Marshall Gittler’s weekly comment: FOMC, Bank of England, Payrolls, Japan holiday to make for active week

I thought that without Brexit I’d be bereft of things to write about. No such luck! Several themes in the market this week:

The “monetary policy convergence” theme was in full display over the past week. The two market-effecting events were the further slowdown in Australian inflation and the change in the Bank of Canada’s rate bias. Both countries are now expected to cut rates this year (well, almost for Canada). This is a big change for Canada, which just six months ago was expected to hike rates not once but twice during 2020.

The Bank of Japan also went along with the “lower for longer” trend as it clarified its stance. Up to now it has said it intends to keep rates at their current extremely low level for “an extended period of time;” it spelled out that this means “at least through around spring 2020.”

As the idea of a global slowdown in inflation took root, bond yields around the world began to fall again. This is a reversal from the trend we’ve seen since the beginning of April, when yields started to move higher again. German 10-year yields are back below zero.

With fears of higher interest rates receding and bond yields falling, the major stock markets tended to do well (China being the major exception in the last few weeks, despite the government’s reflationary efforts)

Emerging market currencies fell sharply over the week. The Argentinian peso (ARS – not shown here) hit a record low as the market began to worry about yet another default after the upcoming Presidential election. The five-year Argentinian credit default swap is now pricing in more than a 60% chance of that happening during the swap’s lifetime.

It may be that the money flowing out of EM currencies is what’s pushing up the price of stocks and bonds in the developed countries.

We may also be seeing investors putting on G10 carry trades using USD as an asset currency and EUR and CHF as the funding currency. Bond issuance in EUR and CHF has been quite active recently (about CHF 6bn in foreign bonds issued YTD in Switzerland, the most since 2015). However, the basis swap market shows no signs of excess USD demand in these currencies, so I’m hesitant to fall back on that as an explanation.

Coming week: FOMC, Bank of England, NFP, China PMIs, Japan holiday

The coming week should provide further opportunities for investors to gauge the intentions of central banks as the Federal Open Market Committee (FOMC) and the Bank of England’s Monetary Policy Committee (MPC) meet. Neither meeting is likely to result in any change in rates. Instead, attention will focus on the nuance of the accompanying statement and any change in the perceived bias.

The FOMC meeting on Wednesday is likely to make only modest tweaks to its assessment. I don’t think that much has changed since the last meeting on March 20^th, only a little more than a month ago. If anything, the economic outlook has improved, meaning that any changes in the statement following the meeting or in Fed Chair Powell’s press conference following it are likely to positive for the dollar.

The market is currently pricing in one rate cut this year and one next year. This is despite the fact that the FOMC members themselves expect no change in rates this year and one rate hike next year (at least, that was what the “dot plot” back in March showed).

The market’s expectation for the time of this cut has been receding. Investors currently see a 50% chance of a cut by the time of the October meeting. A month ago, this would’ve been August (although there’s no FOMC meeting in August).

That’s probably because the recent data shows that the risks to the US economic outlook are far more balanced than they were a month ago. The relatively strong US retail sales figure (+1.6% mom in March) shows that consumers are still alive and well, while the continued decline in jobless claims shows that the labor market remains strong. Accordingly, the recession fears that animated markets just a few months ago have been receding.

Some Fed officials have expressed concern that persistently below-target inflation could start to erode inflation expectations. Indeed, the core personal consumption expenditure (PCE) deflator, the Fed’s preferred inflation gauge, which comes out on Monday, is expected to show some deceleration in inflation from January’s rate (no February figure available). The headline figure however is expected to accelerate sharply, probably because of higher oil prices.

But while core inflation may have slowed a bit, the better economic data and higher oil prices have caused inflation expectations to go back up again closer to the Fed’s 2% target. So the concern that some FOMC members have expressed on this topic isn’t really valid right now and isn’t likely to affect their assessment.

We could see the market move the likely date of the rate cut even further out if the Committee presents a positive assessment of developments, as seems likely to me. That would probably be good for the dollar.

As for the Bank of England MPC, at their last meeting, in March, they voted unanimously to keep rates steady (as they did at their February meeting as well).

The main change since the March meeting is that the Brexit deadline has been put off to end-October. This takes some of the heat off of them. In theory they could move interest rates during this interregnum. And indeed growth has been somewhat better than expected, which gives them leeway to do so. The monthly GDP figures suggest that December’s decline was just a statistical oddity and growth remains steady, if not necessarily robust.

