The Week Ahead

The new week starts slowly with the US and UK markets closed on Monday, May 25. Even then, the economic calendar is light. With shutdowns easing in May, April data is too dated to be of much interest to investors. The preliminary May PMIs last week offered a hint that the low point for many high-income countries could be passed.

The US will report more survey data from the regional Feds, the Conference Board, and the University of Michigan. The Federal Reserve’s Beige Book is released in the middle of the week ahead of the FOMC meeting on June 10. It is an anecdotal survey from different regions. They typically are not market movers.

In terms of hard data, the US reports April’s income and consumption figures.  April has already been written off, and economic forecasts are sobering. The three regional Fed’s GDP trackers (St. Louis, New York, Atlanta) range from an annualized contraction in Q2 of 31%-48%. Personal consumption expenditures are projected to have fallen by around 12.5% after a 7.5% decline in March. Although May is likely to show improvement, it is likely to be disappointingly slow. Even where the shutdown has been lifted, consumers have seemed on the whole (often not captured in the media’s prurient focus on those abandoning social distancing) to be reluctant to resume their previous consumption patterns (restaurant, ride-sharing apps, etc.).

April’s income is expected to have fallen around 6.5%-7.0%. Transfer payments from the government likely go a long way to explaining why income has not fallen as much as consumption.  As a consequence, the measured savings rate increased, and some want to draw conclusions from it. That seems premature. It will look quite different in six months. The public health emergency has resulted in major disruptions and de-synchronizing activity. It seems like the savings rate went up because people stayed in did not have opportunities to consume and many lost wages, while self-proprietorships and farmers lost income, with modest government offsets. 

The Fed targets the PCE deflator at 2% and often talks about the core rate. The headline rare will move further away from the 2% target. It may fall from 1.3% to 1.0%, and the core rate may slide to 1.1% from 1.7%. It is clear from Fed officials’ comments that supporting the economy is the number one priority. With industrial capacity utilization rates below 65% and unemployment like on its way above 20%, inflation pressures will likely remain subdued.

Food and energy prices are volatile. Oil prices have snapped back toward $35 for WTI and almost $37 for Brent as demand has begun edging up, and output cuts are curbing supply. US crude inventories have fallen the past two weeks through May 15 by about 5.6 mln barrels. Additional price-driven reductions in output appear to be diminishing, and there is bound to be some shale producers in the Permian Basin that will try to boost production to cover high fixed costs (often in the form of debt). Meanwhile, some beef and pork processing plants are re-opening as some retail prices are softening.

However, the reason the Fed’s core measure of inflation gets so much attention, even though its target is formally the headline rate, is not because food and energy are volatile, which is the commonly cited reason. Rather, it is because food and energy price fluctuations are often driven by short-term supply issues. Over time, economists have found that headline inflation convergences to core inflation and not the other way around. That is to say, the core rate of inflation is the true signal, and the headline can be noisy in the short-run. 

Last week, the fed funds futures strip righted itself and emerged from negative rates. The simple, and likely wrong explanation, is that the repeated denial by Fed officials got speculators to give up on the idea of a negative target rate. Surveys and anecdotes show economists and primary dealers do not expect the Fed to adopt negative rates. It seems hedging by those who swapped floating for fixed and by financial intermediaries who have legacy (older) positions was the main driver pushing rates negative. Once that hedging ran its course, the fair-value models of risk-takers encouraged buying to lift rates back above zero.

This is a different situation than the UK is experiencing. There are several central bank officials who have gone out of their way to warn investors that negative interest rates are under consideration as part of a range of unconventional measures that may be needed. Even the new Governor of the BOE seemed to soften his opposition.

Nevertheless, we suspect that there are still several other measures that are more likely to be adopted first, like increasing the amount and perhaps the quality of the assets being bought. The BOE meets again on June 18. Moreover, by talking about it, the BOE has made a difference. Last week, the Treasury sold its first Gilt (three-year) for an implied rate that was ever so slightly below zero. The 2-year benchmark yield fell to minus 5 bp before the weekend, a historic level. With this backdrop and acrimonious trade negotiations with the EU, boosting the prospect of a disruptive exit from the current standstill agreement, it is little wonder that sterling is easily the worst-performing major currency this month, off about 2.8% compared to the yen, the second-worst performer this month down 0.5%.

While the US reports April PCE deflator, the eurozone releases its first estimate of May CPI. It also targets a 2% rate, like many. However, the baskets of goods are different, and the weights vary. Ironically the target is the same, but what it is measuring is different. In any event, a modest increase in the headline rate, reflecting the sharp rally in energy prices may see the headline rate rise from 0.4% in April. The core rate is likely to be stable around 0.9%.

It has taken the eurozone some time, but the transmission mechanism of its monetary policy appears to have begun working better. The ECB is expected to increase its Pandemic Emergency Purchase Program by 200-500 bln euros from the initial 750 bln euros as early as next month. It is also providing incentives for the market to do some heavy lifting too. In the market’s vernacular, it is called “carry-trades”, buying peripheral debt.

Consider that Italy’s 3-month T-bill yields minus 27 bp, the lowest rate since the first half of March. It peaked near 80 bp on March 17. The six-month bill yield slipped below zero last week for the first time in two months. Italy’s premium over Germany on 10-year bonds narrowed to about 210 bp previous week, the lowest in a month.  

Spain can borrow at negative rates out through four-years. The 10-year premium over Germany has fallen by nearly 50 bp to around 110 bp, the lowest since late March. Spain’s three and six-month T-bill yields around minus 40 bp. Recall that the overnight deposit rate at the ECB is minus 50 bp.  

Investors are anticipating two other events. Next month’s targeted long-term refunding operation that can provide loans to banks for minus 100 bp if specific lending targets are reached. Earlier operations are expected to be rolled into this offering, which could see as much as a trillion euros borrowed. Also, the EU is likely to announce a recovery funding program. Even though there are competing visions and proposals, some combination of grants, loans, and guarantees is likely.  

Lastly, we note that tensions between the US and China are once again casting a pall over the investment climate.  Leaving aside the rhetoric, the US is threatening to sanction individual Chinese officials for human rights violations, and the Senate passed a bill that could force many Chinese companies to delist from the US exchanges (notably, the NASDAQ). Due to last year’s legislation, the State Department must affirm Hong Kong’s independence, or the Special Administrative Region could lose its special trade privileges with the US.  

China, undeterred, indicated it would likely enact new laws that would extend the power of Hong Kong officials (and others) to repress dissent. It did not have to do this now or ahead of the US State Department’s decision. That it chose to do so sends a powerful signal in its own right. China also managed to block Taiwan from having observer status at the recent World Health Organization virtual conference. The risk is that tensions continue to rise. The US political cycle lends itself to it. The bills regarding sanctions and company listing in the US are bipartisan. The main opposition to the Administration’s China policy is that it is not hard enough.  


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