The week behind us: May caves, Powell confirms “Powell Put”
GBP was the best performing G10 currency after UK PM May basically caved in to demands that Parliament should have more of a say in the Brexit decision and there should be the possibility of a delay in Brexit rather than just “my deal or no deal.” However, her concession wasn’t as much of a concession as it seems; any delay (assuming the EU grants her one) is based around the timing of the European Parliament election in May. If Britain takes part in that election, it can keep on extending Brexit after the EU Parliament is seated on 1 July. But if it doesn’t take part, then 1 July becomes an absolutely unextendible “cliff edge” deadline for Brexit. Her strategy is to take Britain to that cliff edge and say “now it’s either my deal or no deal,” and hope that MPs vote for the deal. I think that might work, which would be positive for GBP. But it’s a hell of a way to run a country.
Fed Chair Powell confirmed that the Fed is rethinking its inflation target and may consider allowing an overshoot of inflation to compensate for periods of undershooting. He also more or less confirmed the existance of the “Powell Put” by saying that a change in broader financial conditions “matters for the macroeconomy, it matters for the achievement of the dual mandate,” and the Fed will therefore take change in broader financial conditions into account.
This gives rise to two questions: 1) how do you measure “broader financial conditions” and 2) what is the reaction function by which you take those changes into account? Because the fact is, their own financial conditions index hasn’t shown any significant tightening recently, and indeed was lower at the time of the January FOMC meeting than it was in December, when they did hike rates.
Same with the VIX index – equity market volatilty was much higher in December than in January. So I’m still not sure what their reaction function is reacting to, unless maybe it’s the fact that volatility moved higher – and the stock market even lower – immediately after that meeting.
Finally, we had the long-awaited testimony by Trump’s lawyer/fixer, Michael Cohen. He was devastating about Trump, accusing him of an “expansive pattern of lies and criminality,” as the NY Times put it – although his claim that he saw no “collusion” between the campaign and Russia to sway the election seems doubtful, IMHO.
My favorite exchange was:
Rep. Gosar: "You're a pathological liar. You don't know truth from falsehood. So again—”
Michael Cohen: "Sorry -- are you referring to me or the President?"
The coming week: lots going on!
The coming week is filled with important indicators and events: three central bank meetings, the US nonfarm payrolls, and the start of China’s National People’s Congress.
For the central banks, we get the Reserve Bank of Australia (RBA) on Tuesday, the Bank of Canada (BoC) on Wednesday, and the European Central Bank (ECB) on Thursday. Frankly though, I’m getting bored writing about central banks. Most of them are now on hold once again, so all we’re talking about is whether there will be any subtle change in bias, not a real change in stance. We’re mostly trying to understand how the central bankers see the world and how long they are likely to keep rates on hold. We’re really just looking for scraps of information.
In this context, the RBA is probably the worst of the lot. Unlike most other central banks, which meet eight times a year, they meet 11 times a year (no meeting in January). So I’m going to have to write about them every month for the rest of the year. And currently, the market sees just over 50% (55%) chance of a cut in rates this year. In other words, every month I’m going to have to review the reasons why they probably won’t make any changes in policy. This is expected to last at least until around August, when the possibility of a change rises to 41%. Perhaps I should save my comments each month and just update the numbers and graph?
Recent commentary from RBA Governor Lowe has made clear that the RBA doesn’t plan any changes in policy any time soon. The focus will still be on the labor market and inflation, as it has been for the last 30 years. "In the event of a sustained increase in the unemployment rate and a lack of further progress towards the inflation objective, lower interest rates might be appropriate at some point," he said on 6 February. And again on 22 Feb, he said “It is appropriate to maintain the current policy setting while we assess developments. Much will depend on what happens in our labor market."
It’s true that they haven’t met their inflation target yet. The inflation rate is just below (1.8%) their 2%-3% target range and has been for some time. However, this problem isn’t unique to Australia; every central bank is having the same issue. And Japan has proven that low interest rates can’t necessarily solve this issue.
Meanwhile, the Governor’s stress on the labor market makes a change in policy much less likely. The unemployment rate is as low as it’s been in ages, and employment growth is holding up well too. I expect little change in stance at this week’s meeting and little for the markets to get excited about.
There’s hardly more tension associated with the BoC. The market had been going for a rate hike, but now the betting centers on rates being unchanged for all of this year, with some chance of one hike.
BoC Gov. Poloz recently made a speech in which he discussed the limitations to monetary policy. The first limitation, he said, was that since monetary policy has only one instrument, the Bank cannot use interest rates to target more than one variable. “Ultimately, inflation is the sole target of the policy.”
Given that all three of the “core” measures of inflation that the BoC used to guide its monetary policy are just about at the middle of their 1%-3% target range, they should be very happy with policy at the moment. I see no reason for them to change in either direction. The meeting should be a relative non-event for the markets, I would think.
