Macro: Tell Us Something We Don't Already Know

As September winds down, three sets of economic reports will draw the most attention. We will review them and then offer a snapshot of the emerging market central bank meetings. As we have seen in the UK and Norway, several emerging market countries raised rates early (beginning in the middle of last year) but still experienced an acceleration of inflation. It obviously begs the unanswerable question about the impact on US inflation if the Fed had taken its foot off the accelerator sooner. There does not appear to be a tight relationship between monetary policy and currency performance. This may warn against thinking the Bank of Japan simply needs to hike rates to stabilize the yen.

Many will see the US PCE deflator as the key given the monetary cycle, but its thunder has been stolen. With the CPI in hand, the PCE rarely tells us something different. The point is that a softer headline and a slightly higher core rate are expected. Only if data differs much from this will it spur much interest. The Fed's newest projections (median) have 125 bp of hikes this year and 25 bp early next year. The market sees the first rate cut in late 2023. The median projection in the Fed's latest forecasts sees cuts beginning in 2024, though the median PCE forecast in 2024 is above the 2% average target (at 2.3%).

If the PCE deflator is over-rated in the current context, we suggest the preliminary August merchandise trade balance being under-rated. We say this despite recognizing that capital flows are more important than the flow of goods in determining the dollar's exchange rate. Still, everyone recognizes that the dollar's sharp appreciation has positive and negative knock-on effects. The strong dollar is one of the channels through which financial conditions, the Fed argues, are become tighter. At the same time, more multinational businesses will cite developments in the foreign exchange market as reducing their foreign earnings when translated back into dollars.

Given the extreme valuation of the dollar, one would expect US exports to have fallen. The fact that they rose to a record level in July does not seem to have received the attention due. The US exports have risen by 20% in the year through July. An increase in August would mark the 18th consecutive monthly improvement. In a strong dollar environment, imports are typically expected to rise. They have. In the year through July, imports were up 16%. However, imports have not increased since March. Supply chain disruptions and the lockdown in Shanghai (and elsewhere) may be behind the heightened volatility of imports. Judging from recent comments from some of the large US retailers, they are trying to shed not accumulate inventory. 

Yet, valuations are extreme. The OECD's purchasing power parity model sees the euro around 44% under-valued and the yen 43%% under-valued. Sterling is nearly 27.5% under-valued. As trade and capital flows adjust to these valuations and the heightened risk of recessions next year, US exports will likely weaken. Rising energy prices and exports are unlikely to offset the deterioration of non-oil goods exports. This is part of the pain that Fed Chair Powell may have been referring to recently. Protectionist cries will increase. The strong dollar undermines the already-challenged foreign demand as domestic demand retrenches under tighter financial conditions.

Unlike the Federal Reserve, the European Central Bank meets in October. This also helps make the eurozone September CPI slightly more relevant than the US August PCE deflator. The swaps market has a nearly 85% chance that the ECB will deliver another 75 bp increase on October 27. A big adjustment in the swaps market took the June 2023 implied policy rate to 3.0% from 2.50% on September 16. 

This is to say that the market has seen enough. Regardless of the exact print of the preliminary estimate of September inflation, investors recognize the ECB's pivot. What is giving the Fed encouragement to be bolder may be the same thing in Europe. At the same time that the estimate of CPI is released, the August unemployment rate for the eurozone will be announced. It also is arguably under-appreciated, but the unemployment rate in July was 6.6%, a record low since before the monetary union.

Meanwhile, Italy looks set to elect a right-wing government. This has been expected since the Draghi government collapsed. Conventional wisdom sees the right in Europe has softened its views. Talking about the fascist roots may be like talking about how the Democrats in the US have their origins in states' rights. However, in politics, as in our physical world, motion may be relative. Arguably, in several high-income countries, center-right parties and even some center-left parties have migrated to the right and embraced the framing and substance of the right. The point is that the right may have moderated its view, but the political center has also moved to the right. Tensions between Brussels and a new government in Rome can still be a drag on the euro.  

