. We often find the dollar-yen pair to be
rangebound, and when it does trend, it frequently is moving to a new trend. We
suspect that the JPY127.00 area marks the lower end of the range.
British Pound: Sterling fell for the fourth
consecutive week, and it is poised to fall further. The $1.20 area is the next
important target. There have been 23 sessions since April 13, and sterling has
fallen in all but four sessions, and none of them was last week. In fact,
sterling takes a seven-day slump into next week's activity. It fell to almost
$1.2155 before the weekend, its lowest level since May 2020. The momentum
indicators are stretched but show little inclination of turning. Initial
resistance is likely around $1.2250 but probably takes a move above $1.24 to
be of technical significance.
Canadian Dollar: The close movement of the yen and US
10-year yield has a parallel with the Canadian dollar and the S&P 500. For
the past 30 and 60 sessions, the correlation of the changes is tighter with the
Canadian dollar and the S&P 500 than between the yen and US yields. The US
dollar reached almost CAD1.3080 on May 12, its highest level since late 2020. The
recovery in US equities ahead of the weekend sent the greenback to almost CAD1.2900.
A break of the CAD1.2850 area is needed to boost the chances that a high is in
place. The MACD appears poised to turn down from extreme levels. The Slow
Stochastic has fluctuated a bit but is essentially flat this month despite the
rise in spot. Macroeconomic fundamentals look to be among the best in the G7.
Australian
Dollar: Since
the central bank induced bounce in the Australian dollar (May 4), it has
tumbled about 6% to the May 12 low of around $0.6830. Nearly half of that decline
was recorded on May 11 and 12, yet the bounce ahead of the weekend was not
particularly impressive. It was unable to rise above the previous day's high
(~$0.6955), and the close was still the second lowest since mid-2020. The Aussie
fell by 2.3% last week, and it was the sixth weekly decline in the past seven. It lost around 8% this run. The momentum indicators are stretched. The MACD
could turn higher in the coming days, but the Slow Stochastic is still trending
lower in oversold territory. The next important target on the downside is around
$0.6760, the halfway point of the Aussie's rally from the pandemic low near
$0.5500 in March 2020 to slightly above $0.8000 a year later.
Mexican Peso: The peso's resilience is impressive
even if under-appreciated. While the US dollar has been appreciating multiyear highs against the other major currencies, the peso has held its own. The
peso has appreciated by a little less than 2% this year. Leaving aside the
Russian rouble, only two other emerging market currencies are up
for the year. The Brazilian real has appreciated by 9.6%, and the Peruvian sol
has gained nearly 6%. The swaps market is pricing in 135 bp rate increases in
the next three months when there are three meetings, which is about what the Fed
funds futures have priced in for the Federal Reserve. The momentum indicators
have flatlined near mid-range. Support is seen near MXN20.00, which held
earlier this month. Initial resistance may be around MXN20.25-MXN20.30. It
takes a four-day rally into the week ahead.
Chinese Yuan: There is nothing special
about the Chinese yuan in some ways. It is falling like nearly all the currencies. The yuan
has depreciated by about 6.4% so far this year. The bulk of the move has taken
place in the last four weeks. The greenback rose from around CNY6.37 to reach a
high a little more than CNY6.81 before the weekend. We suspect the dollar would
be higher, but the PBOC seems to be moderating its rise by setting the dollar's
reference rate lower than the market projects consistently since returning from
the labor holidays earlier this month. We suspect the yuan may begin
stabilizing and do not expect it to rise above CNY6.85. Initially, support may be
in the CNY6.72-CNY6.74 area.
Disclaimer