- The jobs data ushers in a three-week period before the Jackson Hole confab at the end of the month that will likely start a new phase
- Macron’s honeymoon in France is over
- FOMC members may find comfort in this week’s CPI report
- EM FX appears to be rolling over
The dollar is mostly firmer against the majors as the new week begins. The euro and sterling are outperforming, while the dollar bloc is underperforming. EM currencies are mostly softer. The CEE currencies are outperforming, while MXN and PHP are underperforming. MSCI Asia Pacific was up 0.4%, with the Nikkei rising 0.5%. MSCI EM is up 0.3%, with the Shanghai Composite rising 0.5%. Euro Stoxx 600 is down 0.2 near midday, while S&P futures are pointing to a lower open. The 10-year US yield is up 1 bp at 2.27%. Commodity prices are mixed, with oil down 1.6%, copper up 0.1%, and gold down 0.2%.
The release of the US employment data before the weekend ushers in a three-week period before the Jackson Hole confab at the end of the month that will likely start a new phase. In September, the FOMC is likely to announce that it will begin not fully rolling over the maturing proceeds of its swollen balance sheet. The ECB will probably announce that it will continue to expand its balance sheet in the first half of 2018, albeit at a reduced pace.
There is a small possibility that the Bank of Japan raises its target for 10-year JGB yield from zero to 10 bp. UK Prime Minister May is expected to deliver an important address on Brexit. Germans are expected to give Merkel a fourth term as Chancellor. Electoral considerations seemed to limit the EU issues that the German government was willing to entertain. When the election is out of the way, Merkel may perceive that she has greater flexibility to address EU issues.
Perhaps the fundamental case for the euro was more compelling than we appreciated in Q2. As we anticipated, the populist-nationalist assault would not secure a beachhead in Europe. When combined with the continued above trend growth and a spike in inflation, it forced investors who had become underweight European exposure to scramble. After selling about 100 bln euros of European equities in 2016, foreign investors returned around a third in H1 17.
At the same time, skepticism increased that the Trump Administration can deliver its economic agenda. At the same time, US data consistently underwhelmed expectations, and core inflation fell. There were a couple of jobs reports that in hindsight proved to be quirks rather than signs of a dramatic weakening of trend, but at the time, contributed to skepticism over the trajectory of monetary policy.
Neither the technical nor macroeconomic considerations are as compelling. It is true that the political climate in the US leaves much to be desired. This does not seem likely to change anytime soon. However, what is changing is European politics. Just like the consensus was slow to recognize and appreciate that the fragmented multiparty political systems act as a bulwark against populist-nationalism, it is slow to see the underlying contradictions within Europe are unresolved and could re-emerge quickly.
The wave of optimism in Europe and among investors in response to the French elections was not simply about the turning back the National Front. It was also the possibility of renewed Franco-German cooperation, which had seemed to wither on the vine in recent years. This project was recognized as all the more important given the UK’s decision to leave the EU and seeming unilateralist (not isolationist) thrust of the US. The necessary precondition is that the France had to regain the authority to do so by getting its own economic and fiscal house in order.
Recall that Fillon, the center-right candidate in the French presidential election, campaigned in part as if to bring to France what Thatcher brought to the UK. Although Fillon did not end up winning, of course, the thrust of his program appears have been adopted by Macron. Labor reforms made to increase the flexibility of hiring, firing and wage settlement, tax cuts wealthy and dramatic spending cuts is the neoliberal agenda.
Macron’s honeymoon in France is over. His support has fallen to levels below Trump’s in the US. Consider Japan’s government too. There is no populist-nationalist challenge to Abe, who articulates a stronger nationalist vision, but the government’s support had fallen to 24% before the recent cabinet reshuffle, according to a poll conducted for the Mainichi newspaper.
UK Prime Minister’s May’s support does not look much better either. Italy has a technocrat government, and although an election must be held next spring, the electoral rules have not been decided. Nonetheless, it is notable that polls suggest a loose coalition of the EMU-skeptical center-right is polling ahead of the governing center-left.
Meanwhile, the July composite eurozone PMI fell to 55.7, the lowest the level since January. It is the second consecutive decline. The Q2 average was 56.6. The region’s economic momentum appears to have peaked. This week’s industrial production reports will support this hypothesis, but with the initial look at Q2 GDP recently reported, June data may not have the heft to move the market. Spain has already reported a decline, and output in France also likely fall. German industrial output has been very strong this year but appears poised to slow.
The dollar’s decline corresponded with a decline in the premium the US offered over Germany. This consideration is also changing. The two-year premium stands at 204 bp. It had fallen from nearly 223 bp in early March to about 192 bp, where it had bottomed previously. It is near the 50- and 100-day moving averages that converge near 200 bp.
The 10-year interest rate differential fell from 235 bp at the end of last year to 170 bp on July 18. It has edged higher since, rising in 10 of the 13 sessions since hitting the low. It finished last week at 179 bp, in between the 20-day moving average (175 bp) and the 50-day moving average (183 bp).
After we first suggested that the Fed would announce the beginning of its balance sheet operations at the September FOMC meeting, our confidence has grown. A survey of prime dealers found they too have shifted to this view. Comments by officials have also been encouraging, and we expect Dudley’s speech in the week ahead to be consistent with this. FOMC members may find comfort in this week’s CPI report. July core prices likely rose 0.2%, which would be the fastest monthly pace since February. A 0.2% rise in the headline would bring it to 1.8% (from 1.6%).
The slowdown in auto sales and cuts in production and employment announced is worrisome, but manufacturing employment is doing considerably better than last year. Through July, 12k new manufacturing jobs have been added each month on average. Last year, manufacturing employment fell by an average of one thousand a month. In July, 16k new manufacturing jobs were created, and June’s one thousand gain was revised to 12k, which fully accounted for the upward revision in the national estimate.
The broader jobs report also will probably be to the Fed’s liking. The unemployment rate returned to its cyclical and multi-year low of 4.3%. The participation rate increased to 62.9% in July from 62.7% in May. Average hourly earnings rose 0.343% and were rounded down to 0.3%, but it is the strongest since last October. Jobs growth this year has averaged 184k, which is essentially unchanged from last year’s 187k average. The diffusion index rose to 63.2 from 62.5, nearly nine index points above the recent low.
The concerns from some corners that the Fed’s tightening is premature rings hollow. Financial conditions have eased. The Chicago Fed’s Financial Conditions measure fell to new cyclical lows at the end of July (-0.94) and is approaching the modern extreme recorded July 1993 (-1.02).
Some are critical that the Fed should not be considering tightening given that inflation is below target and the robust jobs growth signals the existence of more slack than full employment would suggest. Full employment is not a directly observable phenomenon, and its importance is in the medium- and long-term. Why shouldn’t it be able to be overshoot in what is turning into one of the longest expansions on record? There is little evidence that the Fed’s tightening has had a material impact.
The argument sketched here is that many of the key fundamental considerations that have has fallen and the implications for EMU are under-appreciated. The July PMI is another yellow light, and if it were to fall for a third month here in August, it may be difficult for the ECB to ignore it when it meets next month. In the US, monetary policy remains very much in play, even if the odds of fiscal stimulus (tax cuts, infrastructure spending, and deregulation) seem to diminish.
EM FX appears to be rolling over (see our recent piece “Is EM FX Finally Turning?”). Technical indicators are stretched as many EM currencies bump up against strong resistance levels. Strong US jobs data is bringing Fed tightening back into focus. We think ZAR could be shaping up to be the canary in a coalmine. It was -3% vs. USD last week and by far the worst in EM.