China reports its PMI, while Caixin manufacturing PMI will be released. No surprise here that the world's second-largest economy is struggling. Lifting the lockdowns in Chengdu and Dalian was on September 19, perhaps too late in the month to have much impact. We already know from the August data that outside of the property, the economy seems to be finding better traction, helped by strong lending. Still, the economy looks fragile as the 20th Party Congress draws near (mid-October), and the yuan is at two-year lows. It is probably not the kind of economic news that Secretary General Xi would have wished for as he is coronated for a third term.

When the dollar last rose above CNY7.0, there was much fanfare. It was seen as purposefully seeking advantage and blunt the impact of Trump tariffs, which the Biden administration has talked about lifting. Still, the trade representative has made it clear this will not happen without a broad change in China's behavior. This time, official fingerprints do not seem as evident. The PBOC has set the dollar's reference rate with unprecedented large gaps to market expectations (Bloomberg survey). It has cut the reserve requirement on foreign currency deposits. Officials have cautioned businesses against speculating against the yuan. Still, given the policy divergence, a stronger dollar/weaker yuan seems to be an intuitively clear result. Consider that at the start of the year, China paid about 125 bp more than the US to borrow for 10 years. Now the US pays 100 bp more than China.  

Lastly, six emerging market central banks meet in the last week of September, two from Asia (India and Thailand), two from central Europe (Hungary and the Czech Republic), and two from Latam (Mexico and Colombia). This short overview illustrates that emerging markets are not the homogenous as often treated. Among high-income countries, several central banks are likely to slow the pace of tightening in Q4. Among emerging market economies, some, like Brazil, may be nearly finished hiking.  

Generally speaking, Asia Pacific central banks have generally had less inflation than the other regions and have been slower to raise. Thailand began its tightening cycle in August with a quarter-point hike that puts its policy rate at 0.75%. Headline consumer inflation is a little below 8%, while the core is about 3.1%. The Thai baht is off almost 10% so far this year. The swaps market shows a 25 bp hike is anticipated. India has hiked by 140 bp since the tightening began in May. The repo rate is at 5.4%. Consumer inflation is up 7% from a year ago. The swaps market is split between 50 bp and 75 bp. The rupee is off about 6.8% against the dollar this year, making it one of the better performers in the region.

Hungary's central bank has engaged in among the most aggressive tightening. It began raising rates in June 2021. It has hiked rates every month since then. The base rate now stands at 11.75%, up from 2.40% at the end of last year. The year-over-year inflation rate has surged from 7.4% at the end of last year to 15.6% in August. The one-week deposit rate has been steady at 11.75%, which seems to signal that the National Bank of Hungary looks to pause. The swaps market peaked at about 100 bp higher at the end of Q1 23 or early Q2.

The Czech's repo rate stands at 7.0%. The Czech central bank has also been tightening since June last year. The two-week repo rate bottomed at 0.25% and was at 3.75% at the end of last year. Defying economists' expectations, the central bank stood pat in August. Economists expected a quarter-point hike. Consumer inflation reached 17.5% in July before dipping to 17.2% in August. The swaps market does not have any more tightening priced in, and it looks for the first cut by the end of Q1 23. The Czech koruna has fallen by about 11.5% against the dollar, while the Hungarian forint has dropped 19.5%. The euro is off around 12.25%.

Colombian headline inflation reached almost 10.85% in August, and the core is nearly 7.85%. The central bank began to adjust policy last October with a 75 bp move, and at the end of last year, the minimum repo rate was at 3.0%. It raised the rate at 100 bp clips at the first three meetings this year, and in June and July delivered 150 bp increases. The policy rate stands at 9.00%. The market may be disappointed if another 150 bp hike is not delivered this week. The Colombian peso is off around 7.7% this year. 

The Mexican peso is one of four emerging market currencies that have appreciated against the dollar. The Russian rouble leads with a 21.6% gain. The next three are from Latam:  Brazil, Peru, and Mexico. Many had worried that President AMLO would stack the central bank with doves, but Banxico has retained its strong reputation. It lifted the overnight target rate since last June, when it was at 4.0%. It finished last year with a 50 bp hike in December that set the target rate at 5.50%. After three more half-point moves in the first five months of the year, it has accelerated, alongside the Federal Reserve with two 75 bp hikes. It is expected to deliver the third one this week. That would bring the target rate to 9.25%. The swaps market looks for a peak between 10.25% and 10.50%. August CPI stood at 8.7%, and the core rate was 8.05%. 

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