Are markets underestimating Fed resolve?
The Euro’s relentless upward march would not be denied last week. Even a pointedly dovish ECB policy announcement failed to slow the advance. In fact, the passing of the rate decision seemed to open the floodgates for a wave of buying, as though bulls were just waiting for the coast to clear.
According to the newswires, investors latched on to a comment in the post-meeting presser with ECB President Mario Draghi where he said the QE program would be reviewed in autumn. When asked if that meant the September policy meeting, he snapped that if it did, he would have said so.
Did the markets pick through a sea of dovish rhetoric to fish out the one pseudo-supportive remark on offer to justify an explosive Euro rally? Perhaps, but that explanation seems fanciful, particularly since revisiting the size of asset purchases has been largely expected in September along with a forecast update.
On balance, either speculation has become disconnected from fundamental news-flow or monetary policy is not truly the central narrative at play. A much-needed dose of clarity may emerge in the coming days as top-tier economic data and official commentary cross the wires.
The preliminary set of July’s Eurozone PMI surveys and German CPI figures bookend the week ahead. Both are expected to head south, with the pace of nonfarm activity growth at the slowest since February and headline inflation dropping back to 1.5 percent, matching the six-month low set it May.
News-flow out of the currency bloc has deteriorated relative to consensus forecasts since the beginning of the month, hinting that analysts’ models may be overstating the economy’s vigor. That opens the door for more downside surprises, undermining the case for a hawkish policy pivot.
Turning to the speaking docket, ECB Director General for Economics Frank Smets is due to speak. He might offer a flavor for the direction of the forthcoming forecast update. If his remarks echo the dovish posture of Mr Draghi, the case for imminent tightening will be even harder to defend.
The Euro’s response to these developments ought to prove telling. If prices buckle under the weight of disappointing headlines, a level of sensitivity to the fundamentals will be re-established. If the news proves better
than expected and the rally extends, that too will be an encouraging sign of normalcy.
On the other hand, a stubborn push to higher highs against a backdrop of what would otherwise seem like negative developments might speak to speculative overreach. If the rally truly appears to be running on fumes, a violent reversal might be in the cards before long.
In practical terms, such a turn is likely to be most profoundly expressed as Euro weakness against the US Dollar, Yen and British Pound. These currencies have suffered against it even as the commodity bloc scored gains over the past two months, presumably because the ECB edged up in expected policy rankings.
As we came into this week, there were very legitimate bullish prospects for the British Pound, and this wasn’t necessarily a new story. Ahead of Brexit, Bank of England Governor, Mark Carney, warned that the British Pound could undergo a ‘sharp repricing’ should U.K. voters elect to leave the EU. He also warned that this could be coupled with a whole host of unsavory elements; such as slower growth and higher unemployment.
Meanwhile, the ‘sharp repricing’ in the value of the British Pound could lead to unsavory levels of inflation; and this could put the bank in the unenviable position of having to choose whether to mold monetary policy to either a) support the British Pound, which could stem inflation while risking even higher levels of unemployment and even slower levels of growth, or b) support growth and employment by cutting interest rates, which could drive even more weakness into GBP, which could expose even stronger inflationary forces.
It wasn’t more than a week after the Brexit referendum that the Bank of England showed their hand. In response to the flurry of the incalculable risks that could come about, the BoE instituted uber-dovish monetary policy in the effort of supporting growth in the British economy. In August of last year, the Bank of England launched a ‘bazooka’ of stimulus that involved buying a significant chunk of the economy’s corporate debt market. This further depressed interest rates, and the British Pound followed. Given that there was little hope for any hawkish outlays from the BoE, as they had made their dovish stance rather clear,
there was an absolute dearth of demand for the British currency. This led to the ‘flash crash’ in October as the pair tested the 1.2000 level in thin Friday trade after October NFP’s.
But as the British Pound languished near 30-year lows, levels not seen since the Plaza Accord in 1985, those inflationary forces continued to build. Slowly but surely, inflation began to print at higher levels as the ‘sharp repricing’ in the value of the British Pound began to show consequences. Meanwhile, the brutal slowdown that the BoE was afraid might happen after a Brexit scenario simply hadn’t showed up: So the net impact of Brexit, at least at this rather early stage, appears to be a BoE induced bearish trend in Sterling that, eventually, will force inflation to move-higher.
