After US Health Care, Now What?

The first quarter winds down.  The
dollar moved lower against all the major currencies.  The best performer
in the first three months of the year has been the Australian dollar’s whose
5.8% rally includes last week’s 1% drop.  The worst performing major
currency has been the Canadian dollar.  It often underperforms in a weak
US dollar environment.  It’s almost 0.5.% gain is less than half the
appreciation of the sterling, the second worse performing major currency here
in Q1.
Although there are conflicting
impulses, interest rate differentials continue to appear to be the single most
important factor in considering currency movement presently.
 The question of the dollar is in good measure a
question of the direction of interest rates.   US rates have fallen since
the Federal Reserve hiked rates in the middle of the month, as they did following last December’s rate hike.
There are three considerations
in the week ahead:  economic data, Fed comments, and an initial assessment
of the implications of the failure to repeal and replace the Affordable Care
Act.   
Although Q4 GDP may be tweaked higher to 2%, the most
important piece of economic data will be the February personal consumption
figures.  The pullback in the consumer is weighing on Q1 growth estimates,
while the rise in business investment does not appear sufficient to counter it.
 Although February retail sales (~40% of PCE) was soft, the January figure
was revised sharply higher.  This means that the February PCE report should
catch these developments.  The targeted core PCE deflator is expected to
be unchanged at 1.7%.
We note the contrasting
projections by the Atlanta and New York Federal Reserve’s GDP trackers. 
 The Atlanta
Fed’s model has the US economy slowing to a 1.0% annualized pace in Q1. This would be just below the average Q1 pace
beginning in 2010.  However, the New York Fed’s model has the economy
tracking 3.0%.   The market (Bloomberg median) is smack in between.
It is another busy week
for Fed officials.
  Ten
different officials speak, including  Chair Yellen, Governor Powell, and NY Fed’s Dudley.  Outside of
Bullard, it does not appear that anyone
has downplayed the possibility of a June hike, to the extent that the issue was addressed.  There is no reason for the
Fed to be too direct now.  The decision is not imminent.  The
Bloomberg calculation puts the odds at 44.6%, while the CME’s interpolation is
50.7%.
Like some Fed officials, many
investors have made assumptions about fiscal policy in their economic forecasts
and investment strategies. 
 The inability to agree
on the alternative national health care insurance raises questions about
much of the administration’s economic program.  The markets may have held
up well in the face of the news before the weekend as some positions had
already been pared and there is some hope
that the next priority, tax reform, will be more successful.
We are skeptical.  First,
on practical grounds, the savings from abolishing taxes associated with the
Affordable Care Act was going to be an important source to fund tax reform.
 That is why it was embraced first.
 Second, on political grounds, the inclusion of the border adjustment tax,
which is the other major source of funding for
the anticipated tax cuts remains highly controversial.  In fact, the same
Republican group that sank the Trump/Ryan alternative, the Freedom Caucus, is
opposed to the border adjustment tax.
Third, there is a question of
timing. 
 Tax reform cannot be taken up meaningfully over the
next couple of months  This also the assessment of the chairman of the
House Ways and Means Committee, which is its purvue.
 There are some more immediate issues that must be dealt with first. They include approving a budget for the
remainder of the fiscal year.  The one that President Trump first proposed
which included several controversial cuts, including of substantial cut of the
State Department, while funding a large increase in defense and security,
including infamous Wall, will be another fight.
In the coming weeks, Congress
will also have to agree to extend the federal government’s spending authority.
  It runs out at the end of April.  The Treasury
is already taking measures to honor the debt ceiling, which also needs to be lifted.  There is also a two-week
recess in April, and what looks to be a fight (and possible Democrat filibuster)
over the Supreme Court nomination.  A third vacancy on the Fed’s Board of
Governors will be exposed when Tarullo steps down next month.
There is some talk that the
Republicans could force a rule change to allow a simple majority to confirm
Gorsuch for the Supreme Court. 
 Doing so, however, would make it harder to reach out
to Democrats on other issues.  The Republican Party, like other modern
political parties, are coalitions. To be successful, Trump has to forge a
majority coalition with the Republicans or find a rump of Democrats with whom
to deal.  It is questionable whether the requisite skills for either
strategy currently exist.  And even if they do, are they ten-times better?
 Consider that the Affordable Care Act was over a year in the making.
 The new plan about five-weeks-old,
and changing at the last minute. A test for Democratic leadership is whether
they can regain the initiative and propose their own reforms to the Affordable Care Act.
One of the factors that helped
the euro recover in recent weeks is speculation that the ECB could hike rates
this year before ending the asset purchase operations. 
 The
speculation was fanned by comments from
some officials and the steady increase in inflation.  At the end of the
week, investors will likely learn that the six-month rise in CPI was snapped February.  The year-over-year
pace may slow to 1.8% from 2.0% on softer energy prices.  The core rate
may have eased to 0.8% (from 0.9%) and remains stuck in the trough after having
bottomed at 0.6%. 
The Saarland state election in
Germany will draw attention.
  Merkel’s
CDU has governed Saarland one of the smallest states for the past 18 years and now leads a coalition with the SPD.
The rejuvenated Social Democrat Party under Schulz the former speaker of the
European Parliament, not the anti-EMU and
anti-immigration AfD,  poses the biggest threat to the status quo.
 The prospect of an SPD-victory in the national elections in six months are seen as slightly euro negative.  That
said there are two more state elections next month.  
In Japan, industrial output is
improving with the help of better exports.
  Despite firm labor market, household spending remains
depressed.  Since August 2015, it has only risen on a year-over-year basis
once (February 2016).   Meanwhile, core inflation (excludes fresh food) is
expected to rise to 0.2% from 0.1%.  While this may not sound impressive,
it would be the highest core reading since April 2015.   BOJ policy is set, and the immediate interest has shifted
to a scandal involving a conservative school’s ability to get a sweetheart deal
and whether the Prime Minister or is wife gave a modest sum of money to it.
 Although support for the cabinet has fallen, it is not (yet) a
significant factor that is offsetting the other economic drivers, like interest
rate differentials.  
In the UK, May will trigger
Article 50 of the Maastricht Treaty to begin the dissolution of its EU
membership. 
 In so doing, the UK will be subject to rules designed
to discourage a country leaving. It will lose the initiative.  In any
event, the actual trigger is a formality for investors.  The BOE’s
Financial Policy Committee meets and there is an expectation for an update of the counter-cyclical capital buffer
(currently set at zero) that is set to expire in June.  Sterling’s
correlation with the 10-year interest rate differential between the US and UK
is among the strongest since the late 1990s.  
Lastly, we note that OPEC
continues to report high compliance and the drop in prices make it increasingly
likely it will continue at reduced output.
  That said, it seems to be relying on demand catching
up to supply.     US rig count and output are still increasing.
 Still, after declining nearly 14% this month, the downward momentum seems
to be exhausted.   More stable oil prices, and possibly return to $50 a barrel,  also may help
ease the weight on US rates.   

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