Too Much of a Good Thing

Forget the adage about measuring twice and cutting once. Aside from the Bank of Japan, major central banks are in a hurry to tighten financial conditions even as a cyclical slowdown weakens demand. The Federal Reserve's decision to hike by 75 bp instead of the 50 bp that it had previously guided investors and businesses to expect was primarily due to a CPI report. The Fed targets another inflation measure, the PCE deflator, which ran two percentage points lower than the CPI in April. Fed Chair Powell cited the increase in consumer inflation expectations picked up in the preliminary results of the University of Michigan survey. Powell indicated that while a 75 bp hike is unusual, it could be repeated next month. 

The Bank of England hiked its base rate by 25 bp but increased its inflation projection and warned of more forceful action if necessary. The three dissents wanted a 50 bp hike, and the market expects them to prevail. The swaps market is fully discounting at least a 50 bp hike at the next three meetings and almost 200 bp before the end of the year, despite warning that the economy is contracting this quarter. The Bank of Canada has also promised more forceful action if needed. Several Canadian banks are now looking for a 75 bp at the next Bank of Canada meeting (July 13). The swaps market is around 2/3 of the way there.

The Reserve Bank of Australia surprised the market with a 50 bp hike on June 7. The larger than expected hike in the minimum wage, a stronger than expected May employment report, and a jump in June consumer inflation expectations (6.7% vs. 5.0% in May) is spurring speculation that RBA may hike rates 75 bp at its next meeting (July 5). The futures market has 300 bp of tightening priced in for the second half, which is 100 bp more than just two weeks ago.  

The Swiss National Bank surprised many by hiking its policy rate by 50 bp (to -0.25%). Deflation (negative year-over-year CPI) existed from the outbreak of Covid through last March. It finished 2021 at 1.5% and reached 2.9% last month. The SNB antagonized the US Treasury over its interventions in the foreign exchange market, and until last week, it had repeatedly said that the Swiss franc was "highly overvalued." We had thought incorrectly that the SNB would wait a few more weeks and hike after the ECB to minimize the pressure on the franc. 

Instead, the SNB's move drove the franc up around 3% against the euro, lifting it to its best level in two months. The SNB can talk about two-way intervention, but it likely will continue to feel compelled to sell the franc. The OECD's purchasing power parity model shows the franc to be about 13% over-valued. In Q3 20, the recent peak in valuation was recorded, almost 24% rich. It is now the least over-valued in about two decades. The SNB lifted its inflation forecasts (to 2.8% this year from 2.1%, and 1.9% next year from 0.9%, and 1.6% in 2024 from 0.9%, as well). The swaps market is pricing about 75 bp of tightening over the next six months, which would lift its policy rate above zero for the first time since January 2015.

The market expects an aggressive tightening path for the European Central Bank beginning next month. The swaps market has about a one in four chance of a 50 bp hike at the July 21 meeting. However, by the end of Q3, the market has the target rate now at minus 0.5% to stand near 0.35%. The year-end rate has exploded by almost 100 bp over the past three weeks to about 1.35% before consolidating ahead of the weekend. It was below zero as recently as the start of April.

Wow. Synchronized rate hikes and many central banks have begun reducing the size of their balance sheets. Fiscal policy is becoming more restrictive in many countries, including the US, where the budget deficit is projected to be halved this year--or about five percentage points of GDP. Some countries are offering some subsidies or tax cuts for gasoline or energy that may dampen inflation like Japan and Italy. In the other direction, UK's administered gas prices will be hiked in October, which is behind the Bank of England's warning that CPI could reach 11% around then. Despite the various policy responses, the underlying development is a powerful squeeze on the cost of living, even in Japan, where Bank of Japan Governor Kuroda insists that the 2% inflation will not be sustained.

Financial conditions are tightening globally. The energy shock is also biting. Between fire at the facility in Texas that provides about 10% of Europe's natural gas and Russia cutting access, Europe's benchmark soared by more than 50% last week. Estimates for growth this year are being cut (Portugal is an exception, the central bank raised this year's growth forecast to 6.3% from 4.9%, though shaved 2023 growth 0.3% to a still respectable 2.6%). The risk is that the accelerated tightening will hasten the expansion's end and bring forward the economic downturn. The flash June PMI readings will be released toward the end of next week. While inflation is seen as the number one challenge for many countries, concerns about stalling growth may become more pressing going forward. The risk is that the flash PMI shows a further deceleration of economic activity.

This is not a bold call. The US composite PMI fell in April and May. May's 53.6 reading compares with 57.0 at the end of last year and 57.7 at the end of March. The eurozone composite PMI has been alternating between gains and losses this year. After it fell to 54.8 in May, a gain is needed to maintain the sawtooth pattern. Consider that Europe's natgas benchmark is up more than 40% this month as Russia tightens supplies and US  supplies are hampered by the fire at the Texas facility, equities continue to bleed, and recent data typically is surprising on the downside of expectations. The risk is that the pattern breaks and the eurozone composite falls again. 