The ECB is more interesting than the others, because they have started to question their own narrative. The Eurozone economy is slowing down more than they expected and inflation is accelerating more slowly than they expected as a result. This may necessitate a subtle change in their stance.
As for rates, the market thinks there’s a 50-50 chance that they will raise rates this year, otherwise they’ll be unchanged.
But that’s a story for later this year. The market thinks if it’s likely to happen at all, it’s likely to happen towards the end of the year.
So for now the question will be just how do they see the Eurozone economy developing and are they making – or likely to make -- any progress towards their inflation goal. After the last meeting, ECB President Draghi said, “On the basis of current futures prices for oil, headline inflation is likely to decline further over the coming months.” The March meeting will bring with it an updated set of forecasts. The last update, in December, gave a profile of 1.6% in 2019, rising to 1.7% in 20210 and 1.8% in 2021—i.e., still trending towards their goal of inflation “below, but close to, 2% over the medium term.” If they revise down their inflation forecast, can they continue on their policy normalization path? My guess is that they may once again revise it down for 2019 but leave 2020 and 2021 alone – that’s far enough away that they can pretend it’s going to happen. That way they won’t have to change their policy stance right now.
This is of course just a polite fiction that nobody really believes. The 5yr/5yr inflation swap, which Draghi himself identified as his preferred gauge of inflation expectations, now indicates that the market expects inflation to remain around the current level for the next five years – and it’s been trending lower if anything.
There’s also the question about what the ECB should do with their long-term refinancing operations (LTROs). These non-standard financing help for banks have been in operation continuously since the global financial crisis of 2008. There’s still some EUR 720bn outstanding in targeted LTROs (TLRTO). They start to mature in June of 2020 and the ECB is wondering what to do about it: let it roll off (what they would do if the economy were healthy and they were normalizing policy), or replace it in whole or in part, and if so, how. They still have some time to think about this issue so they may not decide at this meeting. The market will want to see any clues.
As for the indicators, it’s once again time for the US nonfarm payrolls! (NFP) I’ve said repeatedly that I think the importance of this indicator is overblown. Unlike the RBA, the Fed believes that has achieved its goal of “maximum employment,” if indeed “maximum employment” can be measured by the unemployment rate.
Some people would argue that full employment can only be measured by looking at wages. That is, you’re not at full employment until workers can extract more money from their employers and the return to labor goes up relative to the return to capital. What we see here is encouraging: the employment cost index (ECI) is trending upwards, while the quit rate – the percentage of people who leave their jobs voluntarily each month – is rising too, indicating that employees have a lot more confidence in the job market nowadays. However, the ECI isn’t rising anywhere nearly as rapidly as it was before the GFC, so the Fed probably doesn’t have to worry about wage-cost inflation (remember that?) any time soon.
In any event, the market is looking for some mean reversion in payrolls after two months of above-trend gains in payrolls. The consensus forecast of 185k is pretty close to what the six-month moving average was in August, September, and November. It seems as good a guess as any. The unemployment rate is expected to fall back to 3.9% from 4.0%, i.e. to remain in its recent range (it’s been between 3.7% and 4.0% since last March).
Given my argument above about how to determine full employment, the average hourly earnings are probably more important than the NFP figure itself. Here too, the consensus is for reversion to the mean. Basically, 80% of the time the mom change is either +0.1%, +0.2% or +0.3%. Since last month it was +0.1%, the low end of the usual range, the market assumes this month it will come out on the high end of the usual range, namely +0.3%. That would push the yoy rate back up to 3.3%, the peak for this economic cycle. That I think would suggest the labor market remains strong and therefore would be beneficial for the dollar.
China’s National People’s Congress will start on 5 March. Premier Li will present the government’s draft working plan for 2019. Global investors will be focusing on the 2019 growth target. Last year’s target was “around 6.5%,” which was met (the average yoy growth rate for all quarters was 6.6%, while it finished the year at 6.4%).
Among China’s 31 provinces, 24 have lowered their growth targets for 2019 while only two raised them, so we can assume that the national growth target will be lowered as well. The only question is how far. The further they target below 6.5%, the worse for the commodity currencies, I would assume. I think anything below 6% would be a big shock, while 6%-6.5% would probably be within the range of expectations.
Investors will also be interested in fiscal and monetary policy and how much additional stimulus, if any, the government will provide. The market consensus is for some further fiscal stimulus, while monetary policy is likely to remain “prudent,” especially given the friction with the US over currency policy. China’s monetary policy plays an important part in driving the country’s economy and thereby driving world commodity prices.
Other things to watch out for during the week: there are a number of Bank of England speakers: Gov. Carney testifies to the House of Lords on Tuesday, while Monetary Policy Committee members Cunliffe and Saunders speak on Wednesday and Tenreyro on Thursday. The Fed releases the Beige Book on Wednesday.
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