A New Phase Begins

<br /> A New Phase Begins – Marc to Market<br />


There were no celebrations; no horn or
trumpets, nary a sound, but an important shift took place last week. 
The shift was signaled by two events.  The first was the US strike on
Syria, and the second was investors’ willingness to look past Q1 economic data.
The US missile strike on
Syria was significant even if it fails to change the dynamics on the ground. 
 It undermines the Trump Administration’s ability to
“reset” the US relationship with Russia. What the new Administration
recognized last week is that the tension in the US-Russian relationship was not
a function of personalities or leadership styles but a genuine and fundamental
difference of national interests. Russia supports the Assad regime as it
supported his father’s.    It is the key way Russia can project its
power and influence into the Middle East.  
The G7 finance ministers
meetings understandably are important for investors.
  The meeting of foreign ministers
hardly draws much notice. However, their meeting on April 10-11 will attract
interest.    Many have labeled the Trump Administration as
isolationist due to its criticism of the WTO, the UN, and other multilateral arrangements.  However, we have
argued this misunderstands the thrust of the Trump Administration.  It is
unilateralist, not isolationist.   
An isolationist may argue
that there is not a direct national interest at stake, and killing people
(including children) with missiles from the sky to punish a government who
killed people (including children) with gas does not make sense.
  A multilateralist would have allowed
UN investigation and international law to run its course.  The US,
arguably, has a vested interested in the international rule of law.  What
Kremlin has called a significant blow to US-Russian relations may allow a new
convergence of US and Europe perceptions of the threat Russia poses, but
whether diplomats can work it out is a different matter.  
Nevertheless, the Russian ruble
will likely yield to the changing circumstances.
  It has been the strongest currency
in the world since the US election, gaining 11.4%.  It had made new highs
for the year last week prior to the US
missile strike (as the US dollar fell to almost RUB55.80).  It would not
be surprising to see the ruble unwind a
good part of these gains, giving the dollar scope to rise toward RUB60-RUB62.
 The dollar-rouble exchange rate and oil
prices typically are inversely correlated.  On a rolling 60-day
basis, the correlation of the percent
change in the exchange rate and the Brent prices
is -0,34, which is among the least over the past year.  
Meanwhile, the EU and Greece
appears to be nearing an agreement that will free up another payment tranche
that will allow Greece to make a large debt payment to its official creditors
that comes due in a few months. 
  Greece’s 10-year bond yield fell 19
bp to 6.86% last week. The yield
peaked two months ago near 8.10%.  It began the year near 7.10%.  
However, one key piece of the puzzle is missing:  The IMF.  
The IMF’s role is important
because both the German and Dutch parliament say it is a prerequisite for their continued participation.  
 The IMF has
comes under criticism from many of its non-European members, including
the US, for overruling its own internal
policies and overexposing the multilateral lender to Greece.    The
US continues to enjoy a sufficient quota (votes) at the IMF to be able to veto
a commitment of new funds.  
Blocking the IMF from
participating in new lending to Greece could come at an awkward time for
Germany given the national election in less than six months.
 Also, while there is awareness of the
French presidential contest, few have focused on the legislative election in
June.   Neither of the leading candidates (Macron and Le Pen) commands a bloc in the current legislature.
 The French premium over German is elevated even if stable in recent
weeks, but it is likely to persist for much of the second quarter.   
The week ahead is short.
After Wednesday,
April 12, full liquidity will not return until April 18, following Easter
Monday.  The Bank of Canada is the only major central bank that meets.
 There is little doubt that policy is on hold.   Under Governor
Poloz, the central bank is very cautious despite a strong rebound in the last two quarters of 2016 (2.8% annualized pace in
Q3 and 2.6% in Q4).  The economy expanded by 0.6% in January, which was
twice the pace expected.  The labor market has been firm, even if
exaggerated,  which should help underpin demand going forward.  The
central bank expects the output gap to take another year to close (mid-2018).  Bringing
it forward could spark investors to anticipate a rate hike sooner.
 Uncertainty about US policy (trade and fiscal) may discourage a
significant change in rhetoric.  
Even though the Federal
Reserve does not meet, Yellen’s speech on Monday (with live and Twitter-sourced
questions) will be closely monitored. 
 Since the FOMC minutes,
the focus has shifted toward the Fed’s balance sheet.  There remain three
issues of concern.  The first is when will
the Fed stop reinvesting maturing issues.  Many had expected this
to be a 2018 story, but the minutes and Dudley’s comments suggest Q4 is
The second issue is how will
this be executed. 
 Will the Fed focus on its MBS
portfolio or its Treasury assets?  The initial inclination is to do both.
 Should it be done all at once or should it be phased in over time?
 The mere fact that it doing it at once is even considered is striking.
 That course would be very aggressive given the maturing issues over the
next two years (2018-2019 ~$770 bln of the $2.4 trillion Treasuries held by the
Fed will mature).   The Fed seeks to do it in a way that is predictable
and transparent for investors and not disruptive.  
The third issue is the
relationship between the balance sheet and the Fed’s interest rate policy. 
 It is clear that the Fed will rely on its Fed funds
target is its primary tool.  Dudley has suggested that when the balance
sheet begins shrinking, the Fed could pause in the interest rate cycle. 
The initial scenario that
this suggests may be a hike in June and September, providing the opportunity is
still there, and pausing to slow the reinvestment process, before, (ideally)