Around the beginning of the year, the theme du jour for GBP was ‘inflation tolerance’ at the BoE. As in, how strong could inflation be before the bank actually began to look at tighter policy options in the effort of stemming those higher prices? Nonetheless, the Bank of England continued to remain dovish with a very passive posture towards inflation. That appeared to begin to change in June: In June, inflation for the month of May came-in at an annualized 2.9%, and at the BoE rate decision just a week later, we saw the most votes for a rate hike since 2011. With three members dissenting in favor of a rate hike, a shift had started to emerge in which a portion of the bank appeared to capitulate from that previously cautious stance. When Mark Carney himself offered similar comments a few days later, remarking that ‘some removal of monetary stimulus is likely to become necessary’ should investment and wages grow, bulls bid GBP-higher with a vengeance.
This was like the red cape being waved in front of buyers, and a stampede above 1.3000 followed shortly thereafter. It appeared that there was finally a theme for traders to work with that could offer some extended continuation potential. After a 50% retracement of that bullish move that began on June 19th, buyers returned to bid prices in GBP-higher ahead of this week’s inflation print. After setting a fresh ten-month high at 1.3126, inflation for the month of June camein below expectations. June inflation printed at 2.6%, still well-above the BoE’s 2% target; but not likely strong enough to retain those elevated pulses at the BoE.
The remainder of the week saw bearish price action in GBP as a bit of pressure was removed, from both the BoE and the British economy, and this was taking place even when the U.S. Dollar was spiraling down to fresh yearly lows.
Next week brings one significant data print out of the U.K. and that is GDP for the second quarter, set to be released on Wednesday morning. First quarter GDP growth wasn’t great at .2% (revised lower after initially printing at .3%); and most estimates for this Wednesday are around the same .3%. Should this print at .4% or above, we could see a return of bullish price action in GBP as markets gear-up for the potential of a more-hawkish BoE at the bank’s Super Thursday in August. But should this print at .3% or below, there simply may not be that compelling reason to nudge inflation expectations higher, and the British Pound will likely remain with some degree of weakness.
The Bank of Japan (BoJ) interest rate decision has done little to alter the near-term outlook for USD/JPY, with the pair at risk of giving back the rebound from the June-low (108.80) if the Federal Reserve endorses a more gradual path in normalizing monetary policy.
Chair Janet Yellen and Co. are widely expected to keep the benchmark interest rate on hold amid the mixed developments coming out of the U.S. economy, and the committee may merely attempt to buy more time as inflation continues to run below the 2% target. Despite preliminary talks of unloading of the balance sheet later this year, waning expectations for three Fed rate-hikes in 2017 may continue to sap the appeal of the greenback especially as Chair Yellen argues that ‘the federal funds rate would not have to rise all that much further to get to a neutral policy stance.’
With Fed Fund Futures still showing a 50/50 chance for a move in December, market participants may put increase emphasis on the 2Q Gross Domestic Product (GDP) report as the growth rate is expected to pick up from the first three-months of 2017. However, a material slowdown in the core Personal Consumption Expenditure (PCE), the Fed’s preferred gauge for inflation, may ultimately spark a bearish reaction in the U.S. dollar as signs of easing price growth undermine the FOMC’s ability to implement higher borrowing-costs.
With Fed Fund Futures still showing a 50/50 chance for a move in December, market participants may put increase emphasis on the 2Q Gross Domestic Product (GDP) report as the growth rate is expected to pick up from the first three-months of 2017. However, a material slowdown in the core Personal Consumption Expenditure (PCE), the Fed’s preferred gauge for inflation, may ultimately spark a bearish reaction in the U.S. dollar as signs of easing price growth undermine the FOMC’s ability to implement higher borrowing-costs.
Over the coming days, and into next week, there will be an OPEC meeting in St. Petersburg, Russia to discuss the agreement to cut productions. The increased production as reported from Petro-Logistics likely shows that further cuts will not develop, but rather justifications for increased supply from OPEC and countries like Russia that voluntarily joined the production to support the market. The increased OPEC production in July shows that OPEC supply has hit the highest levels of the year.