The UK reported last week that its economy unexpectedly contracted in April (-0.3%) for the second consecutive month. In April, the composite PMI fell to 58.2 from 60.9, still an elevated reading. It finished 2021 at 53.6 and fell below there in May (53.1). Australia's composite PMI also has been in a sawtooth pattern, and it fell 3 points in May to 52.9. It finished last year at 54.9 and was at 55.1 at the end of Q1.

Japan's PMI is an exception. It rose for the third consecutive month in May, though at 52.3, it remains below last December's 52.5 reading. Recall that its Covid-related restrictions weighed on activity at the start of the year. The composite was below the 50 boom/bust level in January and February. Japan's economy contracted by 0.5% (annualized rate) in Q1 and is expected to be growing at a 4% clip this quarter, bolstered by consumer spending and private investment.

A day after the flash PMI (early June 23 in Tokyo), Japan reports its May CPI figures. Tokyo's May CPI has already been released, and it was unchanged at 1.9%. Energy and prepared foods accounted for 1.6 percentage points and have a higher weighting in the national CPI basket. Japan's headline CPI stood at 2.5% in April, and the core measure, which the BOJ targets, excludes fresh food, rose 2.1%. As BOJ Governor Kuroda reiterated last week, he distrusts that inflation is sustainable. Team Transitory, as it were, is alive and well in Tokyo. Excluding fresh food and energy, Japan's CPI is 0.8% above a year ago levels. Prime Minister Kishida's fiscal program offers a gasoline subsidy. It may be worth 0.3%-0.5% on headline CPI by late Q3.

The UK reports May CPI figures on June 22. Of course, there is headline risk, but in terms of policy, the implication is minor. The Bank of England does not meet until August 4. This month's inflation will be reported on July 20 and will have more weight on the decision. The Bank of England warns that as the cap on gas prices increases in October, headline CPI could reach 11%. The market may be more sensitive to the retail sales report a couple of days later. After rebounding in April, the British consumer is being forced to slow down. Retail sales, with and without gasoline/diesel, likely fell for the third time in the past four months.

Canada reports its April retail sales and May CPI. Recall that retail sales jumped 3.5% in January (after falling 1.4% in December 2021) and have since struggled, rising 0.2% in February and flat in January. Canada is widely seen as the fastest growing G7 country this year, and May's job growth was well above expectations. Headline inflation was at the cyclical high of 6.8% in May, and the Bank of Canada expects it to fall to 5.3% at the end of this year, which is not independent of what it does. Still, the risk is that Canadian inflation has not peaked. The Bank of Canada next meets on July 13. The swaps market has about a 50% chance that the central bank will deliver a 75 bp hike instead of 50 bp as it has done earlier this month and in April. The peak is now seen around 4%, which is about 100 bp higher than at the end of last month. 

Powell repeatedly claimed that the US economy was strong and could withstand tightening financial conditions. Even with the adjustments to the median projection (slower growth and higher unemployment), Powell noted that the magnitudes were still consistent with a soft-landing scenario. This seems overly optimistic. A few hours before Powell spoke, the BLS reported weaker than expected retail sales (for May and revised lower April), prompting economists to cut their Q2 GDP forecasts. The Atlanta Fed GDPNow tracker is flat. 

Within 48 hours of Powell's assessment, investors learned housing starts in May fell 14.4% (Bloomberg's survey median forecast was -1.8%). Permits were reduced for the second month in a row, and the 7% drop was almost three times larger than expected. The June Philadelphia Fed survey unexpectedly fell. The chart above is the six-month forecast of new orders in the Philly survey. Like the University of Michigan consumer sentiment, these levels have only been seen ahead of recessions. The 0.2% increase in last month's industrial output was half of what the median forecast in Bloomberg's survey anticipated, but this was offset by the upward revision to the April series (1.4% rather than 1.1%). However, manufacturing output itself fell by 0.1% (0.3% gain expected), the first decline since January.  

Much of Powell's assessment seemed to rest on the labor market's strength, and indeed it has been strong. However, the pace of improvement has been moderating, and some cracks are beginning to appear. Consider that the four-week average of weekly jobless claims often used to filter out some of the noise bottomed more than two months ago at 170k. The average is now 218k and trending higher. 

Powell explicitly said he wanted to reduce demand. "Going too far" is only known in hindsight, especially given the variable lag times. Something must break. Powell will likely be pressed on these issues in Congressional testimony next week to the Senate Banking Committee on June 22 and the House Financial Services Committee the following day. The entire House of Representatives and a third of the Senate are up for election in a few months. Some are going to press Powell in a way that reporters may not have, especially what is going to be the tradeoff for higher unemployment. 

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