But why would they raise rates? While they did say that assuming everything goes well with Brexit, “an ongoing tightening of monetary policy over the forecast period, at a gradual pace and to a limited extent, would be appropriate to return inflation sustainably to the 2% target…” But the underlying Brexit uncertainty is still there and will be until October (or Brexit occurs, whichever comes first). Furthermore, inflation has stayed at pretty much right around their 2% target, meaning there shouldn’t be any urgency to change stance.   

Views on the BoE have changed dramatically since the March meeting. Immediately after the meeting, the market saw the possibility of a cut in rates as much higher than that of a hike. But now, the market sees almost no chance of a cut and a moderate (34%, or one-in-three) chance of a rate hike by the beginning of next year. I think it’s unlikely that the MPC will be more optimistic than the market already is about the potential for a successful Brexit and higher economic activity. Accordingly, I expect the statement following the meeting to be more or less in line with current expectations and for the pound to have relatively little reaction afterwards.

The other main event of the week will be the monthly nonfarm payroll (NFP) figure and the accompanying average hourly earnings. These have the same importance as ever for the market, although now they are looked at from the opposite direction from before. Now, the question is: will they be weak enough to hasten a cut in rates?

This time, the market consensus is no. On the contrary, they’re expected to be strong enough that it could diminish expectations of a rate cut this year. That would be positive for the dollar.

The market forecast for the ADP report, which comes out a few hours before the FOMC meeting ends on Wednesday, is for a rise of 180k, going back to a more normal level after March’s unusually low 129k. For the NFP, expectations are that it will be 185k, little changed from the previous month’s 196k and within the recent range of what’s considered normal (excluding the unusually large increases in December and January). These figures would show job creating remaining solid and would give the Fed no reason at all to start worrying about rates being high enough to choke off activity.

The average hourly earnings are forecast to rise a healthy 0.3% mom, which would push the yoy rate of growth up to 3.3% from 3.2%. That’s the more significant figure, IMHO, as higher wages can be expected to eventually lead to higher prices. Furthermore, as many people argue, the labor market can’t be said to be tight unless workers start to exert some leverage vis-à-vis employers. Higher wages are a sign that companies are having to compete for workers. A strong hourly earnings figure is therefore good for the dollar.

The ISM indices in the US will also be closely watched – manufacturing on Wednesday, non-manufacturing on Friday.

There are numerous other important indicators out during the week. For the Eurozone, the first estimate of EU-wide Q1 GDP and German inflation on Tuesday, followed by EU-wide inflation on Friday, will be the ones to watch.

But perhaps the most attention will focus on the China purchasing managers’ indices (PMIs). The official ones come out Tuesday morning China time, the Caixin manufacturing PMI on Thursday. They are all expected to show a further improvement in the Chinese economy. This too may help to dispel fears of a deeper downturn globally and help Fed expectations to recover somewhat, which could also be dollar positive.

At the same time, we saw during the past week how EUR/USD often tended to track USD/CNH (inverted). Given how highly leveraged the German economy is to China, an improvement in Chinese business outlook could boost expectations for Europe much more than for the US and thereby push up EUR/USD.

Finally, the week will also be unusual, indeed unique, in one respect: Japanese markets will be closed for the entire week (and the following Monday, May 6^th) for a “super Golden Week” of 10 consecutive days of holiday as the current Emperor abdicates and a new era begins. This means lower liquidity in the FX market during Asian time. According to the 2016 BIS survey of the FX market, 6.1% of total FX market turnover takes place in Japan. This is a significant amount, but even more, it’s 27% of the trading during the Asian time zone – and many of the other centers largely trade their own currency (such as Thailand and Philippines). In particular, Japanese corporate activity in USD/JPY will be unusually thin.

The risk is not that a retail investor won’t be able to get his or her order filled – that’s not going to be a problem – but rather that the thin market in some currency pairs may be susceptible to sudden sharp movements due to low liquidity, which could cause traders to get stopped out at a loss. In the worst case, we could see another “flash crash” like we’ve seen before when currency-trading computers for no apparent reason suddenly get it in their “minds” to buy or sell a currency in huge size. Incredible movements of 10% or so have happened before with no cause that any human being can discern at the time.

The problem will be particularly acute on Wednesday, May 1^st, when many other centers will be closed as well for Labor Day (UK, Germany, Switzerland and China, for example).

Nonetheless, professionals don’t seem particularly concerned. Far from pulling back, last week speculators actually increased their short yen positions (although we won’t know what they did this week until the figures come out later Friday, and even that only covers up to Tuesday). My guess is that Singapore and Hong Kong can take up much of the slack, especially without the corporate flow emanating from Tokyo.

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