resuming the rate hikes in 2018.
  An important caveat that investors
need to bear in mind is that the configuration of the Federal Reserve Board of
Governors will significantly change over the next 12-15 months.  We had
been surprised that the Fed’s dots last month did not seem to line up with the
rhetoric, but the balance sheet discussion that was
aired in the minutes may explain why.  
Economic data for the US and
Europe may not be important drivers.
  We note that the two most important
US data points, March CPI and retail sales, will be reported on Good Friday,
which is a holiday for many.  The Fed’s March hike means that US Q1 data
is of little consequence.  Policy is
forward-looking, as are investors.
 A tick down in the pace of CPI and soft headline retail sales, which are expected will simply confirm what investors
already know.  Price pressures are elevated but not accelerating, and after
a shopping spree in Q4 16, American consumers pulled back in Q1 17.  
The Atlanta Fed’s Q1 GDPNow was halved
lasted a week. 
 It now suggests
the US economy nearly stagnated in Q1 (0.6% at an annualized pace).
 However, the NY Fed’s tracker put growth near 2.8% in Q1.   Even
splitting the difference (1.7%) seems unrealistically high.   
In Europe, the aggregate
February industrial production will be reported. 
 In the national reports, German surprised big on the
upside, while France and Spain disappointed.  Italy reports an hour before the aggregate figure.  The median
Bloomberg forecast is for a 0.1% gain.  The risk is on the downside.
There are two important points to be made.  First, the survey data in Europe, like in the US,
appears to be running ahead of actual performance.  The key question is
how will these realign.  How much does growth improve?  We are more
confident that below trend Q1 US growth will yield to stronger growth in Q2
than we are that eurozone growth can
accelerate much from the current pace. Sentiment indicators may also soften in
the months ahead.  
The second point is that for
the ECB’s reaction function, the real sector is not the driver of policy.
 It is to boost consumer prices toward the
ECB’s target of near but less than 2%.  However, there are now numerous
case experiments, and it is not clear that expanding the central bank’s balance
sheet through the purchase of debt has a very high success rate it boosting the
basket of goods and services that make up the CPI.    The rise in
inflation that raised the ire of the Bundesbank and a few other European
central banker was a mirage caused primarily by the recovery in energy prices.
 Core inflation bottomed in early 2015 at 0.6%.    The ECB’s
balance sheet has expanded by more than a trillion
euros, and the initial estimate suggests
that core inflation stood at 0.7% last month.  
The UK reports on inflation
and employment in the holiday-shortened week.  
Core inflation in the UK is expected to
tick down to 1.9% from 2.0%.  Headline inflation may slow, but if it does,
it will likely prove temporary.  The past decline in sterling and the
rally in energy prices has not completely worked their way through the system.
 Inflation has yet to peak in the UK.  On the other hand, the labor market remains firm, and the ILO measure of unemployment is
expected to be steady at 4.7% in February.  
The market often pays more
attention to the average weekly earnings than to the unemployment rate. 
Average weekly earnings are expected to be steady at 2.2%,
but they appear to be holding up due to bonus payments.  Excluding
bonuses, average weekly earnings growth is expected to slow to 2.1% from 2.3%.
 That would be the slowest rise since last July, which itself was the
lowest since the end of 2015.  Softening wage growth will likely allow the
BOE to look past the near-term overshoot of inflation.  
US 10-year yields (as a
proxy for the rate differential) still seems to be the single largest influence
on the dollar-yen exchange rate. 
 However,  there are a couple of economic reports that are important
for investors.  First, Japan reports is February current account.
 February always improves over January.  Japan’s surplus is expected
to be near JPY2.5 trillion after JPY65 bln surplus in January.  In
February 2016 it was almost JPY2.4 trillion,
and in February 2015 it was nearly JPY1.5 trillion.  Still
under-appreciated by many, Japan’s current account surplus is driven more by
its investment income balance than its trade balance.  Moreover, in
February, the US Treasury makes a coupon payment,
and as of the end of January, US data suggests Japanese investors held $1.1
trillion of US Treasuries.  
The strengthening
international activity for Japanese companies is boosting capital expenditures
and industrial output in Q1. 
will likely be seen in the upcoming
machine tool orders and industrial output figures.  Also, Japanese fund
managers had been sellers of foreign bonds and stocks in recent weeks but
turned buyers at the end of March.  A renewed portfolio outflows can
remove one source of the upward pressure on the yen.  On the other hand,
the anticipation of a weaker yen may
encourage foreign investors to return Japanese equities, which underperformed
in Q1 (both the Nikkei and Topix have fallen thus far this year while the other
G7 markets have risen).  
Lastly, we note that
Australia may receive more attention too. 
The Australian dollar was the weakest of
the major currencies last week, falling 1.7% to its lowest level since
mid-January.   It reports mortgage lending, which probably was flat in
February, and credit card usage before the employment report on April 12.
 The median expectation in the Bloomberg survey calls for a 20k increase
in net new jobs Down Under.  It would be the most in four months.
 The unemployment and participation rates are expected to be unchanged at
5.9% and 64.6% respectively.  
Although speculators in the
futures market are still net long Australian dollars, the more recent price
action warns of a sentiment shift. 
 The RBA is thought to be one of the
few major central banks that could still cut interest rates later this year.


A New Phase Begins
A New Phase Begins

Reviewed by Marc Chandler

April 09, 2017

Rating: 5

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